CEDA State of the Nation Keynote Dinner Address

CEDA State of the Nation Keynote Dinner Address

PM&C Who We Are The Secretary
Monday, October 10, 2016

Department of the Prime Minister and Cabinet

Abstract

Innovation is critical for improving living standards. Measured innovation has fallen off in advanced economies, including Australia, since the early 2000s. There is some evidence that the pace of diffusion of ideas has been slowing across a wide range of industries. There is room for improvement if business, governments and the community are committed to reforms that encourage openness and competition.

Key Themes: The Innovation imperative: what it means for industry, services and the economy.

Introduction

Tonight I will talk about the contribution innovation makes to our living standards; the role government can play, both as a facilitator of innovation across the economy and as a service provider; and the importance of businesses’ commitment to openness and competitive markets.

I have spoken extensively in the past on the four forces that are reshaping our country and the global economy – technology, demography, sustainability and shifting economic weight towards our region.

Our success or otherwise in responding to these four forces, and the future growth in our national living standards, rests on innovation – innovation in products and processes, in business models, and in public policy and service delivery.

I don’t want to downplay the importance that innovation can make to our environment, leisure or other non-pecuniary activities, but for tonight’s purposes I’ll focus on how innovation feeds through to our incomes.

Innovation that raises our incomes also increases our capacity to afford the lifestyle that we desire, and the ability of governments to provide the services that society demands.

It is also the case that the extant problem in advanced countries, including Australia, is that growth in incomes has slowed markedly, with impacts on living standards and fiscal positions – in part due to a measured fall in the pace of innovation.

What is innovation and why is it important

So, what is innovation and why is it important?

A term often used, but not well understood, at its core innovation is simply the creation and application of ideas.

Occasionally, the ideas that drive innovation are truly original – that is, new to the world. But most of the time innovation is the result of the adoption or adaptation of an existing idea.

Innovation improves our national income when ideas are successfully applied to production or processes.

Unlike labour and capital, innovation does not depreciate with use, nor is it something that only one firm or sector can use at a time. Rather, it is the unconstrained, but ephemeral, input essential to productivity.

What sets our living standards apart from those of one hundred years ago is not how many workers or how much capital we have available, but how we use them.

We tend to think of innovation as being done by start-ups or people in white coats, but it’s much more than that. By and large our greatest gains have come from building a culture that adapts and diffuses the ideas of others.

As I will argue later, government has a role to ensure that the conditions are in place to both facilitate and encourage the importation and diffusion of ideas across the economy.

But it’s business that has to adopt the ideas – to bring them into your product and process mix and to take the chance that they will give you a competitive advantage.

Government has to do the same when it comes to policy development and implementation. The work underway around rethinking our ways of engaging with the community, particularly around service delivery is one example of public sector innovation.

Measuring innovation

While innovation can be difficult to define, it is even more challenging to measure.

We should be wary of some proxy measures of innovation, including the number of patents, PhDs or even spending on R&D.

Patents can both help and hinder innovation; PhDs can sometimes channel our smartest into the wrong activities; and spending on R&D may not translate into new products or efficiency improvements, particularly if driven largely by tax concessions.

Of course, often these things produce substantial amounts of innovation – it’s just as raw indicators they are not that useful as a measure of our innovation performance.

Innovation performance

So if innovation is so important because it can change our incomes and living standards, how are we doing?

Economists tend to favour ‘multifactor productivity’ as the standard and probably broadest measure of efficiency and innovation in the market economy.

It’s a measure of how well we are able to combine inputs to produce outputs – in a sense, of how “smart” we are in our operations. Why? Because we improve multifactor productivity by applying technology and know-how to the basic building blocks of the economy.

Properly measured, we can think of multifactor productivity growth as a proxy measure of the pace of innovation in products and the processes for making them.

In the long run, it’s the combination of multifactor productivity and the amount of capital available per worker that determines the growth in labour productivity, real wages and material living standards.

This chart shows that multifactor productivity growth for the G7 and Australia has fallen since the early 2000’s.

