Wednesday, July 18, 2007


Old Parliament House, Canberra
July 18, 2007

David Gruen has asked me to talk about the policy issues I believe Treasury should be thinking about in briefing an incoming government, new or returning. I’m not convinced I could give you much useful advice on that score, but I’m going to address the topic quite broadly in the hope of saying something that gives you something to think about, even if - as I suspect is often the case - all I do is help you realise why you don’t agree with me. I’ll also focus fairly heavily on my special subject: the politics of economics.

In thinking about the next government I’m going to err on the side of envisaging a change of government, not because I think it’s a sure thing - I don’t - but because it gives us more interesting things to think about and because preparing a briefing for a new government is a more challenging exercise. It’s possible I may have had more experience than some of you of observing change-overs. In my career I’ve seen three at the federal level: from Whitlam to Fraser in 1975, from Fraser to Hawke in 1983 and from Keating to Howard in 1996.

Thinking about a change of government

At one level you might think that a change-over from Howard to Rudd would be a relatively simple affair given that the remarkable success of existing policies means there’s broad agreement between the two parties on the question of macro management - on the medium term frameworks for monetary policy and for fiscal policy, including balancing the budget on average over the cycle and limiting the growth in revenue as a proportion of GDP. In case any of you have any doubts, I’d remind you that politicians’ behaviour in opposition usually offers a poor guide to their behaviour in government, so that the behaviour of Labor when last in government offers the best guide to its behaviour when next in government. We can expect a Rudd government to be quite conservative and responsible, anxious to lay to rest the popular stereotype that Labor is no good at economic management, anxious to avoid getting offside with the financial markets, anxious to be seen as ‘pro-business’ - more anxious about it than the Libs ever need to bother being - and anxious to avoid being seen as the lackeys of the (in any case, hugely politically weakened) union movement. The more the Libs push that line against Labor in the run up to the election, the more determined a Labor government would be to disprove it in practice. This time there’d be no Accord to give the unions a seat at the Cabinet table.

But it would be a mistake to see the lack of significant difference between the two sides on macro policy as making the briefing of an incoming Labor government a ho-hum affair. That’s because a change of government represents a rare and vitally important point of challenge and opportunity for Treasury. It’s a quickly passing opportunity for Treasury to establish a relationship of two-way trust and loyalty with the new administration. Treasury does so by demonstrating its commitment to apolitical service to the government of the day, by demonstrating that it’s already been giving much thought to the new government’s problems from the new government’s perspective and by demonstrating its competence (including its detailed knowledge of the new government’s stated policies). The more politicised the public service becomes, the more important this welcoming-committee role becomes.

But there’s a second reason the first few days of the new government’s term are of such strategic significance: they represent an unparalleled opportunity to get action on all those issues the outgoing government had consigned to the too-hard basket, including those that most offended the interests of its core constituency.

The first duty of Treasury is to immediately present the incoming government with evidence of a budgetary crisis that demands an immediate and radical response. That’s what John Stone did for the incoming Hawke government even before it had been sworn in and what Ted Evans did for the incoming Howard government in 1996. I’ve seen it done at the state level many times and incoming CEOs of major companies almost invariably do something similar. I call it ‘doing a Mother Hubbard’: we came to government, looked in the fiscal cupboard and were shocked and appalled to discover it was bare. It’s actually a time-honoured trick that will be much harder to pull off in the era of the PEFO. The first point of it is to get all your predecessor’s dirty fiscal linen out in the open while the recognition of those presently hidden, unacknowledged costs can be blamed on your predecessor. It has to be done in an atmosphere of high-drama crisis, so your alibi will stick in the mind of the electorate and so any early economic setback or lack of progress can be excused.

But the second purpose of the crisis is to provide a cover for a process by which the incoming government slashes away at those budget measures aimed at its predecessor’s political heartland so as to make room for those measures it has promised to grant its own political heartland. The process also allows the new government to defer or abandon some of its non-core promises. This is a vitally important exercise from Treasury’s perspective because of the need to prevent the new government from merely adding its pet projects on top of its predecessor’s pet projects.

