agenda, volume 3, number 2, 1996...agenda, volume 3, number 2, 1996, pages 135-142 liberalising...

___________ Agenda, Volume 3, Number 2, 1996___________

Contents

Tony Makin, ‘liberalising Australia’s Foreign Investment Policy’ 135

Harry Evans, ‘The Australian Head of State: Putting RepublicanismInto die Republic’ 143

Scott Mitchell, ‘Do Australian Firms Undertake Too LitdeResearch and Development?’ 153

Michael Pickford, ‘Pricing Access to Essential Facilities’ 165

B. Stephen Labson, ‘International Response to Greenhouse Gas Abatement’ 177

Jell Bennett, ‘The Contingent Valuation Method: A Post-Kakadu Assessment’ 185

Kim Hawtrey, ‘Financial Market Reform in Transition Economies’ 195

Ramesh Thakur, ‘The Politics of India’s Economic Liberalisation Agenda’ 207

__________________________ REVIEW ARTICLE__________________________

Mark Harrison, ‘Some Economic Perspectives on School Reform’ 219

_________________________NOTESAND TOPICS_________________________

Peter Attiwill, ‘Victoria’s Mountain Ash Forests: A Case ofSustainable Management’ 229

Brian Dollery and Joe Wallis, ‘An Economic Perspective on Crime andPunishment in Modern Australia’ 235

______________________________ REVIEWS______________________________

Patrick Morgan reviews A Truly Civil Society: 1995Boyer lecturesby Eva Cox 241

134 Contents

Mark Lyons review Conditions o f Liberty: Civil Society mid its Rivals by Ernest Gellner

Ramesh Thakur reviews New Zealand and Australia: Negotiating Closer Economic Relations by Steve Hoadley

Stephen Rimmer reviews The Mad Ollicials by Christopher Booker and Richard Nordi

David Walker and Struan Jacobs review Australian Political Ideas edited by Geoff Stokes

245

247

249

251

________________________ CORRESPONDENCE

From Bryce Wilkinson, Wayne Mapp, and Dan Corry 253

________________________ NON-AGENDA ______________

Garry M. White, T h e Economic and Social Impact of Tax-Deductible Household Help’

William Maley, ‘Realising a Minimal State: The Case of Afghanistan’

Editorial Committee

Jeff Bennett, University oi New Soudi Wales James Cox, NSW Government Pricing Tribunal

John Freebairn, University of Melbourne Knud Haakonssen, Boston University

Tony Makin, University of Queensland Wayne Mapp, University ol Auckland

Gabriel Moens, University ol Queensland Tony Rudierford, Institute of Public Affairs

Grant Scobie, Centro Internacional de Agriculture Tropical Judith Sloan, National Institute for Labour Studies

Tony Sorensen, University ol New England Michael Warby, Parliamentary Research Service, Canberra

Garry White, Corporate Economics Australia Alan Woodfield, University of Canterbury

Agenda, Volume 3, Number 2, 1996, pages 135-142

Liberalising Australia’s Foreign Investment Policy

Tony Makin

INCE tlie early 1980s, global foreign investment flows have grown four times faster than world output and three times faster than world trade. The economic impact of foreign investment and multinational corporations (MNCs) on

host economies has been subject to vigorous policy debate this century. For example, Lenin, die founder of die former Soviet Union, claimed diat foreign investment exploited host countries and represented die final stage of global capitalism. But diis hostile view has been rejected by many governments in bodi die developed and developing world, including communist China, whose high double-digit growth rates posted in recent years undoubtedly stem pardy from investment from Western nations and die concomitant new technology and expertise it has transferred.

Even diough governments of all ideological persuasions around die world are actively vying to increase dieir reladve shares of expanding transnational investment flows, die Australian government, dirough die operations of die Foreign Investment Review Board (FIRB), continues to discourage certain forms of foreign investment, particularly in die financial, media, real estate and transport sectors of die economy. Indeed, diere is a widespread view, often expressed by die Australian Democrats, that Australia’s foreign-investment policy is not restrictive enough, particularly as it relates to f oreign takeovers of Australian enterprises.

On what economic (as opposed to political) grounds is die Australian government curbing foreign investment? And why should foreign investors be treated any diller- endy from domestic investors as generators of income? In reality, die further liberalisation of foreign investment, including the abolition of die FIRB, would lead to significant national economic welfare gains. Present foreign-investment policy is economically cosdy insofar as it deprives die economy of additional economic activity and so limits growth.

The Nature of Foreign Investment

Analysts of die impact of foreign investment on host countries usually make an important distinction between direct and portfolio foreign investment. Regulations governing cross-border investment flows generally apply to direct foreign investment. For

l _77te Economist, 27 March 1993. Oxelheim (1993) also contains a discussion o f general international

investment trends.

Tony Makin is Senior Lecturer in Economics at the University o f Queensland.

136 Tony Makin

measurement reasons, foreign investment is classified as ‘direct’ if at least 10 per cent of a firm’s equities are owned by foreign shareholders, since diis share is judged to confer a significant degree of foreign management control over the routine operations of the enterprise. It also includes real estate acquired by foreigners.

‘Portfolio’ foreign investment, in contrast, does not have management control implications and covers foreign purchases of the equities of Australian firms or debt instruments issued by Australian entities for portfolio investment purposes.

Direct foreign investment has always been a major component of total foreign investment in Australia. It often occurs through the establishment of subsidiaries of MNCs. In general, however, when non-resident entities fund expansion of the domestic capital stock, irrespective of whether it is direct or portf olio investment, the rise in external liabilities recorded as part of die economy’s foreign-investment position in die international accounts must be matched by a rise in die level of productive plant, equipment and buildings recorded in die national capital stock data of die national accounts.

‘Official’ foreign investment consists of foreign purchases of financial liabilities of the government sector, excluding government business enterprises, as well as changes in die Reserve Bank’s official reserve asset position. It includes not only bonds purchased by foreigners on first issue, but also bonds acquired in the secondary markets, as when Japanese investment houses buy large parcels of outstanding Australian government securities in order to diversify dieir international investment portfolios. This form of foreign investment has grown markedly in OECD economies in die wake of die financial liberalisadon diat occurred diroughout die 1980s. At present diere is no formal discriminatory policy against it.

The different forms of foreign investment in Australia can be depicted schematically dius:

Foreign investment

Government

Official (bond purchase)

Public enterprises

Purchases of real estate

Takeover of existing private enterprise

Private enterprises and banks

Creation of new private enterprises

Private portfolio (provision of foreign funds through equity participation and lending)

Direct (facilitates management control of branches and subsidiaries of multinational corporations)_________

Liberalising Australia’s Foreign Investment Policy 137

At die macroeconomic level, total foreign investment in all forms, net of investment abroad by domestic enterprises, is rellected in die capital-account surpluses diat match die regular current-account deficits of a host nation. W hat is generally not appreciated is diat die more foreign investment an economy attracts, die higher its current-account deficit and foreign liabilities are likely to be.

W idi direct investment, MNCs often take real investment and funding decisions togedier. Thus, increased imports of capital goods recorded on die nation’s trade account may be matched simultaneously by financial capital inflow from abroad recorded on die nation’s international capital account to direcdy fund dieir purchase. However, MNCs sometimes fund die accumulation of capital through domestic borrowings.

Foreign Investment in Australia since World War II

Australia has persistendy attracted foreign investment over more dian two centuries, as has been reflected in its persistent current-account deficit In absolute tenns, die degree of foreign investment in Australia rose quite strongly from die early 1980s, mainly because of increases in portfolio investment. In die past few years, official flows have also risen sharply. Nonetheless, as a percentage of GDP, foreign investment flows were proportionately greater in earlier times, such as die late 19th century.

Under die managed exchange-rate system diat prevailed in die postwar years undl 1983, foreign-investment flows were regulated mainly by die exchange controls administered by die Reserve Bank of Australia. No separate body oversaw direct foreign- investment proposals undl die FIRB was formally established by die Fraser Government in 1976. However, before diat dine, and especially from die 1960s, federal governments of bodi polidcal persuasions had intervened in an ad hoc way (see Kasper, 1984). Since 1976, die guidelines governing FIRB operadons have been liberalised substandally as dereguladon has proceeded in odier spheres. Nonedieless, die power to deny direct foreign investment in Australia still rests with the Commonwealdi treasurer and is exercised frequently, to Australia’s uldmate cost.

The legisladve backing for die Commonwealdi government’s foreign-investment policy is provided by die Foreign Acquisidons and Takeovers Act 1975, which permits die Commonwealdi treasurer to disallow proposals diat are contrary to die (undefined) ‘national interest’. Foreign investment in die banking sector is also governed by die provisions of the Banking Act 1959 and die Banks (Shareholdings) Act 1972; and foreign investment in radio and television has to be consistent widi die Broadcasdng Act 1942. State government agencies also liaise widi die FIRB and in- dependendy monitor foreign investment aedvity dirough separate official means, such as dirough Queensland’s register of foreign ownership of land.

The reladve shares of die main types of foreign investment over recent years are shown in Figure 1. Partly offsetting die higher level of foreign investment in Australia, from die mid-1980s Australian investment abroad, largely of a direct nature, rose sharply. This was a result of Australian-owned enterprises, in fields such as brewing

See McLean (1989) for further liistoiical details.2

138 Tony Makin

and transport, expanding dieir operations abroad. Since the main focus ol diis article is inward foreign investment and die policy dial restricts it, outward foreign investment is not shown in Figure 1. Nonedieless, it is worth noting diat die acquisition ol foreign assets by residents is sometimes funded dirough offshore borrowings which are recorded as part of portfolio investment in Australia.

Figure 1

Direct, private portfolio and official foreign-investment flows to Australia, 1984-95

16000

14000

12000

10000

8000

A$m 6000

4000

2000

0

-2000

-400084-85 85-86 86-87 87-88 88-89 89-90 90-91 91-92 92-93 93-94 94-95

Source: Reserve Bank of Australia, Bulletin, December 1995, Table H.2.

According to FIRB data, approved direct investment expenditure by foreign interests to establish new businesses or acquire existing firms amounted to $24 billion in1992- 93 and $23.5 billion in 1993-94. These FIRB data on expected foreign investment suggest diat more direct foreign investment spending in Australia is actually decided abroad dian die Australian Bureau of Statisdcs (ABS) foreign investment and international capital account data actually convey. For instance, die ABS (1995) measured capital account surpluses at $15.9 billion in 1992-93 and $16.3 billion in1993- 94, well below die FIRB estimates of expected foreign invslment for diose years. However, in explaining die discrepancy between FIRB and ABS foreign investment

data, it needs to be recognised diat FIRB approvals can include projects which may never be undertaken or completed. At the same time, because die FIRB’s expected direct foreign-investment data have persistendy exceeded measured capital account surpluses over recent years, it seems unlikely diat foreign investment in die form of external borrowing is direcdy funding household consumption expenditure in Australia, even diougli many commentators believe it is.


Economic Benefits of Foreign Investment

As a general principle, the greater the international trade in assets, the greater are the potential economic welfare gains. Although it is widely accepted that the liberalisation of international trade in goods and services enhances welfare, the similar gains arising from international trade in assets, both financial and real, are often, and inconsistently, ignored or denied.

Widespread concern about private foreign investment in Australia relates mainly to direct investment, and specifically to the loss of control of established domestic firms through foreign takeovers or the acquisition of real estate by non-residents. Accordingly, whenever this happens on a large scale it is often said that Australia is ‘selling off the farm’. Yet despite these nationalistic concerns, economic benefits always accrue to the residents who choose to dispose of their assets to foreigners. In particular, opponents of foreign investment generally fail to appreciate that whenever domestic financial or real assets are purchased by non-residents, the amount of funds available to residents f or additional spending is thereby supplemented.

Moreover, when foreigners buy existing Australian assets at higher prices than residents would be willing to pay, the Australian sellers of those assets make capital gains that they odierwise would not have made. The proceeds of the sale of assets may then be used to create new domestic assets, to be spent on consumption, or even to acquire new foreign assets. Such economic gains suggest that, as a nation, Australia may be better off allowing foreigners greater freedom to purchase domestic assets, including all forms of real estate. Sales of domestic assets by residents to foreigners actually enable residents to upgrade the existing capital stock or spend the proceeds acquiring something else entirely.

The economic impact of direct foreign investment and MNCs can be considered also at the enterprise or industry level. MNCs generate important economic benefits through tile transfer of technology and product development, even though the domestic operations of MNCs are by definition foreign-owned and controlled. Furthermore, domestic employees of foreign-owned firms are exposed to intenlatioilal management practices; and the presence of new entrants in domestic markets stimulates imitative behaviour and acts as a spur to competition.

Foreign capital inflow in aggregate also improves the nation’s economic welfare to tiie extent that it frees Australia from the constraint of its own saving level. The amount of additional economic activity in a range of domestic activities would not be as great and overall GDP growth would be lower without the benefit of net foreign investment. Without foreign capital inflow, long-term interest rates would also probably be higher, as the economy would then be totally reliant on domestic sources of funds to finance its investment requirements. So if greater direct or portfolio foreign investment is forthcoming, then the higher associated current-account deficits should be welcome, lor macroeconomic reasons, in addition to the microeconomic ones outlined above.

3Sec Caves (1971), Hymer (1976), Dunning (1988) and Maikuscn (1995) lor more formal treatment o f

the microeconomic theoiy o f direct foreign investment.

140 Tony Makin

In general, foreign purchases of Australian assets can generate more investment expenditure in Australia. Moreover, the funds available for domestic investment are also supplemented when real domestic assets like property are bought by foreigners. Greater foreign investment makes jiossible faster growth in the size of the nation’s capital stock; this creates additional employment and improves the overall productivity of die workforce. In turn, die higher labour productivity also allows domestic wages to be higher dian would be possible widi die smaller capital stock diat would result from reliance on domestic saving alone.

The Economic Cost of Australia’s Foreign Investment Policy

Just how much is Australia losing in an economic welfare sense because of die existing Commonwealth regulations or because foreign-investment proposals have been rejected by die Commonwealdi treasurer lor die sake of the nebulous ‘national interest’? The size of any such economic welfare loss is difficult to quantify widi any precision. Nonedieless, die data on total foreign investment proposals published by die FIRB over recent years are a starting point, especially as diese data provide a rough basis for estimating how much foreign capital Australia has forgone as a consequence of die current foreign-investment policy.

Table 1

Foreign-investment proposals to the FIRB by number and total expected expenditure, 1990-94

Type of proposal 1990-91 1991-92 1992-93 1993-94No. $bn No. $bn No. $bn No. $bn

Approved 928 12.7 1048 11.98 1334 18.9 1734 16.3Approved conditionally

1597 7.6 1933 3.85 2268 5.1 3085 7.2

Total approved 2525 20.2 2981 15.8 3602 24.0 4819 23.5Rejected 69 1.9 66 1.81 58 0.1 84 0.1Total decided 2594 22.2 3047 17.63 3660 24.1 4903 23.6Withdrawn 235 ? 227 ? 165 ? 384 ?Total considered 2829 3274 3825 5287

Source: FIRB (various years).

Table 1 shows diat, between 1990-91 and 1993-94, die number of foreign investment proposals approved by die FIRB far exceeded rejections. But over diat period around $4 billion of foreign capital was explicidy disallowed. This figure is a direct measure of die additional investment Australia could otherwise have enjoyed. Foreign-investment policy as implemented over recent years deprived Australia of die opportunity to accumulate $4 billion of additional capital, dirough eidier die creation of new assets or die acquisition of existing ones.


Yet this figure underestimates die true amount of additional investment lost under die existing restrictions, for several reasons. The number ol proposals wididrawn lar exceeds die number disallowed. Wididrawals occur when foreign-investment proposals are seen to be inconsistent widi existing policy and hence likely to be rejected outright by the FIRB. If it is assumed diat die average annual dollar value of each withdrawn foreign-investment proposal put to die FIRB between 1990-91 and 1993-94 was of similar magnitude to die average annual value of each unconditionally approved proposal, dien Australia’s foreign investment policy cost die nation a further $6 billion in unrealised foreign investment over die period. Adding this amount to die value of foreign-investment proposals actually rejected by die FIRB gives a total of $10 billion in potential lost development capital. As well, die salaries of die executive of die FIRB and of die 20 or so Commonwealdi treasury ollicers engaged full-time on foreign-investment matters cost between $lm and $2m annually; diis too should be taken into account in estimating die total economic welfare cost of existing policy.

Admittedly, die assumption underlying die costing of die economic welfare loss due to die number of proposals wididrawn from FIRB consideration is somewhat arbitrary; and some disallowed investment proposals may be approved subsequendy in revised form. Ideally, of course, die FIRB should itself be providing data on the value of foreign investment diat is lost as an explicit result of present policy. Nonedie- less, even if actual FIRB data on die actual value of wididrawn proposals put by foreign interests were published by die FIRB in its annual reports, such values would still tend to understate die full cost of die existing foreign-investment restrictions, since proposals classified as conditionally approved may actually be trimmed versions of earlier proposals. Finally, die value of proposals actually wididrawn would not account for diose proposals diat foreigners would have submitted had diey stood a chance of acquiring assets in die heavily protected media, real estate and transport sectors of die economy.

Conclusion

The existing anomaly between Australia’s policy toward international trade in goods and services and its policy toward international trade in assets — liberal in the former but restrictive in die latter — is likely to become more internationally apparent in die near future. The OECD has long been advocating freer capital movements dirough die Code of Liberalisation of Capital Movements, first draf ted in die early 1960s; and a new OECD agreement on global capital flows proposes diat foreign investment be treated no differendy from domestic investment. Not only is Australia’s existing foreign investment policy at odds widi die OECD’s view of die benefits of freer capital movements, it is also inconsistent widi die 1994 APEC Bogor declaration, which advocated ‘free and open investment in die region’ on die same principle as contained in die OECD code, namely, diat foreign and local investors be treated equally.

The point often missed by diose suspicious of foreign capital, and unrecognised by present foreign-investment guidelines, is diat foreign investment, irrespective of

See Bureau o f Industry Economics (1995) for related discussion.4 ,

142 Tony Makin

whether it creates new assets or is used to purchase existing ones, including residential real estate, facilitates extra economic activity in Australia. Foreign investment can be interpreted as a measure of how much money foreigners are willing to invest in die economy’s future and hence of how much additional domestic investment, production and consumption is achievable.

This brings to mind an astute comment made by die 19di-century English economist, Walter Bagehot, which is as relevant and true today about die significance of foreign money as it was originally meant to be about domesdc money:

W e have endrely lost die idea diat any undertaking likely to pay, and seen to be likely, can perish for want of money; yet no idea was more familiar to our ancestors, or is more common now in most countries. (1873:7)

Surprisingly, Bagehot’s basic point is apparendy still not fully appreciated by die Commonwealdi treasury and die FIRB. As a result, die foreign investment restrictions in place continue to cost Australia billions in lost investments.

ReferencesAustralian Bureau o f Statistics (ABS) (1995), Balance o f Payments, Austialia, AGPS, Canberra (Cat No.

5302.0), September.

Bagehot, W . (1873), Lombard Street: A Description o f the Money Market, London.

Bureau o f Industry Economics (1995), Foreign Direct Investment in APEC: A Survey o f the Issues, AGPS, Canberra.

Caves, R. (1971), ‘International Cor]>orations: The Industrial Economics o f Foreign Investment’, E conom ical. 1-27.

Dunning, J. (1988), ‘The Eclectic Paradigm o f International Production: A Restatement and Some Possible Extensions’, Journal o f International Business Studies 19: 1-31.

Foreign Investment Review Board (FIRB) (various year s), AnnualRejxnts, AGPS, Canberra.

Hymer, S. (1976), The International Operations o f National Finns: A Study o f Direct Foreign Investment, MIT Press, Boston.

Kasper, W . (1984), Capital Xenophobia: Australia’s Controls o f Foreign Investment, Centre for Independent Studies, Sydtrey.

Markusen, J. (1995), ‘Tire Boundaries o f Multinational Enterprises and tire Theory o f International Trade’, Journal o f Economic Pers/iecdves 9: 169-89.

McLean, I. (1989), ‘Growth in a Small Open Economy: An Historical View’, irr B. Chapman (ed.), Australia]} Economic Growth, Macmillan, Melbourne.

Oxelheim, L. (ed.) (1993), D ie Global Race for Foreign Direct Investment, Sptirtger Verlag, Berlirr.

The author is grateful to two anonymous referees for helpful comments.


The Australian Head of State: Putting Republicanism Into the Republic

Harry Evans

A reasonably detached observer could be forgiven for thinking that the Austra- Z-A lian republican movement is floundering. The arguments against sharing a

jL -mmominal head of state with another country, which is now a member of a foreign quasi-federation, seemed so irresistible. Why does the movement fall so far short of die degree of popular support required to carry the change? A large part of the explanation is provided by a lack of coherence in the official republican movement, which is illustrated by the head of state issue. Having proclaimed that the monarchy must go, and that we must have an Australian president, the movement immediately founders on the question of how the replacement is to be chosen. The response of a large majority of Australians, according to the polls, is that they want to elect a president (The Bulletin, 1 August 1995, p.28). The official republicans recoil in horror from such a suggestion, resort to irrational arguments against it, and speak of the need to re-educate the public (Byers, 1995). It has to be explained to the people that the change is being made in such a way as to avoid changing the system of government: an odd argument for any kind of reformers attempting to persuade people to change anything. Never has there been a republican movement which wanted to replace a monarchy with something designed to look as much as possible like a monarchy.

Republican Culture

The problem is that official republicanism is no more than a nationalist and anti- hereditary movement to remove the British monarchy from Australia. It does not seek to foster or to build upon a republican culture. Historically, there have been two essential ingredients of republican theory and practice: institutions so structured as to provide a balanced system of government capable of avoiding the growth of monarchical power, and a reliance on the people as a whole as the only repository of sover-

tThe conclusions of the official movement are contained in a statement by die Prime Minister (Keating,

1995), wliich is based on die Reiiort o f die Republic Advisory Committee (1993), wliich in turn is largelybased on Winterton (1986).2

‘A president must not lie jioliticised’, lh e Australian, 5 July 1995. It is ironic diat two ol die greatest defenders o f die oilicial republic are knights o f die realm: Sir Maurice Byers and Sir Zelman Cowen. The Primate o f die Anglican Church lias also rallied to die dien Prime Minister: ‘Church leader backs Keadng republic model’, The Sydney Morning Herald, 4 July 1995.

Harry Evans is Clerk o f the Australian Senate.

144 Harry Evans

eigiity. A republican culture is one which recognises diese central tenets ol republicanism, and seeks to build upon diem. Official Australian republicanism, however, is characterised by a neglect of questions of institutional structure and constitutional balance, and by a positive aversion to involving die people in government to a greater extent than diey are now involved. It is in relation to die head of state issue diat these characteristics are most clearly exposed.

The absence from official republicanism of a republican culture is maintained by an avoidance of serious historical or dieoretical analysis. A little such analysis reveals the necessary elements of such a culture.

The idea diat die absence of monarchy may be a necessary, but is not a sufficient, condition to constitute a republic is far from new. "Hie reader has to get well into the ancient Roman Cicero’s treatise De Re Publica before finding die statement that the holding of an office of state for life is incompatible widi res publica, which by definition is a partnership belonging to die whole community. Hie essence of res publica lies not in the absence of a king, but in institutional arrangements diat maintain the partnership and avoid anybody using die state to dominate everybody else.

The founders of die first modem republic, die United States of America, might be diought to have had a ready-made republican culture on which to build. Before diey broke from Britain, die colonies were de facto self-governing republics only nominally under die crown; effective power was held by assemblies elected on wide franchises, and two colonies even elected dieir own governors. The founders drew up dieir new constitution, however, against a background of demonstrated failures of die republican state governments. These failures, manifest in one case in armed rebellion and war, were attributed to die weaknesses identified by Cicero: domination of government by factions and absence of balanced institutional structures. Not just any union, but a well-constructed union, was required to provide republican remedies against die diseases common to republics (Madison et al., 1787:1970, 10:41-8; 51: 263-7).

The Australian founders were more republican dian dieir current would-be successors. Aldiough diey constructed dieir union under die British crown, diey embraced die salient features of republican government, even adopting die name ‘Commonwealdi’, die English equivalent of res publica and of die latinate ‘republic’. They had a keen appreciation of die importance of well-designed institutions. Thus, diey readily accepted die foreign model of federalism as die institutional basis of die Australian union. Federalism for diem encompassed such institutional devices as specified central powers, equal representation of die States in die Senate and coordinate powers in die two houses of parliament, all un-British innovations. They de-

Sir Ridiard Baker, die leading federalist among die roundel's, reminded liis colleagues ot die foreign nature o f die federal system, and also referred to responsible government as a ‘British sliam’: Convention(1897), Sydney: 785-7.4

Remarks by Sir Samuel Griilidi (quoted by Sir Ridiard Baker), Dr Jolm Cockbuni, Mr John Gordon and Sir Ridiard Baker, Convention (1897) Adelaide: 28, 326, 340, Sydney: 784, 789. Aldiough die pow-

The Australian Head of State: Putting Republicanism Into the Republic 145

voted much of their debates to the shape and relationships ol institutions. They were also good republicans in relying on the ultimate power of the people: both houses of the parliament were to be directly elected, and the new constitution would be approved by, and amendable only by, referendum. The only deficiency in Australia’s republican culture may be seen not in accepting the British crown but, on one view, in having self-government handed down from above before federation instead of building it from below, as had largely occurred with die American colonies. Federation itself , however, was an indigenous growdi widi strong popular participation.

The head of state issue is gready illuminated by bringing to bear upon it die essential republican principles of sound institutional design and ultimate popular control.

The Head of State and Institutional Design

Some have suggested diat we do not need a head of state (Republic Advisory Committee, 1993:47-51). Parliament alter each election could elect die ministry, which would remain in office until the next parliament is elected, and if necessary could elect a new ministry in the course of a parliament But diis would mean diat die prime minister or premier would become die de facto head of state. There would also be die question of whedier lower houses should be dissolvable within dieir term, and, if so, who is to exercise die dissolution power and how its misuse by a prime minister or premier is to be restrained. Most people would agree that, if we are to retain die responsible government, or cabinet system, whereby the executive government is carried on by a ministry having die support of die lower house, a constitutional umpire will be needed, holding die powers currendy held by die Governor-General or some modification of diem, to act as a final arbiter in situations in which the lower house is not able to constitute or support a ministry or die ministry seeks to subvert or bypass die processes of responsible government.

The official republican movement, represented by the previous government’s ‘preferred option’, embraces die ‘minimalist’ position of changing die head of state widi die aim of little or no change to the system of government. This is diought to rule out an elected president. The contradiction in calling diis position ‘republican’ has already been noted: it is intended to provide a sort of indigenous, noil-hereditary constitutional monarch. It is thought diat the ghost of die monarch should remain behind, radier like die Cheshire cat’s smile, and that widiout diis remnant our system of government must fail. 41 le great republicans of die past, such as Tom Paine, would have found diis determination to maintain die shadow of monarchy as even more ludicrous dian real monarchy (Paine, 1776/1986:80-1).

File foundation of this position is that an appointed president will most closely resemble die appointed Governor-General. The latter is de facto appointed by die prime minister alone; die favoured ‘minimalist’ mediod is for appointment by bodi houses of die parliament by a special majority. It is interesting to note diat appoint

e d o f die House o f Lords were not statutorily reduced until 1911, diey were regarded in die late 19di century as limited by parliamentary practice.

146 Harry Evans

ment of a president by the prime minister alone, although originally proposed by Mr Keating on die ABC’s Lateliiie (15 September 1993), is not contemplated and is regarded as obviously unacceptable. Presumably, diis is because it is diought diat a president should not be merely die creature of die prime minister, and diat die role of president requires greater independence. This appears to be die sole concession ol die ‘minimalists’ to republicanism properly so called, a small concession to die idea ol balanced government. It is also notable diat appointment by a simple majority of bodi houses is not favoured because it is diought diat diis would not be different from appointment by die prime minister. This is an admission of die real major problem widi our system of government: excessive concentration of power in die hands of die prime minister, and prime ministerial control of die lower house.

The different mediod of appointment which is contemplated, however, would be likely to lead to a different result and to change die system of government, contrary to die stated intention. The favoured system of nomination by die prime minister and approval by a two-diirds majority of bodi houses means diat die prime minister, who now alone appoints die Governor-General, would have to gain die approval of at least die odier major political party in parliament for die prime ministerial nomination. This means diat die prime minister would have to pul forward a nominee acceptable to die odier major party, which implies diat consultations would take place before die nomination is made. Consultations among politicians lead to deals. The deal may be lor a candidate acceptable to bodi parties and not likely to offend any major strand of opinion in eidier party. A lowest-common-denominator effect could well set in. Recent appointees as Governor-General might not have passed muster in such a party agreement. A political deal can also take die form of a trade-off. An opposition may well accept die government’s nominee on die basis of some returned favour. The deal could be: ‘W e do not really like your presidential nominee, but we will support die nomination if you will do somediing in return for us.’ Political negotiations also notoriously tend to leak. The way in which die presidential nominee has been selected would inevitably become known to die public. The deals would be explained in die press. The selection process would dien be looked upon unfavourably by outsiders, leading to a demand to replace diis unsavoury process widi direct election.

Regardless of whedier diis forecast would be likely to prove accurate in all respects, die point is diat die different mediod of selection favoured by die ‘minimalist’ option would not leave die system of government as it is.

Contrary to die ‘minimalist’ position, a strong case can be made out diat a direedy elected president would constitute die least change from die current system of government. It is a question of constitutional design. The current system of constitutional monarchy and responsible cabinet government centres on a head of state, die monarch, who is independent of die parliament Apart from occasions of revolution, die parliament does not choose die monarch; die crown as an institution is separately constituted. The dieory of constitutional monarchy envisages diat die monarch will enjoy wide public support, shoring up die independence of die crown. Govemors- General and governors, as representatives of die crown, were also originally supposed to be independent of parliament. The change to de facto appointment by die prime


minister or premier may have undermined that independence, but the appointees may still be supported by the aura of die crown. But parliamentary appointment of a president, even by a special majority, would remove diat independence ol die head ol state. The prime minister’s freedom of choice would be removed, but so would any remaining aura of die crown. The head of state would be, and would be seen to be, dependent on die parliament, or, in reality, on die two major parties. The proposal to have the president removable by die parliament widiout stated cause (Keadng, 1995) would gready reinforce diat dependence.

A direcdy elected president, however, would provide a republican replacement for die crown, widi independent public support and no dependence on parliamentary support for appointment or continuance in office.

Whenever die possibility of elecdon is mentioned, die official republicans raise die quesdon of die powers of die office (Republic Advisory Committee, 1993:72-3). It is pointed out diat die Governor-General possesses great powers under the Constitution, principally die power to appoint and dismiss ministries. It is claimed diat diese powers could not safely be entrusted to an elected president. This too is a curious argument from persons who call diemselves republicans. The powers are regarded as safe when vested in an appointee of die prime minister or a nominee of die prime minister approved by a deal widi die odier major political party, but diey may not be safely vested in a person independent of die ministry and die parliament and endorsed by die electorate. Surely it is more rational to argue diat die extensive powers of die office require die independence and popular support of election. This contention is supported by die history of constitutional government. Extensive powers require election; appointed bodies can have only limited powers. Thus, die United States Senate, widi its great constitutional powers, was changed from an appointed to an elected body, while die hereditary and appointed House of Lords had its powers taken away.

Even if a president is to perform only die role of die Governor-General, holding great powers but exercising diem according to conventions, diis role would seem to require die independence and public support of direct election radier dian dependence on die politicians. The Governor-General’s role may be regarded as diat of an umpire, largely observing die political game and intervening only at times of difficulty to ensure compliance widi die rules. The role of a Governor-General becomes crucial when responsible government ceases to work: when a lower house is incapable of supporting any ministry, when a prime minister refuses to resign or advise an election upon loss of die support of die lower house, and in similar situations. Many such cases have occurred, including recent cases in Australia. If vice-regal representatives have been successful in resolving diese situations, it is because it is understood diat diey perform die role of die crown. An effective republican umpire to resolve such

Following the Tasmanian general election o f 1989, the governor rejected a request from the premier for a new election and required die leader o f die opjiosiüon to provide him evidence o f his ability to form a stable coalition government. Many odier cases arc set out in Evatt and Forsey (1990).

148 Harry Evans

situations requires independence and public support in substitution for the residual prestige ol the crown.

The powers of the Governor-General are exercised in accordance with the practices, precedents and conventions associated with responsible government. In a republic, an independent president is likely to observe them more scrupulously dian one beholden to the politicians.

In short, considerations of institutional design, including the contention that we must follow the scheme of the existing system as far as possible, indicate that a president dependent on the major parties is the most unsound option, and that direct election achieves both of the aims of institutional balance and as little change as practicable to die existing system.

The Head of State and Popular Sovereignty

The official, ‘minimalist’, position, by rejecting so emphatically die option of an elected president, creates at die heart of die republican movement an enormous democratic deficit, which places it under a severe handicap, particularly in persuading die electors.

It is said diat we must have an indigenous head of state to be a symbol of die nation, to represent Australia and its people, and to represent die people to themselves. It is not clear how such an exalted role can be performed by any officeholder unless die office has a strong and close link widi die people, or how such a link can be attained except dirough popular election. It is highly unlikely diat such a role could be performed by a person appointed by die politicians. Govemors-General, widiout die handicap of being appointed by subterranean political deals, have not been able fully to perform such a task; one has die feeling diat in recent years diey have been less conspicuous to die people than in die past.

It is also said diat popular election would lead to a party contest and die election of a party politician, and diat a person selected by diis process would be incapable of properly performing die role of national symbol or that of constitutional umpire. It is somewhat contradictory so to imply diat an elected president would follow die partisan interests or instructions of die party which nominated and campaigned for him or her, while it is supposed diat a president appointed as a result of a deal between die major parties would not suffer from a similar, and more debilitating, dependence.

It is a non sequitur to claim diat a president elected alter a party contest would be incapable of performing die required role. To a certain extent, die function of representing die nation as a whole is performed by die prime minister of die day, who is invited to make inspiring speeches and to launch great events, perhaps more often dian die Governor-General. A party politician elected to die presidency, and without die responsibility of actually exercising executive power, would be more capable in dial regard dian a prime minister. Such a president would be likely very quickly to become a former party politician transformed by die high office. This occurred, alter all, widi Mr Hayden and his politician-predecessors to a large degree.

In any case, it does not follow diat die electors would vote for party politicians. The unstated premise here is diat die electorate would be incapable of distinguishing


between an election to choose a government to carry out favoured policies and an election to choose a head of state. It is more likely that die voters, if presented widi die choice of non-party candidates, would forsake die established political parties and return persons widiout partisan attachments. It would be important to ensure that the right to nominate candidates is not confined to political parties in or out ol parliament. The political parties would dien be likely to follow die signals ol die voters and nominate or support attractive 11011-party candidates. I11 order to facilitate diis effect, it may be desirable to restrict campaign spending by political parties in presidential elections.

It also does not follow, as has been repeatedly stated by exalted personages in recent times, diat an elected presidency would preclude die choice of distinguished persons. If candidates really are distinguished, diere is every likelihood that opinionleading groups would support diem and diat die people would vote for diem.

Other Republics

These contentions receive some support from die practices of die established republics of die world.

The number of stable republics widi constitutions diat have functioned for reasonable periods widiout major unconstitutional episodes is relatively small, but so is die number of stable, democratic constitutional monarchies. Thirteen republics have been stable for die past 25 years or more under dieir current constitutions: Austria, Botswana, Finland, France, Germany, Iceland, India, Ireland, Israel, Italy, Singapore, Switzerland and die United States of America. Four of diese countries have executive presidencies. The United States has a pure executive presidency; Botswana, Finland and France have hybrid systems in which die government is carried 011 by ministers in die legislature but die president also exercises executive power. Switzerland has a separately constituted, but not direcdy elected, collegiate executive, quite different from a parliamentary cabinet.

O f die remaining eight countries widi parliamentary cabinet systems of government, four have direcdy elected presidents who perform a role similar to diat of Australia’s Governor-General. In Singapore and Ireland, party nominees have been elected as president, aldiough Singapore has had only one presidential election since changing to direct election, and at die last Irish election a 11011-party person was returned, which may well inspire a change of practice in diat country. I11 Iceland and Austria, it has been die practice to elect distinguished persons who may or may not be supported by political parties. The current president of Iceland is regarded as so distinguished diat she has been re-elected on several occasions unopposed. Iceland also provides a refutation of die claim diat die combination of an elected president and a cabinet system of government requires codification of die powers of die head of

Principally die other knight ol' die realm, Sir Zelman Cowen: see liis remarks rejiorted in ‘State a republic too, says ex-G-G’, The Mercury, 12 July 1995.7

Although formerly a member ol die labour Party, President Mary Robinson did not stand as a candidate o f diat paily.8

President Vigdis Finnbogadottir, a former dieatre director.

150 Harry Evans

state: the Icelandic constitution contains as little specification of those powers as Australia’s.

The remaining four countries have cabinet systems of government with appointed presidents. All of diese countries drew up dieir constitutions in die aftermadi of World W ar II, and had historical reasons for avoiding elected heads of state. The constitution of die German Federal Republic was drafted amid die ruins of the war; since presidential elections were associated widi Hindenburg and die appointment of Hider, it is not surprising diat die precedent of die Weimar Republic was not followed. India, which established its constitution immediately after a period of terrible communal violence, likewise eschewed presidential elections, which could have set one community against anodier. Israel in die same period was in a constant state of warfare, which made government by a single chamber possessing all powers appear to be die only option. Italy in die post-war period was haunted by die memory of Mussolini, and theref ore opted for collective (and weak) leadership. None of diese countries offers useful parallels for Australia.

Making allowance for die necessarily small number of examples, it can be said diat a cabinet system of government widi a head of state who performs essentially similar functions to Australia’s Governor-General is compatible widi popular election of diat head of state. Such a combination does not necessarily involve the election of party politicians, but may also lead to die election of distinguished 11011-party persons.