MFP growth – Australia and G7 countries

Multifactor productivity growth, for Australia and G7 countries. The chart shows the average growth rate for Australian multifactor productivity for the period 1990 to 2003 at 1.4 per cent per annum, which compares to the average for the period 2003 to 2014 at 0.3 per cent per annum. For G7 countries the median multifactor productivity growth for 2003 to 2014 has also been weak, averaging just 0.1 per cent per annum. Sourced from OECD statistics department.

Between the 1990s and 2000s, average annual growth in multifactor productivity fell by around a percentage point across several advanced economies and was barely positive in Australia over the past decade.

As the Chart below shows, Australia’s weak multifactor productivity growth can partly be attributed to very high investment in the mining and utilities sectors.1In the utilities sector, over-investment occurred during a period of unexpected weak demand.2

Australian multifactor productivity

, Australian multifactor productivity index levels over the period 1991 to 2015. The first time series is for 12 market sector industries and the second series is for 10 market sector industries, which excludes mining and utilities. There is a clear change in the trend for each series, with the trend being much flatter for the most recent period 2004 to 2015. Sourced from the Australian Bureau of Statistics, catalogue number 5260.0.55.002.

In the mining industry, the installation of capital has long lead times before output comes on line, resulting in a temporary reduction in measured productivity.

High prices for commodities also made the extraction of deeper ores and lower yielding resources financially attractive, even at high unit costs, which also lowered actual productivity.

Clearly, these are understandable phenomena and can help explain Australia’s aggregate productivity performance.

What is less understandable is that, even if we exclude the mining and utilities sectors, Australia’s multifactor productivity growth has fallen significantly over the past decade, with 10 of 14 Australian market sector industries recording lower multifactor productivity growth over the past decade than the previous one.

And the mining sector cannot explain the slowdown in global productivity.

This suggests something more fundamental is at play.

Drivers of weak global multifactor productivity growth

So what might be going on?

I can think of four things worth exploring.

Cyclical factors

First, Professor Brad de Long3 of University of California, Berkeley, emphasises the cyclical, and hence temporary, factors behind recent global productivity performance.

This includes the observation that productivity growth typically declines during economic downturns as firms hold onto labour and capital even as productivity falls, in anticipation of an improvement in economic conditions in future.

Longer term trends

Second, some argue that Australia’s poor multifactor productivity growth is part of a phenomenon and that the rate of innovation is slowing globally, with long term impacts on global productivity growth.

Prominent economists such as Professor Robert Gordon4 of Northwestern University and Professor Tyler Cowen5 of George Mason University argue that this global slowdown in productivity may be structural in nature. If true, this has profound implications for future potential growth.

At their root these arguments are inherently sceptical about the productivity benefits associated with what Gordon calls the ‘third industrial revolution’ – the revolution in communications and information technology.

This argument is supported by the relatively weak productivity performance of the US and other leading advanced economies over recent decades even as these new technologies have moved ahead in leaps and bounds.

Professor Gordon asks the question, “Does the New Economy merit treatment as a basic Industrial Revolution of a magnitude and importance equivalent to the great inventions of the late 19th and early 20th century6 ?”

Gordon’s research highlights the transformative nature of innovations such as: electricity; sanitation; the internal combustion engine; and air transport.

Interestingly, these ideas were inventions largely of the 19th century but didn’t have major payoffs until the mid-20th century.

Diffusion of ideas often takes time.

One example is how long it took electrification to improve productivity.

Business managers took decades to work out that electricity freed them from having to situate all of their machines around the steam power source to be linked by pulleys and leather belts.

Even though electricity was available from around the 1880’s, it took until the 1920’s for machines to be set up with standalone motors and more sensibly dispersed throughout the factory and for their increased output to show up in US productivity statistics.

Professor Gordon thinks most of the major transformative inventions have already been discovered, and current innovation only incrementally improves productivity – a sentiment we have admittedly heard before, when Charles Duell, Commissioner of the US Patent Office, said in 1899, “everything that can be invented has been invented”.

We could only discover flight once, now innovation is more about improving: fuel efficiency; aircraft construction and size; along with the quality of in-flight entertainment.

In this view – innovation comes in waves and we are currently in the middle of a low ebb.

On the other hand, the economic historian Joel Mokyr7 believes that the digital economy has further untapped potential that could boost productivity in the years to come.

