Wednesday, November 14, 2007


Talk to Australian Business Economists Annual Forecasting Conference, Sydney, November 14, 2007

One reason I’m invited to speak on the political and economic outlook each year is that I can’t do so without making some political predictions and, since I normally leave the economic forecasting to business economists, this is their chance to get their own back and have a laugh at my expense when, inevitably, some of my predictions prove badly astray. This year you’ve really set me up, holding your forecasting conference just 10 days before a very heavily contested federal election campaign.

But, like a good journalist with an eye to a good read, I’m going to lead with my chin and take my chances. I confidently predict Kevin Rudd will win comfortably and we’ll see a change of government. I don’t believe Labor’s win will be narrow. Hesitant people are always predicting elections that ‘go down to the wire’ but, actually, such close calls are not common. Landslides are more common. Nor do I believe in trying to predict the outcomes of elections by counting the particular seats likely to be won or lost. There’s an old saying that, if the swing is on, it’s on. If the swing is on, the necessary seats will come - but not necessarily those the Mackerras pendulum says should come. It’s like being asked where the jobs will come from in a recovery. When you’ve been around for a while, you learn not to make detailed predictions, just to be confident they’ll come from somewhere. I always reply, ask me again in a few years time and I’ll look up the figures for you.

Defeated Liberals’ dire prospects

Almost everything that follows will be based on the assumption of a Labor win. That’s mainly because pondering what life would be like under a Rudd government is the more interesting and potentially useful thing I could do. Life under a re-elected Liberal government - possibly without John Howard - would be little changed. Peter Costello’s accession to the leadership - either immediately or after a year or so - is undoubted. His two main rivals - Tony Abbott and Malcolm Turnbull - have both had most unimpressive campaigns. Even so, Costello will survive one term at best. His chances of ever making it back into government are zilch. Being out of office in every state and territory as well as federally will leave the Libs in a terribly weakened and demoralised state, susceptible to much infighting. It will take them years to recover. Business will swing all its focus onto trying to influence and ingratiate itself with the Rudd government. Even so, the election of a Labor government at the federal level is the necessarily first step towards breaking Labor’s stranglehold at the state level. The Australian voters’ penchant for having an each-way bet at the federal and state levels is a potent force. The election of a few Liberal state governments will be a most healthy development and I look forward to the day, sorry only that it didn’t start last March with the defeat of the Iemma government.

Why Rudd will win

If I’m right in predicting a Rudd win, the central question is why Howard was defeated at time when the economy was positively booming. It’s true that - leaving aside the Left’s regiment of Howard Haters - the public has not developed a dislike of Howard comparable to its loathing of Gough Whitlam or Paul Keating. I think it’s mainly the It’s Time factor. Howard is looking old and wizened - televising his morning walks doesn’t do him any favours - whereas Rudd is young, good looking, obviously intelligent, well-spoken and capable of behaving with dignity on public occasions with presidents and the Queen. Equally importantly, unlike Howard - whose voice and visage we’ve grown tired of after his three decades in public life - Rudd has no track record. No list of broken promises to his name. It’s important to understand that the flip side of cynicism is naivety and the electorate regularly flip-flops from one to the other. In short, Rudd’s new face makes him someone in whom hope can spring eternal.

This election campaign is about personalities, not policies. Rudd keeps saying he stands for ‘fresh ideas’. What is the fresh idea? It’s Kevin Rudd. He’s sold himself as a younger John Howard and that’s what the public has been happy to buy. Rudd represents a change (which is nice) without change (which isn’t). So the electorate’s switch from Howard to Rudd is the ultimate act of consumerism: we’ve simply traded Howard in on the new model.

But I don’t think it’s quite as superficial as that. I think Howard has suffered a significant erosion of his credibility in the eyes of the electorate. With his non-core promises, his weapons of mass destruction, his children overboard, his Tampa, his mistreatment of David Hicks, his AWB scandal and his promise to keep interest rates at record lows, he’s led us up the garden path one too many times. Every time Howard got caught misleading us, his minders would assure the press gallery that the public didn’t really care. Case by case, that was true. But after 11 years of misbehaviour, all those cases leave a cumulative distaste in the electorate’s mouth. At the time of the sudden discovery of an Aboriginal national emergency in the Northern Territory, I was struck when I heard John Laws ask his listeners whether this was Howard ‘doing a Tampa’. I’m sure that, at the time of the Tampa, neither Laws nor any of his listeners thought Howard was merely pulling on a stunt to help him win an election. At this remove, however, Laws was sure his listeners would know that ‘doing a Tampa’ meant. With Howard’s loss of credibility, the public stopped listening to him, just as they stopped listen to Keating in 1996.

The other point to make in explaining the switch to Rudd is that one policy really did affect a lot of votes: Work Choices. It worries workers who perceive themselves to have little personal bargaining power and others who worry their children may be adversely affected. There’s circumstantial support for this proposition in the big swings to Labor among young people and women. In any case, Howard tacitly acknowledged Work Choices was hurting electorally with his major watering down of the policy and reintroduction of a fairness test, the attempt to abandon the name Work Choices and the huge advertising campaign. But this backdown has come too late to register on the public’s consciousness. I’ll bet Howard lies awake a night wishing he’d never touched Work Choices.

Me tooism

One of the most widely remarked features of this campaign is the way Rudd has said ‘me too’ to so many of the Government’s policies. But though this may be the most extreme example we’ve seen, it’s by no means the first. As you recall, Howard tried to make himself a ‘small target’ when he beat Keating in 1996. He promised ‘never ever’ to introduce a GST, abandoned a lifetime of opposition to Medicare and played down any plans he had to reform industrial relations. Me tooism is a strategy that appeals to oppositions. In any argument over policy, government’s have an inbuilt advantage because they enjoy the authority of office. It’s the government that’s best able to introduce policies it hopes will ‘wedge’ its opponents, dividing them internally. Howard wedged Labor so successfully over the years that it has learnt to protect itself by instantaneously agreeing to every policy Howard proposes.

But me tooism is best seen as one way of competing, with clues to what’s happening coming from Hotelling’s law. Labor has sought to make its product indistinguishable from the Liberals’ in areas where the Libs are perceived by voters to be more capable (such as the economy, defence and security), but sought to differentiate its product in areas where Labor’s perceived to be more capable (education, health, the environment and industrial relations). So Labor has not said me too in these areas, but has sought to focus the election debate upon them. But me too is a game for both sides. Consider all the respects in which Howard sought to narrow the gap with Labor because he was fighting on Labor territory and wanted to shift debate back to his own territory: he has heavily modified Work Choices by restoring a safety-net, completely reversed his scepticism on climate change and opposition to an emissions trading scheme, suddenly discovered a belief in symbolic reconciliation, gone cold on nuclear power and stumped up big bucks for water, tertiary education, hospitals and child care.

What kind of a man is Rudd?

Australian election campaigns have become more presidential and so have the day-to-day operations of government - that is, more centred on the personality and preferences of the prime minister. That’s been true of Howard; it will be truer of Rudd. The Libs have always been a leader-calls-the-shots party, whereas Labor has been more democratic, with caucus having the final say. Rudd seems more self-willed in the style of a Liberal prime minister, as revealed by his unilateral announcement that he, not caucus, will decide who gets into cabinet. The question is whether, once Labor is safely back into government, the rest of the parliamentary party is still willing to stifle their differing preferences in the way they have been in their efforts to defeat the cleverest politician of our age, John Howard. My guess is they won’t be, and that Rudd will face a fair bit of internal dissent.

With all of Rudd’s me tooing, there is a suspicion in many people’s minds that, once he’s installed, he’ll be revealed to be something other than he presented himself as before the election. Liberal supporters fear he’ll reveal himself as a closet socialist; Labor supporters hope he’ll reveal himself as any kind of socialist. I suspect both sides will be surprised - that, with Rudd, what you see is what you get. He really is just the younger version of John Howard he’s portrayed himself as. I believe he’s a very conservative man, with views on foreign affairs, defence, national security and terrorism that are little distinguishable from Howard’s (even on Iraq), and views on economic issues that aren’t far from Howard’s, either. Despite the Libs laughable attempt to portray him as a tool of the union movement (like Bob Hawke was, d’ya mean?) and imaginary claim that he would return us to centralised wage-fixing, the changes he’ll make to the now heavily modified Work Choices are quite cautious.

I suspect Rudd is big on tactics, but weak on strategy. You can see that in his decision to adopt 90 per cent of Howard’s tax cuts. As a political tactic, this was smart: he knew the Libs’ advantage on taxation meant he couldn’t win a comparison of rival tax cuts, so by matching the Libs he removed taxation as an election issue. As a strategy, however, it left much to be desired. He claimed that the hugely expensive areas education and health were his highest priorities but, at the first opportunity to spend $31 billion on cutting tax rather than fixing education and health, he seized it. Nor was he prepared to use a refusal to match Howard’s tax cut to demonstrate his superior credentials as an economic manager and economic conservative.

