Insights Volume 12 November 2012

insights Melbourne business and Economics volume 12 november 2012

After the Great Recession: recovery or stagnation?

By Dale T. Mortensen What is full employment today?

By John Freebairn The review of the Fair Work Act and its implications

By Geoffrey Giudice The Great Recession and the distribution of household income

By John Micklewright China update: rebalancing and sustaining growth in China

By Ross Garnaut The world in transition

By John Brumby Fraud in Australia

By Colin Ferguson Fraud, ethics and corporate governance

By Dean Newlan Occasional addresses

Margaret Jackson Christian Bennett

Insights: Melbourne Business and Economics ISSN:1834-6154 Editor: Associate-Professor Geoff Burrows Associate Editor: Ms Danielle Roller Sub-editor: Ms Rebecca Gleeson

Advisory Board: Professor Kevin Davis Professor Colin Ferguson Professor Emeritus Ian McDonald Design: Ms Sophie Campbell Illustration: Ms Sonia Kretschmar

insights vol 12 Table of contents 02 Welcome

By Geoff Burrows, Editor

05 After the Great Recession: recovery or stagnation?

By Dale T. Mortensen

Why has it taken so long for the levels of US business activity and employment to recover?

13 What is full employment today?

By John Freebairn

Could Australia reduce unemployment to the 4 per cent level achieved in 2008, or even the less than 2 per cent level achieved in the 1950s and 1960s, without causing breakout inflation?

19 The review of the Fair Work Act and its implications

By Geoffrey Giudice

While employers and unions share much common ground, experience tells us that it is unlikely that the two sides will join together in the common pursuit of worthwhile economic and social goals.

27 The Great Recession and the distribution of household income

35 China update: rebalancing and sustaining growth in China

By Ross Garnaut

Structural change in China is mostly in a direction that will reduce internal and external tensions and support more productive interaction with the global economy.

41 The world in transition

By John Brumby

We ought to be struck by the simultaneous occurrence of four major global transitions – epidemiological, geopolitical, technological and environmental – and the challenges and opportunities they present.

47 Fraud in Australia

By Colin Ferguson

Simple greed and the opportunity to live beyond one’s normal lifestyle are the primary motivations for fraud.

53 Fraud, ethics and corporate governance

By Dean Newlan

There is a growing sense that some of those at the top of this country’s largest corporations sometimes engage in less than exemplary conduct.

By John Micklewright

Occasional Addresses

What was the impact of the large shock of the Great Recession on the incomes of households?

57 Margaret Jackson 59 Christian Bennett

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Welcome Insights publishes condensed and edited versions of important public lectures connected with the Faculty of Business and Economics. Its object is to share these lectures with the wider public, especially Alumni. The issues presented and developed generally relate to research findings on public economic and social policy. Insights also constitutes an archival source of an important part of Faculty life. Suggestions and comments from readers on any feature of the journal are welcome.

Seemingly intractable rates of unemployment in, respectively, the US and Australia, are the focus of articles by Dale Mortensen and John Freebairn.

Nobel Laureate Mortensen examines why US employment, post the Global Financial Crisis, is taking so long to recover. Freebairn – who spoke at a conference to mark the retirement of Ian McDonald, one of the Faculty’s most distinguished professors – queries the common assumption that Australia’s ‘natural’ rate of unemployment is now 5 per cent and cannot be reduced to the lower figures experienced in earlier decades.

Industrial-relations aspects of the Australian labour market are considered by Geoffrey Giudice, former chairman of Fair Work Australia, in his Foenander lecture. Giudice examines the report of the panel appointed to review the operation of the Fair Work Act 2009.

Focusing on the income-distribution consequences of the GFC – or Great Recession, as it is often called elsewhere – Downing lecturer John Micklewright finds only modest short-run changes in advanced OECD economies but anticipates much greater changes in the medium and longer terms.

China provides a common theme in contributions

by Ross Garnaut and John Brumby. Former Ambassador to China, Garnaut summarises the proceedings of the Melbourne Institute 2012 Forum on China in which presenters identified four points of tension necessitating the rebalancing of the Chinese economy. From an Australian standpoint, former Victorian Premier Brumby nominated geopolitics, particularly the rise of China, as one of the four future challenges and

transitions facing the nation, the others being epidemiology, technological change and the environment.

Complementary perspectives on business ethics, fraud and governance are provided by Dean Newlan and Colin Ferguson in the two articles which follow, based on presentations to the Faculty’s Alumni Master Class series.

In Occasional Addresses to graduands, distinguished alumni Margaret Jackson and Christian Bennett discuss respectively the role of learning as a part of life and the importance of relationships, both business and personal.

May 2012 saw the retirement of Professor Bryan Lukas from the Insights Advisory Board.

An inaugural member of the Board and one who, together with Professor Bruce Grundy, was responsible for the Insights concept, Lukas has provided valuable strategic and editorial advice which has enhanced the role and quality of the publication. All connected with Insights thank him for his work. Insights also welcomes his replacement on the Board, Colin Ferguson, Professor of Business Information Systems in the Department of Accounting who, coincidentally, makes his author debut in this edition.

The illustrations accompanying articles are always an important aspect of Insights. The current edition has been enriched by Sonia Kretschmar’s depictions of the themes of the articles.

Geoff Burrows Editor ghb@unimelb.edu.au

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Article heading here

after the great recession: recovery or stagnation?

Why has it taken so long for the levels of US business activity and employment to recover? by dale t. mortensen

An edited version of a public lecture given at the University of Melbourne on 3 July 2012.

Although it is now three years since the Great Recession was declared over by the National Bureau of Economic Research (NBER), the US unemployment rate is still 3 percentage points above the roughly 5 per cent average level experienced during the seven-year period from December 2000 to December 2007. Moreover, the period since January 2008 has been the longest with an unemployment rate above 8 per cent since the Great Depression. In the meantime, many European economies have also experienced high unemployment which has particularly affected young people trying to enter these labour markets.

Why has it taken so long for the level of business activity and, with it, the employment level in the US to recover?

Although the timing of the Great Recession was not fully anticipated, its causes are clear. After a long run up in the market values of residential housing and other assets, the price bubble burst. As the value of residential housing fell for the first time in over 70 years, so did the value of the mortgage loans secured by these assets.

Questionable practices – extending the loans that fuelled the bubble and introducing complicated and opaque financial instruments used to sell these mortgages to investors – added to the problems. These complications, together with a banking system that had inadequate reserves to deal with the risks taken, led to the crisis, one

that required unprecedented actions by the federal government and the nation’s central bank, the Federal Reserve (FED).

Financial distress and labour markets But why did all these financial developments affect the labour market? What is the connection between a banking crisis and unemployment? The answers to these questions are not well understood by economists, in part because financial crises are relatively rare.1 Indeed, the 2008-2009 recession was the only one in the US caused by such a crisis since the 1930s. In other words, there is little history to guide us.

The unemployment rate – the fraction of the labour force actively looking for paid work – tends to remain high after recessions but typically only for short periods. This is not the case this time – in the US the unemployment rate only fell below 9 per cent a full two years after attaining its peak of 10.1 per cent in December 2009. An unemployment rate of this magnitude implies that the economy could produce many more goods and services. For example, the difference between 5 per cent and 10 per cent represents about 7.5 million people who could have been employed.

As the dollar value of goods and services, gross domestic product (GDP) per employed worker in 2010 was $112,000 ($14.6 trillion divided by 130 million workers), so it stands that a reasonable estimate of the forgone national income during Insights Melbourne Business and Economics

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that year was $840 billion. By comparison, the annual US defence budget is about $700 billion.

Of course, the shortfall in GDP is considerably larger, approaching the $1.2 trillion deficit of that year, if one also accounts for those working part time who sought full time employment.

Furthermore, the recession itself was the major factor causing that record deficit because taxable income falls with employment.

of unemployed workers, which can be interpreted as the probability with which typical workers find a job in a month, is roughly proportional to the ratio of the number of job openings to the number of actively searching workers. This relationship, derived from that known as the matching function, is crucial to understanding the dynamics of the level of employment, as clearly illustrated in Figure 1.

The principal reason unemployment is defined to reflect active job search is that it is these people who are participating in the job-matching process.

The other side of the process is reflected by the number of job openings that employers want to fill.

These are measured in the monthly Job Opening and Turnover Survey (JOLTS) conducted by the US Census, which asks a sample of employers to report the number of job openings as well as the number of workers that joined and left employment in each firm during the previous month.

The two curves in Figure 1 represent the numbers of job openings available in each month, measured on the left vertical axis, and the total employment in the US along the right-hand vertical axis. For each month during the last decade, vacancies have fluctuated between 3 and 5 million job openings per month while total employment varied from a high of 138 million workers in December 2007 at the beginning of the Great Recession to a low of 129 million in December 2009. The shaded areas represent the Great Recession of 2009.

Demonstrably, the level of employment follows the movements in the number of job openings with a delay or lag of a few months. This is predicted by the proportional relationship between the log of the hires to unemployment ratio and the log of the ratio of measured job openings to measured unemployment; as well as the fact that the level

Economists have found that the number of searching unemployed workers and the number of job openings are, together, important determinants of the flow of workers hired in that month.2 Indeed, the log of the ratio of the monthly flow of hires from unemployment to the number Figure 1: Job openings and employment 5,500

4,000

134,000

3,500

132,000

3,000

130,000

2,500

128,000

2,000

126,000

Note: Shaded areas represent recessions as determined by the NBER

After the Great Recession: recovery or stagnation?

Employment (‘000)

136,000

Source: Bureau of Labor Statistics, Current Employment Survey and Job Openings and Labor Turnover Survey, June 19, 2012

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138,000

4,500

Ja nM 02 ay Se 02 pJa 02 nM 03 ay Se 03 pJa 03 nM 04 ay Se 04 pJa 04 nM 05 ay Se 05 pJa 05 nM 06 ay Se 06 pJa 06 nM 07 ay Se 07 pJa 07 nM 08 ay Se 08 pJa 08 nM 09 ay Se 09 pJa 09 nM 10 ay Se 10 pJa 10 nM 11 ay Se 11 pJa 11 n12

Job Openings (‘000)

5,000

140,000 Employment Job Openings

of employment changes to balance the difference between the flow of workers hired and the flow who separate from employment every month.

That it is movements in job openings that generate fluctuations in the level of employment is an important observation. It is the demand for labour, derived from a need for workers to supply goods and services to the economy as a whole, that is the primary driver of employment fluctuations.

The source of those fluctuations in job openings over the period from August 2003, the low point of the previous recession, to August 2006, the date in which openings began to recover after the 2001 recession, is relatively easy to understand. It is also closely related to the causes and consequence of the financial crisis of 2007-2008.

Asset bubbles and employment The period in which job openings rose sharply, from August 2003 to mid-2006, corresponds closely to the run-up in the prices of residential housing and other real estate at a rate that far exceeded the general rate of inflation. There were two important responses to this rise in the relative price of real estate. First, home-owning households regarded their increased home values

as a form of wealth accumulation. As real estate is the predominant asset in the portfolios of almost all households, they responded to this large perceived windfall by buying more goods and services, particularly durable goods such as autos, recreation vehicles and pleasure boats. They did so even though the disposable income of the median household increased only modestly during the period.

To finance this surge in expenditure, households added to their debt, in part by borrowing against the increased value of their homes, which banks were willing and able to supply at relatively low interest rates as a consequence of accommodating monetary policy. Simultaneously, the construction sector cashed in on the increase in prices of their product and the ready availability of cheap credit to expand the employment of construction workers in order to supply more housing units.

Next, the boom in employment generated by this surge in construction fed on itself to create more employment in other sectors of the economy.

Inevitably asset price bubbles burst, and when that happens there are often dire consequences.

In spite of an apparent belief that housing prices never fall – after all they had not since the Great Insights Melbourne Business and Economics

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Depression – a decline began in 2006. Households had already reduced their expenditure on durable goods – in part because they had recently purchased new ones and in part because of the growing need to pay the interest and principal on the newly-acquired debt. Furthermore, as the value of their homes fell they could no longer expand their borrowings and, indeed, realised that a readjustment of their portfolios to include less debt was both desirable and necessary.

Simultaneously, the value of the mortgages held by banks fell along with the value of the assets that secured them. A rise in the rate of defaults on these loans further reduced the value of bank capital, resulting in credit restrictions on employers, particularly those starting new businesses (that disproportionately contribute to the flows of new hires). These credit restrictions combined with falling demand for goods and services caused the number of job openings to tank and with it the level of employment.

The market response to an excess supply of goods and services, which excessive unemployment represents, should result in two forms of price adjustment that tends to offset the unbalance.

First, interest rates should fall thereby encouraging households to substitute current for future goods and services. However, the banks were already experiencing high default rates on existing loans and were not about to incur additional risk. They either refused to lend at all to finance durable goods purchases and business investment, or required higher rates of interest to compensate for the perceived additional risk. Led by Chairman Ben Bernanke, the FED attempted to offset this effect by pursuing traditional monetary policy designed to lower the rates at which banks pay for funds. It became apparent that these actions could not stem the tide, in part because rates had fallen close to their zero bounds. If negative rates of interest were required to return the economy to normal, this was beyond the ability of traditional monetary policy as we know it. Consequently, the FED began an asset-buying strategy designed to affect rates on long-term bonds, a policy that became known as quantitative easing (QE). Although these actions helped, they did not directly address the principal problem: the shortfall in demand for goods and 08

After the Great Recession: recovery or stagnation?

services relative to the ability of the economy to produce them.

As an excess supply of goods and services is directly reflected in an excess supply of labour services, theoretically wage rates should also fall relative to the prices of goods and services, restoring employer incentives to hire workers. In fact, real wage rates did fall relative to trend but so did prices, in part because firms found ways to substantially increase labour productivity. As employers saw no early revival of demand for goods and services, the increases in productivity did not encourage them to expand employment. Instead, it allowed them to further raise profits by either laying off more workers or by hiring cheaper parttime workers. For both reasons – falling wages and reduced employment – the labour income of households fell quite dramatically. This decrease had a further negative effect on household demand for goods and services.

Of course, the federal government can offset the reduction in private demand for goods and services by increasing expenditure on defence, education and infrastructure. Indeed, President Obama asked for and received a $787 billion fiscal stimulus package in February 2009 – via the American Recovery and Reinvestment Act – which included a combination of additional federal spending as well as substantial tax cuts for individuals and businesses. In addition to a tax rebate, taxes on payrolls were reduced to discourage further layoffs and the unemployment benefit period was extended to provide disposable income to families experiencing long unemployment spells.

Although the spending component of the package has been criticised for being wasteful and misdirected by some and of insufficient size by others, in retrospect responsible professional assessments seem to agree that job losses would have been much larger in 2009 and 2010 without it. Indeed, once the money ran out in 2011, large numbers of teachers, police and other public servants employed by state and local governments – whose earnings had been financed by the Act – were retrenched. Finally, any move to sustain the fiscal stimulus died when the President’s party lost control of Congress in November 2010.

Instead, the focus was redirected toward the future

problems associated with the increase in federal debt that had been accumulated in no small measure because of the reduction in tax revenues attributable to the recession.

Mismatch in the labour market In the two years since the end of the recession, some economists have pointed to problems other than the lack of aggregate demand for the slow recovery. As evidence, the fact that unemployment did not fall initially in response to the weak recovery in job openings in the first half of 2010 has been used to argue that there are new problems of matching workers to jobs not present before the recession. For example, well known academic economist, Narayana Kocherlakota, who is also currently president of the Minneapolis Federal Reserve Bank, commented in August 2010 that ‘this change in the relationship between job openings and unemployment ... [connotes] in a word, mismatch. Firms have jobs, but can’t find appropriate workers . . . the Fed does not have the means of transforming construction workers into manufacturing workers.’

