John Quiggin's Great Expectations:

Microeconomic reform and Australia.

A review article by Fred Gruen .

This is an important book. It's critique of microeconomic policy is rooted fairly and squarely in mainstream economic theory. This, of course, distinguishes it from a great many tirades against socalled 'economic rationalism'. It is also the first time an able and informed economist has attempted to challenge the current conventional wisdom in the Australian economic policy debate about the desirability of microeconomic reform.

While many Australian economists have studied individual issues associated with such reforms, these contributions are mostly scattered. This book represents the first overview of many key issues in the professional economic debate. This overview does not take place in a political vacuum. As Quiggin argues 'it is, perhaps, impossible to undertake policy analysis in a way that is completely free of ideological preconceptions' (64) .

Quiggins' particular view is that 'the policy elite displays a clear consensus that microeconomic reform is both urgently needed and beneficial (viii); the problem with the current Australian policy debate is not an excessive reliance on economics but the substitution of dogmatic precommitment for objective analysis (ix)'. Primarily, 'current economic policy is based on a combination of a priori theory and an emotional rejection of the policies of the 1950s and 1960s'.(5)

While we have had a good deal of root and branch criticisms of current economic policies by sociologists, political scientists and other social scientists, Quiggin tries to differentiate his critique from this literature: saying 'much criticism of current economic policy is based on nostalgia for the "good old days" of full employment and rapid growth without any clear analysis of what made those "good old days" possible (5)'.

The contention here will be that Quiggin is not wholly successful in differentiating himself from this literature; that he himself does not, in fact, succeed in providing a convincing analysis of what made those good old days possible, how we could return to them or whether they truly existed . On the other hand it will also be suggested that Quiggin scores some telling points in his critique of the current policy consensus.

(i) 'Great Expectations' : An Overview.

The first third of the book is devoted to an historical discussion of microeconomic reform in Australia and internationally, to an outline of the theoretical economic issues Quiggin regards as relevant and to the changing theories of government among mainstream economists--in particular the move from the public interest to the private interest approach to government.

This is followed by the main section of the book; 8 chapters discussing various types of microeconomic reform; dealing with financial deregulation, airline deregulation, telecommunications, tariff reform, privatisation and private infrastructure, competitive tendering and contracting and a relatively brief chapter on the Hilmer reforms.

Finally we have two concluding chapters, occupying about one-eighth of the total space. These attempt to assess the benefits and costs of microeconomic reform and make some final observations regarding competitiveness, choice, the intensification of work and the outlook for the future.

As Quiggin recognises, the most obvious omissions are labour market deregulation (which, he suggests, would require a different author) and changes in tax and welfare arrangements. Nevertheless Quiggin is justified in arguing that he has given us an overview of some of the most important issues which arise in assessing microeconomic reform.

(ii) Some key issues canvassed by Quiggin.

(a) What is the counterfactual?

To assess the effects of microeconomic reform, we have to attempt to ascertain what would happen in its absence. Even where microeconomic reform has already taken place, it is often not possible to provide a conclusive assessment of its effects. Quiggin provides this schematic example of what we should be measuring or assessing (203).

If there has been a steady increase in productivity before the introduction of microeconomic reform, the productivity gains attributed to the reform should be equal to A-B and not A-C, as has been suggested occasionally-- for instance by the Industry Commission in its assessment of the benefits of microeconomic reform of the postal system and Austel's ascribing all price reductions in telecommunications to the benefits of competition, whilst such reductions were a common feature even before any competition was introduced into the telecommunications industry.

In fact, the real world is usually not so simple that one can project past productivity (or price) trends and argue that this is what would have happened in the absence of some type of institutional reform. After all, mechanical projection of past trends is basically an admission of ignorance.

This is not to deny the validity of Quiggin's basic point: namely that it is necessary to examine what would have happened in the absence of some institutional change in order to assess what the likely effects of the institutional change under consideration are likely to be. Past changes in prices and/or productivity are obviously relevant; on the other hand, so is other suggestive evidence (such as international comparisons).On the whole, Quiggin seems reluctant to use international comparisons and tends towards too mechanical a use of projection of past trends .

In most cases it will not be possible to arrive at completely clear-cut quantitative assessments of the effects of an institutional change such as the introduction of microeconomic reform. We cannot usually conduct controlled experiments in the social sciences to settle such matters beyond reasonable doubt.

However, it would have been useful if Quiggin had made a couple of other important distinctions. For instance, under what conditions would one expect institutional changes to have primarily level effects with little or no effect on the longer term growth rate--as shown in Diagram B.

Thus one would expect the previous Labor Government's attempt to remove excess labour from the Australian waterfront in 1989 to have had primarily such level effects. As suggested later, those who regard trade liberalisation as primarily a resource allocation issue (as does Quiggin) should also believe that it primarily has level and not long run growth effects.