The Problem of the States

The issue of die head of state arises at die State level, but widi an additional difficulty. One of die greatest problems widi State parliaments is diat diey are too small to support a proper system of cabinet government. Widi a house of fewer dian 100 members, when a ministry is appointed from die majority and a shadow ministry from die minority, diere are few backbenchers left to undertake die parliamentary roles of monitoring executive activities and scrutinising legislation, particularly dirough a parliamentary committee system. It is politically very difficult to expand die State houses; indeed, diere are pressures to reduce dieir size as a way of lessening die burden 011 die taxpayer (see Tasmania, Board oflnquiry, 1994).

It has been suggested diat die federal head of state could also act as die head of state of each of die States, just as die Governor-General is in effect head of state of die Australian Capital Territory, and diat States could share governors (Winterton, 1986:107). Having to look after more dian one jurisdiction, however, would place too great a workload on die officeholders, if diey perform dieir duties diligendy, and would violate die federal principle of die independent constitution of die States.

The suggestion diat each of die States should have an elected governor, which is here submitted to be die appropriate constitutional arrangement if we are to retain parliamentary cabinet government, is likely to meet widi die very strong objection diat such an elected office would simply add to die burden 011 die taxpayer, especially if gubernatorial elections are to be held separately from parliamentary elections. But a solution exists diat would solve bodi die head of state issue at State level and die problem of die small size of State parliaments. This is a scheme dial could be under-


taken as an experiment by one of the less populous States, such as South Australia or Tasmania. One advantage of federalism is that such experiments can be undertaken without affecting the whole country.

The houses of the parliament of the State which experiments with this reform would continue with their current composition, or with their membership marginally reduced if it is desired to make the change cost-neutral. At the same time as the lower house is elected, a governor would be directly and separately elected by the electorate. The governor would be the head of state as well as the head ol government This officer would conduct the executive government and would appoint a small cabinet of ministers from outside the parliament The parliament would perform the legislative f unctions of passing laws and scrutinising die operations of government. The simultaneous election of die governor and die houses, or die lower house if die upper house has different tenns, would reduce die likelihood of serious deadlocks between die houses and die executive government. As each would be elected for a fixed term, diere would be no power of dissolution and no early elections. Upper houses would perform dieir present scrutiny and review functions. It is suggested that die houses should have die ability to scrutinise, but not to veto, executive appointments. An executive veto of legislation could be overridden by a special majority of die houses.

This would not be die American system. There would be no mid-term elections to increase die likelihood of disagreements between legislature and executive, and it would not involve adopting die American party or electoral systems. Even if die current disciplined Australian party system remained in all its cohesion and discipline, diis scheme would still be an improvement, because die legislature would be freer to perform die legislative functions and die choice of ministers would not be limited to die parliamentary members of die majority party. The scheme would amount to die adoption at die State level of die basics of die system which has been used widi success in local government in some States for many years, whereby die mayor and council are separately but simultaneously elected. (On one view, an amendment of die Australia Act 1986 may be necessary to allow a State to adopt diis system: see Waugh, 1996.)

If one of die small States undertook diis experiment, we could assess whedier we should be so fearful of changing die system of government as die official republicans suggest. It is suggested diat, if adopted, diis scheme would prove so effective diat odier States would follow suit, and it may even be adopted at die federal level. The system of government would dien undoubtedly have been changed. There would be no doubt, however, diat it would be dioroughly republican. W e would also have followed in die footsteps of die founders by not being af raid to try a system new and foreign to our traditions, as was federalism, in order to provide die country widi an efficient as well as a truly republican constitution.

See die statement by Justice Braiuleis, quoted in Winteiton (1986:107); Kasjier (1993).10

A similar scheme has been suggested by Maityn Webb in O ’Brien and Webb (1991:327-8).•1

Other commentators who liave questioned die ollicial oithodoxy about electing a president include McGuinness (1993), Ratnapala (1995) and living (1995).

152 Harry Evans

A Head of State for Australia

W e are constantly reminded by die official republicans diat die issue is all about an Australian head o f state: we must have a head o f state to suit Australia.

But diis premise does not lead to die conclusion diat the head o f state must resemble as closely as possible die British constitutional monarch. On die contrary, the institution o f an Australian head o f state should build upon die nascent republican culture o f Australia, as exemplified by die founders o f die federation, with their em phasis on institutional design and on popular participation. Building on that foundation entails an elected head o f state.

ReferencesByers, Sir M. (1995), ‘Presidential poll will lead to cliaos’, The Australian, 5 July.

Convention (1897), Debates o f the Ausüalasian Fedeial Convention, Adelaide, Sydney, SA and NSW Government. Printers.

Evatt, H. & E. Forsey (1990), Evatt and Forsey on the Reserve Powcis, a reprint, with a lengthy introduction by Dr Eugene Forsey, of liis The Royal Power o f Dissolution o f Parliament in the British Commonwealth (1943) and Dr H. V. Evatt’s The King and His Dominion Governors (Legal Books, Sydney, 1936).

living, H. (1995), ‘Why shouldn’t we choose our head of state’, Die Ausüalian, 14 March.

Kasper, W. (1993), ‘Competitive Federalism: May The Best State Win’, pp.53-69 in Restoring the line Republic, Centre for Independent Studies, Sydney.

Keating, P. (1995), ‘An Australian Republic, The Way Forward’, statement by die Piime Minister, 7 June, House o f Representatives Debates. 1434-41.

Madison, J., A. Hamilton &J. Jay (1787, 1970), Die Federalist Pa/jers, Dent, London.

McGuinness, P. (1993), ‘President needs proper I lowers’, The Australian, 14 May.

O ’Brien, P. & M. Webb (cds) (1991), The Executive State: WA Inc. and die Constitution, Constitutional Press, Perth.

Paine, T. (1776/1986), Common Sense, Penguin, Harmondsworth.

Uatnapala, S. (1995), Westminster Democracy and die Sejxuadon o f Powers: Can diey Coexist?, Canberra, die Senate (Papers on Parliament No. 26).

Republic Advisory Committee (1993), An Australian Republic- The Report, AGPS, Canberra.

Tasmania, Board of Inquiry (1994), Report of die Board of Inquiry into die Size and Constitution of the Tasmanian Parliament, apixiinted by die Tasmanian government, Tasmanian Government. Printer, HobarL

Waugh, J. (1996), ‘Australia’s State Constitutions, Reform and die Republic’, Agenda 3(1): 59-69.

Winterton, G. (1986), Monarchy to Republic: Ausüalian Republican Government (1st edition), Oxford University Press, Melbourne (reprinted widi additions in 1994).


Do Australian Firms Undertake Too Little Research and Development?

Scott Mitchell

W N recent times, Australia has spent less on R&D (as a proportion of GDP) than I all but half a dozen of the OECD and ASEAN nations. This shortfall is not

-A^due to public R&D expenditure, which is die fourth-highest in the OECD/ASEAN group. Radier, it reflects die fact diat Australian companies carry out significandy less R&D dian dieir overseas counterparts. Of die 23 nations listed in die 1994 edition of die OECD’s Main Science and Technology Indicators (1994), only five spent less on business R&D dian Australia (see also Figure 1).

None of diis means diat Australia undertakes too litde private R&D. Australia could even be undertaking too much research for a resource-based economy. In order to determine whedier Australia’s R&D effort is appropriate, it is necessary to ascertain what drives innovation, and to what extent diese forces may be distorted. This article argues diat competition drives innovation, and diat protectionist policies have held back Australia’s R&D effort.

Business innovation matters. Most growdi in real GDP per head has come from technological change, which in turn is due to product, process or organisational innovation. For most of diis century, Australia’s real per capita growdi rates have been below die OECD average, perhaps because Australia’s expenditure on business R&D has also been below die OECD average as far back as statistics are kept (Price Waterhouse, 1985). As Figure 1 indicates, innovation undertaken by private firms appears to have a significandy stronger effect on productivity dian does government R&D. In countries like Australia, where business innovation is low, government innovation tends to be high, but widi seemingly litde effect on productivity. Perhaps public research has been driven more by scientific priorities dian by industry requirements.

Why Does Australia Innovate Less?

Since a high propordon of its industries are characterised by low returns to R&D, Australia could be expected to undertake less innovation dian other OECD nations. Manufacturing, usually die most R&D-intensive sector, is smaller in Australia dian in most OECD countries. High-technology industries, which usually invest heavily in R&D, are a smaller proportion of manufacturing in Australia dian in many de-

Scott Mitchell is an economist in the Commonwealth Treasury and a postgraduate student in economic history at The Australian National University.

154 Scott Mitchell

veloped nations. However, even taking into account sucli structural considerations, Australia’s business expenditure on R&D is still comparatively low (Hall, 1993).

Figure 1

Contributions of business and government R&D to productivity, by OECD country relative to average, 1991

160 -

140 -

o 120 -

o) 100 -

<o 80 -

UJ 60 ----------Productivity per person

employed--------Government R&D relative to

national R&D- - - Business R&D relative to GDP

n 3 5 S f 3 5 S I=> & i

Source: EMF Foundation (1993).

Innovation in Australia may be low also because of ‘spillovers’, which allow firms to benefit freely from one another’s research efforts. But it is equally possible that government intervention may overcompensate for the effects of spillovers. There appears to be no strong evidence to show Uiat spillovers are greater in Australia than in other OECD nations (IC, 1995); yet the Australian government’s supply of basic R&D to the private sector represents one of die largest public-sector R&D programs in die OECD. Financial assistance to private innovation is also generous. For example, business R&D expenditure is allowed a 150 per cent tax deducdon in Australia, a considerably higher amount dian in most countries.

Anodier possible reason for Australia’s low levels of innovation is diat it may be cheaper to import new technology dian to develop it domestically. The dieory of comparative advantage suggests diat a country is best off if it concentrates on diose goods and services it can produce most efficiendy and imports odier goods and

Do Australian Firms Undertake Too Little Research and Development? 155

services. However, while it can be relatively easy to acquire the technology itself, it may be difficult to understand, modif y, or even use it without a knowledge of how it was developed. It is difficult to acquire this knowledge separately, since information cannot be easily bought and sold. The classic problem of inf ormation is that people are unwilling to buy it without knowing what it is, and dien unwilling to pay for it once diey do know. Even if diey were willing, much of die knowledge gained from innovation does not exist in a tradable form. It is often tacit radier dian explicit, residing in a firm’s collective memory radier dian its blueprints. In odier cases, die required knowledge may simply not be available elsewhere — or its possessors have not revealed its existence to potential competitors. Finally, if a firm does acquire die information it needs, it may be unwilling to invest in sufficient in-house research to enable it to understand it.

These factors explains why very few Australian companies’ innovadve technologies are developed from sources outside die firm: die Bureau of Industry Economics (BIE) (1993) found diat 79 per cent of innovations used by Australian firms were sourced from widiin die firm itself. For die same reasons, diat diere are few firms specialising in supplying research for odier companies.

Innovation and Theories of Growth

Apart from die structural, spillover and comparative advantage factors, ordiodox neoclassical dieory has litde to say about why one nation (or firm) may undertake more or less R&D dian anodier. The standard model assumes diminishing returns to capital: die more a firm increases its capital in proportion to its labour, die smaller die increases in output it will obtain. Yet a cursory glance at history shows diat increasing capital intensity has been raising output for at least the last 1,000 years (see, for example, Snooks, 1993). When neoclassical dieory is applied to real- world data, all die observed increases in outputs in excess of increases of inputs have to be put in a residual column, usually tided ‘Total Factor Productivity’ and attributed to innovation; but diere is nodiing in die dieory as to how, when, where or why such innovation might occur.

The foremost attempts to include growdi in neoclassical models are by Solow (1956) and Swan (1956). But diougli madiematically elegant, such models have managed only to duplicate retrospectively given real-world outcomes. As diere has been litde replication of real-world processes, diese models have had litde predictive power or usefulness for policy. As Snooks (1993:83) notes:

. . . even diougli technological change was more clearly specified . . . it wasnot treated endogenously hut radier grafted awkwardly on to die body ofdiese growdi models.

One of diese models, die recent ‘New Growdi Theory’, does away widi die central ‘stagnation’ of neoclassical dieory and permits growdi to occur dirough increasing returns to scale. However, while diis model allows technical change to occur, it still sheds litde light on what drives innovation.

156 Scott Mitchell

To ascertain what drives R&D and why Australia has undertaken so little, it is necessary to venture outside the world of maths-based theories and to look instead at dieories derived from observations of real-world innovation.

Theories of Innovation

Arguably the two best-known innovation theories are those ol Jacob Schmookler and Joseph Schumpeter. Schmookler (1966), after studying over 1,000 innovations, rejected the ‘science-push’ theory of innovation. This earlier theory held that scientists make serendipitous breakthroughs, which businesspeople can then develop and sell. Schmookler found that all but a handful of innovations came about as a result of research directed at identified market needs. His ‘market-pull’ theory argues that innovation is driven by market demand: firms develop new products il the estimated profits exceed die estimated development costs.

However, Schmookler’s theory does not appear to hold in the Australian case. Demand for new technology is high in Australia; there are more mobile phones, faxes, videos, PCs and internet accounts per head in Australia than all but one or two nations in the world. Yet on the supply side there is little innovation. Perhaps the shortcoming in Schmookler’s theory lies in the relative ease of innovation: in his theory, firms face few transaction costs, but simply draw what they need from a pool of scientific knowledge and develop a new product that will meet the identified needs.

Schumpeter (1934, 1942), in contrast, recognises that innovation has very high transaction costs. Innovation is a ‘strongly uncertain’ activity. An event is considered to involve risk if both the outcomes and their probabilities are known (for example, rolling a die). It is uncertain if only the events are known but not the probabilities (for example, whether the dollar will rise or fall tomorrow). It is strongly uncertain if neither the events nor their probabilities are known (lor example, what will happen if I mix several unknown chemicals). Not only is innovation strongly uncertain, but the factors affecting it are manifestly complex. For example, ‘pure’ information (which often resides only in human memory banks) can be dependent on the current state of the various scientific disciplines and institutions, the apparatus for transferring information, the numbers and types of knowledge bases and the search procedures used to glean them. Similarly, ‘embodied’ information (technology) is more complex than Schmookler assumes. In reality, a firm cannot produce an innovation by just dipping into the available pool of technologies whenever it detects a new demand; it has to learn how to use existing technologies before it can combine them in new forms. Further, no existing mechanism is efficient at dealing with die uncertainties and complexities of innovation. As discussed above, diere are often prohibitively high transaction costs to acquiring information dirough die market. Aldiough die state undertakes vast amounts of research, little useful information crosses die cultural divide between it and private firms (which is why joint government and private Cooperative Research Centres have recendy been set up in Australia).


Schumpeter found that, because of all these uncertainties, complexities and other difficulties, innovation is driven by competition: most firms’ managers were unwilling to engage in innovation unless they really had to. Exceedingly large potential profits would be required to act as an incentive to innovation, for several reasons. First, strong uncertainty requires much greater potential returns to yield positive expected values than does mere risk (venture capitalists operate in the hope that one wildly successful project in every few hundred will recoup the costs of all the others). Second, innovation tends to be expensive. A widely quoted rule in industry is that for every dollar spent on research, ten need to be spent on development and a hundred on commercialisation. The BIE (1993) surveys confirmed this rule for major R&D projects on manufacturing.1 For a given degree of risk, the greater die sums involved, the greater is the return needed to make a project attractive: people will chance $20 on an even bet, but they won’t risk their company on one. Given that managers (like most people) are risk-averse, it will often be entirely rational not to invest in innovation.

Schumpeter noted that firms’ incentives to innovate decreased as profits increased. Only when profits are reduced by competitors will firms be driven to innovate. Even firms that once innovated under competitive pressure often cease doing so once they can shelter their profits behind their innovations. For example, IBM originally became involved in computers only because it feared that competitors might use them to threaten its core business of census tabulating. Later, feeling safe behind its mainframe hegemony, IBM did not bother to undertake the R&D for its new personal computers but paid Intel and Microsof t to do so.

Innovation and Competition

As well as being intuitively plausible, Schumpeter’s theory is testable. If we can establish that competition drives innovation, and that there is a sub-optimal degree of competition, then, other tilings being equal, we can establish whether or not there is a sub-optimal level of innovation.

We know that innovation has been low in Australia. We know also that there have been many impediments to competition, both domestic and trade-related, in Australia; that diese impediments have been reduced over die last 20 years; and diat business R&D has been increasing. Moreover, several audiors have tested — and confirmed — Schumpeter’s dieories in odier countries (see, for example, Grabowski & Baxter, 1973; Gort & Konakayama, 1982; Montgomery & Wascher, 1988). What does die qualitadve and quandtadve evidence indicate for Australia?

As noted above, a number of madiemadcally sophisticated, but policy- redundant, models of innovation and growdi have been developed. Hence, before conducting any stadsdcal analysis, it is wordi examining die insights of diose who have been involved in innovation in Australia. As diose in applied market research say: ‘If a number seems right, it probably is’.

1 However, because much innovadon involves only increments to established processes, die total ratio of research to development and commercialisation is around one to two (see ABS, 1995).

158 Scott Mitchell

Many researchers have noted that die ‘institutionalised uncompetitiveness’ that results from tariff walls has had a detrimental effect on innovation. Brian Hickman, who heads die ARC’s efforts to encourage collaboradve research between universities and industry commented:

. . . die major problem has been diat until recendy, die whole economic environment in which industry has been operating has not encouraged innovation. But change has been forced in diis situadon in die last five years by die greater degree of international compeddveness diat is being forced on industry [which is] providing encouragement to innovation. (IC, 1993:870)

Similarly, Peter Hall (1992:14) observes diat protectionist policies ‘have reinforced preexisting conditions in Australia to influence firms and markets to interact in ways which, until recendy, have created a range of negative feedbacks in reladon to die effective development and applicadon of new technology’. Manufacturers have no- dced diis too. The Business Council of Australia also found diat increased compeddon is having a significant effect on innovation. After interviewing 700 CEOs of Australian firms for its 1993 study Managing the Innovative Etiterprise, die Council concluded diat: ‘The intemadonalisadon of die Australian economy and die new performance standards it requires are die predominate drivers of enterprise innovadon’ (Carnegie, 1993:331). Indeed, nodng diat a number o f ‘now strong and successful’ enterprises such as Comalco, Toyota, Ericsson and Du Pont had faced a ‘very serious’ risk of closure not long ago because of cuts in protecdon, die Council observed: ‘Tariff reducdons, and warnings of tariff reductions to come, figure among die most effective triggers for improvement among die enterprises die Study Commission saw’ (Carnegie, 1993:80). The BIE (1993), in its survey of 900 firms, found diat die need ‘to create a competitive advantage’ was die foremost influence on R&D expenditure. Market opportunities (Schmookler’s ‘demand-pull’) had a signiticandy lower impact on innovation decisions. Technological changes, or ‘science push’, had only about die same influence as subsidies.

So bodi diose who practise and diose who observe innovation in Australia consider diat removing protection has given firms much greater incentive to innovate. The numbers seem to bear diis out. Figure 2 shows diat since die protection afforded by tariffs began to decrease in die mid-1970s, business R&D has steadily increased. However, a number of factors odier dian increased competition might have had an impact on R&D in Australia. Government subsidies for business R&D have increased considerably over diis period, most of it in die form of a 150 per cent tax concession for business R&D, which was introduced in die mid-1980s.2 The BIE (1993) estimated diat die subsidy provided under die Tax Concession is

2 The odier main subsidies are grants for specific projects, which, having changed little, are unlikely to account for die significant increase in R&D.


equivalent to approximately 20 per cent ol total business expenditure on R&D, and has led to an increase in business expenditure on R&D ol around die same order.

Figure 2

Effective protection and business R&D in Australia relative to 1985 levels, 1973/74 -1990/91

120 - = - = ■

60 -------Business R&Drelative to GDP

------ Effective rate ofprotection

1973/74 1976/77 1978/79 1981/82 1984/85 1986/87 1988/89 1990/91

Sources: ABS (various years a, b, c); IC (various years).

Profits have also increased signilicandy since tariff reform. Could diey be driving up R&D? The Department of Industry, Science and Technology (DIST) often argued diat firms needed subsidies because it was hard to finance innovation privately in Australia; widi dieir newfound profits, firms now have more resources to devote to R&D should diey want to (see, for example, DIST, 1992). On die odier hand, DIST’s research arm, die BIE (1993), found diat retained profits and cashflow were fairly low-order motivations for R&D. It seems odd diat profits have risen since competition has increased. Perhaps new competition drives R&D, which dien increases profits. A complementary possibility is diat rents may have been larger before competition, but were dissipated by workers and management — ‘X inefficiency’ — and did not appear as accounting profits.

Statisdcal analysis can often be useful for answering questions like die extent to which tariffs, profits or tax concessions drive R&D. However, one reason economists have neglected innovation is die poor quality of die available data. In Australia, such historical data as exists have been collected only infrequendy (nine times to

160 Scott Mitchell

date) and irregularly. Any results gleaned from statistical analysis must therefore be treated with considerable caution.

A Statistical Test

This article uses a time-series regression model3 to test to die effects of profits,4 tariffs and taxes on R&D for die Australian manufacturing sector as a whole and its eleven Australian Standard Industrial Classifications (ASIC) subdivisions from 1973/74 to 1990/91. The manufacturing sector was chosen because, unlike die mining sector, it was gready favoured by tariffs and lost from dieir removal; die vast majority of R&D in manufacturing is carried out by private enterprise, unlike agriculture; and manufacturing accounts for die most business innovation in Australia.

Tariffs were chosen as a proxy variable for competition, and measured by Industry Commission (various years) estimates of effective rates of protection. As noted above, while diere are many odier forms of protection, tariffs have probably accounted for most of die changes in die period covered. This is not to say diat effective protection is a good proxy for competition, but it is one diat lends itself to being modelled.

The Tax Concession was measured using die BIE’s (1993) estimates of nominal percentage rate of subsidy. Profits were measured as a ratio of Gross Operating Surplus to Gross Domestic Product from ABS (various years a, various years b). R&D was measured as a percentage of Business Expenditure on Research and Development (BERD) to Gross Domestic Product, from ABS (various years c).

The model accurately simulated die observed changes in business R&D in die manufacturing sector. The regression of tariffs, tax concession and profits against R&D had a ‘goodness of fit’ (or R2 ) of .97, indicating diat changes in diese diree variables ‘explained’ nearly all of die changes in R&D (see Table l).5 This establishes diat die overall model fits die facts well enough to test die diesis.

The results for manufacturing as a whole support die diesis dial competition drives innovation. First, die results for tariffs showed diat, as effective protection decreased, BERD increased. While die impact of protection on R&D was not a strong one, it was statistically significant. Second, some support for die diesis was also obtained from die results on profits. Aldiough not significant, die sign on die profit variable was negative, indicating diat higher profits tend to be associated widi diminished incentives to invest in R&D, as Schumpeter predicted.

3 While panel or pooled data may be preferable to a time series, this would require tire assumption diat die sensitivity of output to R&D is die same across industries and over time, which is unlikely (see Bernstein & Nadiri, 1989).4 There may be an endogeneity problem to die extent diat diis period’s profits are influenced by diis period’s R&D (aldiough die correlation is under 0.10 in most cases). Lagged profits could be a suitable substitute but for die lengdiy and variable lag.3 Most Durbin-Watson statistics were between 1.8 and 2.5, which indicates die high R^s are probably not due to regressing difference stationary variables.


Table 1

Impacts of profits, tariffs and tax concessions on R&D, by industry

industry ~ w Profit(x100)

Tariff(x100)

Tax concessions (x100)

Food, beverages & tobacco .91 -0.80(-0.6)

-0.01(-0.1)

1.84(2.7)

Textiles, clothing & footwear .66 0 .16(0.1)

-0.11(-0.7)

0 .66(0.7)

W ood, wood products & furniture

.93 -0.21(-0.2)

0.18(0.2)

0.75(3.2)

Pulp & paper products .76 -1.40(-0.8)

-1 .40(-1.2)

0.25(0.3)

Chem icals, petroleum & coal .93 -0.28(-0.1)

-4.51(-1.2)

2.69(1.6)

Non-metallic mineral products .88 1.86(1.9)

3.56(0.6)

0.92(1.8)

Basic metal products .85 1.03(0.7)

0.25(0.1)

2.23(2.5)

Fabricated metal products .83 -1.53(-1.1)

-0.87(-0.9)

0.98(1.3)

Transport equipment .90 10.21(1.8)

0.21(0.1)

7.48(3.1)

O ther equipment .92 -0.12(0.0)

-2 .86(-0.3)

14.72(3.3)

Miscellaneous n.e.c. .97 0.93(0.9)

-1.61(-1.0)

1.81(3.2)

Total manufacturing .97 -1.37(-0.8)

-6.79(-2.7)

1.48(1.4)

Notes: R2 indicates the extent to which change in R&D is ‘explained’ by cumulative changes in profits, tariffs and tax concessions. The coefficients for these variables show how much a unit change in each will change R&D. For example, a 1 per cent increase in effective subsidies from the tax concession should lead to a 0.15 per cent increase in R&D to gross product. The figures in brackets are T statistics, which indicate the probability of a statistically significant relationship between the dependent variable and R&D. In this particular case, a t statistic greater than 1.53 indicates a 90 per cent probability, and one greater than 2.13 indicates a 95 per cent probability.

These results for die manufacturing subcategories also lend some support to die diesis. Not many variables appear as statistically significant, but, widi such few observations, only comparadvely strong reladonsbips would do so. (A better proxy for competition dian tariffs may be needed to show a stronger relationship.) The coefficients did, however, tend to have die right signs. R&D increased as tariffs decreased in eight of die eleven ASIC diree-digit manufacturing industries. Profits similarly had an inverse effect on R&D in eight of die eleven industries.

162 Scott Mitchell

The model tended to be most supportive of die thesis in sectors that were innovative or competitive, and least supportive in those that were neither. For example, sectors with high R&D intensities such as Other Equipment6 and Chemicals, Petroleum & Coal had some of die strongest coefficients on effective rates. The regression also had its best fit with these sectors. Conversely, those sectors with the highest tariffs, such as Textiles, Clothing & Footwear and Transport Equipment, had some of the weakest relationships between competition and R&D. Textiles, Clothing & Footwear was also the sector die model fitted least well.

Finally, although it was not significant for total manufacturing, the tax concession variable tended to have the strongest coefficient and die highest degrees of significance for all categories.

Conclusion

Schumpeter’s diesis that competition drives innovation is supported by the qualitative evidence, and appears to be supported by such quantitative evidence as exists in Australia. It is widely accepted that restrictions on competition have damaged efficiency in a static sense by reducing firms’ incentives to choose die lowest-cost combinations on their production frontiers. This article’s findings may indicate that restrictions on competition in Australia have also damaged efficiency in a dynamic sense by reducing firms’ incentives to shift their production frontiers. Hence, to the extent that Australia’s below-average business expenditure on R&D is caused by its above-average levels of protection, Australia has indeed undertaken ‘too little’ R&D.

Continuing to increase competition would appear to be die most effective policy to overcome diese sub-optimal levels of innovation. Fortunately, this is happening. However, should die government retain obstacles to competition (like diose in die labour market, for example), dien using tax concessions to fund more business R&D may be a second-best solution.

° This category is R&D-intensivc clue to computer software, which accounts lor over 20 per cent o f all Australian business R&D.


ReferencesAustralian Bureau of Statistics (ABS) (various years a), Austialian National Accounts: National In

come, Expenditure ajid Product, AGPS, Canberra (CaL No. 5204).

------ (vaiious years b), Australian National Accounts: National Income, Expenditure and Product,AGPS, Canberra (CaL No. 5206).

------ (various years c), Research and Experimental Development, Business Entcipnscs, Australia,AGPS, Canberra (CaL No. 8104).

------ (1995), Innovation in Austialian Manufacturing 1994, AGPS, Canberra (CaL No. 8116).

Bernstein, J. & M. Nadiri (1989), ‘Rates of Return on Physical Capital and R&D Capital and Structure of die Production Process: Cross Section and Time-series Evidence’, in Advances in Econometrics and Modelling, Kluwer, London.

Bureau of Industry Economics (BIE) (1993), R&Ü, Innovation and Competitiveness: An Evaluation o f die Research and Development Tax Concession, AGPS, Canberra (Research Report No. 50).

Carnegie, R. (1993), Managing die Innovadve Enterprise: Australian Companies Compering with die World’s Best, Business Council of Australia, Melbourne.

Department of Industry, Science and Technology (DIST) (1992), ‘DITAC/IR&D Board Submission to Industry Commission Inquiry into the National Development Procurement Program’, Can- lieiTa.

------ (1994), Austialian Science and Innovation Resources B rie f1994, AGPS, Canberra.

EMF Foundation (1993), World Competitiveness Report 1993, Switzerland.

Gort, M. & A. Konakayama (1982), ‘A Model of Diffusion in the Production of an Innovation’, American Economic Review72(5): 1111-20.

Grabowski, H. & N. Baxter (1973), ‘Rivalry in Industrial Research and Development — an Empirical Study’, Journal o f Industrial Economics'. 23: 209-35.

Hall, P. (1992), ‘The Domestic Economic Context for Scientific and Technological Development in Australia’, paper presented to the Conference on International Dimensions of Australian Scientific and Technological Development, University College, UNSW, Canberra, October.

Industry Commission (IC) (vaiious years), Annual Report, AGPS, Canberra.

------ (1994), ‘Transcript of Proceedings, Inquiry into Research and Development’, Spark and Cannon, Canberra (November).

------ (1995), Research and Development, AGPS, Canberra (Report No. 44).

Montgomery, E. & W. Wascher (1988), ‘Creative Destruction and die Behaviour of Productivity over die Business Cycle’, Review o f Economics and Statistics 70(1): 168-72.

Organization for Economic Cooperation and Development (OECD) (1994), Main Science and Technology Indicators, Paiis.

Price Waterhouse (1985), The Promotion o f Indigenous IRSiD in Austialia and die Effectiveness o f die Industiial Research and Development Incentives Scheme, Canbeira.

164 Scott Mitchell

Schmoolder, J. (1966), Invention and Economic Growth, Harvard University Press, Cambridge, Mass.

Schumpeter, J. (1934), The 'Theory o f Economic Development, Harvard University Press, Cambridge, Mass.

------ (1942), Capitalism, Socialism and Democracy, McGraw-Hill, New York.

Snooks, G. (1993), Economics widiout Time, Macmillan, London.

Solow, R. (1956), ‘A Contribution to the Theory of Economic Growth’, Quarterly Journal o f Economics 70: 65-94.

Swan, T. (1956), ‘Economic Growth and Capital Accumulation’, Economic Record32(63): 334-61.


Pricing Access to Essential Facilities

Michael Pickford

n n H E pricing and odier terms of interconnection to natural monopoly facilities in the utilities sector has become an important issue both in Australia, with

JtL die new ‘right of access’ policy under die recent reforms to competition policy (King, 1995), and in New Zealand, under ‘light-handed’ regulation. The recent joint report by die New Zealand Ministry of Commerce and die Treasury represents the first published attempt by government officials to review experience with die distinctive New Zealand regulatory approach. The report discusses

. . . die issues arising from die New Zealand experience widi telecommunicadons interconnection negotiations and die implications of die decision of die Privy Council in die case of Telecom Corporation v Clear Communications for die economic regulation of access in die telecommunications industry and odier vertically-integrated natural monopolies in New Zealand . . . (Ministry of Commerce, 1995:1)

On die cridcal issue of die pricing of interconnecdon widi natural monopoly facilides, such as telephone and electricity networks, die report states diat die Bau- mol-Willig (B-W) rule may or may not be appropriate to New Zealand’s circumstances. However, it recognises diat die landmark decision on Telecom v Clear by die Privy Council — diat charging on such a basis does not consdtute use of a dominant posidon under s.3d of die Commerce Act — sanedons die use of die rule by incumbent natural monopolists under die present law.

The Interconnection Problem

Vertically integrated natural monopolies occur where die incumbent bodi owns die natural monopoly facility and competes in a vertically related upstream or downstream market. Since die natural monopoly facility (such as die telephone network) cannot economically be duplicated, an entrant in die vertically related market (such as a provider of telephone services) must be able to gain access to die incum-

For a review of the litigation and its implications, see Blanchard (1995) and Ross (1995).2

In simple terms, a natural monopoly occurs where, because ol economies ol scale, an industry’s output can be produced more clFiciendy by one firm than by two or more smaller firms.

Michael Pickford is Chief Economist at the Commerce Commission.

166 Michael Pickford

bent’s facility in order to compete. Since most utilities historically have operated on a vertically integrated basis, providing a right of access amounts to creating new property rights for entrants (Ergas, 1995). The incumbent has an obvious incentive to deny access in order to preserve its monopoly power and profit, derived from the facilities ownership, in the related market (foreclosure). Where outright refusal to provide access may breach competition laws, the incumbent may instead set a high interconnection price so as to render entry uneconomic even for an efficient entrant. Recent attention in New Zealand has centred on telecommunications markets, but the same access issues arise in die electricity, gas, postal services, and odier sectors.

Such access disputes are meant to be resolved in New Zealand through ‘light- handed’ regulation (Bollard & Pickford, 1995). Section 36 ol die Commerce Act, under which a firm occupying a dominant posidon in a market must not use diat position for die purpose of excluding competition, has die effect of restraining die price (in some undefined way) diat can be charged by diat linn for an essendal input, such as access. Industry-specific reguladons also require owners of certain natural monopoly facilides to disclose pricing and operadng information, so as to facilitate transparency and benchmark comparisons, and to encourage entry. This approach avoids die costs of more ‘heavy-handed’ forms of regulation, such as die productive inefficiencies associated widi state ownership, the losses of scale and scope economies linked widi die break-up of monopoly firms, and die market distortions involved widi price control.

By mid-1995, five interconnection agreements had been successfully negotiated widi Telecom, including diose widi Clear for toll calls, BellSoudi for a cellular services, and Sprint for international calls. Moreover, broad terms for die interconnection of Clear’s proposed local Central Business District telephone service to die Telecom network were agreed in September, after four years of negotiations and millions of dollars spent on negotiation and litigation. Ill addition, numerous odier disputes have occurred between die two companies — most of which have been setded — over odier terms and conditions, including die access dialling code,

3

The terms ‘interconnection’ and ‘access’ are used interchangeably here, although die former is moreappropriate in telecommunications and die latter in odier utilities.4

Where a natural monopoly facility is owned by a non-vertically integrated firm (for example, Trans Power’s ownership of die electricity transmission network), die exclusion of customers is not a problem, but die issue of monopoly power remains. In bodi cases die upstream monopolist can exploit its market power to extract excess profits from die sale of die final good. This shows diat the interconnection issue of foreclosure is pail of a broader class of problems involving natural monopoly at dieintermediate goods stage. I acknowledge my debt to a referee for emphasising diis point5

For a brief review of die massive distortions, mainly regulation-induced, currcndy faced by UnitedStates utilities, see Kalin (1995:2-5).6

Aldiough die agreement became operational in September, die final technical details took longer to work ouL The signing of die contract was postponed from end-September to end-October, and dien to mid-December. See Frances Martin, ‘Phone deal delayed yet again’, 77/e Dominion, 8 November 1995.

Pricing Access to Essential Facilities 167

the allocation of toll-free ‘0800’ numbers, and Clear’s contribution to the ‘Kiwi Share’ social service obligation imposed on Telecom at the time of privatisation.

Similar access problems are starting to emerge in the electricity sector, where die local distribution networks are natural monopolies and the power company owners also compete in the local retailing markets. Some access agreements with new retailers have been reached in the relatively short time since deregulation, but some intending entrants have complained to the Commerce Commission and in public forums about access difficulties, including pricing issues. In natural gas, where deregulation is not yet complete, the replacement of pre-deregulation supply contracts between the natural monopoly wholesaler and local network retailers have yet to be resolved. In postal services the statutory monopolist has standard charges for bulk mailers, of which there are several in die market (see below).

Aldiough competition from new entry has begun to appear in parts of diese udlity sectors, die Ministry of Commerce (1995:3) argues diat die Privy Council decision raises diree concerns about interconnection issues:

1. The appropriateness of die B-W rule for pricing access to the natural monopoly facility of a verdcally integrated incumbent. The rule is designed to ensure diat only efficient firms are able to enter die market. It does not eliminate monopoly pricing (if any) by die incumbent.

2. The appropriate treatment of die costs incurred by die incumbent monopolist in meedng its social obligadons, such as Telecom’s Kiwi Share obligadons or New Zealand Post’s universal service obligation.

3. The delays involved in relying on die courts and die Commerce Act to resolve interconnection disputes. While the pricing issue has been setded for die time being by die Privy Council decision, in local telephony (and odier areas) various terms and conditions remain ill-defined and could dierelore become die subject of future litigation. Under light-handed regulation, die incumbent has an incentive to delay entry by testing die legal limits, where die legal costs of so doing are less dian die profits diat would be lost by conceding entry. Disgrunded would-be entrants dien lobby die government for help radier dian continuing widi negotiations. Neidier leads to a resolution of disputes.

The Baumol-Willig Rule

The interconnection problem arises when a vertically integrated incumbent firm is die only supplier of an input or component (such as access to a natural monopoly network), which is used bodi by itself and by intending noil-integrated competitors in die market for die final product. The central issue is die price die incumbent may charge for access. According to die ‘efficient component pricing’ or ‘Baumol- Willig’ rule (Baumol & Sidak, 1994a,b), price setting should be guided by effi-

7The rule was devised independently by Kalin, who called it die ‘competitive parity principle’ (Kalin &

Taylor, 1994). It lias been suggested that die antecedent of die rule is to be found in Judge Hand’s


ciency considerations, as it would in a hypothetical competitive market. This involves setting a price that is neither so low as to allow an inefficient rival to enter profitably nor so high as to render entry unattractive to a more elficient competitor.