Kocherlakota’s quote refers to what economists know as the Beveridge curve. The curve itself is the consequence of the fact that the job-finding

rate – the likelihood of finding a job in any time period – increases with the ratio of job openings to the number of unemployed, on the one hand, and the fact that the level of employment tends toward that which balances new hires and job separations on the other. These two facts together generate a strong negative association between the ratio of job openings to unemployment, the vacancy rate, and the unemployment rate. This relationship for the period since December 2000 is illustrated in Figure 2.

Each point in the figure represents the particular vacancy and unemployment pair observed in a given month during the period where the vacancy rate is indicated along the vertical scale and the unemployment rate can be read on the horizontal scale. Each point is then connected with a line to the points corresponding to the pairs for the previous and subsequent month. As illustrated in the figure, all the points lie on a common curve during the period December 2009 to the end of the recession in June 2009. However, for several of the early months of the subsequent recovery, job openings rose but unemployment did not respond.

Later, unemployment did start to fall but the points all seem to line up on another higher curve, implying that more vacancies are now required to generate a given level of unemployment.

Figure 2: The Beveridge curve 4.0 Dec ’00 – Feb ’01 Dec ’00

3.5

Mar ’01 – Nov ’01 (Recession)

Mar ’01

Dec ’01 – Nov ’07

Job Opening Rate

Dec ’07 – Jun ’09 (Recession) 3.0

Jul ‘09 – Apr ’12

Dec ’07

Apr ’12

2.5 Nov ’01

2.0 Jun ‘09

1.5 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0 10.5 Unemployment Rate Source: Bureau of Labor Statistics, Current Population Survey and Job Openings and Labor Turnover Survey, June 19, 2012

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Several plausible reasons have been given for the increase in mismatch unemployment. The construction industry was devastated by the collapse in demand for new housing units – indeed, about half of those who lost their jobs during the recession were so employed. Others have argued that the inability of households to move to areas where jobs are more plentiful, because either their own mortgage exceeds the value of their home or a buyer cannot be found, has hampered an important labour-market adjustment mechanism.

The extension of unemployment benefits is another possible cause for the longer duration of unemployment that is responsible for the higher unemployment rate at each level of job openings.

However, recent attempts to quantify the effects of these possible causes of unemployment conclude that they are responsible for at most 1-1.5 percentage points of the 5 percentage point increase in unemployment.3 That is, were aggregate demand to return to pre-recession levels, then the unemployment rate should fall back to the long run average of 6-6.5 per cent rather than 5 per cent. Furthermore, research suggests that this effect will diminish with time as labour and housing markets adjust and the length of unemployment benefits shorten.

Household demand Most economists believe that much of the unexplained difference between the current unemployment rate of 8 per cent and say 6 per cent is the consequence of continued lack of demand by households for goods and services. For example, Martin Feldstein, a chair of President Reagan’s Council of Economic Advisors, asserted in the Financial Times on 25 July 2011, that ‘the high unemployment reflects the lack of demand rather than any fundamental problems with the US labor market.’

The continued shortfall in household demand seems to reflect attempts to de-lever the debt 10

After the Great Recession: recovery or stagnation?

acquired during the housing bubble. The fall in the value of homes resulted in a sharp increase in household debt relative to the value of the principal asset held by households. Of course, some households were forced to default on their mortgage reflecting an extreme constraint on expenditures but the majority who did not default responded by reducing their expenditures on goods and services in order to rebuild their asset positions. This process continues. Consequently, the demand for goods and services that employed workers supply is still depressed. Only after the process is complete and/or housing prices return to normal will job openings return to levels seen before the recession.

Evidence for this hypothesis finds support in a recent research paper by Mian, Rao, and Sufi (2012) which compares trends in expenditure by those household which are highly levered and those that are not. One example of their evidence is illustrated in Figure 3, which plots expenditure on automobiles by households with high debt to the expenditure of those who are not highly levered.

As the figure shows, the total expenditure on autos by the latter group fell slightly during the recession period but has increased substantially since while the expenditure of those with a debt problem fell more sharply and has not recovered.

Until it does, employers are reluctant to make the investments needed to meet the future increase in demand because they simply don’t know when the future will arrive.

Figure 3: Auto sales through 2011q3 1.50

Normalised to 1 in 2006

Some view this ‘shift’ in the Beveridge curve as evidence that it is now harder to match vacant jobs with unemployed workers than it was before the recession – there is more ‘mismatch’ between the jobs available and the collection of workers seeking employment.

1.25 1.00 0.75 0.50 0.25 0 2006q2 2007q2 2008q2 2009q2 2010q2 2011q2

Source: Mian, Rao, Sufi (2012)

High leverage/inelastic counties Low leverage/elastic counties

European influences Recently, the financial crisis in Europe has threatened to derail the US recovery. Several European countries, for example Ireland, Spain and Denmark, all experienced their own housing bubbles and bursts which impacted the balance sheets of their banks. The problem with the banks then led to ‘sovereign debt’ crises because the reserves used to support bank loans in each country are invested in the debt instruments of the country rather than diversified more broadly.

This fact has led to a substantial drop in bond prices which is equivalent to a sharp increase in the debt-carrying costs. As a consequence of the increase, bond-market investors began to question the ability of some governments to service their debt, notably those of Ireland, Greece, Spain and, more recently, Italy. The lack of fiscal coordination and a flawed monetary union in combination with the unwillingness of the more fortunate countries of Northern Europe to aid those of the South has forced policies of short-run fiscal austerity on those in trouble, which has proven to be counterproductive. Namely, the increase in taxes and decrease in government expenditure have produced a recession – which of course reduces a country’s ability to reduce deficits. How this situation will be resolved is unclear. In the meantime, the demand for US goods and services by some of its most important trading partners is adversely affected.

1 For a notable study of the history of financial crises over the past 800 years, see Reinhart and Rogoff (2011).

2 This discovery along with the model development required to apply it were cited by the Nobel Committee in awarding the Nobel Prize in Economic Sciences to Peter Diamond, Christopher Pissarides and myself in 2010.

3 Recent studies of the issues include Barlevy (2011), Sahin et al (2012) and Daly et al (2011).

References Barlevy, G 2011, ‘Evaluating the role of mismatch for rising unemployment’, Federal Reserve Bank of Chicago, Economic Perspectives vol. 35, no. 3, pp. 82-96.

Daly, M, Hobijn, B & Valletta, R 2011, ‘The recent evolution of the natural rate of unemployment’, Federal Reserve Bank of San Francisco, working paper.

Mian, A, Rao, K, & Sufi, A 2011, ‘Household balances sheets, consumption, and the economic slump’, working paper.

Reinhart, C & Rogoff, K 2011, This time is different: Eight centuries of financial folly, Princeton University Press, New Jersey.

Sahin, A, Song, J, Topa, G, & Violante, G L 2012, ‘Measuring mismatch in the US labor market’, Federal Reserve Bank of New York, working paper.

Conclusion Obviously, this view is far from the ‘good news’ that we would like to hear. However, experience suggests that recovery will occur and indeed a new boom, perhaps based on an exciting new technology that we cannot now foresee, may well be in our future. To prepare for that event, we need to tread a tricky path that requires that we collectively invest in the education and innovation that will be needed to produce that future boom, while managing the long-term effects of the financial crisis, including the additional government debt that it produced.

Joint winner of the 2010 Nobel Prize in Economics, Dale T. Mortensen is Professor of Economics at Northwestern University.

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Article heading here

what is full employment today?

Could Australia reduce unemployment to the 4 per cent level achieved in 2008, or even the less than 2 per cent level achieved in the 1950s and 1960s, without causing breakout inflation? by john freebairn

A revised version of a paper presented at a Conference to honour Professor Ian McDonald on 15 February 2012.

Employment, or its complement, the level of unemployment, is an important measure of national welfare, along with national income and equity in relation to opportunity and outcomes.

Unemployment is also one of the key variables considered in setting monetary and fiscal policies.

In this connection, a crucial question arising from the work of Ian McDonald is whether the current (early 2012) unemployment rate of just over 5 per cent is close to full employment and cannot be reduced without creating inflationary pressures? Alternatively, could Australia reduce unemployment to the 4 per cent level achieved in 2008, or even the less than 2 per cent level achieved in the 1950s and 1960s, without causing breakout inflation?

Different measures of unemployment There are important background questions about the meaning and measurement of full employment. Together with most of the media, economists in their formal models invariably use the Australian Bureau of Statistics (ABS) measure of unemployment. Although the ABS measure follows International Labour Organisation conventions, it is a restricted measure: being counted as ‘employed’ requires employment for a minimum of only one hour or more in the past week, while inclusion in the ‘workforce’ requires being employed or, if unemployed, both actively

seeking work and being ready to start work in the reference period.

A broader measure of labour under-utilisation collected by the ABS includes those wanting to work more hours – that is, the under-employed – as well as the unemployed. At over 7 per cent of the workforce, the number under-employed now exceeds the official number unemployed.

Importantly, the relative incidence of underemployment has trended upwards in the last two decades. Compared with earlier downturns, the cyclical downturns in 2001 and 2008–09 affecting the labour market were largely accommodated by falls in average hours worked rather than in numbers employed (Borland, 2011, Table 11).

Two other groups who would value employment but are not included in the measured workforce – and are more difficult to measure – are: – Those marginally attached to the workforce who would like a job at current conditions but are not actively seeking work; and – The unemployed who have shifted from NewStart to the disability support pension.

Overall, the ABS unemployment rate is a conservative measure both of the under-utilisation of production capacity and of the equity costs of labour-market outcomes. While it is important that economists and policy makers focus on broader Insights Melbourne Business and Economics

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measures of unemployment than the headline ABS rate, the following analysis assesses a desirable unemployment rate as conventionally measured.

Causes of unemployment Unemployment occurs for a number of reasons.

A minimum level of unemployment will reflect both search and structural factors. Employees and employers search for mutually beneficial employment matches in a world of changing vacancies driven by shifts in buyer preferences, production technologies and so forth, and a world with new entrants to and exits from the workforce. The Beveridge-curve and job-search models seek a level of unemployment matched by a similar level of vacancies. It seems likely that search and structural unemployment will be greater the larger the degree of structural change in the economy. The current mining boom and historically high real-exchange rate are creating structural unemployment due to the mismatches in skills required for expanding resource-based industries compared with those possessed by workers released from the (currently) declining retailing and manufacturing sectors. Furthermore, the higher and more accessible the social security benefits available to the unemployed, the greater the opportunities for more extended job searches (and the higher the rate of ‘search’ unemployment).

Excessive labour costs relative to labour productivity – encompassing not just wages but also other forms of remuneration and on-costs such as workers’ compensation and leave entitlements – cause what is known as classical unemployment.

Classical unemployment associated with labour costs running ahead of productivity was a substantial component of the sharp increases in unemployment in Australia during the mid-1970s and early 1980s. The industrial relations system and the relative power of organised labour may contribute to classical unemployment through their influence on rates of wage increases and productivity improvements. Evidence suggests that the extremes of highly-centralised or highlydecentralised systems perform better than ‘mixed’ systems (see Calmfors and Driffil,1988).

Insufficient aggregate demand associated with cyclical downturns and recessions is another key 14

What is full employment today?

cause of undesired unemployment. Important challenges for monetary and fiscal policies are to sustain aggregate demand growth for full employment with low and stable inflation.

Phillips-curve model and nonaccelerating inflation rate of unemployment (NAIRU) The Phillips curve has been the standard economic model for analysing the trade-off between unemployment and inflation. Originally, Phillips (1958) found a robust statistical relationship between the rate of wage inflation and the inverse of the unemployment rate. Building on the Phillips-curve idea, more recent studies in Australia have focussed on the CPI inflation rate, unemployment, and a number of other causal forces including the replacement rate (measured as the social security payment while unemployed as a ratio of the average or median wage), union density and other measures of the industrial relations system, import price inflation, and measures of changes in industry structure. In particular, the studies by Kennedy et al. (2008), Lim et al. (2009) and Battacharyya and Hatton (2011) have allowed the coefficients in their Phillips-curve model determining the NAIRU to vary over time. Estimates of the NAIRU for current circumstances point to a maximum unemployment rate at around 5 per cent. Further, recent RBA decisions regarding loosening and tightening monetary policy are consistent with the view that a 5 per cent unemployment rate is a good guide.

Range of equilibrium model and umin A much lower rate of achievable unemployment without inflation is generated by the range of equilibrium unemployment model used by Ian McDonald and colleagues (Lye et al., 2001, Lye and McDonald, 2004, and McDonald, 2007).

While in a sense the model builds from the Phillips-curve model, it is critical of it and embraces the Phillips curve as a special case. At low levels of unemployment below umin, further reductions in unemployment result in inflation in labour costs with labour demand running ahead of labour supply, as in the Phillips-curve model.

But, unlike the Phillips-curve model, there is no symmetry of increases in unemployment above umin reducing inflation; rather, for rates of unemployment above umin the Phillips curve becomes flat and there is a range of equilibrium unemployment rates. The range of unemployment over which higher unemployment has no effect on wage inflation reflects ideas from behavioural economics. These ideas include the resistance to lower wages relative to a reference or normal wage, and fairness; whereas the Phillips curve assumes downward wage flexibility. Over the range, stimulatory monetary and fiscal policies can drive unemployment down to umin in a Keynesian sense without adverse inflation side-effects.

The value for umin is allowed to depend on a number of essentially supply-side factors. McDonald and co-authors adopt what they call a parsimonious pair of factors, namely the replacement rate and the share of the workforce unionised. The higher the replacement rate, with a big increase in the early 1970s and a slow decline over the 2000s, the higher the reservation wage and the lower the

opportunity cost of searching for a better job, and so a higher umin. The lower the union-membership share of the workforce (which has steadily declined since 1990), the less the insider pressure for higher wages and resistance to productivity-increasing changes. The union-share variable may also be a proxy for other microeconomic reforms driving employers to push harder both for wage restraint and productivity growth with more-competitive product markets.

The time-varying estimates of umin are an interesting framework for thinking about an attainable unemployment level. For contemporary Australia umin is estimated at around a 2.5 per cent unemployment rate, with a 95 per cent confidence interval of plus or minus 2 percentage points (Lye and McDonald, 2006b).

Further thoughts One might consider other supply factors affecting umin and the achievable lower unemployment rate in the future in addition to McDonald’s Insights Melbourne Business and Economics

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parsimonious list of the replacement rate and the union-membership share of the workforce.

A priori, the importance of search and structural unemployment, which forms the core of umin, likely increases with the rate of structural change, and in particular that associated with the current mining boom. Yet, data in Connolly and Orsmonde (2011, Figure 15) suggest only small increases in indices of structural changes in employment by industry and by state. Further, to my knowledge no published study has found a significant explanatory effect of statistical measures of structural changes on Australian labour market outcomes. Changes in the mix of the workforce, including larger shares of female, part-time and mature-age workers, likely includes more who, once unemployed, exit the labour force relative to a declining share of full-time middle-age males and career females. Another interesting contemporary debate concerns the industrial relations system and the effects of the shift from Work Choices (2006) to Fair Work (2009) as an independent driver of the non-inflation level of unemployment not captured in the union-membership share of

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What is full employment today?

the workforce variable. Changes in the taxation of labour income and means testing of social-security benefits alter effective marginal and average tax rates and the incentives of employees to leave and enter the workforce and to actively job search.

