Wednesday, October 31, 2012

White paper shows way to Asian century

When governments make grand policy unveilings, as Julia Gillard has with her white paper on the Asian century, it’s terribly tempting for people in jobs like mine to sit back and criticise. After all, unlike you and me governments tend to be less than perfect.

If you’re disposed to criticise, there’s never a shortage of material - particularly if you’re prepared to offer mutually inconsistent criticisms, or shift your angle of attack from one week to the next.

Sometimes the media are so eager to fan controversy they hardly pause to summarise the content of a 300-page document before launching into their own and other people’s criticisms. And no matter how weighty the subject matter, you can bet it’ll be done and dusted within a week.

I prefer to be a little more considered, even more co-operative with our elected leaders (and nor do I regard a diet of unrelieved negativity as a smart way to sell news). So, though I have some major criticisms of my own, I’ll leave them for another day.

Throughout the life of the Rudd-Gillard government people have criticised its failure to articulate an ‘overarching narrative’ - an encompassing story of what Labor stands for and what it’s on about. A vision of the future; something that gives meaning and direction to our national life.

Well, it may have taken five years, but here’s Gillard’s best shot. It’s not, as some have imagined, the report of another committee headed by Dr Ken Henry; it’s a white paper, a firm statement of government policy intention.

So what do the critics say? It’s just more talk. Where are the new decisions? When will we be getting them? What about my pet project?

You may say this is a narrative with an arch that stretches from the economic to the commercial via the financial (and I may agree), but that makes it an accurate depiction of the breadth of this government’s priorities.

Some say suspiciously that the white paper includes a mention of just about every project Labor is working on: the carbon price, the national broadband network, education reform etc. Sure. That’s what overarching narratives do.

It’s a vision of increasing our material prosperity by ensuring we fully exploit the opportunities presented by our proximity to Asia, which is transforming itself from poor to rich within the short space of our lifetimes.

Within that limited purview, it’s on the right track. It’s hard to imagine our equally materialist opposition disagreeing - though you can be sure it will find plenty to criticise.

The white paper says that, to succeed in this objective, Australians need to act in five key areas. First, we need to build on our own economic strengths. In particular, we’ll need ‘ongoing reform and investment’ across ‘the five pillars of productivity - skills and education, innovation, infrastructure, tax reform and regulatory reform’.

Second, we must do more to develop the necessary capabilities. ‘Our greatest responsibility is to invest in our people through skills and education to drive Australia’s productivity performance and ensure that all Australians can participate and contribute.’

Third, we need businesses that are highly innovative and competitive. ‘Australian firms need new business models and new mindsets to operate and connect with Asian markets.’

Fourth, we need stable defence security within the region. And finally, we need to strengthen our relationships across the region at every level. ‘These links are social and cultural as much as they are political and economic.’

It’s easy to say there’s nothing new in the white paper. We already knew about the rise of Asia. And prime ministers have been banging on about our need to get closer to Asia since Malcolm Fraser.

It’s all true. But it misses the point. The experts may be full bottle, but public doesn’t know as much about Asia as it should; this is an attempt to lift our ‘Asia literacy’ as well as getting more study of Asia and its languages into curriculums.

And governments bang on about a lot of things; this is a decision to give our relations with Asia top priority. This is a long-term project and it didn’t start yesterday. It doesn’t hurt to have a grand renewal of our commitment. It maybe old to us oldies, but to our kids it’s new and sparkling.

The white paper seeks to dispel a lot of misperceptions among Australians. For one thing, it’s not just about China. It’s also about India, South Korea and developing Asia in general - and hugely populous Indonesia in particular.

For another, it’s not just about mining. Though the mining boom has further to run, it’s also about selling a lot more food and fibre to Asia at much higher prices, and supplying Asia’s burgeoning middle class with education, tourism, sophisticated niche manufactures and many services.

But deepening our economic (and, inevitably, social and cultural) relations with Asia is two-way street. Exporting more to Asia will mean importing more from it (giving the lie to criticism this is about exploiting the poor people to our north)
And increasing our business investment in Asia will mean accepting more Asian investment in our businesses.

And, as we’ve already seen with the mining boom, maximising our benefit from the rise of Asia will inevitably mean accepting change and upheaval in our economy. The more we try to preserve the world as it was, the more we pass up the opportunities Asia presents.

