 I'm going to say at the outset that the topic I've chosen is quite a challenging topic. And I've got a lot of words to get across to you this evening. So please bear with me. This will be something of a homily to some of my colleagues in the economics profession who have felt motivated to involve themselves in the task of economic reform. I hope the address will be of wider interest. Recently, one of those colleagues, Rick Symes, called for a clearer focus on ultimate objectives, much less focus on rhetoric. Similar views are being expressed by leaders of business. The Business Council of Australia recently launched a publication entitled Building Australia's Comparative Advantages. In the words of its President, Catherine Livingston, underscores the case for putting in place deliberate strategies to improve our competitiveness, fostering innovation and playing to our strengths. Catherine argues that it's time to confront our complacency and that we need to imagine and fashion our future and then we need to pursue a path of purposeful action. She argues that there's no point in pursuing growth that doesn't generate wealth and that so-called structural reform must assist in transforming the economy. In this address, I'm going to focus on two questions. How should one assess the wealth of a nation and what are its policy determinants? Well, these questions, of course, were the subject of Adam Smith's Wealth of Nations published in 1776. In that treatise, the Scottish moral philosopher mounted an assault on the dominant economic narrative at the time, which held that the wealth of a nation should be measured simply by its reserves of gold and those reserves of gold, of course, represented the accumulated bounty of its export activity. Prior to Adam Smith, if public policy had a purpose, it was to protect and to advance the mercantile activity that generated exports. Now, like Adam Smith, all economists know that mechanicalism is misguided. The idea that public policy should be organised to protect and advance the interests of exporters, believe it or not, has no support in economics. And yet, in Australia today, 238 years after the publication of The Wealth of Nations, the dominant economic narrative goes like this. Reforms that enhance productivity and cut costs build international competitiveness. International competitiveness drives exports. Exports drive growth. Growth drives jobs and jobs support living standards. Gold isn't mentioned in this narrative, but with its focus on exports as the foundation of living standards, this narrative is strongly relevant of the mechanicalism that Adam Smith set out to discredit 238 years ago. So I'm going to label this narrative Australian mechanicalism. Australian mechanicalism hasn't been all bad. The emergent public support for tariff reform in the late 1980s and early 1990s was welcome, even though the case that was being argued was classically mechanicalist. Tariffs on imported equipment had to be removed because they undermined the international competitiveness of exporters reliant upon imported equipment, especially of course agricultural exporters. And there were many other structural reforms in the two decades from 1983 for which Australian mechanicalism proved equally expedient. These include labour market deregulation, a national competition policy and indirect tax reform. But we're now paying a price for past expedience. The mechanicalist narrative is so deeply entrenched that it's crippling sensible attempts to deal with some of our biggest challenges. In this address I'm going to explore a more honest narrative of the wealth of nations. Along the way I'm going to attempt a reframing of the concept of international competitiveness and the need for such a reframing has been illustrated by recent commentary about the dangers of governments picking winners. But I will argue that the wealth of a nation should be assessed according to metrics that go well beyond international competitiveness. I'm going to illustrate some of the limitations of our mechanicalist narrative with three contemporary examples of policy underperformance. First, making the most of the so-called mining boom. Second, implementing a responsible climate change policy. And third, finding Australia's place in the Asian century. But first, a short refresher on some elementary economics. Our conventional measure of the international competitiveness of a business or of a country is not really very sophisticated. It's about as sophisticated as pre-Ricardian labour theory of value. We call this metric the real exchange rate. For Australia the real exchange rate is approximated by multiplying an index of domestic nominal unit labour costs, that's the term we use, multiplying that index by the trade-weighted index of nominal exchange rates. And then we take that product, product of nominal unit labour costs and the trade-weighted index of nominal exchange rates. And we compare that product with an average of the nominal unit labour costs in our major trading partners. Nominal unit labour costs importantly are obtained by dividing the average wage rate in the economy by average labour productivity. Now, if we observe that the Australian product, that is nominal unit labour costs multiplied by the trade-weighted index of exchange rates, has increased at a faster rate than the index of unit labour costs in our major trading partners, we say that Australia has experienced a real appreciation. And it has therefore lost international competitiveness. And of course, conversely, for a real depreciation. This is the language in which economists talk. Unit labour costs are a crude measure of the unit cost of production. More sophisticated concepts recognise other components of unit costs including the true opportunity cost of additional capital that has to be utilised to expand production, the costs of various