These may also warrant consideration.

Another interesting feature of McDonald’s (2007) research on achievable unemployment is his view on the long term unemployed (LTU). While many studies of the Phillips- and Beveridgecurve models treat the LTU as an important explanatory variable (as a measure of difficult-toemploy persons), he takes the opposite position, viewing LTU as a response to the aggregate unemployment rate. In fact, he finds a very tight linear relationship which, if extrapolated, suggests LTU would be close to zero with a 3 per cent aggregate unemployment rate.

Concluding observations Available estimates from Phillips- and Beveridgecurve models imply a minimum unemployment rate without inflation of about 5 per cent, and this

number seems to conform with RBA decisions to tighten and loosen monetary policy. On the other hand, estimates from Ian McDonald’s range of unemployment equilibrium model imply a much lower rate of achievable unemployment, suggesting the use of more adventurous monetary and fiscal policies.

Phelps: The range versus the natural rate in Australia, 1965:4 to 2003:3’, Australian Economic Papers, vol. 45, no. 3, pp. 227-240.

John Freebairn holds the Ritchie Chair in Economics at the University of Melbourne.

McDonald, I 2007 ‘Where is full employment?’, Dialogue, vol. 26, no. 2, pp. 81-92.

References Bhattacharyya, S and Hatton, T 2011, ‘Australian unemployment in the long run, 1903-2007’, Economic Record, vol. 87, no. 277, pp. 202-220.

Lye, J, McDonald, I and Sibley, H 2001 ‘An estimate of the range of equilibrium rates of unemployment in Australia’, Economic Record, vol. 77, pp. 35-50.

Phillips, A 1958, ‘The relation between unemployment and the rate of change of money wages in the United Kingdom, 1861-1957’, Economica, vol. 25, no. 100, pp. 283-299.

Borland, J 2011 ‘The Australian labour market in the 2000s: the quiet decade’, in Gerard, H and Kearns, J (eds.), The Australian Economy in the 2000s, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp. 165-218.

Calmfors, L and Driffill, J 1988, ‘Bargaining structure, corporatism and macroeconomic performance’, Economic Policy, vol. 3, no. 6, pp. 13-61.

Connolly, E and Orsmond, D 2011 ‘The mining industry: from bust to boom’, in Gerard, H and Kearns, J (eds.), The Australian Economy in the 2000s, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp. 111-156.

Kennedy, S, Luu, N and Goldbloom, A 2008 ‘Examining full employment in Australia using the Phillips and Beverage curves’, Australian Economic Review, vol. 41, no. 3, pp. 286-297.

Lim, G, Dixon, R, and Tsiaplias, S 2009 ‘Phillips curve and the equilibrium unemployment rate’, Economic Record, vol. 85, no. 271, pp. 371-382.

Lye, J and McDonald, I 2006a ‘An evaluation of unemployment policy in Australia using the range of equilibria’, Australian Economic Review, vol. 39, no. 2, pp. 239-256.

Lye, J and McDonald, I 2006b, ‘John Maynard Keynes meets Milton Friedman and Edmund Insights Melbourne Business and Economics

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Article heading here

the review of the fair work act and its implications The well-known paradox of deregulation is that successive attempts to deregulate workplace relations have, in many respects, led to increases in regulation by geoffrey giudice

A condensed version of the 2012 Foenander Lecture given at the University of Melbourne on 16 August 2012.

The recently released Report of the Fair Work Act Review Panel (the Report) established to review the Fair Work Act 2009 has reactivated longstanding debates about policy and regulation. What powers should the national industrial tribunal have, and what constraints should be put on the way those powers are used? What limitations should be put on the conduct of the parties and, in particular, what limits should be put on industrial action and the ability of employers to contract with whomever they please on mutually agreed terms?

– The award system; – Enterprise bargaining; – The role of unions, particularly in bargaining; – Productivity under the Fair Work Act; and – Individual flexibility.

This review occurred, and the Report has been released, in a pre-election period. Usually, review and change occur after an election as part of the implementation of the election platform of the new government. And even if an Opposition does not have a reform platform, there is likely to be a reform bill if the government changes. Of course politics bedevils good policy formulation in many fields, but it does seem that so far as industrial relations is concerned the problem is more acute than normal.

The well-known paradox of deregulation is that successive attempts to deregulate workplace relations have, in many respects, led to increases in regulation. Over the last two decades more and more limits have been placed on the exercise of compulsory arbitration powers, and conditions have been attached to the exercise of those powers that remain. Constraints, which are sometimes quite detailed, have been placed on the behaviour of the parties. Arbitration powers in relation to some matters have been replaced with substantive legislative provisions, such as the National Employment Standards (NES), and issues of interpretation and application have arisen in relation to those provisions. Some arbitration powers have been replaced with detailed process requirements. The bargaining and industrial action provisions are examples.

The Report contains a great deal of useful macroeconomic data, analysis of a wide range of issues and 53 recommendations for change. My remarks are confined to some issues relevant to policy formulation in a limited number of areas, namely:

Reform has opened up new areas of policy differentiation. Until 20 years ago, federal awards and agreements could deal with any matter which pertained to the relations between employers and employees. Since 1996 – when limits were put on Insights Melbourne Business and Economics

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award and agreement content – there have been ongoing debates about what the limits should be.

The range of matters was narrowed by the Work Choices legislation and widened somewhat by the Fair Work Act 2009. Individual remedies for unfair termination of employment, introduced in 1993, are a similar case. There are ongoing issues about access to an unfair dismissal remedy and related matters.

What is important is that if you want to place limits on the exercise of powers by the tribunal or on the conduct of the parties this will often lead to greater complexity and, in many cases, more expense. There will often, although not always, be a negative process and procedure trade-off.

The award system Are award wages and conditions too high and unfair on employers, as a number of employers suggest? Relevantly, the 122 modern awards were only introduced in 2010. It was inevitable that award modernisation would lead to changes in conditions as employers and employees move from the old to the new awards.1 It was a condition of modernisation that award wages and conditions should be rationalised and that state-based differences should be removed.

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The impact of modernisation is not uniform.

Where award dependence is relatively high – such as in the retail and hospitality industries – cost increases have had a greater effect than in industries such as mining and manufacturing.

And the experience of employers within a particular industry may differ. For example, in retail, the working hours and penalty rates in the modern award are not a direct reflection of a particular predecessor award, but an amalgam of provisions found in a number of federal and state awards. Accordingly, the effect on an employer previously under a state award in Queensland will not be the same as the effect on an employer previously under a state award in New South Wales, or on a Victorian employer previously under a federal award. Although modernisation has meant some cost increases for some employers, there are benefits overall from a simpler, uniform and less-prescriptive award system. The Report refers in turn to a report by Access Economics which assesses the value of the national system to the economy at around half a billion dollars a year over the next 10 years.2 With the passing of time, and the completion of the transitional process in July 2014, the benefits of the new system will become increasingly apparent.

There are some submissions which focus on the annual minimum wage reviews under the Fair Work Act and suggest that the increases have had negative employment effects. The Report contains ABS data which suggest that the increase in minimum wages in the last seven years has been ‘modest’ and that in the last four years minimum wages have increased in real terms by only 0.4 per cent. It is arguable that this data does not capture the real influence of the Fair Work Act, as only two annual wage reviews had been conducted under it during the period covered by the data.

The most recent Annual Wage Review, the third under the Fair Work Act, is likely to have a fairly small effect on real growth in minimum wages.

Despite relatively high minimum wages being a feature of the Australian economy for decades, reliance on award rates of pay has declined to around 15 per cent of the workforce. While employment in industries with high award-dependence is more likely to be sensitive to minimum wage increases, it is hard to find quantitative evidence of substantial negative employment effects, even in those industries, in recent years.

Enterprise bargaining The data on agreement-coverage in the Report are a little difficult to interpret, but it can be accepted that around 16 per cent of private-sector employees are covered by current agreements under the Fair Work Act.3 A much greater proportion of the public sector workforce is covered by federal and state agreements. Formal enterprise bargaining in the private sector is not as widespread as is sometimes assumed.

The Report indicates that nominal wages have grown at an average rate of about 4.5 per cent over the last 15 years, a period of generally strong economic growth, low inflation and relatively low unemployment. Wage increases have been higher in mining and construction and there have also been some regional differences. While it is likely that unions have taken advantage of their strategic bargaining position in some industries, it can be argued that it is legitimate for them to do so in a market-based bargaining system provided the outcomes overall do not threaten economic progress. Nevertheless, the Report has

sensibly recommended a change in the process for establishing Greenfields agreements. The recommendation envisages an arbitral intervention

by Fair Work Australia (FWA) where agreement cannot be reached by negotiation.

As regards industrial disputation, industrial action is only permissible during enterprise bargaining and then only in limited circumstances. The Report notes that industrial action as measured by working days lost due to strikes remains at historically low levels. While there was more disputation in 2011 than in 2010, more agreements were being renegotiated in the later year and disputes in the public service in New South Wales, not covered by the Fair Work Act, made a significant contribution to the 2011 figures. Some commentators emphasise recent increases in days lost to strikes, treating the historical position as largely irrelevant. There have also been suggestions that union militancy is increasing.

Successive reform acts have made the bargaining process more elaborate. The complexity of industrial action procedures has also provided opportunities for unions to increase the negotiating pressure on employers. The legislation contains a series of pressure points in the bargaining process, some inbuilt and others discretionary, which progressively deepen hostilities. It may be that this has played its part in employer perceptions that unions have become more militant.

Certainly, if we are to have a free trade union movement it is inevitable that there will be strikes and threats of strikes, otherwise unions would have the status of social clubs. It is rational for unions to attempt to maximise the returns to their members through the application of economic pressure, just as it is for corporations to use their market power to maximise the returns to their shareholders. These are the realities. The question is: how much industrial action is too much? On that question views will differ. Taking the industrial dispute statistics on face value, I am somewhat sceptical of reliance on historical comparisons to downplay current levels of disputation. While we are obviously doing much better than in the past, community expectations have changed. No one would suggest that 1970s Insights Melbourne Business and Economics

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and 1980s levels of industrial action would be acceptable these days. It is desirable to pursue policies which encourage cooperative workplace relations and reduce industrial action, regardless of the historical position.

Nevertheless, there are already significant limitations on the taking of lawful or protected strike action. The ACTU has suggested that there are too many restrictions on industrial action and many of them are inconsistent with the right to strike under international law. While there is a case for strengthening the provisions which encourage parties to exhaust negotiations before taking industrial action, it would not be appropriate to place further substantial limitations on industrial action. The ability of unions to take industrial action to advance and protect the interests of their members is currently regarded as one of the defining characteristics of a free society.

One of the principal employer objections to the Fair Work Act is that there is no restriction on a union taking protected industrial action when an employer refuses to bargain collectively. The Report has recommended that the law be changed so that a union cannot take protected industrial action against an employer which refuses to bargain unless FWA has made a majority support determination.4 If implemented, this proposal would have a significant effect. Any employer could refuse to bargain unless or until FWA had determined that the majority of the employer’s employees did want a collective agreement.

Union role in bargaining The Report sets out some interesting statistics concerning union membership, specifically: – A loss of 1.4 million union members in the last 20 years; – In the private sector, union members total 1.1 million employees, representing less than 15 per cent of the private sector workforce; and – Union membership is higher in the public sector where membership is around 1.8 million or just under 20 per cent of the workforce.

It is not surprising that a relatively low proportion of the workforce is covered by collective enterprise 22

The review of the Fair Work Act and its implications

agreements. It is difficult for unions to recruit in some industries for a number of reasons – such as the high proportion of employees who are casual or part-time, patterns of working hours, employer size and geographical dispersion. It may also be that collective approaches to employment issues are less popular these days. The relatively low rate of unemployment could be important, with the Report noting that there was a small spike in union membership during the Global Financial Crisis.

There are other factors contributing to the decline in union membership. The union role in the fixation of the safety net has been reduced and the role which remains is probably not well known.

Many conditions of employment are now found in NES legislation, rather than in respondencybased awards. The terms of modern awards must be reviewed periodically by FWA and the review is not dependent on union action. The scope for union-initiated alterations to awards between reviews is limited. Another important consideration is that some benefits are provided by legislation which in other countries might be a matter for bargaining.

In contrast to the US, the role of Australian unions in the establishment and improvement of basic conditions such as superannuation, health insurance, leave and other minimum wages and conditions has changed. The enjoyment of these conditions is not often connected in the public mind with union membership and collective action.

While good economic times are good for the workforce, they may not necessarily be so good for unions. If our economic fortunes decline at some point, and if unemployment increases and living costs start to accelerate, union membership is likely to regain some of its former attraction.

Accordingly, it is too early to write unions off as outmoded or confined in appeal to a relatively small sector of the Australian workforce. In any event, sound public policy should be predicated on a free and healthy trade union movement.

A legitimate issue for consideration in enterprise bargaining is whether the Fair Work Act gives unions too much influence in the bargaining process. For example, unions have bargaining representative status, provided they have at least

one member that will be covered by the prospective agreement. In relation to Greenfields agreements, unions have automatic bargaining representative status in the area of employment they cover. Should unions be required to show some greater level of employee membership and support?

Historically, Australian unions have recognition and status at the national level. In other countries most collective bargaining systems are based on local union recognition. The systems in the US, for example, are often based on local recognition as the trigger for collective bargaining even though the local recognition road can be very bumpy and expensive. When it comes to local union recognition, it is necessary to balance a number of considerations – including the history of our system, the role unions have had in it, and the increase in complexity which any additional qualifications on union participation would bring to the bargaining process. If we do go further down the local recognition road, the legislation

should ensure that a union which receives majority support is able to enjoy the fruits of victory in the collective sense.

Productivity In relation to productivity and its place in the workplace relations system, it is well known that Australia’s multi-factor productivity growth has been stagnating for some years and that in the last few years the recent slow growth in labour productivity has also halted. One of the Report’s central conclusions is that no link can be discerned between changes in the legislative framework and productivity growth. This is not to suggest that there is in fact no link. There are linkages between industrial regulation and productivity, but measuring the effects is difficult. There are many factors which influence productivity and at different times they pull in different directions.

We simply do not have data about the interaction between the application of the Fair Work Act and Insights Melbourne Business and Economics

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movements in productivity. But one thing is clear from the data in the Report: it is not possible to increase productivity simply by changing the nature of industrial regulation.

The Panel received a number of submissions which proposed that the Fair Work Act should be amended to ensure that productivity is directly addressed in the bargaining process. It seems to me that any greater regulation in this area is undesirable. If parties were formally required to take productivity into account in enterprise bargaining, definitional and quantitative issues would arise. In the case of parties who were already having difficulty reaching agreement, any additional requirement would not be helpful. Where parties are in agreement, there would be a temptation to find spurious productivity improvements where none existed in order to satisfy the statutory requirements.

Building in further process would be unlikely to yield a net benefit – as such, the Report has resisted that approach.

Instead, the Report has recommended that FWA and the Fair Work Ombudsman initiate programs to encourage parties to adopt measures, particularly in bargaining, which are likely to lead to increased productivity. In my view, programs designed to emphasise the importance of productivity enhancement and to assist the parties to increase productivity should only be undertaken with a reasonable degree of support from employers and employees. The Advisory Conciliation and Arbitration Service (ACAS) in the UK has many training offerings which are of the general type proposed in the Report, but ACAS has a tripartite governing board that provides broad-based support at the policy level for its training activities.

If the training and development functions of FWA are to be expanded, as I think they should be, an equivalent level of bipartisan support is required.