The other bad news is that full benefit from Asia isn’t something this government or any other can deliver us on a plate. It needs to be a national effort, with most of the heavy lifting done by business, schools, universities, unions and individuals.


Monday, October 29, 2012

It's better to honour budget commitments

Those economists who’ve joined the smarties in proclaiming Julia Gillard’s seeming resolve to get the budget back to surplus this financial year to be purely political and of no economic merit are revealing how little they know about political economy - the politics of economic policy.

They don’t understand the vital role faithful adherence to ‘frameworks’ has played in giving Australia it’s widely envied record on fiscal (budgetary) responsibility.
It ought to be blindingly apparent just how much trouble successive governments in the United States and Europe have got themselves and their people into by their chronic failure to discipline their spending and taxing the way our governments - Labor and Liberal - have for many years.

Our pollies have done this by setting for themselves and sticking to policy frameworks - in particular, the bipartisan ‘medium-term fiscal strategy’ to ‘achieve budget surpluses, on average, over the medium term’ - regularly supplemented by more explicit, shorter-term targets.

When, in the throes of the global financial crisis, Kevin Rudd embarked on huge fiscal stimulus, he nonetheless bound the government to various strictures to keep his actions consistent with the medium-term strategy and the requirements of Peter Costello’s Charter of Budget Honesty Act.

For openers, he pledged to ensure all stimulus programs were temporary - which they were. And as early as February 2009 he committed the government to a ‘deficit exit strategy’ in which it pledged to avoid further income-tax cuts and limit the real growth in government spending to an average of 2 per cent a year until the budget was back into significant surplus.

So far, the government has stuck to that commitment. When, in the 2010 election campaign, Gillard took Treasury’s projection that the budget would be back in surplus by 2012-13 and turned it into a solemn promise, she was binding herself more that the medium-term strategy required her to.

As the future has unfolded, this has proved an ever-more difficult promise to keep, mainly because of weaker-than-expected growth in the world economy and the now-apparent structural weakness on the budget’s revenue side.

In consequence, keeping the surplus in prospect has required Gillard to find further savings in just about every budget and mid-year update since. Question is: why is that a bad thing?

It’s not as if the economy’s fallen off a cliff. It’s continued growing at about its medium-term trend rate, with unemployment steady in the low 5s for the past three years. It’s expected to continue growing at a fraction below trend, with unemployment edging up only to 5.5 per cent.

What’s more, the tightening in fiscal policy is occurring that a time when the Reserve Bank has plenty of scope to compensate by easing monetary policy - with an outside chance this could help lower the dollar a little.

This is consistent with the strategy: that, except in emergencies, fiscal policy move in a more inexorable, medium-term way, with the far more easily adjusted monetary policy used as the ‘swing instrument’.

Admittedly, a lot of the savings measures have been cosmetic. But shifting planned expenditure by more than just a few weeks either side of June 30 is real. And not all the measures have just been such ‘reprofiling’.

Wayne Swan and Penny Wong have been chipping away at middle-class welfare in a way they probably wouldn’t have were it not for their alleged ‘surplus fetish’. Why’s that a bad thing?

They’ve significantly reformed the tax treatment of superannuation, reformed the concessional treatment of company cars under the fringe-benefits tax, begun phasing out the dependent spouse tax rebate and means-tested the baby bonus and the private health insurance rebate, as well as tightening means tests elsewhere.

In last week’s effort they cut the baby bonus for subsequent children (few people remember the original rationale for the bonus: it was a substitute for paid parental leave, which has since been introduced) and further tightened the health insurance rebate (in a way that saves little in the first few years, but causes the saving to grow each year forever).

A further consequence of the surplus promise has been to strengthen the purse-string ministers’ hand in insisting new spending commitments be matched by savings on existing programs. Why’s that a bad thing?

As for the smarties’ claim that Gillard’s motive in trying so hard to keep her surplus promise is purely political, it’s naive. All of us do many of the things we do for mixed, even ulterior motives. Pollies are no exception. Indeed, if you’ve had much to do with them you know everything they do is politically motivated.

So to say Gillard fears what the opposition would say if she failed to achieve a surplus is to state the obvious. The real question is, regardless of her political motives, is what she’s been doing consistent with disciplined fiscal policy? I’ve been trying to show it is.