Rudd is highly ambitious and I suspect his ambition outweighs his commitment to Labor values. If so, he’ll be good at winning elections, but not at knowing why he wants to win apart from the obvious. He’ll survive for a long time, but achieve surprisingly little. He’s not a class warrior nor highly ideological, but he is a control freak, who looks set to expand the role of his own department. He’s self-willed, a tough boss, a hard worker and a detail-man.

Rudd as an economic manager and reformer

This is not a good election to win. The longstanding pattern is for federal governments to be tossed out only after they’ve presided over a recession. That’s true of the Whitlam, Fraser and Hawke/Keating governments. But the Howard government will be the exception to the rule: it presided over 11 years of strong economic growth, low inflation and falling unemployment, all the time grinding into the public’s consciousness its claim that Labor was a hopeless economic manager. The Rudd government is unlikely to be as lucky as the Howard government. With the expansion phase now in its 17th year, the chances of recession occurring some time in the next three years would have to be high. And in the meantime, of course, the Reserve will be grappling with a runaway economy, possibly raising rates a fair bit further. So there’s a fair chance the Howard government will go down in history as an exemplary economic manager, whereas Labor’s reputation as hopeless economic manager will be confirmed for a generation. Added to this we have a government that said me too to pretty much all of the Howard government’s now clearly inappropriate three years of tax cuts and general spending spree. It’s standard practice for incoming governments to use their first budget to change the direction of their pre-election rhetoric and also clean out a lot of the favourite spending programs of their predecessors. Labor has announced spending cuts it says are worth $3 billion and also made noises about establishing a razor gang. The press gallery has treated these announcements with scepticism; if it knew a bit more economic history it wouldn’t.

I think that when economists look back on the economic record of the Howard government they’ll conclude it had such good luck it didn’t have to try very hard and, in fact, didn’t try very hard. They spent so long telling us what good managers they were they came to believe their own bulldust. Paradoxically, Labor’s reputation as a hopeless economic manager means it knows it must always try hard on economic policy if it wants to survive in government. Similarly, when you’re a Liberal you can afford to take the business community for granted, but when you’re Labor you always have something to prove. Rudd Labor will be seeking legitimacy and will try hard to establish good relations with business. Labor is likely to listen more closely to Treasury, and Treasury stands a good chance of giving Rudd and Wayne Swan something to believe in and fight for, just as it did Keating. Between Treasury and Professor Ross Garnaut, I expect Labor’s implementation of the tradable emissions regime to be quite sensibly done. It wouldn’t be realistic to expect a Rudd government to be as committed to micro reform as Treasurer Keating was - the days of continuous reform are gone - but I do think there’s a good change it will be more interested in reform than the Howard government was.

Labor will not, of course, have control of the Senate. But nor are the Libs likely to retain control - certainly not after the new senators take their places in July. The balance of power is likely to be held by the Greens, which raises a novel circumstance. In the past, having the Australian Democrats holding the balance of power acted as a brake on Labor implementing some of its more radical policies, probably no bad thing. But now with the Greens in may be that Labor has to make some of its policies more radical to get them through.

Observations on monetary policy

Over the past couple of years the Reserve Bank has developed a clear modus operandi in which it waits for the quarterly CPI release, revises its inflation forecast on the basis of the new information and then adjusts the stance of policy if necessary at the board meeting about two weeks later. This says rates are most likely to be adjusted at the February, May, August and November meetings. This established MO has many attractions for the Reserve. For a start, the timing of the quarterly Statement on Monetary Policy has been adjusted to come soon after those board meetings and also come shortly before the half-yearly appearances before the parliamentary committee. This means that, whether or not the board decides to move, only a few days pass before the Reserve is able to provide a highly detailed exposition of its reasoning. A late draft of the SoMP would be available at the time of the meeting. It’s always difficult for central bankers to make a detailed public statement - or worse, be subjected to detailed public questioning by their parliamentary masters - when the case for a rate change has become apparent, but before they’ve had a chance to put it into effect. They always want to be in a position to assert that, in present circumstances, the current policy setting is ‘about right’. So the beauty of this alignment of meeting, SoMP and hearing is that it maximises the chance of the central bankers been able to report publicly after they’ve acted, not before.

Another advantage of this MO is that it focuses attention on inflation and the prospects for inflation. Rate rises are never popular, but neither is inflation, and this alignment - acting so soon after the release of the CPI - highlights the Reserve’s justification for its unpopular action. When you’re trying to control inflation expectations, it’s important to keep reminding the public that you’re obsessive about controlling actual inflation and about achieving your target. But it’s worth remembering - as we were reminded by Glenn Stevens’s statement last week - that while inflation is the end result we’re worried about, it’s excessive growth that’s the cause of the result, so it’s growth that interest rates work on to get to the result. A simple point, but one the politicians were happy to dissemble in the election campaign, with their eulogising of growth in one breath and their pious expressions of concern about inflation in the next.

A further advantage of this MO is that it makes it easier for the financial markets and business economists to form more accurate expectations about future rate movements. It’s a very clear signalling device. The Reserve has nothing to gain and a little to lose by catching the markets out. The downside of catching the market with its rates down is that it makes embarrassed economists more likely to want to cover their embarrassment by arguing that the rate rise is unjustified. It’s a mistake to imagine that being an independent central banks means you can do as you please. In a democracy, no public institution can do as it pleases. If it becomes too unpopular, eventually it will have its wings clipped. The consequence is that independent central banks have to do their own worrying about politics. And one consequence of this is that, when you’re doing unpopular things like raising rates, it helps to have a chorus of market and business experts calling for and predicting a rate rise, thereby giving the rise an air of legitimacy as well as softening people up.

Finally, when you’re tightening rates in a heavily indebted economy, this MO allows you to proceed cautiously, responding to the flow of incoming evidence as you go ever higher - something that’s important if you believe, as most central bankers seem to, that rate rises aren’t linear. That eventually you hit a point where the penny drops and behaviour really starts to change.

But there are a couple of qualifications to be made to this happy story. First, making one potential move a quarter is fine provided it allows you to move fast enough. It may not. As you know, the Reserve probably would have tighten at its September meeting after seeing the June quarter national accounts, had it not been for the sub-prime turmoil. Second, this as an MO for a tightening cycle. It doesn’t make as much sense for an easing cycle - rate cuts are never unpopular - and, particularly if you thought the economy was slowing sharply, you might want to move a lot faster than once a quarter. The moral of the story is that, no matter how entrenched the quarterly MO becomes, the Reserve with always reserve the right to make changes in other months if it judges that to be necessary. Were that to happen and were you to be caught out, there’d be no point feeling aggrieved and claiming the bank had broken an unwritten convention. This MO will last only as long as it suits the Reserve.

Looking to next year, some economists think they can see two, even three more rate rises coming. They may prove right but, if you’re in this camp, just remember that you’re making a pure forecast. That is, you’re getting ahead of the game. The Reserve has no game plan that calls for two or three more rises. While it clearly has a bias to tighten, it will take things a month at a time, responding to the data as it rolls in. That data includes the national accounts and the labour price index, not just the CPI, of course. Remember, too, that the need for further rises in the cash rate will be affected by the likelihood of the major banks instituting a mortgage rate rise of their own and by the possibility of a further slowing in the world economy, particularly the Asian end of it.


Friday, October 19, 2007


Public Lecture in Economic and Social Policy, University of Wollongong, Friday, October 19, 2007

I could today say something terribly polite and complimentary about economics, but instead I want to keep you awake by saying something a little thought provoking and challenging to the economic orthodoxy, influenced by some of the reading Ive been doing lately, particularly a most interesting book by Avner Offer, a professor of economic history at Oxford, called The Challenge of Affluence.

As many of you know, the overriding goal of conventional economics – specifically, microeconomics – is to help the community deal with the problem of scarcity – the fact that the physical resources available to us are finite, whereas our wants are infinite. Theres any amount of goods and services wed like to consume, but the wherewithal to produce those goods and services is strictly limited. So micro economists see their role as to advise the community on ways to stretch those limited resources further, to help us get more bang for our buck. This explains economists obsession with efficiency, because its by using resources more efficiently that we can stretch them further. Economists seek to promote more efficiency in the sense of greater economy in the use of resources, the reduction of waste and the discovery of better ways to do things, but also in the sense of more efficiently allocating resources to that particular combination of goods and services the community values most highly. If you think about the push for microeconomic reform that weve seen economists successfully urging on governments for the past 25 years, its been all about using increased efficiency to raise the communitys material standard of living.

But Offer and others have advanced an interesting proposition: that the developed market economies attack on the problem of scarcity over the time since the industrial revolution has been so remarkably successful that weve actually defeated the problem of scarcity and replaced it with a different problem, the problem of abundance. Now, technically, for an economist to say that a resource is scarce is merely to say that it can only be obtained by paying a price, that its not so abundantly available as to be free. Clearly, in that technical sense, the problem of scarcity is still with us.