intermediate and other inputs including transport costs and of course various taxes that might be embedded in production. All of these things too contribute to a country's level of international competitiveness as that concept is commonly understood. Now, in the case of a single Australian producer, the various core components of international competitiveness, that is wage rates, labour productivities and nominal exchange rates, these things might be regarded as independent and essentially exogenous to that single producer. But for a country, these things may not be regarded as either exogenous or independent. One influence on real exchange rates that's featured a lot in Australian commentary over the years is the stance of fiscal policy. And it goes like this, an expansionary fiscal policy pursued by one country in isolation will normally cause a real appreciation in that country with both the nominal exchange rates appreciating and unit costs of production increasing at a faster rate than in other countries. That is, we would have a higher rate of inflation than our trading partners. Accordingly, expansionary fiscal policy unless it occurs in a country's trading partners at the same time will usually weaken international competitiveness. That's the standard argument. Other shocks have their impacts muted or even completely offset by movements in the real exchange rate that they induce. For example, the Australian dollar normally depreciates if well the demand for our exports softens. Or even if capital markets anticipate a softening in the world demand for our commodities. Of course, this is precisely what happened in the wake of the Asian financial crisis of 1997-98 when the Australian dollar depreciated in trade-weighted terms by about 10%. It happened again following the United States tech wreck of 2000-2001 when the Australian dollar depreciated by almost 30% in trade-weighted terms. And it happened again during the so-called global financial crisis when the Australian dollar fell by about 20% over the two months following the collapse of Lehman Brothers. In each of these cases, the nominal depreciation compensated in macroeconomic terms to some extent for weaker demand for Australian exports by reducing the costs of our exports measured in the currencies of the consumers of our exports. As the terms have trade have fallen recently with declining iron ore prices, a nominal depreciation has once more been observed. As on earlier occasions, it's not been as large nor as it happened as quickly as some would want. Nominal exchange rate movements can also compensate to some extent for domestic cost shocks. For example, if Australia's nominal unit labour costs increase at a faster rate than our competitors, either because we have faster wages growth or because we have lower trend productivity growth, then there are good reasons in economic theory to expect a depreciation of our nominal exchange rate. And that depreciation would serve to restore our international competitiveness at least to some extent. Thus in a small trading economy like Australia, an economy that's subject to large and variable shocks, some of the components of the real exchange rate act as automatic stabilisers. And the real exchange rate, as I've already mentioned, also plays a useful, if somewhat highly simplified, pedagogic tool for describing the transmission mechanism for both monetary policy and fiscal policy. Well, that's the economics lesson. But how did this concept get to occupy such a prominent space in the Australian economic policy toolkit? Well, the answer to that question explains both the origins of Australian mechanicalism and why it should by now have been consigned to history. The Australian dollar was floated and capital controls were abolished way back in December of 1983. Ironically, the principal economic argument, that is amongst policy advisors at the time, principal economic argument for floating the currency was that it would disenfranchise a lazy rural constituency that had been able to persuade successive governments to pursue artificially low nominal exchange rates as an artificial source, that is, of international competitiveness. And with its shackles removed, the Australian dollar did indeed appreciate for a time before appearing to stabilise into 1984. But by the middle of 1985, with the terms of trade having fallen by six and a half percent, the Australian dollar had depreciated by nearly 20% from its high again in trade-weighted terms. And over the next 12 months, through to June 1986 associated with the further 6% fall in the terms of trade, the Australian dollar depreciated by a further 13%, having lost more than a quarter of its value from when the hawk government was elected in March 1983. And then in just one month in July 1986, the exchange rate depreciated by a further 12% in one month. These nominal depreciations provided a considerable boost to Australia's international competitiveness. But the problem was that much of the gain in international competitiveness was being eroded by strong increases in nominal unit labour costs. These were increasing at about 10% a year. The policy problems lay in two areas. First, Australia in those days had a centralised wages system characterised by a strong element of wage indexation according to which nominal wages were adjusted to compensate for increases in consumer prices. That was the first problem. And second, Australia's product markets were characterised by a distinct lack of competition. A lack of competition that allowed labour cost increases and increases in import prices due to currency depreciation to be passed straight on to domestic consumers. An economy with those institutional features will experience a permanent spiral of wage inflation, consumer price inflation and currency depreciation leading back into further wage inflation, consumer price