Balancing budgets is politically hard. Most voters, interest groups, backbenchers and even spending ministers don’t give a stuff. The temptation not to bother is huge. So it’s crazy for the one group that cares - economists - to be joining those who don’t in urging the pollies not to bother meeting their commitments to run a tight ship.

Of course, it would be a different matter if the economy was falling off a cliff. In any case, the smarties and slackos may yet get their wish. If you listen carefully to what Swan and Wong are saying about the future, it seems last week’s effort to get the surplus back on track will be their last.

Should the revenue side deteriorate much further, they’re ready to let it go.

Saturday, October 27, 2012

How the budget redistributes income

In a capitalist economy such as ours, the rich have loads of money, the poor have next to none and the government does little about it.

Is that what you suspect? It's a long way from the truth. While some (including me) may argue they could be doing more, between them our governments - federal and state - are doing a lot more to redistribute income from the rich to the poor than many people imagine.

The reason so few people realise this is the system that brings it about is very complex. To see what's going on requires a special study - which is just what the Bureau of Statistics does every six years.

In its publication, Government Benefits, Taxes and Household Income, the bureau uses several of its surveys to take all the taxation we pay - federal and state - and attempt to attribute it to households of differing incomes. It does the same for all federal and state government spending.

But not all the taxes we pay can be attributed to households - company tax, for instance. Similarly, not all government spending can be attributed - spending on defence or roads, for instance.

In the latest study, for 2009-10, it managed to attribute $194 billion, or 62 per cent, of total government revenue and $234 billion, or 51 per cent, of total government spending.

It ranks households lowest to highest according to their income, dividing them into five "quintiles" (groups of 20 per cent). This is handy because, if income was equally distributed, each quintile would have a 20 per cent share of total income. So you can judge how unequally income is distributed by comparing each quintile's actual share with that 20 per cent benchmark.

Households start out with "private income" - income they've earned themselves from wages, investments or any unincorporated business they may own. Then the government gives them cash benefits (such as the pension, the family tax benefit or the dole) and benefits in kind (such as free or subsidised education, healthcare, subsidised childcare and public housing).

But governments also take money away from households in the form of income tax and indirect taxes (such as the goods and services tax, several sin taxes and various state taxes).

Allow for all these things and you end up with households' "final income". So how much does all the governments' taxing on the one hand and spending on the other end up changing people's incomes?

Quite a bit. The poorest quintile is composed mainly of pensioners and people on the dole. Its share of total private income is less than 5 per cent, whereas its share of total final income is more than 7 per cent.

The second poorest quintile (composed mainly of self-funded retirees and the working poor) has its share of total income increased from 9 per cent to 13 per cent.

The middle quintile (composed mainly of working families) has its share raised from 15 per cent to 17 per cent.

The second-highest quintile's share is virtually unchanged at 23 per cent. But get this: the highest quintile (mainly two-income couples without dependants) has its 48 per cent share of private income reduced to 40 per cent of final income.

So the system of taxes and benefits takes 8 percentage points of total income from the top 20 per cent of households and redistributes it to the bottom 60 per cent.

But how exactly does it bring this about? For a start, income tax is "progressive" - it takes a progressively higher proportion of tax as income rises.

The bureau's figures show income tax takes about 8 per cent of the private income of households in the lowest quintile but the proportion steadily increases until you get the highest quintile, which loses more than 19 per cent.

(If that last proportion seems low, remember income tax is levied on the incomes of individuals, not households. Most top households would have two income-earning individuals, probably with one partner earning a lot more than the other, thereby lowering their average tax rate.)

Of course, you'd expect the progressive effect of income tax to be offset by the "regressive" effect of indirect taxes. A regressive tax takes a higher proportion of low incomes than high incomes.

And that's just what the bureau's figures show. On average, households in the lowest quintile lose 19 per cent of their "gross income" (private income plus cash benefits) in indirect taxes. That proportion falls steadily until you get to the highest quintile, which loses less than 8 per cent.

So what's the story when you put the two types of tax together to examine the effect of the total tax system? You find the tax burden as a proportion of gross income is very roughly U-shaped. The lowest quintile loses 24 per cent, but then the proportion drops to 22 per cent before slowly rising to reach 27 per cent for the highest quintile.