Without it, the activities would be difficult to implement and might jeopardise public perceptions of independence, ultimately reducing public confidence in the tribunal.

Individual flexibility Awards and enterprise agreements are required to include provision for individual flexibility arrangements, subject to the provision that the 24

The review of the Fair Work Act and its implications

employee is better off overall. Unions seek to limit these arrangements to prevent them from becoming an avenue for avoiding award conditions.

Employers are concerned the arrangements are too cumbersome and do not permit real flexibility.

The history of individual flexibility arrangements is interesting. Prior to the 1990s, and for a century before, it was unlawful to contract out of award provisions. It was possible to bypass some award provisions, but only if the salary was sufficient to cover the award entitlements. In 1996, statutory individual contracts or Australian Workplace Agreements (AWAs) were introduced.

The theoretical basis for AWAs was to provide greater flexibility in employment arrangements to the mutual advantage of the employer and an individual employee. AWAs were sometimes used to increase individual remuneration above the level generally applying in an award or a collective agreement, sometimes to average out the effect of penalty and overtime payments and sometimes to pay enough to satisfy award entitlements and substitute the employer’s remuneration scheme.

Currently, there is no provision for statutory individual contracts under the Fair Work Act. Some employers maintain that the individual flexibility arrangements should provide the same amount of flexibility as AWAs and that they do not do so. Adjustments could be made to address that issue and I do not want to canvass the Report’s recommendation other than to make four observations: – The idea of individual flexibility has strong symbolic value as a counter to collectivism, so philosophical differences often cloud the issues.

– Many employers apparently believe that individual flexibility should be a means to reduce award or agreement obligations. While that can be an effect, flexibility should be directed more at mutual benefit arising from the way in which the obligations are carried out in a particular case. If it is suggested that the employer’s legal obligations should be reduced, that is a different question and one to be addressed at the award level.

– The take-up of AWAs was not great. Precise data is hard to find but it is likely that at any one

time less than 5 per cent of the workforce was covered by an AWA and the figure was probably closer to 3 per cent. I am excluding the short period during the Work Choices regime when AWAs could undercut award provisions. There were considerably more AWAs during that time, but the point is that the idea of statutory individual arrangements had limited popularity even when AWAs were available. – It is sometimes forgotten that it is often possible to make individual over-award arrangements which satisfy legal obligations and provide flexibility. This approach has been traditionally followed by many employers. Individual contractual arrangements were common in parts of the mining sector, for example, well before AWAs were introduced.

The Hon. Geoffrey M. Giudice, AO, is Honorary Professorial Fellow in the Department of Management and Marketing and the Law School at the University of Melbourne. He was President of the Australian Industrial Relations Commission and its successor, Fair Work Australia, from 1996 to his retirement in 2012.

1 [2009] AIRCFB 800 paras 4 & 5.

2 Report of the Fair Work Act Review Panel, p. 49.

3 Report pp.57 and 58 4 Majority support determinations are dealt with in the Fair Work Act 2009 ss. 236-7.

5 Sawer, G 1972, Australian Federal Politics and Law, 1901–1929, Melbourne University Press, Carlton, Victoria.

Conclusion The field of workplace relations reform is wide and it has not been possible to do much more than make a few marks across the surface. I have supplied a few ideas that might shed dim light on some of the many issues that policymakers have to wrestle with. While I would like to end on an optimistic note, it is hard to do so. Employers and unions share much common ground, yet experience tells us that it is unlikely that the two sides will join together in the common pursuit of worthwhile economic and social goals. The idea of cooperation between social partners seems a long way off in Australia, at least where critical aspects of the industrial relations system are concerned.

I would like to end with a quotation from Professor Sawer, who said of the passage of the Conciliation and Arbitration Act of 1904: [The Act] was to have profound effects on the social structure, because of the encouragement it gave to trade union development on a national scale; on the economic structure, because of its consequences for wages and hours fixation; and on politics, because of the periodical party crises caused by attempts to alter the system.5 I like that quotation very much because it illustrates how important the industrial relations system is and how wide its impact: social, economic and political.

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Article heading here

the great recession and the distribution of household income What was the impact of the large shock of the Great Recession on household incomes? by john micklewright

A condensed version of the Downing Lecture presented at the University of Melbourne on 8 March 2012.

Richard Downing would surely have approved of this lecture’s aim. Coming from a generation of economists who were not compartmentalised into macro- and micro-economics, his upbringing during the Great Depression gave him a lasting concern for the implications of major economic events for household welfare. This lecture considers the impact of the Global Financial Crisis (GFC) – or the ‘Great Recession’ (GR) as it is often called outside Australia – on the distribution of household incomes. I and my co-authors are concerned with total and average incomes, income inequality and income poverty.1 We consider evidence from 21 OECD countries, albeit in differing degrees of detail.

Our headline findings are that in the short-term – to the end of 2009 – there was little or only modest change in the distribution of income, including in countries with large changes in aggregate output. But in the medium- to longer-term, much greater change can be expected due to the fiscal consolidation that is now following governments’ efforts to counteract the initial impact of the crisis and the sluggish recoveries or renewed downturns.

Key features of the research First, we compare the experiences of 21 rich, industrialised OECD countries.2 Are there general patterns for what happened to the distribution of income? Is the experience of one country, for

example the US, misleading as a guide to what happened elsewhere? As part of this, we study Germany, Ireland, Italy, Sweden, the UK and the US in more detail. These six countries include the largest OECD economy and the origin of the crisis – the US – and three of the largest economies in Europe. They differ in degrees of labour market flexibility, welfare state regimes, pre-crisis growth and income inequality. They differ also in the economic shock experienced – for example, housing busts in the US and Ireland, and trade shocks in Italy and Sweden. Their subsequent macroeconomic experiences also differed after the onset of the crisis.

Second, we study all sources of household net income – earnings, investment income and state benefits (and direct taxes). We consider income, not consumption or wealth. While consumption has obvious attractions as a measure of welfare, income measures ‘command over resources’ and has practical advantages in terms of measurement.

Third, we consider all individuals in the population – young, old, employed, unemployed – within their household contexts (aggregating each household’s incomes and adjusting for differences in household size). This contrasts with the narrower approach in some of the literature on the business cycle and inequality which focuses on the earnings of employees. In the UK, for example, such an approach would exclude about 30 per cent of net Insights Melbourne Business and Economics

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income and over half of the population. It would also ignore support provided to individuals by their households – the insurance role of the household.

The distinction between the elderly and people of working age, as well as the household context in which people live, turn out to be important elements in the story of the GR’s impacts.

We start by considering the lessons of the existing literature on the effect of recessions on the distribution of income. We then try to establish what actually happened in the shortterm for our 21 countries, drawing particularly on cross-national OECD and EU data. Finally we summarise and consider any lessons for policy. We do not attempt a formal evaluation of the GR’s impact against some counterfactual concept such as the distribution of income that would have prevailed had neither the bust nor the unsustainable boom that preceded it taken place.

This is clearly very difficult to estimate with confidence, so we are left with the less satisfactory – but feasible – alternative of measuring change relative to a baseline of around 2007, but checking that year against trend.

Is this research premature? First, many OECD countries have not yet regained their pre-crisis levels of GDP and some are currently faltering again – for example, the 2012 recession in the UK. Second, the consequences of the GR for incomes will last for many years, through the impact of such things as unemployment, future labour market prospects or pension entitlements. These long-term effects are outside our ambit but we do consider in a limited way the medium-term consequences arising from the consolidation of government budgets. Third, we face lags in the availability of householdsurvey data measuring income distribution. These lags can be years. By contrast, the first estimates of GDP may be produced within a few weeks of the end of a calendar quarter. Nevertheless, there is much we can say with available data about the short-term, notably the period to 2009 and, in some cases, 2010.

The impact of recessions What do we already know about the impact of recessions on the distribution of household income? I’ll mention just one of our case studies 28

The Great Recession and the distribution of household income

in this lecture – the US in the 1930s, before the era of regular sample surveys with probability designs. Systematic evidence on changes in the distribution of household incomes across the Great Depression is in fact pretty limited. One exception is Horst Mendershausen’s analysis of the incomes of 250,000 households in 33 US cities in 1929 and 1933.3 This information was collected by recall in 1934, which is far from ideal, but Mendershausen’s study is interesting for the attention he paid to different parts of the income distribution. He identified the impact of (i) unemployment – focused on the bottom half of the distribution – in increasing inequality and poverty, (ii) a fall in capital income at the top of the distribution, reducing inequality, and (iii) the movement apart (as he put it) of the top and bottom of the distribution. The net result was a rise in income inequality as measured by the Gini coefficient, on average across the 33 cities by 5 percentage points – a substantial increase.

However, the evidence of other recessions shows no general simple conclusion about their impact on the distribution of income. Rather, the impact depends on the nature of the shock, whom it impacts on most, and the government response.

The GFC and changes in total household incomes The GFC began in the second half of 2008 with a number of events, notably the collapse of the US investment bank, Lehman Bros. The burst of housing bubbles in the US and elsewhere exposed the weakness of banks, leading to a broader financial crisis and a collapse in international trade.

The result was the first contraction of the world economy since WWII and the worst downturn in the OECD since the Great Depression of the 1930s – hence the label ‘Great’ for this new recession.

Overall OECD output fell by 5 per cent. For the GR there were big differences across the countries we consider, ranging from no fall in GDP in Australia to 13 per cent in Ireland. There have also been large differences in the speed of recovery. Figure 1 shows changes in real GDP in index-form for our six case-study countries across 2007–2011, with the values in 2007q1 set to 100.

Germany (DE) exhibits a modest fall and a quick

Figure 1: Real GDP in 6 countries, 2007q1 – 2011q3 110

Real GDP (2007q1 = 100)

105

100

95

90

SE DE US UK IT

IE

Figure 2: Percentage change in real household disposable income (from National Accounts) and in real Gross Domestic Product (GDP), 2007–9 Percentage change in real household disposable income, 2007–9

recovery. Sweden (SE) has a sharper fall and sharper recovery. The UK and Italy (IT) exhibit faltering or weaker recoveries than in the US. Ireland (IE) saw GDP fall by over 10 per cent, the economy then bumping along at the lower level reached.

10 NO

8 CA

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ES PT

2 0

BE

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UK DE IE

CH

US AT

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-10 -8 -6 -4 -2 0 2 Percentage change in real GDP, 2007–9

85 2007q3 2008q3 2009q3 2010q3 2011q3

At this point, one might be tempted to go straight to household survey data to see what these aggregate changes in economic output implied for household incomes. But National Accounts – the source of data on GDP – also show how the household sector fared. Figure 2 plots changes between 2007 and 2009 in real GDP on the horizontal axis against changes in total disposable income of the household sector on the vertical axis.

The changes in household income are typically small but positive – most countries are in the topleft quadrant, including the US where there was a very small rise in total household income. There was no change in disposable household income in Ireland, despite a 10 per cent fall in GDP. The largest fall in disposable income was for Italy, by some 4 per cent (compared to 6 per cent for GDP).

We then decomposed the changes in the household sector’s disposable income among the different sources of income that households receive. The main explanation – in an accounting sense – for the pattern in the graph is the support given by governments through lower taxes and, in particular, higher spending on state benefits. Higher state benefits contributed at least 2 percentage points of the change in household income almost everywhere, between 3 and 4 points in the US, Portugal, Belgium and

Norway, and over 4 points in Greece, Ireland, Spain and the UK. Without the changes that occurred in state benefits between 2007–2009, these eight countries would typically have been down in the bottom-left quadrant with negative overall change in disposable income. Governments did a lot.

While National Accounts data are revealing, they depict only the total income of the household sector. To consider income inequality or poverty we must go to administrative and survey data on individuals and households. Note that the definitions of income in National Accounts and household survey data differ. For example, the National Accounts include imputed income from rent for owner-occupiers, typically excluded from survey data. So for this and other reasons the changes in aggregate incomes in the two sources may differ somewhat.

Changes in employment incomes Labour income is the most important source of household income. We need to recognise that most individuals live in households with other people so we look at employment both at the individual and the household level. We then consider what has happened to the distribution of earnings for those in work. Finally, we look at other forms of income – less data is available from cross-national sources Insights Melbourne Business and Economics

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than for earnings. On this matter, I merely make two obvious points: the impact of state benefits will tend to have been concentrated in the bottom half of the distribution (given the incidence of unemployment); and changes in capital income will have impacted most on the top half of the distribution, although widespread falls in interest rates will have affected pensioners on modest incomes with savings.

Changes in total employment over 2007–2011 displayed considerable heterogeneity, reflecting in part the variation in size of the fall in output and the nature of shock experienced. Germany saw little change mostly due to ‘short-time’ working.

By contrast, the US was one of the few countries where changes in employment were larger than expected from the fall in GDP, given the evidence from past recessions. Ireland and Spain saw very sharp falls in employment. The changes for women were rather different than those for men. In about half of our 21 countries, total employment rose for women during 2007–2009 while it fell almost everywhere for men. Female employment fell by only 5 per cent in Ireland compared to 20 per cent for men. The explanation for these different gender experiences lies largely in the nature of the economic shocks – they tended to hit maledominated sectors: construction in Ireland and Spain with housing busts, and manufacturing in Germany and Italy, affected by the sharp fall in

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The Great Recession and the distribution of household income

international trade. This gender difference was larger than in previous recessions. More familiar from the past was the impact on the young, who were very severely hit, while there were rises in employment for older workers over 2007–2011 in about half of our countries.

The key point for an analysis of household incomes is that men and women often live together, as do younger and older people. Hence the changes in the percentage of households with no work can be expected to be smaller than the changes in total employment. Data for EU countries show modest changes in this percentage over 2007–2009 in most countries. Spain and Ireland were outliers, with rises of about 5 percentage points: the extent to which co-residence can play an insurance role is limited when employment losses have occurred for women as well as men, old as well as young.

What happened to earnings? Typically average real earnings across 2007–2009 rose for those in work at the same time as employment fell (Australia and the US excepted). This pattern is most likely a selection effect as employment losses were concentrated in the bottom half of the distribution. As for the distribution of (pretax) earnings, we traced changes to 2009 only for Anglophone countries. The main period of the GR, 2007–2009, did not see clear changes in trend in earnings inequality when viewed against the changes earlier in the decade.

Figure 3: Inequality of net household income, 15 European countries, 2005–10 (Gini coefficient, %) Western Europe 40

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35 Gini (%)

Gini (%)

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2005 2006 2007 2008 2009 2010 Greece

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Note: The data refer to distributions of equivalised net household income among individuals (the equivalence scale is the modified-OECD scale).

Changes in the distribution of income Labour income is the most important element of household income but it is not the only element – we also need to consider people outside the labour market. Moving to the distribution of equivalised total household net income from all sources, and allowing for direct taxes and bringing all persons into the analysis, our results draw on statistics from harmonised household surveys published

by Eurostat, the EU’s statistics agency, and on analyses by the US Census Bureau.

The picture for median incomes across 2007– 2009 is similar to that for total household sector income measured in National Accounts: modest changes, often positive. Figure 3 shows what happened to inequality of household income in our 15 EU countries, as measured by the Gini

index, a common measure of income inequality which ranges from 0 to 100 with higher values indicating a more unequal distribution. The countries are divided into four groups: each graph has the same vertical scale for the Gini index, from 20 to 40, and covers the period 2005–2009 (2010 in the case of the UK and Ireland). The broad message is one of little obvious change in income inequality over 2007–2009, viewed against the changes in the years immediately preceding – but with one or two exceptions. US data also show little obvious change in overall income inequality over 2007–2010, despite an almost 5 per cent fall in GDP and a big drop in employment.

