In Search of the Third Way

An Address to the Melbourne Institute Policy Forum:
Economic and Social Policy in Australia:  Is There a Third Way?
University of Melbourne, 11 November 1998

INTRODUCTION

Australia at the Crossroads:  Radical Free Market or Progressive Liberalism by Fred Argy and Civilising Global Capitalism by Mark Latham are two local versions of what has become known as 'the third Way.

In common with Prime Minister Blair in the UK and President Clinton -- the two left-of-centre politicians who have popularised the concept of the third way -- both Argy and Latham argue that some economic liberalisation is good and markets are often the best way to allocate consumption and production.  Indeed both authors argue for more -- in Latham's case much more -- liberalisation in some areas.  They also reject the socialist agenda of government ownership, control of capital and trade.  However, like their fellow travellers from overseas, Argy and Latham believe that too much economic liberalism leads to a lower standard of living, higher unemployment, decline in social cohesion and a loss of national sovereignty.

Although both authors reject socialism and have reconciled themselves with the market, they retain the old values of the left -- an enduring collectivism and anti-individualism.

And these old values are what are wrong with these books.

Although both books share common beliefs and solutions, they nonetheless vary greatly -- in style, purpose, ideas and policy recommendations.

Mr Latham's book is explicitly designed as a reform agenda for the Australian Labor Party.  Mr Latham is a working politician and when he wrote the book was shadow spokesperson for education.  The book has the hallmarks of a working politician.  It is overly verbose and convoluted.  It focuses too much on "the big picture".  It focuses far too much on education -- his current obsession.  It has something for everyone.  It suffers from the restriction to ideas imposed by the party.

Although there were a number of professional attacks on the Howard Government, it is a remarkable evenhanded and well-mannered book.

Although I think the book has a number of serious flaws, its direction is right and the path it advocates is far better than the path the ALP to whilst in government and the path it is currently intent on following.

As Gary Johns said of the book, "Its great strength is that it has been published.  Its greatest weakness is that much of it will remain unread.  The electorate is the better for knowing that there are real thinkers in Parliament, but Latham's thoughts will need to be distilled if they are to generate the renewal he seeks on the left of the political divide.

Argy's book is also political in intent.  It is designed to steer the "political left" away from the economic nationalism.  Indeed it is more overtly political than Latham's book with the last few chapters being a clarion call of political mobilisation to fellow "progressives".

Argy lacks the good manners and even-handedness of Latham.  Indeed Argy is obsessed with moral posturing and constructing and fighting "straw men" and this seriously detracts from the quality and usefulness of the book.

Its most useful function is to inform the progressives that reform in Australia has yielded benefits and has not shredded the social fabric.  The main weakness of the book is that its version of the third way has been tried, it has proven not good enough and there we have to move on to better paths.

I fear the book will probably backfire politically by feeding rather than redirecting the paranoia of the economic nationalist.

KEATING UNPLUGGED

Argy sees the third way in our recent past in a policy stance best described as "Keating unplugged".  His basic argument is that Australia was already going along the third way, until the election of the Howard government.  According to him the past ALP Governments -- in particular the Keating Governments -- were taking a middle road approach, avoiding the stultifying excess of European social democrats, while also avoiding the hard hearted policies of the "far right"

He argues for a return to expansive macro-economic policies of yore -- but, of course, this time done right -- including pump priming, permanent budget deficits, looser monetary policy and less weight given to national savings and to inter-generation equity.  He argues for a return of Keating's grand plan for regional development, job creation and industrial plans.  He see no need for the new fangled ideas proffered by from other "third wavers" such as reform of the welfare, ending the era of big government, or lower taxation of capital.  He is mute about civil society and devolution power.

He recognises that the Keating era had a problem with tax which is that it taxes were not high enough to do what they wanted.  The electorate was simply unwilling to pay more taxes.  One aim of the book then is to unplug government from democratically imposed limit to tax.  He plea is that if we want "humane reform" we need higher taxes -- of course only paid by the rich.  Argy also recognises that the Keating era has an image problem with fellow "progressives".  Keating is blamed for introducing economic rationalism to Australia and in order to re-invent these policies they must be unplugged from the aura economic rationalism.  Argy's solution is to create the fiction of two types of economic liberals:  good ones -- reflective, humane, progressives like him -- and bad ones -- ideological, hard hearted, radical -- well -- like me.  He seeks to redirect the ire of fellow progressive to the evil one.