But, in the broader sense, its hard to deny that the citizens of the developed world live lives of great abundance. Our material standard of living has doubled or trebled since 1950 and has multiplied many times over since the start of the industrial revolution in the mid-1700s. No one in the developed world is fighting for subsistence; even the relatively poor among us are doing well compared with the poor of Asia or Africa; we satisfied our basic needs for food, clothing and shelter a mighty long time ago; our real incomes grow by a percent or two almost every year, and each year we move a little higher on the hog. Our greater affluence can be seen in our ability to limit the size of our families, in the growth in the size and opulence of our homes, the fancy foreign cars we drive, our clothes, the private schools we send our children to, the restaurants we eat in and the plasma TVs, DVDs, video recorders, personal computers, mobile phones, stereo systems, movie cameras, play stations and myriad other gadgets our homes teem with.

How has this unprecedented and widespread affluence come about? Its the product of the success of the market system and even of the sound advice of the economists in identifying ways to fine-tune that system. But above all its the product of all the technological advance – the invention and innovation – the capitalist system is so good at encouraging. Malthuss dismal prediction in the late 1700s that the growth in the population would outrun the growth in food production was soon disproved.

It's therefore reasonable to say that, when we look around us, what we see is not scarcity but abundance. This is something to be celebrated. But, as with everything in life, no blessing is unalloyed. Every good thing has its drawbacks and difficulties. The first and most obvious problem with abundance is the damage the huge expansion in human activity – most of it economic activity – is doing to the natural environment. For millennia, the environment was so vast and economic activity so limited that it was easy to see the environment and the economy as completely divorced. Air and water and fish in the sea were in such abundance that economic analysis could class them as free goods and promptly ignore them. By now, however, the huge expansion in economic activity has started to overwhelm the environment. We see that everywhere around us: air pollution in cities, widespread over-fishing and the destruction of species, waste discharges leading to the degradation of waterways and beaches, the damage caused by European farming methods, the near drying up of some of our river systems, the opening of the hole in the ozone layer and, of course, global warming. All these environmental concerns are the product of the abundance of human and economic activity, a concern that didnt exist when our major concern was scarcity – our then limited success in overcoming natures impediments to the satisfaction of wants.

The next but less obvious problem with abundance is that it exacerbates humankinds difficulty achieving self-control. Thanks to their assumption of rationality, this is a problem that simply doesnt register on the conventional economists radar. You and I are assumed to know exactly what we want, to always want whats in our best interests, to have a clear idea of what the future holds, to have no difficulty balancing short-term benefits against long-term costs, and to have an iron will in being able to choose and stick to what we judge to be best for us in the long run.

In truth – and as the psychologists have demonstrated – humans have a big problem with self-control. Consider the simple example Offer quotes of the student trying to decide whether to go out tonight and have fun with her friends, or to stay home and study. To make the right decision, she must know her own preferences, and how they rank; must be confident that if she chooses to go out, she will not regret it tomorrow morning. She must know the payoffs for academic distinction, that she will like them, that she will be around to have them, that the world will have a use for her skills, that her vision of the future will not change, that some completely unforeseen factor or event will not sideline her prudent choice. In short, were always facing choices where the benefits are clear and immediate, whereas the costs are uncertain and distant. The greatest problem is our willpower to defer gratification, but its compounded by uncertainty about our own preferences and about what the future holds.

Problems of self-control are ubiquitous to daily life. The one were most conscious of these days is the temptation to eat too much. But there are many more: to get too little exercise, to smoke, to drink too much, to watch too much television, to gamble too much, to shop too much, to save too little and put too much on your credit card, to work too much at the expense of your family and other relationships.

The more stuff we have – the fewer among us whose main problem remains satisfying our basic needs – the more problems of self-control emerge as our dominant concern. But theres a deeper point: humans have never been good at self-control, but as long as we were poor and resources were scarce, our self-control problem was naturally held in check. Its when things become abundant, when we can afford to indulge so many more of our whims, when we have a huge range of things or activities to choose from, that self-control problems become more prevalent and we have trouble making ourselves choose those options that are best for us in the longer term, not just immediately gratifying.

Its worth asking a question economists dont ask because their model assumes it away: why do humans have such trouble controlling their emotional urges and behaving in a more thoughtful, far-sighted way? I think the answer lies in our evolution, specifically in the way our brains have evolved. Our brains evolved to cope with the problem of scarcity, not abundance. The older, more primitive part of our brain – the part that deals with the fight or flight response, for instance – has evolved to make an instantaneous, emotional response to cues without waiting for more information or for more evaluation of options. Its the newer, more cerebral part of our brain that cuts in later with a more careful analysis of the choices and the longer-term implications. This is the neurological dimension of the problem of abundance and it explains why its common for psychologists and others to speak of humans as having two selves: our present-self and our future-self. This is the essence of the self-control problem: finding ways to allow our future-self to have more wins over our present-self.

The highly topical and worrying problem of obesity provides an excellent example of the way the move from scarcity to abundance has exacerbated self-control problems. Humans evolved in conditions where nutrition was scarce. Our brains are therefore hardwired to eat everything that comes our way while weve got the chance, and theyre are surprisingly poor at signalling to us when weve had enough. For as long as food remained scarce – that is, relatively expensive – and work remained highly physical, there wasnt a problem. But as we triumphed over scarcity the former natural balance was lost. Technological advances in the growing, transport, storage, preservation and cooking of food greatly reduced its cost to consumers. As humans have become more time-poor, weve seen an explosion in inexpensive fast food, all of it cunningly laced with those three ingredients our brains were evolved to crave: fat, sugar and salt. Then, on the output side, weve seen technological advance strip the physical labour first out of work and then out of leisure. We dont play sport, we watch it being played and these days we dont even go to the effort of travelling to the grounds.

There's a third aspect to the problems of abundance: the increased resources devoted to the socially pointless pursuit of social status through consumption. When we have long passed the point where our basic needs for food, clothing and shelter are being satisfied, but our real incomes continue to grow by a couple of percent a year, we have to find something to do with the extra money. Partly, we spend it on superior goods – goods you want more of as you get richer – such as health and education. Thats fine. But a fair bit of the extra income is spent on positional goods – goods whose purchase is designed to demonstrate to the world our superior position in the pecking order. Everyone needs a car, but that need can be met quite adequately by a 10-year-old Toyota. When we feel we must buy a new car every few years, or when we buy an expensive imported European car, the extra we pay is commonly motivated by a conscious or unconscious desire to impress people and so constitutes a positional good. The fields in which we can use our spending to demonstrate our high social status are legion: the size, opulence and desirable location of our homes is probably the most significant instance, but theres also the clothes we wear, the clothes we put on our children, the restaurants we visit, the cars we drive, the schools we send our kids to and much else. The point here is that, from the viewpoint of the community rather than the individual, the pursuit of status is a zero-sum game: the gains of those individuals who manage to advance themselves in the pecking order are offset by the loss of status suffered by those they pass. Thus a perpetual status arms-race is socially pointless. From the perspective of society, a lot of resources are simply wasted.

So thats the case for believing that, at this late stage in our development, the problem of scarcity has been superseded by the problem abundance. This has happened without the economics profession noticing. And should the profession fail to take notice, it will go on urging on our political leaders policies that make things worse rather than better. If Im right then the economists hitherto single-minded pursuit of efficiency is inadequate at best and damaging at worst. Economists will need to add more strings to their bow, learn some new tricks. But which new tricks?

The first point to make is that, while economists have a major – perhaps the major – contribution to make in fashioning policies to reduce the conflict between economic activity and the natural environment, this is the exception to the new rule: here, their conventional approach of using greater efficiency to fight scarcity remains appropriate. The trick is that, while its the abundance of economic activity and greenhouse gas emissions that are doing so much damage to the environment, its still best to define the problem as the scarcity of water and the scarcity of low-emission-intensive goods and services. Internalising the externalities to the prices of goods and services by means of economic instruments such as pollution taxes and tradable permit schemes is the best way to achieve environmental goals with minimum economic disruption.

In the main, however, to contribute to solving the problem of abundance economists need to learn the new trick of helping people cope with their self-control problems. People know they have trouble controlling themselves, trouble allowing their future-selves to dominate their present-selves and so avoid myopic choices. The way they do this is by developing commitment strategies and commitment devices. Economists must, first, understand the need for and accept the legitimacy of commitment devices and, second, become expert in the development of such devices. This will require a small revolution in their thinking.

Commitment devices come at three levels. First, the restrictions individuals choose to impose on their own behaviour. Second, the restrictions the members of groups choose to impose on themselves by submission to group norms of acceptable behaviour. Third, the restrictions governments impose on us to remove temptation from our paths. Economists will have trouble coming to terms with each of the three levels. With self-imposed commitment devices, conventionally trained economists are tempted to regard them as irrational behaviour. I may try to limit my consumption of ice cream by keeping only one small serve in the fridge. Should I want to eat more than Ive pre-decided should be my daily limit, I have to go the shop and get it. Technically, this behaviour is inefficient and irrational: its cheaper and easier to by ice cream in bigger quantities.

With group-imposed behavioural norms, conventional economists often arent conscious of their existence or dont appreciate their value until some economic upheaval destroys them. Increased competitive pressures, for instance, can cause a breakdown in professional standards of behaviour towards clients.