Clearly, the total tax system does surprisingly little to redistribute income from the top to the bottom.

See what that means? Though few people realise it, most of the redistribution done by the budget comes not from its tax side but from its spending side.

That's particularly the case with cash benefits which, after all, are tightly means-tested. The cash benefits received by households in the lowest quintile are equivalent to 47 per cent of their private income.

But that proportion falls sharply until you get to the highest quintile, whose cash benefits add just 2 per cent to their private income. Mental note for all lefties: means-testing makes the cash benefits system highly progressive.

By contrast, most benefits in kind are provided on a universal basis - that is, without means-testing. That's true of healthcare and education spending. So you wouldn't expect their distribution to be particularly progressive.

You wouldn't expect it, but for some reason it is. The in-kind benefits received by the lowest quintile are equivalent to 53 per cent of private income. But that proportion falls sharply to reach just 12 per cent of the highest quintile's private income.

All told, the whole tax and benefits system adds an average of $241 a week to the incomes of the bottom 20 per cent of households but subtracts an average of $484 a week from the incomes of the top 20 per cent. That's quite a redistribution.

Wednesday, October 24, 2012

Budget redistributes income over life cycle

Listening to all the argy-bargy over the budget update makes you think - what strange things budgets are. The government spends all this money - hundreds of billions a year - but where does it come from? From us, of course. The politicians use the budget to take money from us with one hand, then give it back with the other.

They have one set of public servants to take our money from us and another to give it back. What's the point of all this "churning"? Wouldn't it be a lot simpler and cheaper to have lower taxes and lower spending?

If we each got back pretty much what we put in, it would indeed be a pointless, wasteful exercise. In reality, high-income earners put in a lot more than they get back, whereas low-income earners receive a lot more than they pay in taxes.

But even that doesn't adequately describe the rearranging brought about by the budget.

Every six years the Bureau of Statistics conducts a study in which, using several of its surveys, it takes all the taxation we pay - federal and state - and attempts to attribute it to different classes of household. It does the same for all federal and state government spending.

Of course, not all the taxes we pay can be attributed to households - company tax, for instance. Similarly, not all government spending can be attributed - spending on defence or roads, for instance.

In its latest study, for 2009-10, the ABS managed to attribute $194 billion, or 62 per cent, of total government revenue and $234 billion, or 51 per cent, of government spending.

Remember Shakespeare's seven stages of man? The study divides Australia's 9.8 million households into 10 main life-cycle stages. It turns out whether your household's a net payer or a net recipient depends heavily on where you are in the life cycle. We'll limit ourselves to six stages.

Most people start their working lives as single and under 35. On average, people in this category pay $226 a week in income tax and $115 a week in indirect taxes, such as the goods and services tax and the various excises.

They get back very little in cash benefits ($28 a week) and not a lot more in benefits in kind, $80 a week, mainly health care plus a bit of public spending on tertiary education.

So, on average, younger singles pay $233 a week more in taxes than they get back in benefits.

The next typical life stage is being young (under 35) and married, before the kids start coming. Households in this category - in which both partners are likely to be working - pay an average of $384 a week in income tax and $196 in other taxes.

They get back virtually nothing in cash benefits ($12), but $136 worth of benefits in kind, mainly healthcare and tertiary education.

So, on average, young childless couples pay no less than $432 a week more in taxes than they get back in benefits.

Once the kids start arriving, however, the tables turn. Somewhat older couples with dependent children, the eldest of which is aged between five and 14, pay more income tax ($454) and a bit more indirect tax at $227 (a sign of a more frugal life style).

Cash benefits jump to $133 a week (mainly family tax benefit) and benefits in kind leap to $608 a week (mainly school education, but also a lot more healthcare and a bit of childcare subsidy).

So, on average, couples with a kid or two get back $60 a week more than they put in. They think they're paying a lot of tax but, in truth, they're getting a net subsidy from other taxpayers.

Once the kids grow up, however, the tables turn again. Couples with non-dependent children average $604 a week in taxes. Against this, they get cash benefits of $176 and benefits in kind (overwhelmingly healthcare) of $328.

So older working couples revert to paying more in taxes than they get back, to the tune of $100 a week.