The relevant price is that which the incumbent would charge itself for the use of die input in the hypothetical competitive market, including any monopoly profit forgone. Thus, when a Clear customer makes a call that previously would have been a Telecom call, Telecom should charge Clear the revenue it forgoes on the call (including monopoly profit, if any, plus the cost of providing interconnecting switches), minus the saving it makes on its average incremental cost by Clear carrying tlie call for part of the way through the Clear network. The price thus equals the sum of tlie direct or incremental production costs incurred by die owner in supplying die access, plus die opportunity cost associated widi diat supply (die contribudon toward common costs and profit diat it would have earned had it continued to supply diose units of final product). At any lower price die firm in a compeddve market would be unwilling to supply, since die price would not recoup its costs (including opportunity costs); at any higher price, die equally efficient rival would be unwilling to buy since it would be placed at a compeddve disadvantage in reladon to die incumbent.

As an illustration, suppose diat die unit incremental costs of network use and of downstream processing are $3 and $4 respectively, and diat die incumbent’s final product price is $14. Each sale dius yields $7 ($14 minus ($3+$4)) as contribution toward die incumbent’s common or overhead costs, which cannot be allocated between different products (between local and toll calls, for example) except on an arbitrary basis. Here die optimal input price, die one which would leave die incumbent indifferent as to whedier it or die rival supplies die unit of final product, is $10 ($3 in compensation for die costs of access plus $7 to cover contribution forgone). At diis price only an equally or more efficient rival (one whose downstream unit costs are $4 or less) will be able to enter die market for die final product. The absolute sizes of die charges to cover access and contribution forgone do not matter in terms of ensuring efficient competition, or ‘competitive parity’, between die two in die supply of die product in question, unless die height of die price so reduces die size of die market diat entry is impaired because of die inability of an entrant to spread its overheads sufficiendy in its downstream processing operation.

There are difficulties in measuring die opportunity cost element in die access price. For example, when a tolls customer transfers from Telecom to Clear, Tele

opinion in die 1945 ALCOA case in the United States. Tlie basic assumption is diat die usual economic welfare-maximising access price, set at die short-run marginal cost of die facility (Ng, 1987), is not appropriate because it would result in die owner making a financial loss dirough an inability to cover common costs, which die government is not prepared to subsidise. The usual dieoretical solution to diis problem — die use of Ramsey prices, where different markups arc added to die marginal costs of different products and different customer groups in inverse proportion to dieir price elasticities o f demand — is rejected by Baumöl and Sidak (1994a:38-9) because it is virtually impossible to obtain die data required to implement such a scheme. A further assumption is diat die facility is not congested, in which case peak-load pricing becomes appropriate.


com loses not only the profits earned on the calls the person would have made, but also die profits on other complementary telephone services (like international calls) likely to be earned by die tolls provider. However, die B-W rule specifies diat diose odier profits are to be ignored in compudng die access price (Arnold, 1995:133-4), which should increase die attractiveness of entry. Furdier, as Albon (1994) points out, die access price would be too high if die contribution forgone component was based on die output gained by die entrant, radier dian diat lost by die incumbent. The former is likely to be higher to die extent diat die entrant taps into new demand, whereas die price should be based on die latter.

An Evaluation of the Rule

The B-W rule has been cridcised on a number of grounds, not all of which are well founded. These range from claims diat odier pricing rules might produce superior outcomes in terms of economic welfare, to flat rejections by Clear on die grounds diat its entry would be rendered lion-viable. Here we evaluate die rule in terms of its ability to promote economic welfare, as judged by allocative, productive, and dynamic efficiency. W e also consider die implications for access pricing when the government imposes a social-service obligation on die incumbent.

Allocative elliciency. One criticism of die rule diat featured prominendy in Tele- coin v Clear is diat it serves to preserve any monopoly profit earned by die incumbent. The presence of such profit implies a socially undesirable restriction of output by die incumbent, which leads to a loss of allocative efficiency. Using the illustration above, suppose diat of die $7 of contribution, die unit common costs are actually only $5, leaving $2 of monopoly profit per unit of output. The access price of $10 allows die incumbent to recoup die monopoly profit forgone dirough conceding sales to die entrant, diereby preserving diose profits. This seems to defy logic, since in die assumed competitive market, an input supplier would not be able to earn monopoly profit. The paradox arises because die rule was developed for regulated markets in die United States, where price or odier controls restrict monopoly profits. When die rule is applied to markets subject to light-handed regulation where diere are no such controls, its effect is blunted. As Baumöl and Sidak (1994a: 177) note, ‘Final product prices must be constrained by market forces or regulation so as to preclude monopoly profits . . . die one rule widiout die odier, does not guarantee results diat serve die public interest’. Since price controls are unlikely to be introduced in New Zealand because diey would add undesirable regulatory distortions to die access regime, die B-W rule clearly fails on allocative efficiency grounds.

Productive elliciency. The rule serves die purpose of excluding inefficient entry. Suppose in our example diat die access price was set at $9 radier dian $10. This

A normal profit on capital funds, which a limn in a competitive market would expect to earn in the long run, is included as an element of cost in the common and/or incremental costs as appropriate.


would allow less efficient firms — ones whose downstream processing costs exceed $4, and which could be as high as $5 — to enter the market. Clearly this would be undesirable from an economic welfare viewpoint, since industry production would absorb more scarce inputs than die minimum necessary. Society is interested in having its demand for die product met at die lowest cost. Therefore, it is socially not desirable for a new entrant to replace some of die incumbent’s production with its own unless it can do so at a lower cost. Odierwise, static efficiency requires diat die incumbent produce all of die industry’s output. The rule dius promotes productive efficiency, in die limited sense of excluding inefficient entrants.

However, a problem in die B-W rule is die implicit assumption that the owner of die essential facility is fully efficient — as it would be in die hypothetical competitive market — so diat die unit incremental cost of die essential input is at a minimum. That minimum cost is dien built into die optimum access price, as a means of ensuring production efficiency. But the incumbent lacks any competitive pressure to be fully efficient in its production of die essential input, for even should entry occur^ die higher cost can simply be passed on in die access price quoted to die entrant. Since die cost of die component is dien a cost to bodi pardes, competition between diem will not necessarily eliminate die inefficiency. If die incumbent moves to reduce die cost in order to improve profits, die saving will be passed on to die entrant in a lower access price at die next review. Consequendy, any advantage to die incumbent will be temporary, and hence any incentive to improve efficiency will be muted. However, die scope for productive inefficiency in monopoly (see, for example, Siegfried & Wheeler, 1981) raises problems for all forms of monopoly regulation, not just for die B-W rule.

Dynamic efficiency. An entrant widi lower downstream processing costs will be able to price below die incumbent; assuming a standardised product, diis will force die incumbent to respond widi a lower price, diereby eroding its monopoly profit. Using die numerical illustration, if die rival’s processing cost is not $4 but $3, it could undercut die incumbent’s price by as much as a $1 and still earn a normal profit on capital. Some price cutting may be necessary for an entrant to gain market share by overcoming incumbency advantages, as seems to have happened when Clear entered die tolls market in competition widi Telecom. However, it is unlikely diat price will be pared down to die full extent of die entrant’s superior efficiency.

If die entrant’s efficiency (as judged by levels of average incremental cost) is only equal to diat of die incumbent, die revenue it earns from a call matches die average incremental cost incurred in taking die call (assuming diat it charges the same price for die entire call as Telecom), leaving no contribution toward its own

A possible example is the connection by Telecom of consumers living in remote rural areas to the network using traditional wire-based technology, willi die associated high maintenance costs, when cellular telephony today probably provides a cheaper alternative. More generally, in die years following privatisation in 1987, it is evident diat Telecom’s costs were inflated bodi by X-inelliciency and by a history of inadequate levels o f investment. See: Fanner (1993:7, 21); de Boers and Evans (1995).


overhead costs. Hence die entrant has to be more efficient than the incumbent to be able to enter at all, and even then entry may be possible only if the entrant can gain sufficient market share to spread its overheads thinly. Moreover, where entry requires a substantial investment in sunk costs — such as expenditure on promotion and on other specialised assets with low resale value, which cannot be recouped if die firm subsequently decides to exit die industry — the entry of an efficient competitor may be deterred. The potential losses should exit be forced may discourage die firm from entering in die first place.

These considerations may help explain die lengdi of time Telecom and Clear needed to resolve dieir long-running local interconnection dispute, despite continued pressure from die government (which is committed to competition) to do so. It may be diat die efficient interconnection price would not have allowed Clear to earn a profit, even diough it may odierwise be an efficient producer, and can bring to the market odier sources of competitive advantage, such as lower overheads or more modern technology (Farmer, 1993:21-2).

If die B-W rule serves to exclude even efficient entrants from die market, productive efficiency — in a more dynamic sense — might decline as die incumbent lacks die competitive pressure to maintain a tighdy run ship. Under competition, efficient firms expand, while inefficient firms contract and exit die market. A greater number of firms in die industry allows benchmarking of performance, widi superior performers gaining die lion’s share of die market, and increases die number of independent centres for innovation. But, perhaps of most concern, in an industry experiencing rapid technological advance such as telecommunications, die incumbent monopolist might lag in developing and adopting new products and processes. This handicapping of dynamic efficiency is likely to be more damaging to economic welfare over die long term dian impairments to static productive and allocative efficiency.

Aldiough an entrant may ultimately be as efficient as die incumbent, it is likely to incur high start-up costs diat may render entry unattractive. The question then arises as to whedier some sort of aid ought to be given to help it over die difficult entry period. But die same criticisms apply to diis ‘infant company’ argument as to die ‘infant industry’ argument. If entry is viable in die long term, dien banks or odier investors should be willing to provide finance. If private funds are not forthcoming, and die government supports die venture instead, die protected company may never grow up. Vested interests will lobby for continued subsidy long after private investors would have withdrawn support (see Kalin’s arguments quoted by Farmer, 1993:31-3).

The argument can be taken a step further. Suppose die potential entrant may never become as efficient as die incumbent. A case could still be made in favour of watering down die B-W rule so as to allow die firm into die market, provided diat die benefits of die superior dynamic efficiency induced by competition exceed the losses in terms of reduced productive and allocative efficiency. But diis argument is

For a formal demonstration with variations, see Albon (1994:417-18).i°


even more difficult to sustain, because the entrant will (by assumption) never grow up. In addition, pricing rules designed deliberately to disadvantage one firm and favour another might be considered inappropriate in the deregulated economy.

Social service obligations. The imposition of a social service obligation on the incumbent by die government, and its associated cost, gives rise to a potential problem for access pricing. ‘Cream-skimming’ firms have an incentive to enter only the more profitable market segments, which provide die incumbent widi the monopoly profit it needs to cross-subsidise odier, unprofitable, segments diat die obligadon requires it to supply. Right of access may dius undermine the government’s social objecdves. The B-W rule has die advantage of being the only uniform pricing rule which overcomes die problem of cream skimming by inefficient firms (Ministry of Commerce, 1995:28-9). In our example, if die introduction of die social obligadon has die effect of raising die incumbent’s costs by $ 1 per unit, die final product price becomes $15, and die optimum access price becomes $11 ($3+$7+$l). By requiring an entrant to compensate die incumbent for any lost contribution to die social obligation, entry will be discouraged unless die entrant is at least as efficient as die incumbent. Since die cost of die social obligation is built into die incumbent’s prices, it will automatically be included in die access charge. However, die precise cost of die obligation was a major bone of contention in Telecom v Clear.

Summary. The B-W rule is designed for die limited purpose of promoting productive efficiency in a market by deterring die entry of inefficient firms. If die industry in question is a natural monopoly, dien all entrants are likely to be excluded unless die incumbent suffers from substantial productive inefficiency which offsets die natural monopoly cost advantages. The rule does litde (and is not intended) to undermine monopoly profit, and so does not cure any allocative inefficiencies. Indeed, any such profit earned by die incumbent is, dirough die opportunity cost principle, built into die interconnection price. Odier forms of regulation are needed to deal widi excessive prices. Finally, die rule does not direcdy promote dynamic efficiency. In fact, where it serves to restrict entry and diereby lower competition, die rule may harm dynamic efficiency.

Application of the Rule to Other Utilities

The application of die B-W rule is not limited to telecommunications, but is intended to apply generally to any industry where diere is a vertically integrated natural monopoly. Access pricing issues have arisen recendy in New Zealand in at least two odier utilities — electricity and postal services — aldiough so far no cases have come before die courts. These disputes are now briefly reviewed.

Local electricity distribution and retailing. Under die recent reforms in die electricity industry, die locally owned and vertically integrated line distribution and retailing activities were corporatised, and dieir monopoly franchises were removed. While each power company retains a (natural) monopoly over its local line services,


new Finns are able to enter the retailing market by signing up customers, and so compete with the incumbent’s retailing arm, provided they can negotiate access to the local lines in order to deliver die electricity. Some entry by new energy traders has already occurred. For example, Netco, a subsidiary of die Wellington power company, has won a contract to supply BP service stations nationwide.

The Commerce Commission has received complaints from some would-be entrants diat some power companies have acted to protect dieir retailing businesses against competition. A common complaint is diat an incumbent sets up a cross- subsidy from its line to its distribution businesses, diereby artificially raising die costs of die distribution aedvity and lowering die costs of its retailing. Arlidge (1995), general manager of Netco, alleges diat, despite die Ministry of Commerce guidelines for separating line and retailing costs, which state diat billing (one of die key costs in energy trading) falls into die latter, some power companies allocate die cost to dieir line business, and odiers split it evenly between die two. As a result, an equally efficient entrant attempting access under die B-W rule, where die lines charge is based on die costs furnished by die incumbent, would pay an inflated access price and dius be unable to compete against die subsidised incumbent retailer.

Postal services. The Ministry of Commerce report covers interconnection issues in die telecommunications and energy sectors, but not in relation to postal services. New Zealand Post, a state-owned enterprise, has statutory protection in die basic letter market in return for a social service obligadon. Section 3 of die Postal Services Act 1987 imposes a price lloor of 80 cents on die carriage of letters of 200 grams or less by rival firms, which are not dien able to compete widi Post’s lower price (currendy 40 cents). This statutory protection may reinforce what appears to be a natural monopoly universal delivery network.

However, die reference to carnage of letters in die Act is believed not to extend to die sordng function (aldiough diis has not been tested in court). In any case, several firms offer a bulk sordng service. They collect mail from individual customers, do a limited part of die sordng, and dien pass it on to Post for die remaining sordng and final delivery. It is understood that Post has a set of standard charges (depending upon die amount of sordng done) for delivering letters sorted by bulk mailers. This is an instance where entrants have gained access to die incumbent’s network widiout obvious difiiculdes or recourse to die courts. Post also has longstanding arrangements widi certain local audiorides and udlides to accept from diem mail sorted by street for final sordng and delivery. But a dispute has existed

In other instances entry lias been impeded by allegations of refusal to negotiate access, unreasonable insistence on using the local network’s metering and datalogging equipment in contravention of die industry-wide MARIA power-use reconciliation agreement, and die imposition of various unreasonable access, metering, and customer site charges.12

The protection is given to compensate for die universal sei vice obligation diat requires New Zealand Post (among odier diings) to continue to supply loss-making services to rural communities.


since 1993 over the price for access to Post’s mail delivery network by an intending entrant, who plans to collect mail from large customers and do all of die sorting.

General observations. Interconnection issues are likely to be easier to resolve in die electricity, gas and postal services sectors dian in telecommunicadons because dieir economic and technological structures are simpler. In die former group, die product Hows in one direction and tends to be less differentiated; die successive markets are more clearly defined, and vertical integration is not universal; and entry does not usually involve die pardal duplication of, and interconnection widi, die incumbent’s network as in telecommunications. In contrast, die telecommunications network is characterised by rapid technological advance, widi an expanding array of differentiated products; complex interactions between system components; and an openness which allows messages to enter and terminate in many places. Here, incremental costing is very difficult, widi costs tending to change widi time ot day and configuration of die system (Ministry of Commerce, 1995:39-40; Maddock, 1995). The focus to date on telecommunications may dius tend to overstate die difficulties associated widi interconnection pricing.

A Role for Arbitration?

The discussion so far indicates diat die application of die B-W rule is likely to be far from straightiorward. As Ross (1995:369) remarks, die rule establishes only a mediodology for determining a price. Even if die rule were to be applied widiout modification, diere would seem to be plenty of scope for haggling about costs, and regular reviews would be required to update die access charge. Detailed analyses would have to be undertaken of die average incremental cost incurred by die incumbent in supplying die access service, togedier widi die contribution to common costs and to profit. The latter might include die costs of social service obligations, and contributions forgone on sales of complementary products. The need to rely upon cost information supplied by die incumbent — as owner of die unique network — would provide scope lor opportunistic behaviour by bodi parties.

Given diese potential dilliculties, as well as die incentives noted earlier for die incumbent to drag its feet, and for die entrant to complain in die hope of getting a better deal, it is not surprising diat die Ministry of Commerce report considers various alternatives to die status quo as a means of bringing protracted disputes to a conclusion. These comprise six different combinations of access principles and regulatory institution, diree of which involve compulsory arbitration. The favoured option appears to be ‘broad legislative principles widi compulsory arbitration’. But introducing a compulsory arbitration system to resolve interconnection disputes risks injecting arbitrariness into die outcome (Maddock, 1995). Two intriguing issues emerge. The first concerns die danger diat die resulting price-setting process will be akin to price control, widi its well known associated problems such as die danger of regulatory capture, die setting of prices diat distort investment decisions, and die promotion of perverse efficiency incentives. Such problems provided die grounds for die lif ting of all price controls in New Zealand.


The second issue concerns die pricing principles that the arbitrator will (or be required to) adopt. Will die principles he designed purely to lurdier economic efficiency, or will die goal of introducing competition be paramount? Access pricing may raise again die debate as to die appropriate goal of competition and regulation policy. The long tide of die Commerce Act emphasises competition, but die audiorisation provisions it contains indicate diat efficiency is favoured where serious conflict arises. The government’s goal for telecommunications has undoubtedly been to promote competition, albeit as a means of enhancing efficiency, given its pressure on Clear and Telecom to reach a setdement diat would allow Clear to enter die local market, and its direats to introduce lurdier regulation if diey did not. Yet our analysis of die B-W rule, sanctioned by die Privy Council, indicates diat it is designed to place productive efficiency above competition.

Conclusions

The B-W rule is designed to promote productive efficiency, not competition. As a result, die odier two components of economic efficiency — allocative and dynamic — tend to be neglected because they are enhanced by competition. Because die rule is designed to set die access charge in markets in which entry is frequendy difficult, it seems likely diat entrants faced with a B-W price will often be deterred, and so competition will remain absent. However, as the extensive cost analysis required to set die B-W price would presumably reveal die incumbent’s monopoly profit (if any), die access charge could be set at a level net of monopoly profit. Productive inefficiency (if any) might also be eliminated in die same way. Aldiough such an approach is usually rejected on die grounds diat it would encourage inefficient entry, it would at least have die advantage of stimulating competition. The incumbent would dien be forced to cut its price to match die entrant, diereby eroding monopoly profit and improving allocative efficiency. While inefficient entrants would be vulnerable to price-cutting by die incumbent, which would not need to be predatory to succeed in driving diem from die market, efficient firms might provide continuing competitive constraint. In odier words, it seems dial die rule could be applied so as to offer some hope of promoting diese odier elements of economic efficiency.

file report on die regulation of interconnection provides an overview of current government diinking on die issues, but seems unlikely to result in any swift change to policy, for at least diree reasons. First, die elevendi-hour setdement of die local interconnection dispute between Telecom and Clear seems to have removed die major impetus lor lurdier regulation. It is apparent diat die agreed prices reflect a pragmatic, cost-based approach emerging from negotiations between monopoly seller and monopsony buyer radier dian an application of die B-W rule (even along die lines just suggested). Second, die extensive consultation process has reportedly resulted in 58 submissions, ranging from two to several hundred pages in lengdi. Finally, because its majority is so diin, and so dependent upon die support of minor parties, die present National government is unlikely to risk introducing contentious legislation dial may undergo substantial (and, from its point of view, unwanted) revision in its passage dirough parliament. Given die likelihood of a mi-


nority government under die first mixed member proportional representation election in 1996, die consequences of die Privy Council judgement on Telecom v Clem could well be felt for a long dine.

ReferencesAlbon, R. (1994), ‘Interconnection Pricing: An Analysis of’ the Ellicient Component Pricing Rule’,

Telecommunications Policy 18(5): 414-20.

Arlidge, R. (1995), ‘How to Frustrate the Intent of Electricity Deregulation’, paper presented to the conference on electricity rationalisation, 29-31 March, Wellington.

Arnold, T. (1995), ‘The Courts and die Pricing of Access to Essential Facilities - The “Old” Law and Economics at Work?’, New Zealand Business Law Quarterly 1: 123-44.

Baumol, W. & J. Sidak (1994a), Towaixl Competition in Local Telephony, MIT Press, Cambridge, Mass.

------ (1994b), ‘The Pricing of Inputs Sold to Competitors’, Yale Journal on Regulation 11: 171-202.

Blanchard, C. (1995), ‘Telecommunications Regulation in New Zealand: Light-Handed Regulation and die Privy Council’s Judgement’, Telecommunications Policy 19(6): 465-75.

de Boers, D. & L. Evans (1995), ‘The Economic Efficiency of Telecommunications in a Deregulated Market: The Case of New Zealand’, Graduate School of Business and Government Management, Victoria University of Wellington (Working Paper 8/95).

Bollard, A. & M. Pickford (1995), ‘New Zealand’s “Light-Handed” Approach to Utility Regulation’, Agenda 2(4): 411-22.

Ergas, H. (1995), ‘Managing Interconnection: Issues of Institutional Design’, paper presented to the Interconnection Workshop, International Telecommunications Society, Wellington.

Farmer, J. (1993), ‘Transition from Protected Monopoly to Competition: The New Zealand Experiment’, Competition and Consumer LawJournal 1: 1-32.

Kalin, A. (1995), ‘Deregulation of die Public Utilities — Transitional Problems and Solutions’, paper presented at the Second Annual Utility Markets Summit, 27-28 April, Wellington.

------ & W. Taylor (1994), ‘The Pricing of Inputs Sold to Competitors: A Comment’, Yale Journal onRegulation 11: 225-40.

King, S. (1995), ‘Guaranteeing Access to Essential Infrastructure’, Agenda 2(4): 423-31.

Maddock, R. (1995), ‘Access to Essential Facilities: Implementing Hilmer’, Department of Economics, Monash University, Melbourne (Seminar Paper No. 1/95).

Ministry of Commcrce/The Treasury (1995), Regulation o f Access to Vertically-Integiated Natuial Monopolies, Ministry of Commerce, Wellington.

Ng, Y.-K. (1987), ‘Equity, Elliciency and Financial Viability: Public Utility Pricing with Special Reference to Water Supply’, AusUalian Economic Review 79: 21-35.

Ross, M. (1995), ‘New Zealand’s Experiment in Pricing Access to Essendal Facilities’, Agenda 2(3): 366-70.

Siegfried, J. & E. Wheeler (1981), ‘Cost Elliciency and Monopoly Power: A Survey’, Quarterly Review o f Economics and Business 21: 25-46.

The views expressed here do not necessarily represent those of the Commerce Commission. The author gratefully acknowledges the helpful comments of three referees. The usual disclaimers apply.


International Response to Greenhouse Gas Abatement

B. Stephen Labson

W INTERNATIONAL response to the enhanced greenhouse effect is underpinned I by the United Nations Framework Convention on Climate Change (FCCC),

JLw hich came into force on 21 March 1994. It was signed by 154 countries and die European Economic Community (including all OECD countries except Turkey) at die United Nadons Conference on die Environment and Development held in Brazil in June 1992.

The FCCC’s overall objective is die ‘stabilisation of greenhouse gas concentrations in die atmosphere at a level diat would prevent dangerous andiropogenic interference widi die climate system’ (United Nations, 1992:Article 2). Specifically, die Convention calls for die conditional reduction of greenhouse gas emissions to 1990 levels by 2000. This is to be achieved primarily dirough measures to be undertaken by developed countries: die so called ‘Annex 1’ countries. At die first Conference ol die Parties held recendy in Berlin, it was agreed diat die commitment to diis objective should be strengdiened by requiring Annex I countries to set quantified limitation and reduction objectives, taking into account regional characteristics, die need to maintain strong and sustainable economic growdi, and die need for equitable contributions by each of die relevant parties.

Such prescriptive action based on targeted levels of emissions forms an integral part ol Australia’s National Greenhouse Response Strategy (NGRS), under which an interim planning target has been adopted

to stabilise greenhouse gas emissions (not controlled by die Montreal Protocol on Substances diat Deplete die Ozone Layer) based on 1988 levels, by die year 2000, and to reduce diese emissions by 20 per cent by die year 2005 . . . subject to Australia not implementing response measures diat would have net adverse economic impacts nationally or on Australia’s trade competitiveness, in die absence of similar action by major greenhouse gas producing countries. (Commonwealdi of Australia, 1992:8)

While diese targets are cast in terms of ‘objectives’ under die FCCC, and ‘as a yardstick against which die implementation of greenhouse response measures can be assessed’ under die NGRS, die question remains: do diese relatively arbitrary targets

Stephen Labson is Director, Energy Economics, at the Victorian Department o f Agriculture, Energy and Minerals.

178 B. Stephen Labson

provide a useful metric in which to benchmark emissions? That is to say, are such targets based on a rigorous assessment of die science of climate change, its impact on society, and the costs and benefits stemming from emission reduction policies?

The Enhanced Greenhouse Effect: The Basis For Action

At its most basic level, the greenhouse effect is a reasonably well understood process whereby the earth’s atmosphere is warmed through die entrapment of energy by gases, including water vapour, carbon dioxide, mediane, nitrous oxide and chloro- fluorocarbons. It is also known diat die concentradon of such ‘greenhouse gases’ has been gradually increasing since die beginning of die industrial revoludon.

What is not currendy well understood is die extent to which die concentradon of such gases is expected to increase in die future; die effect diis will have on die eartli’s climate and die well-being of its inhabitants; and die extent to which human intervendon enhances die greenhouse gas effect. While a great deal has been learned about diese matters, a comprehensive understanding of die enhanced greenhouse effect is likely to require a significant leap in our understanding of die dynamics of climadc systems.

In its 1990 report, the Intergovernmental Panel on Climate Change (IPCC) (Houghton et al., 1990) concluded diat die global mean surface-air temperature has increased by 0.3°C-0.6°C over die past 100 years. Evidence provided from more recent research (summarised in IPCC, 1995) suggests diat human activity has had a discernible influence, aldiough die data are insufficient to quantify die impact on climate diat is direedy attributable to human activity.

Atmospheric scientists regard computer-driven climate-change models as die only feasible means of assessing die impact of increased greenhouse concentrations. The IPCC (1995) has reported a projection based on a mid-range of assumptions regarding population and economic growdi, land use, technological change, energy availability and a ‘best estimate’ of die expected change in global mean surface temperature for a given increase in greenhouse gas concentrations. Under diis midrange scenario, it is projected diat global temperatures rise by 2°C by 2100. Under diis same scenario, die sea level is projected to rise as a result of diermal expansion of die oceans and glacial melting by 50cm from die present to 2100.

Best estimates notwidistanding, projected increases in global warming are still subject to a great deal of uncertainty.1 The IPCC (1995) has commented diat furdier work needs to be done: to form more accurate estimates of future emissions and biochemical cycling (die effect of sources and sinks); to represent climate processes in models, especially feedbacks associated widi clouds, sea ice and vegetation; and to systematically collect data by which to test modelling results against observation and aid in die quantification of die impact of human activity on climate.

1 The IPCC mid-range ‘best estimate’ projections for mean surface temperature increase and sea level rise are roughly one-third and one-quarter respectively, lower than die same projections formed in 1990. This may oiler some information regarding die level of scientific uncertainty diat policy-makers are f aced widi.

International Response to Greenhouse Gas Abatement 179

More troubling is the fact that it is extremely difficult to quantify the impact of, or to place a cost on, the disruption to physical, social and economic systems for a given level of global warming (see, for example, Schmalensee, 1993). But preliminary estimates surveyed by Nordhaus (1993) suggest diat, for the US, an increase in atmospheric temperatures would cause domestic output to fall by between 1 and 1.3 per cent. Nordhaus stresses that die results from die study of a single region in isolation cannot be applied to die world as a whole. Moreover, such studies are likely to overesdmate considerably die costs of climate change because diey ignore die many ways in which economies, especially dieir climate-sensidve agricultural sectors, adapt to climadc change dirough mechanisms such as trade. For example, Rosenzweig and Parry (1994), using a model dial links climate, crop yield and trade, found diat a doubling of global concentrations of carbon dioxide would cause global output of basic cereals to fall by between zero and 5 per cent under dieir assumed baseline level of producer adaptadon, widi die possibility of a slight increase in global production under a more substantial level of adaptation in farming mediods.

Carbon Emission Levels in Different Countries

Carbon dioxide has so far received more attention dian odier sources of greenhouse gas emissions, principally because of its relative importance (it accounts for roughly 75 per cent of total greenhouse gas emissions stemming from human activity), and pardy because emissions of odier greenhouse gases are more difficult to estimate. The US is by far die greatest emitter of carbon dioxide, accounting for an estimated 20 per cent ol global emissions. Brazil and China also are significant emitters, being responsible respectively for 18.8 and 10.5 per cent of global carbon dioxide emissions. Australia ranks relatively low in terms of die total level of carbon dioxide emissions, contributing an estimated 1.4 per cent, but relatively high in terms of per capita emissions.

Carbon emissions stem primarily from die burning of fossil fuels for energy consumption, fo r any given level of energy use, a country’s emission of carbon from fossil is determined by luel resource endowment and policy choices. For example, countries which have access to zero or low-emission fuel sources such as hydro and natural gas have an advantage over countries such as Australia, which relies heavily on low-cost, high-quality coal. Policy choice comes into play widi respect to die use ol zero-emitting nuclear power. For example, nuclear power contributes 34 per cent to total electricity production in die European Union, 25 per cent in Japan, and 20 per cent in die US. Australia, in contrast, has no nuclear- powered generating capability.

The differences in energy consumption levels among countries stem from several underlying factors, above all a region’s stage of economic development and die combination of resources and technology unique to individual regions. Economists have observed diat energy use closely follows die level of industrialisation widiin a region. Typically, a developing country’s economic activity is based on a relatively larger proportion of energy-intensive industrial processes such as manufacturing and metals smelting. Thus, die rapidly expanding economies of Soudieast Asia could


be expected to increase energy use far above the level expected for the mature economies of the US or European Union. The availability of resources, combined with access to advanced technologies, also has an important bearing on energy use within a region. For example, Japan, which faces relatively high energy prices due to a lack of domestic resources but has access to advanced technologies, has one of die world’s lowest energy-GDP ratios. However, it is important to note diat diis technological efficiency is not a criterion of general economic efficiency. In response to die reladve prices it faces, Japan has chosen an efficient set of production plans diat use less energy per unit of total output. But it would probably make no economic sense for high-energy-intensity countries such as China or Australia, which are endowed widi inexpensive energy resources, to seek to match die energy-GDP rados of countries such as Japan.

The Cost of Meeting Stabilisation Targets

Meeting emission targets will have diree general effects on a region. First, the fuel mix of die energy sector will change. Coal will tend to be displaced by greater use of low-carbon fuel sources such as oil, natural gas, hydro, nuclear and renewables. Second, an internadonal agreement to stabilise emissions will lead to a decrease in global demand for carbon-intensive energy sources, diereby limiting trade and export revenue from such commodides. Thirdly, die de facto tax implicit in most stabilisadon opdons will serve to reallocate resources away from energy-intensive industries. This change in die sectoral balance of die economy would uldmately have an indirect effect on die level of output diroughout die endre economy.

McKibbin et al. (1994) have estimated die cost of meeting several stabilisadon scenarios under a phased carbon-tax regime. To return to 1990 emission levels by 2005, Australia would need to decrease emissions by 34 per cent of die level diat would have obtained widiout die policy intervention. The estimated cost to Australia acting in tandem widi odier OECD countries to stabilise emissions would amount to a loss in GNP of A$56 billion by 2005. As a proportion of total GNP, diat cost would be considerably greater dian diat required of die OECD as a whole (and particularly die US, die world’s biggest carbon emitter), primarily because Australia’s relatively high rate of growdi in bodi population and general economic activity results in a correspondingly higher business-as-usual increase in emissions diat would need to be curtailed to meet a stabilisation target. Odier factors include Australia’s ability to source low-cost energy alternatives and die general ability of die overall economy to adjust to changing relative prices.

It is important to understand diat diese results are defined in terms of meeting interna] stabilisation targets. Developing countries not currendy subject to targets are expected to account lor by far die largest share of global emissions of greenhouse gases into die 21st century, rendering regionally based programs largely ineffective in terms of global outcome (ABARE & Department of Foreign Affairs and Trade, 1995).


Reducing Greenhouse Gas Emissions: Policy Choices

Optimal policies to deal with an environmental externality such as the enhanced greenhouse effect are diose in which the marginal benefits ol the policies are equal to the marginal costs. Nordhaus (1991) has pointed out that the appropriate level ol abatement of greenhouse gas emissions depends explicidy on the cost ol controlling greenhouse gas emissions, the cost ol the damage brought about by the enhanced greenhouse gas effect, and the dynamic interplay of diese two factors.

The current scientific and economic literature gives us a preliminary view ol some very relevant costs of abatement and damage. Moreover, a new generation ol integrated models is being developed to study die interactions between die economy and die environment. But such current modelling efforts should be viewed as a way of focusing attention on proper frameworks for evaluadng greenhouse policies, not as a way of quantitadvely assessing die appropriate level of emissions and abatement measures.

It seems reasonable to presume diat die reladvely arbitrary emissions targets diat have been endorsed bodi nationally and internationally are a direct response to scientific and economic uncertainty. But it is hardly comforting to know diat the targets correspond to some emission levels found in die latter part of die 20th century. Depending on how one judges die significance of die enhanced greenhouse effect, its cost to society and die cost of abatement, optimal emission levels would probably be eidier greater or smaller dian diose observed in die recent past. The issue is furdier complicated by die relationship between emissions and atmospheric concentradon of greenhouse gases. Presumably, our primary concern should be global concentratioir, but diis is seldom direcdy addressed in policy analysis and development. For example, even if emissions were stabilised, global concentrations of greenhouse gases would continue to increase well into die future. So an arbitrary emission target would seem to be a very crude — indeed useless — yardsdck on which to base policy, regardless of die significance of die enhanced greenhouse effect.2

For a given global target, uniform abatement requirements oiler a reladvely transparent means by which to achieve global abatement. But it is becoming increasingly well understood diat uniform targets are excessively inefficient, mainly because diey offer a region litde flexibility in allocadng its resources vis-ä-vis odier regions. For example, it might pay Australia, which employs coal-intensive technologies in reladvely high-value-added sectors, to encourage odier regions to use correspondingly less coal-intensive processes, to die benefit of both.

The FCCC allows pardes to die convention to undertake joint acdon to reduce greenhouse gases. Opcradonally, diis would take die form of measures such as die transfer of energy-efficient technology, equipment and services from developed to developing countries. Such ‘joint implementation’ measures would midgate global

2 Feasibility would seem to be an obvious precondition of policy choice. However, Tucker (1994) argues that diere has been a ‘decoupling of Greenhouse policy and science’, whereby governments have endorsed emission reduction targets diat are clearly unattainable.


emissions more effectively and economically than would unilateral action by developed countries, since die fairly simple and relatively low-cost technologies that the developing countries could utilise would have a far greater impact on global emissions per dollar spent dian would a comparable investment in emission reduction in die developed countries.3

Uniform targets are not likely to promote equitable outcomes eidier. Countries widi high levels of growdi in population and general economic activity require a continuous increase in energy consumption. Uniform standards, particularly those based on historic emission levels, would impose a relatively cosdy burden on these high-growdi countries. Furthermore, regions have vasdy differing resource bases from which to substitute among fuel types. For example, a country such as die US, which has access to a wide range of energy sources including coal, oil, natural gas, hydro and nuclear, will be able to move away from carbon-intensive sources such as coal much more cheaply dian a country like Australia, which is more constrained in its fuel choice.

Recognising die problems of efficiency and equity posed by uniform targets, die FCCC states diat implementation measures should take into consideration die

situation of Parties, particularly developing country Parties, widi economies diat are vulnerable to die adverse effects of die implementation of measures to respond to climate change. This applies notably to Parties widi economies diat are highly dependent on income generated from die production, processing and export, and/or consumption of fossil fuels and associated energy intensive products and/or fossil fuels for which such Parties have serious difficulties switching to alternatives. (United Nations, 1992:Article 4.10)

To balance issues of equity and efficiency, economists have proposed burdensharing mechanisms diat apportion abatement costs among countries. For example, die Tasman Institute (1994) has suggested diat country targets be developed diat give each OECD country die same proportional loss in national income. Alternatives might include targets based on equal per capita reducdons in emissions, or equal percentage reducdons in emissions from baseline levels.

Alternative Measures

Given die great uncertainty about die costs and benefits of reducing greenhouse gas emissions, ‘no regrets’ policies have formed a major component of Australia’s National Greenhouse Response Strategy. No-regrets policies are typically defined as

3 It is commonly suggested that joint implementation could lie developed as a first step toward establishing an international tradable emissions scheme (see, for example, Bureau of Industry Economics, 199.5). This type of scheme is potentially much more efficient than joint implementation. But distributional concerns would probably be significant in view of the quite transparent maimer in which wealth would be reallocated under this system.


having no net costs; they arise because the absence of well-functioning markets (whether because of government failure or market failure) makes possible actions that can be implemented at zero net cost to society.

Probably the greatest international scope for such policies lies in the reform of policies that distort energy prices through implicit and explicit taxes and subsidies. Burniaux et al. (1992) find die total value of global energy subsidies (net taxes) to be US$235 billion (in 1985 dollars), which is equivalent to US$45 per tonne of carbon. They find diat die removal of existing distordons in energy markets would lead to a global carbon emissions to be 18 per cent less dian odierwise by 2050. Moreover, liberalisation of energy markets would increase GDP (pardcularly in die non-OECD countries) by promoting die efficient allocation of resources widiin die broader economy.