And my layperson’s understanding of advances in biotechnology and materials technology suggests that these too could turn out to be transformative in diverse fields such as medicine, agriculture, data science, and computing.

The point is that, just as contemporary observers have sometimes underestimated the impact of technological innovations in the past, it may be that we have barely scratched the surface of the productive potential of emerging technologies.

Indeed, the Prime Minister has noted that in many cases we overestimate the short term impact of an innovation and underestimate its long term impact.

In short, we just do not know whether technological advance is speeding up or slowing down.  What we can be confident about is that hastening the pace at which we innovate is critical to our relative competitiveness, and ultimately our living standards.

The measurement challenge

A third possible explanation for the apparent slowdown in multifactor productivity growth across advanced economies is that innovation is not captured very well in national statistics.

Conceptually we should be picking up innovation whenever output increases but inputs don’t. But there are inherent problems with how we measure output.

In a factory producing homogenous widgets, measuring output is simply an accounting exercise.

But often innovation means improving the quality of products and this can be difficult to measure.

In a paper from a couple of years ago, the RBA8 estimated that quality improvements to the iPhone meant its effective price declined 35 per cent between 2010 and 2012 (iPhone 4 and 5), despite the headline purchase price not changing much at all.

Indeed the effective price of the iPhone has probably decreased by a lot more, given that the RBA were only adjusting for the storage capacity of the device.

This doesn’t take into account other innovations that have improved quality, such as enhanced cloud storage, battery life, processing speed and software improvements.

The RBA has estimated that failing to take into account such effects across all goods and services could mean the CPI growth rate is over-stated by up to a ½ a percent a year.

And from a measured productivity perspective, Professor Charles Bean – former Deputy Governor of the Bank of England – suggests phenomena like this could be understating UK growth rates by as much as 0.7 per cent annually.

Technological diffusion

A fourth possible explanation for the slowdown in MFP growth is that, while the technological frontier may be continuing to expand at a rapid pace, the rate at which new ideas are being taken up more broadly across the economy – that is, by individual businesses ‑ may have slowed. The OECD finds some evidence for this.

As shown in the below chart, the OECD has identified a large and rising labour productivity gap between “frontier” firms – defined as the most productive firms operating in advanced economies - and the rest.

The gap is significant in the manufacturing industry and even larger for services based firms.

Percentage change from 2001 levels of labour productivity, for the period 2001 to 2009. The first panel includes a time series for manufacturing frontier firms (which increases to around 30 per cent by 2009) and all other manufacturers (which increases to around 15 per cent in 2007, then back to around 5 per cent in 2009). The second panel has a time series for services frontier firms (which increases to over 40 per cent by 2009) and all other services firms (which increase to just under 10 per cent and then by 2009 returns to the same 2001 level). Source is the OECD 2015 paper “The Future of Productivity.”

Now an optimist can look at this and say it’s a positive since it may help explain the productivity slow down. The ideas are there, they just haven’t disseminated yet to all businesses.

Or a pessimist can ask whether it indicates something wrong with how innovative ideas are transmitted across the economy – the incentives and the pressures!

Policies to support the diffusion of innovation

So, what might be stopping the take up of new ideas?

Let me lightly touch on some possibilities.

Through intellectual property rights, we impose rules on the use of ideas. This can entail restrictions on the use of ideas or require innovators to pay for using the ideas from others. If we get the balance wrong, we stifle innovation – if we get it right, we encourage it.

Governments which restrict access to data not only reduce the chances of innovation in public policy, but often reduce political accountability as well.

We often penalise risk taking through tax and regulatory settings.

Innovation is not certain to be successful. It often involves failure, sometimes a lot of it – innovation is, after all, inherently risky. Yet often we impose too many costs on the efforts of those who fail from taking a legitimate risk.

We do this when bankruptcy penalises those able to start again or when the tax system fails to give due recognition for tax losses.

Some people will lose, either because their innovation fails or they are displaced by a successful competitor. We need to make sure they see pathways back, including through retraining and skills development.

Regulatory authorities have incentives to be risk averse, rather than risk neutral, since the benefits are to the community but one of the costs of something going wrong is often the reputation of the regulator.

Moreover, where we allow anti-competitive behaviour, we tend to favour incumbents over more potentially innovative businesses, and we always end up favouring producer interests over those of consumers.