After the introduction of microeconomic reform there is often a period of heightened uncertainty and increased and unsustainable competitive pressure before those in the industry become familiar with the new rules and with what is now practical and profitable. Financial deregulation and airline deregulation (especially in the US) were typical examples where it took quite some time for the longer-term effects of microeconomic reform to become clearer.

Under these circumstances one might get stylised productivity changes as shown in Diagram C. A complete assessment of the effects of microeconomic reform should require an examination of both the transition and of the longer term effects of microeconomic reform.

(b) Shonky quantification.

The quantification of the benefits of microeconomic reform got off to a bad start when the first systematic program for microeconomic reform in Australia was presented in Australia at the Crossroads: Our Choices to the Year 2000 by Kasper, Blandy, Freebairn, Hocking and O'Neill. These authors contrasted two alternative paths which they called 'mercantilist' and 'libertarian'. The mercantilist path would produce a per capita GDP growth rate of 1.7 per cent per annum (over the period 1973 to 2000) whilst the libertarian path could be expected to more than double this (to 3.8 per cent per annum) implying a cumulative gain of 77 per cent relative to the base scenario. These relative figures were basically picked out of thin air, using selectively chosen international comparisons. Quiggin is kinder in saying they were based 'on judgement rather than formal modelling' (200).

Since then, of course, there has been a plethora of modelling of the effects of microeconomic reform, often using ORANI or other general equilibrium models. One problem with these models is that they require a large number of guestimates regarding the numerical values of many parameters which are used to grind out final numerical results of the effects of particular types of microeconomic reform. The most professional outside review of ORANI by Pagan and Shannon concluded about a decade ago 'The likely variation in parameter values is such that ORANI should always be subjected to some sensitivity analysis' (Pagan & Shannon 42, Economic Record March 1987).

To the best of my knowledge no sensitivity analysis using ORANI has been published by the many agencies cited by Quiggin who have used ORANI to examine the effects of microeconomic reform (such as the Bureau of Industry Economics, the Business Council of Australia or the Industry Commission) . This is despite the fact that at least the Industry Commission has drawn attention to 'the limitations of the model and the uncertainties of the data base' on one occasion when ORANI results clashed with its a priori expectations (209).

As a result, the estimated benefits from different types of micro-economic reform are subject to a very wide margin of error. For instance, the Industry Commission estimates the direct and final benefits of the Hilmer reforms at 2.3 and 5.5 per cent of GDP, whilst Qiggin's estimates are around 30 and 10 per cent of those respective gains (214). This reviewer is not in a position to adjudicate between these widely differing estimates; he suspects that the two estimates might represent upper and lower bounds.

One reason why I am inclined to treat Quiggin's estimates of the benefits of microeconomic reforms as lower bound estimates concerns his treatment of the gains from lowering tariffs and border protection generally. Here Quiggin relies on Harberger triangle estimates which suggest that a 40 per cent tariff is associated with a decline in GDP of around 1-3 per cent (134) . If tariff reduction is associated with an increased dispersion of rates (as it was in Australia from the mid-seventies to the early 1990s) tariff declines on average can even be associated with declines in GDP (137).

As argued recently by Nicholas Gruen(1996) 'From the late 1950s through till the 1970s, a variety of relatively new perspectives came to suggest that the allocative efficiencies at the heart of traditional economic analysis were only a part--and possibly quite a small part--of the productive benefits of market competition and trade. These perspectives raised the prospect that the greatest gains from trade liberalisation might come from X-efficiencies, scale economies, lower rent seeking expenditure and dynamic economies associated with knowledge creation through learning by doing and research and development (Abramovitz, 1956; Solow, 1957; Arrow, 1962; Leibenstein, 1966; Vernon, 1966; Krueger, 1974)'.

While Quiggin mentions the thesis that there may be both dynamic gains associated with the move to free trade and X-efficiency arguments, he tends to dismiss both (128-130), though, later, he is concerned that 'the extent of intra-industry trade remains a puzzle for trade theorists, and there is no general agreement on how it should be modelled' (138). Intra-industry trade is particularly relevant to the assessment of trade liberalisation, since it expands greatly when trade restrictions are removed and may hold the key to the typical adjustment process of an industry subjected to reduced protection.

Finally Quiggin falls back on casual empiricism of a kind which might even be labelled 'shonky quantification': 'Experience since the move to free trade has done little to support optimistic predictions of large dynamic gains' (138). A February 1996 EPAC study by Neil Ferry (published perhaps too late for inclusion in Quiggin's book), using cross-country regressions with 14 OECD countries, suggested that Australia's previous and announced tariff reductions could be expected to increase our GDP by around 15 per cent by 2020; i.e. nearly 0.5% in annual per capita GDP over the period 1990-2020.