RADICAL REFORM WITH LIMITS

Latham's route is far more radical and one much more in tune to with Blair in the United Kingdom.

Like Argy, Latham believes in open capital markets including free trade in goods and services open capital markets, greater domestic competition, and privatisation.

He shares with Argy the belief that governments should take a large role in directly providing jobs on a permanent basis.  He shares Argy desire to focus government attention on the regions.

However, unlike Argy -- here the two could hardly be different -- Mr Latham see a much reduced range of roles for government -- though not a diminution in the over all role of government.

He rejects Argy's call for a return to an expansive macro-economic policy.  He does so -- correctly -- on the grounds that at best such polices do not work and or worst they augment an already volatile economy.  He argues that the federal budget should be balanced over cycle, that price stability is vital and that higher levels of national savings is crucial.

This stance -- according to Argy -- makes Latham a "hard-hearted and hard-headed liberal fanatic".

Latham also argues against all assistance to industry -- and therefore presumably in industry plans.  He argues for radical reform of the welfare state -- applying the principles of reciprocity, work or training rather than passive assistance, and tailoring of services to the individual.  He argues for a reduction in government provisioning -- though not in funding -- of social services.  He advocates the elimination of a host of government programs providing assistance special groups eg multi-cultural affairs.

Latham wants government to concentrate its resource on three tasks -- provision of skills and infrastructure;  providing income and job protection, and providing what he calls social capacity.  Nowhere in the book does Mr Latham argue for a larger government sector.  Indeed he makes it clear that there is no political support for big government.

Latham argues for radical reform to taxation and welfare funding designed to promote savings, inter-generational equity and greater personal choice.  In my opinion his ideas on tax and welfare funding are the best part of the book.  Although there is lot of thinking left to do, I strongly believe that his direct is right.

THE MISSING LINK -- INDUSTRIAL RELATIONS

Latham and Argy differ most markedly from the third wave types overseas in the area of industrial relations.  The two Australian want to wind back the relatively minor reforms to the industrial relations system that have taken place in Australia over the past decade and a half.  They want to see a move away from enterprise bargaining back to collective bargaining.  They want a return to an income and wages policy.  They see no need for a reduction in unfair dismissal laws and other so-called workers rights.  They want to expand the "social wage" function of the wages system.  They want a greater role for unions.  Most importantly they see the need to maintain high minimum award wages.

In contrast, overseas third wave types -- at least in rhetoric if not in action -- no longer think of themselves as defenders of organised labour and have come to accept Thatcherite labour market reforms.  There has been little rolling back of labour market reforms by the Blair Government.  It does plan to introduce a minimum wage but this will be at a level not much higher then the US minimum wage.  The Clinton Administration has not attempted to reduce the flexibility of the US labor market or enhance the power of the unions.  It has increased the minimum wage, but the new wage remains relative low to average wages.

FLAWS IN THE ARGUMENTS

Both books suffer from three major defects.

First, they incorrectly assume that market liberalism -- economic freedom -- threatens social cohesion and the poor.

Second, they retain a misplaced faith the capabilities of government.

Third, their minds are closed when it comes to the labor market.

I must emphasise that the flaws are much less pronounced in Latham's and Argy's book.

MARKETS AND SOCIAL COHESION

The main belief of the third way is that economic liberalism or to use another phrase -- economic freedom -- by itself will lead inexorably to the rich getting richer while the poor get poor.  If this occurs as a general tendency, it would be reasonable to argue -- as Argy and Latham do -- that higher levels of economic freedom are not consistent with widespread sharing of the benefits of economic activity and hence not consistent with social cohesion.

But the evidence does not support their claim.

Clearly there has been a tendency for some time in Australia and most other OECD countries for the distribution of income to become more unequal.  Also globalisation, in tandem with economic liberalisation, is assisting the rich to get richer.