Where governments continue to support loss- making businesses, through protection in its many guises, we inherently stop resources from flowing to more innovative ones.

Even where we allow government services to be uncontested and directed more by employee interests, rather than consumer interests, we most likely harm innovation.

In all these areas, it’s important that policy settings are not acting as an impediment to innovation.

While government has a role to create the conditions, ultimately, businesses drive commercial innovation.

It is important that our businesses have the vision and management acumen to identify and successfully pursue long-term gains through cutting edge product and process innovation.

A prominent international study of management practices in manufacturing found that management practices in Australia are mid-range.9

We are well below top performers like the United States, Germany, Sweden, Japan and Canada, but more similar to France, Italy and the United Kingdom.

There is also significant variation in management performance within countries. Australia, like some other countries, has a somewhat larger tail of companies with relatively poor management performance than the United States.

Regression analysis suggests that lifting management practices in Australian manufacturing firms to the average level in the US would raise the level of productivity in Australian manufacturing by around 8 per cent.10

Reasons for optimism

So they are some of the impediments, now I want to outline why I am inherently an optimist about the role innovation will play in driving national incomes.

The Prime Minister is clear on the challenge - as he says, ‘Innovation must be an economy-wide story; doing things better and smarter’.

We know some of the key drivers of innovation. What matters most is giving people and businesses the right incentives to innovate.  The more competitive a sector, the more likely businesses in that sector are likely to innovate.

Competition means businesses are encouraged to get ahead, or to adopt the successful innovations of others quickly. Competition also means the resources of unsuccessful businesses are quickly reallocated to more productive uses.

By maintaining open trade arrangements, Australia’s relatively small market benefits from producer specialisation in our exports and more domestic competition. 

When faced with the threat of imports, sectors which appear highly concentrated are forced to innovate to keep their advantage.

This is particularly relevant given the world is seeing a marked shift in economic weight from the countries of the trans-Atlantic toward those of Asia. With around ¾ of annual world growth coming from emerging market economies, there is a real opportunity in the Asian marketplace11 .

This also presents challenges, as tradeable goods companies know only too well. More and more it will be service based companies that are competing in the global marketplace. Unlike in resources and commodities, Australia has no inherent comparative advantage in the services sector writ large. As I have noted before, Beijing is closer to Berlin than it is to Brisbane.

If we are to grasp these opportunities, we will need to work for them and, above all else, innovate to gain a competitive advantage.  

We also need to ensure that we are well-positioned to capitalise on the rapid growth in innovation that will inevitably come from within our own region. Within the 800 million Chinese 12 who no longer need to focus solely on subsistence, we will see more entrepreneurs and innovators whose ideas will benefit us all.

Open trade, investment, modern communication and data technologies vastly open up the scope for innovative growth across our economy. Businesses now face more price and product competition than ever before.

Those industries and businesses that are international in their outlook, have hooked into global supply chains, embraced change and adapted to the challenges will remain competitive. They will not only survive the structural shifts in the global and national economy, but they will thrive from tapping into the global marketplace.

Innovative businesses, such as Romar Engineering from Sefton, New South Wales, demonstrate this.

Established in 1968 as a toolmaking and engineering business, servicing the automotive and industrial trade, Romar now supplies precision manufactured components to the medical, aerospace, and aeronautical industries.

In September this year, Romar opened its new 3‑dimensional additive manufacturing machine that it will use, in collaboration with CSIRO, to conduct industry leading research into the manufacture of medical devices. 

Another company, Australian Numerical Controls and Automation was established in 1974 as a very early adopter of technology to make computers13. Today, it is a global manufacturer of high precision, computerised machinery and cutting tools which are used to make smart phones, aircraft components and medicine.

Last year it was Australian Exporter of the Year and Australian Manufacturing Exporter of the Year, exporting an impressive 99 per cent of its production14.

Technological innovation and the drive to be globally competitive helped these companies to expand and prosper.

Innovation in the non-traded sectors of the economy

A globally competitive traded sector is important, but it’s not enough. We also need to ensure that our non-traded sectors are innovating.

We are at risk of Baumol’s famous cost disease15 where it’s the relatively less productive sectors which attract workers through time.