We've reached the last two stages of life: couples 65 and over, then single people 65 and over. On average, largely retired couples pay next to nothing in income tax and a bit in indirect taxes, totalling $168 a week. Against that, they get cash benefits of $378 (mainly the age pension) and benefits in kind (mainly healthcare) of $481.

So, on average, retired couples get back $691 a week more than they pay. For surviving single retirees it's a net gain of $475 a week.

See what all this proves? As well as redistributing income from rich to poor, the budget acts as a giant, multi-faceted mutual support scheme. At some points in your life you're a net contributor, at others a net recipient.

The system requires those without dependents to subsidise those with, particularly when the little blighters need educating. It requires the well to subsidise the sick. It requires those who work to subsidise those too old to work.

I think it's a good system, a sign we live in a reasonably caring, civilised society, where those in need get supported by the rest of us.

It's a reason we should pay our taxes with a lot less grumbling. The pity is, the system's so complex and convoluted it's not until you see a special study such as this that you realise how it works - it's inbuilt fairness and solidarity.

Something to think about next time you're tempted to justify a demand on government because you've "paid taxes all my life". You've also been benefiting all your life.

Monday, October 22, 2012

Business cons the states out of tax revenue

WHEN we see the mid-year budget review today, all eyes will be on the savings Wayne Swan will announce to ensure he still achieves a surplus this financial year. The measures will be needed because the weakness in tax collections is even greater than expected.

Deciding how much we should cut spending is one thing, but working out what to do about the budget's structural problems on the revenue side is quite another.

One way the Gillard government is seeking to reduce pressure on its budget is by demanding bigger contributions to joint projects by the states. They, however, always see themselves as recipients of federal spending, not contributors.

I have a fair bit of sympathy for the states. They have primary responsibility for the big-ticket spending areas of education, hospitals, law and order, roads and transport, and much else, but their revenue-raising power is limited, having been progressively whittled away by the High Court.

That's why John Howard bequeathed them all the proceeds from the goods and services tax. But the GST is no longer the growth tax it seemed to be. Consumer spending will never again grow as strongly as it did during the tax's first seven years, and an ever-growing proportion of consumer spending goes on items excluded from the GST base.

Because the revenue-raising capacity of the two levels of government is so unequal, any serious funding problem for the states ends up being the federal government's problem.

But it's harder to feel sorry for the states when you remember - as prompted by the secretary to the Treasury, Martin Parkinson, in a recent speech - the way they have knowingly and over many years perverted one perfectly good tax in their possession, payroll tax.

The states' limited taxing ability is an old problem. As long ago as the early 1970s, Billy McMahon sought to fix it for good and all by giving them the federal payroll tax.

Clearly, it didn't work. For a while the states raised the rates of their payroll taxes, but soon enough they began cutting rates to curry favour with business before election campaigns and eroding the base, thereby turning it from a reasonably neutral tax into one that distorts business choices.

Advocates of a federal system like the idea it allows a degree of competition between the states. But when the states compete to lower tax rates - or use offers of tax holidays to attract investment projects away from other states - they all lose. Business plays them off a break. The standard argument against payroll tax is that, by raising the cost of labour, it discourages employment. But this is ill-considered.

In the end, you can tax only three things: land, labour or capital. Income tax is largely a tax on labour; tax economists say company tax is largely a tax on labour, the GST is largely a tax on labour (most consumer spending is done from wages) and payroll tax is also a tax on labour.

Business people tend to approve of the GST - they're always saying its rate should be increased - but invariably oppose payroll tax, even though, in principle, the two are quite similar. Business people know the burden of GST is passed on to consumers, but many seem to imagine the burden of payroll tax remains with them. In both cases, who writes the cheque that goes to the tax man doesn't tell you who ultimately bears the tax.

Business people lap up the fashionable idea that, in a globalising world of ever-greater mobility between economies, we should be relying more on taxing land and labour, and less on taxing capital. But all the while they're inveigling the premiers into reducing payroll tax.

When Parkinson spoke in defence of payroll tax (merely echoing the opinion of all treasuries, federal or state), the states responded that the tax was bad for small business. This is pretty much the opposite of the truth.

Apart from cutting the rate at which the tax is applied, the main way the states have undermined this - the biggest of their own taxes - is by regularly raising the threshold at which the tax applies to a business's wages bill.

So high is the threshold in the various states that genuine small business doesn't pay the tax. It's actually a tax on big business. It's really medium-size business that's most affected by where the threshold is.