In some countries -- perhaps also including Australia -- the living standards of some low-income groups have tended to stagnate over the last 25 years.  This trend varies across the regions within countries, including Australia.

However it is wrong to suggest that the trend towards greater inequality can be attributed to specific measures of liberalisation, or that liberalisation favours the rich rather than the poor, or that growing inequality is a necessarily feature of an more open, less regulated and less heavily taxes economy as is current in Australia and most other OECD countries.

The key to social cohesion is economic opportunity -- as Latham correctly points out.  The main way to create opportunity is economic growth and wealth creation.  The evidence strongly suggests that economic freedom is the best way we have to create wealth and growth.

James Qwartney and Robert Lawson (1998) -- in a project that I have been involved in for a number of years -- has attempted to both define and measure economic freedom and examine it relationship with economic growth.

Although no one suggests that their index is without flaws -- indeed amajor flaw is that it does not yet include data on freedom to work.  Nonetheless, it does provide an objective measure.  Importantly, it reduces the need for a subjective assessment based on "judgement calls" and diminishes the ability of people to "cook the books".  In his book, Argy is highly critical of this index, but his critique lacks the objectivity and rigour necessary to be taken seriously.

What the study finds is, not surprisingly a strong relationship between economic freedom and prosperity.  The countries (Figure 1) that score in the top quintile of the "most economically free" countries had an average per capita GDP of $18,142 -- over twice the income level of the next quintile of countries.  The study also found a positive and significant relationship between economic freedom and economic growth (Figure 2).

Importantly, the study (Figure 3) also found that the greater the improvement over time in economic freedom the higher the per capita growth in GDP.  Specifically, the study found that countries with the most improvement in economic freedom (3 points out on a ten point scale), such as New Zealand, achieved growth of 2.7 per cent, while countries like Australia which achieve increase 2 to 3 point second achieved per capita growth of 2.1 per cent.

This finding is directly contrary to one of Argy's main arguments, which is that beyond a certain point economic freedom does not generate improvements in wealth or economic growth.

This relationship between economic freedom and growth should not be controversial to third way types -- though Argy resists.  Their concern is supposedly about the people being left behind.

But here again, the evidence shows a positive relationship between economic growth and the growth in income of low-income groups.  Bates (1996a, 1996b) found that low-income earners tend to be better off -- indeed much better off -- in countries with higher economic growth and higher level of economic freedom.

How does this happen?  For two reasons, a fast growing economy gives people the opportunity and incentives to help themselves -- work learn and invest.  It also gives people the financial capacity either through voluntary means or through government action to assist those left behind.

This evidence is fully consistent with Australia's record over the last decade -- contrary to Argy -- the case for more freedom and reform.

Over the last 25 years, Australia has made major strides in freeing up it economy.  In 1975 it was ranked 24th amongst 119 countries in terms of economic freedom, in 1997 it was ranked 8th.  Over this period, Australia's growth rate has improved, as has productivity.  It has done a credible job at creating jobs.

However, Australia's record has number of black spots.  First, although productivity has improved in recent years, it remains substantially behind other countries.  Moreover, overall measures of productivity give a false picture of Australia's record on productivity.  Australia has chosen to lock a large proportion of its low skilled-low productive people out of work and on the dole.  Because these low productive jobs and works are not in labour force, the data shows higher productivity.  In other words aggregate measure of productivity cn be a perverse measure of performance.

Second, although the Australian economy has done a good job at creating work for the skilled, better educated and more motivated, it has steadily locked away the unskilled, poorly educated and unmotivated.  Over the last twenty years, the average duration of unemployment has increase from about 13 weeks in 1976 to 53 weeks in 1997.  During the same period the duration of unemployment in the US has remain practically unchanged at 16 weeks.  Australia has created a system where the insiders -- those with jobs -- do well, while those without jobs -- are kept lockout of work.  This is the largest threat to the nation's social cohesiveness.

Importantly it arises not from the reform or from an over-zealous pursuit of economic freedom or from market failure but rather from restrictions on freedom and the market.  The countries rated above Australia in terms of economic freedom -- Hong Kong, Singapore, New Zealand, the US, UK, Argentina and Canada -- all have lower levels of long-term unemployment and -- except Canada -- much lower levels of overall unemployment.