With government-imposed restrictions, conventional economists assumption that individuals behave rationally – that is, always in their own best interests – leads them to disapprove of many government interventions. How could governments know better than individuals what was in those individuals best interests? Why not leave people free to choose for themselves? Short answer: because individuals know they have trouble controlling themselves and would appreciate government taking temptation out of their way. In practice, we see any amount of often quite punitive government intervention aimed at protecting both the individual and the community from the consequences of speeding on the road, excessive drinking, smoking, air and water pollution, drug use, gambling, usury and much else. Its notable that most of these impositions on our freedom were introduced without great opposition and today are quite uncontroversial. Prohibition of smoking in pubs is a recent example. Why do we accept these restrictions so readily? Because we – and the politicians who impose them – know they help us control our more myopic selves.

If economists are to help the community deal with the problem of abundance by assisting us to control ourselves theyll need to develop greater awareness and respect for group behavioural norms and also see the value the rest of us see in government-imposed solutions to our self-control difficulties. There is probably scope for a lot more carefully judged intervention, appalling though that may sound to libertarians. One obvious candidate, relevant to the obesity epidemic and more, is greater controls over advertising. Will the day come when economists are designing and advocating such interventions rather than opposing them? Psychologists know something economists dont: that rather than it taking a change in attitudes to bring about a change in behaviour, if you can use intervention to force a change in behaviour, people will then change their attitudes to fit.

As well as such coercive interventions there are less intrusive ways governments and others can change behaviour merely by changing the way choices are framed. For instance, in encouraging employees to join voluntary saving schemes, automatically enrolling them but permitting them to opt out will be far more successful than inviting them to opt in. Economists can master these behavioural tricks.

The remaining domain of self-control for us to consider is individuals imposing their own commitment devices on themselves. In his book Mindless Eating, the Cornell psychologist Brian Wansink writes that the 19th century has been called the Century of Hygiene and the 20th century the Century of Medicine. This century, he predicts, will be the Century of Behavioural Change.

Changing your personal behaviour isnt easy, but it is possible. It involves adopting better habits, which eventually become part of our unconscious selves and so become lasting. In The Happiness Hypothesis, the psychologist Jonathan Haidt says that trying to control yourself is like riding an elephant. The elephant has a mind of its own and cant just be ordered to obey. It can, however, be carefully trained and cajoled into more desirable ways.

There is work to be done here in researching the use of personal commitment devices and in educating the public about the usefulness of this approach and the effectiveness of particular devices. It maybe that this is more a role for psychologists than economists, but that really brings me to the pointy end of this lecture: will economists simply go on fighting the last war – the war against scarcity in which efficiency is the sole objective – or can they learn new tricks and help us cope with the new problem of abundance, a problem where the solutions often involve some loss of efficiency? If they cant, they may find their dominance in the provision of public policy advice being usurped by interlopers from the newer science of psychology.



Thursday, September 27, 2007


Industrial Relations Commission of NSW annual conference
September 27, 2007

I want today to give you a crash course on the strengths and weaknesses of economics, with special reference to the labour market. It occurs to me that, because of the specialised nature of your work, most of you probably already know a fair about the topic. If so, I hope you’ll find what I say reinforcing rather than boring. Let me start by saying that I don’t see myself as an economist, but rather as a journalist who writes about economics. This allows me to act as a kind of interpreter and go-between, standing between the economists and the public. I see my role as providing my readers with a critique of economics and economists, much as our theatre critics provide our readers with a critique of the latest plays. My goal is to explain and demystify economics, advising my readers on when they ought to accept the advice of economists and when they shouldn’t.

The subject matter of economics

Economics is the study of how market economies organise the production and consumption of goods and services. In other words, it deals with a very important aspect of life - all of us are consumers and most of us are producers - but only one aspect. It’s preoccupied with the practical, material aspect of life, so that if you get too preoccupied by economics - as many business people, politicians, economists and economic rationalists do - you risk neglecting or devaluing the non-material aspects of life, such as the social, the artistic and the spiritual.

Macro-economics is concerned with seeking to manage or guide the overall, national economy as it moves through the ups and downs of the business cycle. The managers of the economy use various instruments to stabilise demand, holding it back when the economy is growing strongly and threatening to worsen inflation, but boosting demand when the economy’s growth is weak and unemployment is high or rising. The object of demand management is simply to reduce the amplitude of the cycle, pulling down the peaks and filling in the troughs, thereby keeping both inflation and unemployment low. Historically, the main instrument used to manage demand was the budget (known as fiscal policy). But for the past 20 years or so the dominant instrument has been the manipulation of interest rates by the now-independent Reserve Bank (known as monetary policy). The Reserve raises interest rates when it wants to discourage borrowing and spending and thus inhibit inflation pressure; it lowers rates when it wants to encourage borrowing and spending and thus hasten growth and job creation.

A primer on microeconomics

But that’s as much as I want to say about macro. Micro-economics is trickier, more interesting, more germane to our purpose and more controversial. Micro is the study of individual consumers, workers and firms using markets to produce and consume goods and services. At the heart of microeconomics is what’s called the ‘neo-classical model’ in which price is set by the interaction - and intersection - of demand on the one side and supply on the other. So conventional microeconomics is preoccupied with price; it strips away other commercial considerations so it can get to what economists regard as the heart of the matter, price. If economists wore tee-shirts, what they’d say is: Prices Make The World Go Round.

It’s the ‘price mechanism’ that economists see as bringing supply and demand - and hence markets - into equilibrium, or balance. Movements in relative prices - that is, the price of one good relative to other goods - are seen as conveying ‘signals’ to both buyers and sellers, consumers and producers. A rise in price says to producers, produce more - it’s now more profitable to be selling these things, so get cracking and make more of them. A rise in price says to consumers, buy less - look for cheaper substitutes or be more economical in your use of this stuff. Now, if a rise in price calls forth an increase in supply on the one hand, but a decrease in demand on the other, what happens? The price falls back and supply and demand settle at a new equilibrium point. Similarly, a fall in relative prices will send the opposite signals to buyers and sellers, calling forth a reduction in supply and an increase in demand which raises the price and establishes a new equilibrium. Here you see the rationale for the cry of laissez faire - the market is assumed to be a self-righting system, provided you leave it alone to do its own thing.

Another definition of economics is that it’s the study of ‘the economic problem’, which is the problem of scarcity. Scarcity arises because our resources - of land, labour and capital - are finite, whereas our wants are infinite. Scarcity in this context doesn’t mean as scarce as hen’s teeth, merely that things aren’t free - they can be acquired only at a price. Economists believe the right price for something is the price that reflects the degree of scarcity (ie the cost) of the resources embodied in it. Prices are too high when they exceed the item’s scarcity value; prices are too low when they understate the item’s scarcity value.

So microeconomics is about economists seeking to help the community grapple with its abiding material problem, the problem of scarcity, which causes many of our wants go unsatisfied. Economists’ contribution is to help the community use its finite resources in ways that allow it to satisfy the optimum quantity of wants - that is, not the maximum number of wants but the combination of wants the community most highly values. In other words, microeconomics is about helping the community get a quart out of a pint pot, get more bang for its buck. This explains the microeconomists’ preoccupation with efficiency - getting the most bang for your buck - and its close relative, improved productivity. But ‘efficiency’ is a word to which economists attach their own meanings. At one level, what economists call ‘technical efficiency’ (or sometimes productive efficiency) is about being economical in the use of resources, eliminating waste, finding better ways to do things. That’s pretty much the common meaning of efficiency. But economists are more interested in what they call ‘allocative efficiency’ - which is about making sure the community’s resources are allocated to producing that combination of goods and services that it most highly values. The market could throw up lots of different combinations, but economists want to help us strive for the combination we most highly value. While we’re at it, let me just define productivity - it’s not production, its production relative to the resources used to produce it, or output per unit of input. The most common measure of productivity is the productivity of labour - output per worker, or per hour worked.

But economists aren’t engineers or management consultants or even business people. So how do they think they can contribute to making factories more efficient or improving the overall allocation of resources? They don’t profess to know much about the detail of any of these things. But they don’t think they need to because what they understand is the power of market forces, and it’s market forces that - if you stand out of the way - will bring about improvements in technical efficiency and allocative efficiency. Firms seek continually to improve their technical efficiency because of their assumed desire to maximise their profits. Consumers, in their efforts to maximise their utility (satisfaction), unconsciously seek to maximise allocative efficiency. And firms co-operate in this, giving consumers exactly what the consumers want because that’s the way firms maximise their profits.

How do consumers and firms decide what to do? By reacting to prices and changes in prices. Prices (and remember that interest rates and wages are prices) act as incentives, and yet another definition of economics is that it’s the study of incentives. If a market isn’t as efficient as it could be, the reason is likely to be that the incentives it faces have been distorted in some way, probably by misguided government intervention. So you should reform intervention in the market (deregulate), which will increase the competitive pressure on firms in the market. Increased competition will increase the pressure on firms to improve their technical efficiency - raise their productivity - but will also oblige those firms to pass the benefits of their higher productivity on to their customers in the form of improved service or lower prices. The lower and less distorted prices - prices that more accurately reflect scarcity value - will lead to greater allocative efficiency. As I’m sure you’ve realised, what I’ve been outlining is the rationale for micro-economic reform, the goal of which is simply to use improved technical and allocative efficiency and higher productivity to increase our material living standards.