Although payroll tax is an efficient, non-distorting tax in principle, its way-high threshold makes it distorting in practice. It's a tax that favours small business and penalises big business.

The obvious reform, which would gradually reduce the distortion of business choices and aid the states' revenue problem without involving too much political pain, is simply to leave the threshold where it is in nominal terms, allowing wage inflation to progressively lower it in real terms.

The insouciance which has allowed the premiers to fritter away their strongest and soundest source of ''own-revenue'' makes you suspect they're privately perfectly happy with the ''vertical fiscal imbalance'' whereby the federal government gets most of the opprobrium for collecting taxes, while the states are perpetual beggars at the federal table, only ever prepared to co-operate with federal reforms if they receive a big enough bribe.

The feds are unlikely to seriously consider changes to the GST until the premiers have shown a willingness to undertake the revenue-enhancing reforms that lie within their own control.


Saturday, October 20, 2012

Game theory can be practical

Children play games. Teenagers play video games. Footballers play games. Economists don't admit to playing games. They prefer to say they study game theory.

This week two academic gamesters, the economist Alvin Roth, of Harvard Business School, and the mathematician Lloyd Shapley, of the University of California, Los Angeles, were awarded the Nobel Prize in Economics for their efforts.

This brought to 10 the number of academics who've won the prize in recent years for helping to develop game theory.

You read a lot about economics in newspapers, but you rarely read about game theory. This may be because, as yet, it's still pretty theoretical without much practical application - though, as we'll see, Roth's endeavours are a notable exception.

But, as all those prizes attest, it's a relatively new area of economic inquiry, one the academics are greatly excited by and believe holds much promise. It's also an approach that's spread to other social sciences.

I'll try to explain it simply, using information cribbed from various sources, but it's actually highly mathematical - another reason it's so attractive to academics, who seem to be turning economics into applied maths.

Economists study how societies allocate resources between competing uses. Conventionally, they study how this is achieved by the movement of prices paid in markets bringing supply and demand into equilibrium.

The standard model assumes the buyers and sellers in those markets are each so small they have no effect on the prices being paid. In reality, many markets are dominated by a few big companies which do have the ability to influence the price.

So game theory began as an alternative way of studying the behaviour of the many ''oligopolies'' that characterise modern economies.

Game theory is the study of how people or firms behave in ''strategic'' situations - those where each player in a market, when deciding what to do, has first to consider how others might respond to that action. So, like a game of chess, the ''games'' economists study have a set of players, a set of moves or strategies available to those players and a range of ''payoffs'' (consequences) of each combination of strategies.

Economists use game theory to describe, predict and explain people's behaviour. They've used it to study auctions, bargaining, merger pricing, oligopolies and much else.

Unlike conventional analysis, game theory allows the possibility of ''multiple equilibria'' - more than one possible outcome the participants regard as satisfactory. And it studies ''decision-making under uncertainty'' - having to make decisions without knowing what the future holds.

Game theory is also able to study co-operative games (where players may form coalitions in competing with other players) as well as non-co-operative games (where all players compete as individuals).

For the most part, however, game theory retains the conventional (unrealistic) assumption of ''rationality'' - people know what's in their best interests and that's what they do.

Game theory began with simple two-player, ''zero-sum games'' - if I win, you must lose. It's moved on to multiple-player, positive-sum games - games where all players may gain because of the ''gains from trade'' (exchange) between people.

The classic game is ''the prisoner's dilemma'', where two prisoners must separately decide whether to co-operate with the other (by admitting nothing) or to ''defect'' (dob in the other in the hope of a lighter sentence). It shows why, in the absence of trust between them, the prisoners may choose not to co-operate (the ''rational'' choice for each), even though it's in their best interests to do so. This game is so famous because it studies the great problem of civilised societies: how to deal with ''free-riders'' - people who take advantage of others' willingness to co-operate.

The work of Shapley and Roth is a long way from that. Shapley, a theoretician who did most of his work in the 1960s, studied ''matching markets''. In most markets you choose what you want and hand over your money. In matching markets you make your choice, but you also need to be chosen by the other side.

If a market has an application or selection procedure, it's a matching market. Such markets determine some of the most important changes in our lives. Marriage, for instance. You don't like thinking of marriage as a market? That's why, in many matching markets, the transaction occurs without the use of money. Using money to determine who gets what would be ''repugnant''.