How have different groups within the population fared? The most common pattern in EU countries was for a slight increase over 2007–2009 in median incomes of the elderly relative to other persons, Insights Melbourne Business and Economics

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Figure 4: Absolute poverty rates, USA, 2005–10 (percentage of persons below official poverty line) 25 Percentage below official poverty line

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20 All persons

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0 2005 2006 2007 2008 2009 2010

Figure 5: General government balance expressed as a percentage of GDP, 2007 and 2009 Switzerland

The changes in Figures 3 and 4 relate only to the short-term: 2007–2009 or occasionally 2010.

What of the medium-term, say 2010–2015?

The key issues here are the slow and faltering recovery in output in many countries and the fiscal consolidation now underway as OECD governments attempt to reduce the deficits created in the depth of the crisis.

Figure 5 shows the general government balance as a percentage of GDP in 2007 (grey bars) and 2009 (green bars). Governments had to spend substantially more in 2009 through automatic stabilisers (for example, unemployment benefits) and stimulus packages to counteract the downturn, but were able to collect less in tax revenue given the reduction in output. The result was a sharp worsening of government balances. For example, Australia moved from a small surplus in 2007 to a deficit of 5 per cent of GDP in 2009. Ireland, balanced in 2007, had a deficit of 14 per cent GDP in 2009 (and an even worse position in 2010 following the bailout of its banks). By 2009, Portugal, the UK, Spain, the USA and Greece also had deficits of 10 per cent of GDP or more.

Financing these deficits increased the stock of government debt, often to unsustainable levels.

Sweden New Zealand Finland Denmark Germany Australia Austria Canada Italy Netherlands Belgium France Japan Portugal UK

Governments are therefore now trying to reduce their debt – in some cases drastically, for example Greece’s partial write-off. But one or two countries have little problem, including one of our case studies, Sweden, atop Figure 5.

Spain USA Ireland Greece

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showing that the elderly were relatively well protected during the GR – in the short-term. They were less affected by labour-market changes and the real value of state retirement benefits was often maintained. The elderly also did relatively well in the US: Figure 4 shows changes in poverty rates for different age groups, as measured by incomes below the official US poverty line. Overall poverty rose modestly in 2007–2010, by about 3 percentage points. This was driven by rises for those aged under 65 (children and working age) while the rate for those aged 65 and over fell slightly.

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The Great Recession and the distribution of household income

How are they doing it and what are the distributional impacts of the choices that are being made? An OECD survey in Autumn 2010 of members’ plans for fiscal consolidation

showed the four areas most frequently reported were ‘welfare’ (state benefits), health, pensions and infrastructure in the case of expenditure, and consumption taxes, tax expenditures, income taxes and taxes on the financial sector in the case of revenues. Expenditure cuts are more likely to hit the bottom half of the distribution harder.

The targeting of health and pensions implies that prospects for the elderly in the medium-term may differ from their experience in the shortterm. But overall, the distributional impact is unclear. For example, it depends on the incidence of public sector employment and the choice of cutting employment or wages, and it therefore needs detailed modelling country by country. The impact of the tax increases depends on exactly how increases are implemented – for example, a change in income tax could be progressive or regressive.

Obviously, the potential distributional impact is lower in countries with less need to consolidate their finances.

Conclusions, caveats and lessons The short-term impact of the GR on the distribution of household income was typically modest, whether we consider average incomes, inequality of incomes or income poverty. As far as average incomes are concerned, the elderly generally fared better than other age groups. Many of the medium- and longer-term impacts remain to be measured, and may be significantly larger.

They will depend on the pace and pattern of recovery, the extent of fiscal consolidation needed, and the precise measures adopted to consolidate government finances.

Two further caveats. First, any comprehensive measurement of the distributional impact of the GR needs to go beyond a measure of cash incomes, the focus of this lecture. The impact of cuts in government services will not show up in cash incomes (other than through reductions in public sector employment); nor will increases in indirect taxes. Second, our detailed investigations have not included three countries at the heart of the Eurozone sovereign debt crisis: Spain, Portugal and Greece. The threats to incomes and other measures of living standards faced by households in Greece are particularly notable.

Finally, what broad-brush lessons for policy do we learn from our analysis? First, governments can do a lot to stabilise income distributions in the short-term. Where welfare states are stronger, stabilisation will be stronger as automatic stabilisers kick in more quickly. Among our case studies, the softest short-term landings were experienced by the strongest welfare states, notably Sweden.

Second, the decisions that governments need to make now will affect distributional outcomes.

These decisions require timely data on household incomes, rather than being based on outdated evidence. Our research also underlines the benefits of timely cross-national databases such as those at Eurostat and OECD and of greater use of data on the household sector in National Accounts.

Richard Downing placed much store on measurement, including the National Accounts, and the last words in this lecture should go him. In his National Income and Social Accounts he rightly emphasised, ‘The provision of information as a basis for policy to increase the community’s production and employment, to improve the distribution of its income, and to change the allocation of its resources’.4 John Micklewright is Professor of Economics and Social Statistics at the Institute of Education, University of London.

1 The lecture draws on a project organised by myself and three others – our leader, 2009 Downing Fellow Stephen Jenkins (LSE), Andrea Brandolini (Bank of Italy) and Brian Nolan (University College Dublin), assisted by contributions from a large number of other persons. The work was part-funded by the Fondazione De Benedetti, in Milan. A book reporting our results, The Great Recession and the Distribution of Household Income, will be published in January 2013 by Oxford University Press.

2 Australia, Austria, Belgium, Canada, Denmark, Germany, Greece, Finland, France, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, UK, US. 3 Mendershausen, H 1946 Changes in Income Distribution During the Great Depression. New York: National Bureau of Economic Research.

4 Downing. R 1965 National Income and Social Accounts: An Australian Study, 9th ed. London and New York: Melbourne University Press, p7.

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Article heading here

china update: rebalancing and sustaining growth in china Structural change in China is mostly in a direction that will reduce internal and external tensions and support more productive interaction with the global economy by ross garnaut

A condensed version of presentations to the Melbourne Institute Forum on sustaining China’s growth through global stagnation held at the Grand Hyatt Melbourne on 13 July 2012.

The 2012 annual Melbourne Institute Forum on the Chinese economy focussed on the contemporary structural adjustment – involving rebalancing growth towards domestic demand and away from labour- and energy-intensive activities. The discussion was led by Cai Fang, Director of the Institute of Labour and Population Studies at the Chinese Academy of Social Sciences; Guonan Ma, Chief Economist for Asia of the Bank of International Settlements; Ligang Song, Director of the China Economy Programme at The Australian National University; Xiabo Zhang of the International Food Policy Research Institute; Beijun Wang from Peking University and The Australian National University; and myself, from the University of Melbourne.

The Chinese economy has been expanding at an average rate of over 9 per cent annually since late 1978, when market-oriented reform and opening to the international economy began; and at over 10 per cent since the year 2000. At many points along the path of reform and growth over the last 33 years, major adjustments of policy, institutions and economic structure were necessary to allow strong growth to proceed. China is currently at a point where several structural imbalances require major adjustments if the nation is to move beyond its current middle-income status towards the

per-capita productivity and living standards of the advanced industrial countries.

Tensions in the Chinese economy At the heart of the need to rebalance the economy for sustained growth are four points of tension.

First, China’s burgeoning demand for labour is colliding with rapidly reducing growth rates and imminent contractions in labour supply.

Second, whereas after the first decade of reform and internationally-oriented growth there was increased equality in the distribution of income within China, growth since the early 1990s has been associated with wider inter-personal and inter-regional dispersions of incomes. Growing inequality is now generating substantial social and political tensions.

Third, the Great Crash of 2008 and subsequent economic stagnation in the North Atlantic region has focussed attention on the large and rising Chinese external payments surpluses that played an increasingly important role in the global economic story through the first eight years of the current century. Growing international and domestic pressures are leading to less reliance on increases in exports and more on expanding domestic demand.

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Fourth, sustained rapid expansion has been accompanied by manifold pressures on the domestic and global environments, which must be changed fundamentally if rapid growth is to be sustained.

Adjustments in the labour supply Cai Fang, the leading authority on the economics of Chinese population and labour markets, drew attention to analysis from the recent census which requires us to further reduce expectations for Chinese fertility, population growth and labourforce growth. Cai Fang’s calculations from the recent census suggest that fertility is plumbing new depths: 1.19 children per woman at present.

The labour force is expected to peak this year or next and then decline. Population will continue to increase for only a few years and then decline from a peak of only 1.4 billion – far from the 1.6 billion quoted until recently in domestic and international official projections.

Meanwhile, demand for labour at any given wage rate has continued to grow strongly. China reached the ‘Lewisian turning point’ in economic development in about 2004 – the point at which labour ceases to be available in large quantities from the countryside for urban development without substantially raising wages in either rural or urban areas. Since then, with the exception only of the immediate aftermath of the year following the critical point of the Great Crash in September 2008, wages of unskilled workers have grown by around 15-20 per cent annually. The scarcities of labour and increases in wages that were initially concentrated in the coastal cities are now evident in rural as well as urban areas across all regions.

Several contributors pointed out that there were clear indications that each of the four sources of tension is being eased by structural changes driven by the increases in wages. The rise in the real exchange rate associated with the rising share of wages and falling share of profits in national income is forcing decline in the labour-intensive industries that have contributed strongly to export and employment growth from the mid-1980s.

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China update: rebalancing and sustaining growth in China

decades in which the increasing profit share of national income was the main source of growing inequality, wage increases have started to reverse that longstanding tendency. The shift from profits to wages has also contributed to a reduction in the savings share of income and therefore to savings rates – while Chinese households save an unusually high proportion of their incomes by international standards, the proportion of profits saved by businesses has been even higher. Lower savings have contributed to moderating externalpayments surpluses. Finally, the shift of income from profits to wages is leading a shift from investment to consumption, and from expenditure on goods to expenditure on services. Over time, this could lead to reduced intensity of energy use and reduced pressure on the local and global environments.

Thus, the first force for rebalancing and structural change was the labour adjustment being driven by market pressures, and supported by policy directed to easing imbalances and the four points of tension. Much of the discussion at the Forum focussed on these policies, the extent to which rebalancing was occurring, and the additional policy interventions that would be required to sustain strong growth in future.

Currency and external payments Guonan Ma underlined the extent of the external payments adjustment that had already occurred.

The Chinese current account surplus had widened from approximately 2 per cent of GDP in the year 2000 to as much as 10 per cent immediately before the Great Crash of 2008. There had been much international comment about how this reflected the undervaluation of the Chinese currency, the renminbi. However, the current account surplus could be understood more clearly as a shortfall of the domestic absorption of output – whether consumption, investment or Government spending – in relation to the economy’s production.

When the Great Crash hit, Chinese Government spending rose sharply and agencies of subnational governments borrowed from banks to boost infrastructure and other public investment.

This response shrank the current account surplus

both quickly and substantially, and raised the investment share of output to an unprecedented level that is widely seen as being unsustainable as well as undesirable. The scale and distribution of credit losses from this investment boom remain a matter of concern, and worries about them constrain a repeat of the post-September 2008 policies as economic growth eases in 2012 to rates that are low for the reform era. The investment share of output is easing moderately as rising wages boost consumption.

In this scenario of current account adjustment, the exchange rate plays a subsidiary and complementary role. The nominal renminbi had by the end of 2011 appreciated by 21 per cent against an average of its trading partner currencies from June 2005 – when a long period of pegging tightly against the US dollar ended. China’s relatively high consumer-price inflation-rate pushed up real effective appreciation to 30 per cent over the same period. Guonan Ma added that this real appreciation approaches 50 per cent if one focuses on unit labour costs rather than consumer prices.

So China’s combination of huge domestic demand expansion and appreciation of the real exchange rate has brought about an adjustment from the largest current account surplus amongst developed countries, to one that is well within the experience of significant economies today.

Although China’s consumption growth during the period of high surpluses was extremely high by any standards, it was not high enough to keep up with the even more rapid growth of production and incomes. In the period ahead, structural change is likely to cause both savings and investment rates to fall, so the average current account surplus is likely to remain near or below the moderate levels of 2012 – even as the temporary boost to demand from the post-2008 stimulus is replaced by more cautious fiscal and monetary policies. It would be reasonable to expect an average surplus of around 1 per cent of GDP. In these circumstances, the renminbi will eventually come to be seen as embodying a two-way risk, rather than the certain prospect of appreciation. This would provide a more propitious backdrop to further international financial liberalisation in China.

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Foreign investment Beijun Wang led discussion of how the greatly increased outflow of direct foreign investment in China is assisting the nation’s structural transformation.

China’s outward foreign investment flows rose from US$2.85 billion in 2003 to US$68.8 billion in 2010. Australia has been the largest single destination for direct investment over this period. The most important motives for direct investment abroad have been to secure access to energy and metallic mineral resources, or to purchase assets that are valuable in restructuring the economy in productivity-enhancing ways, such as through new technologies and the development of brand names and distribution networks. The resources motive has so far been dominant in Australia, while the motive of upgrading the quality and value of Chinese production is likely to become increasingly important over time. Wang sees Chinese direct investment abroad as having the capacity to contribute to (i) upgrading the Chinese economy to higher-value activities, (ii) facilitating reform of state-owned enterprises, (iii) improving corporate governance, and (iv) strengthening the business environment within China.

Regional factors Xiaobo Zhang drew attention to some of the regional factors affecting the sustainability of Chinese growth, noting that labour became scarce and expensive first in coastal China, where

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China update: rebalancing and sustaining growth in China

internationally-oriented growth first took root.

This phenomenon is creating incentives for the movement of labour-intensive industries and processes to inland areas of China – an analogue to the movement of labour-intensive production capacity from one to another country in East Asia as labour became more expensive in the more advanced economies. This movement supports the upgrade of industrial structures in the more advanced regions.

Zhang also noted the threats to the sustainability of growth – particularly with the increasing pressure on the natural environment, and the scarcity and deteriorating quality of water and agricultural land in many locations. Improved systems of management and higher productivity in land and water use could ease these pressures; although wise, market-oriented policy was a prerequisite for improvement.

Rebalancing growth Ligang Song looked broadly at the rebalancing of growth in China. He drew attention to the necessary role of policy reform in reducing price distortions, encouraging innovation, widening access to high-quality education, and reducing opportunities and rewards for rent-seeking behaviour. He argued that China required a new pattern of growth built on reform of the labour market, directed towards removing discrimination against migrants from rural areas; market-oriented reform of the financial system, in particular to

improve access for smaller and private firms; and to improve government processes and structures.

However, reform of the financial system would require liberalisation of the exchange rate and capital movements.

Overview and future prospects The Forum highlighted the extent to which domestic and international rebalancing has already occurred. The consensus prediction was that growth would be slower in the rebalanced economy than on average in the reform period so far. Importantly, there would be no contribution to growth from increased total labour supply, and few new gains from suddenly and significantly lifting the productivity of workers by moving them from underemployment on farms to productive employment elsewhere.

It was believed that investment rates would probably decline somewhat, but the total level of investment would at once continue to grow, and continue to raise the amount of capital available to each worker and therefore raise labour productivity. China’s multi-factor productivity had grown strongly through the reform period – rising wages and continued deepening of integration into the international economy were expected to keep it high.