Economic rationalism

Mention of microeconomic reform brings me to explaining the difference between economists and economic rationalists. Not all economists are economic rationalists and not all economic rationalists are economists. Economic rationalists are people who take a fundamentalist attitude towards the neo-classical model that’s at the heart of conventional microeconomics. They have a simple, almost religious faith in the efficacy and applicability of the model. Most government, business and media economists and many academic economists would be happy to wear the economic rationalist label, but many academic economists wouldn’t. The latter are far too conscious of instances of ‘market failure’ and other limitations of the simple neo-classical model, whereas economic rationalists tend to think problems of market failure aren’t a big deal. The non-economists who are economic rationalists - such as the former Liberal backbencher John Hyde and the chairman of the ACCC, Graeme Samuel - tend to be libertarians and great believers in individualism, who are attracted to the certainty, logicality and simplicity of the model. It offers a simple, obvious (though not necessarily easy) answer to every problem - which is the attraction of all forms of fundamentalism.

In my experience, those mainly academic economists who specialise in the study of particular markets - such as health economists and labour economists - tend to be much more conscious of the relevance of instances of market failure to that market, whereas general economists are happy to run any particular market through their pocket neo-classical model without worrying too much about the peculiarities of that market.

This may be the place for me to observe that, in my experience, labour economists (and the related discipline of industrial relations specialists) tend to be highly factionalised. Most tend to be openly sympathetic to the union cause, though you can always find a few who defend the employer interests. I regret that it’s so hard to find knowledgeable labour economists who try to call it down the middle.

The strengths of economics

Having given you a very basic explanation of what economics and economists are on about, let me move to the critique. The first thing to say is that there’s a lot of truth and power to demand-and-supply analysis. Market forces are powerful. People do change their behaviour in response to price signals. You do see people driving the long way to avoid paying a toll, driving round to find the cheapest service station, queuing and pushing and shoving to get the best bargains at the Boxing Day sales. You do see black markets emerging where governments attempt to hold prices below the market-clearing level. You do see rent control leading to an inadequate supply of rental accommodation.

One of the useful roles economists play is to remind us of the importance of opportunity cost. Because resources are finite and can be used only once, if you use them to acquire item A, you can’t use them to acquire items B to Z. The opportunity cost of an action is the cost of the next most desirable action you must give up. It’s a pathetically simple concept, but it’s surprising how often we forget it, so economists do well when they continuously remind us to be sure we really want the things we say we want because, in choosing them, we’re giving up other things.

A related benefit of the economic way of thinking is that it encourages us to continually ask the follow-up question: but then what happens? People are always coming to wrong conclusions on economic questions because they look only at direct, first-round effects, failing to trace through the second, subsequent or indirect effects. For instance, non-economists often conclude that computerisation destroys jobs in the industry in which it’s applied. They don’t go on to ask the question: but then what happens? What happens is that the productivity of the firm’s labour improves - it can now produce more output per worker, which constitutes an increase in real income. Some of that increase may be passed on to the firm’s remaining workers in higher wages, some may be passed on to customers in lower prices (or prices that are ‘lower than they otherwise would be’) and some may be retained by the firm’s owners. The point is that, wherever the income ends up, it will be spent, and when it’s spent it will create jobs. This why economist say that new technology doesn’t destroy jobs it ‘displaces’ them, moving them from the original industry to industries elsewhere in the economy.

Now, you may say, but what if the jobs lost are for middle-aged blue-collar males in manufacturing, whereas the jobs created are more suited to white-collar women working in the service industries? Good question. I think this happened a lot as computerisation worked its way through manufacturing in the 1970s and 80s. Sometimes the problems of the individual tend to be overlooked as economists focus on generalised answers. Some would say we should have done more to help these men retrain to make them suitable for other jobs, but a hard-line economic rationalist would claim that these men would have found jobs had it been possible for the price of their labour to fall to a level low enough to reflect its now reduced value, thereby making that labour attractive to some employer.

One way to test an economic argument you’re being given is to ask whether it’s approaching the issue from the demand side or the supply side. An argument isn’t fully persuasive unless it takes account of both sides. For instance, it’s not enough to say that part-time jobs have become more prevalent over the past 30 years because it’s more efficient for a firm to employ two or three workers for a few hours on Thursday nights and Saturday mornings, rather than one worker for 40 hours a week. This is undoubtedly true and it’s a good example of the kind of things employers do to keep the productivity of labour steadily increasing from year to year. But, in the context of the labour market, it’s a demand-side explanation; it focuses on what suits the buyers of labour, employers. It’s not fully convincing until you can find a story that explains the growth in part-time work from the viewpoint of the suppliers of labour, the workers. But you can find such a story, of course: it’s not hard to believe there’s been a growth in the number of married women and full-time students who’ve been happy to take up part-time rather than full-time jobs.

The role of models

Even so, the neo-classical model often oversimplifies things and leads to mistaken analysis and wrong predictions. Just like model trains or model planes, economic models consciously simplify complex reality. They’d be of no use if they didn’t. The idea is to include and highlight the key factors and get rid of the unimportant issues that merely cloud the workings, thereby capturing the essence of what causes what. The question to ask of a model is not whether it’s left things out, but whether what it’s left out is important. And the test of that is how good it is at predicting how people (‘economic agents’) will behave in given circumstances. I believe that, in many circumstances, the standard model’s prediction record is poor.

The weaknesses of the model can be seen by looking at the assumptions on which it’s built. It’s important to understand that formal economic reasoning, which is often done mathematically, is rigorously logical - given the assumptions on which it’s based. So if you don’t like the conclusions of economics, the thing to examine is the assumptions on which the reasoning is based.

The weaknesses of economics

To me, conventional economics’ greatest weakness is its assumption that agents are ‘rational’ - that is, that we always act with carefully calculated self-interest. We know from much psychological research - not to mention common observation - that people are instinctive rather than rational. They frequently make decisions contrary to the model’s predictions, they have trouble predicting their own utility, make logically inconsistent decisions, have trouble making themselves do what they know is in their longer-term best interests, are moved by altruism and perceptions of fairness and much, much more. One of the most effective criticisms of economic analysis is: I don’t believe real people behave that way. How do you, the economist, know they do? Honest answer: we don’t know it, we just assume it.

One major weakness of the model that economists readily acknowledge (but don’t necessarily take sufficiently seriously) is its inability to take account of factors than aren’t reflected in prices. Any costs or benefits that aren’t reflected in market prices are known as ‘externalities’. When I run a factory that emits pollution into the atmosphere or the river this imposes a cost (a ‘negative externality’) on the rest of the community that isn’t reflected in the actual costs I incur and pass on to customers in my prices. When, in the good old days, statutory authorities trained far more apprentices than they needed, knowing they’d be poached by the surrounding private employers, they were generating a benefit (a ‘positive externality’) those firms didn’t have to pay for and for which the statutory authorities received no recompense. The existence of externalities - positive or negative - constitutes an instance of ‘market failure’. That is, the market and its price mechanism can’t be relied on to deliver the favourable outcomes the standard model promises. The solution is to find ways to ‘internalise’ the externalities to the costs and benefits faced by firms and consumers - to get them reflected in prices - so the price mechanism can deal with them. This is done by devices such as pollution taxes, tradable permit schemes and government subsidies.

There are various other classes of market failure apart from externalities, but I tend to think of them in terms of ‘model blindness’. Economists suffer the same problem as every other profession: what I call model-blindness - a tendency to view the world and to analyse problems exclusively through the prism of their model. To focus on those variables their model focuses on and a tendency to ignore all those factors from which their model abstracts. This is a simple error, but it’s amazing how often it’s made.

The community is preoccupied with perceptions of fairness, whereas standard microeconomic analysis ignores equity considerations. When you press them, economists will tell you they have nothing to say on the fairness and redistributive effects of their policy prescriptions because this involves value judgments that are beyond their area of competence. Yet it’s remarkable how often economic rationalists in particular will press policies on the community without bothering to warn people that, in reaching those policy prescriptions, they have taken no account of equity issues. This is unprofessional behaviour.

The neoclassical model focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of problems and market failure. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Problems with the simple model of the labour market

These are general problems with economists’ use and abuse of their model, but let’s cut to the chase and focus on problems with the use of the conventional model to analyse issues in one particular market, the market for labour, in which workers are the suppliers and firms the demanders. General economists have a tendency to analyse the labour market as though it’s just another market, but there’s an obvious and most important respect in which the labour market differs from other markets. In every other market you’re dealing with the buying and selling of inanimate objects, whereas in the labour market the thing being bought and sold can’t be separated from the seller - that is, whether you like it or not, the unit of labour you buy comes with a live human being attached. That human may be agreeable or disagreeable, cooperative or uncooperative, hard working or lazy, capable or incapable. The fact that labour comes with humans attached cannot fail to affect the behaviour of both the buyer and the seller, something the model makes no allowance for. The role of humans is a strong argument against analysing the labour market in a way that totally ignores considerations of fairness. Another consequence is that the cost of labour to the employer is the income of the employee (ignoring the role of labour ‘on-costs’ such as payroll tax, workers compensation premiums etc). The attachment of humans to labour also invalidates the usual assumption that the items being bought and sold are homogenous. Two carpenters with identical qualifications and experience may be quite different as employees.