A common practice is for the new government to establish a committee of audit to reinforce the message that it inherited a fiscal mare’s nest, but the Howard government’s experience shows that the auditors need to be selected with care. Give the job to a bunch of academics and they’ll give you a report whose recommendations are too radical to your taste.

On a related theme, I have to tell you that the older I get the more I doubt the pertinence of the old cry in response to election promises, ‘where’s the money coming from?’. The honest answer - which no politician would dare give - is, ‘if and when we win the election, Treasury will tell us’. Why? Because that’s what Treasury’s paid to do: tell the government of the day how it can cover the cost of the policies it wishes to pursue. Hidden in that is a more subtle task: to take the incoming government’s election promises and explain to it how, by adding qualifications and limitations that were not mentioned or explicitly ruled out before the election, it can significantly curtail the budgetary cost of the promise. It may also be able to gain some budgetary leeway by fiddling with the timing of commencement of the program.

Thinking about the next recession

I have a feeling this election won’t be a good one to win. Why not? Because of the high chance that the record expansion phase finally comes to an end sometime in the next few years, leaving us in recession. Think about it: we have a history of governments being thrown out of office after they’ve presided over a recession. That’s true of the Whitlam, Fraser and Hawke-Keating governments, although in Paul Keating’s case there was a one-term lag thanks to John Hewson’s GST/Fightback package. Parties that are in government generally have good reputations for economic management, then lose it during their recession and leave office being regarded as pretty hopeless. The incoming government then does its best to rub in their predecessor’s bad reputation and live off it for as long as possible. The Hawke-Keating government suffered this fate notwithstanding its unprecedented record of economic reform. I might add that, though the Labor government’s poll ratings on economic management weren’t too bad during most of its term, the voters’ views on which party is good at which policy area are terribly stereotyped, meaning that the Liberals’ identification with business gives them a big inbuilt advantage.

But now consider what would happen if the Libs lost office this year and a recession occurred during the new government’s term. The Libs would have managed to enjoy a completed period of more than 11 years in power without a recession, whereas Labor would have plunged the economy into recession within a year or two of regaining power. Nothing could be more calculated to reinforce for the long term the perception Peter Costello has been so successful in inculcating with all his talk about Labor’s Beazley Budget Blackhole, deficits and debt, that the Libs are God’s gift to economic management, whereas Labor simply can’t be left in charge of the till.

So that’s why I say I’m not sure this would be a good election to win. I’m sure that wouldn’t discourage Labor from wanting to win, but I’m equally sure the scenario I’ve just outlined would have occurred to Labor and that, should it win, it will quickly turn its mind to this potential problem. It will do all in its power to blacken the economic reputation of its predecessor in the hope that, should a recession occur reasonably soon after the change of government, it will be able to shift the blame back on the Libs. If I’m right, it will be expecting Treasury to play its part in this exercise.

But now let’s turn out minds to the possible nature of the next recession (and remember that this discussion applies equally to Liberal or Labor governments). Dr Don Stammer, formerly of Deutsche Bank, says no economist or economic journalist is worth feeding unless they’ve lived through at least four recessions and, if they have, they’re entitled to charge a premium for their advice. In my working life I’ve experienced the recession of the mid-70s, the recession of the early 80s and the recession of the early 90s - and they’ve left a lasting impression on me.

The first thing to say is that I don’t see any signs that a recession in imminent. But I don’t believe for a moment that the business cycle has been abolished and nor do I believe our luck can hold forever. Equally, however, I don’t think you ever get much warning that a recession is on the way. They tend to be brought on by what Don Stammer famously calls the X Factor - the factor no one had been expecting. But I do think there are a few things we can say. One is that I don’t think we’ve ever had a recession of exclusively domestic causes. Equally, I don’t think we’ve had a recession of exclusively external causes - though in 2001 we did have a mild world recession that didn’t lead to a downturn here.