There was also a general belief that China would continue to grow strongly by international standards, at rates easing from the 9-10 per cent of the past, to perhaps 7-8 per cent annually. It would be a very different pattern of growth involving reduced focus on investment in heavy industry and infrastructure but with relatively stronger growth of higher-value activities embodying relatively little energy and metals – such as in services and the less energy-intensive elements of the manufacturing sector.

developments in the labour market.

Structural change in China was now mostly in a direction that would reduce tensions and support more productive interaction with the global economy. While the shift away from high levels of energy and metals use would reduce strains on global resources-markets and the global environment, it would, however, introduce some challenges for Australia. The resources boom that has been the main driver of exceptionally rapid growth in Australian incomes since 2003 is due to the energy- and metals-intensive structure of Chinese development, as well as the growth in the Chinese economy. Continued Australian access to opportunities in China and sustaining high growth in Australia will require rebalancing and restructuring locally. Policy and business investment will need to be built on taking advantage of new opportunities for export of high-value manufactures and services. While the resources trade will remain a major feature of Australian export trade to China, the most rapidly growing opportunities in Sino-Australian trade will relate to the new, high-value components of the Chinese economy.

Australian Ambassador to China from 1985 to 1988, Ross Garnaut AO, has also had longstanding roles as policy advisor and company director. He is currently a Vice-Chancellor’s Fellow and a Professorial Fellow in Economics at the University of Melbourne.

These new directions were foreshadowed in and encouraged by the twelfth five-year plan, scheduled to run from 2011 to 2015 which, inter alia, was aimed at markedly reducing the intensity of greenhouse gas emissions and energy use, and placing greater emphasis on conserving the natural environment. Fiscal policy would reinforce the directions being set for structural change by Insights Melbourne Business and Economics

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the world in transition The simultaneous occurrence of four major global transitions – epidemiological, geopolitical, technological and environmental – presents both challenges and opportunities by john brumby

An edited version of a presentation to the Creating Future Leaders Series at the University of Melbourne on 2 August 2012.

Former US President Bill Clinton once said that a mark of a good leader was the ability to see around corners. I’ve always liked that way of putting it, because it neatly sums up the need for leaders to be able to identify emerging trends, and act early to get ahead of the curve. At a time of rapid and profound global change, it is more important than ever that leaders in government, business and throughout the entire community learn to look around the corner.

If we look around the corner now, we should be struck by the simultaneous occurrence of four major global transitions: epidemiological, geopolitical, technological and environmental.

Each throws up both challenges and opportunities; each is linked to each of the others; and each requires both leadership and partnership between governments, business and academia.

To my mind, the real threat is complacency. In a rapidly changing world, the luck of the so-called ‘lucky country’ is by no means guaranteed. But at the same time, the right decisions now can put Australia in a position to improve the lives of our own citizens and those of our region, to secure our prosperity in the emerging global economy, and to create new and better opportunities for the generations to come.

So what do we see around the corner today?

Epidemiological transition In the twentieth century, Australian life expectancy rose from 55 years for men and 59 for women, to 75 and 81 respectively. This was a major public health victory, but one that is now under threat.

In fact, there is credible evidence that on current trends the life expectancy of an Australian child alive now will fall two years by the time he or she turns 20.1 This is symptomatic of a new phase in a global trend we call the epidemiological transition, which means that for the first time in history more people are dying of non-communicable than communicable diseases. The rising killers today are not smallpox, malaria or polio, but rather ‘lifestyle’ diseases such as type-2 diabetes or heart disease.

If we don’t stop this rise we will face what Professor Mike Daube of the Public Health Advocacy Institute has called a ‘public catastrophe’. A few simple figures tell the story: the Commonwealth Government currently spends about 15 per cent of the Budget on health – which is around 4 per cent of GDP. The Third Intergenerational Report in 2010 predicted that number to rise to 26 per cent by 2050 – or around 7 per cent of GDP. For the states – which undertake the bulk of health spending – the story gets far worse, and far more quickly. In just the next decade, as GST revenues Insights Melbourne Business and Economics

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grow by around 4.5 per cent annually, health expenditure growth will be almost double that rate.

While these statistics are disturbing, no number can ever fully capture the human cost. I remember being told in my first year as premier that in the previous 12 months, 847 Victorians had had a lower limb amputated because of diabetes.

Then there are the heart attacks, strokes, kidney failure and blindness that can also result from this vicious disease.

Something must be done, and if the history of public health in Victoria has taught us anything, it’s that prevention works. VicHealth, set up by the Cain Government in the 1980s, was the first health promotion body in the world to be funded by a tax on tobacco, and it helped get the rate of smoking in Australia down to around 15 per cent from somewhere in the high sixties. In 1989 the Cain Government set the TAC a brief to ‘upset, outrage and appal Victorian drivers’, and the resulting series of ad campaigns contributed to a fall in the Victorian road toll from 776 people in 1989 to 287 last year.

In 2009 our Government launched WorkHealth, which aims to offer Victoria’s 2.6 million busy workers a free, confidential health check in the workplace. Armed with the information from a 15-minute consultation, people can make simple changes to their lifestyle in order to feel better immediately, and protect themselves from devastating problems later on. The early results from WorkHealth are both concerning – they show, for example, that three quarters of men are at medium to high risk of developing diabetes – but also reassuring, as with the right advice and early action, health can be improved and lives saved.

At a time when Australia is debating ways of lifting productivity, it makes sense to identify the low hanging fruit in this national effort.

A business that is proactive in the face of the epidemiological transition will have happier and healthier workers, greater productivity and lower sick leave costs. KPMG’s health and wellbeing program, for example, which covers around 5000 workers, has an estimated return on investment of $2.3 million over two years, based on fewer absences and improved productivity.

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Geopolitical transition The rise of lifestyle diseases affects developing countries, too. In China, for example, 80 per cent of deaths and disability are now caused by chronic disease. Here, we see the epidemiological transition feeding into the geopolitical transition.

Soon after Labor won office in Victoria in 1999, I spoke to a large business audience in Melbourne and made a bold prediction: within a few short years China would be Victoria’s single largest trading partner. I remember a number of people telling me afterwards that I had my figures wrong – that it couldn’t possibly happen that quickly.

But it did, in 2006. Things move fast when it comes to China.

Today, as Dr Ken Henry completes his ‘Australia in the Asian Century’ whitepaper, no-one is in any real doubt that Australia must engage, and engage closely, with China. But the real question now is: will we engage with the China of yesterday, or the China of tomorrow?

We’re familiar with the story of modern China: almost 10 per cent growth per annum for over 30 years; 500 million people lifted out of poverty; and low global inflation at a time of high global growth, thanks to massive reductions in the real costs of consumer goods.

But I believe the next chapter of the story will be about innovation. China is determined to avoid the ‘middle income trap’, in which developing countries, relying on low cost labour and existing technologies, hit a wall in terms of productivity growth. China knows that the way out of the trap is innovation. Dr Ken Shao of Murdoch University recently pointed out that when China had the strongest economy in the world in the early nineteenth century (a position which they will soon hold once again) their growth was in fact driven by innovation – in the form of silk and porcelain, as well as printing, papermaking, the compass and gunpowder.

Consequently, we are now seeing what the Australia China Business Council has called ‘the largest investment in research and development in human history.’ Again, the numbers tell the story: China’s twelfth five-year plan aims to increase total

R&D spending to 2.2 per cent of GDP by 2015. In 2010 they were at 1.75 per cent – or $105 billion – which means that in the next 18 months, China’s R&D spend will increase by more than the total amount Australia spends on R&D each year.

Last year China became the world’s top nation for domestic patent applications, surpassing both the US and Japan. And the World Intellectual Property Organisation records that in 2011 international patent applications from China rose by 33.4 per cent on the previous year – by far the largest increase of any nation.

So what does all this mean for Australia?

First, it means we must bring down barriers to trade, both visible and invisible – or we risk settling for second-best technologies, second-best solutions, and a second rate economy.

Second, we must welcome Chinese investment.

KPMG predicts between US$1 trillion and US$2 trillion of Chinese investment will head overseas between now and 2020. Commencing 2012, China had directly invested just $13.4 billion in Australia. To put that in perspective, the equivalent US amount was over $122 billion.

Those who would question the desirability of Chinese investment need to remember the

following facts: Australia has almost always been a net importer of capital. Estimates of our current infrastructure deficit range from $250 billion to $700 billion. Some estimate that we will require $200 billion of investment in resources and energy infrastructure alone by 2030. We have a growing and ageing population, strong competition for jobs and industries from overseas, and an urgent need to lift productivity.

The fact is that China is no longer just a demand sink for resources, nor just one of the world’s cheap manufacturers. They are a growing source of the capital we need to secure Australia’s prosperity and security.

Third, Australia must seek new partnerships with the new China – which brings me to the next global transition, which is technological.

Technological transition A group of scientists at the Australian Regenerative Medicine Institute at Monash University are attempting to rebuild damaged muscles in zebrafish whose cells detach when their muscles contract. These researchers were the first in the world to discover that zebrafish could be used as a model for Muscular Dystrophy. About one in every 3600 boys born in the world today

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will develop Duchenne Muscular Dystrophy – a muscle wasting disease that causes massive debilitation and early death, with no known cure.

This is just one of many examples of high-level research occurring right now in Victoria that has the potential to change many thousands – even millions – of lives for the better.

When our Government came to office we reflected on the fact that just as the world had been transformed by the agricultural, industrial and information revolutions, so we were on the verge of yet another revolution when it came to biotechnology and the life sciences.

We also believed that the best place to be in a revolution is out in front, which is why we invested so heavily in institutions such as the Walter and Eliza Hall Institute, the Melbourne Brain Centre, the Biosciences Research Centre at Latrobe, and Bio21; as well as the new Comprehensive Cancer Centre, the IBM Blue Gene Supercomputer, and the Australian Synchrotron. In fact, we set a goal that by 2010 Melbourne would be one of the top five biotechnology hubs in the world – and on a number of measures, we achieved that goal, with Fortune magazine naming Melbourne one of their top 15 ‘new cities for business’, specifically citing our biotechnology strengths.

Beyond biotech, of course, the possibilities in IT are also increasing rapidly. The number of internet users in the world has doubled in the last five years. In 2008 the number of internet connected devices surpassed the number of people on earth – and by 2020, there will be 50 billion such devices.

As the NBN is rolling out we are starting to glimpse the possibilities that lie ahead: our vast continent will be connected in previously unheard of ways; the distinction between rural and urban will flatten; older and disabled Australians will be able to stay in their own homes longer thanks to remote telehealth monitoring; and productivity will rise as businesses discover creative ways of employing the new technology.

So what does leadership look like at a time of rapid technological advance?

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I believe that now is the time to leverage our significant strengths in science, technology and innovation by forging new partnerships with emerging centres of innovation like China. We have a high level of expertise, passionate scientists, great universities and research centres, and excellent scientific infrastructure – all of which can be used to leverage some of China’s unprecedented R&D spend. After all, General Electric’s 2011 Global Innovation Barometer suggests that 40 per cent of innovation in the next decade will happen in collaboration across borders.

There are some positive steps already being taken in this area: the University of Wollongong is developing a 33-hectare ‘innovation campus’ dedicated to partnerships between research and industry – along with a full-time team seeking new partnerships in China. Monash University recently became the first Australian university licensed to operate in China. They’ll soon enrol their first cohort of postgraduates at a new facility near Shanghai. When I was Premier in 2010, Huawei Technologies – whose Australian Board I joined last year – signed a Memorandum of Understanding with the Institute for a Broadband Enabled Society at the University of Melbourne.

But there is potential for much, much more. Last year IBM opened their new R&D laboratory at the University of Melbourne. It will employ 150 researchers over the next five years. This is a major coup for the University and for Victoria; and it is exactly the kind and scale of partnership we should now be exploring with Chinese companies.

Another area ripe for partnerships is that of clean energy – which brings me to the final transition I want to discuss, which is environmental.

Environmental transition According to Bloomberg New Energy Finance, there was $257 billion of new investment in renewable energy across the world last year – up 93 per cent on the total for 2007, the year before the GFC. The fact is that while Australia argues about climate change, the world is moving. China, for example, knows from experience that it simply must grow greener and cleaner. Over the last

10 years, environmental degradation and depletion cost them 10 per cent of GDP. It’s no wonder they have doubled their wind power capacity every year since 2005, and are now the world’s largest manufacturer of solar panels.

unprecedented – but so is the speed and scale of technological advance, with more international patent applications filed each year than ever before.

Our Government introduced the nation’s most ambitious emissions reduction target for Victoria, as well as Australia’s first mandatory renewable energy and energy efficiency targets, because we wanted to create an environment in which innovation could occur, and new technologies emerge.

– Helping workforces, entire communities and even nations improve their health and wellbeing proactively rather than reactively – which is vital for productivity growth, personal wellbeing, and government fiscal balance;

That’s also why I have been a strong supporter of the Gillard Government’s decision to put a price on carbon. The opponents of carbon pricing have ignored the opportunities presented by the emerging global green economy – a clear case of looking backwards rather than seeing round corners. Smart business leaders have been preparing for a price on carbon for many months, if not years – and are already seeing the benefits in terms of lower costs and energy savings.

If leadership is about ‘seeing round corners’, then leadership today means:

– Engaging in a creative and open way with a rising China – which is vital for driving new economic growth through foreign direct investment, trade in services, and new R&D; and – Working both smarter and cleaner as technology advances and the world responds to climate change – which again is vital to driving productivity growth, improving liveability, and repositioning the Australian economy post the resources boom.

As Premier in 2009 I visited a Victorian company, Ceramic Fuel Cells Ltd (CFC), to launch their new ‘Bluegen’ unit. The Bluegen is a power station for a single household. About the size of a washing machine, it converts natural gas to electricity and heat via fuel cells. It’s being taken up all over the world – in fact, this year Ceramic’s revenue increased by 75 per cent.

Forward thinking leadership is required from the smallest start-up to the oldest established company – and from all levels of government, the public sector and indeed the entire community. Seeing round corners today will result in an Australia able to shape its own future, and to decide where we want to be in the years and decades to come.

As a CSIRO spin-off company, CFC is a great example of a forward-thinking collaboration between science and industry, carving out their future in the midst of a global transition to a cleaner economy.

The Hon. John Brumby was Premier of Victoria during 2007–2010 after earlier serving as Treasurer for over 10 years.

Among the varied board and advisory positions he now holds, he is an independent director of Huawei Technologies (Australia) Pty Ltd.

Conclusion It is important to note that each of these transitions – epidemiological, geopolitical, technological and environmental – are linked.

Epidemiological changes place new urgency on the work of medical researchers who are trying to find solutions to diabetes and heart disease using stem-cell and other new technologies. The rise of China shifts the technological revolution eastwards, but also sees millions more at risk of chronic disease. The threat of climate change is

1 Holman C and Smith F, ‘Implications of the obesity epidemic for the life expectancy of Australians’ (Report to the Western Australian Institute for Public Health Advocacy, 2008)

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Article heading here

fraud in australia Simple greed and the opportunity to live beyond one’s normal lifestyle are the primary motivations for fraud by colin ferguson

An edited version of a presentation to the Faculty’s Alumni Master Class series on 21 September 2011.

With so many pressures on the bottom line in today’s fraught business world, companies cannot afford to face the high cost of fraud. Yet, as the recent Fraud and Misconduct Survey (2010) shows, it is a serious issue in Australia and New Zealand – and it is proving a significant cost to business.

The Fraud and Misconduct Survey was undertaken by financial services firm KPMG in conjunction with staff from the Department of Accounting at the University of Melbourne. This biennial survey, which dates back to the early 1990s, is comprised of a questionnaire sent to Australasian firms of different sizes across a wide range of industries.