Like most empirical work of this kind, one can find reasons for dismissing the numerical estimates. The point to be made here is that such empirical estimates are as suggestive as is evidence from theoretical reasoning based comparative static models--models which we know to be incomplete in explaining the real world. Needless to say, even if Ferry's estimates are near the mark, they could still be swamped by other changes in economic performance and would thus not be noticeable if one adopts the type of casual empiricism which Quiggin produces in the p.138 quote given above.

On the other hand Quiggin is on firmer ground when he disputes the widely cited Prices Surveillance Authority estimate that the real cost of air travel has declined by some 24 per cent since airline deregulation. While this is what has happened to the average revenue per passenger kilometre; that measure is not a normal price index like the CPI or the GDP deflator. According to Quiggin, what has happened is that discount fares have fallen substantially (by 18 per cent), and now account for some 70 per cent of all tickets sold (compared to 45 per cent before deregulation); whilst normal economy and premium fares have risen by some 10 per cent in real terms. Averaging all this out suggests that average real airline prices have changed only modestly since airline deregulation--though with the large growth in discounting, the choices of those flying have greatly increased.

(c) Microeconomic reform, the distribution of income and employment.

Originally economists attempted to avoid interpersonal comparisons. The literature told us to advocate policies only in cases where one could make Pareto optimal improvements--i.e. changes which made at least one person better off and no-one worse off. Unfortunately this proved impossibly restrictive and few, if any, policy changes could be advocated if one restricted advice to such policies. The Kaldor-Hicks criterion advanced in the 1940s argued--plausibly in my view--that economists should also recommend policies which produced potential Pareto improvements (i.e. policies which raised aggregate real incomes sufficiently so that gainers could be made to compensate losers with something left over).

At least until the early 1970s, this seemed a sensible and common sense criterion. During the long boom, most western countries basically had full employment and income differentials were generally declining. Whilst no attempt was made to compensate everyone for any government action which might have affected them adversely, most people's real incomes were increasing fairly steadily; even if, occasionally, some were adversely affected by particular government policies (e.g. the lifting of import restrictions in the early 1960s).

Quiggin objects to the exclusive concentration on efficiency in the microeconomic reform literature--and the subordination of equity (and employment) considerations. Such concentration has been broadly justified on two grounds (i) that equity is difficult to define (and, one might add, it is often defined in such contradictory ways that it is impossible to meet the various conflicting equity criteria at the same time), (ii) once greater efficiency is achieved, it implies a greater capacity to do more about social justice, poverty, community objectives etc. 'In practice, advocates of microeconomic reform undertaking analysis of any policy issue tend to assume that equity will be dealt with "somewhere else"' (45).

Redistribution 'somewhere else' in practice means through the tax and welfare systems. Given that such redistribution is costly, Quiggin makes the eminently valid point that 'redistribution through pricing (e.g. in telecommunications) should be pursued up to the point where the marginal cost, in terms of efficiency losses, is equal to the marginal efficiency cost of pursuing redistribution through the tax-welfare system' (121). In other words--once it is accepted that redistribution is not costless--the complete separation between efficiency and distributional criteria cannot be justified.

Again, in a world where there is a good deal of unemployment and underemployment and where there is evidence that such slack labour markets are not wholly the result of labour market rigidities (Cross 1995; Ball 1996), microeconomic reform measures leading to more short run unemployment should not be evaluated purely on the basis of any efficiency improvement which have been achieved.

These efficiency improvements implicitly assume that workers displaced during microeconomic reforms are able to obtain alternative jobs. Quiggin cites a 1993 ABS Survey of Victorian retrenched workers originally provided in evidence to an Industry Commission Inquiry that, in that case, some 50 per cent of workers made redundant by reform, were still unemployed 3 years later. As labour's share of output in the economy as a whole is around 70 per cent, such a labour withdrawal rate suggests that 35 per cent of the total productivity gains from microeconomic reform will be lost as a result of labour force withdrawal (213).

(d) Privatisation and the equity premium argument.

Quiggin argues against privatisation on a number of grounds, but 'by far the most important...is the equity premium. Because the rate of return demanded by holders of equity is well above the government's cost of funds, a sale at full market value will, other things being equal, leave the public worse off' (159).

The equity premium argument has been around at least since a seminal 1985 paper by Mehra and Prescott which suggested that the average real rate of return on American equities (over a period of some 9 decades) has been six percentage points higher than the risk-free average real return on bonds .

Basically, the equity premium is too big to be explained by plausible levels of risk aversion, suggesting that private capital markets are unable to diversify risks efficiently. It does not seem a valid argument against the privatisation of the Australian National Line, the Commonwealth Bank, Telstra or other government agencies.