In general, higher economic freedom leads to the lower levels of unemployment and lower levels of long-term unemployment.  This applies across the 119 countries studied and for a sub-sample of OECD countries -- though for latter the relationship is weaker because of the distorting effect of government job creation schemes.  For example Sweden's official unemployment rate is about 10 per cent but this exclude an additional 10 per cent of the population on job creation schemes.

EQUITY AND ECONOMIC FREEDOM

It is true that the income distribution in the US, New Zealand and the UK -- countries which are further up the economic freedom ladder -- have widen more significantly in recent years than in Australia.  Moreover, there is some evidence that Australia has done a better job at maintaining the income level of low-income groups than these countries when measured on after-tax and after-government transfer basis.

Argy puts this down to pursuing too much freedom, too quickly and not redistributing enough of the gains to lower income groups via taxes.

First, attention should focus to a greater extent on whether economic growth and freedom provide opportunities for the poor to improve their lot in an absolute sense rather than as a result of more equal distribution of income.  After all, if the rich get rich whilst the poor also get wealthier there is no problem.  On the evidence this is what happens with move to greater economic freedom.

Second, some widening in the distribution of income is necessary to help people help themselves.  This is particularly the case in NZ and UK, where income distribution was suppressed by socialist policies for decades -- to level far below the range prevailing in Australia and almost all other OECD countries.  In 1975, for example, the distribution of income in the UK was half the range prevailing in Australia.  The compression of income levels -- achieved largely by lower growth and disincentives to work, invest and learn -- did not make the UK a happy and cohesive society and Australia's relative wider distribution of income did not deter the many thousands of British working class migrant from coming to live Australia.

Third, economic freedom does not conflict with a "social welfare net" which concentrates on correcting for the failures of private markets for insurance.  Nor does it necessarily conflict with a policy of assisting those most significantly effected by structural adjustment.  What it does conflict with are policies designed strictly to transfer wealth from rich to poor and more importantly from middle income earner to middle income earner.  Of course all welfare systems are a combination of all three elements -- redistribution, structural adjustment and insurance functions.  Latham appears to have grasped this distinction.  Although Argy seems to understands the diverse elements of the transfer system, he clearly emphasises the priority of redistribution.

Fourth, the biggest failing of the NZ and UK transfer systems, relative to Australia's is not their miserly nature but their poor targeting and inefficiency.  Thanks to reforms to the welfare system -- reform driven by the pressure to restraining the growth of government expenditure -- Australia does a relatively good job at getting transfer payments to low-income groups.

Fifth, within the OECD counties, there is no evidence to indicate that countries with wider distribution of income are less cohesive than those countries with a more narrow range of income.  For example, it is hard to believe that the US with its wider distribution of income is any less cohesive as a society than Italy.

In short the principle on income transfers should be:

"We must learn to see through demands for compassion when its measure is how much the government undertakes.  And we must learn to see through the demands for absolute security at the hands of politicians.  Yes there should be a safety net;  and yes a helping hand should always be there, but not at the risk of total dependence.  Help should be respectful and self-liquidating.  Wherever possible, it should be a pathway to self-support." (Green, 1996)

Latham sees the threat -- not as one of ideas as Argy -- but from a growing structural failure in the economy.  He believes that because of globalisation the economy is no longer able to create the job at anywhere near an acceptable level.  The task, as he sees it, is not to fight globalisation -- that he sees is impossible and counter productive -- but to embrace it.  However, he sees globalisation resulting in what he calls 30-40-30 society, a society where thirty percent of the people benefit directly and greatly from the processes of globalistion, the middle forty benefits indirectly from globalisation though weakly and with greater uncertainty.  According to Latham thirty percent of the population are simply left behind by globalisation.  Latham also argues that globalisation will have a differential impact on the regions.

Globalisation is definitely having a significant impact on labour markets, it is widening the distribution of income, putting a higher premium on skills and requiring greater mobility.  Capital is becoming more mobile and technology is broadening and deepening markets a frightening pace.  Nonetheless, Latham significantly exaggerates the impact of globalisation and underestimates the creativity of people and the market -- without the assistance and guidance of governments -- to create work and prosper.