I deduce from this that our economy goes into recession when some external disturbance combines with some domestic imbalance or vulnerability. I don’t think we have to look far to find the most likely source of domestic vulnerability: our extraordinarily heavily indebted household sector. It’s highly vulnerable to a sudden fall in employment - from whatever cause - which would make it impossible for affected households to maintain their mortgages. This threatening atmosphere could put the wind up many employed but heavily indebted households which, in their efforts to reduce their exposure, could significantly slow their consumer spending. The contraction would come not so much from the direct effect of newly unemployed households as from the indirect, contagion effect on other indebted households.

I believe that, when it comes to dealing with recessions, it’s important not to get caught fighting the last war. I say this because of my painful experience with the recession of the early 90s. Early in that process, despite widespread gloom and doom in the business community, Treasury was confidently predicting just a ‘soft landing’. Treasury argued that the prime domestic cause of the two previous recessions - in the mid-70s and early 80s - had been wage explosions and, since this time wages were well under control thanks to the Accord, this downturn was not likely to be severe. I bought that argument and loudly and confidently predicted a soft landing, knowing to ignore all the contrary anecdotal evidence I was hearing. As it transpired, the landing was anything but soft. So that proved a terribly wrong call on my part and caused me a lot of grief in the office, where all the anecdote merchants tried hard to convince the editor of my incompetence.

The problem with that analysis was that, as is the bias of most macro economists, it sought evidence and explanations for recession only in the real economy, ignoring the financial economy. But, as Ian Macfarlane was the first to explain publicly, financial factors were the key cause of that recession and its severity. The deregulation of the financial system and the admission of foreign banks had led to an orgy of business borrowing associated with successive asset price booms in the stock market followed by the commercial property market. When high interest rates eventually caused the music to stop, the corporate sector found itself heavily leveraged and highly exposed, many with assets that were no longer worth what had been paid for them. The response was that the corporate sector, including the banks themselves, entered a protracted period of ‘balance sheet repair,’ which involved running down debts by cutting investment spending, cutting staff and otherwise cutting expenses. The problem with this, of course, is that it spreads the problem to other firms, which deepens and prolongs the adjustment period.

Now, the point I want to make is that, in thinking about the next recession, we shouldn’t focus exclusively on what could go wrong in the real economy, but remember that we could again be clobbered by the financial side. For a long time I believed that we’ve got so proficient at controlling inflation - we’ve become so vigilant - that the next recession couldn’t possibly involve the usual train wreck of inflation getting away and interest rates being held so high for so long that a deep recession becomes inevitable. If so, the next recession would be a mild one. I no longer think that because, as Ian Macfarlane made pretty clear in his Boyer Lectures last year, the smart money is expecting the repair of household balance sheets to be the major domestic cause of the next recession. That means it’s likely to be severe and protracted - especially when measured the way politicians and the electorate measure the severity of recessions: by the effect on unemployment, not the effect on output.

At present, thanks to the long-lasting salutary effect of the last recession our corporate sector is not highly geared. But should the next recession be delayed and the private equity craze continue (which it may not), by the time the next recession does arrive we could find ourselves with a highly geared corporate sector as well as a highly indebted household sector. If so, expect the next recession to be doubly severe.

Here it’s important to remember what I think of as a cross between Goodhart’s Law and Murphy’s Law. When monetary policy manages to get a handle on goods and services price inflation control, it tends to encourage the emergence of a problem it finds much harder to handle, credit-fuelled asset price booms. To put it another way, when the economy has been growing strongly and steadily for some time, businesses in search of ever-growing profits tend to become emboldened to take on more risk by gearing up. We see the perfect demonstration of this in the private equity fashion. Trouble is, we all know it will end in tears. Note that here we see one reason for the perpetuation of the business cycle, where the very success of the expansion phase sows the seeds of its eventual destruction.