inflation, further currency depreciation and so on. These dynamics are what characterised as a group of economies labelled banana republics. And that is how Australia's challenge was described by Treasurer Paul Keating in 1986. That Australia was at risk of becoming a banana republic. Treasurer Keating's challenge was to ensure that nominal currency depreciations became real currency depreciations and that required that wage indexation be abolished. It required that Australia's product markets be made more competitive through tariff cuts and through the introduction of robust domestic competition policies and institutions. And it required that microeconomic reforms be pursued to lift national productivity. Real wages had to fall except to the extent that they could be supported by gains in productivity. But how on earth do you persuade a sceptical electorate they need to accept lower real wages, a substantial lift in workplace productivity, that is produce more each hour, and embrace the chill winds of international competition? Well you convince them that their living standards are tied to the success of Australian exporting. That they will actually be made better off in due course if they accept the sacrifice of lower waging prices and large scale structural adjustment in the present. Because exports means growth and growth means jobs and jobs means higher living standards. Thus was born Australian mechanicalism and it was quite an achievement. And there was another complimentary piece of the narrative developed in Australia in the 1980s and it went like this. A tighter fiscal policy would improve the prospects of a real depreciation in precisely the way that I outlined earlier and that would provide a further boost to exports and export growth would cause the current account deficit to narrow and that would deal with the threat posed by ever increasing international indebtedness. Thus was born the sub-narrative of debt and deficits that we've heard so much about in recent years and this sub-narrative is part of the broader story of Australian mechanicalism. The narrative with the real exchange rate sitting at its core proved powerful in motivating action. Action to deregulate the labour market. Action to enhance product market competition. Action to implement a broad ranging set of microeconomic reforms to boost productivity and action in the pursuit of aggressive fiscal consolidation. The set of reforms implemented in the 1980s and the 1990s did indeed boost Australia's international competitiveness and exports did grow strongly. And while the Australian economy experienced a deep recession in the early 1990s, that turned out to be but a brief interruption to a very long period of strong economic growth and employment growth that has continued until very recently. Average living standards have also grown strongly. But for some time now Australian mechanicalism has been compromising policy development and I want to illustrate that point with just three examples. First, the mining boom. Policymakers in a country blessed with an abundance of mineral and energy resources should be asking themselves how those natural resources, those natural endowments might be transformed into higher value foundational investments that benefit future generations of Australians. Instead though, Australian policy has been preoccupied with the cost competitiveness of Australian exporters, notably Australian minerals and energy exporters. Over the decade commencing in late 2003, accelerating world prices of Australian minerals and energy exports caused a significant real appreciation. This real appreciation has been in the order of 50%. The real appreciation has damaged our international competitiveness. The fact that it's also played an important role in macroeconomic stabilisation and it had, and the fact also that it has provided the principal endogenous mechanism for redistributing to Australian households the benefits of higher world commodity prices, these two facts have turned out to be beside the point because according to Australian mechanicalism if our international competitiveness falls then governments have to do something about it. Thus successive Australian governments have had to respond to various proposals now designed to reverse the real currency appreciation caused by international commodity price inflation, proposals to cut business costs especially wages and taxes, proposals to boost productivity and proposals to cut government spending. That is what governments will be called on to do when the terms of trade were rising strongly from late 2003 through to 2011. Now that the terms of trade are weakening and amid growing concerns about declining aggregate real national income governments are being called on to do what? Well it should sound familiar. They're being called on to cut business costs especially wages and taxes. They're being called on to boost productivity and they're being called on to cut government spending. So no matter what the melody Australian mechanicalism will always prescribe the same treatment and of course it must because no volume of exports will ever satisfy a committed mechanicalist. And then there's the matter of tax. Taxes on minerals and energy provide a means of financing foundational investments in the nation's future. So why was the right government's mining tax unsuccessful? Myths are bound most of these myths frankly don't matter but some should be addressed. On my recall none of the tax reforms of the 1980s and 1990s other than tax cuts enjoyed bipartisan political support. Most were also deeply unpopular in the broader community. New taxes are not easy. But the task of legislating a new tax on mineral and energy resources faced headwinds that the GST and those other tax reforms did not. These headwinds came from Australian mechanicalism. If our mechanicalist narrative was