Australia’s Strategy also develops some first-phase ‘insurance’ measures to reduce die uncertainty about die impacts of climate change as well as about die viability of responses. These measures involve research and review studies, giving particular attention to energy production, distribution and end use. The objective is to provide a clearer understanding of die emissions mechanisms involved in energy use, die scope for taking no-regrets actions, and our ability to measure emissions and emission reductions. This phased approach reinforces die insurance mechanism by assessing first-phase measures before second-phase measures are formulated and implemented.

Concluding Remarks

Lack of scientific and economic certainty does not justif y policy paralysis: if certainty were a necessary condition for action, it is difficult to imagine how policy-makers could act at all. The point is dial die uncertainty inherent in climate-change issues must be factored into die decision-making process in which die risks and associated costs of global warming are balanced against die costs of mitigation strategies. Badly devised strategies present a danger as well. Greenhouse-induced climate change is a global phenomenon and is well addressed only as such. Numerous studies have demonstrated diat policies will be largely ineffective if not carried out widi die cooperation of developing economies, which are expected to substantially increase emissions well into die 21st century.

Embracing arbitrary targets diat have litde apparent relation to diese factors would seem to militate against die development of an optimal greenhouse response strategy. It may well be diat our current ‘yardstick’ based on a metric of stabilisation is so imprecise diat we would be better off casting it aside for die time being. An international response similar to Australia’s phased approach, based on no-regrets measures and well-understood actions such as continued investment in research into climate change, could well be die most appropriate policy.


References

AB ARE & Department of Foreign Alfairs and Trade (1995), Global Climate Change: Economic Dimensions o f a Cooperative Internationa1 Policy Response beyond 2000, ABARE, Canberra.

Bureau of Industry Economics (1995), Greenhouse Gas Abatement and Burden Sharing, AGPS, Canberra (Research Report No. 66).

Bumiaux, J., J. Martin & J. Oiivaria-Martins (1992), ‘The Effect of Existing Distortions in Energy Markets on the Costs of Policies to Reduce CO2 Emissions: Evidence from GREEN’, OECD Economic Studies 19: 141-65.

Commonwealth of Australia (1992), National Greenhouse Response Strategy, AGPS, Canberra.

H ouston , J., G. Jenkins & J. Ephraums (eds) (1990), Climate Change: The IPCC Scientific Assessment, Intergovernmental Panel on Climate Change, Cambridge University Press, Cambridge.

Intergovernmental Panel on Climate Change (IPCC) (1995), Summary for Policy Makers o f the Contribution on Working Group I to the IPCC Second Assessment Report, IPCC Eleventh Session, Rome, 11-15 December.

McKibbin, W., D. Pearce & A. Stoeckel (1994), Economic Effects o f Reducing Carbon Dioxide Emissions, Centre for International Economics, Canberra.

Nordhaus, W. (1991), ‘To Slow or Not to Slow: The Economics of the Greenhouse Effect’, Economic Journal 101: 920-37.

------ (1993), ‘Reflections on die Economics of Climate Change’, Journal o f Economic Perspectives7(4): 11-25.

Rosenzweig, C. & M. Parry (1994), ‘Potential Impacts of Climate Change on World Food Supply’, Nature 367 (13 January): 133-8.

Schmalensee, R. (1993), ‘Symposium on Global Climate Change’, Journal o f Economic Perspectives 7(4): 3-11.

Tasman Institute (1994), Carbon Dioxide Emissions: Abatement and Burden Sharing in the OECD, Tasman Institute, Melbourne.

Tucker, B. (1994), Greenhouse: Facts and Fancies, Institute of Public AlTairs, Melbourne (Environmental Backgrounder No. 21).

United Nations (1992), United Nations’Fiamework Convention on Climate Change, New York.

The views stated here are solely the author’s. The author would like to acknowledge the helpful comments provided by Brian Tucker and two anonymous referees on a previous draft.


The Contingent Valuation Method: A Post-Kakadu Assessment

Jeff Bennett

r p H E environmental dimension ot public policy-making continues to grow in importance. Decisions as diverse as the relocation of die naval ammunition

-A- dump from Sydney and die drainage of saline sub-surface water in die Upper Soudi-East ol Soudi Australia involve environmental issues diat capture public interest. Economists charged widi providing information to assist policy-makers in diese cases are more and more being requested to deliver esdmates of die values of environmental benefits and costs involved. This has proved dillicult because die traditional valuation tools used by economists are based on data diat are observable in markets. Most environmental benefits and costs, such as biodiversity conservation and air quality, are not bought and sold. New valuation techniques have had to be devised. For instance, where quantifiable relationships can be established between lion-marketed environmental effects and marketed goods, economists have been able to infer die 11011-market values from available market data. People’s preferences, as revealed by dieir behaviour in markets, are dius used to estimate dieir values for 11011-marketed environmental goods.

For some environmental effects, diese revealed preference techniques are ineffective because of die absence of any related markets. This is usually die case for die so-called 11011-use values ol die environment. These arise where people experience some gain or loss from die environment even diougli diey do not come in direct contact widi it. For example, people may gain satisfaction from die continued existence of an endangered species even diougli diey have 110 desire to see it face to lace. Similarly, people may suffer a loss when diey hear diat colonies of penguins have been harmed because of an oil spill. In such cases, values cannot be estimated dirough die analysis of peoples’ revealed preferences. Reliance must be placed 011 die analysis ol peoples’ stated preferences. One such stated-preference valuation techniques is die Contingent Valuation Mediod (CVM).

11 lie I ravel Cost Method, for instance, establishes the value of the recreational experience by using

people’s revealed preferences for travelling to a recreational site. The Hedonic Pricing Techniqueuses die relationships existing between market prices (for real estate) and determining environmentalfactors (traffic noise, air quality) to estimate die value of diose 11011-market factors.2

The most comprehensive guide to CVM remains Mitchell and Carson (1989).

Jeff Bennett is Associate Professor in the School of Economics and Management, University College, The University of New South Wales, Canberra.

186 Jeff Bennett

The history o f CVM in Australia is a rather chequered one. But a watershed in die use o f die technique occurred in 1990 when die Resource Assessment Commission (RAC) released die results o f its CVM analysis of die environmental costs likely to arise from proposed mining acdvides at Coronation Hill (Imber, Stevenson & Wilks, 1990). This study became widely known as die ‘Kakadu study’ because die Coronation Hill site is adjacent to Kakadu National Park in die Northern Territory.

The Elements of Contingent Valuation

CVM involves asking a sample of people experiencing die 11011-market benefit or cost under consideration how willing diey are to pay for a hypothetical project or program diat will eidier provide die benefit or prevent die cost. The mediod is called ‘contingent’ because die esdmates o f value it yields are dependent on die construct of die ‘market’ diat is formed in die questioning process.

No single template describes all CVM quesdonnaires. But most involve diree elements. First, die hypodietical program or project diat is being proposed is described. For example, a proposal to declare a new Nadonal Park may secure die continued survival of an endangered species; or a requirement for all oil tankers to be double-hulled may reduce die possibility o f an oil spill. Second, a mechanism for eliciting die respondents’ values is established. An ‘open-ended’ payment question would be o f die form ‘What is die most you would he prepared to pay in increased taxes for project X?’. Alternatively, a ‘dichotomous choice’ CVM question takes die form ‘W ould you be willing to pay $X in increased taxes for project Z?’, where die amount o f $X is varied across a pre-determined range. Third, die socioeconomic and attitudinal characteristics o f die respondent arc sought for estimation and validation purposes.

Background

The origins of CVM can be traced back to Ciriacy-Wantrup (1947) in die US. In Australia, die mediod achieved a public profile only in 1990, widi die release of die RAC’s Kakadu study. Prior to diat, CVM applications had been mosdy small-scale and limited largely to academic studies. The New Soudi Wales EPA Environmental Values Data Base lists twelve Australian CVM studies diat pre-date die one at Kakadu. In diese studies, which appear in data collected in 1979 (Bennett, 1984; Johnston, 1982; Scott; 1982), die mediod was applied in cases including air quality, protected areas, recreation, soil erosion and water quality. Aldiough Australian economists lagged behind dieir US counterparts in applying CVM, diey were among die vanguard of diose experimenting widi die technique in die rest of die world.

The breakdirough in die use o f CVM in Australia occurred when die RAC commissioned a study o f die environmental costs expected from a proposed mining

A willingness to accept compensation format is an alternative.

The Contingent Valuation Method: A Post-Kakadu Assessment 187

venture at Coronation Hill. The study was undertaken with a view to providing value estimates to be incorporated into a benefit-cost analysis of a proposal to allow mining to proceed. It was the first CVM application in Australia that related to a high-profile, national policy issue.

The results of the study precipitated a lively debate. The estimate ol the environmental costs of mining at Coronation Hill provided by die CVM application was in the order of 60 times greater dian die esdmate ol die surplus generated by mining. Not surprisingly, die interests suppordng die mining venture claimed diat the CVM esdmate was unrealisdcally high. They were backed by Brunton (1991), who suggested diat respondents to die CVM quesdonnaire had enjoyed a ‘moral free lunch’ by registering dieir opinions widi ‘play money’; furthermore, he argued diat to compare die ‘play money’ values against die ‘real money’ generated by mining was fundamentally flawed. Moran (1991) argued diat respondents to die Kakadu CVM quesdonnaire were not constrained by any real budget; nor were diey fully appraised of die array of substitute goods diat were available for die Coronation Hill site. He also suggested diat most respondents were entirely unfamiliar widi die area and were dius very poorly placed to value its environment. The media were particularly taken by Moran’s comparison of the per hectare CVM value of die Coronation Hill site widi land prices in downtown Tokyo. Moran estimated, on die basis of die values ottered by die RAC study, diat Coronation Hill, which had been described by one federal minister as ‘clapped-out buffalo country’, was die more valuable real estate.

The RAC did not allow die criticism to go unchallenged. Carson (1991), a leading American CVM researcher who had been appointed as an adviser to die RAC’s CVM project team, attacked die critics’ ‘glib characterisations’, which demonstrated ‘a complete lack of understanding of welfare economics’. For instance, he argued diat Moran’s comparison of die price per hectare of Tokyo real estate widi die consumer surplus per hectare estimate provided by die CVM study of die Coronation Hill environment was inappropriate, since two different economic concepts were being compared. Furthermore, it was a comparison between a private good, where die benefits can be captured by die individual who owns die property, and a public good, where individuals’ benefits can be summed. Carson’s rebuttal relied very strongly on die evidence, provided by US studies, diat well designed and implemented CVM applications are capable of yielding accurate estimates across a wide variety of benefits and costs.

Whatever die validity of die Kakadu CVM estimates, die RAC’s final report on die proposal to mine Coronation Hill made only passing reference to die study. It undertook no explicit benefit-cost analysis of die mining proposal, and included only a descriptive statement of die CVM work. But aldiough die critics of CVM could view die RAC report a vindication of dieir efforts, dieir criticism was not ef-

4This has become known as the ‘embedding effect’: when individuals are asked how much they are

willing to pay for a good as a separate item, they are likely to bid more than when the question forms only one component of a sequence of willingncss-to-pay questions.

188 Jeff Bennett

fective in ensuring the success of the mining proposal, since the federal government decided to incorporate the Coronation Hill site as an extension to Kakadu National Park. The decision was, however, based not on environmental factors but radier on die significance of die site to die aboriginal people of die area.

The Exxon Valdez and the NO A A Panel

While the debate over die validity’ of die Kakadu CVM study was taking place in Australia, a parallel debate was proceeding in die US. Following die grounding of die Exxon Valdez in Prince William Sound, Alaska, in 1989, the US federal government and die Alaskan State government launched legal suits against die Exxon Corporation for die recovery of damages caused to die natural resources affected by die resultant oil spill. Under die so-called 'Superfund’ legislation, trustees were permitted to sue for loss of use and 11011-use values derived from natural resource damage. Furthermore, Department of die Interior regulations specified die CVM as an appropriate technique for estimating diese values. With such high stakes involved, die CVM became die focus of attention, and valuation studies were commissioned by die Alaskan and federal governments and by Exxon.

CVM was also receiving attention from anodier quarter. Alter die Exxon Valdez spill, die US congress passed The Oil Pollution Act as a means of reducing die likelihood of future spills and recovering damages if a spill should occur. As part of diat legislation, die Department of Commerce, acting dirough die National Oceanic and Atmospheric Administration (NOAA), was required to establish regulations pertaining to die estimation of damages. To perform die task of drawing up the required valuation regulations, NOAA set up a panel of experts, led by Nobel laureates Kenneth Arrow and Robert Solow, to assess die ability of die CVM to yield reliable estimates of natural resource damages. The panel concluded (Arrow et al., 1993) diat ‘CV studies can produce estimates reliable enough to be die starting point ol a judicial process of damage assessment, including lost passive-use values’.

However, die decision in f avour of die CVM was not unconditional. The panel was careful to state diat CVM estimates were only one input into die process of determining damage assessments. It was also at pains to put die onus of proof of die appropriateness of CVM studies 011 diose undertaking diem. Perhaps most important, die panel set out numerous guidelines diat it considered necessary to be followed for a CVM application to yield reliable results. These guidelines — in much condensed form — are:

5Use values relate to the benefits people receive from a direct involvement with the resource, such as

recreational use. Non-use values are enjoyed by people who are removed from the resource; for example, die benefit received from knowing that an endangered species remains in existence is a 11011-usevalue.6

The issues central to the US debate are set out in papers by Portney (1994), Hanemann (1994) and Diamond and Hausman (1994). Portney was a member of the NOAA panel, Hanemann was a consultant to die State of Alaska in die Exxon case, and Diamond and Hausman were employed by die Exxon Corporation.


• Personal interviews should be used.• Willingness to pay for projected events should be elicited.• The dichotomous choice questioning form should be used.• The hypothetical situation described should be accurate and understandable.• Reminders regarding respondents’ budget constraints should be included.• Reminders of available substitute goods should be included.• Follow-up questioning to ascertain die level of understanding achieved should

be included.

It must be noted diat die rigour required by diese guidelines implies diat applying die CVM for lidgadon purposes would be cosdy. Furdiermore, die guidelines seem intended to generate conservadve esdmates. Neverdieless, it is apparent diat die panel’s deliberadons have fordfied die advocates of CVM. However, die out-ol court setdement by Exxon for die natural resource damages caused by die Valdez spill amounted to only about one-diird of die damages estimated by die trustees’ CVM applications. It dierefore remains to be determined how much weight die judicial process would give CVM esdmates; but it would seem diat die trustees in die Exxon case were confident of a proportion not greater dian one-diird.

Post-Kakadu Applications

In contrast to die US and Europe, only a very limited array of CVM applications has been performed in Australia in die 1990s. The debate arising from die Kakadu application has discouraged decision makers from commissioning furdier studies. Moreover, die scepticism diat arose from die Kakadu study has been reinforced by some post-Kakadu applications. For instance, die Commission of Inquiry set up by die Queensland government to investigate anodier high-profile resource use decision — die future of Fraser Island — received a submission from die Queensland Department of die Environment diat included a CVM application. In diis case, die value of die old-growdi forests of die island was estimated. Like die Kakadu study, die Fraser Island analysis (Hundloe et ah, 1990) yielded estimates diat swamped die value of die extractive resource-use alternative. As widi die Kakadu results, die Fraser Island values were not incorporated into die filial report of die Commission, and die decision to stop logging on die island was made widiout reference to die CVM results.

The RAC undertook a furdier CVM application before its demise in 1994. That application, which formed part of die Forest and Timber Inquiry, was designed to estimate die value of protecting die old-growdi forests in die soudi-east of Australia. The Final Report of die Inquiry noted die results of die study — which were ol a more modest magnitude dian eidier die Fraser Island or Kakadu estimates — but concluded diat diey were not sulFiciendy reliable to form the basis of policy decisions (Bennett & Carter, 1994).

A lurdier application of CVM occurred when die NSW Department of Water Resources used it in an experiment to estimate die value of water quality improvements in die Darling River (Hill, 1994). Currendy, die Australian Bureau of Agri-

190 Jeff Bennett

cultural and Resource Economics is involved in a CVM application designed to estimate some environmental costs of increasing soil salinity levels in the Upper South East of South Australia. Other studies have been more academically oriented. Jak- obsson (1994) used CVM to estimate the existence value of Leadbeter’s Possum. Fladey and Bennett (1994) applied die technique in estimating the values placed by Australian tourists visiting Vanuatu on tropical forest protection. Blarney (1995) undertook extensive testing of die behavioural assumptions implied in die use ol die CVM. But use of die technique has not exploded in Australia as it has elsewhere.

The NOAA panel’s findings have had a very strong influence on die way in which CV studies have been undertaken, especially in die US. It appears diat, in order to win legitimacy, studies must be matched against die NOAA guidelines. This is true not just for studies diat are aimed at providing evidence for litigation, but also for applications designed to provide ball-park value estimates to natural resource decision-makers. The effect of diis has been to make die CVM a more complex and more expensive instrument to implement. This is demonstrated by a CVM application performed by Carson et al. (1994) for NOAA as evidence lor a Superfund litigation case. The application involved estimating die environmental costs caused by die release of DDT and PCBs into die Southern Californian Bight dirough die outfall pipes of die Los Angeles County sewer system. The study took over diree years to complete. The development work included focus groups, cognitive interviews, small pre-tests and pilot studies. The main survey consisted of 2,810 in-person interviews. The findings of die study are reported in a volume of 250 pages and are accompanied by an even diicker volume of appendices. At every stage, die study’s development and performance is self-evaluated by comparison widi die recommendations of die NOAA panel. In particular, extensive ‘reliability’ tests are performed. Primarily, diese involve die assessment of relationships between respondents’ valuation choices and various independent variables such as the cost of remedial works, die respondents’ socio-economic characteristics, and dieir interest in, and proximity to, die damage. However, most stress is placed on die ability of die valuation data to demonstrate sensitivity to die scope of die environmental damage described to respondents in die CVM survey. That is, it was necessary to show diat die CVM-generatcd value for extensive damage is significandy greater dian a similarly determined estimate of lesser damage.

Clearly, die expense involved in undertaking a study of die magnitude of die Carson et al. (1994) work will rarely be justified in die Australian context. The value of die improved information provided by such a study has to be weighed

7Evidence of this explosion is provided in Carson et al. (1995), which lists 2,131 CVM studies and

papers world-wide. Hie CVM Newsletter, coordinated from die Swedish University of AgriculturalSciences, is now distributed to 225 members worldwide.S

Carson et al. (1994) report a per household estimate of US$55.61 for the damage. This extrapolates over die population of California to an aggregate estimate of US$575m (widi a standard enor of $27m).


agains: the additional costs of supplying it. As Flatley and Bennett (1994) point out, die future of CVM, particularly in developing country applications, will be determined by its ability to provide reliable information at an affordable cost. The direction taken by CVM applications in the US litigation setting is dierefore questionable for a wide range of cases where 11011-market value information would be useful to decision makers. What dien are die alternadves?

Choice Modelling

The NOAA panel findings are important in providing policy-makers using CVM results some guidance as to die quality of die estimates provided. However, die importance diat has been placed 011 die findings of die NOAA panel, and the implied seal ol approval it has given a pardcular version of CVM, may militate against die development ol a wide diversity of mediodological variadons. Such diversity is important in die evoludon ol die technique. The greater die array of CVM variants being trialed, die greater will be die chance and rate of improvement.

The brake 011 die development of CVM diis implies will most likely be applied hardest in die areas of lidgadon and policy advice. It can be expected diat experimentation will continue among academic researchers. This trend is evident from recent work diat has attempted to merge CVM widi techniques developed in die disciplines ol markedng and psychology. The resultant approach has become known as ‘choice modelling’ (Louviere, 1994). I11 a choice modelling exercise, respondents are faced widi a sequence of choices between two or more options. Each option is made up ol a set ol attributes which includes die 11011-marketed element under consideration and a cost factor. Varying die levels of attributes gives rise to die array ol options diat make up die choice set. For instance, in a study aimed at estimating die existence value ol tropical rainforest reserves in Vanuatu, Rolfe and Bennett (1996) present respondents widi a set of 16 choices. Each choice is between two alternative proposals to set aside areas of tropical rainforests. Each proposal is made up ol a specific combination of pre-tested attributes such as rarity, size, location and cost. The choices made by respondents are analysed statistically to determine die impact ol each attribute. I11 turn, die contribution made by each attribute to die utility ol die respondent relative to die contribution made by money is estimated, dius quantifying die trade-oil dial respondents are willing to make between more ol die 11011-marketed attributes and less money. This is die willingness- to-pay measure ol value diat is required by benefit-cost analysis.

Choice modelling can be viewed simply as a variant of die CVM. Whereas die dichotomous choice model ol die CVM involves a single choice where only die 11011-market element and die cost attributes are varied across die options available, choice modelling embodies a wider array of factors diat are variable. The dichotomous choice ol CVM is dierefore expanded and repeated under choice modelling. What dien is gained by die deepening and widening process?

Choice modelling has at least live advantages over conventional CVM. First, it allows die valuation exercise to be framed adequately. Widi a CVM application, it is necessary to ensure diat respondents are well aware of die range of substitute and

192 Jeff Bennett

complement goods that are available, so that the single valuation choice made is not taken in a vacuum. Usually, diis involves respondents being given a statement ol availability and a caution to ensure dial they bear in mind the availability ot other goods when making their choice. This is an adjunct to die questioning process and may not be well assimilated by respondents. Under die choice modelling approach, substitute and complement goods can be included as options or as attributes, and become integral to die choice process. The framing provided is dierefore much stronger. In die Rolfe and Bennett (1996) study, die Vanuatu rainforest reserves being valued are framed against an array of substitute areas in bodi Australia and overseas.

Second, under die choice modelling approach, cost is only one of a number of attributes diat vary across a sequence of choices. This tends to downplay die significance of die dollar value trade-off in die choice exercise. The incendve for respondents to behave strategically could dius be smaller dian under die CVM approach, where die dollar trade-off is made more explicit. Choice modelling also makes it possible to introduce a range of marketed and lion-marketed goods as options. This can assist respondents in coming to terms widi die concept of 11011-marketed goods being included in choices where money is involved.

Third, die variety of attributes and options diat can be presented to respondents makes it possible to reduce die significance of any particular attribute or option diat evokes significant protest. This situation may arise if specific ill-will is directed at a corporation or a government diat is involved in die provision of a 11011-marketed effect diat could impact on respondents’ choices independent of dieir underlying valuations.

Fourdi, die introduction of bodi marketed and 11011-marketed goods in a choice modelling exercise opens die way for die calibration of die 11011-market effect. It is also possible to integrate market data relating to ex post circumstances into choice modelling data to calibrate die data. For instance, Ixiuviere (1994) demonstrates die integration of travel-cost mediod (revealed preference) into a set of choice modelling (stated preference) data to calibrate estimates of ski-field recreational values.

Finally, choice modelling allows die various contributing attributes of an option to be valued. It is dierefore possible to create hypodietical scenarios of option combinations and carry out ex mite estimations of value. The technique presents an opportunity to introduce a new degree of flexibility into die value estimation process. It makes it possible to transfer valuations across a variety of case studies. For instance, a choice modelling exercise directed at valuing wedands, generically, could provide data relevant to die valuation of a wide range of specific wedand sites.

Choice modelling dius appears to offer some advantages over conventional CVM as an estimation technique. But its development is still at a relatively early stage; and some doubts remain about its applicability. I11 particular, its ability to yield dollar valuations for 11011-market effects relies 011 a set of relatively restrictive assumptions. Substantial experimentation in developing die technique will be required for choice modelling to come of age. For instance, very litde work has yet


been done on die use of choice modelling to estimate non-use environmental values such as existence demand.

Conclusions

CVM has become widely used and accepted in die IIS and Europe as a technique for die estimation of 11011-market effects. Its acceptance in Australia has been far more limited and, as a consequence, it has been applied radier sparingly. This is despite particularly strong demands for estimates of 11011-market values being expressed by diose responsible for resource use decisions where environmental consequences are apparent.

The high profile of die RAC’s Kakadu study, die heated debate diat followed it, and its eventual relegation from die policy-relevant category discredited it in die eyes of many Australian policy-makers. Subsequent domestic applications of die technique have done litde to improve its local standing. For CVM to achieve in Australia die status it has attained overseas, policy-makers will need to become better informed about die technique itself. like all tools of economic analysis, it has strengdis and weaknesses. Its results need to be interpreted carefully. Above all, users of CVM results need to be aware of die differences between good and poor applications of die technique. As has been demonstrated by die NOAA panel, many elements of a CVM study may be used to judge its reliability as a source of policy relevant information. Perhaps die single most important point for policymakers to realise is diat die CVM will never provide simple answers for all natural resource allocation problems. All it can do is provide anodier element of information to die decision-making process. Over time, die quality of die information provided by CVM and its descendants, such as choice modelling, will be improved, but it will never be a panacea.

References

Arrow, K., R. Solow, P. Portney, E. Learner, R. Radner& H. Schuman (1993), ‘Report of the NOAA Panel on Contingent Valuation’, Federal Register 58: 4601-14.

Bennett, J. (1984), ‘Using Direct Questioning to Value die Existence of a Preserved Natural Ecosystem’, Australian Journal ofAgricultural Economics 28: 136-52.

-------& M. Carter (1993), ‘Prospects for Contingent Valuation: Lessons from die South-East Forests’,AustiaJian Journal o f Agricultuial Economics 37: 79-93.

Blarney, R. (1995), Citizens, Consumers and Contingent Valuation: A11 Investigation into Respondent Behaviour, unpublished PhD diesis, Australian National University.

Brunton, R. (1991), Will Play M oney Diive Out the Rea! Money, Institute of Public Affairs, Canberra {Environmental Backgrounder No. 2).

Carson, R. (1991), ‘The RAC Kakadu Conservation Zone Contingent Valuation Study: Remarks 011

die Brunton, Stone and Tasman Institute Critiques’, in Resource Assessment Commission (1991), Commentaries on the R A C ’s Contingent Valuation Survey o f the Kakadu Conservation Zone, Canberra.

194 Jeff Bennett

Carson, R., M. Hanemann, R. Kopp, J. Krosnik, R. Mitchell, S. Presser, P. Rudd & K. Smith (1994), Prospective Interim Lost Use Value due to D D T and PCB Contamination in the Soudiem Californian Bight, Natural Resource Damage Assessment Inc., La Jolla.

Carson, R., J. Wright, N. Carson, A. Alberini & N. Flores (1995), A Bibliography o f Contingent Valuation Studies and Papers, Natural Resource Damage Assessment Inc., La Jolla.

Ciriacy-Wantrup, S. (1947), ‘Capital Returns from Soil-Conservation Practices’, Journal o f Farm Economics 29: 1181-96.

Diamond, P. & J. Hausman (1994), ‘Contingent Valuation: Is Some Number Better Than No Number’, Journal o f Economic Perspectives 8(4): 45-64.

Flatley, G. &J. Bennett (1994), 77le Value o f Vanuatu Forest Protection to Australian Tourists, Department of Economics and Management, University College, The University ol New South Wales, Canberra (Vanuatu Forest Conservation Research Rejiort No. 6).

Hanemann, M. (1994), ‘Valuing the Environment through Contingent Valuation’, Journal o f Economic Pers/iectives 8(4): 19-44.

Hill, C. (1994), ‘Water Quality Improvement in the Darling River: a Contingent Valuation Study’,paper presented to the 38th Conference of the Australian Agricultural Economics Society, Wellington.

Hundloe, T., G. McDonald, R. Blarney & M. Carter (1990), Socioeconomic Analysis o f Non- Extractive Natural Resource Uses in die Great Sandy Region, Institute ol Applied Environmental Research, Griffith University.

Imber, D., G. Stevenson & L. Wilks (1990), A Contingent Valuation Survey o f die Kakadu Conservation Zone, Resource Assessment Commission, Canberra (Research Paper No. 3).

Jakobsson, K. (1994) Methodological Issues in Contingent Valuation: An Application to Endangered Species, unpublished PhD diesis, LaTrobc University, Melbourne.

Johnston, B. (1982), ‘External Benefits in Rural Research and die Question of Who Should Pay’, paper presented to die 26di Annual Conference of die Australian Agricultural Economics Society, University of Melbourne, February.

Louviere, J. (1994), ‘Relating Stated Preference Measures and Models to Choices in Real Markets: Calibration of CV Responses’, paper presented for die DOE/EPA Workshop on Using Contingent Valuation to Measures Non-market Values, Herndon, Virginia, May 19-20.

Mitchell, R. & R. Carson (1989), Using Surveys to Value Public Goods: The Contingent Valuation Mediod, The Johns Hopkins University Press, Washington DC.

Moran, A. (1991), Valuing die Kakadu Conservation Zone, Tasman Institute, Melbourne (Occasional Paper No. 138).

Poitney, P. (1994), ‘The Contingent Valuation Debate: Why Economists Should Care’, Journal o f Economic Perspectives 8(4): 3-18.

Rolfe, J. & J. Bennett (1996), The Existence Demand for Vanuatu Forest-Protected Areas, Department of Economics and Management, University College, The University of New Soudi Wales, Canberra (Vanuatu Forest Conservation Research Report No. 12).

Scott, W. (1982), Public Willingness to Pay for Clean Air, AGPS, Canberra (Australian Environment Council Report No. 7).

An earlier version of this article was delivered to a meeting of the Victorian Branch of the Australian Agricultural Economics Society in September 1995.


Financial Market Reform in Transition Economies

Kim Hawtrey

'I FINANCIAL market reform is vital for the development and successful transir e tion o f die former socialist economies, because of die pivotal role that die

j I l. modern monetary sector plays in attracting committed capital and in facilitating enterprise.

Yet financial reform, represented by deep asset markets and modernised banking insdtudons, remains far from complete in Russia and die odier East European countries. Monetary policies are unpredictable and diere is inadequate infrastructure to define and support regularised trading in financial instruments. Key factors in a mature financial system, such as availability of credit, efficient banking services, and secure contract law, are frequendy absent. As a consequence, real investment (especially by foreigners) is being seriously affected by die presence of irregularities in trading between various financial assets, and an unstable and frequendy unworkable banking system.

For instance, Alexander Kliandruyev, Deputy Chairman of die Russian central bank, acknowledged in January 1995 dial diere were signs of a ‘banking crisis’ in die wake of die Black Tuesday rouble crisis of October 1994 when die currency slumped by 27 per cent against die US dollar (to 3,926 roubles per dollar) in a single day. Following diis, the bank attempted to impose several control measures: a rise in die refinancing rate, a 30 per cent cut in banks’ open currency posidons, and heavy raising of commercial banks’ reserve requirements. In August 1995, die interbank market was frozen for several days, banks were shut and interest rates shot up to 1,000 per cent.

Policy in diese countries dierefore needs urgendy to address die operation of banks and financial markets. Many banks in die transition economies are unprofitable and are not yet functioning effectively in die role of allocating credit; diey are still largely state owned, and die majority of assets are still controlled by banks created in die communist era. For example, 70 per cent of bank assets in Hungary are concentrated in four state banks; in Poland only diree of nine banks proposed for privatisation in 1991 have been sold off; and Hungary’s diree largest banks (Budapest Bank, Magyar Hitel Bank, Kereskedelmi Bank) are still not privatised. In addition, financial services markets, such as diose for company shares, insurance, bonds, bills of exchange, derivatives and foreign currency, suffer from inadequate

Kim Hawtrey is Lecturer in the School of Economic and Financial Studies at Macquarie University.

196 Kim Hawtrey

securities laws in what amounts to a legal vacuum. I.arge and variable fluctuations are not unusual in listed share prices, which in die space of twelve months typically rise or fall by more dian two or diree times. This twin uncertainty — about legal rights and market values — is currendy impeding die creation of deep equity and debt securities markets.

In turn, diis hampers wider industrial enterprise. Under central planning, die mechanisms for credit and value transfer were centralised and closely administered, often involving barter or inter-regional trade agreements conducted by government agencies radier dian banks. The move toward a market approach therefore represents a major shift, widi large adjustments required of bodi government and industry. Many economic agents and government officials have litde experience of financial instruments, credit, contracts, free banking, and die like. Consequendy, governments continue to finance unviable enterprises, and industry lacks access to basic value-adding monetary mechanisms. Widiout laws to enforce bills or loans, firms cannot obtain inputs on credit because suppliers do not have legal recourse to recover monies unpaid. Hence die urgent need to develop an institutional framework for financial transactions diat will encourage die money and credit markets to function properly.

A Micro-Financial Reform Agenda

To improve die operation of financial markets, policymakers need to address a range of issues.

Tax reform. Russian banks lace a tax rate of 43 per cent, compared widi only 35 per cent lor industrial enterprises. In general, taxes at present tend to be arbitrary, changeable and too high. Many taxes apply not to net profits, but to gross sales; normal business expenses such as advertising are often not deductible. As noted by Pardy (1992), countries diat have in die past favoured directed credit and state ownership of commercial banks tend to have tax systems diat discriminate in favour of bank savings at die expense of securities vehicles, and bank loans at die expense of public capital raisings. Such tax biases distort allocative efficiency.

The monetary value transfer system} This ranges from die simplest level, such as secure postal services and couriers, to die more complex level of die bank chequeclearing mechanism and electronic money transfers. If diese are not functioning, die community will have an incentive to resort to barter. Failure to develop an adequate international payments system has already worsened die transition economies’ debt problem, and fostered inferior barter trade. In particular, bank cheque-

lThe essential elements of a non-cash interbank payments system include flexible methods by which

customers may make payment for goods (such as credit card, EFT, debit card, and so on), effective arrangements for the interbank dealing o f payments instrucüons (including rapid soiling, accounting and transporting, bodi centralised and bilateral), and settlement processes (which refers to the exchange of final value between financial institutions to extinguish net obligations upon dealing).

Financial Market Reform in Transition Economies 197

clearing in Russia and other transition economies can take between four and eight weeks, which is very cosdy under hyperinflation.

Securities legislation. The securities law is presently underdeveloped. Russia, lor instance, urgently needs legislation to cover certificate ot title, insider dealing, registration, corporate disclosure, purchases by foreign investors, the role of brokers and fund managers, and so on. The new Russian Securities Commission, appointed in January 1995, is a positive step, but is only a beginning. An example of the type of problem that needs to be addressed is die burdensome re-registration procedures involved in share trading: to evade diis, many companies have issued shares diat carry die company’s name as die registered owner, allowing buyers freely to trade die stock as if it is a bearer security radier dian inscribed. One serious problem widi diis is die scope it provides for tax evasion.

Transferable property rights. In a market economy, where transacdons occur on voluntary basis, bodi pardes to a transacdon must be assured diey will fully own dieir asset (and fully relinquish dieir liability). An example of policy failure here is diat Russian law currendy does not automatically confer on a mining company die right to mine ore it discovers: odiers are allowed to bid for it, even diougli diey have played no part in discovering it. Widiout guaranteed property rights, bank lending policies and risk guidelines are rendered meaningless.

In diis regard, die first part of die Russian Civil Code (proclaimed in December 1994) is a vital first step. It repealed two inferior (1990) laws (On Enterprises, On Property) as from 1 January 1995. The second part of die Code, which will include provisions on securities, is scheduled for later in die decade. As a minimum it needs to include exclusivity and inalienability of legal property tide. Attempts to introduce a fully articulated land code have so far not been forthcoming, hampering banks’ ability to underwrite development projects.

Bankruptcy law. The essence of bankruptcy law is die ranking of various classes of creditors’ claims against die bankrupt debtor, so diat as die defunct company is liquidated, its assets are pooled and competing claims are satisfied in order from highest to lowest priority. In accepted Western law, ‘secured’ claims (diose contractually backed by collateral) are usually ranked above all odier claims, giving creditors possession of collateralised assets before secondary creditors can be paid. However, under Section 64 of Part One of die Russian Civil Code, secured claims are subordinated to two odier classes of creditor: diose seeking compensation for personal injury, and workers seeking unpaid wages or royalties. As a result, traditional secured creditors now have no recourse or control in respect of such commitments entered into by die debtor alter a loan is contracted.

The Pace of Financial Reform

Two broad questions are raised by die process of financial reform: die pace at which it is implemented, and die need, if any, for a fixed sequence of reforms. In

198 Kim Hawtrey

this section it is argued that die case for rapid financial restructuring widi minimal sequencing is stronger dian diat for gradual reform.

Most transition economies have adopted a gradualist approach to reforming dieir financial systems, apparendy because of die strain diat ‘shock dierapy’ could place on die domestic political economy, leading to instability and unpredictability. Such instability, it is said, could create excessive hardship, unemployment and loss of markets. It is sometimes argued diat die old rigidities are so deeply ingrained diat diey will take a generation to change; after all, die financial systems of Western countries took decades to evolve. Thus, many of die restructuring economies have attempted bite-size reforms, one at a time.

However, evidence from die five years or more of gradualism suggests diat die experiment has failed. Table 1 provides a broad-based comparative assessment of die progress of reform in die various east and central European transition economies. Some caution needs to be exercised. Data for diose countries may be subject to statistical irregularities. Further, it may in some cases be too early, as well as inappropriate for analytical reasons, to draw strong conclusions from macroeconomic data, which are subject to a multitude of influences apart from die banking sector. In particular, aid assistance received from die West varies markedly from country to country; susceptibility to Russian influence differs widely; and resource endowments are unequal. Notwidistanding diese caveats, however, die table provides a point of reference for die discussion diat follows.

The five columns on die left side of die table show die speed widi which transition economies have undertaken reform since 1990. The diree columns on die right hand side show some macroeconomic indicators diat, over time, would be expected to respond to bank reform. Overall, Table 1 suggests diere is a broad correlation between die speed of banking ref orm in a transition country and its early macroeconomic performance. The faster reformers, by and large, are experiencing better (non-negative) growth in real output and lower inflation rates. Most telling, however, are die figures on long-term capital inflow, which are positive for die fast reformers and negative or low for Russia and die odier slow-reform countries. While many odier factors affect diese macroeconomic outcomes, die data tend to vindicate early bank reform.