Shapley was concerned with reaching outcomes in non-monetary matching markets that were ''stable'' - where nobody wanted to change their pair in the belief they could do better.

(This equilibrium is the co-operative games' equivalent to a ''Nash equilibrium'' in non co-operative games. In a Nash equilibrium, each player is making the best choice they can, given the choices of the other players. John Nash, an earlier Nobel laureate, was the mentally disturbed mathematician played by Russell Crowe in the movie, A Beautiful Mind.)

Shapley's contribution, with David Gale, was to discover an algorithm (a mathematical set of rules for solving a problem) that would lead to stable pairs. Say thousands of students have applied to enter 20 universities, setting out their preferences.

The algorithm turns on ''deferred acceptance'' - the unis make their offers, the students select the best offer they've received, but delay accepting it, rejecting any other offers. The unis make further rounds of offers until the process is complete and students then accept the best offer they've had.

Gale and Shapley proved their algorithm always leads to stable pairs. They also showed the side that starts the process gets the better deal. Their approach discourages players from attempting to game the system by not stating their true preferences.

The contribution of Roth, who spent time at Sydney University this year, is more practical. He's taken the Gale-Shapley algorithm, studied it using laboratory experiments and applied it to real-world matching exercises.

He's expert in ''market design'' - changing the rules in markets so they work more efficiently in producing the best outcomes for people. He says a ''free market'' is one that moves freely in achieving efficient outcomes, not necessarily a market with no intervention by the government. In the United States, Roth has helped make changes that improve the pairing of medical interns with hospitals, the pairing of students with high schools and the matching of kidney donors with recipients. He's also done the last one in Australia, actually improving some people's lives.


Wednesday, October 17, 2012

Psst. Don't tell anyone about poverty

It's remarkable that, despite all the effort and expense the government goes to in measuring gross domestic product, it doesn't run to the modest extra expense of measuring poverty. But this being so, it's hardly remarkable the media and the public pay far more attention to the gyrations of GDP than to the extent of poverty.

Why the lack of official interest in such a basic measure of how we're doing as a nation? Because, in an egalitarian country such as ours, poverty isn't much of a problem?

Err, no. In the mid-2000s, Australia's rate of poverty was the fourth highest among 18 developed economies. Surely the reason couldn't be that our record is so bad that the government would prefer us not to think about it? Hmmm.

The more I think about it, the more I want to know what there is to know about poverty in Australia.

And, when some of our big charities - Anglicare, St Vincent de Paul and the Salvos - feel it worth expending some of their precious funds to commission a report on the subject, as they did this week, I'm inclined to take notice. Who knows when next the problem will be drawn to our attention?

As you've seen from the headlines, the report finds that more than 2 million Australians - one person in eight - is living in poverty. This poverty rate of almost 13 per cent has changed a bit but not a lot over the past decade. It's not shooting up, but neither is it falling.

What exactly is meant by ''living in poverty''? How is it measured?

There is more to being poor than just an absence of money. Another dimension is how isolated you are from the support of other people. But this measure - calculated from official surveys by the social policy research centre at the University of NSW - is a purely monetary one.

The next point is that poverty is measured differently in rich countries from poor countries.

In the developing world they measure ''absolute poverty'' - whether you're so poor you're at risk of death from malnutrition.

In rich countries few people, no matter how poor, are starving. So we measure ''relative poverty'' - how many people or households have incomes well below what's typical in our community. And how low is ''well below''? Usually, that's a case of drawing an arbitrary line, and drawing it so low there isn't much room for argument.

This study sets the poverty line at a level commonly used in comparisons between the rich countries. It ranks the disposable (after-tax) incomes of all households from highest to lowest, then draws the line at 50 per cent of the median (dead-middle) income.

The study finds almost 13 per cent of households fall below the line. Hold that thought.

The main way people avoid poverty is by having a job and earning income from it. So you'd expect that, unless people were on particularly low wages, or could find only part-time work, or had a lot of others depending on them, working households would avoid poverty.

The main way governments seek to avoid poverty in the community is by paying a range of social security benefits to those people who, for one reason or another, are unable to work.