The 2010 results – based on the responses of 214 firms – highlight the extent of fraud in Australia and New Zealand. The report profiles the main perpetrators and the motivations for their dishonesty, identifies how frauds were eventually discovered, and highlights the main factors that allowed fraud to occur.

Corporate Australia needs to be aware of the incidence and magnitude of fraud, particularly because of its impact on company net incomes.

Losses through fraud reduce net income (not revenue) directly, and it takes significantly more revenue to recover the effect of fraud on net income than the ‘cost’ of the fraud itself. For example, a company with a variable profit margin of 40 per cent that discovers a fraud loss of $400,000

needs to generate extra revenue of $1 million just to achieve the aggregate profit that would have been earned in the absence of fraud.

Definition of fraud While a definition of fraud does not exist in the criminal code in Australia, the Australian Fraud and Corruption Control standard defines fraud as: A dishonest activity causing actual or potential financial loss to any person or entity including theft of moneys or other property by employees or persons external to the entity and whether or not deception is used at the time, immediately before or immediately following the activity. This also includes the deliberate falsification, concealment, destruction or use of falsified documentation used or intended for use for a normal business purpose or the improper use of information or position.

In essence, the key elements of a fraud include a representation about a material point which is false and intentionally so, which is believed and acted upon by the victim to the victim’s damage.

The Fraud and Misconduct Survey focuses primarily on ‘misappropriation of assets’ fraud. Wells’ taxonomy of organisational fraud describes misappropriation of assets fraud as the theft or Insights Melbourne Business and Economics

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misuse of an organisation’s assets via, for example, stealing cash or inventory, falsifying payroll records to create ‘ghost’ workers, and ‘skimming’ revenues.

underlying incidence of fraud, respondents believe that only one-third of total losses due to fraud are being detected.

Extent of fraud

Figure 1: Fraud and firm size

So, what is the state of misappropriation of asset fraud in Australia? Analysis of the responses to the 2010 KPMG survey strongly suggest that fraud is a significant economic problem in Australia (and, for that matter, internationally). Fifty-three per cent of all respondents reported incidences of fraud in their organisations. Figure 1 shows that the larger the organisation, the more likely it is that fraud will occur. In firms with less than 100 employees, only 30 per cent experienced fraud.

Some 75 per cent of organisations with over 500 employees reported experiences of fraud, while the comparable rate for firms with more than 10,000 employees was 86 per cent. The average loss from fraud in each organisation amounted to $3 million and, on average, there were 813 frauds per organisation. Asked to estimate the extent to which detected fraud represented the total

100%

Fraud in Australia

26%

21%

14%

80%

70%

69%

60%

74%

40% 20% 0%

30%

79%

86%

31%

Less than 100 101-500 501-1,000 1,001-10,000 More than

10,000 % experiencing fraud % not experiencing fraud

Source: KPMG Australia 2010

These results highlight the fact that it is much more difficult and costly to build and maintain adequate control systems and processes in large complex organisations compared with smaller organisations. Against this background, it is

clearly very important that large firms develop and maintain strong corporate governance systems that ensure continual monitoring and testing of business processes, to better withstand attempts by potential fraudsters to circumvent them. While it may appear costly for organisations to undertake this monitoring and testing, it is important to remember the bottom-line impact of fraud in organisations.

The underlying real rate of fraud strongly supports the notion that fraud has a significant impact on the profitability of organisations and consequently on the economy generally. For example, if fraud in the corporate sector approximated zero during the period of the Global Financial Crisis (GFC), the negative impact on superannuation funds would have been significantly lower. Self-funded retirees would likely have been much less affected by the GFC. Is fraud a major problem in Australia? Figure 2 below provides some interesting results when this question is posed. While 75 per cent of respondents agree that it is a problem generally for business and over 50 per cent believe it is a problem for the industry they are in, most don’t believe it is a problem for their organisation. These results strongly suggest that many organisations are in denial about what the real effect of fraud might be for them. This attitude could well be seen as one of the main reasons why we have seen no significant reduction in the rate of misappropriation of asset fraud in Australia over the last decade.

The Fraud and Misconduct Survey identifies the financial services sector as being the most vulnerable to fraudulent behaviour. While overall, the most common type of fraud within an organisation is the theft of cash or inventories, banks and insurance companies are the organisations that feel the greatest financial effects of fraud. For banks, credit card fraud (a form of identity fraud) poses the greatest challenge, whereas in the insurance industry, false claims for motor vehicle accidents and for general insurance incidents are the biggest concerns.

Figure 3: Fraud perpetrator by value 100%

8% 7%

80% 60%

43% 84%

20%

85%

40% 20%

2%

37%

14% 0%

Financial and insurance organisations Management

Non-financial organisations Non-management

Public sector organisations External parties

Source: KPMG Australia 2010

Figure 4: Fraud perpetrator by number of incidents 100%

12%

80% 60%

Figure 2: Is fraud a major problem?

99%

98%

1%

2%

62%

40%

100%

20%

35%

80%

18%

40%

20%

19%

0%

68%

24%

48%

25%

Problem for Australia/NZ Agree

Financial and insurance organisations* Management

47% 20%

33%

12%

51%

60%

0%

Industry factors

Non-financial organisations* Non-management

26% Public sector organisations External parties

* Fraud incidents by management totalled less than 1 per cent

Source: KPMG Australia 2010 Problem for my industry

Problem for my organistaion

Neither agree / disagree

Source: KPMG Australia 2010

Inevitable cost of doing business

Disagree

Consistent with these observations, Figures 3 and 4 clearly show that external parties are responsible for the overwhelming majority of frauds in the Insights Melbourne Business and Economics

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financial services and insurance sectors. However, we can also see that while management commit frauds that are the most costly to organisations in the public sector (Figure 3), non-managerial employees are involved in most frauds in these organisations (Figure 4). These results suggest again that an organisation’s controls and processes should be the continual focus for management with a view to ensuring that a firm’s transactions are complete, valid, and accurate.

Figure 5: Major fraud motivators

Identity of fraudsters

Source: KPMG Australia 2010

So, who are the people that commit fraud within organisations? An analysis of the responses to the Fraud and Misconduct Survey provides us with a profile of the typical fraudster in Australia. He is a male non-management employee who acts alone with no known history of dishonesty. He is 38 years of age, earns around $113,000 per annum, will have been employed by the organisation for a period of five years and held his current position for three years at the time of detection. Typically, he steals $229,000 and will be detected by the organisation’s internal control system some 12 months after the commencement of the fraud.

Motivation for fraud A range of factors motivate fraud as shown by Figure 5.

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Fraud in Australia

Corporate financial pressure

0.19%

Substance abuse

0.25%

Other

1.69%

Gambling

2.09%

Personal financial pressure

3.07%

Greed / lifestyle

92.71% 0%

20%

40%

60%

80%

100%

These results may run counter to expectations and are explained by the context of the survey – that is, workplace fraud perpetrated against employers.

Substance abuse is associated with much petty crime and anti-social behaviour, while problem gambling can devastate personal and household budgets, but as causes of workplace fraud, their incidence is relatively minor. Much more typical is the lower- or middle-ranking employee who takes advantage of weak control systems to misappropriate funds to purchase prestige cars, indulge in expensive holidays or spend heavily on big-ticket consumer items. Simple greed and the opportunity to live beyond one’s normal lifestyle (until detection occurs) are the primary motivations for fraud.

Figure 6: Factors allowing major frauds to occur 1%

Poor ethical culture

5% 2%

Poor hiring practices

3% 3%

Collusion between internal parties Poor physical security

5% 4% 0%

Lack of accountability Risks peculiar to the industry Collusion between employees and third parties Other

5%

9% 8% 11% 11% 9%

2008 12% 11%

2010 22% 22%

Override of internal controls

32%

Poor internal controls

26%

0% 5% 10% 15% 20% 25% 30% 35%

Source: KPMG Australia 2010

How do frauds occur?

Figure 6 shows quite clearly that the greatest continual threat to an organisation from potential fraudsters (and this applies equally to internal and external parties) is through the overriding of internal controls that are in place and/or through the complete lack of adequate internal controls.

These results, while disturbing to organisations, suggest that there is a remedy, and one that is not necessarily costly or complicated. That remedy is for organisations to develop, implement and, most importantly, monitor and maintain strong internal controls that ensure that there are few opportunities available for potential fraudsters.

Conclusion Analysis of the results from recent years’ KPMG Fraud Survey data consistently shows that misappropriation of asset fraud is a serious problem for organisations in Australia. This type of fraud has a significant impact on corporate profits. Most fraud in financial and insurance organisations is perpetrated by external parties; while for other organisations most fraud is committed internally by male employees exploiting poor control systems

to fund excessive lifestyle needs. The single most important step an organisation can take to reduce the risk of fraud is to build and maintain strong internal control systems.

Colin Ferguson is Professor of Business Information Systems at the University of Melbourne.

References KPMG 2010, Fraud and Misconduct Survey, Australia and New Zealand.

Standards Australia. 2008, Fraud and Corruption Control (AS 8001–2008).

Wells, JT 2005, Principles of Fraud Examination, John Wiley, Hoboken, NJ.

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Article heading here

fraud, ethics and corporate governance There is a growing sense that some of those at the top of this country’s largest corporations sometimes engage in less than exemplary conduct by dean newlan

An edited version of a presentation to the Faculty’s Alumni Master Class series on 21 September 2011.

There has been much discussion in the financial media in recent years about the conduct of senior figures in the Australian corporate scene. Barely a week goes by without some new exposé of corporate misconduct at very senior levels.

There is growing concern about these individuals’ behaviour. They are people who should be setting an example for others to follow – and yet they sometimes engage in conduct that is less than exemplary. In an all too familiar scenario, the conduct of a few taints the reputation of many.

Drivers of corporate misconduct While it is true that there has been increased discussion of this topic, a lingering problem is that the discussion focuses almost exclusively on the behaviours themselves and not on the underlying causes. Rarely, it seems, is there a consideration of what sits behind questionable executive conduct – in other words, the factors that drive those behaviours. Instead, pronouncements of corporate or personal ‘greed’ are made and we all move on shaking our heads, chalking up yet more instances of corporate excess which are becoming increasingly typical of the modern commercial world. One of the most worrying aspects of the problem is the desensitisation of the Australian business community and, for that matter, the population generally, to behaviours which we inherently know are ‘probably’ wrong.

In reflecting on these and related issues, it is important to distinguish between: – Behaviours where the perpetrators directly benefit from the misconduct, for example, where senior managers award themselves bonuses and remuneration increases that are not linked to the financial performance of the business, or who divert business to other entities in which they hold interests; and – Behaviours where the authors believe they are acting for the benefit of other parties, typically the businesses they control and, by extension, the owners of those businesses.

Rather than embarking on a further discussion of the behaviours themselves, I intend to consider the forces driving senior business people to engage in ‘wrong’ behaviours for the ‘right’ reasons. Having noted the distinction between the two categories (self-benefit behaviours as distinct from behaviours that are intended to benefit organisations), it is arguable that there is overlap between the two – senior executives may engage in behaviours that ostensibly benefit their organisations but which, in the end, benefit themselves as well through performance bonuses, increased value of personally held shares or perhaps even just keeping their jobs.

The role of the company executive/director has undergone steady change over the last 20 to 30 years. Things have moved far beyond the way they were – when directors or senior executives Insights Melbourne Business and Economics

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were appointed to companies by reason only of their connections, when shareholders’ were only interested in their companies’ annual reports, and when the regulatory framework was passive by modern standards. Now, shareholders demand much more of their directors and executives than previously – and these senior figures are only too aware of these expectations. Moreover, they are only too familiar with the fate that awaits executives of underperforming businesses or divisions.

More than ever, the question of business viability looms large in the minds of modern directors and senior managers. Being in ‘survival mode’ can cause business people to behave in ways they would not have thought possible of themselves. In the pursuit of revenue and profit growth, Australian firms have become increasingly aggressive and have expanded into foreign markets in ways that they would not have contemplated even 20 years ago. Technology is also changing the business landscape. Some industry sectors are shrinking rapidly, others are disappearing altogether, while still others are experiencing exponential growth.

This puts pressure on managers and directors to deliver superior financial performance in an ever-changing business landscape just to meet, let alone exceed, shareholder expectations. At the same time, the expectations of shareholders and market analysts are focused on the delivery of profitability and efficiency targets within shortening time horizons.

Overlaying all of this, directors and managers need to somehow navigate a regulatory patchwork under the watchful eye of ASIC, APRA, ACCC and an ever-vigilant media sector. Recent legal decisions have also imposed more-exacting accountabilities on directors in terms of understanding and questioning the financial information that is placed before boards.

All of these developments create pressure on organisations, their businesses, and the individuals with operational control of those businesses. These pressures can and do cause business people to respond in a variety of ways – some of which are foreign to their own principles and the espoused principles of their organisations. Here are just a few examples of what can go awry.

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Fraud, ethics and corporate governance

– Companies that have made strategic decisions to operate off-shore can find that business is conducted very differently in these new locations and markets. Directors and managers can become tempted to pay bribes to foreign officials or to private-sector business partners having convinced themselves that this is ‘the only way’ to operate in those places.

– Companies that are not meeting performance targets that have been disclosed to the market under Australia’s continuous-disclosure regime may be tempted to bring forward revenues that should really be recognised in the next financial year.

– A building contractor facing increasing revenue pressures in a struggling construction sector might be tempted to bribe someone on the inside of a potential client or even on the inside of another tenderer to get confidential bid information to ensure the success of its own bid.

– A senior executive of a struggling retailer facing increasing competition from online operators might be tempted to launch a ‘denial of service attack’ on someone else’s website.

– A take-over offer that would deliver shareholders an above market return is rejected by the board without proper due diligence leaving shareholders to wonder whether self-interest played a role in the decision.

These examples are not just the stuff of an overactive imagination – they have all happened in our own backyard and at the instigation of members of the senior echelons of some of this country’s largest corporations.

While business and governance pressures do not excuse aberrant behaviour, they do go partway to explaining it. Desperate business people who find themselves in desperate situations can take desperate actions in ways they wouldn’t contemplate in more normal circumstances. In most cases they know that what they are doing is wrong and frequently illegal, or bordering on illegal, but they do it all the same because they feel a need to do the ‘right thing’ by their shareholders. Having found themselves with such choices and committing to certain courses of action, however, business people will reflect

on their conduct and then correctly conclude that what they are about to do is wrong or could be wrong. This will usually lead to a period of ‘rationalisation’ or ‘normalisation’ of the conduct during which the managers will be able, often with some mental gymnastics, to justify their behaviour with arguments such as: – ‘It’s Okay because everyone else is doing this’; – ‘We can’t compete if we don’t do this’; or – ‘If I am doing this, it can’t be wrong because I don’t do the wrong thing’.

In many cases, senior managers will actually feel a responsibility to engage in questionable behaviours and come to the view that they are failing in their duty to the company and its owners if they don’t.

Some might question whether harm really does arise from these kinds of behaviours where the objective is to increase market share, boost profits or even save underperforming businesses, and where those

objectives are likely to be achieved as a result.

Yet there is no question that real harm is done when senior managers engage in aberrant behaviour. This harm manifests itself at a number of levels: – Unwanted regulatory attention is likely to be given to these organisations, resulting in significant distraction of management time and effort and diversion from profit-generating activity; – The reputation with customers and suppliers is materially impacted, resulting in business being referred elsewhere; – Financiers, concerned about being associated with such entities, may be less willing to provide finance; and – Public confidence in equity markets generally can be tainted with a consequent reduction in willingness to invest, risking diminutions in shareholder value.