The basic problem for die slow reformers is diat ‘bad money drives out good’: so long as die old political connections remain intact, diere is a strong inertia in favour of vested interests; and so long as die bureaucracy still plays a major role in credit allocation, it is difficult for commercial banks and market forces to gain a foodiold. Given continued access to state credit, underpinned by soft budget constraints or barter, die ‘hard credit’ of a truly markedsed banking system remains in a subordinated role to die former, less demanding avenue preferred by borrowers.


Table 1

Finance sector transition: progress indicators

COUNTRY_________________ Stance on reform__________________ Effects of reform(1) (2) (3 ) (4) (5) (6) (7) (8)

S iz e of G N P , 1993: U S $b n

P aceofbankreform

Tw o- tier b a nking

B ankprivatisation

Legalfra m e work

G N Pgrowth1994

(% )

Inflation1 9 94

(% )

N et av e rag e annual foreign capital inflow 1 9 9 0 -9 4 (% G N P )

A rm en ia 2 .4 slow late m ed. * 3 .0 2 6 7 0 .3 n.a.A zerba ijan 5 .4 slow late m ed. * - 2 1 .9 1 2 6 6 .3 n.a .

B elarus 2 9 .3 slow late m ed. * -2 1 .5 1 9 4 0 .7 n.a .B ulgaria 10.1 m ed. late low * - 2 .4 7 6 .0 2.1

C ze c h R ep . 2 0 .7 m ed. m id m ed. ** 2 .2 9 .5 . 4 .0E ston ia 4 .9 fast early high ** 6 .0 5 0 .8 3 .2H ungary 3 4 .2 fa s t—>

slowearly low ** 3 .8 19.1 7.1

K azak h s tan 2 6 .5 slow late m ed. *- 2 5 .0 2 0 6 1 .2 n.a.

K yrgyzstan 3 .9 slow late m ed. •-2 6 .5 15 5 .5 n.a.

Latvia 5 .3 fast early high *** 0.1 3 0 .0 2 .9Lithuania 4 .9 m e d ./

fastearly m ed. ** 2 .0 6 9 .0 3 .8

M o ldova 4 .7 slow late m ed. * -2 2 .2 2 5 9 .4 n.a .P oland 8 6 .6 fast early m ed. *** 5 .6 3 1 .9 2 .3R o m an ia 2 5 .9 slow /

m ed.mid low ** 2 .2 13 9 .2 3 .0

R ussia 3 4 7 .9 slow late m ed. *- 1 4 .3 3 5 6 .7 - 1 .0

S lovak ia 1 0 .3 m ed. m id m ed. ** 4 .2 11 .7 0 .2Ta jik is tan n.a . slow late m ed. • n .a. n .a . n.a.Tu rk m e n is tan n.a . slow late m ed. * n .a. n.a. n.a.U kra ine 1 1 4 .0 s lo w -»

fastlate m ed. * - 2 6 .7 8 7 0 .4 n.a.

U zbek is tan 2 1 .2 slow late m ed. •- 4 .5 2 3 4 .9 n.a .

Notes: The former Yugoslavia has been omitted from the table due to the effects of internal conflict. Columns: (1) aggregate GNP in 1993, in US$ billions; (2) author’s overall assessment of the general rate of progress in bank reform; (3) ‘two-tier banking’ refers to the separation of central banking institutions from commercial banking institutions; (4) proportion of the banking sector transferred from state to private ownership; (5) stars broadly indicate how advanced each country is in implementing essential legislation for banking and securities markets; (6) 1994 annual real percentage growth in GNP; (7) 1994 annual inflation rate as measured by percentage change in the GNP deflator (but consumer price index for Czech Republic); (8) average annual long-term foreign capital inflow over the five years 1990-94, expressed as a ratio of GNP; net long-term capital inflow comprises changes (excluding valuation adjustments) in residents’ long-term foreign liabilities minus their foreign assets; Czech Republic includes medium- as well as long-term capital.

Sources: World Bank (1995), United Nations (1995a,b).

200 Kim Hawtrey

In 1994 the Ukraine realised this and began to move Taster towards full financial reform. Prior to that, the economy was deteriorating: productivity had lallen 40 per cent, and yet at the same time credit was ballooning, die currency was devalued, and interest rates were negative in real terms. Then in 1994 die central bank, led by first deputy chairman Vladimir Stelmach, implemented a radical reform package. Although problems remain, interest rates in after-tax terms are now positive, inflation is lower and foreign investors are responding positively. (This hapjiened too late to show up in Table 1.)

A crucial point to recognise is diat die transition economies are capital hungry. They are ‘shortage economies’ not only in die sense diat basic consumer products such as milk and bread are in short supply, but in die financial sense that capital is extremely scarce. Comparisons widi die development of Western economies are instrucdve at diis point: die West may not have grown its modern banking institutions rapidly, but neverdieless has always mobilised capital. It is misleading to focus simply on die institutional evolution of banking in die West, because die real question is its historic ability to mobilise capital for investment. This is what is lacking in die transidon economies — which is why capital market reform is urgent. The too- slow pace of financial sector reform is starving diese economies of essendal capital; and when reform progresses unevenly, as it has, die cost in terms of lost opportunides mounts up. The polidcal honeymoon is dissipated, and die economic instability in die currency (and hyperinfladon) destabilise die economy. When interest rates are not posidve in real terms, saving is not adequately encouraged.

A central argument is diat true enterprise (real sector) reform will not be possible in die absence of banking (finance sector) reform. In die wake of 70 years of Soviet rule, the banking systems in Central and East European economies are somedmes even less sophisdcated dian diose in developing countries. Banks and enterprises are choked with old debts and outdated procedures. If enterprises are to be markedsed, diey must be placed on a hard-budget, ‘acdve’, best-pracdce financial foodng. In turn, diis can occur only if diey are dealing widi a liberalised banking system diat imposes die disciplines of die marketplace. This implies diat die banks need to be reformed as early as possible.

The effect of die pace of reform on small business should not be ignored. Pleskovic (1993) argues dial delays discourage small-scale entrepreneurs, inhibit die entry of new firms, and retard die transidon process by placing a burden on household living standards dirough high taxes. Financial costs, especially interest rates, are a major determinant of die vitality of die small enterprise sector.

Estonia, I^atvia and Lidiuania have all used shock dierapy, and are probably die leading examples of die success of diis approach. Since winning independence five years ago, Estonia embarked on rapid financial reform and has transformed itself into one of die fastest growing economies in Europe. Per capita foreign investment

2T o put diis in perspective, Russia’s current debt stands at around US$120 billion, and to date it is yet

to sign agreements with creditors on its former USSR liabilities. The IMF stand-by loan amounts to only US$6.5 billion.


is high (comparable with Poland and Hungary, two further examples of rapid reform), die unemployment rate is only 2 per cent, and inflation is under control.

Hungary’s reforms until 1994 were mostly driven by the finance minister, Laszlo Bekesi. His resignation in January 1995, however, signalled some loss of resolve in Hungary, with Prime Minister Horn appearing now to opt for less budget deficit reduction and slower privatisation. For example, in January 1995 the privatisation of die state-owned chain Hunger Hotels was reversed af ter it had earlier been approved by die State Privatisation Agency. This backsliding carries the very real risk of alienadng foreign investors who have so far injected over US$8 billion into Hungary. Indeed, in 1995 die Hungarian central bank had to dip into its foreign reserves; from 1 February 1995 reserve requirements were increased for commercial banks, and official bank reserve requirements were raised from 12 per cent to 14 per cent. To reduce credit pressures, die Nadonal Bank of Hungary in early 1995 also had to eliminate its currency swap and one-mondi repurchase facilities, and increase die base lending rate by diree points (to 28 per cent). This has led to a fall in stock-market prices.

The clear lesson of die Hungarian case is dial markets are sensitive to die pace of reform: markets responded positively to die early years of Hungarian reform, but have become cautious since late 1994, when the pace of financial reform slowed. (This market sensitivity factor is also highlighted by recent developments in Vietnam, where die government is implementing a ‘big bang’ approach to reform, and is gaining a very warm response from investors.) The relative success of early shock dierapy in Hungary, Poland and Estonia indicates diat bold strikes taken earlier radier dian later yield die greatest gains.

Anodier significant argument for rapid reform is die potential benefit to die central government budget in die form of increased revenue. This happens in diree ways. First, stronger market activity produces higher general business taxation revenues. Second, privatisation of banks generates income diat goes direcdy into central revenue and can be used to repay debts. Third, channelling household savings dirough formal bank accounts radier dian informal alternatives creates a new base for taxation. By speeding up die improvement in die revenue base, rapid financial reform is an aid to fiscal improvement.

It has been argued by McKinnon (1991) dial banks should be die last part of die economy to be reformed, on die grounds of risks f rom lack of supervision and poor controls. This quality-control issue is not insignificant, as illustrated by a recent episode in China where weak controls led to a financial crisis. Yet it does not justify postponing financial reform; radier, it shows die need for an active prudential central bank and proper financial legislation. McKinnon’s argument (1991:138) is diat ‘die sorry history of bank lending in partially liberalised regimes — such as Yugoslavia, Poland, Hungary and die PRC in die 1980s — shows die severe moral hazard from state banks overlending to enterprises diat local or central governments

In a single day in February 1995, die Shanghai International Securities limn was pushed to die brink, o f bankruptcy dirough bond market futures, causing die audiorities to close die market temporarily.

202 Kim Hawtrey

wish to promote’. As loss-making enterprises were the main absorbers of credit, according to McKinnon, in die early stages enterprises should be restricted to self- finance and 11011-bank capital. Quite apart Irom die fact diat episodes such as die 1995 Barings Bank collapse in die UK occur also in high-quality Western systems, die problem with McKinnon’s argument is diat diose early liberalisadon episodes in die 1980s were not proper tests of deregulated transition banking. Radier, diey demonstrate die folly of liberalisadon diat is only pardal. A11 equally plausible conclusion is diat die bad loan problem arose because banking markedsadon was incomplete. die state was sdll die dominant player, and relorm was too slow. This allowed loss-makers condnued access to credit precisely because die banking system was not able to perform its function as an opdmal credit-allocadon mechanism.

The major reforms of die financial system — securides markets legislation, bank prudential regulation, marketisation of financial institutions — can and should be implemented largely concurrendy, subject to resource constraints and central coordination, along widi macroeconomic policy discipline. The evidence suggests diat a clean break widi die past, and rapid modernisation, will produce die best results for international integration widi global capital markets and for domestic economic advance. More than die real sector, die financial sector closely approximates die textbook notion of a perfect market in die sense diat it does not easily tolerate barriers, 11011-neutralities (diat is, an unlevel playing field) and dividing lines. Capital Hows easily across borders and between locations, implying diat capital global suppliers will not readily meet die massive funding needs of die capital-scarce economies in die presence of existing anomalies.

Managing Reform

Sequencing. One of die effects of adopting a f ast rate of financial sector reform is to concertina die various steps involved. But if die reform agenda is conceived in terms of a series of distinct steps, die ideal sequence would be die following. First, commercial banking is separated from central banking, and market-based financial legislation is established (including prudential rules). Second, basic infrastructure, such as skilled banking personnel (especially supervisory) and standardised payment systems, needs to be put in place. Third, competitive hanking markets are created dirough privatisation of existing state-owned banks, demonopolisation of banking, and controlled entry of foreign banks. Fourth, a plan for managing die most pressing old debts (possibly including equity swaps or discounted write-offs) is implemented, so diat die marketised banks and enterprises can be free to develop dieir balance sheets. And fifth, education in credit assessment (for banks) and use of banking services (for die public) is conducted.

4Notably, the W orld Bank granted a US$558 million credit facility to Russia on 28 April 1995 to fund

projects to upgrade the tax system, and train financial stall.5

One estimate suggests that around 75-80 per cent o f total bank loans in transitional econom ies are unlikely to be repaid (Caprio & Levine, 1992:18).


Nevertheless, rapid reform implies little or no sequencing. If changes are made in a piecemeal fashion, die interdependence ol financial markets may be ignored, which can result very quickly in rate of return distortions and unjustified economic rents. Capital requires equal access to competing uses, and economic dieory tells us diat a ‘general equilibrium’ approach to reform requires diat diis principle should be adhered to from die outset.

A case in point is Latvia, where simultaneous progress in structural adjustment of bodi real and financial sectors has been significant. Alongside price liberalisadon and small-business development, banking industry privadsadon is well advanced and programs have been set up to train die public in finance. The government has established die Latvian Investment Agency as a one-stop shop to provide private investors widi easy access to information on banking laws, securities regulations and investment opportunities. Demonopolisation has progressed steadily from die beginning. Lidiuania, after a slighdy slower start, has gained similar momentum. The separation of commercial banking from central banking occurred early in die reform process; and a program to restructure and privatise die diree largest state- owned banks has been implemented. New central and commercial bank laws have been introduced, including prudential requirements on bank balance sheets. Current efforts are focused on improving credit-assessment skills and refining securities legislation.

State fuid private ownership. Related to die issue of die sequence of bank reforms is privatisation and die optimal mix ol state and private ownership. Privatising ex- Soviet banks widi dieir balance sheets unreconstructed can do more harm dian good. The newly privatised bank will carry a heavy burden of old debt which is unlikely to be repaid, and will hang like a millstone around die neck of private enterprise. Profit-making borrowers could end up subsidising older loss-making ones. One solution is for die government to accept on to its own books some of die outstanding bank claims, dius allowing die new institution to start widi a cleaner slate.I his (ould be accomplished by replacing die bank claims widi government paper. Although simply an accounting transaction, diis step has positive implications for die speed and efficiency of privatisation, because die way in which die audiorities treat past debts will allect die rate and sustainability ol economic liberalisation.

Discriminatory incentives for reform. A lurdier question is whedier die government, having decided on a strategy of rapid banking reform, should actively intervene in favour of die securities markets. For example, it might offer a package of discriminatory measures, including tax incentives, designed to accelerate banking evolution. This might include such measures as waiving securities registration fees, regulating broker charges, capping die interest rate charged on loans, exempting secunties from capital gains tax, giving tax breaks to foreign investors, requiring all firms over a stipulated asset size to list on die stock exchange, subsidising die transaction costs associated widi equity raisings, and so on. But aldiough superficially attractive, especially as it operates on die supply side radier dian die demand side,

204 Kim Hawtrey

tliis approach should be rejected in most circumstances. Using the taxation system or budget expenditures in such a fashion violates the principle of neutrality by fostering uneven and biased economic development. Once such irregular measures become entrenched, they are difficult to revoke.

Asset concentration. State ownership (both direct and indirect) and the oligopolistic market structure of banking remain an obstacle to marketisation. Bank assets are still concentrated in a few institutions; this forms a barrier to entry by new banks, reduces genuine competition and hampers attempts to improve operational efficiency. State ownership of commercial banks causes potential conflict of interest between central bank prudential policy and political or state interests.

One way of combating asset concentration is to disaggregate die balance sheet of die few, large exisdng banks into many, smaller institutions. But diis can spread resources and expertise too diin, so losing die benefits of economies of scale. A second approach is to foster competition by region, giving a degree of control and autonomy to various provinces and even municipalities; at die same time, some central functions and controls can be maintained in die interests of stability. A diird mediod is die partial or full privatisation of existing state-owned banks. This has die benefit of exposing rigid institutions to die disciplines of free enterprise. The obstacles here, however, include die absence of suitable buyers (especially if die bank carries a lot of debt from die past) and die clash between die old Soviet culture and die new business culture. A fourth approach is to introduce foreign banks, hoping diat diey will do quickly what ex-Soviet banks are able to do only slowly: modernise die banking environment. On 27 April 1995, Russia’s President Yeltsin signed a decree lifting all previous restraints on foreign bank operations in Russia for diose granted licences. However, diis raises die issue of foreign control over die domestic banking system. The ideal solution is likely to involve a mix of die above approaches.

A related principle is die separation of financial and industrial enterprises, unlike die so-called ‘wild cat’ banking diat has occurred in Russia, where a financial service institution springs up diat is backed by an ordinary company (operating widi a soft budget constraint). A recent example is die Samara Region Financial Industrial Company, to be named Volzhskie Automobile 2000 (Volga Cars). It comprises die AutoVAZ joint stock company, die AutoVAZ bank, die Samara branch of die Inkombank, and 24 ex-defence enterprises of die region, which will provide die production capacities for manufacturing cars. Such companies are a recipe for financial disaster and fraud, overturning as diey do die arms-lengdi relationship between commercial banks and die firms to which diey lend dial is a key principle of

6However, a positive step the government might take with less (listortionaiy cllect is the bearing of risk

in die early stages ol market development. An example is die ‘national bond fund’ established by China in February 1995 to protect investors against losses on turbulent bond markets. Investors can buy shares in die pool of bonds radier dian direcdy purchasing bonds on dicir own; diis aids liquidity and reduces individual risk.


Western financial structures. This does not rule out trade or inter-enterprise credit, but keeps it separate from the financial sector proper.

Conclusion

Financial sector reform is an urgent priority in transition economies. If monetary liberalisation lags behind enterprise liberalisation, old credit channels will continue to dominate new ones. Budget constraints at the microeconomic level will remain soft. In die presence of a distorted interest rate, die reladonship between exisdng wealdi and future income Hows will be inefficient, and credit will not be allocated opdmally. Widiout a secure liquid investment asset bearing a posidve real rate of interest, enterprises will elect to hold excessive levels of inventories, and individuals will not save.

The stress being currendy caused by financial delinquency in die shortage economies is such diat die whole development process is cridcally contingent upon fixing it. Dornbusch and Reynoso (1993:65) state diat in development, ‘financial factors are important, but probably only when die financial instability becomes a dominant force in die economy’. This direshold has been well and truly exceeded in transition economies. Poor finance leads to inflation and credit and external botdenecks, which in turn paralyse macroeconomic policy and retard growdi. Savings are underworked, misallocated and incorrecdy rewarded: a core illness diat has widespread real effects in what are essentially capital-deficient economies.

Should die Western economic powers play a targeted supportive role in promoting rapid financial sector reform? If so, at what level? It is tempting to suggest diat die IMF and/or World Bank could assist in die privatisation of banks, by selectively underwriting old Soviet debts diat die state must write down if bank privatisation is to accelerate. But die debts are huge; and such Western assistance could create an incentive for superficiality on die part of receiving governments. But die West can help to market die debt at discounted prices and undertake equity swaps; moreover, Western banks can oiler to help widi dieir existing stock of expertise.

fhe present need is to attract die ‘second wave’ of institutional investors, entrepreneurs, and savers. The first post-1989 wave brought an initial influx of foreign investment and an early batch of private small business ventures, driven by curiosity, optimism and the honeymoon effect. However, die next phase will need to be based more squarely on financial fundamentals, where players and new entrants can be convinced of die long-term potential of diese markets. Getting die financial infrastructure right is a necessary condition for marketised enterprise investment and trade; and die ability of diese countries to stabilise dieir financial systems will be a major factor in die success of dieir economic transition.

206 Kim Hawtrey

References

Caprio, G. & R. Levine (1992), Reforming Finance in Transitional Socialist Economies, World Bank, Washington DC, April (Working Paper WPS 898).

Dornbusch, R. & A. Reynoso (1993), ‘Financial Factors in Economic Development’, ch. 4 in R. Dornbusch (eel.), Policymaking in the Open Economy, Oxford University Press, New York.

McKinnon, R. (1991), The Order o f Economic Libeialisation: Financial Control in die Transition to a Market Economy, Johns Hopkins University Press, Baltimore.

Pardy, R. (1992), Institutional Refoim in Emerging Securities Markets, World Bank, Washington DC, May (Working Paper WPS 907).

Pleskovic, B. (1994), Financial Policies in Socialist Countries in Transition, World Bank, Washington DC, January (Policy Research Working Paper 1242).

United Nations (1995a), W orld Economic and Social Survey 1995, New York.

------ (1995b), Economic Bulletin for Europe, vol. 46, Geneva.

World Bank (1995), Trends in Developing Countries, Washington DC.

This article is based on a paper that the author presented at the University of Gomel, Belarus, on 25 January 1995. The author is grateful to the staff of the Economics Faculty at the University of Gomel and to three anonymous referees for helpful comments, but is responsible for any errors. Research leading to the paper was carried out while the author was visiting the University of Gomel, whose assistance is gratefully acknowledged.


The Politics of India’s Economic Liberalisation Agenda

Ramesh Thakur

V N 1995, India began to be ranked as joint top investment prospect with South I Korea among die ten big emerging markets. This partly reflected scepticism

-A-about die legal integrity of China’s contract laws concerning foreign investors. Yet in August 1995, die government of Maharashtra, India’s most industrialised state, cancelled die contract for Houston-based Enron’s Dabhol Power Co. project, die biggest single foreign investment to date in die country. Ironically, Prime Minister P. V. Narasimha Rao was in Malaysia at die time, trying to encourage further investment from Soudieast Asia. Rao, who has been responsible for die most radical departure from four decades of socialism, tried to downplay die significance of die Enron reversal. Nevertheless, it was clear diat die issues were being clarified for die general election scheduled to be held widiin a year of die decision. Political expediency seemed once again to be in conflict widi economic rationality.

Strategic Choices in 1947

H ie strategic choices diat Indian policy-makers made alter independence was achieved in 1947 reflected historical and political as well as economic considerations. The Nehru Government’s strategy was to industrialise India by means of central planning. The achievements were substantial. Breaking widi pre-independence stagnation, India’s economy grew dirice as fast in die 1950s and 1960s as during die Raj. In marked contrast to recurrent famines under die Raj, food security was achieved. In just 40 years, infant mortality was halved, life expectancy nearly doubled, and adult literacy almost trebled (see Table 1). Even so, die chosen padi of development retarded further growdi.

Bhagwati (1993) argues diat India’s persistent low productivity is explained by extensive bureaucratic controls over production, investment and trade; inward-looking trade and investment policies; and an inefficient, over-extended public sector. To- gedier, diese created a render instead of an entrepreneurial economy. Industrial capacity was under-utilised, allocations of foreign exchange and investment capital were inefficient, land reforms were blocked. A generally corrupt polity, based on a stable exchange relationship between bureaucrats, politicians and a narrow circle of proper- ded and favoured groups, severely inhibited development

Ramesh Thakur is Head o f the Peace Research Centre in the Research School o f Pacific and Asian Studies at The Australian National University.

208 Ramesh Thakur

Table 1

India’s quality of life indicators, 1901-93

J 1901 | 1921 1941 1951 1978 1993Infant mortality (per 1000 live births) 183 132 80Life expectancy (years) 20 21 31 32 51 61Adult literacy (per cent) 6 8 15 17 29 48*

*1990.

Sources: Tomlinson (1993:4); World Bank, World Development Report, annual volumes.

The Indian mixed economy suffered from internal contradictions. The goal of massive and rapid industrialisation required a shift in resources from the agricultural to die industrial sector. But as 70 per cent of the people lived in the countryside and were dependent on the fanning sector, attempts to help the poor meant directing increasing resources to the rural economy. It also required state support for small, labour-intensive farms at the expense of bigger capital-intensive industries. Small units attracted government support. The goal was to boost employment, since small-scale industries employed more workers per unit of output and capital. The effect was to proscribe the expansion of successf ul small linns, discourage economies of scale and encourage high-cost production. The result was that India ended up with inefficient small companies and monopolistic large ones.

Externally, India had one of the most protected economies in Asia, in stark contrast with die East Asian dragons. By erecting frontier protection and fortifying it with an array of policy instruments such as import-substitution policies, the government forced the people to pay more lor consumer goods and the producers to allocate resources on the basis of false prices.

A complicated mix of mutually undercutting policies eventually created an impossibly labyrinthine command economy. The prices of inputs were raised by inefficient state enterprises and by regulating and protecting the private sector. More than 40 years of industrial licensing created delays in investment, cost escalations, slow growth in output and employment and perennial market shortages. Designed to guard die public interest against private monopolists, die Monopolies and Trade Practices Act protected die public sector monopolies against die public interest

Since die 1970s, India has had a reputation for for economic stagnation, structural rigidity and backwardness, emergency infusion of international capital to stave off defaults, and persistent poverty and inequality. While Soudi Korea and Singapore have left die poorer countries further and further behind, India has slipjied behind even die low-income economies’ average (see Table 2). World Bank data show diat India’s 1993 inf ant mortality rate of 80 deadis per 1,000 live births was much higher dian that

lIt is worth noting that much of India’s labour legislation is a legacy ol the British Raj, which protected

British manufactures by, among other means, raising labour costs in India.

The Politics of India ’s Economic Liberalisation Agenda 209

of East Asian countries: China 30, Hong Kong 7, Malaysia 13, Singapore 6, South Korea 11, Thailand 36 (World Bank, 1995b:214-15). If East Asia provides examples of successful if selected intervention, then ‘South Asia has traditionally been the region where government interventions have done the most economic harm in the past’ (Lai, 1993:117).

Table 2

India’s continuing relative poverty, 1976-92

GNP/capita (US$) Rank b y GNP/capita1976 1993 1976 (N= 125) 1993(N = 132)

Low income economies 150 380 - -

India 150 300 108 113Singapore 2,700 19,850 36 14South Korea 670 7,660 64 28

Source: World Bank, World Development Report, annual volumes.

Market Reforms in 1991

The accumulating economic stagnation produced a major balance-oi-payments crisis in 1991 as India’s foreign exchange reserves fell to US$1 billion, enough to cover just two weeks’ imports. The crisis forced Delhi to look abroad for emergency capital infusion. Yet the world outside had changed f undamentally since 1947. The minority Rao government assumed power in India at a time of an emerging new global consensus on economic development jiolicy: a noil-inflationary macroeconomic policy built around modest budget deficits and prudent monetary policy, greater openness to trade and foreign investment and greater reliance on market forces as efficient allocators of resources. The government began to tackle the underlying structural deficiencies by dismantling the apparatus of controls and the culture of subsidies and lossmaking public sector enterprises, and opening up the country to foreign investment. The national economic crisis and the fundamental international political and economic changes helped the government to break with the decades-old consensus on socialist economic policies. Whereas the centrally planned USSR had collapsed, China had itself enthusiastically embraced economic liberalisation. A political factor was also at work in India: no group in parliament want to precipitate another election by bringing down die government.

The reforms dial have been insdtuted are mainly macroeconomic, including a gradual removal of quandtadve restrictions on imports; a lowering of tariff barriers and of import dudes on many items, including inputs for export production; and convertibility lor the rupee on die trade account Industrial sectors diat were previously

210 Ramesh Thakur

reserved for the public sector, such as hydrocarbons, power, roads and ports, have been opened up to domestic and foreign investors.

The realisation that a new economic policy was necessary coincided with the collapse of 40 years of strategic certainties in India’s foreign policy. The combination ol a centrally planned economy in the USSR and a mixed economy in India generated both Indo-Soviet economic cooperation and irritation (Thakur & Thayer, 1992: ch.7). In the 1990s, the imperatives of India’s domestic economy demanded a reorientation of foreign policy towards Europe, Japan and the United States. But improved relations with diese countries would be difficult so long as India’s economy was not liberalised bodi domestically and externally. Only die W est and die major US- dominated multilateral institutions (die IMF and die World Bank) can provide India widi die necessary amounts of aid, credits and investment India needs US money, business, market and technology, as well as die help of expatriate Indians living in die US, to maintain its economic momentum. The US is India’s most important trading partner and also India’s largest foreign investor, accounting for 42 per cent of die US$2 billion approved by India in 1993 — roughly equal to die cumulative total investment in die 40 years up to 1991.

The Dragon and the Elephant

The prospects of China and India, die largest Asian countries, can be fruitfully compared. Bodi can exploit matching ‘comparadve advantages’: huge, hard-working populations diat achieve high rates of saving because, diougli poor, diey are dirifty. Bodi at home and abroad diey have been successful entrepreneurs.

China enjoys some big advantages. India still suffers from a reflexive antipadiy towards multinational corporadons. But foreign investment would improve Indian industry’s access to higher technology and modern managerial and marketing skills; stimulate domestic competition which has been constricted by import, entry and exit barriers; improve domestic quality control standards; create more employment; and enhance competidveness. In Soudieast Asia, foreign investment has been a key to economic success. Continuing economic failure leaves India vulnerable to outside criticism and pressure; economic success will transform it from a dependent into a self-reliant nation.

India’s liberalisation failed to generate immediate enthusiasm from foreign investors. Several factors have been blamed, such as social volatility after the destruction of the Ayodhya mosque in 1992, financial dislocation after the 1993 Bombay bomb blasts and fear of potential political and social instability. A better explanation is that the benefits of foreign investment can be maximised only in a market that is freer than India’s yet is. India has the attraction of a sizeable market and a plentiful and cheap labour force. But foreign investors also look for productive labour; managerial, technical and operational skills; access to world-price inputs free of tariff distortions and bureaucratic controls; an expanding domestic base of suppliers and services; and reliable and efficient infrastructure.

India needs to devote more resources to human capital formation (education, skills and training) as well as to power, transport and communications infrastructure.


The administrative culture needs to be transformed from a suspicious to a helpful attitude towards foreign investment Flexible labour markets are a crucial component of competitiveness in a dynamic economy; but India’s inflexible labour laws make shedding of excess labour difficult and costly. In all diese respects, China outscores India and so attracts considerably higher volumes of investment. China’s audioritanan rulers can forcibly keep wage rises below productivity increases. Though lower dian earlier levels, China’s investment inflow in 1994 was still almost US$28 billion, much more dian die die $4.5 billion coining into India since liberalisation began four years ago.

China’s liberalisation program had a 13-year headstart on India’s. China also has die invaluable asset of Hong Kong, and benefits from die large expatriate Chinese community diat provides much of its capital and managerial resources. By contrast, die smaller expatriate Indian community is made up mainly of professionals. Unlike China, India has not yet begun to exploit die asset of a substantial diaspora of its people overseas. At 39 per cent of GDP, China’s gross domestic savings rate is double India’s.

But in some respects India has die advantage over China. India already has die sort of grass-roots capitalism and consumer ediic from which a healdiy market economy can grow. Official statistics understate the vibrant private sector. India has a rudimentary financial system, a huge consumer base, a large professional class, an education system widi established links to the English-speaking world, a well-developed system of property rights and commercial law, an independent judiciary and a free press. The legal system is important, for example, in bolstering investor confidence against any sudden and unfair policy reversals in die future. Contract has less sanctity in China dian in more familiar systems of law. The outcome of die Enron affair will be crucial for diis.

India’s democracy is stronger dian is generally realised. Once die political will was diere, India was able to move to currency convertibility widiin two years of economic liberalisation, whereas China still maintained multiple foreign exchange rates for its non-convertible currency 15 years af ter liberalisation. Moreover, having survived decades of social, political and religious volatility, India can offer investors better reliability in worst-case risk assessment.

India can play off die established economic powers against one anodier. It can help die US to keep pace widi Japan’s dominance in Asia. The Japanese have estalr- lislied a commanding presence in East and Soudieast Asia, but not in Soudi Asia. Conversely, Japanese interests and capabilities are so much at variance widi India’s diat Delhi has never vied for competitive influence widi Tokyo. Japan’s presence in Soudi Asia is not constrained by memories of wartime hostilities and atrocities. In die past, India figured little in Tokyo’s hierarchy of foreign policy priorities because it was relevant neidier to Japan’s security interests nor to its international economic strategy. Historical and linguistic ties to die West, economic policies of import-substitution and protectionism, and close relations widi die USSR kept India at a distance from Japan. By die 1990s, Japanese investment in China exceeded diat in India by about 20 times.

212 Ramesh Thakur

Japan is also India’s largest aid donor, supplying 40 per cent ol the total. There has been no commensurate increase in Japanese trade and investment, due partly to the social and political instability of South Asia, but mainly to die complex and restrictive foreign capital laws and excessive regulation. Even so, India offers a stable and expanding market But for now die caudous Japanese are awaiting die outcome of die Enron cancellation.

Resilience

If India is to emulate China’s economic record over die past 15 years, its liberalisation drive must be sustainedin die long run. The economic reform program, now into its fourth year, has been indisputably successful on most objective measures. All four key indicators in Figure 1 were heading in die wrong direction in 1991, but are now trending in die right direction. The proportion of Indians living below die poverty line has dropped from 30 to 20 per cent. The current account deficit is below 1 per cent of GDP, annual inflation under 10 per cent, industrial output grew by 8.4 per cent in 1994-95, exports grew by 27 per cent, and food stocks are at a record 37m tonnes (The Economist, 12 August 1995). Whereas exports financed 60 per cent of die imports in die 1980s, diey now finance 90 per cent Foreign exchange reserves have risen to $21 billion. GDP grew by a modest 1.2 per cent in 1991-92; it is now growing by up to 5 per cent a year. The budget deficit shrank from 8.3 per cent of GDP in June 1991 to 4.7 per cent two years later.

Yet India’s economic reforms are incomplete. The insurance market needs to be opened up to foreign investors, barriers to consumer goods removed, die banking sector strengdiened, taxes lowered on capital and intermediate goods and government regulations reduced. Prospective investors are still frustrated by inadequate infrastructure, Delhi’s slow pace on regulatory and price settings, and obstacles to actual implementation of invesUnent plans. Odier concerns relate to still-high import tariffs (India’s import-weighted average tariff is 40 per cent), inadequate legal protection of intellectual property, and weak enforcement of existing laws.

W hat die government has done so far is dius better described as ‘stabilisation’. It has yet to create genuine competition and free trade (many consumer goods still cannot be imported), tackle labour market reform, and generally establish an arms-lengdi relationship between die government and business sectors. India’s infrastructure and service industries remain in state control because die politicians are reluctant to barter away such strategic sectors as banking, power and telecommunications, and because a large, unionised and inefficient workforce riglidy fears for its survival in a competitive environment.

The focus of India’s economic agenda must now shift from stabilisation to structural reform. Three principal areas of microeconomic reform remain: labour market and industrial relations (die government wants to create a minimal safety net for workers before introducing any ‘exit policy’); die fanning sector, including die removal of price-distorting subsidies, providing additional infrastructural investment, and abolishing die state-monopoly marketing boards; and die imposition of die new pro-business- attitude on die lower-level bureaucracy and state governments.


Figure 1

India’s economic indicators, 1980/81 -1994/95: % change on a year earlier

-------GDP------Agricultural production- - - Industrial production— CPI f a industrial workers

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

Sources: Government of India (1995); Euromoney Supplement, April 1992.

The federal government remains committed to economic reform. But the 1995 budget showed that political imperatives took precedence over economic rationality. Investors were disappointed at the lack of any new impetus to the reform program. Instead, stung by criticism that the reform process has done little to benefit the poor, the government announced policies to alleviate poverty (lor example, through old age pensions and maternity care) and court the middle class through lower income taxes and excise duties. Having just lost elections in the two industrially crucial states of Gujarat and Maharashtra, the Congress Party could not afford to exclude populist measures from the budget. That lesson was underlined by the loss in the politically crucial state of Bihar soon alter in March.

While the liberalisers argue that the budget failed to broaden or deepen economic reforms, political scientists respond that the budget undercut the ability of the left to embarrass Rao and exploit discord in the ruling party. Yet in May 1995, a group of disaffected party members split away to form a rival party under die leadership of former cabinet ministers Aijun Singh and N. D. Tiwari. Accusing die Rao government of having betrayed die party’s socialist ideals, diey seek to resurrect die marriage of political expediency and socialist ideology diat had proven so electorally successful for Indira Gandhi.

The importance of die political factor has been underlined by die controversy surrounding die Enron’s power project in Maharashtra, which was scrapped (diough later bodi sides agreed to try to renegotiate die deal). Part of die Bharatiya Janata Party (BJP) strategy is to identify Congress as die party of corruption catering to die

214 Ramesh Thakur

interests of rich foreign firms against those of Indian business, consumers and workers. Before, at the time of and after the cancellation of the Enron deal, the BJP insisted that it was not opposed to foreign investment, but it does reject contracts involving lucrative counter-guarantees from the government where the risks are borne by the public and profits accrue to foreign investors. And it does question the propriety and economic rationalism of contracts awarded without competitive bidding. It favours foreign investment, but not in consumer goods. Nevertheless, the BJP remains committed to attracting foreign investment into Maharashtra, where it governs in partnership widi die Shiv Sena, and Gujarat, where it is also in power.

Phe controversy generated by the Enron cancellation and the debate on the merits of foreign investment and unilateral cancellations of previously signed contracts are healthy developments. In a strongly worded editorial on 5 August 1995, The Hindu (Madras) criticised the Maharashtra government lor having allowed ‘negative and purely political considerations’ to prevail over ‘larger national interests’. The financial consequences of the decision, the paper noted, would be borne by die people of die country. The complexities of India’s politics can be shown from anodier angle. The majority of workers at die Dabliol site were lower caste and outcastes. Suddenly unemployed, diey attacked die BJP-Shiv Sena government for its ‘braliminical conspiracy’ in halting work on die project (Diwakar, 1995). Since they comprise die largest single voting bloc in India, diere is scope for die Congress Party to gain die advantage over die BJP by exploiting diis sentiment.

The Enron-led Dabliol Power Co. project had been cancelled by die newly- elected BJP-Shiv Sena government of Maharashtra on 3 August 1995 on diree grounds: it was alleged to be too expensive, to have been awarded by die previous Congress administration widiout competitive bidding, and to have been awarded dirough bribery. On 8 January 1996, die government announced diat die deal had been renegotiated. The tariff was to be reduced from die original Rs. 2.40 to 1.86 (one US dollar = 36 rupees); capital costs would come down by about US$365m; and a regasification facility would be separated into a new company, saving anodier $400m. But the feeling in India was diat in most key respects die deal was essentially unchanged. Enron is still die fuel manager of die plant, and die state-run electricity board is contractually bound to purchase 90 per cent of its power generation.