Firstly, there are other, important, considerations dealing with the relative virtues of public versus private ownership which seem of major importance in deciding this issue. Thus some have reluctantly qualified their support for public enterprise because of endemic problems of overmanning and unprofitability in many public enterprises festering on indefinitely (see, for instance, Rowthorn 1989).

Second, there is still a good deal of argument about the statistical validity of the equity premium across the world's major equity markets; even though it may be true for U.S. equity markets. Third, even if we accept the validity of the equity premium, does this suggest that governments should hold equities in the proportion in which a particular government has inherited them? If there is a general equity premium, it is an argument for governments selling bonds and investing the proceeds in a fairly wide spread of equities; rather than concentrating one's equity holdings in some very specialised equities which history (or certain political leaders such as King O'Malley) has bequeathed to these governments. Again, if there is a general equity premium, it may be sensible for central banks to hold some part of a country's external reserves in the form of equities rather than either foreign exchange and/or foreign fixed interest securities.

The privatisation of infrastructure raises additional issues--apart from the privatisation of such government enterprises as the Commonwealth Bank. In particular, infrastructure projects such as roads often form part of a network. In such cases, as Quiggin points out, 'the risk associated with many infrastructure projects depends more on public policy decisions than on the management skill of the operator ...(as a result) ...the private operator must either demand a large risk premium in addition to the usual equity premium or must demand guarantees of favourable treatment' (166) It appears that both the Sydney Harbour tunnel and the Melbourne CityLink road are examples where private operators are receiving such favourable treatment. It is difficult not to agree with Quiggin that 'many current proposals for private sector involvement in infrastructure provision appear to be generated by the inappropriate incentives associated with global borrowing limits' (171) rather than by an in principle decision that private sector ownership and operation of a given infrastructure project is socially optimal.

(iii) Where does Quiggin stand?

Enough has been said to give a broad flavour of Quiggin's critique. This critique might make one believe that Quiggin is opposed to most microeconomic reform. However this is too simplistic a view.

Quiggin is also opposed to turning the clock back and abandoning microeconomic reform. ' ...it is difficult to sustain the view, implicit in much criticism of "economic rationalism", that microeconomic reform has caused large reductions in social welfare. The major economic factors reducing social welfare over the past twenty years have been the slowdown in productivity growth and the rise in large scale unemployment. These developments have been common to the majority of OECD countries, including those that have undertaken no systematic program of microeconomic reform. The primary contributions of microeconomic reform to higher unemployment in Australia have been indirect...although the benefits of microeconomic reform have been systematically overstated, they are still positive and significant in many, perhaps most, cases.' (222, italics added)

Given that the benefits of many, perhaps most, examples of microeconomic reform are 'still positive and significant' one might puzzle about Qiggin's earlier statement that the Australia's policy debate has substituted 'dogmatic precommitment for objective analysis'.

On the other hand, it is hard not to agree with Quiggin that--in the case of natural monopolies in such areas as road and telecommunications networks and other infrastructure services--the pendulum has now swung too far against government and in favour of simplistic laissez faire remedies. As Krugman (1994, p.181) put it '..markets are not magical. They can work well when conditions are right, but leaving a natural monopoly free to do its worst is blind ideology'.

Quiggin rightly draws our attention to some of the waste currently incurred in the name of micro-economic reform. Prominent among these is the duplication of networks by the present Telecommunications duopolists, Telstra and Optus. According to The Australian Financial Review (23 November 1996, p.13) some $ 4 billion has been spent on this vitrual duplication exercise with a good deal more to come in other capital cities such as Adelaide, (not to mention duplicating existing networks more completely in Sydney, Melbourne and Brisbane).

King and Maddock (1996, p.3), in their recent book on infrastructure industries include among their main findings 'national competition policy does not eliminate the desirability of some regulatory controls over infrastructure industries; access to essential infrastructure does not guarantee and, by itself, is unlikely to achieve any significant improvement in economic efficiency; reliance on access terms which are negotiated privately...cannot be expected to produce any significant improvement in the wellbeing of final consumers'.

In other words, while microeconomic reform is a useful tool in our armoury; it is neither a cure for all our micro-economic problems, nor can we be sure that what is simplistically promulgated as microeconomic reform will always live up to its reform label.

But I am not convinced by Quiggin's claim, quoted earlier, that current economic policy is based primarily on a combination of a priori theory and an emotional rejection of the policies of the 1950s and 1960s. There were some good reasons why economists in the later 1960s and early 1970s started to doubt that stimulatory macro-policies could always be relied on to solve growing unemployment. In most OECD countries, the Phillips curve trade-off between inflation and unemployment seemed to become more and more unfavourable.

It was the experience of these years which convinced the economic policy establishment to take microeconomic issues and 'supply-side economics' more seriously. After all, the preachings by the committed anti-Keynesians of their day (such as Milton Friedman and Hayek) had started a couple of decades earlier--with relatively little effect on the policy establishment.

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