Now let me introduce a complication I’ve been thinking about lately, but haven’t yet resolved in my mind. In the past 10 or 15 years it’s become terribly fashionable to analyse the challenges of business life in terms of ‘risk management’. I’ve even seen business types getting climate change and emission trading legitimised in their minds by branding it as risk management. Risk management can be about risk spreading, but easily degenerates into nothing more than risk shedding. Businesses can shift risk to their customers, but for the most part they shift it to their employees. I suspect that the protracted period of companies seeking to maintain double-digit profit growth by eternal cost cutting involves a lot of risk-shifting to employees. It’s not greatly relevant to Australian circumstances, but the classic example of risk-shifting to employees has been the move from defined-benefit to defined-contribution pension schemes - which has made older employees far more vulnerable to vagaries of the sharemarket. Another example is the advent of just-in-time inventory management, where firms’ economising on inventory costs has shifted the risk and cost of supply-chain disruption to their employees - who are now far more likely to find themselves temporarily laid off because of, say, a strike at a supplier’s factory. I don’t think there’s much doubt that Work Choices - including the neutering of the unfair-dismissal provisions and reduction in the availability of redundancy payments - has greatly increased firms’ ability to shift risks to their employees. Added to that you have the growth in casual employment, the conversion of employees into contractors and the widespread use of labour-hire firms.

My point is that this risk-shifting trend may have altered the internal dynamics of recessions in ways that are hard to predict. If in a downturn firms are better able to limit the fall in their profits by more easily cutting their wage bills - and thus their employees’ and erstwhile employees’ incomes - does this make the recession less severe or more? If Work Choices gives employers the upper hand in industrial relations, does this mean a recession is likely to see more lay offs or more workers on four-day weeks - that is, is the pain more concentrated on a few or more evenly spread across the many? Does it make much difference? One possibility is that the greater freedom to dispense with the services of casuals, contractors, labour-hire workers and even permanent employees means unemployment will shoot up much earlier than it did. The corollary, however, should be that the absence of labour hoarding means unemployment recovers earlier. We shall see.

Now for a more positive note. If I’m right in predicting that the next recession is more likely to arise from some disruption giving rise to adverse balance sheet effects than from a loss of control over inflation, that does have one big advantage. It means the macro managers ought to feel free to respond to the downturn by the quick and wholehearted application of stimulus. The Reserve Bank can afford to slash interest rates in the way the Fed did in 2001. That’s one of the rewards from our return to good control. Similarly, with general government net debt eliminated, there’s no impediment to the government adding significant discretionary fiscal stimulus on top of the reversal in the automatic stabilisers. There maybe some political embarrassment arising from the way the medium-term fiscal strategy has degenerated into the promise of eternal surpluses, but in the pressures of the moment that will be quickly cast aside.

Here it may be useful to recall the experience of the last recession, where it was originally argued that all the discretionary stimulus should come exclusively from monetary policy, with fiscal policy holding to its medium-term goal apart from the automatic response of the automatic stabilisers. This is what produced the most amazing budget of my career, the only one delivered by John Kerin who, with Paul Keating skulking on the backbench, proceeded to be more Keating than Keating, and stood up in the middle of the recession (August 1991) and declined to kick-start the economy. (That budget was also remarkable for being delivered in the early afternoon without a lockup, thereby uniquely demonstrating that the lockup serves no economic purpose, but survives purely as an instrument of media management.) The joke of all that, of course, was that once Keating became prime minister a few months later, he lost little time in organising the hugely stimulatory mini-budget of February 1992. And the lesson of all that is that the politician who can resist the temptation to use the budget to stimulate the economy during a recession has yet to be born. That being the case, it makes more sense for Treasury to switch to recommending a stimulatory stance of fiscal policy as soon as possible.