The standard model of the labour market assumes that, ceteris paribus, the higher the price of something, the less of it people will buy. This is the rationale for economists’ opposition to minimum wage rates. Set the minimum wage at a level higher than the rate the market would determine - that is, set the rate at a level that’s ‘binding’ - and the result is the market doesn’t ‘clear’. Some people remain unemployed. There is truth to this simple argument, but it ignores a complication: by how much would wages have to fall to achieve the elimination of unemployment? In other words, to what extent would people already employed under a binding minimum wage have to suffer a loss of income to achieve jobs for those at present unemployed? Would a small fall in the rate bring about a large increase in demand or would it take a large fall to bring about a small increase in the quantity demanded? In the jargon, is the demand for labour relative to its price elastic (sensitive to changes) or inelastic? This is the question on which economists need to be pressed. They will come armed with empirical estimates of the price elasticity, but how much faith you should have in those estimates is another matter. They’re pretty safe to have picked estimates that suit their case and to have ignored estimates that didn’t.

The basic model of the labour market assumes that the suppliers of labour face a simple choice: supply an hour of work and earn income or choose an hour of ‘leisure’ (which just means non-work) and enjoy yourself. The bit the model gets right is that leisure yields utility (satisfaction) - though this is something business people and economists often fail to acknowledge in their rhetoric. However, what the model gets wrong is its assumption that work yields disutility - that the only reason people work is for the money, the spending of which yields utility. In real life, most of us derive considerable utility from our work; much of our very identity comes from our work. This flaw in the model prompts economists to underestimate the importance of job satisfaction, job enrichment and job security. They underestimate the personal pain of unemployment - pain greater than can be explained by the loss of income involved - partly because of the hidden assumption of their model that the unemployed are to be envied for all their leisure time. (Another reason is the neo-classical model’s assumption that the macro economy is in a permanent state of full employment, so no one stays jobless for long.)

A related problem - which should really come under the heading of model-blindness - arises from the fact that the model takes account of only those factors that can be readily expressed in monetary terms. This leads to the sloppy assumption that the only incentives that matter are monetary. In truth, the working world abounds in non-monetary incentives: the satisfaction of a job well done, loyalty to employers and a desire for the boss’s approval, not to mention the pursuit of power and status.

An implicit assumption of the model that’s highly relevant to Work Choices, but which many economists conveniently forget, is that the parties to a transaction have roughly equal bargaining power. Where the parties’ bargaining power is highly unequal you won’t necessarily get the mutually beneficial outcomes the model promises. Certainly, the gains aren’t likely to be evenly distributed. This is the economic rationale for economists’ long-standing acceptance of the legitimacy of collective bargaining. The fact that so many economic rationalists are supportive of the push for individual contracts makes me suspect their analysis has been clouded by partisanship.

Work Choices has made me increasingly conscious of another of the model’s weaknesses: its neglect of what you might call ‘social externalities’. I’m disturbed by the attack on - the demonisation of - penalty rates for work at unsociable hours and the scope for partially cashing out holiday pay. My worry is not so much that the compensation for the loss of these benefits may be inadequate, but that these penalties performed an important social function. Combined with the deregulation of shopping hours, the attack on penalty rates is bringing about the steady demise of the weekend. Why is this a good idea? Although all of us like being free to shop or visit places of entertainment on the weekend, the trend to working at unsociable hours must be harmful to family life - something of great utility to all of us.

There’s no denying that, if increasing productivity and our material standard of living were our sole objective, keeping our shops, offices and factories operating for as close to 24/7 as possible would help us achieve it. But who in their right mind would have such an unbalanced approach to life? Workaholic businessmen and economists blinded by their model to the importance of social externalities.

Labour market reform

I have no doubt that our move from the centralised wage-fixing system to bargaining at the enterprise level - the end of flow-ons and one-size-fits-all national wage increases and the downplaying of comparative wage justice - has played a major part in the economy’s improved performance: the return to low inflation, the record-length 16-year expansion phase that has allowed so much progress to be made in reducing unemployment and the fact that our biggest commodities boom in 50 years has so far led to no wage breakout.

But I think this has more to do with the decentralisation of wage-fixing than the deregulation of it. It’s far too soon for Work Choices to have played a significant part in these outcomes - with the possible exception of the remarkably low wage increases being recorded in retail and hospitality. The productivity of labour grew extraordinarily strongly in the second half of the 90s and this helps explain the quite strong growth in real wages during the Howard Government’s term, notwithstanding the maintenance of low inflation.

When it suits them, the economic rationalists like to attribute all the credit for our improved productivity performance to the reform of the labour market. They can’t prove this, of course, and at other times they’re inclined to give the credit to all the other reform we’ve seen in the financial system and the markets for particular products: the floating of the dollar, the deregulation of the banks and countless other industries, privatisation, the virtual ending of protection, the reform of monopoly public utilities, tax reform and so forth.

My guess is that more of the credit should go to product market reform. The intensity of competitive pressure - both domestically and from imports - in so many markets has reduced the market power of firms, ended the sweetheart deal and put a lot of pressure on managers to improve the performance of their firms. They, in turn, have passed the pressure on to their workers, exhibiting a toughness, even callousness that wasn’t there to nearly the same extent in the good old days. Having said that, the move to enterprise bargaining has undoubtedly made it easier for managers to drive a harder bargain with their employees.


Economists specialise in studying the material aspect of our lives and how we can improve it. They are knowledgeable and their advice is effective. As we have proved for ourselves over the past 20 years, following that advice will make the community more prosperous. But while the material aspect of our lives is important, it’s not all important. Sensible people seek to balance affluence against other considerations - fairness and the social, artistic and spiritual dimensions of our lives. The trouble with economists is that their advice is narrow - sometimes narrower than they’re aware of and often more narrow than their hearers realise. Sensible communities don’t allow economists to advise on areas outside their field of competence and balance the advice of economists against the advice of experts in the other important aspects of life.


Tuesday, September 18, 2007


September 18, 2007

The rationale for microeconomic reform

The fundamental objective of microeconomic reform is to improve the economy’s technical, allocative and dynamic efficiency and thereby raise our material standard of living. In distinction to conventional macro management – which focuses on stabilising demand over the short term – microeconomic policy focuses on improving the supply (production) side of the economy over the medium to longer term.

The mechanism for micro reform

The basic mechanism of microeconomic reform is to reduce government intervention in product and factor markets (the capital or financial market and the labour market) in ways designed to increase the degree of competition in those markets. Increased competition in markets should increase the pressure on firms both to raise their technical efficiency and to pass the fruits of that higher productivity on to their customers in the form of better service or lower prices. Combined with prices that better reflect the true ‘resource costs’ of producing goods and services, this should improve the efficiency of the allocation of resources within the economy, thereby causing a higher trend rate of economic growth and thus higher material living standards.

Dynamic efficiency

Dynamic efficiency refers to the economy’s ability to adjust over time in response to changing circumstances. A dynamic economy is adaptable, responsive and flexible. It is able to cope with external or domestic economic shocks to supply or demand without generating either too much inflation or too much unemployment. Our economy’s ability to sail through the Asian crisis of 1997-98 – assisted greatly by the dollar’s depreciation when demand for our exports fell off – convinced many economists that micro reform had made our economy a lot more flexible than it had been.

And, as part of this, our lasting return to low inflation has shown the economy to be much less ‘inflation-prone’ than it had been. Intensified competition in so many markets has greatly reduced the scope for firms to exercise pricing power, for importers to pass on imported inflation and for unions to negotiate excessive, ‘sweetheart’ wage deals. In short, we now have much less problem with ‘cost-push’ inflation. Another part of this is that the move to enterprise bargaining and away from centralised wage fixing has greatly reduced the scope for big pay rises in one area to ‘flow on’ to workers in other areas. This would have helped to lower our NAIRU – the ‘non-accelerating-inflation’ rate of unemployment - thereby permitting the unemployment rate to go lower without igniting wage-inflation problems.

The economy’s greater dynamism and ability ‘roll with the punches’, this has made it less unstable and thus made the macro managers’ job of stabilising the economy as it moves through the business cycle a lot easier – a major, but largely unexpected benefit from micro reform.

Key microeconomic reforms

We can list eight key areas of micro reform over the past two decades:

1. Capital markets. The Australian dollar was floated in December 1983 and controls over foreign exchange removed. Bank interest rates were deregulated and foreign banks licensed to operate in Australia.