having difficulty accepting what I've described as an endogenous loss of international competitiveness due to currency appreciation and wage inflation then none of us should have been surprised by that narrative's intolerance of higher taxes on mineral and energy products. Even a consummate communicator was going to have difficulty explaining why it made sense to apply a new tax to an accelerating export sector while at the same time promoting the narrative that the cost competitiveness of exports was the principal driver of growth, the principal driver of jobs, the principal driver of living standards. One might even have been accused of wanting to kill the goose that was laying the golden egg. My second example that illustrates the deficiencies of the mechanicalist narrative is climate change policy. Australian mechanicalism sees any domestic price on carbon as an unfair imposition on Australian producers who have to compete internationally. Exports will be weakened, imports will be encouraged, GDP will be damaged jobs will be destroyed and living standards will suffer. It really is that simple. My third example concerns Australia in the Asian Century. Now the white paper on Australia in the Asian Century was commissioned by Prime Minister Gillard because it had become obvious to at least a group of senior public servants and to the government that the Australian mechanicalist narrative could not support thinking about the requirements posed by the Asian Century. According to Australian mechanicalism, and this is what I recall from discussions particularly in the 1990s, our international competitiveness and our ability to compete in Asia was being damaged by the cost to Australian businesses of a set of national attributes developed over generations and these include such things as excellence and governance, believe it or not, incorruptibility, respect for the rule of law, safe working conditions, a concern with environmental sustainability and animal welfare, and institutions that support social harmony, economic and social opportunity and tolerance. These things were making us uncompetitive against Asian competitors. For good reason many Australian policy thinkers would rank these attributes as one of the greatest assets in doing business in Asia. But Australian mechanicalism maintains that all are costly to business, that Australia's international competitiveness could be improved by ditching any or all of them and indeed all of them are at risk. The failure of policy in these three areas, the mining boom climate change and the Asian Century should have had all of Australia's economists wondering about this narrative. All of us I would suggest should have been wondering whether the simple metrics we've been employing and thinking about Australia's international competitiveness. The notion of international competitiveness that's embedded in Australian mechanicalism as I've described it, whether any of these metrics really make any sense is international competitiveness really about nothing more than the real exchange rate? And is international competitiveness really what it should all be about anyway? Some have even been prepared to venture a more meaningful concept of international competitiveness as part of a vision for Australia's future. The former government's white paper on Australia and the Asian Century is one example. Another is the Business Council of Australia's recently released report Building Australia's Comparative Advantages. Given the limitations of the mechanicalist narrative with its tired fixation on the real exchange rate it must be especially galling for some of those involved in these two projects to find themselves accused of recommending that governments pick winners. During the 1980s and 1990s Australian mechanicalism was used to motivate support for a set of policy reforms that was long overdue. But it is long past time when in respect of those things for which Australian mechanicalism could conceivably prove useful as a narrative, long past time that we should have been declaring success. We no longer have centralized industrial relations delivering wage indexation. Instead we have some measure of aggregate wages flexibility and this has been demonstrated by the moderation in nominal wages growth in recent times as the terms of trade have receded. Capital markets are open and flexible. We no longer have a highly distorting wholesale sales tax. We no longer have most of the economy shielded from effective competition with lazy business operators able to pass all costs forward onto Australian consumers. The structure of the economy has been transformed and it's been transformed in a process that provided a considerable boost to productivity. We even have a bipartisan political commitment to a medium term anchor for fiscal policy. But we face a new set of challenges and these are challenges which the narrative of Australian mechanicalism either provides no answer or provides the wrong answers. It's time for a more honest narrative. The case for reforms to boost competition to enhance labour market flexibility and to provide the conditions for productivity growth, that case is strong. But it doesn't rest on export competitiveness. Whether they induce a real depreciation and in turn boost exports or not, these things should be pursued because they expand opportunities, they enhance freedoms and in so doing they improve the wellbeing of the Australian people. And the same is true of much of the rest of the economic reform program implemented in Australia from 1983. The mercantilist narrative diminishes the efforts of a generation of Australian policy reformers some at least of whom have been focused on more respectable goals. All economists since Adam Smith have emphasised the dependence of aggregate economic outcomes upon the exercise of individual agency. That's actually what economics