The fact is that the non-traded sector of the economy in Australia still represents around 75% of the nation's economy and directly accounts for the vast bulk of the workforce.  Indeed, the trade sector today represents just slightly more of the economy than it did at the turn of the century.  The traded sector will expand over time and, as a result of globalisation, put pressure on the non-trade sector to compete international indirect via traded goods.  Nonetheless in developed countries the domestic economy and domestic conditions will drive growth in income and jobs.  For example the wages of a barber in, for example Camberwell, earns an income something like 20 times higher than the a barbers in Dhaka despite exactly the same service.  This arise difference arise from the relative wealth and productivity of the Australian economy and it not going to change much with globalisation -- unless the nation becomes poorer.  In other words, globalisation is not going to drive the wages of the Camberwell barbers to that the level earned in the third world.

Although financial markets have become much more integrated than traded goods, the view there is fully integrated capital market where foot-lose sloshing around the word without restriction is a gross overstatement.  The most obvious evidence is that, within a margin of 2-3 per cent, countries tend to invest as much as they save.  This is one reason why domestic saving is so important.  If there were a single global market for capital, international imbalances would be larger and less of a concern.

It is also wrong to believe that capital is perfectly malleable.  The North West Self project is not going to be transferred off-shore.  It might be closed down or be sold, but the physical assets are no going to leave Australia.

Importantly, the economies that are most open to global forces, for example the US, Hong Kong, Netherlands and UK -- and Australia -- are also the ones with high employment and lower unemployment levels.  In a modern globalised economy, the maxim -- we have the level of unemployment we choose -- remains valid

GOVERNMENT FAILURE

Mr Argy is right to argue that many economic liberals are concerned about the unchecked growth of the state but as David Henderson (1995) has stated

"Liberalism is not to be identified with hostility of the State, nor with a doctrinaire presumption that governments have only a minor role in economic life.  On the contrary, the liberal view of the role of the state both internal and external is positive.  Such a view is consistent with the principal of limited government, for to limit the scope of an institution is not to reject it.  Such limitation is calculated to rather to strengthen it.  Today, as in the past, the authority of the state is weakened not enhanced, when governments engage in interventionist measures as a means of winning or keeping favour of a particular interest groups, with no wider aim in view, or when they assume specific commitments and responsibilities which they cannot effectively maintain.  A captive state, or an over extended one, is not a strong state".

It is beyond dispute that the modern state has and continues to attempt to do too much.

The best indicator of an over-extended state is unemployment.  The main rationale for the growth of the state sector has been that the private sector is incapable of creating enough jobs.  Has this worked?  The answer is a resounding no.  Indeed, there is a general strong positive relationship between the size of government revenue and the level of unemployment.

The tendency of the state to go past the point of diminishing returns should be the main rationale for the "third way".  What the "third way" requires is a "reluctant" collectivist agenda -- one which seeks to establish a social safety net that compensates for the failures in the insurance market, rather than one aimed at redistributing wealth and managing economy.  In other words, it should concentrate on real, rather than fanciful market failure and recognises the limits of the state.

This is something Argy fails to comprehend.  Latham seems comprehend it -- at least most of the times.

One of most serious failing of the modern state has been it use of neo-Keynesian policies to attempt to securing the "optimal" or "warranted" level and pattern of growth.

Of course the Keynesian promise is a dream come true for politicians.  It gives them the ability to promise growth with security, and the ability to play the political cycle with big money.  The result has been disastrous, it has resulted on inflation, bloated government, high taxes and greater macro-economic instability.  Eventually the process had to come to an end, and with the discrediting of Keynesian policies.

Argy's plea for a return of these bad days and claims that the failure to do so is a result of grand conspiracy of right-wing ideology is absurd.  Even by his own assessment, the main cause of lower than "optimal" growth and the growth of structural unemployment over the last two decades has been disruptive macro-economic management.  What he does not seem to realise is that if state financing is intended to stabilise the economy, it must not itself be a major source of instability.