2. Trade reforms. Import quotas – mainly for motor vehicles and textiles, clothing at footwear – were removed in the late 1980s and tariff protection for manufacturing and agriculture phased down. The effective rate of assistance to manufacturing fell from around 35 per cent in the early 1970s to 5 per cent by 2000.

3. Infrastructure services. Airlines, coastal shipping, telecommunications and the waterfront were partially deregulated. Government utilities – including railways, ports, electricity and water – were made more efficient and less overstaffed. Many were commercialised and corporatised; some were privatised. Government-owned banks, insurance companies, airlines and a telephone company were privatised.

4. Industry deregulation. Many industries – including stock broking, petrol distribution, eggs, bread and dairy – have been deregulated, as have shopping hours.

5. Government services. Many reforms have been introduced, including competitive tendering and contracting out, performance-based funding, the formal definition and costing of ‘community service obligations’ and user-pays pricing.

6. Labour market. The prices and incomes Accord, operating from 1983 to 1996, restructured and simplified awards and shifted from centralised wage fixing to enterprise bargaining. The Howard Government’s Workplace Relations Act of 1996 further reduced the scope of awards and introduced a formal system of individual employment contracts known as Australian Workplace Agreements. Work Choices seeks to discourage collective bargaining and unionism.

7. Taxation reform. Capital gains tax, fringe benefits tax and the dividend imputation system were introduced in 1985 and 1987, along with large cuts in income tax rates. The goods and services tax was introduced in 2000, replacing the narrow wholesale sales tax and a range of state stamp duties. The company tax rate was cut to 30 per cent.

8. National competition policy. An agreement between Paul Keating and the state premiers in 1995 had four main elements: extension of the Trade Practices Act to government businesses and the professions; reforms to public monopolies; introduction of a regime to provide other firms with access on reasonable terms to privately owned monopoly infrastructure services; and introduction of a program to review all federal and state legislation restricting competition. National competition policy has now been replaced by the National Reform Agenda.

Evidence of the benefits of micro reform

During the five years to 1998-99, labour productivity grew at the highest rate for at least 30 years. The improvement in the average productivity growth rate over this five-year period (of about 1 percentage point) provided the equivalent of an additional $7000 to the average Australian household.

This remarkably strong performance is widely attributed to the delayed effects of micro reform. In the years since then, however, our productivity performance has fallen back to normal levels. This may be because of the fall-off in further reform under the Howard Government. The poorer performance in very recent years is thought to be due partly to the surge in mining investment associated with the resources boom which, while the new production capacity is still coming on line, means the mines are employing more workers without any increase in output. This should be just a temporary factor, of course.


Thursday, September 13, 2007


Talk to Sydney University Economics Society
September 13, 2007

I want to start by saying that, in a minor way, The Sydney Morning Herald is an employer of economics graduates from Sydney University. We hire about one every two years. Over the years we’ve hired Steve Burrell, Stephen Ellis (now a columnist from America in the Business Australian), Tom Allard, Jessica Irvine and Jake Saulwick. We’ll have another one coming on board next year. (I wish I’d hired another name you may recognise, Stephen Long of the ABC.)

The thing to note is that everyone on that list is a product of Political Economy, not the mainstream economics course. So I have pretty well-formed views about Sydney University graduates as potential employees. Why do I hire out of PE? I like PE students because PE is an essay-based course (and economic journalists have to be able to explain economics in words, not diagrams or equations), because PE students have a demonstrated interest in politics (and I regard economic journalism as a branch of political journalism) and because PE seems to attract a disproportionate share of very bright students (and I try to hire only people who are exceptionally bright).

In passing I should tell you that I don’t select trainees on the basis of the marks they got. I’m more interested in their extra-curricular activities - whether they were on the SRC, got involved in running clubs and societies, whether they wrote for Honi or the Union Record - because what I’m really looking for is people with a burning desire to be a journalist, people who’ll throw themselves into it, people who are ‘hungry’ to succeed.

I should tell you that I’m very happy with the people I recruit from PE, which is why I keep going back. In recent years, however, I’ve encountered one problem: most PE graduates haven’t actually done any courses in standard, neoclassical economics. It’s amazing, but true. This is a significant weakness and I usually have to insist that the people I hire go back and do some standard economics by distance education. I don’t think the people running PE are doing their students any favours churning out supposed economists who know less about conventional economics than someone who’d done economics at high school.

What I say to my PE graduates is that I don’t require them to believe the neoclassical model - as we’ll see, I have a lot of doubts about it myself - but I do require them to know it inside out. Why? Because the neoclassical model is the language of the public debate about economics in this country and every other country. If you don’t speak the language, you don’t participate or even understand the argument. You’re certainly in no position to convince the participants in the debate they’re barking up the wrong tree.

Of course, some of the conventional economics graduates who are whizzes at the maths aren’t good at speaking the language, either. But while I’m offering a critique of PE, let me be equally frank about the conventional course. I think its great weakness is the opposite of PE’s - it’s so busy teaching the intricacies of the neoclassical model that it doesn’t find time to give students an adequate understanding of the significant limitations of the model and the alternatives to it. To teach the model without adequately explaining its limitations is, to me, professional negligence. So there’s nothing wrong with economics at Sydney Uni that couldn’t be fixed by rolling the rival courses together - by making sure each side gets a fair dose of what the other side is teaching.

I also suspect the conventional course would be better if it devoted less time to exploring the model’s limiting cases and more to giving students practice at applying the model to specific problems. That is, after all, what economic practitioners do: apply the theory they learnt at uni to the real-world policy problems they are grappling with. But don’t get the idea from this I’m critical of the emphasis on theory in university economics courses. I’m not - not a bit. Universities should be all about theory. Theory is their comparative advantage. It’s the only thing they’re good at and they should stick to it. They shouldn’t worry about teaching vocational skills because it’s hard to learn vocational skills at uni and surprisingly easy to learn them on the job - when you get a job. It’s because economic practitioners spend their professional lives applying the theory they learnt at uni - because pretty much all the theory they know is the theory they learnt at uni - that unis should concentrate on giving their students the best understanding of theory possible. And students should concentrate on tanking up with theory while they’ve got the chance and not worry that it’s all too theoretical. The practice will come later. And when you’ve had a bit of practice you’ll realise that the theory was more useful than you thought when you were learning it.

That’s probably the most useful thing I could say to many of you: don’t sit around telling yourself how useless and unrealistic all the theory is they’re trying to make you learn. You haven’t actually had enough experience to have an informed view of what theory’s useful and what isn’t. So take your lecturers on trust: accept that if they think it’s worth teaching it must be worth learning. If my experience is any guide, when you are experienced enough to judge you’ll realise most of what they taught you was worth learning.

Of course, decent teaching of theory gives plenty of attention to teaching the limitations of the theory. So now that I turn to my topic of what’s wrong with standard theory please don’t think I’m saying economics is rubbish and you’re wasting your time with it. I’m not saying that and I don’t believe that. I could give you a speech on what’s right and useful about the neoclassical model - and if I had time I would - but instead I want to talk about the limitations of the model because that’s where I suspect the conventional course is weakest. Everything in life has strengths and weaknesses and neoclassical economics is no exception.

Perhaps before I launch in I should explain that my view of my role as an economic commentator has changed over the years. For a long time I saw myself as a sort of missionary for economics, explaining the economic way of thinking and trying to persuade people to accept the economic rationalists’ policy prescription. But that was before I’d thought more and read more about the limitations of standard economics. So now I see my role as someone paid to provide the Herald’s readers with a critique of economics and economists, just as theatre critics provide our readers with a critique of the latest plays. Economists are so influential in the debate about public policy - and they act so certain that they’re the bearers of God’s Infallible Truth - that our readers often need reminding of their blind spots and the narrowness of their advice. Of course, putting economists back in their box when I consider they’ve overstepped their area of competence doesn’t stop me still devoting a lot of time to explaining economic concepts and the motivation behind government policy positions.

I suspect the biggest problem with economics is that it split off from the rest of science - the natural sciences and the social sciences - over 100 years ago, so that while there have been many major advances in those sciences since then, economics has been in its own, self-contained world and has carried on down its own path oblivious to those advances.

In Eric Beinhocker’s recent book, The Origin of Wealth, he argues that, thanks to the work of Leon Walras and others in the 19th century, the primary inspiration for neoclassical economics was physics, particularly the physics of motion and energy. Walras introduced differential calculus to economics and the organising paradigm that the economy is an equilibrating system. But Beinhocker says economics took its inspiration from physics at a time when physicists had discovered the first law of thermodynamics, but not yet discovered the second law. As a result, economics is based on terribly out-of-date physics. It’s now clear to physicists - but not economists - that the economy isn’t a closed, equilibrating system at all, but rather an open, disequilibrium, complex adaptive system.