is about. Recent contributions by Nobel Laureates Jay Stiglitz and Edmund Phelps draw attention to some of the capabilities required of individual agents if they are to be relied upon to support the wealth of nations and they draw attention also to the need to nurture those individual capabilities. Edmund Phelps published an extraordinary book published last year entitled Mass Flourishing. Details the primary role played by innovation in an historical accounting of material progress, economic inclusion and human fulfilment. According to Phelps, innovation has been driven historically by grassroots dynamism. That's his phrase. Something which he sees as the product of modern values transcending traditional values. And he maintains that this grassroots dynamism has broken down in much of the western world due to short termism in government, short termism in business and finance and in a thundering echo of Adam Smith by corporatism organised to protect vested interest. The poor consequences of short termism and of the advancement of vested interest are emphasised also by Jay Stiglitz in his recent publication The Price of Inequality. The importance of an emphasis on individual capabilities has been argued forcibly for some decades now by another noble laureate, Amartya Sen. Sen emphasises individual capability not only because of its implications for aggregate outcomes but because individual capability is a matter of primary interest in itself. Indeed it is the primary matter. The core concern should be the extent to which individuals enjoy a set of capabilities that provides them the freedom to choose a life of value. I'll come back to that concept. A renewed focus on individual agency and in particular on the capabilities enjoyed by citizens informs a more sophisticated understanding of international competitiveness and it informs a more honest economic reform narrative. The narrative I would suggest should comprehend the role played by national endowments in driving national performance. That is, it should be capable of explaining how the economic, social and environmental outcomes of a nation and also the distribution of those outcomes among its people how those things rest upon the country's particular set of endowments. While some of a nation's endowments are a consequence of nature others have been developed by earlier generations of humans. In the former category are a set of natural assets including things like geographic location such as the one that Singapore enjoys, demography, energy, minerals and soil deposits, native flora, fauna and ecosystems. While these endowments are the product of nature they're not static of course the human population of Australia is growing rapidly and it's aging mineral energy and soil resources are being depleted native flora, fauna and ecosystems are being degraded in many cases irreparably. In the category of endowments created by humanity are to be found the products of foundational investments in such things as our rich indigenous cultures. Modern multiculturalism the visual and performing arts, our legal and regulatory structures, our education and health facilities, our economic infrastructure in systems supporting research and innovation such as they are in policy frameworks that promote freedom and economic security and in working conditions that support human dignity these are created in Australian endowments. These foundational investments have been truly transformational transformational in precisely the sense that Catherine Livingston has demanded of those who today advance various structural reform proposals. National endowments are the source of individual capability. A core component of individual capability is human capital of course a term that gets bandied around much but no amount of human capital will ensure that an individual has the opportunity to choose a life of value if national endowments omit other capabilities. These other capabilities include a set of freedoms and institutions that for some years now and I would suggest at increasing costs we have been taking for granted including freedom from bigotry. A well functioning political system with politicians who are motivated to enhance national well-being. A well resourced and respected public service strengthened by the doctrine of ministerial responsibility. Independent transparency mechanisms a truly accessible judicial system. Independent unpoliticized media. A tax system that can be relied upon to meet emerging fiscal requirements with minimal damage to incentives to work, save and invest infrastructure governance that anticipates a better future education systems that offer pathways to knowledge and science and innovation systems that support creativity and the dissemination and commercialization of ideas. We have been taking these things for granted at our cost. The need to ensure that Australians are endowed with the capabilities that will be relevant to success in this Asian century calls for a renewed focus on all of these and other national endowments. The white paper on Australia in the Asian century identified a need for new foundational investments including public investments in our schools in our universities and in vocational training centres in developing Asia capable workplaces and institutions in developing a much deeper understanding of the history, the cultures, the languages the geography and the governance of our regional neighbours in devoting more effort to what has become known as track 2 diplomacy in building strong people-to-people relationships based on trust and mutual respect and in encouraging adaptability and those involved in writing the white paper would also have endorsed Edmund Phelps emphasis on the fostering of grassroots dynamism. International competitiveness in the Asian century will be enhanced by paying attention to all of these endowments and by