The reasoning is simple – as businesses become more productive, they tend to reduce the number of workers they need, while the less productive continue to use more labour.

We need to create the conditions for innovation in areas like human services that will become an increasingly large share of our economy as our population ages.

Placing the consumer at the centre of service provision and creating the conditions for continuous improvement is at the heart of Professor Harper’s recommendations that we introduce competitive forces into non-traded parts of the economy, like health and aged care.

Although as Professor Harper notes in his report, we also need to recognise that there are limits.

The cost of delivering services to Australia’s ageing population is projected to nearly double as a share of the economy between 2015 and 2055.

If we want to avoid these sectors being a drag on national income growth and to lift the incomes of workers in these industries, we need to improve their multifactor productivity.

But more important still, we need to ensure that conditions are in place to ensure these sectors are responsive to consumer interests. They are the least reformed of all of sectors of the economy, largely escaping the previous reform efforts in the 1980’s and 1990’s.

So you can say that I am optimistic about our ability to lift innovation because there is so much more to do.

Conclusion

In the 1930’s Keith Hancock said that Australians “have not grown rich because of their policies, but that being already rich, they have been able to afford (such policies)”16.

Perhaps at times in our history demand for our resources has made many of us rich for reasons other than our ability to innovate.

But those times are now well and truly behind us.

Australia’s future will be determined by the resourcefulness of its people, not the resources lying under it. Multifactor productivity is a measure of how we as a nation choose to use the endowments we have been given.

It underpins long term national income growth and is the broadest measure of innovation in our market economy. It is where we see the benefits from all the policies which favour no single interest group but the wider community.

It incorporates all the innovations flowing from past institutional reforms, such as  processes that result in us building more productive infrastructure when needed; tax reforms that reduce barriers to investment; and a more open economy that allows workers and capital to flow where they are most needed.

The Prime Minister is clear on the challenge - as he says, ‘Innovation must be an economy-wide story; doing things better and smarter’.

This really is the main game.

[END]

Footnotes

1. Martin Parkinson, The 2014-15 Budget and Sustaining Board Based Growth in Living Standards, 2014.

2. D’Arcy P and L Gustafsson (2012), ‘Australia’s Productivity Performance and Real Incomes’, RBA Bulletin, p26-27.

3. de Long, B. “Productivity growth in the 2000s.” NBER Macroeconomics, 2002.

4. Gordon, R.J., “Does the new economy measure up to the great inventions of the past?” NBER working paper, August 2000.

5. Cowen, T., “The great stagnation.” Penguin group, 2011.

6. Gordon, R.J., “Does the new economy measure up to the great inventions of the past ?” NBER working paper, August 2000.

7. Mokyr, J. “The Enlightened Economy. An Economic History of Britain, 1700-1850.”, New Haven, Yale University Press, 2009.

8. Jacobs, D., Perera, D. and Williams, T. “Inflation and the Cost of Living.”  RBA Bulletin, March 2014.

9. This section draws on a speech by my colleague, Dr David Gruen, to the 41st Australian Conference of Economists in 2012, titled Productivity and Structural Change. International results are summarised in Bloom, N., Genakos, C., Sadun, R. and van Reenen, J. Management practices across firms and countries, National Bureau of Economic Research Working Papers, no 17850, 2012. Detailed results from the Australian component of the study are in Green, R. Management matters in Australia: just how productive are we? Report commissioned by the Department of Innovation, Industry, Science and Research, 2009.

10. Bloom, N., Genakos, C., Sadun, R. and van Reenen, J, Management practices across firms and countries, National Bureau of Economic Research Working Papers, no 17850, 2012. The same findings are found in the latest paper by Bloom, N., Lemos, R., Sadun, R., Scur, D. and Reenen, J.V. The new empirical economics of management.” NBER working paper 20102, May 2014.

11. International Monetary Fund, “World Economic Outlook.” October 2016. 

12. World Bank. “China overview.” 14 September 2016.

15. Baumol, W.J. “Health Care, Education and the Cost Disease: A Looming Crisis for Public Choice.” Kluwer Academic Publishers, 1993.

16. Hancock, K., “Australian Society.” Cambridge University Press in association with the Academy of the Social Sciences in Australia, 1989.