Congress politicians insisted diat die government had been compelled to widi- draw accusations of bribery, and to reverse die repudiation of the project’s first phase as well as die cancellation of die second phase. The fine print of die revised agreement showed diat die gains were largely illusory; die only real ‘achievement’ was ten mondis’ delay. Economic nationalists widiin die BJP itself were also dismayed and openly complained about die government having sold out to foreign interests, diereby reinforcing die public perception diat die state government had had to retreat radier more dian Enron. The state government had been forced to realise diat its case was very weak under compulsory international arbitration (such legal relief for investors being one of die major advantages diat India offers over China); diat electricity supply is already up to 20 per cent below demand and falling further behind; and diat die


Enron delay had placed a major hurdle in the way of other states’ urgently needed power projects which could only be financed by the international private sector.

State Governments

State governments account for 56 per cent of expenditure on social services and 85 per cent on economic services. Rao pointed out after die state elections of December 1994 diat even non-Congress state governments have adopted more pro-market- policies. The opposition parties might differ on die pace and details of die reforms, but diere is a national consensus on die broad direction of economic policy (Far Eastern Economic Review, 2 February 1995).

Interestingly, die Marxist Chief Minister of die state of W est Bengal, Jyod Basu, also emphasised die national consensus on economic reforms widi regard to deregulation, delicensing and foreign investment to upgrade technology. At a press conference in Washington during a trip to attract foreign investment (Hindu international edition weekly, 1 July 1995), he said die reforms would dierefore hold regardless of which party is in power in New Delhi after die next election. The state’s campaign was backed by a report commissioned from die international management consultancy firm Price Waterhouse, which identified investment opportunities in agricultural, manufacturing and service industries in die state, whose advantages include low settingup costs and proximity to Soudieast Asian markets. And it has been successful: since die start of 1993, W est Bengal has been second only to Maharashtra in foreign investment approvals (TheEconomist, 24June 1995).

This is a remarkable reversal for a chief minister who has ruled W est Bengal at die head of a Marxist government since 1977. Not long ago, die state was infamous for frequent power cuts, pot-holed roads and phones diat refused to work. Throughout die 1970s and 1980s, local and multinational companies abandoned a business- hostile environment dominated by a militant and unionised workforce and crumbling infrastructure. Die long-term costs of disinvestment were impressed on die state government when die basic ethos of economic policy changed in India in 1991. Now state cabinet ministers openly and often talk in reformist, pro-growdi tenns. The net result is an industrial renewal diat has revived memories of Bengal as die industrial heartland of pre-partition India.

This highlights anodier positive development: competition between die states to attract outside investment. A number of state governments of all political persuasions have become self-confident and aggressive in promoting dieir comparative advantages. The new chief minister of die BJP-Shiv Sena coalition government in Maharashtra went on an investment-seeking foreign tour very early in his tenure. Chief Ministers H. D. Deva Gowde of Karnataka and laloo Prasad Yadav of Bihar head Janata Dal governments. The Janata Dal is the party diat expelled IBM and Coca-Cola from India in die 1970s. The two ministers went, at die same time, courting Southeast Asian investors. Bodi promised one-stop clearance windows and expeditious removal of bureaucratic botdenecks. So understanding of die benefits of market reforms and foreign investment has spread to die states. Moreover, commanding secure majorities in

216 Ramesh Thakur

their respective state legislatures, Gowde and Yadav can promise political stability to investors nervous about policy changes by replacement governments.

Conclusion

The combination of democratic populism and bureaucratic elitism gave the worst ol both worlds to India and anchored it firmly to a Third W orld status. To lift itself into die ranks of die developed world, India needs to establish international investor credibility by unleashing market forces and behaving in a fiscally responsible manner.

The distance diat India has still to travel on die road to a free market was highlighted recendy by die World Bank( 1995a), which urged New Delhi to follow dirough its four-year old economic reforms by cutting farm subsidies, trimming its budget deficit and eliminating legal, regulatory and administrative red tape diat impedes private investment in infrastructure. The government was also urged to spend more on social services such as primary education and healdi care.

Yet India is one of very few countries to have pursued a structural adjustment program widi minimal adverse consequences. Moreover, die opposition parties in several states have retained economic policies diat are favourable to markets and investment. No single political party is expected to win die next general election diat must be held by mid-1996. The BJP and Congress could end up with 150-180 seats each in die 545-strong federal parliament, widi die Left Front-Janata Dal coalition not far behind. All parties are talking about die advantages of globalisation and markets, differing only on detail. No party promises to bring back industrial licensing, go back to nationalisation or restore taxes, quantitative restrictions and tariffs to pre-1991 levels. None wants to stop foreign investment completely.

And yet, paradoxically, economic policy will for die first time ever be a national issue in die next election. At a party meeting in Surajkund on 25 July, Rao exhorted his audience to grasp die essentials of die new economic policy and dien sell Congress as die pioneer of reforms. Private investment in sectors widi substantial investment needs, like power and oil, he pointed out, would free up public resources for investment in housing and odier social sectors. The party’s distinct electoral identity, dierefore, is going to be defined in terms of its leading role in implementing die major economic reforms, and die reforms are going to be sold as being vital for alleviating poverty. But diis strategy was assisted by populist spending: on 29 July, Rao commanded national television to announce a US$1 billion package of welfare measures for school children and die poor.

The differences in emphasis and direction between die political parties mean that die exact fate of reforms will depend on the outcome of the election. The pace of reform may slow. One group may favour globalisation, die odier privatisation. The public and private sectors are in competition for die provision of goods and services; state governments compete against one anodier; and state bureaus are more appreciative of problems faced by industries in their states (Chandra, 1995). Competition may impose short-term and firm-specific costs and pain, but it can only be lor die better in die long term.


The dynamism of India’s economy since the reforms of 1991 cannot conceal chronic and deep-seated problems. The public sector is still large and subject to bureaucratic and political interference, and infects many parts of the economy. Parties still make populist promises at election time, such as greater subsidies to farmers, which exact opportunity costs in investment in education, health and basic infrastructure.

Equally, however, |>olitical volatility and persistent economic nationalism cannot disguise a national consensus on the central planks of the reform process. The Enron cancellation, renegotiation and reinstatement may therefore be a symptom of transition pains rather than a prelude to basic policy reversal through shifting political alignments.

References

Bhagwad.J. (1993), India in Transition: Freeing the Economy, Oxford University Press, New Delhi.

Chandra, S. (1995), ‘Reform is die buzzword now’, Fitt:uiciaJExjttess (New Delhi), 21 July.

Diwakar (1995), ‘Caste ramifications o f Enron’, Economic Times (New Dellii), 13 August

Government of India (1995), Economic Survey 1994-95, Ministry of Finance, New Dellii.

Lai, S. (1993), ‘Foreign Direct Investment in Soudi Asia’, Asian Development Review 11(1): 103-19.

Thakur, R. & C. A. Thayer (1992), Soviet Relations with India and Vietnam, Macmillan, London.

Tomlinson, B. (1993), The New Cambridge Histoiy o f India - The Economy o f M odem India, 1860- 1970, Cambridge University Press, Cambridge.

W orld Bank (1995a), India: Recent Economic Developments and Pmsjjects, Wasliington DC.

(1995b), World Development Rc/xtit 1995, Oxf ord University Press, New York.

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REVIEW ARTICLE

Some Economic Perspectives on School Reform

Mark Harrison

Edwin G. West, Education and the State: A Study in Political Economy (third edition), Liberty Press, Indianapolis, 1994

Eric A. Hanushek, Making Schools Work: Improving Performance and Controlling Costs, Brookings Institution, Washington, 1994

RECENT book and a new edition o f an old classic provide interesting perspectives on die perennial issue of school reform. How can we fix up education, an industry dominated by public provision, where producer inter

ests rule and parents’ wishes are routinely ignored?Bodi books are written by economists and give short shrift to the idea diat edu

cation should be exempt from economic analysis. West contends diat an activity diat claims so much public expenditure can hardly expect to get away widi no economic scrutiny at all. Moreover, assertions diat educadon is ‘important’ or ‘special’ or a ‘right’ do not help in making public policy choices, such as what type of education to subsidise and by how much. In fact, choices must be made between spending on educadon and spending on odier important, special and essendal services, such as liealdi and jusdce. Hanushek comments ‘Some have argued that schools are too important to be subject to economic rigour. We argue diat, on die contrary, diey are too important not to be’ (p.xvii).

Yet neidier audior argues diat die economic ends of educadon are all- important. West advocates a market system where parental preferences determine die role of schools. Hanushek focuses on die academic role of schooling, but emphasises die economic costs of a schooling system diat does not equip students widi academic skills. Bodi books are written for general readers, and economic concepts are explained in a clear and understandable manner. West focuses on die English educadon system, Hanushek on die American. Bodi offer valuable insights on die similar problems in Australia and New Zealand.

Mark Harrison is Lecturer in Economics in the Faculty o f Economics and Commerce at The Australian National University.

220 Mark Harrison

Arguments for State Intervention in Education

Education and die State was first published in 1965. In its third edition, the main body of it is unchanged. But then the substance and style of the arguments and dogmas of the education lobby have not changed either.

West closely scrutinises the rationale for public education and finds it wanting. Not only is public provision unnecessary for achieving goals such as protecting children, reducing crime, making democracy work, increasing equality of opportunity, inculcating common values and promoting economic growth; it has actually made tilings worse.

Protecting children. This argument for state education assumes that the uneducated may not be competent judges of education: not only are young children unable to judge for themselves, but they may need protection from ignorant parents. But children can be protected by measures targeted at problem families; a vast and comprehensive system of state schooling is not needed unless most parents are negligent or ignorant. But, if so, political pressure for universal schooling would be unlikely:

For it envisages an electorate which virtually condemns most parents for being ignorant or negligent about their children when that same electorate consists to a large extent of the parents and relatives themselves. . . why, if such ignorance and negligence is so serious, should we presume that it will not equally express itself at die ballot box and with equally ‘unfortunate’ results when die parents and reladves choose dieir representatives, (p.9)

West warns against ‘acceptance of institutions from mere habit or imitation radier dian from any conscious and rational purpose’ (p.xxiv). His clever analogies repeatedly show how we accept state education largely because we are used to it. For example, aldiough die state requires drivers to pass a driving test, it has not so far prescribed how persons should acquire die knowledge and skill; nor does it take over driving schools and supply driving instruction ‘free’ out of general taxation.

In fact, diere have been proposals lor driver training to be offered in public colleges in die Australian Capital Territory (ACT). Why should die community pay for teenagers to receive driving lessons? More important, are schools die most suitable institutions for providing driving instruction? Or are commercial providers, who must satisfy customers? If die service is to be provided in school time, radier dian outside school hours as at present, what part of die curriculum is to be dropped to allow for it? If tax-financed schools are permitted to drive die for-profit sector out of business, how long will it be before diere is pressure to abolish external driving tests? If schools are to certify who is able to drive, will die roads be safer?

Neighbourhood effects. Anodier argument for state involvement in education is diat education generates jiositive externalities or ‘neighbourhood effects’. West

Some Economic Perspectives on School Reform 221

examines the argument that education reduces crime. Crime has increased as state education has been growing. West examines die statistical evidence. For example, ‘die last year of compulsory educadon was also die heaviest year for juvenile delinquency and . . . die tendency to crime during school years was reversed when a boy went to work’ (pp.40-1). This remained true when die school-leaving age was raised. In fact, diere is no evidence dial state schooling reduces crime. West contends diat state iiitervendon has reduced die role of religious organisadons in educadon, so weakening moral and religious iiistrucdon: diis should be measured as a social cost of state schooling.

Making democracy work. Is educadon needed to encourage polidcal literacy? West argues diat polidcal literacy is ‘more sadsfactorily provided by a variety ol sources dian by a single system of state schools’ (p.55), such as journals and newspapers. As widi odier externalides, only limited acdve government policy is needed if a ‘substandal number of people would not acquire a necessary minimum ol educadon diemselves widiout die help of government agencies’ (p.46).

Economic growth. There is nodiing new in recent extravagant claims diat educadon is die ‘secret ingredient’ of perpetual growdi. West observes diat ‘Many of diose widi personal stakes in educadon, once outraged by die suggesdon diat it could be treated like an industry, are now more likely to be outraged if people “can’t see” diat it is die “most important” industry we have’ (p. 109).

West makes a few simple points dial should caudon us against jumping from new dieories reladng growdi and human capital investment to policy recommenda- dons such as more public expenditure on educadon. There are many sources ol economically useful knowledge odier than public schooling (such as on-die-job training and learning by experience), and not all public schooling has die same economic significance. Indeed, die only steady growdi resuldng lrom die burst ol educadon spending in die 1970s was in jobs for educators.

Equality o f opportunity. West illuminates die meaning of this goal, carelully sets out its limitadons as a philosophical ideal and shows how it conflicts widi odier values, like liberty, family life and efficiency. He draws an analogy widi a race and likens die objeedve to ensuring diat ‘each compedtor starts level at die stardng line’ (p.61). The objeedve of equality of opportunity creates immediate problems, even if it is assumed diat all children have die same potendal ability:

How do we begin to measure die numerous and typical environmental handicaps which are supposed to hinder some children in die race? For instance, on what basis do we sort out diose children who have not had die extra educadonal sdmulus incidental to richer middle class homes? More difficult still, how do we detect diose homes, whatever dieir social class, which give better educadonal environments dian odiers? The quandty ol empirical evidence needed to decide diese matters will surely be enormous.

222 Mark Harrison

Even then no two persons are likely to make the same judgment on it.(p.62)

And where do we draw the line? Do we equalise the opportunities of poor children in other countries? If not, why is the concept constrained within geographical boundaries? At what age does the race start? There is a danger diat equality of opportunity will be confused with equality of result. If there is inequality of potential ability, then diere is bound to be inequality of result, so that ‘If we insist that there shall be equality of result it follows that we penalise ability’ (p.69).

In practice, state education has meant requiring a child be sent to die local public school, which is financed out of taxes that must be paid even by diose not using die public school. ‘This reduces, and for poorer families abolishes, all practi- cal choice’ (p. 17). Zoning makes where you live die crucial factor in determining die type of educadon your child will receive. Moreover, it is difficult for die poor to move to good neighbourhoods, particularly if diey live in subsidised public housing. The result has been to decrease equality of opportunity. In addition, diplomatic and negotiation skills become more important when dealing widi government bureaucracies, but are unequally distributed among parents. In diis sense, inequality of opportunity for some children probably now stems from having parents who are politically weak (p.72).

West emphasises die need to take account of die taxes required to finance public schooling. If ‘free’ state education given to die average family is paid for out of taxes levied on die same average family, dien die current system reduces dieir choices, and puts diem at a disadvantage relative to rich families who use die private sector. The state can contract out of education and reduce taxes in a way dial leaves all income groups better off. Eurdier, a lrequendy ignored cost of die current system is die efficiency costs of die taxes needed to fund government education expenditure. In Australia, diese costs have been estimated to be as high as A$0.65 for each extra dollar raised (Findlay & Jones, 1982).

The Origins of Public Education

In his account of die establishment of public education, West destroys a few myths diat have wide currency. For example, Rupert Murdoch, ironically in a defence of free markets, attributed die success of die launch of die Daily Mail in 1896 to ‘a previously unsuspected mass audience, newly literate because of die educational reforms of die 1870s and 1880s’ (Murdoch, 1994:3). Public education was not die cause of literacy amongst die working class or high levels of participation in schooling. Nor did die introduction of public schooling increase the amount of schooling undertaken.

The level of literacy and amount of schooling received by children in England grew rapidly diroughout die 19di century and were at high levels. For example, by 1840, two-diirds to diree-quarters of male adult workers were literate (slighdy less for females), despite die taxes dial were levied on paper in die early 19di century to discourage reading, which was linked to political unrest. By die 1860s, 90 per cent


of the working class was literate. Literacy was taught in Sunday schools and literary societies. The purchase of schooling by the labouring classes was also widespread and growing.

West oudines the rise of an extensive framework of private schools for the masses. The statistical evidence collected at the time reveals a large private schooling sector which had grown vigorously since die early 1800s. Alter 1833 die government gave matching grants to some schools, mainly diose set up by religious groups and private charides, in return for regulation and inspection. Many schools were financed solely by fee-paying parents, and some were maintained by endowments. Most parents purchased education for dieir children and die fees diey paid were die largest source of school income.

From 1857 to 1861 die Newcasde Commission conducted a comprehensive survey of schooling, using sladsfical techniques. It found diat almost every child received at least primary school education, on average 5.7 years of it. ‘The Commission concluded diat diere were no serious gaps in die provision of schools and apparendy no call for state nadonalised schools’ (p. 179). Yet in 1870 die Board School system was started, and die nadonalisadon of die school system began. The Central Education Department had supplied information diat 25-50 per cent of die English school population was widiout schooling. Public provision was promoted as being necessary to ‘fill die gaps’. The presentation of misleading statistics to promote vested interests is nodiing new. West argues diat die Department’s figures were based on incorrect assumptions about average school duration and school-age population. The figures assumed diat die relevant ‘population of school age’ comprised children between live and 13 years of age and diat die number of children actually in school was diree-quarters or less of diis number. But die assumption diat each child received eight years of schooling exaggerated die actual average duration by at least 25 per cent. The evidence was consistent widi all children receiving some schooling.

The introduction of Board schools in effect replaced inspection and subsidisation widi public provision and nationalisation. The Board schools crowded out (and took over) existing private schools. The subsidised Board schools could call on rate aid (which fell pardy on parents using rival schools) and charged fees diat undercut die private schools. According to West, public schooling was financed by regressive consumption taxes. It is fair to say diat public schooling for working-class families was financed by taxes imposed on diose families.

West concludes diat state subsidy radier dian state provision is die preferable way to increase die amount and quality of schooling undertaken by die poor. He maintains diat die driving force behind die introduction of public schools was a self- interested bureaucracy. The abolition of fees completed die supplanting of die market process widi die political process, ensuring die primacy of public education.

The voice of die organised professional teacher and educationist would predominate, and diat of die parent would be critically weakened. For die parent, having been accustomed to a powerful mediod of voting in die

224 Mark Harrison

market would be relegated to the much less articulate method of votingthrough die political process at periodic elections, (p.219)

What started as Tilling die gaps’ has become ‘full government education paternalism for all’ (p.222), promoting equality for it is much easier to demonstrate inequalities dian inadequacies.

Recent Developments

The developments in public education since die second edition of West’s book appeared in 1970 demonstrate die audior’s prescience. Events in die 1970s illustrated how parents have lost control of public education. Major changes were introduced even diougli most parents opposed diem. Strange new philosophies, couched in incomprehensible jargon, dominated education dieory. The curriculum was politicised and softened. Illiteracy grew.

West gives an interesting perspective on die Thatcher reforms, which carry a warning for Australia. In die 1980s British schools became more autonomous and accountable. Parents can now opt out of die local education system by reorganising dieir schools under individual trusts run by parent governors. The trusts are financed by central government, and funds cannot be supplemented by charging parents fees. Central government prescribes teaching methods, curriculum and examinations. West observes diat parents are ‘better consumers dian managers’ (p.238) and dieir choices as consumers are limited. The Thatcher reforms did not introduce a market arrangement. Parents are restricted to a choice between public systems and diere are no price signals to show which options are most highly valued relative to costs. West views die reforms as a victory of a strong and ambitious central bureaucracy over local bureaucracies.

West considers appropriate state intervention in education, systematically weighing all die costs and benefits of different approaches, considering die competence of parents to choose and die relevance of external benefits. He carefully argues diat universal compulsion and subsidisation may be inappropriate. Should die government be involved in information provision and performance measurement? West documents how information was distorted to furdier die interests of educational bureaucracies from die very beginning of public education. Would assessment agencies or franchising develop under a market system? Should diere be competition and experimentation in assessment too?

West considers die issues raised by home schooling. He details die Baker case, which shows how die current system has limited freedom of choice. The local audiorities had declared a particular village school as suitable for Mrs Baker’s children, because it was die nearest public school to dieir home. Mrs Baker expressed her desire to educate her children at home, which resulted in an expensive struggle lasting ten years. She was fined twice and sentenced to two mondis’ imprisonment, before an appeal court found diat she was giving her children an education diat was suitable for diem. Her son was examined in court. One barrister tested his educa-


tion by asking him die dates of King George III. One wonders how the products of today’s education system would have fared.

The magistrate, during dieir formal examination, asked what was in a camel’s hump; when die boy gave die answer ‘fat’ diey rejected it, saying it was ‘water’. The boy asked diem to look it up. The magistrates had to admit he was right. Despite all diis, diis court still found diat Mrs Baker was not satisfactorily educating her son. (p.229).

An Agenda of Reform

West’s book stops short of suggesting an explicit reform agenda. But Eric Ha- nushek’s Making Schools Work contains die recommendations of die Panel on die Economics of Educational Reform, which brought togedier a dozen economists who have been studying various aspects of die US education system for over 25 years. Haiiushek argues diat die economic analysis of education reform deserves more attention. Aldiough economic issues, such as disappointing economic growth, stagnating living standards and increasing income inequality, often motivate school reform, economic ideas are absent from die plans for reforms. He ‘seeks to infuse a seise of economic reality into die discussion of school reform’ (p.v) — somediing nucli needed in Australia and New Zealand.

In die US, as in Australia, ‘most discussions of educational costs focus on die funding (o*, more commonly, lack of funding) for specific new programs’. But ‘Perhaps reformers should really be asking not where new money for schools is to come fron, but whedier schools spend existing funds wisely’ (p.39). Hanushek proposes that reform should be based on current spending levels to develop a disciplined aporoach to decision making. Spending more widiout reform would lead to a more expensive system, but not a better performing one.

Hanusiek proposes diree broad economic principles of reform: ‘efficient use of resourcts, implementation of appropriate performance incentives, and continuous learniig from experience’ (p.51). Aldiough die goal of efficiency is often twisted intc somediing unpleasant, it merely means diat

educabrs should measure bodi die costs and benefits of various ap- proacles to education — and choose die approach diat maximises die excess olbenefits over costs in dieir particular circumstances. Today by contrast, tie benefits of new plans are often assumed radier than systematically measued, and litde effort is made to compare die potential net benefits of prograns competing for limited resources, (p.xvi)

Efficiency toes not mean simply cutting costs. Nor are die relevant benefits of education confned to narrow measures of test scores.

Reforn proposals often pay litde attention to incentives. But die need for schools to introduce well-crafted perf ormance incentives is more important dian increased esources. In contrast, ‘die current system concentrates much more on

226 Mark Harrison

taking away individual initiative and incentives and replacing those with central direction’ (p.53). There are few rewards for good teaching, and few sanctions against poor teaching.

Hanushek maintains that there is no one cure for the ills of today’s schools. Instead, mechanisms are needed to improve continually, to experiment, and to adopt good programs and weed out bad ones. But in die current system, ‘There is no systematic approach to learning from existing or proposed programs’ (p.56). Certainly drastic changes have been introduced in Australia widi no attempt at evaluation.

Hanushek recognises diat measuring die impact of a teacher, or even a school, is difficult, because diese factors are hard to disentangle from odier influences on student performance. He suggests die use of random experiments. But diey are not suitable in education: it would be hard to ascertain whedier die effects of die school program are being confounded by responses to die program, such as die substitution of odier educational inputs like parents’ time. The outputs ol programs may take years to become apparent. Furdiermore, any ‘random’ experiment faces selection problems as parents can opt out by sending dieir children to a private school or by moving to anodier area.

The Role of Parental Preferences

But, in any case, are we really as ignorant about what makes a good school as Hanushek implies? Aldiough large-scale random experiments would be a boon to academic researchers, are diey really necessary? A cynic would suggest diat die calls for increased research funding from a panel of academic economists were entirely predictable. If opinion polls are to be believed, diere is no mystery about what parents want: effective discipline, high academic standards, high-quality staff, emphasis on social values, and, for some, a religious orientation. One advantage of a market- based system is diat it would meet diese parental desires. It is also flexible and can initiate small-scale experiments diat are quickly copied if successful.

But Hanushek is not very interested in parents’ preferences. He mentions school choice, but as only one possible reform, to be evaluated against alternatives by die political process. Hanushek questions whedier parents make good decisions; he doubts whedier school-choice programs should be extended to private schools because diey may ‘be less responsive to die needs of disadvantaged students or may reinforce existing social structures’ and ‘could confer gains on well off families’ (pp. 106-7). The effect of odier recommendations on ‘existing social structures’ is not considered. Hanushek asserts diat parents will make school choices on die basis of ‘race and social status’. But if public education is being regulated so as to suppress such parental preferences, a private education system can be regulated in die same way.

Yet Hanushek does draw our attention to die fact diat choice reforms are carried out by die political process, and die result is not always apt. School-based management has often been used as an end in itself. Often, no clear goals are established, and die reforms are seldom linked to student performance or any incen-


tive structure, or evaluated in any way. The reforms seldom involve autonomy in personnel matters, perhaps the most crucial for educational success. ‘The result may be worse than centralised decision making’ (p. 101). But aldiough Hanushek recognises die need for local autonomy, he recommends diat die federal government should take a primary role in supporting broad program evaluation and developing performance information, mainly dirough controlling testing and its role in funding research. He implicidy accepts diat government funding will continue, so diat governments will demand a major voice in determining reform.

Hanushek accepts uncritically a role for government in achieving objectives such as promoting equality of opportunity and reducing crime. Aldiough he establishes diat our current system is performing poorly and diat reform efforts have not worked well, he assumes diat a public system will remain in place. ‘Public provision of schooling is not incompatible widi proper incentive structures, even diough public schools have not done much yet widi performance incentives’ (p.157). After all, diey’ve only had 100 years. Hanushek attributes diis lack of progress to public decision-makers’ avoidance of risk and to parents’ reluctance ‘to put dieir children in experimental educational programs’ (p.157), aldiough he documents die appeal of a choice experiment in Minnesota. He even recommends diat die government should be acting to strengdien incentives for parents to involve diemselves in their children’s education. But present arrangements do not give parents much incentive to become involved; indeed, diey are often denied crucial choices. Those who do exercise choice and leave for die private sector are dien said to be creating social division.

The Role of Political Pressures

The main weakness of Hanushek’s book is diat it ignores die political pressures diat have led to current arrangements. Public education is run dirough die political process and Hanushek does not explain why die political system will adopt his recommendations. True, Hanushek proposes a very different public education system, widi much local autonomy, but he also argues for more centralised funding and evaluation. A system whereby decentralisation is promoted by a centralised government does not seem particularly plausible. He blames reform failure on a refusal to follow economic principles, as if die problem were solely a matter of ignorance of economics diat could be solved by instruction f rom economists radier dian as due to die operation of die political process. Hanushek does recognise diat, under present arrangements, schools have no incentive to adopt labour-saving technology such as computers. Why dien does he expect proposals to link pay to student performance to be adopted?

Hanushek establishes diat die vast increase in spending on education has not been associated widi improved academic performance, as measured by standardised test scores. He assumes diat ‘large amounts of resources are being used ineffi- ciendy and could be freed for more effective use’ (p.71). But anodier possibility is diat die resources are used to pursue odier ends, such as benefiting special interest groups. One clear group of gainers from extra spending has been teachers. If stu-

228 Mark Harrison

dent-teacher ratios fall by one-third, this may reduce class sizes by one-third, reduce teaching loads by one-third, increase leave entitlements or allow administrative loads to be reduced. In practice, the fall in student-teacher ratios has been used to achieve a combination of these possibilities: it has reduced workloads, and only partly been translated into smaller class sizes. But even smaller class sizes make the teacher’s life easier, since such classes arc more easily controlled, marking loads are reduced, and teachers can devote less time to administrative matters and more to other ends. But what incentive does a teacher have to devote the extra time to improving die quality of education? Under current arrangements, not much.

A more fundamental question is whedier public education can deliver evaluation and more effective performance incentives. Hanushek states diat ‘Effective incentives require clear definitions of good performance. These definitions in turn require agreement on die goals and objectives of die schools’ (p.xxi). But he skips over how diis can be achieved dirough die political process, except to say ‘we cannot offer an easy solution to die political difficulties of defining a good educadon’ (p.xxi). Hanushek furdier states diat ‘die ability to distinguish good results is crucial to any working system of incentives. Flexibility in die means of educadon must be balanced by crystalline clarity regarding die desired ends’ (p.88). But public educadon is run from above, even diougli some school outputs can be measured properly only by diose involved at die school level. If educadon is uldmately judged by die polidcal process, die judgment will be made on incomplete informadon.

Conclusions

Hanushek attacks die way public schooling is run. West attacks its very foundations. These two books highlight die need to specify carefully die objecdves of educadon reform. The relevant question is whedier educadon is better run in die light of parents’ choices in a market setting or of government decisions in die polidcal process. Which is die better system for resolving die differences of opinion about die purposes of educadon and die weighting to be given to various objecdves? Which system is better at determining resource flows, setting objecdves, monitoring performance and testing for success? It is important to consider all die options radier dian make implicit judgments about political feasibility.

The decision to try to reform public education radier dian move to a market- based system is crucial. Keeping education in state hands means diat educational outcomes are judged dirough die political process radier dian dirough die test of die market, so giving special interests an advantage. Attempts to reform public education may all too easily be hijacked by an ambitious central bureaucracy. The critical question is whedier successful and lasting reforms are possible in a public system.

ReferencesFindlay, C. & R. Jones (1982), ‘The Marginal Costs o f Australian Income Taxation’, Economic Record

.58: 253-62.

Murdoch, R (1994), The Century o f Networking, Centre for Independent Studies, Sydney.


NOTES AND TOPICS

Victoria’s Mountain Ash Forests: A Case of Sustainable Management

Peter Attiwill

IT TiCTORIA has extensive forests of high value for conservation, for timber, for % / water — indeed, of high value lor all of the benefits that society seeks from

▼ its forests. These forests can yield hardwood timber of high quality and of large size, for which world demand is rapidly increasing. This demand will not be met, either physically or economically, by wood from eucalypt plantations. Australia, which has a substantial trade deficit in timber and wood-fibre products, is in die position to cultivate world demand for die high-quality dmber and dmber products diat its native forests can yield.

Whedier or not Australia wants to capitalise on tiiis compeddve advantage is a polidcal issue diat turns on differing conceptions of ‘conservation’. John Passmore differentiated between ‘conservation for’, or conservation in die sense of die wise use of natural resources so diat diversity and future supply are maintained, and ‘conservation from’, or preservation and protection of natural resources. While the traditional and die green conservationists have many common interests, ‘diey soon part company . . . and often widi dial special degree of hostility reserved f or former allies’ (Passmore, 1974:73). Central to die conservation movement and die emerging green parties is die policy of die Australian Conservation Foundation (ACF), which advocates ‘diat all remaining native forest and woodland in Australia should be preserved’ and diat ‘all native species and communities in native forest and woodland ecosystems . . . be protected to conserve biodiversity and all ecological processes’. The ACF dierefore ‘opposes die logging of native forest. . . believing diat our society is currendy incapable of harvesting wood . . . in a manner which respects and maintains ecosystem processes’ (ACF, 1995:2).

Fire and Eucalypt Forests

Periodic disturbance is common to forests around die world (Attiwill, 1994a). Old views of plant ecology were very much concerned widi dieories of succession and widi the notion diat die natural progression of succession leads to a stable, harmonious and self-perpetuating end-state. But we are now well aware diat diere is 110

Peter Attiwill is Associate Professor of Botany at The University of Melbourne.

230 Notes and Topics

such end-state. Forests are disturbed ecosystems. They are dynamic in time and space, and, as with other ecological systems, maximum diversity is reached at some level of random disturbance.

The most common disturbance in the forests of the world is fire (Spurr & Barnes, 1980), and nowhere is tliis more evident than in Australia. The ecologist R. W. Mutch (1970) argued that natural selection has led to fire-dependent species being highly flammable. At first sight tliis seems to be contradictory: why has evolution not selected fire-resistant species? But tliis would be impossible. Fire has been common throughout the northward drift of the Australian continent from its Gondwanan connections; today, Australia is widest at die Tropic of Capricorn, the driest part of the world. Given the right conditions — a long dry summer so that die fuels are tinder-dry, a hot day and strong nordierly winds — and given an ignition source like lightning, bushlires can develop in our forests to an intensity where no fire-fighting capabilides of any nation could stop diem.

The frequency of fire increased when Aborigines came to Australia more than 40,000 years ago, and increased again widi die arrival of Europeans. Noble (1986: 230, 231) wrote of die profound effects of fire and of our role as managers of die land:

The Australian llora and fauna evolved widi fire as an integral part of its environment . . . Not only are most species able to survive under die fire regimes diey have experienced over die millennia, but some species require a specific fire regime for dieir continued existence. European setdement has changed die fire regime in most parts of Australia and as a result die balance between many species has altered.

Thus our decisions as to how we treat our forests — to suppress fires, to protect old-growdi qualities, to harvest for timber and odier products — are management decisions diat will have dieir own consequences for forest development and species diversity.

Fire and the Mountain Ash Forests of Victoria’s Central Highlands

Forests cover only 5.5 per cent of die total land area of Australia, and are concentrated in eastern, soudi-eastern and soudi-western Australia. These forests contain an array of biological diversity (including 600 species of die genus Eucalyj)tus) and an array of management structures and procedures.

Mountain ash (Eucalyptus regimiis, die ruler of die eucalypts), which grows in die Central Highlands of Victoria, is die world’s tallest flowering plant and die epitome of die interdependence of forests and fire (Ashton & Attiwill, 1994). All of die characteristics suppordng Mutch’s (1970) hypodiesis of high flammability are present in die mountain ash forest. In die mature mountain ash forest, no regeneration occurs after fire, which kills die trees and exposes die mineral soil on to which die seeds fall a few weeks later. The seeds germinate and competition for survival begins in earnest. By age diree years, diere may be 60,000 to 100,000 trees per bee-

Notes and Topics 231

tare; competition reduces die number to about 2,500 trees per hectare at ten years and to about 20 at 250 years. Under diese conditions, die forest remains even-aged, and thus diere are extensive areas of even-aged mountain asli in Victoria. Sometimes diere may be two or at die most diree age-classes where subsequent fires have provided die right conditions for rcgeneradon widiout killing die previously established trees.

Silvicultural Management of Mountain Ash Forests

Ash forests (mountain ash and similar species including alpine ash and shining gum) cover some 480,000 hectares of public land in Victoria (about 10 per cent of die total forested public land). About one-third of die area of ash forest is widiin parks, catchment reserves and odier reserves. The remaining 316,000 hectares has been declared, dirough die various land-use planning procedures, as State Forest, available for die sustained production of high-quality dmber. Of diis, 34,000 hectares is not suitable for dmber production and 53,000 hectares is protected from harvesting under die Victorian government’s Code of Forest Practices. Thus, management of die ash forests for timber production is currendy based on a litde less than one-half die area of ash forest, die remainder being managed lor odier benefits, among die most important of which is high-quality water for die city of Melbourne.

Over die past 30 years or so, die ash forests available for timber production have been managed using die silvicultural system of clear-felling and burning. Most of die trees widiin a designated cutting area (or ‘coupe’) are felled. The commercially valuable parts of die trees are harvested, and all of die material remaining on die coupe alter harvesting is burned to provide die right conditions for regeneration. Seed is dien broadcast over die soil made bare by die lire. This system has been for die most part very successful; small areas of forest are scattered dirough die Central Highlands of Victoria, forming a mosaic of age classes. The creation of a planned series of age classes is fundamental to management of timber-production forest for sustained yield into die future.

The values of die forest are many and varied, including protection of native llora and fauna, water supply, wilderness qualities, aesdietic and artistic qualities, control of erosion and of salinity, recreation, timber and wood-fibre, eucalypt oils, honey and many odiers. Most of die forest estate in Victoria is publicly owned, and dius diere are competing demands.

The use of public land in Victoria, including for commercial timber harvesting, is based on studies and recommendations of die Land Conservation Council. The initial, detailed study reports and all of die recommendations of die Council, region by region, are widely available, and public consultation is promoted over lengdiy periods. Eventually, die Council presents its final reports to parliament and die use of public land widiin each region of die State becomes die subject of legislation. Forestry operations widiin die available timber-harvesting areas are dien controlled dirough die Timber Industry Strategy, die Code of Forest Practices, and legislation such as die Native Fauna and ldora Conservation Guarantee and die Rainforest


Policy. The last of diese excludes timber harvesting widiin all rainforests. For each management area, diere is a Forest Management Plan and diis too is opei to extensive public participation. For each coupe widiin die management area, d.ere is a detailed plan of how logging is to be controlled.

Of a total of 8.8m hectares of public land in Victoria, 4.7m hectares is forested. The area of forest available (following recommendations by die Land Conservation Council) and suitable for timber harvesting (under die Code of Forest Practces and various legislations) is 1.3m hectares (about 28 per cent of die forest area).

Forest Management and Species Diversity

The natural forest is not at some pre-ordained equilibrium; it has evolved through a continuum of disturbances, bodi natural and human-generated (Taylor, 1990). Through our understanding of die processes of disturbance and recovery alter disturbance, we should be able to accommodate planned management within die framework of natural disturbance.

The extensive literature on die effects of bushfire and ol timber harvesting on floral and faunal diversity in mountain ash and similar forests has been recendy reviewed (Attiwill, 1994b). There is litde evidence of marked change in die flora alter clear-felling and burning over a range of higher-rainfall forests of Victoria and Tasmania. However, studies in East Gippsland (Mueck & Peacock, 1992; Ougli & Ross, 1992) indicate a reduction in die number of tree-ferns and associated epiphytes, presumably caused during timber extraction. Coupe plans and logging techniques for diese forests must dierefore be modified to minimise damage widiin ecologically-acceptable limits.

The mountain ash forests support a rich mammal fauna, and all of die species found in one or more older forests have been found in one or more of die regrowdi forests burned or logged in die past 50 years and which include larger trees diat provide nesting hollows (Macfarlane, 1988). Similarly, Loyn’s (1993) study in East Gippsland found diat die numbers and diversity of birds in regrowdi forests 25-40 years alter logging were similar to diose in mature forests, and emphasised die importance of retaining old trees as nesting sites. This is not to imply diat all species of mammals and birds are found in all older forests and in all regrowdi forests; a fundamental component of diversity is diat each patch of bush is different from every odier patch of bush.

