Why the RBA should ignore calls to raise rates

When the Reserve Bank decided to keep the cash rate on hold on Tuesday, it laid part of the blame on Australia’s weak productivity growth.

But is our productivity growth as bad as it looks or are we measuring the wrong industries?

Labour productivity growth is simply the extra amount of GDP produced in all parts of the economy in a particular period.

Since farm output rises and falls depending on how good or bad seasons have been, the Reserve Bank prefers to use non-farm GDP per hour worked in its economic forecasts.

In the most recent quarter, non-farm GDP per hour worked is estimated to have declined by 0.1 per cent. But the Reserve Bank forecasts it to pick up to about 0.8-0.9 per cent a year in the coming couple of years.

Still, that’s weak by historical standards and in comparison with the performance of other developed economies.

It has been noted famously by economist Paul Krugman that productivity growth isn’t everything, but in the long run it’s almost everything.

If an economy can produce more goods and services with the same amount of labour and capital through productivity growth, it can grow without causing inflation.

Conservative economic commentators have argued, following the Reserve Bank’s decision to keep the cash rate on hold, that the Australian economy is already growing as fast as its speed limits imposed by its poor productivity performance.

Any increase in the economic growth rate, they say, would be inflationary.

They cite the most recent inflation number used by the central bank in deciding on interest rates – the so-called trimmed mean rate – of 3.2 per cent, which is just above the target range of 2-3 per cent a year.

Some conservatives are suggesting the next move in the cash rate might have to be up, not down.

Yet the most recent movement in the unemployment rate was also up – from 4.3 per cent to 4.5 per cent. Any increase in the cash rate would force unemployment even higher.

High and rising unemployment would make workers think twice about demanding pay rises, so the conservative argument goes.

But is Australia’s productivity performance as bad as we are led to believe?

Statisticians can readily measure the productivity of a mineworker. It’s the value of ore produced for each hour worked.

Similarly, the value of a manufacturing worker is the value of the goods he or she producers per hour worked.

But what is the value of a services industry worker? Is it the number of haircuts performed each hour? Do we really want all men, women, boys and girls to get quick and easy crewcuts in the name of productivity growth?

And what about the so-called non-market service sector? Are we realty better off if we increase class sizes per teacher to 50 in the name of productivity growth, or do we want each aged-care worker to look after 50 residents instead of 15?

In 1950, agriculture, mining and manufacturing were responsible for about half of Australia’s GDP and employment. Services production contributed the other half.

Services now contribute about 80 per cent of GDP and 90 per cent of employment.

But we don’t know how to measure the productivity of many service industry workers, especially teachers, nurses and aged care workers.

Yet the doyens of productivity analysis, members of the Productivity Commission, have come up with a measure of productivity in the health sector. It takes account of improvements in the quality of services.

It turns out that in the one-third of Australia’s healthcare sector that the Productivity Commission has studied, annual healthcare productivity grew by a strong 3 per cent. This placed Australia third among 28 high-income countries for healthcare productivity.

The areas studied were the treatment of cancers, cardiovascular disease, blood and metabolic disorders, endocrine disorders and kidney and urinary diseases.

The improved quality showed up in longer and healthier lives but would not be captured under conventional productivity measurement approaches.

Much of the improvement has come from quickly adopting new treatments.

But isn’t the whole purpose of economic growth to produce longer and healthier lives?

The lesson from this story is that yes, productivity growth is important but it is a means to an end.

The debate about slow productivity growth being a handbrake on the RBA being able to cut the cash rate without causing an outbreak of inflation relates only to that part of the economy whose productivity growth is readily measured.

We seem to be doing better with productivity in the large and growing parts of the economy whose productivity is not easily measured.

This doesn’t mean the Reserve Bank should let it rip and slash interest rates. But it does mean conservatives who want the cash rate to stay where it is or go higher are missing an important part of the story.