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Legislation designed to control corporate misconduct is, of course, becoming increasingly prescriptive in response to perceptions of a growing trend in these behaviours. But often, the legislative option only ‘kicks in’ after the damage has been done. Generally, it is cumbersome and tedious.

So, what is the answer? How can organisations guard against the outcomes outlined above? The solutions begin and end with the organisations themselves.

Leadership values Business cannot rely on the legislative framework.

Chairs, boards and senior managers need to show leadership. They need to do more than make positive statements about organisational values – they need to demonstrate that their organisation lives those values. The people who make up every organisation, large or small, look to their leaders to set the objectives of the organisation and to develop and implement the strategies by which those objectives will be achieved. It is a natural human trait that people tend to observe and then adopt the behaviours of their leaders.

Organisations which engage in questionable business practices will tend to attract and retain people who have no difficulty with those practices and so the problems become self-perpetuating.

The examples set by those in the upper reaches of organisational structures are, therefore, the most important element of any program to prevent aberrant corporate behaviour. Well-drafted statements of corporate values and robust codes of conduct, no matter how well communicated, will not by themselves change behaviours. The senior people in any business need to establish the organisation’s own business principles, its own corporate ethos – and then put in place a program to infuse those principles throughout the organisation. They need to ensure that everyone within the organisation understands and embraces these principles and agrees to abide by them. Most importantly, they need to demonstrate that they themselves, as the organisation’s guiding hands, adhere to those principles in everything they do, not just most of the time or some of the time when it is particularly important – but all of the time.

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Fraud, ethics and corporate governance

In organisations which get this right, the behaviour of the remainder of the staff and, ultimately, the perception of the wider community follows.

In addition, organisations can look to incentivise their senior teams in ways that will drive desired behaviours by setting organisational goals that align with organisational principles. Incentive systems that reward short-term profitability driven by opportunistic cost cutting and underinvestment in required capacity, will achieve short-term gains but to the long-term detriment of these business and shareholder value.

Independent directors Finally, the wisdom that independent directors can bring to organisations is often overlooked.

Australian companies need to embrace the role of independent directors who have real voices and who can promote real debate in boardrooms about the way in which companies conduct their businesses.

A former member of the Victoria Police, Dean Newlan is a partner in specialist insolvency and forensic firm, McGrathNicol.

occasional address

learning and living go together The world will change and challenge you as an individual and cause you to draw upon all your resources – particularly the skills you have developed through your education by margaret jackson

An edited version of her Occasional Address given at Wilson Hall, the University of Melbourne, on 13th December 2011.

From where I stand now, on the stage of Wilson Hall, I think I have one of the best views in Australia. I see before me a host of achievers – graduands who have set high goals for themselves and who have dealt with personal challenges along the way. Each of you graduating today can take great pride in your achievement. Well done to you all.

It takes a lot to get to this point. At the back of this Hall, I see the personal support systems – the mums and dads, husbands and wives, brothers, sisters, friends, children; infrastructures of love, sacrifice and enduring support.

On the podium are the academic staff – the teachers who have encouraged learning and imparted knowledge. They have changed the lives of those who passed through Melbourne University and helped all of you who are graduating today.

There are approximately 300 graduates from the Faculty of Business and Economics, as well as PhD graduates in a variety of disciplines receiving awards today. Such commitment to quality is an outstanding achievement for each graduate and must be a source of rejoicing to us all.

As for the University of Melbourne itself, it is a vital and unique Australian institution in a free society. It is a pre-eminent intellectual nervecentre of our nation, a place which unashamedly encourages excellence.

In life beyond the University, you will move beyond these sources of support. The world will change and challenge you as an individual and cause you to draw upon all your resources – the values you grew up with in your families and the skills you have developed through your education.

Yet you will still be confronted by things you don’t understand, and you will certainly need courage to stand up to them.

I am reminded of myself sitting in this hall on my graduation day almost 35 years ago. I was excited by life and wondered what it would hold. Looking back, I can see the things that made a difference.

I always invested and built skills for tomorrow, not just for today. I tried to anticipate change and prepare myself for it. I always contributed to my community and always tried to help those who were following me, just as I learnt from those who came before me.

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I have found that the learning never stops. Learning and living go together. Our lives are changed by our learning and our learning is shaped by our life situation. Each lends support to the other, each dignifies and civilises the other.

As you go out into the world, remember this: the golden opportunity you are seeking is in yourself.

It is not in your environment, it is not in luck, or chance, or the help of others. It is in yourself alone. Inside everyone is a special you. Go find it in yourself. Live it. Be it.

The world is changing. Every day there’s something new to deal with – new challenges, new opportunities, new knowledge, new sciences and technologies, new ideas. You will need to embrace change, anticipate it, prepare for it and be adaptable to survive as change occurs. Sometimes things go wrong and the universe can make you feel very small indeed. This has been proven time and time again over recent years as we deal with global economic and environmental problems, further complicated in the last few months by the economic, financial and political challenges of Europe.

All of these challenges will show that each of us has a tremendous capacity to make a difference. But to do that you will have to find that special you and understand your own special gifts. Discover this, and you can change the world.

My friend and fellow University of Melbourne alumnus, Simon McKeon, was made Australian of the Year this year. About 10 years ago Simon was diagnosed with multiple sclerosis. This was not how he expected his life to unfold. Simon could have retired. Instead, he went to undertake part-time employment in the corporate world and became a working crusader for the philanthropic sector – and managed to hold the world speed sailing record for 11 years whilst he was at it.

Simon has never stopped making a difference.

As you make the most of your own life, acquiring further knowledge and wisdom, you will have a greater opportunity to help those that follow you.

I can also say without hesitation that effort spent in constructively and sensitively helping people less fortunate than yourselves will bring you great personal rewards.

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Learning and living go together

Each of you has broadened your base for life during your time at the University of Melbourne, building on your times at school and all you have learnt from your families and friends.

Whether success lies in material, social or spiritual achievements, you now have the means to make the choices that will deliver this success to you. You are on the path of finding, creating and fulfilling the special you.

Eleanor Roosevelt once said, ‘the future belongs to those who believe in the beauty of their dreams’.

Long may you all dream. Long may you believe, and most of all, may you all achieve your dreams.

Originally a chartered accountant, Margaret Jackson, AC, has held multiple board appointments in the corporate and public sectors, including the chairmanship of Qantas during 2000–2007.

the power of relationships – an anchor in uncertain times The world will change and challenge you as an individual and cause you to draw upon all your resources – particularly the skills you have developed through your education by christian bennett

An edited version of his Occasional Address given at Wilson Hall, the University of Melbourne, on 6 August 2012.

Today confers an indelible stamp on your identity – that you are someone with high potential. The day carries, therefore, both reward and expectation.

Of these suggestions, it is the third – relationships – on which I will focus; although the others will get some attention.

I was reminded recently that George C Marshall used his 1947 address to the graduating class of Harvard to outline his plan to rebuild Europe – the Marshall Plan. A few years prior, in 1941, Winston Churchill implored the graduating class of Harrow to ‘never, never give in’.

On the first point, it is unreasonable to ask those fresh out of university to write their life KPIs. There is far too much yet to learn. But keeping the long-term in mind remains an important point to make in a world where short-term thinking is increasingly dominant. As Lewis Carroll observed, ‘If you don’t know where you are going, any road will get you there’. As you develop your career and explore the world, what makes you tick will become increasingly apparent. It may confirm what you already know. It may lead to something very new. Whatever it is, keep a line of sight to the horizon – do what makes you passionate, aspire to do your best, and then do it.

I carry neither a modern day Marshall Plan – though it would be nice if someone had an economic plan for Europe – nor a profound battle cry. Rather, I have four simple suggestions based upon personal experience. I offer these as food for thought as you determine your own overarching philosophy and look to find a secure anchor around which to pivot in an era of profound change.

My suggestions are: – Keep the long-term in mind – what change do you want to inspire? What do you want to be remembered for?

– In everything you do, do it with absolute and unfettered integrity.

– Invest time and effort in face-to-face relationships at all levels – personal, community and professional.

– Incorporate global experience early into your career.

Regarding integrity, I take a very simple albeit uncompromising approach. You either have it or you don’t. You can’t have a bit. Integrity is the foundation of your reputation – something hard earned, easily lost. I measure integrity by benchmarking off the Customs and Quarantine Declaration forms when arriving into Australia.

If I were to ask a prospective employee whether they have ever knowingly signed a false declaration, and the answer were ‘yes’, that’s the end of the interview. On matters of integrity, you either play by the rules or you don’t. It is one thing to make Insights Melbourne Business and Economics

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a business mistake – it is part and parcel of career development and often a useful learning point. But as your career progresses, you will be increasingly confronted by complex, ethics-based decisions, many of which will not have the rules spelt out clearly on a form. Sometimes the low bar is the hardest to clear – and if you can’t clear that…

Strong face-to-face relationships are increasingly important in an era of rapid change in how we communicate and interact. By face-to-face, I mean relationships measured by personal interaction and the bond of trust. Not by the number of Facebook friends or LinkedIn connections. Faceto-face relationships are a bespoke mechanism to source and exchange advice and ideas, share emotions, and receive constructive criticism. They are integral to personal decision-making and the pursuit of success – not to mention happiness.

In a professional environment it is through these relationships that your academic knowledge translates most acutely into ideas, influence, leadership, outcomes and, hopefully, promotion.

Whether you are preparing spreadsheets, drafting reports or managing inventory levels – relationships will be the critical conductor of your professional reputation and links to your immediate environment and networks beyond. And the more networks in which you choose to participate, the more intense the rate of conductivity.

A famous Oxford personality and Warden of Wadham College, Sir Maurice Bowra, was once asked how he was appointed to the Wardenship.

His response was ‘just being around’. There is a great deal to be said for just being around. It’s what happens when, for example, you participate in community groups, in alumni events of this great University or professional associations linked to your employment. It means being physically seen – not just digitally read or heard.

Such relationships are especially important for those inevitable moments in a career when neither gut instinct nor personal judgment is enough.

Some of you may have already had to confront such moments. For others those moments are yet to come and they will be potentially traumatic.

Some will hold out great opportunity – a job offer overseas. Some will test your resilience and mental 60

The power of relationships – an anchor in uncertain times

discipline – retrenchment, missed promotion.

Some will catch you by surprise.

My surprise moment came seven years ago. It was a simple choice in the abstract – to commit to a career-for-life in what is a terrific career, the Australian foreign service, or forego that 14-year investment by starting afresh and unproven in the private sector. Without knowing it at the time, I consulted a group that today I refer to as my personal Board of Directors. This group includes two mentors within the Department – both seasoned diplomats – and a small group outside my work environment, including a school mate and friend of my parents. Individually, they know what makes me tick just as I trust implicitly and respect their views. Only after carefully weighing up their advice to my question – ‘what would you do?’ – did a decision take shape.

Of course, the critical insight came from the most important relationship of all. My wife, knowing me better than any other, succinctly and accurately said, ‘For once in your life, leave a party while you are still enjoying it!’. It was some years later that I applied the term Board of Directors to that small group, which continues to provide 360 degree feedback to help interpret and navigate change.

The Board concept was first suggested to me by a former CEO for whom I worked and greatly respect. If you don’t already have one, I strongly recommend you get your own Board.

Earlier, I deliberately used the anchor metaphor.

For while an anchor represents great stability, an anchor allows a ship maneuverability as it responds to changes in wind direction. At a macro level the world is going through great change, from structural reform in the global economy to the inexorable rise of Asia through to the manner in which we communicate. I expect the winds of change only to blow harder. Detecting, let alone preparing, for change as part of our micro, or individual, outlook is hard given the demands of daily life.

Some changes take a century or more, limiting the impact on careers to an inter-generational timeframe. Not even the iconic is immune. The Federal Minister for Workplace Relations, Bill Shorten, has made the observation that in 1900,

for example, Australia had some 35,000 shearers and no registered personal trainers. Today, there are about 3,500 shearers and some 90,000 registered personal trainers.

But for you, I expect the pace of change will quicken, affecting intra-generational career choices, including what you do and where you do it. The ability to predict, analyse and respond to change will become increasingly important. If you agree with that hypothesis, putting in place today a framework within which to manage such change may be akin to another arrow in your quiver.

I would place face-to-face relationships – and your Board of Directors – at the heart of that framework.

But remember, face-to-face relationships require a daily investment of time and effort over years, if not decades. My concern is that as the world increasingly shifts from atoms to bytes, the value attributed to developing such relationships is inadvertently diminished.

I’m not for a moment suggesting the shift from a ‘bricks and mortar’ retail experience to online shopping, for example, is a bad thing. Far from it – just think about the enormous productivity gains from the rapid exchange of data and ideas provided by email and web-based applications.

Or how powerful it is that traditionally hard-todetect human rights violations in various corners of the world can now almost instantaneously be elevated into the global consciousness. And if only to bring a father’s face onto a screen when he finds himself regularly removed from the place he’d rather be – with his family.

My point is simply this – never overlook face-to-face relationships while immersed in the sea of digital communication. No information technology can replicate the intimacy and trust implicit in a firm handshake or a kiss on the cheek, the nuance of the spoken word, let alone a reassuring whisper, or the ability to visualise and interpret body language. The knowledge that flows through such relationships will help you detect the change in the breeze, position for your next tack and ensure the wind remains in your sails.

Finally, into that framework I encourage you to inject global experience. Many of you are doing it right now living here in Australia. International

experience gives you the opportunity to move beyond simple assumptions made from afar and to be more deliberate and informed. It enables you to harness a greater sense of objectivity and relativity than a purely domestic perspective allows. It will give you a more complete palette of experience from which to sketch what you stand for, and what you want to be.

The world is converging. The more you know about it, the more fulfilling your career will be. My experience in Africa, for example, had a significant impact on my outlook about justice, democracy and fairness and about the perils of opportunity squandered whenever politics and power trump policy. Walking through a school playground in Angola – while carefully following a narrow path because the yard was laced with landmines – sharpens a naïve mind about the capacity for human evil. Watching an invalid with deformed wrists and ankles crawl out of the woods to line up for hours in the hot Malawi sun so he can cast his vote in that country’s first democratic election, clenching his identity papers between his teeth, reminds one that nothing important is too difficult to fight for. Sitting in the White House Situation Room as plans to bring democratic choice to the people of East Timor are developed contradicts at times simplistic assumptions by some about the motives of a democratic superpower.

John F Kennedy once observed, ‘Too often we enjoy the comfort of opinion without the discomfort of thought’. Global experience is an excellent way to develop thought. Graduands, you are individually gifted and educated. Collectively, you represent so much potential. Over the years ahead, I look forward very much to hearing how the 2012 Graduate Class moves the needle on many fronts, securing prosperity and potential wherever you may call home. Most of all, I look forward to meeting you.

Congratulations and thank you.

Christian Bennett is a former Australian diplomat and now public affairs practitioner in the private sector.

Insights Melbourne Business and Economics

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Mailing Address: The Faculty of Business and Economics The University of Melbourne Victoria 3010 Australia Telephone: +61 3 8344 2166 Email: droller@unimelb.edu.au Internet: http://insights.unimelb.edu.au Published by the Faculty of Business and Economics, November 2012 Š The University of Melbourne Disclaimer Insights is published by the University of Melbourne for the Faculty of Business and Economics. Opinions published are not necessarily those of the publisher, printers or editors. The University of Melbourne does not accept responsibility for the accuracy of information contained in this journal. No part of this journal may be reproduced without the permission of the editors.