In summary, timber harvesting has not resulted in die extinction of species nor in loss of diversity of species. Through planned disturbance of some portion of die forest estate by harvesting widiin die framework of natural disturbance, we create a mosaic of age classes so diat diversity is maintained for die future. This diversity complements diat produced by odier management strategies in die rest of the forest estate. For example, buffer areas along streams are excluded from logging under die Code of Forest Practices. Gullies are relatively rich in bodi density and diversity of birds, possums and gliders. Furdiennore, diey are most likely to remain un- bumed by bushfire, and so diey contribute to diversity — to die mosaic of forest — after fire.


Sustainable Management in Victoria

Australia’s present consumption of timber products for 1994/95 was 4.5 billion cubic metres o f sawn-wood (more than one-third of this coming from native eucalypt forests), 1.4 billion cubic metres of other wood (including railway sleepers, plywood and particle board) and 3.4 billion tonnes o f paper and paperboard. In the same year, Australia imported sawn-wood and round timber at a cost o f $539m, and other forest products at a cost o f $2,46 lm . Thus, total imports ol lorest products were $3 billion, while exports were only $1 billion, giving a trade deficit in Umber products o f $2 billion for the year (ABARE, 1995).

Australia’s high-rainfall eucalypt forests produce timber in large sizes and of ex- traordii arily high quality. There is an increasing world demand lor such a product; exports o f sawn Umber increased by 22 per cent in 1994/95, divided evenly between hardwood and softwood (ABARE, 1995). The assessment by D. A. Neilson and Associaies (1995:iv) o f the Australian native forest sector was that it ‘is in a superb positioi. to contribute to the future wood demands of an expanded Pacific Asian community on a long-term sustainable basis’ and that our international benchmark standard in native forest management was excellent; the study concluded that ‘it would le a great pity if the decision makers do not consider . . . the opportunities to maximize the value to all Australians of the internationally important Australian native forest resource’. Australia therefore has all the components of a competitive edge: ai increasing world demand for its timbers, a timber industry which is constantly iicreasing the output o f value-added products, and a forestry profession that can ensure that Australia’s forests are by and huge managed sustainably, and managed to die best standards commensurate widi accumulating ecological knowledge.

The Commonwealth government has developed a system of Comprehensive, Adequite and Representative forest reserves, aiming at die broad benchmark of keeping 15 per cent o f die pre-1788 distribution of each forest community in a dedicaton conservation reserve. A large amount of effort has gone into diis planning as part of die Regional Forest Assessments under die National Forest Policy. At die end of die process, Australia should be in a sound position to provide bodi for a guaranteed forest industry and for preservation.

If tie forest debate could be resolved, attention could turn to die environmental problens diat are orders-of-magnitude greater in dieir impacts dian diose stemming from p operly managed forestry for timber production. These problems include devastaion o f bodi land and native fauna caused by introduced and feral animals like rabbits, foxes, dogs and cats. In addition, problems have arisen from excessive clearing o f forests in die past, such as soil erosion and dry-land salinity. In contrast to maniged forestry for wood products, excessive clearing leads to biological extinctions aid has major consequences for biodiversity. The economic consequences of decreased productivity o f die land are enormous. Restoring die land should dierefore ha/e a very much higher priority for environmental action dian the issues of logging and wood-chipping in our native forests.

234 N otes an d Topics

References

Ashton, D. & P. Atliwill (1994), ‘Tall open-forest’, pp. 157-96 in R. Groves (ed.), Australian Vegetation (2nd edition), Cambridge University Press, Cambridge.

Attiwill, P. (1994a), ‘The Disturbance of Forest Ecosystems: The Ecological Basis for Conservative Management’, Forest Ecology and Management 63: 247-300.

------ (1994b), ‘Ecological Disturbance and die Conservative Management of Eucalypt Forests in Australia’, Forest Ecology and Management 63: 301-46.

Australian Bureau of Agricultural and Resource Economics (ABARE) (1995), Quarterly Forest Products Statistics:June Quarter 1995, Canberra.

Australian Conservation Foundation (ACF) (1995), Policy Statement No. 59: Forests Policy, Sydney.

Loyn, R. (1993), ElTects o f Previous lagging on Bird Populations in East Gippsland: VSP Retrospective Study, Wildlife Section, Department of Conservation and Natural Resources, Melbourne (VSP Technical Report No. 18).

Macfarlane, M. (1988), ‘Mammal Populations in Mountain Ash (Eucalyjrtus Rcgnans) Forests of Various Ages in die Central Highlands of Victoria’, Australian Forestry 5 1: 14-27.

Mueck, S. & R. Peacock (1992), Impacts o f Intensive Timber Harvesting on die Forests o f East Gippsland, Victoria, Flora and Fauna Branch, Department of Conservation and Natural Resources, Melbourne (VSP Technical Report No. 15).

Mutch, R. (1970), ‘Wildland Fires and Ecosystems: A Hypodiesis’, Ecology 51: 1046-51.

Neilson, D. A. & Associates (1995), The Future Management o f Australian Native Forests. A n International Perspective, Rotorua, New Zealand.

Noble, I. (1986), ‘Fire’, pp.224-32 in H. Wallace (ed.), The Ecology o f tire Forests and Woodlands o f Soudr Australia, Government Printer, Soudi Australia.

Ough, K. &J. Ross (1992), Floristics, Fire attd Cleatfelling iit W et Forests o f the Central High/airds, Victoria, Flora and Fauna Division, Department of Conservation and Environment, Melbourne (VSP Technical Report No. 11).

Passmore, J. (1974), M an’s Responsibility for Nature. Ecological Problems artd Western Traditions, Duckworth, London.

Spun-, S. & B. Barnes (1980), Forest Ecology (3rd edition), John Wiley & Sons, New York.

Taylor, S. (1990), ‘Naturalness: die Concept and its Application to Australian Ecosystems’, in D. Saunders, A. Hopkins & R. How (eds), Australian Ecosystems: 200 Years o f Utilization, Degradation and Reconstruction, Surrey Beatty &. Sons, Chipping Norton, New Soudi Wales (Proceedings o f tire Ecological Society o f Australia 16: 411-18).


An Economic Perspective on Crime and Punishment in Modern Australia

Brian Dollery and Joe Wallis

'k ECENT election campaigns in New South Wales, Queensland and Western Australia have witnessed the emergence of law and order as an important

A ^electoral issue. In their attempts to sway voters, politicians from virtually all the mainstream political parties have sought to persuade electors that diey are comparatively ‘tough on crime’. In some instances, competing politicians try to forge anti-crime credentials by calling for harsher sentences for many types of crime and limitations on early parole for convicted offenders.

In many respects this emphasis on crime and justice in Australian politics resembles a more established tradition in American politics, where candidates for public office now routinely denounce their opponents for being ‘soft on crime’ and almost unanimously support the death penalty for certain serious offences. Remember George Bush’s successful ‘revolving door’ advertisement involving die notorious Willie Horton which badly undermined Governor Dukakis’s presidential campaign in 1988?

The legal establishment has generally not welcomed the emergence of law and order as an electoral issue in Australia. Numerous commentators have condemned politicians from all parties for focusing on crime, especially candidates who call for harsher sentencing laws. For instance, Broadhurst and Loh have argued that the Western Australian Crime (Serious and Repeat Offenders) Sentencing Act 1992, which imposed higher penalties on juvenile criminals, was politically motivated: ‘. . . die government, in our diesis, was not primarily legisladng to control dangerous young offenders at all — aldiough it may have hoped or believed die Act would operate to catch and deter die “hard core” offender. Radier die government persisted widi die legisladon because it appeared to be tough and harsh on “hard core” offenders’ (Broadhurst & Loh, 1993:267). Similarly, Findlay has observed dial ‘in New Soudi Wales bodi sides of politics prefer views on crime, control and prevention, which not only exaggerate die crime direat, but imply diat short term, and dramatic political responses are die answer’ (1995:325). Moreover, various experts have assured us diat available data show diat crime rates are not rising and diat die streets are not any less sale dian diey used to be (see, for example, Grabovsky, 1995).

Sometimes die media are blamed for generating a public fear of crime disproportionate to die actual incidence of crime. Thus, Findlay has argued diat ‘all too

Brian Dollery is Senior Lecturer in Economics at the University o f New England. Joe Wallis is Senior Lecturer in Economics at the University o f Otago.


often the media chooses to distort the reality of crime across a range of communities in die face of empirical evidence which supports die alternative view’ (1995:325). It is also argued diat even if crime rates do cause alarm and distress in the community, harsher sentences will not reduce die incidence of crime since the ‘real causes’ of criminal behaviour are to be found in die socioeconomic backgrounds of offenders, most notably ‘alienation*, material and psychological deprivation, and unemployment. Indeed, some commentators have even argued that many offenders, especially younger criminals, are diemselves ‘victims’ of society and accordingly deserve compassion and not punishment.

Yet despite its widespread acceptance among criminologists, die conventional wisdom diat, in general, punishment does not deter die crime can be questioned on bodi logical and empirical grounds.

The Economic Theory of Crime

Two generic approaches to crime and punishment can be found within the social sciences. On the one hand, criminologists, psychologists and odiers have argued diat (in the words of two of dieir critics) ‘criminals are not rational and are driven to commit crimes by influences outside dieir control’ (Buchanan & Hartley, 1992:48). Economists, on die odier hand, have applied dieir standard model of homo economicus to die problem of crime and characterised criminal choice as a rational and calculated process. This approach follows Gary Becker’s (1968:170) observation diat a useful dieory of crime does not require anything beyond die conventional economic analysis of rational behaviour.

The key difference between die two approaches to crime resides in die fact diat whereas noil-economic dieories all provide deterministic explanations for criminal behaviour, die economic approach emphasises die role of individual choice. Al- diougli economists readily concede diat an individual’s environment can influence bodi his preferences and die options available to him, diey nevertheless insist that people always have die freedom to choose between alternative courses of action. Economists do not deny dial poor education, limited work opportunities, and numerous odier environmental, psychological and biological factors may influence criminal activity. They simply argue diat so long as diere is an element of rational choice involved in criminal behaviour, actual or potential criminals will respond to changes in dieir choice environment, including changes in die probability of apprehension and the severity of punishment.

The origins of die modern economic analysis of crime may be traced back at least as far as the seminal work of Beccaria (1794/1971) and Bendiam (1831/1838). Despite being restated in increasingly sophisticated madiematical terms, die essentials of diis approach to crime and punishment have changed litde in die intervening years. The economic dieory of crime centres on die putative decision by rational individuals on die marginal allocation of dieir scarce time between illegal and odier activities. Individuals will participate in criminal activity if die expected net benefit accruing from crime exceeds die expected net benefit derived from alternative legitimate activities. Rational individuals are dius modelled as weighing up die antici-


the anticipated benefits and costs associated widi some given form of crime and comparing the outcome against die outcomes of equivalent legal endeavours. The individual is dius seen as deciding how to allocate his or her scarce time, labour and odier resources amongst competing activities, some of' which may be criminal. Rational behaviour consists in selecting dial course of acdon believed most likely to generate die highest return to die individual. Aldiough outcomes are convendonally ranked in terms of wealdi maximisadon, diis need not be die case: physical, psychic and odier conceivable benefits may also be included.

The risk of detecdon, apprehension, convicdon and punishment is simply one of die many possible kinds of costs diat must be taken into consideradon. The economic dieory of crime is dius merely a special case of more general economic dieory of resource allocadon under constraints. In his classic contribudon to die economics of crime, Becker (1968:176) observed diat ‘criminal behaviour becomes part of a much more general dieory and does not require ad hoc concepts of differ- endal association, anomie and die like, nor does it assume perfect knowledge, liglit- ening-fast calculation, or any of die odier caricatures of economic dieory’.

The economic approach of crime dius provides a coherent analytical framework for explaining die level of criminal activity. The number of illegal offences committed in any given period depends on (among odier diings) die probability of conviction and die magnitude of punishment relative to die expected benefits flowing from a criminal act. Accordingly, potential criminals can be deterred from illegal activity by increases in die probability of detection, apprehension, conviction and punishment and also by increases in die severity of punishment attendant upon conviction. The probability of conviction and punishment and die severity of punishment are dius simply two sides of die same expected costs-ol-crime coin. A smaller probability of punishment can dierefore be compensated for by increasing die severity of punishment to deter criminals and vice versa. As Becker (1968:178) has argued, ‘die widespread generalisation diat offenders are more deterred by die probability of conviction dian by die punishment when convicted turns out to imply in die expected utility approach diat offenders are risk preferrers, at least in die relevant region of punishments’.

The prediction that potential criminals can be deterred from committing offences by (among odier diings) increases in die severity of punishment has significant implications for die formation and implementation of criminal justice policies and for die wider debate on law and order in Australia. If die severity of punishment and die rate of apprehension of offenders are two factors diat can reduce die incidence of crime by deterring potential criminals, diis c an significantiy assist policy formulation. For example, it follows diat we do not necessarily have to increase die rate of apprehension of criminals, which almost certainly involves a considerable and expensive increase in die number of police, in order to reduce die incidence of criminal behaviour. Increasing die severity of punishment while maintaining die current level of apprehension will also serve to reduce die incidence of crime. Al- diough increasing die severity of punishment by means of, say, longer prison sen-


tences is not a costless alternative to higher apprehension rates, it may well prove a cheaper means of achieving the intended reduction in crime rates.

Although deterrence is an important objective of legally inflicted punishment, it is by no means die only one. Odier objectives, including incapacitation, rehabilitation, reparation and retribution, and die reinforcing of informal penalties and shared moral values, are also sought by criminal justice systems. Neverdieless, it is important to determine whedier die central predictions of die economic approach do indeed have die support of evidence drawn from die real world.

The Empirical Analysis of Crime

Most empirical work based on die economic dieory of crime consists of cross- section regression analyses which seek to find statistical correlations between crime rates and putative determinants of crime covering many categories of crime, regional areas and estimation techniques. Here, we are especially interested in die quantitative effects of different factors in die criminal justice system on die incidence of crime. This mediodology seeks to establish die effects of die probability of punishment, die severity of punishment, and odier socioeconomic variables associated widi die perceived incidence of crime on die actual crime rate.

The vast majority of studies in die area1 have focused on die United States. But useful work has also been conducted in Australia, Britain, Canada, Finland, India and Sweden. In general, available econometric evidence provides strong support for die economic dieory of crime. Bodi die likelihood and die severity of punishment are stadstically significant deterrents of crime, however it is measured. Erling Eide (1994:156) has summarised die outcome of empirical research on die economic dieory of crime as f ollows:

As a whole, criminometric studies clearly indicate a negative association between crime and die probability and severity of punishment. The result may he regarded as a radier firm corroboradon of die deterrence explanation in die dieory of radonal behaviour; an increase in die probability or severity of punishment will decrease die expected udlity of criminal acts, and diereby die level of crime.

While die numerous empirical analyses of crime in tliis tradition have all employed different sets of data and embodied varying model specifications, diey also demonstrate diat die deterrent effect of certainty of punishment is generally greater dian die deterrent effect of die severity of punishment. However, die deterrent effects of die probability and die severity of punishment differ significandy between different kinds of crime.

1 Several useful surveys of tliis voluminous empirical literature exist: see, for example, Lewis (1987), Cameron (1988), Eide (1994) and Pyle (1995).


The statistical analysis of crime has at least two significant shortcomings. First, problems exist with the nature of the data on crime and punishment.2 For instance, most crimes are under-reported, and the extent of under-reporting is likely to vary considerably from one jurisdiction to die next, and, widiin a given jurisdiction, from one period and crime category to die next. Similarly, problems exist widi police crime statistics and dieir relationship to court stadsdcs on convicdons and prison stadsdcs on sentences actually served. Many invesdgators simply rely on aggregate data and hope die biases will not be significant enough to obscure die true underlying relationships. Second, bias arises from die simultaneous equations used in regression analyses of die data. For example, if crime in some community increases, dien diat community is likely to support harsher penalties as a means of coping widi die heightened crime problem. In a statistical analysis, diis could translate into a positive correlation between die level of crime and die severity of punishment, which distorts die apparent deterrent impact of punishment in die short run. Despite diese problems in die statistical analysis of crime, die weight of evidence overwhelmingly supports die view diat die crime rate is influenced by expected penalties.

Available evidence on odier possible determinants of crime is much less conclusive. Various proxies, like median family income, median income, labour income to manufacturing workers, mean family income, mean income per tax unit and mean income per capita, have been used to measure die benefits of legal activities. But no systematic relationship has been found between legal income opportunities and crime rates. Similarly, estimates of various measures of die economic gains to crime and dieir relationship to die level of criminal behaviour have generated ambiguous results. Moreover, die effects of income differentials widiin society on crime rates are statistically inconsequential.

Unemployment deserves special mention. Ordiodox opinion in Australia and some European countries holds diat unemployment is a significant ‘cause’ of crime since, in die absence of ‘socially adequate’ welfare payments, crime is an attractive alternative to a life of poverty. Indeed, interest groups often argue diat one of die benefits of die increasingly expensive welfare state is diat it limits die growdi of criminal activity. Neverdieless, die available evidence shows litde systematic relationship between unemployment and crime rates.

Various sociodemographic variables have also been tested, most often age, population density and race. Several studies have found youdi to be a statistically significant determinant of crime. Similarly, a preponderance of research indicates diat population density is positively correlated widi criminal activity, aldiough diere may be reason to believe population density may reflect underlying influences, such as differences in die degree of social control. Race is also statistically significant, at least in die American national context: numerous studies find diat die proportion of 11011-whites in a given population is statistically associated widi high crime rates.

2 See, for example, Haikler and Dagger (1993) for a discussion of diese problems.


Concluding Remarks

The recent emphasis on law and order issues in State election campaigns shows that politicians from across the political spectrum believe that voters are concerned about crime. The question of whether or not actual crime rates have indeed risen is largely beside the point. To be sure, controversy exists as to whether various measures of criminal activity, including victim surveys, reflect any increase in crime. But even if crime rates are not rising, growing public alarm surely shows that people are becoming less inclined to accept existing crime levels: an entirely legitimate popular sentiment to which politicians have legitimately responded.

The economic theory of crime assumes that potential criminals are essentially rational individuals who weigh up the expected benefits and costs ol crime before engaging in criminal activity. There is strong evidence showing that raising the expected costs attached to criminal behaviour will reduce the incidence of crime, other tilings remaining constant. The economic approach to crime thus provides a rational basis for the development and implementation of criminal justice policies.

ReferencesBeccaria, C. (1794/1971), ‘On Crime and Punishment’, in S. Grupp (ed.), Theories o f Punishment,

Indiana University Press, Bloomington.

Becker, G. (1968), ‘Crime and Punishment: An Economic Approach’, Journal o f Political Economy 76(2): 169-217.

Bentham, J. (1831/1838), ‘Principles of Penal Law’, pp.365-580 in J. Bowring (ed.), The Works o f Jeremy Bentham, Vol. 1, Tail, Edinburgh.

Broadhurst, R. & N. Loh (1993), ‘The Phantom of Deterrence: The Crime (Serious and Repeat Offenders) Sentencing Act’, Australia and N ew Zealand Journal o f Criminology 26(3): 251-71.

Buchanan, C. & P. Hartley (1992), Criminal Choice: The Economic Ih eo iy o f Crime and Its Implications for Crime Control, Centre for Independent Studies, Sydney.

Cameron, S. (1988), ‘The Economics ol Crime Deterrence: A Survey of Theory and Evidence’, Kyk- /os'41(2): 301-23.

Eide, E. (1994), Economics o f Crime: Deterrence and the Rational Offender, North-Holland, Amsterdam.

Findlay, M. (1995), ‘From the Director’s Desk’, Cunent Issues in CriminalJustice 6(3): 325-6.

Grabovsky, N. (1995), ‘Fear of Crime and Fear Reduction Strategics’, Cunent Issues in CriminalJus- tice 7(1): 7-19.

Haikler, J. & D. Dagger (1993), ‘Improving Crime Statistics by “Correcting” for System Characteristics: A Methodological Note’, Austialia and N ew Zealand Journal o f Criminology 26(2): 116-26.

Lewis, D. (1987), ‘The Economics of Crime: A Survey’, Economic Analysis and Policy 17: 195-219.

Pyle, D. (1995), ‘The Economic Approach to Crime and Punishment’, Journal o f Interdisciplinary Economics 6(1): 1-22.

We would like to thank two anonymous referees and the Editor for helpful comments on an earlier draft of this note.


REVIEWS

Civil Society and its Enemies

Eva Cox, A Truly Civil Society: 1995 Boyer Lectures,ABC Books, Sydney, 1995

Reviewed by Patrick Morgan

r 1 ^HE idea of ‘civil society’ has been revived to explain developments in Eastern Europe over the last few decades. Communist regimes had dissolved

.A . die myriad voluntary, non-political associations which in normal times act as a cushion between citizen and state, and replaced them with a few artificial, state- controlled bodies. This resulted in an absence of civil society — die state and its quangos combined in an alliance to dominate die cidzenry. Then Solidarity in Poland and similar bodies elsewhere set to work to resurrect die natural, intermediate associadons which exist in normal sociedes. In diis new situadon, cidzens and civil society combined to diwart die tyrannical state structure, which, soon revealed as a hollow shell, collapsed.

In her 1995 Boyer Lectures, Eva Cox appropriates die term ‘civil society’ in a peculiar way. She launches a wide-ranging attack on die family, private life and die nodon of individuality, while supporting an alliance between intermediate organisadons and government. Thus she supports die very arrangement diat civil society was developed to counter: an alliance of die powerful diat can render ordinary people powerless. The meaning she gives die term is, dierefore, not just misleading, but die opposite of diat which is usually intended.

The post-war Western welfare state also had die problem of an over-loaded public sphere. It built up a network of government-sponsored, government- financed organisadons, such as (in Australia) die ABC and die Australia Council, which made die public sector top-heavy. Concomitandy, voluntary community organisadons, tradidonally strong in Australia, are in decline, as a recent survey conducted for die IPA Review (Vol. 48, No. 2, 1995) reveals. Cox states quite unequivocally ‘die state is die best hope for posidve change’ (p.47). This is hardly die position of an advocate of ‘civil society’. What we need, given diat die executive and bureaucracy have too much clout, is an alliance of die private sphere and civil society to curb such power.

Cox’s main public policy position is diat of state intervention. For diis reason she strongly opposes die small government and deregulatory policies in favour in die past few decades. Her term of universal demonisation is ‘Economic Rationalism’. Like Marxists who condemn our society as ‘capitalist’, diis term is used mosdy by opponents of diese policies, and its blanket nature makes it possible to avoid detailed refutation of what is a complex series of policies involving the dis-

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mantling of large government and quasi-government bureaucracies. Instead of arguing against any of diese in detail, Cox simply dismisses diem as aggressive, competitive and dierefore masculine, die products of Economic Rational Man (die additional term of denigration being included to confirm her feminist preoccupations).

Cox sets up an opposition between die social and die economic spheres of life, as if diey are necessarily competing entities, diough diere is no argument to show diis. She favours enhancing die social side by increasing ‘social capital’, as she calls it, following die sociologist Robert Putnam. Social capital is die trust built up by cooperative, communal activity. This is to be a new social initiative, feminised because trusting, cooperative and inclusive. But she doesn’t show how social capital operates in economic terms, except for a negative example. Advocates of law and order wrongly see crime as increasing, she believes, and advocate more gaols and crime prevention measures; but diis is a waste of money, because die real problem, in her view, is diat die law and order advocates suffer from social distrust diemselves. She concludes, ‘We are left widi die contradiction diat a government’s failure to spend on enhancing social capital will actually reduce die level of financial capital. Indeed, high social capital may well be die prerequisite for economic growdi’ (p.26). On die contrary, if die wheels of community life are well oiled by voluntary activity — if a community has, in Putnam’s terms, high social capital — dien diere is less need for government intervention, financial or otherwise. In a recent article ‘Notes on Australian Intellectual Decadence’ (Adelaide Review; December 1995) Kennedi Minogue has shown what happens widi high levels of government intervention:

Where unreality really begins to bite is in die ubiquity of politics. In Australia, wherever two or diree are gadiered togedier in any activity, a politician will infallibly pop up into dieir midst and cry, like Richard II: ‘I will be your leader’. Aesdietic endeavours cannot be left alone, but must be subsumed under Paul Keating’s creative nation. Backpackers cannot trudge along die roads of Australia widiout die Minister for Tourism announcing, in Cairns, a national strategy on backpacking. Wherever a special interest lobby can set up some plausible claim to justice or virtue, government will ride over it to extend its power.

The crucial question is whedier Cox favours government sponsored top-down organisations or voluntary private ones. Some idea is given by die tide of her diird lecture: ‘The Dark Side of die Warm Inner Glow: die Family and Communitarians’. She reveals her position when she says: ‘The state needs to be part of creating tolerable social structures’ (p.46). She is not really in favour of many community groups, who are, she believes, like die family, inner-directed, based on fear of the outside, fear of die Odier, and so huddling in unhealthy intimacy. This is die dark side she alludes to. The f amily is damned as an agent of over-bonding, and she is scornful of ‘modiers who want to experience child bearing and rearing as a continuous ecstatic experience’ (p.33) (anodier straw target).

Reviews 243

Any group must have a raison d ’etre, there is nothing wrong or necessarily inner-directed with this. If one set up a chess club, it is legitimate to exclude poker players. This is not being ‘lion-inclusive’; it simply follows from die integrity of die particular institution. Cox does not allow individuals and groups to have dieir own identity; she is so wholly oriented to societal aspects as to deny individuality. She says: ‘I act for odiers so I can live widi myself (p.5), a psychologically dubious proposition. Those who do not possess personality equanimity will not acquire it from odier-directed activities; diey just become perpetual critics. Cox sees everydiing in terms of groups, classes and genders, and passes judgment on diem in diis generalising way. ‘We define ourselves dirough how odiers see us’ (p.70). This is die social reconstruction of reality.

Cox’s policies have already been tried in Australia under die Cain-Kirner, Burke-Lawrence and Bannon State Labor governments in die 1980s and found wanting. These governments formed alliances widi powerful, often government funded, unelected lobbies like women’s groups, social welfare lobbies, and arts and multicultural oudits, who captured die ear and die purse of diese governments. This is die public behaviour Cox favours. Look at die results. These neo- Keynesian hand-out governments eventually ran into fiscal crises, widi adverse consequences for die genuinely needy. The lesson here was diat everyone loses power when economic policies are ruinous. The low esteem politicians are now held in by ordinary Australians results from dieir being seen to be captives of unrepresentative groups like diose Eva Cox supports.

Cox claims diat she is inclusive, dial she wants debate, discussion and dissent. But die word ‘inclusive’ is simply a rhetorical device to gain support. Who would not want to seem ‘inclusive’? But is Cox really inclusive and interested in debate? She condemns but does not discuss what she opposes, such as smaller government. She pushes for compulsory policies, like government child care for all children, not because parents want it, but because it is good lor children to be away from die over-bonding she alleges is associated widi families. She is not tolerant of odier views: diose widi whom she disagrees arc derided as ‘merchants of simple solutions’ (p.27) and ‘ill-informed nostalgia merchants’ (p.43). As an activist for child care she says: ‘We learned diat translating what we did into bean counting terms meant diat we could talk to die animals and make some progress’ (p.77). I take it diat die ‘animals’ are die government economists she had to convince. This is hardly inclusive language designed to increase ‘social capital’.

Her views are a dirowback to 1930s utopian socialism, but presented in new rhetorical guise. She wants to politicise all issues, and she looks to governments for solutions. She wants increased taxes and, like many people in protected industries like universities and social welfare lobbies, more government protection. She claims to support Hannah Arendt’s notion of die vita activa, but diis is not at all die same as Cox’s politique d ’abord. Arendt in The Origins o f Totalitarianism made clear die dangers of politicising everydiing. At die beginning Cox says she wants ‘to persuade diose in high places’ (p.l). This is die aim of die lobbyist. Ordinary Australians are not addressed. Cox aligns herself widi Arendt as Jew, refugee and

244 Reviews

woman, and therefore as a pariah figure, a perpetual outsider. This is to turn herself falsely into a victim figure. She wrongly says that Arendt’s ‘dissenting views were often ignored because they were different from the prevalent male writings of that time’ (p.7). The Times IJtcrary Supplement of 6 October 1995 published a list of die 100 most influential books since World War II, and two of Arendt’s were on die list. Cox was constandy called upon for her opinions during die recent federal election and was invited to give die Boyer lectures — hardly a case of marginalisation.

These lectures set up lots of polarities: women versus men, public versus private, social versus economic, inclusive versus exclusive, always widi die former favoured and latter denigrated, so diat die argument is determined in advance. This is a self-enclosed ideological merry-go-round widi diminishing contact widi reality. When she looks for an example of ‘social capital’, she lamely turns to die writing of her own Boyer Lectures and die group of women who helped her prepare them. This reveals die self-referential nature of her enterprise. One of her helpers was Geraldine Doogue of die ABC, die sponsor of die lectures. This is an example of die blurring of functions caused by networking, which makes independent views impossible. It is not surprising diat die views expressed here are diose beloved of die ABC.

Patrick Morgan is Senior Lecturer in English at Monash University (Gippsland Campus).

Reviews 245

Between State and Market

Ernest Ge liner, Conditions of Liberty: Civil Society and its Rivals,Hamish Hamilton, London, 1994

Reviewed by Mark Lyons

n n H E collapse of communism in Eastern Europe has led to a renewed interest in civil society. As articulated by intellectuals in Eastern Europe before die

J L 1989 revolutions, civil society is diat public space outside die state where people can freely associate to pursue shared interests. It was a space which communist regimes sought to extinguish. Civil society barely existed, and hardly at all publicly, under diose regimes.

The late Ernest Gellner, who was a distinguished philosopher and social an- diropologist, and Research Professor at die Central Eastern European University in Prague since 1991, argues diat civil society is a condition of liberty and seeks to explicate it by reviewing its diree rivals. According to Gellner, civil society emerged as a fortunate consequence of die Protestant reformation and industrialisation in Western Europe. Its prototype could be found in die commercial city states dial emerged in die late middle ages. In diese city states, one of die essential characteristics of civil society was established: tolerance. The pursuit of wealdi dirough trade generally discourages domination by eidier priest or prince. In die division of labour of emerging capitalism and industrialisation, ruling, soldiering and preaching became merely forms of employment, widi dieir own rewards. Continual and exponential economic growtii meant diat diese rewards were sufficient to weaken die temptation to dominate a whole society. A crucial creation of diis emerging world, one which established die basis of civil society, was ‘modular man’, people who had a capacity to police diemselves and to associate for die pursuit of limited goals widiout needing to refer to an overarching total world view or ideology (pp.99-100).

Anodier essential precondition of civil society, according to Gellner, was nationalism and die emergence of strong nation states. Western European nationalism created, and was created by, language communities diat spread a common ‘high culture’ widiin die boundaries of die nation. Civil society institutions were important creators and creations of diis nationalism. Strong but not dominant regimes protected die nascent institution of civil society widiin each nation, despite some occasional odier disastrous consequences.

Gellner contrasts diese liberal societies widi diree odier social formations that do not permit civil society. The first contrast is widi die various segmentary communities of isolated tribes and villages. These societies, more common in die past dian now, were characterised by highly prescriptive sets of mutual obligations, producing a ‘tyranny of cousins’ (p.7). Anodier form of tyranny was diat produced by communist regimes widi dieir totalising secular ideology. Gellner’s diird direat to civil society is Islam, widi its strong tendency towards establishing an u/mna, an overall community based on shared faidi and implementation of its laws, inter-

246 Reviews

preted by its theologian-jurists, the ulaina. The expansion of Islam, Gellner argues, represents the main modem threat to the spread of civil society.

Conditions o f Liberty is a challenging and sometimes frustrating book. It reads more like a series of overlapping essays rather than a single, fully considered and articulated diesis. It has at least two important gaps. One concerns Islam. Gellner is certainly familiar widi die Islamic societies of North Africa and die Middle East. Yet die followers of Islam are more numerous in south and soudi-east Asia. Indonesia is the world’s largest Islamic nation. It is not at all clear that the social and economic conditions of die Middle East diat encourage an intolerant fundamentalism and die kind of fundamentalist regime diat is found in Iran are present diroughout die entire Islamic world.

The second gap concerns die relationship between civil society and die economy. Most East European writings about civil society define it in terms of associations diat act separately from die state; civil society dius includes private firms as well as unions, sports clubs and churches. Odier writings about civil society, especially from die Asian region, distinguish civil society from bodi state and market, conceiving of it in terms of private non-profit associations which occupy die public space between state and market and which are needed to prevent die domination of eidier.

Gellner seems to share diis latter position, but he does not explore it as fully as he might. He writes at one point about die importance of economic decentralisation in die development of western, capitalist, civil society. But later he acknowledges diat capitalist economic development is so powerful diat it produces its own distinctive tyranny unless it is checked by state institutions. He says, clearly, diat successful economies will be mixed economies. This seems correct. Yet die power of capitalist development poses anodier problem diat he does not address: die way economic globalisation is reducing die power of die nation state. This process might, as some suggest, create a democratic deficit, a disillusionment widi national states and a revival of regional and local concerns and interests. Such a new local democracy movement could be characterised by a growth in local groups and associations, fuelled by and fuelling a stronger civil society. But die growing global reach of a few huge corporations and die extraordinary if undirected power of die money traders who share a common ideology pose new challenges to bodi die state (particularly international state institutions) and to civil society.

Mark Lyons is Associate Professor in the School of Management, and Director of the Centre for Australian Community Organisations and Management, at the University o f Technology, Sydney.

Reviews 247

To CER with Love

Steve Hoadley, New Zealand and Australia: Negotiating Closer Economic Relations, New Zealand Institute o f International Affairs, Wellington, 1995

HIS study is die latest instalment in a fruitful triangular collaboration between Steve Hoadley of die University of Auckland, the New Zealand Institute of International Affairs and the Ministry of Foreign Affairs and Trade.

The result is a slim (134 pages), unpretentious yet very useful handbook for students of New Zealand foreign policy, Australia-New Zealand relations, and bilateral trade negotiations between asymmetric state actors.

New Zealand and Australia signed a Closer Economic Relations (CER) Agreement in 1983, aiming at the progressive establishment of a free-trade regime across die Tasman by 1995. In attempting to identify and analyse die political dynamics diat gave rise to diis reform, Hoadley concentrates on die genesis of die CER idea, die motives actuating its proponents, and die means by which die institutional- political-sectoral hurdles to comprehensive trade liberalisation were overcome.

The formal review in 1988 accelerated, broadened and deepened die scope of CER. Various memoranda of understanding were signed and letters exchanged between officials and ministers to implement die letter of die CER treaty and die spirit of free trade: by die standards associations of die two countries; for die cessation of quantitative export restrictions on 1 July 1990; on die harmonisation of customs policies and procedures, and of business law; on technical barriers to trade; and on die termination of die dairy products memorandum. One of die most interesting aspect of die CER process has been die tackling of issues at die f rontiers of international trade. Australia and New Zealand signed a protocol on 18 August 1988 extending free trade to services from 1 January 1989. Its long-term goal is die eventual removal of all inscribed services. Migration flows across die Tasman are of a magnitude to suggest diat labour market integration has been in existence since before die signing of CER. In some respects, however, die goal of full free trade in services has yet to be realised. Trans-Tasman merchandise trade, on die odier hand, became fully free on 1 July 1990.

A second review in 1992 attempted to tackle ‘second generation’ issues and reached agreement on rules of origin, industry assistance, technical barriers to trade and air services (which was later cancelled, unilaterally, by die Australian government). Differences remained on aspects of auto market integration, migration and residence procedures and rights (for example, social welfare benefits), inspections and standards regimes, investment tax and competition law and shipping.

Hoadley concludes sensibly diat while propinquity and cultural-political similarities facilitated economic convergence, diey did not determine such an outcome. For diis, visionary and committed political leadership was critical. Moreover, botii partners have benefited from die deal; New Zealand may have benefited propor-

Reviewed by Ramesh Thakur

248 Reviews

tionately more than, but not at the expense of, Australia. Nor is it clear that CER has been relatively more beneficial than Zealand’s more wide-ranging reforms.

Hoadley righdy notes that CER has taken on a wider meaning and a broader context. In the trade and economic relationship, a host of ancillary agreements and practices have grown alongside CER, if not directly out of it. In die military sector, New Zealand consciously tried to draw upon die consensus support of CER in dubbing die growing nexus as ‘closer defence relations’ (CDR). Hoadley could perhaps have dwelt a litde more on die differences between die two. In origins, while CER was on outgrowdi of frustrations widi die previous trade framework, CDR aims to build on existing good military relations. In goals, die framers of CER knew what diey wanted; die eventual shape of CDR has always been blurry. Most important, CDR does not and cannot emulate die central objective of CER of achieving efficiency gains dirough market rationalisation and specialisation along comparative advantages. Yet Hoadley is surely right to conclude diat neither the two countries’ defence forces nor dieir polities will completely merge: ‘Australian advocates argued diat New Zealand’s debt and defence burdens would be lightened by federation, but sceptics countered diat New Zealand would have to take on Australia’s debts, taxes, regulation, union militancy, race tensions and crime’ (p.l 13).

Hoadley does not pretend to have made fundamental breakthroughs in die economics or politics of trade dieory. The study is not an exhaustive account of die negotiation, implementation and results of CER. It is also one-sided: the story is told from die New Zealand point of view, using almost exclusively New Zealand sources. Nevertheless, die story is told well, clearly and to good effect. Hoadley draws upon academic frameworks of analysis, notably negotiation dieory; explains and follows his structure widiin each chapter as well as over die booklet as a whole; summarises his findings in easily understood language; and concludes widi a characteristic few pages of lessons learned. One may quibble over diese lessons, but one cannot deny die value of such summaries to students struggling dirough masses of information. Equally helpful are tables which summarise die negotiating goals sought, diose achieved, and diose diat had to be compromised or abandoned.

