Poor Little Big Country: On the importance of a country choosing its economic priorities wisely (Part One).

One of the themes of what passes for my ‘professional life’ in economics has been this. We’re a small country and it’s a big world. Now that might not be news to you â it’s certainly wouldn’t appear to be news to any of the politicians or officials that are endlessly intoning it as a clich©.

But often something else happens in those subtle moments when we have to choose between one of two competing and apparently similarly attractive principles. We’ve also got this penchant for thinking of ourselves as an outpost of civilisation in Asia. Accordingly in the 1960s we were able to lean on our great and powerful friends in the developed world to organise what turned out to be disastrous exemptions from the disciplines that the GATT was imposing on other developed countries � particularly the reduction of trade barriers on goods (other than agricultural goods).

The now standard view that tariffs have mucked up our economy was not standard then � even amongst many economists. But the pattern has repeated itself. Thus in the 1970s and 80s as we were (ever so painfully and tentatively) dismantling tariffs there was a sensible argument for transitional export assistance. Why? Two reasons � one theoretical the other politically pragmatic and empirical.

1. Theoretically we were gradually reducing protection � so protection was to remain for a long period. So if the industry was not a basket case (and the industry I’m thinking of here is the auto industry and it wasn’t) then it would make sense to provide whatever assistance one provided to the industry at least equally to exports and import replacements to improve the efficiency with which the industry searched for the right product and production mix to survive lower assistance.
2. Successful Asian countries like Japan, Korea and Taiwan did precisely this. They didn’t just liberalise import replacement (though this is not to argue that that would not have worked). They boosted exports from protected industries and then tended to liberalise on behalf of successful exporters as the exporters realised that they needed to reduce their costs with imported inputs. There’s a lot going for this model. Firstly liberalising for exporters helps the politics of liberalisation � one has exporters championing the painful adjustment imposed on the least competitive firms. Secondly it provides good feedback on priorities if liberalisation is gradual � one liberalises where (the exporters tell you) the payoffs seem to be greatest.

What did our economic advisors do? Well there were two camps. The pragmatists (in which I included myself, quite a few in the PM’s Department and Ross Garnaut) wanted to walk and chew gum. We didn’t want to be pure about stopping export assistance. We thought it might do some economic good and that it would also assist us to reduce tariffs. The purists in the (then) IAC (and some allies in Treasury) argued that tariffs were hard enough to reduce, so why would you start other hares running by giving those industries export assistance as well. (My answer would be that the slogans of the two camps don’t really determine the argument, but that looking at what tradeoffs were made does. In 1981 the IAC was aware that it’s proposal for 35% tariff only assistance for cars was a political non-starter. So between its ‘draft’ and its ‘final’ report on cars it increased the long term (ie ten year) tariff it recommended to 50%! I would have left the tariff at 35% and gone for more export assistance.)

The idea of neutrality between sectors � the levelling of the playing field between them � was applied with great passion. But it doesn’t determine the problem logically. As I pointed out at the time, there are two neutrality questions to be thought about � level playing fields between one industry and another (here the IAC had conceded the protectionists call for greater assistance to the industry as politically inevitable) and level playing fields between import replacement and export within the auto industry.

Ironically it was Malcolm Fraser � someone who continues to assert his economic illiteracy in his insistence that Australian industry needs ‘some reasonable protection’ (a pre-Ricardian and essentially incoherent thought) � who forced export facilitation on a reluctant auto industry. At the time there were quotas, and export facilitation allowed auto exporters duty free imports to the value of their exports. Indeed, export facilitation was a classic example of what was going on in Asia � liberalisation on behalf of exporters. But it was far more liberalised and rational that the Asians’ import/export links which involved all sorts of bureaucratic supervision of how the mechanisms were used.

As a small country the importance of exporting those traded goods we’re good at making should have been very much at the top of our minds. But I think another thing that blinded us was that we somehow identified with economies in Europe and America � that is large economies. We were a big little rich country. In (economic) actuality a small country, we nevertheless focused on what was happening in our domestic economy and assumed that exports would pretty much look after themselves (and come from other sectors).

When the Tariff Board � gloriously reconstituted by self styled ‘Rattigan man’ Gough Whitlam in 1973 � held its inquiry into the industry, it was to be a showcase of what could be accomplished with economic expertise. And so it was. It was in many ways an extremely impressive piece of work for the time full of modelling and careful reflections on themes in the economic literature. Sadly, it was also horribly wrong � sometimes obviously when it is pointed out.

Thus for instance the inquiry report spent lots of time discussing the industry’s capacity to reach minimum economic scale (MES). But MES was taken (as far as I recall) from textbooks written for large countries. It was defined at that scale at which a doubling would not reduce unit costs more than two per cent. Why two per cent? Well no-one said. The figure is quite arbitrary � but two per cent was in the textbooks. (Five per cent was in other textbooks, but it’s equally as arbitrary). The IAC concluded that we were unlikely to get to MES, and therefore that it would be best to try to contain the industry. It could be made much more competitive than it was at the time, but that it was unlikely to ever be really competitive at free trade. In fact there were auto manufacturers at the time manufacturing fewer cars than Australia’s GMH was and exporting them viably around the world with minimal protection � like the Swedish Saab (from memory Volvo had production only a little larger than Holden. But we took our idea of MES from the British and American textbooks.

The IAC’s model of demand was a model of domestic demand even though around 15 per cent of production was exported � with the most competitive producer exporting 20 per cent. When the industry said exports were about to collapse � from the combined effects of a rising dollar, high wages Asian competition and a swing away from large car consumption in the rest of the world (sound familiar?), the econocrats said their consultant’s modelling was professionally unsound and should be regarded as irrelevant”. Professionally unsound it certainly was. It was just a report of the industry’s claims. But then the IAC hadn’t modelled export demand at all! Exports collapsed by around 80 per cent within a few years.

As economists shone the light of their discipline on the Asian success stories of the 1970s and 80s their ‘top of mind’ hypothesis tended to be that success equated with liberalisation. But the better ones conceded that they couldn’t make it stick. And my favourite quote summarising the state of play in the mid 1970s and the arrival at what I call the ‘new development consensus’ is from Jagdish Bhagwati.

Instead of the chaotic selectivity of the incentive policies for ‘import substitution’ which seems to be the main focus of our trade-theoretic analysis, a more important inhibition on growth may in practice be the speed with which import substituting industrialisation is geared toward ‘export promotion’. . . . [T]he key to success is not the absence of detailed, selective and target-oriented export promotion . . . . The distinguishing feature of superior export performance seems to be the pursuit of ‘indiscriminate’ and ‘chaotic’ but energetic policies to promote exports from industries which have been nurtured under protection in the first place.

Energy – and I would add getting one’s economic priorities right so that one’s energies are expended on the things that matter most at the time as a key to economic success! It sounds compelling to me.

In the next part of this post I’ll argue that this pattern of preoccupation with domestic arrangements tending to crowd out the more important search to find an optimal niche for ourselves in the world economy also diverts our attention from the most promising opportunities in tax policy.

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