He may well believed that if he were in charge things would be different and more omnipotent.  This is simple just a pipedream.

Most economists -- even most politicians -- have learned from the past and now argue for sound money, sound finances and low taxes.  This consensus is not the result of ideology but rather a long and open debate and the testimony of experience.

Latham, by and large, accepts limits of government.  He rejects a return to activity macro-economic management.  He recognises the limits of the government provision and worries about welfare dependency.

There is one area, I believe, he forgets the limits of government and that is civil society.

Latham is quite right to worry about what is vaguely refereed to as civil society but his proposals may well harm rather than help civil society.

The strength of non-government sector is that it is not government;  that it is they are independent of government in funding, functions, purpose and objectives.  They provide a mechanism for people to work together voluntarily, to solve collective aims in non-commercial manner.  Although it is not widely recognised, the sector is very active in Australia and funded mainly from private or non-government source.

Government funding to NGOs is already high and increasing and there are already reasons for concern about this trend.  When government funds things, particularly things as important and complex as health and welfare, they rightly demand certain standards.  They need to answer for expenditure of public money to parliaments, and will require certain standards of performance, and due process.  This inevitably leads to detailed intervention, which has the potential to fundamentally alter the nature and the basic strength of the sector.  Also, government funding -- at least beyond a certain point -- tends to crowd out voluntary activity.  Why volunteer to do something if government pay other a commercial wages?  Why give to a worthy cause if the government controls the agenda?  Why donate funds if the government will do it for you?

What Latham proposes to do is to shift an even larger proportion of the delivery of social service to NGOs which will greatly exacerbate the problem and thereby undermine the core of civil society.  It will make them more dependent upon the state, and undermine voluntary action.

John Hyde thinks I overstate the problem and that there are ways of sheltering the NGO's from the perverse effects of government fund.  Perhaps, but, not I believe, if the shift is as large as imply by Latham.

IT'S THE LABOUR MARKET STUPID!

Latham and Argy share a common blind spot -- the labour market.  They both want to turn back time by re-regulating the labor market.

They want to go back to a system that has demonstrably failed.  The Australian system has been good for the skilled, the motivated, and the clever.  It has created many high paying jobs.  However, it has left a significant and increasing proportion of Australians behind in long-term unemployment, under employment and out of the work force.

They claim to be reformers, but when it comes to unemployment, they offer nothing new -- just more "I am from the government and I know best".

They claim to accept that markets often work and are keen on greater freedom to trade in good and service but not labour.  They claim to be concerned about personal responsibility, but not if it means that people are free to work at a wage and under conditions of their choose.  They claim to be interested in increasing the skills of workers, but not if means also taking a low- paid job.  They claim to be concerned about regional unemployment, but want to retain a centralised wages fixation system which prices job out of many regions.  They claim to be interested in improving the quality of Australian management, but will not let managers manage their most import asset -- their work force.  They talk about inclusiveness but want to excluded some of societies less privileged people from a livelihood.

The case for greater labor market flexibly is overwhelming The irrefutable fact is that the countries that have more flexible labour market -- lower minimum wages, less union control and more decentralised wage fixation -- have lower unemployment, create more jobs and have a more flexible and vibrant economies.

The agenda for creating jobs is clear.  It includes lower minimum wages over time;  a reduction in the tax levels for low-income earners, with serious consideration given to a US or UK style earned income tax credit;  elimination of unfair dismissal law and a reduction in the power of the Industrial Relation Commission.

Under this agenda the low skilled get jobs and no reduction in income -- there can be no honest claim of unfairness.

The agenda can only added to social cohesion and help the regions adjust and grow.

Job creation schemes can play useful role in easing the problem of "hysteresis" -- the tendency of the working capacity of the long-term unemployed to deteriorate as their time without work increases.  However, we must first know which programs work and why.  Too often politicians and their advisers have desperately cobbled together job creation schemes, without adequate research.  We must also recognise that job creation program are symptom of a problem -- of government failure not market failure -- they are not a solution.

The best measure of cohesive and humane society is not the distribution of income or the size of government, but free and open economy where people -- particularly the unskilled and unmotivated -- can earn a living and advance.