Hoadley may well be right in his judgment diat CER may reach a plateau well short of a dieoretical summit of complete economic integration, let alone complete defence integration and political union. Australia has signalled reluctance to consider mutual recognition of imputation credits. Australia’s 1995 budget, by increasing die corporate tax from 33 to 36 cents for Australian companies, clouded die prospects for harmonisation of die two countries’ tax laws. Most spectacular was die last-minute cancellation in October 1994 of die air services agreement of 1992. Yet there may be hope for resurrecting die single aviation market following die change of government in Australia. While die Coalition has taken a harder line on alleged New Zealand prevarications on defence, its election foreign policy document signalled a desire to revisit die aviation market issue.

Ramesh Thakur is Head of the Peace Research Centre in the Research School of Pacific and Asian Studies at The Australian National University.

Reviews 249

Wooden Spoons Banned: Official

Christopher Booker and Richard North, The Mad Officials,Constable, London, 1994

Reviewed by Stephen Rimmer

V N 1992 die European Community (EC) issued a large number of new regula- I tions, which were implemented by member governments. The Mad Officials

-Previews the recent growdi in die number of new regulations in the UK and analyses dieir detrimental impact on die UK economy. It focuses primarily on die regulation of agriculture, food hygiene, safety, die environment, aged and child care, and consumer protection.

The genesis of die book was a series of articles about die new regulations written by Christopher Booker, who used his Sunday Telegraph column in 1992-93 to highlight ‘bizarre directives and regulations coming out of Brussels’ (p.16). By mid- 1993 he had received over 6,000 letters claiming diat new regulations had not attained dieir goals and had imposed considerable costs on individuals and firms.

The book reviews 140 case studies of how diese regulations impede die efficiency of many businesses. For example, a school nursery diat had operated successfully for 25 years was told by social workers to implement new space regulations, compliance widi which required a 33 per cent reduction in die numbers of children. The social workers also instructed staff on how diey should greet parents, required die renovation of facilities such as die badiroom, and advised diat die dolls in die toy box did not adequately reflect cultural diversity. The owners of die nursery anticipate closing down, because of loss of management control.

According to Booker and North, UK regulators have interpreted and implemented new EC regulations more stricdy dial odier member countries, imposing additional costs. For example, Scottish oyster growers were told diat only half of diem met new EC healdi regulations, whereas all oyster growers in France and die Nedierlands were advised by dieir respective governments diat diey conformed to new regulations, including Dutch growers near die heavily polluted river Rhine. Such new regulations impose considerable costs on commerce and industry. Indeed, according to die UK government, implementation of EC healdi and safely regulations introduced in die UK in 1993 cost commerce and industry die equivalent of A$ 1 billion in additional compliance costs in die first year.

The audiors conclude diat British regulators often unnecessarily increase the scope and complexity of EC regulations. For example, one EC directive resulted in 84 pages of new UK regulations, while die French equivalent covered only four pages. The audiors cite a number of cases where new UK regulations are so complex diat diey impede die goals of regulation, such as enhancing food hygiene.

Many regulations have unintended side effects, such as eliminating well established practices and customs diat have been implemented successfully for centuries. For example, new EC regulations prohibit Welsh roof diatchers from using ‘seed

250 Reviews

aquila’ reed. And just before Christinas 1992, the South Dorset District Council informed a local naval base diat, under new food laws, the old tradition of stirring die Christmas pudding with wooden oars was no longer permitted: plastic spoons must be used instead.

The authors claim that the additional costs imposed on UK commerce and industry exceed the benefits that could be derived by such regulations. However, die discussion of costs imposed by reguladons usually focuses on die costs incurred by individual firms radier dian die costs imposed on particular industries or sectors of die economy. Thus, it is unclear whedier many of die case studies are represen- tadve of particular industries and whedier diey can be extrapolated very far beyond individual firms. In addidon, as die potential benefits of reguladons are usually not identified, most case studies do not provide a systematic analysis of die costs and benefits of new regulations. Nevertheless, it is clear diat considerable costs have been imposed in individual firms, and diat UK regulators have not transmitted effectively to die persons and organisations effected by regulations die rationale and supposed benefits of new regulations.

According to die audiors dierc has been a loss of political control over regulation making, despite die considerable success die audiors had in 1993 in focusing political debate in die UK on die impact of regulations. They claim diat effective control over regulation making has now passed from UK politicians to EC and UK based regulators. They conclude: ‘What we were looking at, in short, was a regulatory monster which had run so much out of control diat, in many instances, it was producing results precisely die opposite of diose intended’ (pp.29-30).

This book is interesting and easy to read. Humorous illustrations by Willie Rushton are included diroughout, such as a depiction of a frightened couple sitting in bed, while liealdi and safety regulators arrive widi a measuring tape and an axe to ensure diat die bed conforms to new EC regulations. The book highlights an apparent breakdown in communication between regulators and regulated firms in die UK. It also shows how die creation of international regulatory bureaucracies can reduce national governments’ control over regulation.

However, it provides litde information about die roles and activities of EC and UK regulators diat develop and implement regulations. It does not discuss initiatives by EC and UK regulators, including moves to increase die quality and transparency of new regulations by using regulation impact statements. Importandy, diis book does not provide much information about whedier new EC inspired regulations have replaced or added to existing UK regulations. In diese respects die book is incomplete, however useful and amusing.

Stephen Rimmer is Director o f the Industry Commission ’s Office o f Regulation Review.

Reviews 251

A Worthwhile Research Program?

Geoff Stokes (ed.), Australian Political Ideas, University o f New South WalesPress, Sydney, 1994

S Geoff Stokes suggests in his introduction to this eclectic anthology, thegeneral history of Australian political thought has yet to be written; theprocess of sifting ‘through die sources and . . . [analysing] in detail die . . .

more systemadc kinds o f reflection about Australian polidcs’ (p.l) has barely begun. One obvious reason for diis neglect is die tradidonally low estimation o f Australian polidcal diought, which W . K. Hancock and odiers denigrated as unoriginal and

Naturally, die editor of Australian Political Ideas refuses to go along widi such a view, dismissing it as an aspect of die ‘cultural cringe’. He insists diat diere is, and has been, ‘a disdncdve Australian polidcal diought’, die result o f work on ‘pracdcal problems’ (p.6). (If so, diere is surely nothing peculiarly Australian about diis; most fruitful polidcal diinking begins widi pracdcal problems.) Very broadly, Stokes considers diat alter a consensus had been reached in die Australian colonies concerning die value o f polidcal democracy, die main sources o f polidcal-dieoredcal problems were designing insdtudons and framing reform proposals for realising ideals of democracy, cooperadon, social jusdce, and equality — modfs diat underwent reinterpretadon as circumstances and needs changed.

Stokes believes diat in order to find Australian polidcal diought one has to go beyond what on die face o f diings are die more likely sources (Hancock and fellow cridcs must have looked in die wrong places). ‘Academic polidcal dieorists resident or born in Australia’ have engaged more in debates abroad dian diey have in domesdc debates (p.6); diey have contributed to ‘universalising’ radier dian to indigenous polidcal diought (p.8). Their prescripdve polidcal dicorising has been specific radier dian universal. Those who have systemadcally reflected on Australian polidcs have by and large been 11011-academic writers, public figures, and polidcal activ- ists. ‘By developing a less restricdve . . . conception of polidcal dieory . . . it is possible to extend die range o f individual people and texts considered suitable for study’ (p.8). Is the game worth die candle? Stokes gives a number o f ‘political reasons’ why distinctively ‘Australian polidcal diought’ deserves study, while its past neglect is blamed for having limited ‘die social and polidcal self-awareness o f Australian society and polity’ (p.9). Maybe.

Australian Political Ideas is devised to broaden ‘die base of scholarly study’ (p. 11). The topics covered are diverse, and include bodi historical and modern developments. No dieme unifies die audiology, but what comes dirough is a sense diat die relative neglect o f die area is undeserved and diat it is dine to redress it. There is a discussion o f ‘Australian Writings on Polidcs to I860’ by die late Len Hume; Colin Hughes deals widi die diought and effect o f Edward Bellamy; and

Reviewed by David Walker and Struan Jacobs

banal.

252 Reviews

Gregory Melleuish contributes a piece on ‘Competing Images of Democracy in Australia’. M. D. Fletcher has companion pieces on Peter Carey’s writing; Barbara Sullivan explores ‘Contemporary Australian Feminism’; and Ian Cook’s ‘From Menzies to Hewson’ analyses ‘Two Traditions of liberalism in the liberal Party’.

The highlight is Hume’s panoramic survey of writers and sources (books, petitions, pamphlets) from the period 1820-60, with roles and powers of governors, administration of justice, rights of free citizens, and control of revenue among die prominent issues. Arguments buttressing claims and criticisms are oudined and illustrated: British birdiright, populism in working class and agrarian forms, utilitarianism, civic humanism. The essay is well versed, subde, and clear; Len Hume was a gifted craftsman when it came to imparting intellectually satisfying shape to intricately detailed subjects.

It is no criticism of Carey’s stature as a novelist to note tiiat Fletcher’s separate chapters on Illywackcr and Oscar and Lucinda appear out of proportion. Why two chapters on Carey when die often explicidy political writers Miles Franklin, Christina Stead and Frank Hardy and die intellectual traditions diey document go largely unrecorded? Why writers at all when one of die strongest vehicles for political comment over die last century has been die political cartoon? If distinctive contributions to our political culture are die object of die exercise, dien a commentary on die incisive wit, burlesque talents and sheer inventiveness of a Bruce Petty would merit inclusion. Audiologies are necessarily very selective, but die rationale for diis particular selection remains puzzling.

In die essays diemselves, Fletcher refers to die manner in which Carey challenges and disrupts large statements about die nature of Australian society and politics, but in doing so makes references to die ‘official reading of Australian history’ and to die ‘standard (“imperial”) history of Australian development’ (p.135). There is surely some doubt in die 1990s about what die ‘official reading’ of Australian history might be and it can certainly be doubted whedier historians would subscribe to die direadbare conservatism dial is proffered.

In bodi essays, we are told diat Carey subscribed to Miriam Dixon’s view diat Australian men were more sexist dian European men, a view diat carried a certain polemical charge when Dixon brought it to light 20 years ago, but which now seems a touch banal, and certainly not wordi two mentions. Which European men? In any case, should we read Carey in order to have our dieoretical positions confirmed or denied? For all die concern about Carey’s post-colonial credentials, it remains hard to accept diat diis dieme deserves such an audior-centred treatment in an audiology of diis kind.

The audiology reveals die need to look beyond political studies for expressions of political diought, and it can be commended for its interesting discussion. But much work remains to be done before die investigation of distinctively Australian political diought can be judged a progressive, not just a possible, research program.

David Walker is Professor of Australian Studies, and Struan Jacobs Lecturer in Social Theory, at Deakin University (Geelong).


CORRESPONDENCE

From Bryce Wilkinson

V T ’AYNE M aP P ’S article ‘New Zealand’s System of Citizens Initiated Ref- % / % / erenda’ {Agenda, vol. 2, no. 4, 1995, pp. 445-54) usefully identifies

▼ t some concerns with this approach to democratic decision-making. One concern is that current legislation allows a special interest group opportunistically or frivolously to inflict a cost on taxpayers of around NZ$10m. For example, die new system was inaugurated on 2 December 1995 by die Professional Firefighters’ Union, which used it as a weapon in an industrial relations dispute (die referendum question asked whether die number of firefighters should be allowed to fall below die number employed on 1 January 1995). The event showed diat an organisation widi diousands of members with time on dieir hands can get enough petitioners’ signatures to satisfy die direshold requirement of 10 per cent of registered voters, even for a motion diat presumes diat voters have information diey do not generally possess. In die event, 87 per cent of diose voting supported die Firefighters Union, but only 27.71 per cent of eligible voters actually took part in die poll.

Wayne Mapp notes diat die costs could be reduced if referenda were held in conjunction widi general elections. That is a valid point, but it does not get to the heart of die problem, which is diat die legislation allows a small group to impose costs on taxpayers widiout being accountable for ensuring diat die benefits to society are commensurate widi diose costs. Candidates at general elections in New Zealand have to put up a deposit of NZ$300, and lose it if diey do not receive at least 5 per cent of die votes. Unsuccessful plaintiffs in civil suits may have costs awarded against diem. Has Wayne Mapp considered die appropriateness of imposing greater financial disciplines on diose who initiate referenda? It’s wordi bearing in mind diat as 10 per cent of die voting population in New Zealand amounts to about 232,000 individuals, each of diem would have to put up less dian $45 on average to cover die cost of a referendum held at a time odier dian a general election.

Wayne Mapp responds:

'M RYCE W ILKINSON is certainly correct to point out that CIR is vulnerable to being used by special interest groups to promote concerns which do not

Ä ß impinge on public policy. However, I could not accept diat a fee should be charged as a precondition of signing a petition as a means of deterring frivolous petitions. It is an essential virtue of democratic government diat all citizens have a right to participate in dieir government irrespective of their economic means. This must include die right to petition government, and die modern means is through citizen initiated referenda. Forty-five dollars is in fact quite a substantial barrier to exercising die right to express an opinion.

254 Correspondence

The Firefighters’ referendum will ultimately be seen as an aberration. Its low turn-out will be an instructive lesson in the use of referenda. Citizens will be less inclined to sign petitions that deal with purely sectional interests, particularly if diere is little likelihood of die interested parties implementing the results in a readily understandable way. In die end, it is die ‘free’ choice of cidzens to hold a referendum on whatever subject they choose. One of die best uses of tax revenue is to enhance our democradc system to give citizens a greater say in dieir own government

From Dan Corry

HARLES CROUCH’S review of Dan Corry, David Souter and Michael Wa-terson, Regulating Our Utilities (Institute for Public Policy Research, London, 1994) in Agenda (vol. 2, no. 4, 1995, pp. 499-501) argued diat we were

simplisdc and too prone to call for sectoral policies. In Britain, many on the Right believe that reguladon will widier away and diat compedtion will solve all policy issues unaided. Our book tries to counter diis simplisdc view, on diree grounds.

First, decisions to restrict die behaviour of a regulated monopoly profoundly affect many people, be diey shareholders, consumers, employees, or potendal new entrants. The Bridsli system gives named, noil-elected individuals enormous dis- credonary decision-making power, giving rise to complaints about die lack of accountability for, and clarity in making, die decisions, and about die absence of clear rights of appeal. Recent debate has begun to quesdon die ‘CPI minus X’ mechanism of price control which may ensure efficiency but is seen as unfair in its allocadon of die benefits among shareholders, chief execudves and consumers.

Second, as Charles Crouch notes, reguladon righdy aims to promote compeddon; but we must in praedee see new entrants emerge, given diat die privadsed udlides are nadonal or regional monopolies. Present regulators have somedmes gone to extremes, subsidising new entrants and screwing down incumbents. Yet Bridsh Telecom’s retendon of most of its market share may mean, not diat it is aedng un- compeddvely, but diat it has responded to compeddon or die direat of compeddon in a way diat benefits all consumers. Why should an incumbent innovate if die gains are likely to be snatched away by die regulator? Would subsidised new entrants be compeddve if and when die subsidies are removed? What of a privadsed and verdcally separated electricity sector diat now wants to reintegrate? Hence die need to consider industry, and in some cases sector-specific, policies.

Third, under compeddon and even contestability, poorer and less desirable consumers lose out as cost-reflecdve pricing begins to replace cross-subsidies; and environmental objeedves in die energy sector become difficult to deliver.

David Souter’s model gives stakeholders a close to formal role in die regulatory body. Alternadves include advisory panels (as the head of Gas Reguladon has herself suggested), and government itself imposing a regulatory framework. These inevitably highly polidcal issues must be debated; odierwise, excess profits and endless corporate takeovers and raids will discredit die whole process of regulated compeddon, to die detriment of all.


NON-AGENDA

With the view of causing an increase to take place in the mass of national wealth, or with a view to increase of the means either of subsistence or enjoyment, without some special reason, the general rule is, that nothing ought to be done or attempted by government. The motto, or watchword of government, on these occasions, ought to be — Be quiet. . . Whatever measures, therefore, cannot be justified as exceptions to that rule, may be considered as non-agenda on the part of government.

RADE liberalisation, technological change and greater competitive pressurein domestic markets are having major positive impacts on die wealdi of dieAustralian community. But diese benefits may well be distributed dispro-

pordonately in favour of die better educated and skilled. The government’s response lias been increasingly to use die tax and welfare systems to redistribute incomes (die ‘social wage’). There have also been major programs to improve die skills and employability of die long-term unemployed. But job opportunides for die poorly educated and unskilled may well continue to decline.

Internadonal specialisadon will send offshore an increasing number of low- skill jobs in die manufacturing and service sectors. Lighdy skilled activides will remain in demand where diere is litde opportunity for foreign compeddon (leaving aside die possibility of importing labour for diese tasks). These jobs will include die provision of services to die reladvely well educated and skilled. Some of diese services, such as die use of restaurants or prepared foods, will be provided outside die home. But die demand for household dudes to be provided by 11011-family members will increase. The demand for quality dine widi children or for recreadon for diose 011 high incomes will furdier increase die demand for help widi home dudes like child minding and transportadon, cleaning, washing, ironing, food preparadon, purchasing of household supplies, gardening, lawn mowing and home maintenance. The

Jeremy Bentham (c. 1801)

The Economic and Social Impact of Tax-Deductible Household Help

Garry M. White

Garry White is Executive Director o f Corporate Economics Australia.

256 Non-Agenda

pressures on home carers for those with disabilities through accident, genetic abnormality or age are also increasing, providing a further demand for home help.

At die same time a significant proportion of die well qualified and skilled populadon (mainly women) is discouraged from working by die expense of purchasing household support from after-tax income. The community has invested heavily in these individuals in educadon and work experience. In addition, the average hours of work for diose employed has been increasing while die rate of unemployment has crept up over time, increasing die demand for household services. For example, in August 1983 die average number of hours worked by a male in fulltime employment was 41 hours a week. Latest figures show diat a male in full-time employment is now working an average of 44 hours a week (ABS, various). As a result, many people are less able to supply dieir home services for diemselves while anodier large group has litde else to do.

A further social development is die aging of the population. Compulsory retirement age and increasing longevity create bodi a pool of productive and skilled people from die early part of die traditional retirement period and a greater number of aged persons requiring support later in life.

These economic trends and pressures are unlikely to be reversed, and will probably intensify over die coming decades.

A Policy Option: Tax-Deductible Home Help

The economic issue is how best to utilise die nation’s resources to create wealdi. The social issue is how to provide die opportunity for meaningful and satisfying lives for all Australians. It is also important diat desirable or inevitable economic changes are not accompanied by avoidable social dislocation.

One option is to make die cost of home help tax deductible. This would have die effect of integrating home and traditional economic activity. The object would be to remove an economic distortion diat currendy stifles economic activity and has die potential to create a community split between die winners and losers from recent and prospective economic pressures.

The proposal might be implemented in die following way:• expenditure by individuals on home support services to diemselves or dieir de

pendants would be tax deductible;• where externally employed household members shared support services, diey

would share equally in die tax deduction for home help; and• tax deductibility for home help expenditure would require evidence diat die

services had been provided at arms’ lengdi and diat home helpers were within die tax system.

Economic Impact

Australian households are already purchasing a modest amount of household help. But die current level of expenditure on diese services suggests diat diere is a considerable scope for die purchase of much greater levels of household services. The

Non-Agenda 257

ABS (1990:10-11) indicates that the average household spends a little over $4 a week on the range of household services being considered here. More than $9 on average was spent by the highest quintile of income earners.

The impact of the proposal can be demonstrated by an example that, while illustrating some broad relationships and magnitudes within this brief exposition, is not intended to be indicative of the economy-wide impact of the proposed policy. The key impacts of interest here are those on national economic output (actual and as usually measured), on household income and on tax revenue.

The household used for the example includes two well-qualified adults, one of whom works a typical professional week of 50 hours and also contributes 12 hours of home duties. The earnings of the first adult might be the equivalent of $30 per hour worked. The other adult is currently working part-time for 20 hours per week earning $20 per hour and also contributes 52 hours of home duties. No outside resources are used to provide home help. The second adult’s earnings are lower because part-time work is relatively less well paid and careers are disrupted by taking responsibility for home duties such as care of children or invalid relatives.

The household has an initial gross income of $1,900 per week. Under current tax rates the household pays total tax of $584, leaving a net income of $1,316 (the Medicare Levy is ignored in this example). Australia’s national accounts would measure diese adults as contributing $1,900 to die nation’s income. However, if dieir contribution to national income included home duties (valued at say $12 per hour) dien dieir total economic contribution would be $2,668.

Now consider an alternative scenario under which die second adult took up a preference to work in a full-time (40 hour per week) position at $25 per hour and replace 25 hours of home duties widi an additional 20 hours of employment plus an additional five hours travelling time and $25 in travel costs. Under current tax arrangements and rates, die second adult would receive a weekly income of $1,000 per week, and die household gross income rises to $2,500 per week. However, $300 — 50 per cent of die additional gross income — would now be spent on outside home help. And after paying additional tax of $230 and $25 in travel costs, die second adult would have only an additional $45, or a net of $2.25 per additional hour worked, as a reward for an additional $600 contribution to national economic activity.

The decision of die second adult to seek additional employment as oudined above increases measured national income to $2,800 from $ 1,900 if die value of unpaid household help is excluded from national income. If die value of unpaid household help is included, die increase in national income is less, widi a rise to $3,268 from $2,668. An increase in national income in our example of between 47 per cent and 22 per cent results in an increase in household disposable income of only 3.7 per cent. An exceptionally high marginal tax rate resulting from die current tax treatment of household help is evident in diis example.

The economic incentives resulting from die tax deductibility of home help are substantial. Taking die previous example, if diese services were tax deductible, net disposable household income (after tax, additional travel costs and household help)

258 Non-Agenda

would increase by $180 rather than the $45 per week previously achieved. The implied marginal ‘tax’ rate (alter PAYE tax, external costs of home help and additional travel costs) in relation to die extra $600 per week earned by die second adult falls from 92.5 per cent to 76 per cent.

Economic Efficiency

The foregoing example shows how die Lax system discourages die use of existing human capital by die artificial separation of home duties and traditional paid work. The loss of economic acdvity results from a reduction in die specialisation of labour as well-qualified persons are encouraged to devote too high a proportion of dieir time to household duties. At die same time, employment opportunities are reduced for diose persons who have a comparative advantage in performing home duties.

It should be noted diat not all home dudes are easily provided by external suppliers. While some mundane dudes (it is asserted diat certain tasks such as cleaning and ironing are regarded as mundane by many Australians) are readily supplied by external suppliers, odier services are less readily provided by external suppliers. Acdvides including interacdon widi children and gardening are often seen as providing noil-pecuniary benefits which would militate against die subsdtu- don of outside suppliers for supply from widiin die household. The subsdtutability of internal radier dian external provision of household help will dierefore vary gready between households and, for pardcular services, widiin each household.

Of interest to die government is die impact on measured levels of economic acdvity. To gain tax deducdbility it would be necessary for providers of household services to be taxed. These providers would also, dierefore, have dieir economic acdvity measured as part of nadonal income. Governments could expect economic growdi to appear to increase lor a period as households and household-help providers adapted to die new tax regime. This increase would be addidonal to die ‘real’ increase in nadonal income resuldng from die proposed policy.

The argument for tax-deducdble home help largely relates to die issue of whedier a fuller measure of die economic costs of engaging in die workforce should be recognised widiin die tax system. There may be a trade-off between die benefits of increased efficiency widiin die labour market and die impact of higher tax rates if die policy resulted in lower tax revenue. However, it is not clear diat overall tax revenue would fall following die introducdon of die proposed new category of tax deducdon.

Tax Revenue and Government Expenditure

The impact on tax revenue of making home help tax deducdble is ambiguous. Tax revenue would fall in situations where current use of home help remained at similar levels. This is because die marginal tax rates of diose employing household help are generally higher dian diose delivering household services. As well, much home help is provided on a cash basis, widi a subsequent loss of tax revenue to die gov-

Non-Agenda 259

eminent. Tax revenue would increase by the extent to which home-service providers were brought into the tax system by the proposed policy. Better compliance in relation to social security payments might also be achieved. Tax revenue would be increased, and social security payments would be reduced, to the extent that die proposed policy created additional employment.

In die above example, die tax revenue increases if home help is made tax deductible. For die household, income tax is $584 in die initial situation, notionally $814 after expanded work hours widiout tax deductibility for home help, and $677 after tax deductibility. In addition, tax is paid by die home help provider.

Household help could be tax deductible at die marginal rates of tax of die employers; alternatively, a tax rebate could be made available at a fixed tax rate. As die objective of die policy is very much to improve economic efficiency (by encouraging diose widi die greatest earning capacity to work more hours in dieir most productive activity), tax deductibility is preferable to a tax rebate.

Social Impact

The social impact of making household help tax deductible would depend on die extent to which Australians took advantage of die opportunity. The potential positive social impacts would include:

• offering a wider range of employment opportunities to diose currendy facing reduced employment opportunities because of factors like structural adjustment, lack of skills or employer bias against mature workers ;

• encouraging a mixing of social groups and diereby demonstrating die belief its of education and vocational skills;

• providing parents widi high professional time demands widi increased quality time widi children or die opportunity to pursue odier leisure activities;

• providing opportunities for professionally trained women to pursue a more satisfying career at higher levels dian might odierwise be possible;

• allowing women from lower-income families to gain additional income dirough work which by its nature often allows flexibility in working hours to fit in widi dieir household responsibilities; and

• providing diose caring for invalids widi die opportunity to afford to mix external employment widi caring and diereby achieving a more satisfying lifestyle.

Are diere any potential social disadvantages? It might be argued diat die proposed policy might see a return to social stratification between servant classes and diose widi households. Whedier diis style of stratification is likely to occur within die Australian community is debatable. It could also be argued diat children may be disadvantaged if modiers are encouraged to become more involved in die workforce. This latter argument is die subject of an unresolved debate widiin anodier discipline.

260 Non-Agenda

Conclusion

The idea of tax deductibility for household help is put forward as a means o f improving die economic efficiency of die Australian economy. W hile die foregoing exercise represents only a first assessment o f die proposal, it appears to lead to a higher nadonal income and better use of die human capital diat die community has invested in over past years. It also has die capacity to solve part o f die problem resulting from die disparate impact o f structural adjustment on certain groups within die labour market. The proposal would provide greatest benefit to women and has die potendal to lead to odier social benefits.

Summary of household simulation

Scenario 1 Scenario 2 Scenario 3Household total paid work hours 70 90 90Household total unpaid domestic work hours

64 44 44

Household total paid domestic work hours 0 20 20Household total gross income per week ($) 1,900 2,500 2,500Household total tax per week ($) 584 813 677Household total net income per week ($) 1,316 1,361* 1,498*Contribution to national Income WITHOUT unpaid household work ($)

1,900 2,800 2,800

Contribution to national income WITH unpaid household work ($)

2,668 3,268 3,268

*Less tax, additional travelling expenses and cost of household help

Scenario 1• Principal income earner 50 hpw paid work and 12 hpw in unpaid domestic work.• Secondary income earner 20 hpw in paid work and 52 hpw in unpaid domestic work.

Scenario 2• Principal income earner 50 hpw paid work and 12 hpw in unpaid domestic work.• Secondary income earner 40 hpw in paid work and 32 hpw in unpaid domestic work.• Third party employed for 20 hpw in paid household work.• No tax exemption.

Scenario 3• Principal income earner 50 hpw paid work and 12 hpw in unpaid domestic work.• Secondary income earner 40 hpw in paid work and 32 hpw in unpaid domestic work.• Third party employed for 20 hpw in paid household work.• Tax exemption.

ReferencesAustralian Bureau o f Statistics (ABS) (various), The Labour Loire Australia, AGPS, Canberra (CaL

No. 6203.0).

• (1990), Household Expendituie Survey Austialia: Detailed Expendituie Items, AGPS, Canberra (CaL No. 6535.0).

Non-Agenda 261

Realising a Minimal State: The Case of Afghanistan

William Maley

W N recent times a great deal of scholarly effort has been invested in tracing the I contours of ‘weak’, ‘failed’, or ‘collapsed’ states such as Somalia, Mozambique,

JL .and Afghanistan. From the grim pictures of a realised Hobbesian state of nature which diese discussions paint, a dose o f‘state building’ might seem exacdy what these countries require to overcome dieir problems. Yet die obliteradon of elements of die state may prove to be a silver lining in dark clouds. In particular, while Afghanistan’s route to die minimal state passed dirough Hell, its prospects for recovering from nearly 18 years of savage conflict may be better dian many commentators are prepared to concede.

The Impact of Communism

The Afghan state before die communist coup of April 1978 was weak, but ubiquitous and corrupt. It had developed into a ‘rentier state’ in which foreign aid and indirect taxes were used to fund a burgeoning bureaucracy. This had die effect of making die state, as one observer put it, ‘independent of its citizens, urban or rural’ (Shahrani, 1986:59). Statist policies produced a How of university graduates who aspired to secure state employment and became increasingly alienated as die drying- up of foreign aid made such positions harder to obtain, at least on die basis of merit radier dian connections.

The results of die 1978 coup are by now all too well known. The new communist regime attempted to enforce social transformation on a scale which far exceeded eidier die wishes of die population or die resources of die state, and met widi almost immediate resistance. Fragmentation in die regime and a real risk diat it would be overdirown triggered a full-scale invasion by die Soviet Union in December 1979. As a result, die Afghan state substantially disintegrated; its domestic revenue sources evaporated, and it depended significandy on Soviet subventions, togedier widi inflation and sales of natural gas, to fund its core activities. Widi die cessation of Soviet aid f rom die beginning of 1992, die regime’s crisis of legitimacy came to a head, and widiin four mondis it had collapsed. Since dien, die country has been fragmented on geographical lines between different forces.

The scale of damage to die Afghan economy during die years of war was staggering. Agricultural output in 1986 stood at less dian half of its 1978 level (SCA, 1988:4), and infrastructure was particularly targeted by Soviet forces: by 1993, approximately 60 per cent of Afghan schools had no buildings (UNO/ESSP Research

William Maley is Senior Lecturer in Politics, University College, The University o f New South Wales, Canberra.

262 Non-Agenda

and Planning, 1994, Vol.I:18). Over 2,300 minefields littered the countryside (MCPA, 1993, Vol.I:l). Transport networks, vital in expanding markets and economies of scale, were severely disrupted, and human capital formation was blocked by die displacement of millions of Afghan refugees (Maley, 1990).

Nonedieless, die Afghan economy has proved more robust dian many might have expected, despite die sharp decline of Western interest in Afghanistan widi the end of die Cold War. The collapse of die communist regime prompted die largest and fastest spontaneous repatriadon of refugees in die history of die Office of the United Nations High Commissioner for Refugees, and diis occurred widiout star- vadon resulting. Furthermore, much of die country has been a hive ol reconstruction activity, belying die image of chaos and turmoil too often presented in die popular press (Maley & Saikal, 1995). While it would be perilous to take too sanguine a view of Afghanistan’s prospects — it remains one of die world’s poorest countries, and performs lamentably when assessed according to standard indices of development such as infant mortality and adult literacy — a number of factors give grounds for guarded optimism.

Grounds for Optimism

First, die state has been reduced almost to die level of night watchman — as I discovered when assisted by die police after a puncture had left me in die streets during die hours of curfew in Kabul in May 1995. While strong enough to confront its armed opponents on die batdelield, it lacks die means to extract resources from its subjects for die personal benefit of die rulers. Furdiermore, die collapse of die state has also fractured die rent-seeking coalitions of state officials and local notables which often made peasants’ lives a misery and prompted diem to seek the protection of benevolent local khans. This has created space for new approaches to economic activity in rural areas, notably die emergence of collectives of notables to manage die local implementation of reconstruction projects, at which a number have proved to be adept.

Second, die Afghan private sector has shown itself to be extraordinarily resilient. It has supplied means of transport for repatriating refugees; it feeds die bulk of die population; it has created most of die jobs. Agricultural activity in particular has revived surprisingly fast: seed quality has risen; fertiliser and farm power are more readily available; diere have been increases bodi in yields and in area cultivated of traditional grain crops; and, in 1993, no fewer dian 31 per cent of farmers surveyed by die SCA (1994:ii, v) had hired tractors to use in dieir work. Furdiermore, a number of Afghan businessmen have recendy returned to Kabul from Europe and America widi highly developed commercial skills and a willingness to invest in die country’s future. Visitors to Afghanistan are invariably struck by die vitality of small business, in which many returnees seek employment. While banking services of die traditional Western variety are nowhere to be found, and Afghan currency is printed under contract in Russia, diere is a highly competitive foreign exchange market (located in a field in nordi Kabul) populated by traders clutching Afghan

Non-Agenda 263

money who adjust their exchange rates to take account of variations in economic circumstances and die political climate.

One of die main reasons for die relatively successful revival ot private initiative is diat die Islamic faith, to which die overwhelming majority of Afghans adhere, continues to provide a framework of rules widiin which contracts are made. This in turn serves as a vital underpinning of die market order, which can exist only widiin a framework of rules establishing property rights and institutions of reciprocal obligation. Powerful social sanctions punish diose who are dishonest in die commercial sphere, and die kind of criminality diat has afflicted post-communist societies in Europe and even die secularised republics of Central Asia has not affected Afghanistan on anydiing like die same scale.

Third, Afghanistan has benefited from an infusion of skills associated widi die involvement for more dian a decade of non-governmental organisations (NGOs) in efforts to assist refugees in Pakistan, and to establish projects to sustain communities widiin Afghanistan. While diere have been problems associated widi die sudden arrival of NGO assistance, notably adverse effects in some cases on community cohesion and independence (Jawad, 1992; Leslie, 1995), die overall effects of NGOs have been distincdy positive. There is now a cohort of energetic Afghans who appreciate die expectations of bodi foreign aid donors and foreign business, and approach reconstruction tasks from an organic radier dian mechanistic perspective, in stark contrast to some of die international agencies widi which diey come into contact. An offshoot of tliis development has been a proliferation of Afghan NGOs, and while a large number of diese are no more dian fly-by-night business firms, derisorily labelled ‘briefcase NGOs’ (Dupree, 1994:21) some have proved extremely effective.

This has led to die emergence of die Afghan ‘Quango’. One of die grimmer elements of die present rulers’ heritage has been a dispirited bureaucracy of risk- averse, rule-obsessed clerks whose interests stretch no furdier dian die regular collection of dieir salaries. While die temptation to invite diem to seek odier employment must have been strong, die political costs of doing so could have been considerable. As a result, diey have simply been bypassed, and new organisations, nominally private but operating widi die blessings of die state and exploiting high- level access to leading regime figures, have emerged to discharge what might ordinarily be regarded as state functions, such as care of die indigent. Notable among diese are die Social Volunteers Association of Afghanistan and die Office for Administrative and Economical Development of Afghanistan. Whedier diis will prove more dian a transient phenomenon is difficult to tell, but it offers a route by which to avoid some of die more exasperating attributes of Third World state administrations, such as a preoccupation widi process radier dian outcomes.

Prospects

Whedier Afghanistan will be able to resist die temptation to press for a larger and more intrusive state remains problematical, because of pressures originating in die wider international system. The weakness of die state, togedier widi opportunities

264 Non-Agenda

for profit, have led Afghanistan to become one of die world’s largest opium producers. This has exposed the Afghan government to significant, if maladroit, sanctions. In March 1995, the United States banned the supply of official nonhumanitarian aid to Afghanistan, on the grounds that the Afghan government had not taken ‘adequate steps’ to meet the goals of the 1988 UN Convention on Drug Trafficking. This was superficially true — but only because die Afghan government had been preoccupied for much of 1994 widi rocket attacks on Kabul by an opponent identified in 1989 as die likely owner of die world’s largest heroin factory, whose weaponry had been substantially funded by die US during die 1980s, and widi whom as late as June 1995 die US ambassador to Pakistan contrived to meet.

Afghanistan’s neighbours pose anodier problem. As a distinguished Afghan journalist remarked to me, while a minimal state may be ideal for economic reconstruction, it also facilitates attempts by Pakistan, Uzbekistan and Iran to seek to dominate Afghanistan in pursuit of dieir own ideological, economic and security interests. The fall of die city of Herat, a model of laissez-fkire reconstruction, to a Pakistan-backed coalition of dieology students in September 1995 unfortunately showed diis to be a real danger (Maley, 1995). Ultimately it is politics, not economics, which poses die greatest obstacle to realising die minimal state.

ReferencesDupree, N. (1994), ‘Afghan Initiatives’, Refugees 3: 20-1.

Jawad, N. (1992), Afghanistan: A Nation o f Minorities, Minority Rights Group, London.

Leslie, J. (1995), ‘Towards Rehabilitation: Building Trust in Afghanistan’, Disaster Prevention and Management 4(1): 27-31.

Maley, W. (1990), ‘Afghan Refugees: From Diaspora to Repatriation’, pp. 17-44 in A. Saikal (ed.), Refugees in the M odem World, Department of International Relations, Research School of Pacific Studies, Australian National University, Canberra.

------ (1995), ‘Afghan plan pure folly for Pakistan’, The Canberra Times, 11 September.

------ & F. H. Saikal (1995), ‘Post-Communist Afghanistan: Mydis and Realities’, Quadrant 39(5): 59-64.

Mine Clearance Planning Agency (MCPA) (1993), Report o f die National Survey o f Mines Situation, Peshawar, Vols.I-II.

Shahrani, M. (1986), ‘State Building and Social Fragmentation in Afghanistan: A Historical Perspective’, pp.23-74 in A. Banuazizi & M. Weiner (eds), The Slate, Religion, and Ethnic Politics: A fghanistan, Iran, and Pakistan, Syracuse University Press, Syracuse.

Swedish Committee for Afghanistan (SCA) (1988), The Agricultuial Su/vey o f Afghanistan: First Report, Peshawar.

------ (1994), The Agiicultural Survey o f Afghanistan: Nineteenth Report, Peshawar.

UNO/ESSP Research and Planning (1994), The Status o f Education in Afjghanistan, Peshawar, Vols.I-II.

agenda, volume 3, number 2, 1996...agenda, volume 3, number 2, 1996, pages 135-142 liberalising...

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