leveraging them into commercial partnerships not by pursuing a race to the bottom on wages, taxes, social foundations, environmental standards or animal welfare. So let me say something about picking winners. The council against governments picking winners in terms of products particular products and particular industries is well based historically no doubt about it, but governments do have a responsibility for building national endowments and we should be comfortable with the fact and it is a fact that a country's pattern of national endowments should favor some industries and some products over others. Now the economists in the room might accept all of that yet still want to maintain that governments should be disinterested in the pattern of commercial activity that emerges that governments should take no interest in the shape of Australia's industrial development for example. Well I want to encourage you all to think differently our reluctance to describe consequences comprises the effectiveness of a narrative that really shouldn't need to be said Australian mechanicalism identifies a winner that winner is exports. Like Adam Smith we know that narrative should have should have no support in economics but we've been happy to go along with it and that's because we know that our reforming arguments will not be persuasive without a compelling narrative. In the 1980s we accepted that for governments and for those who advised them it's not enough to talk in abstract terms about the importance of freedom the importance of opportunity, of competition, of productivity, of economic efficiency we understood that governments have to explain to people the probable outcomes of the exercise of personal freedoms, the consequences of people having access to greater opportunity and the commercial implications of reforms to enhance economic efficiency. Indeed surely it would be unconscionable of government not to do so. In developing compelling narratives there's no choice to identify winners. That's actually a large part of what makes them compelling the identification of winners is the attractive vision bit that follows the scary burning platform part of the story that we economists feel much more comfortable telling. But once the winners of government policy have been identified a government can hardly maintain that it would have preferred a different set of winners and so in that very real sense the winners of government policies are those the government has picked. Let me conclude I've argued that the concept of international competitiveness that's embodied in the Australian mechanicalist narrative with its focus on the cost confronting exporters has outlived its usefulness. Its clouding or understanding of structural adjustments underway in the Australian economy especially those that are a consequence of the China boom and its compromising efforts to deal effectively with a number of confronting policy challenges including climate change and making a success of the Asian century. We need a richer understanding of international competitiveness and that understanding has to be both capable of and has to be comfortable with identifying the winners of a more internationally competitive Australia. As a profession we economists are never going to agree on who those winners should be and indeed many economists will never feel comfortable even thinking about policy objectives at that micro outcomes level but I would encourage them not to be too critical of those who are prepared to give it a go. I would encourage them to accept at least that this discussion is one worth having. In the meantime we economists could serve a useful purpose by articulating a respectable goal for economic policy at whatever level of abstraction we feel comfortable. To that end I'm going to conclude with some propositions with which I feel comfortable. An internationally competitive Australia would be a place in which political activity is predictable with policy based on sound theory and robust evidence. It would therefore be a place in which government policy avoids short termism and has no taste for protecting vested interest. A place in which governments have the intellectual capacity and the political courage to articulate a compelling vision of what could be. An internationally competitive Australia would be a good place to do business. It would be a place that provides access to labour with the right skills and to deep and liquid capital markets that are sophisticated and robust. It would be a place in which those developing regional value chains or even global value chains are placed in which they expect to find world class partners. Partners with a sophisticated understanding of Asian languages of Asian cultures and of Asian institutions. It would be a place that offers its people a high quality education and rewarding jobs and careers. It would be a place in which grassroots dynamism flourishes in which intellectual development is encouraged and in which science, innovation and effort is rewarded. In more abstract terms Australia's international competitiveness should be assessed according to the richness of the set of opportunities it offers the people who live in it and those who could live in it in generations to come. But international competitiveness even conceptualised in this rather more challenging manner does not represent the ultimate goal of public policy. That has to be stated at an even higher, even more abstract level. In this address I've emphasised the responsibility that public policy has in the nurturing of national endowments. The public policy of Australia should be directed to ensuring that all Australians, including those not yet born are endowed with capabilities that afford them the opportunity to choose a life of value. That is the measure of the wealth of Australia and also of the sources of its wealth. Thank you.