To quote Beinhocker, ‘when Walras imported the concept of equilibrium from physics into economics, he gained mathematical precision and scientific predictability. But he paid a high price for that gain - realism. The mathematics of equilibrium required Walras and later economists to make a set of highly restrictive assumptions that have increasingly detached theoretical economics from the real world. Traditional economics has what computer programmers call a “garbage in, garbage out” problem. If you feed a computer bad inputs, it will with absolute precision and flawless logic grind out bad outputs. Likewise, most traditional economic models begin with unrealistic assumptions and then, with mathematical inevitability, work their way to equally unrealistic conclusions. … This is why there is little empirical support for many core ideas of traditional economics, and in some cases empirical evidence directly contradicts the theory’s predictions.’

The point here is not that conventional economics is too mathematical, but that it’s not using the right maths. The right maths would, no doubt, be a lot trickier and permit a lot less precise conclusions. But I don’t want to be drawn any further on this point because, though I’ve been happy to quote Beinhocker, I don’t profess to know anything much about physics and maths.

I’m a lot more confident in pointing to another area of science where, more than 100 years ago, economics split off on its own track, so that it’s now largely oblivious to subsequent advances. That science is psychology. It was quite primitive 100 years ago, but since then has made considerable gains in understanding the drivers of human behaviour. It’s quite understandable that, with psychology being then as primitive as it was, economics built itself on the assumption that economic agents behaved rationally in all things. It was very much a product of the thinking of the Enlightenment.

But psychology’s challenge to microeconomic theory strikes at that central assumption of Homo economicus. Economic man is assumed to be rational and self-interested. He or she always carefully evaluates all the options before making any decision, and always with the object of maximising his or her personal ‘utility’ or satisfaction. But cognitive psychologists have demonstrated that humans simply lack the neural processing power to make the carefully calculated decisions economists assume. People are not rational, they are intuitive. And altruism is often an important consideration in their decision-making. People can’t chose correctly between three options where the best option is not immediately apparent. Rather than carefully thinking through the pros and cons of every decision, people tend to rely on mental shortcuts (‘heuristics’) which often serve them well enough, but also lead them into systematic biases. People are often slow to learn from their mistakes. They are frequently capable of reacting differently to choices that are essentially the same, just because the choices have been ‘framed’ (packaged) differently. This means that, rather than being coldly rational, people’s decisions are often influenced by emotional considerations.

All this means that Homo sapiens differs from Homo economicus in many important respects. He doesn’t conform to economists’ assumption of fungibility (one dollar is indistinguishable from another), he is often not bothered by opportunity cost and thus has a strong bias in favour of the status quo. He doesn’t ignore sunk costs as he’s supposed to and often can’t order his preferences consistently. He is not averse to risks so much as averse to losses and he focuses more on changes in his wealth than on its absolute level.

Unlike Homo economicus, Homo sapiens cares deeply about fairness. Experiments show people will walk away from deals they consider treat them unfairly, even though those deals would leave them better off. People are prepared to pay a price to punish others they consider to have been behaving badly towards the group. Often people are concerned about ‘procedural fairness’ – how things are done, not just how they end up.

I believe this has powerful implications for the aspect of the neoclassical model that economic rationalists (particularly right-wing rationalists) find so attractive: its elevation and celebration of individualism. The individual should be free to choose, and governments should be most circumspect in how they constrain individuals’ freedom, including by taxing them to pay for the public provision of services and to redistribute income. This elevation of the individual and, by implication, denigration of a more communitarian approach, turns out to rest heavily on the assumption that individuals are rational. If individuals are rational decision-makers then it follows, as the rationalists keep asserting, that governments can never know what is good for you better than you know yourself. Governments should therefore tax individuals as little as possible, and maximise the private provision of such things as education and health care. If individuals are not particularly rational in their decision-making, however, then there may well be a case for government paternalism in certain circumstances.

Another aspect of the non-rationality of economic agents is the way, contrary to the assumptions of the model, they aren’t rugged individualists but are heavily influenced by the behaviour of people around them. My tastes and preferences aren’t fixed, but are highly variable, influenced by what others are doing and what happens to be fashionable. I care deeply about winning the approval of others and have a great desire to fit in. At the same time I’m preoccupied with my social status. I want by my conspicuous consumption to not just keep up with the Jones but to overtake them, demonstrating my superior social standing. As my real income rises over time, more and more of it will be devoted to the purchase of positional goods. This is a particular challenge to conventional economics because, while it’s very skilled at raising the material living standards of the community generally, it’s simply powerless to do what most people would wish it to: raise their relative income. Obviously, anything it does to raise the relative income of some people will lower the relative income of just as many. Another aspect of the fact that humans are group animals is the herd behaviour investors so frequently exhibit in markets for financial assets, contrary to the contentions of the efficient market hypothesis.

Thanks to relatively recent advances in neuroscience, we now know a lot more about how our lack of rationality is a function of the way our brains have evolved. It turns out that the primitive, more instinctive, emotional part of our brain often overrides - or beats to the punch - the more recent, more logical part of our brain. This leads to a strange dualism in our minds: we’re often motivated to do things by considerations the more intellectual part of our brain knows to be silly.

It’s as though we have two selves, an unconscious self that’s emotional and short-sighted and a conscious self that’s reasoning and far sighted. We have trouble controlling ourselves in circumstances where the benefits are immediate and certain, whereas the costs are longer-term and uncertain. When you come home tired from work, for instance, the benefits of slumping in front of the telly are immediate, whereas the costs - feeling tired the next day; looking back on your life and realising you could have done a lot better if you’d got off your backside and played a bit of sport or studied harder for exams - are prospective and uncertain. Similarly, the reward from eating food is instant, whereas the costs of overeating are uncertain and far off in the future - being regarded as physically unattractive, becoming obese, becoming a diabetic, dying younger etc. As everyone knows who’s tried to diet, give up smoking, control their drinking, gambling or even speeding, save or get on top of their credit card debt, it’s very hard achieve the self-control our conscious, future selves want us to achieve. Problems of self-control are ubiquitous to modern life, but standard economics is oblivious to their existence.

Before we pass on I should acknowledge that the relatively recent school of economic thought known as behavioural economics is fully aware of the way the assumptions of standard economics fly in the face of advances in psychology and is seeking ways for more realistic assumptions about human behaviour to be incorporated into the equations of the standard model. I suspect, however, it won’t be easy.

Moving to a more mundane level, economists suffer the same problem as every other profession: what I call model-blindness - a tendency to view the world and to analyse problems exclusively through the prism of their model. To focus on those variables their model focuses on and a tendency to ignore all those factors from which their model abstracts. This is a simple error, but it’s amazing how often it’s made. It occurs partly because there is so little engagement between economists and people from other disciplines - so that economists rarely get a chance to see themselves as others see them - and partly because the teachers of economics devote so little attention to ensuring their students fully appreciate the limitations of the model.

As we’ve seen, the community is preoccupied with perceptions of fairness, whereas standard microeconomic analysis ignores equity considerations. When you press them, economists will tell you they have nothing to say on the fairness of their policy prescriptions because this involves value judgments that are beyond their area of competence. Yet it’s remarkable how often economic rationalists in particular will press policies on the community without bothering to warn people that, in reaching those policy prescriptions, they have taken no account of equity issues. This is unprofessional behaviour.

The neoclassical model focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have roughly equal bargaining power – which is often not the case. We’re hearing more about this lately as farmers and other small businesses complain about being squeezed by big business, such as the two supermarket chains. It’s been remarkable to see the Howard Government running advertisements to remind small businesses of the changes to the Trade Practices Act that now permit them to bargain collectively with big business, while at the same time using Work Choices to discourage collective bargaining between individual workers and their employers.

Another assumption of the conventional model is that both buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of the problems and ‘market failure’ in markets. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Yet another major weakness of the model is its failure to take account of social externalities. The deregulation of shopping hours, combined with the attack on weekend penalty rates, is fast bringing about the demise of the weekend without the community ever consciously deciding this would be a good thing. Similarly, I believe Work Choices’ attack on overtime, weekend and public holiday penalty rates and provisions for the partial cashing out of holiday pay could be damaging to family life.

Then there’s the sloppy thinking that goes from the fact that economics is capable of dealing only with monetary incentives to the implicit assumption that only monetary incentives matter. This is classic model-blindness. Clearly, the real world abounds in important non-monetary incentives, including the intrinsic enjoyment of work and pursuit of job satisfaction, and the pursuit of power and status. Ignore these factors and you get wrong answers.

But perhaps the thing that worries me most about standard economics is the way its adoption of the assumption of ‘revealed preference’ - that what people do is a reliable guide to what they want - in the 1930s allowed the goal of economic efficiency to be changed from maximising utility to maximising consumption. Clearly, much utility exists outside consumption - including utility derived from job satisfaction, job security and family life. I fear this derailing of the goals of economics has turned economics into the ideology of materialism and economists into the high priests in the temple of mammon.

This at last brings me to my ostensible reason for being here, to publicise my new book, Gittinomics. What is Gittinomics - what’s my special twist on the subject? Well, most of what I’ve said today isn’t in the book. The book is a kind of exposition of how the micro economy works, but from the perspective of the ordinary person. I call it home economics. My emphasis is on understanding the system to make sure you’re a master of the market system, not a victim. Making it work for you, not you for it. To that end, the first thing to understand is the need to keep economics in perspective and economists in their place.