One last point since I suspect that some of you have never experienced a recession during your working lives. The burden of recessions is felt very unevenly. Some people lose their jobs, others lose their businesses, while the great majority of people are little affected. Overtime will dry up and their real wage may slide a little, but you’ll even find the odd person doubting that the recession is real because the restaurants are still full. Even so, recessions are highly unpleasant times for economists (and economic commentators) to be alive. The public turns on economists, history is rewritten to blame them for everything, the public is not prepared to entertain discussion of any economic issue bar getting unemployment down, and the period of gloom and doom - the regular encounters with punters who can’t see how the economy will ever get back on its feet again - lasts interminably. Two or three years. So if you’ve never lived through a recession, be warned: they’re no fun.


Thursday, July 12, 2007

After dinner speech to Social Policy Conference dinner

Australian Social Policy Conference dinner
Sydney, Thursday, July 12, 2007

Peter Saunders - the Peter Saunders I call the original and best Peter Saunders - tried to inveigle me into giving this talk by promising me a free feed, but something in the back of my mind warned me that meals are never free. So then he tried the line that I could use the occasion to plug my latest book - and he had me. Actually, I’m going to plug my last two books.

What do you get when you cross an economist with someone from the mafia? An offer you can’t understand. Both books seek to defy that prediction. If you happen to be interested in finding an easy-read introduction to conventional economics - the economics of inflation and unemployment and interest rates that you find in newspapers - I recommend the book I published last year, the one with the blue cover, Gittins’ Guide to Economics.

But the book I want to talk about is my latest, one that’s not like any conventional economics book in that its focus is on you, not the economy. It’s about how you live your life within the economy and make sure the economy is working for you, not you for it. This is the book with the red cover, modestly titled Gittinomics.

One of the ways I’ve tried to keep the economics practical and interesting is to mix in with it a fair bit of psychology and neuroscience. Conventional economics assumes we’re all coldly calculating and rational in the decisions we make, but over the past 20 years or more psychologists and neuroscientists have demonstrated how far this is from the truth. It turns out that the primitive, more 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 nonsensical.

The classic example, of course, is advertising. The central proposition of most ads is that mothers who buy a certain brand of margarine - or a certain brand of sliced bread - will have good-looking, healthy, happy families. Intellectually we know such propositions to be absurd. We imagine there must be some simple souls somewhere who fall for such rubbish, but we certainly don’t. Sorry. Advertisers wouldn’t spend millions each year on such ads if they didn’t work on people in general and enough individuals in particular. Clever appeals to our emotions can induce an emotion-driven response from us even though the more reflective part of our brain knows them to be laughably silly.

Once you accept that we’re capable of responding in a quite unthinking way to the opportunities and temptations thrown at us in this consumer economy, various things become clear. For instance, who’d be silly enough to believe you don’t have to pay for stuff you buy with a credit card? Only a few silly teenagers? No, many of us. Consider an experiment undertaken by some marketing professors at MIT. They organised an auction using written bids for some very attractive basketball tickets. They did the experiment twice. The first time they said you’d have to pay for the tickets with cash; the second time they said you could pay by credit card. The people in the credit card auction offered to pay twice as much as the people who had to pay by cash. The trick is that, when you pay by credit card, you can postpone the need to worry about whether you can really afford the thing you’re buying.

Another instance of the difficulty we have keeping control of our money concerns choice. Politicians, economists and business people assume choice is an unmitigated blessing and the more choice we get the better. In truth, the psychologists have demonstrated that when we’re faced with too much choice we find it confusing and debilitating. Consider an experiment in which researchers set up a display of exotic jams in a gourmet food store, offering a saving if you bought a jar. In on case they offered people tastes of 24 different jams; in another case they offered just six varieties. Comparing the two cases, the larger array attracted more people to the table, even though people tasted about the same number of jams in both cases. But get this: when only a small number of jams were offered, 30 per cent of people bought some; when the larger number of jams was offered, only 3 per cent of people bought. In other words, people found the larger array confusing and so avoided making a decision to buy.

This inability to cope with tricky choices makes it fairly easy for retailers to manipulate us. Consider the way theatres sell popcorn.

Or, consider the way we pick wine from a wine list in a restaurant.

Though almost all of us have spent almost all of our lives living in a market economy, many of us don’t know much about how markets work. We have it in our heads that businesses just add a set mark-up to their costs and that’s what they charge us. But often it doesn’t work that way. For instance, the higher prices charged for organic fruit and vegetables or free-range eggs or ‘fair-trade’ coffee commonly far exceed the extra cost involved in producing the item. Why? Because people with tender consciences about the treatment of chickens or third-world coffee growers - or people worried about the chemicals used to produce non-organic food - are willing to pay higher prices to assuage their consciences. When you’re selling free-range eggs you’re selling something extra beside the eggs: conscience balm. And if that’s what you want, the retailers are happy to charge you more and take your money.

While we’re on the subject of what’s called ‘behavioural economics’ I want to talk about something that’s not in the book. I’ve been thinking a lot lately that there’s a contradiction at the heart of the capitalist system. The system includes many people who make their living by tempting you to buy things and do things which are fine if you do them only in moderation, but which can bring you down if you do too much of them. So the key to being a winner - a master - in the capitalist system is to possess the self-control to resist the temptations it continually throws at you. If you oblige the capitalists and always buy what they’re pushing, you’ll help to make them rich but, paradoxically, you’ll become a loser - a victim - of the system.

What are these temptations? They’re manifold. The one we’re 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.

All of those things are being pushed on us by the system. They’re what the capitalists are trying to sell us. A lot of highly paid advertising people, marketers and merchandisers make their living finding ever-more effective ways to persuade us to indulge. In the case of exercise, no one’s selling the lack of exercise, but lots of people are selling ways to avoid exercise - whether it’s going everywhere by car, using the remote or watching sport on telly rather than playing it. Admittedly, people are also selling ways to get fit - from exercise bikes to gym subscriptions and all the right gear to wear - but then you’ve got to make sure you don’t get hooked on being underweight or using steroids to bulk up.

OK, so we need to demonstrate a bit of self-control in our lives. What’s so new and surprising about that? Two things.

First, research by psychologists, neuroscientists and behavioural economists has shown that humans have a great problem exercising self-control. We think it’s up to us to decide how much to eat or how much TV to watch but, in fact, many of us find it very hard to restrain ourselves in the way we know we should. Experiments with people who’ve had the two sides of their brains severed in some accident show that the reasoning part of our brain often doesn’t know why the faster, more instinctive part of our brain decided to do what it did, but is adept at thinking of plausible explanations for its behaviour. In other words, humans are prone to ex-post rationalisation.

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, sought a further qualification at tech, studied harder for exams, spent more time talking to your kids etc. 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, 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. Many of us may have no trouble controlling ourselves in most of the behaviours I’ve listed, but I doubt there’s anyone much who can claim to have themselves perfectly under control in every area.

The second reason for getting so excited about the problem of self control is the likelihood that the very success of the capitalist system in making us more affluent is serving to heighten our self-control problem. Economics is all about coping with the problem of scarcity. But human ingenuity - including the development of the capitalist system - has increasingly overcome scarcity. These days, most of us in the developed economies have a greater problem coping with abundance than scarcity. For instance, we’ve evolved to eat everything that comes our way, because nutrition was scarce on the African savanna, but now food is abundant and, hence, cheap. So we’ve lost the natural control that, until relatively recently, stopped our instinct to overeat from making us overweight. Similarly, the huge growth in our real incomes over the past century has made it easier for us to afford to overindulge in many of the other vices I listed. Credit is another thing that’s become readily available and relatively cheap.

So I’m beginning to think that overindulgence and difficulties in self control are the big problem of our age. There are solutions to this problem - at the government policy level and at the level of individuals controlling their own behaviour (the latter involving subtle ways of tricking our unconscious selves) - which I suspect will become an increasing focus as the 21st century progresses.