Those too old to work get the age pension; those too sick get the sickness benefit; those physically or mentally unable to work get the disability support pension; those too busy minding children get the single parenting payment; those too busy caring for a relative get the carer payment. And those who just can't find a job get the dole.

The federal minimum wage - increased each year by Fair Work Australia - is comfortably above the poverty line which, in 2010, was $358 a week for single adults.

And, most people with children to support get the relatively generous family tax benefit.

So why do 13 per cent of people fall below the poverty line? The biggest single reason is that the levels of the various social benefits fall below the line. Way below in the case of the dole; a little below in the case of the single parenting payment and the age pension.

It follows that, unless they can supplement their payment with income from savings or a little part-time work, people living on social security payments are at great risk of poverty. Overall, 37 per cent of people on social payments live below the line. But the proportions vary widely according to the type of payment: 14 per cent of those on the age pension, 42 per cent of those on the disability pension, 45 per cent of those on the parenting payment and, get this, 52 per cent of those on the dole. Not surprising then, that people on social payments account for almost two-thirds of those in poverty.

The next most important factor explaining why people fall below the line is the high cost of housing.

In particular, the gap between the costs of owning and renting. It's a safe bet the majority of people in poverty are renters.

It may surprise you that the retired account for only about 15 per cent of those below the line. That's because so many own their homes outright.

When you're measuring relative poverty, it follows as a matter of arithmetic that the only way to reduce the proportion of people falling below the line is for their incomes to increase at a faster rate than incomes generally.

Julia Gillard could reduce poverty at a single (expensive) stroke: a decent, one-off increase in the indefensibly low rate of the dole.


Monday, October 15, 2012

Reserve Bank moves to Plan B on interest rates

IT'S not at all clear that falling commodity prices - or the Reserve Bank's latest cut in the official interest rate - will lead to a lower Aussie dollar. But if it doesn't fall, and the economy doesn't look like it will stay growing at its trend rate, the Reserve will just keep cutting rates.

The best way to think of the Reserve's problem in using monetary policy (interest rates) to maintain non-inflationary growth is that for some years it's been trying to keep the economy on an even keel while we're being hit by two powerful, but opposing economic shocks: the expansionary shock from the resources boom and the contractionary shock from its accompanying very high exchange rate.

This involves predicting, then continuously monitoring the relative strengths of the opposing forces, with the objective of keeping inflation in the 2 to 3 per cent range and the economy growing at about its medium-term trend rate of 3.25 per cent a year - neither much less than that nor much more (because the economy's already close to full employment).

For most of last year the Reserve's greatest worry was that the stimulus from the resources boom, applied to an economy already near full employment, would push up inflation. By November it realised any inflation threat had passed - it was actually falling - whereas growth was on the weak side of trend. It therefore cut the cash rate by 125 basis points (1.25 percentage points) between November and June.

The latest reassessment of the balance between the two conflicting forces bearing on the economy is that the fall in coal and iron ore prices and the shelving of expansion plans by some second-tier miners will cause mining investment spending to peak in the middle of next year, a little earlier and a little lower than expected.

This pushed the growth forecast for the overall economy a bit below trend. Hence this month's rate cut.

It's reasonable to attribute the Aussie's remarkable strength since the start of the resources boom predominantly to our high commodity export prices and vastly improved terms of trade.

That makes it reasonable to expect the fall in export prices would lead to a commensurate fall in the Aussie, thus reducing its contractionary effect on our export and import-competing industries.

But the historical correlation between our terms of trade and our exchange rate, while strong, can also be quite loose for fairly long periods. So it's not surprising the Aussie has held up so well.

The plain truth is that, because financial markets simply aren't as ''efficient'' as it suits some economists to believe, no theory they can come up with adequately and always explains the Aussie's ups and downs.

The best you can say is the terms-of-trade theory works well a lot of the time and over the medium to long term, while its main rival - that the Aussie's driven by the size of the ''differential'' between our interest rates and those on offer in the big economies - sometimes works at other times.

So it's equally unsurprising the 150-basis-point fall in our official interest rate since November has done little or nothing to get the Aussie down.

My guess is the Aussie could stay much where it is for years to come. Why? Because of a third, omnibus theory: those countries with the best growth prospects tend to have strong exchange rates whereas those with poor prospects tend to have weak exchange rates.

It's a safe bet that, even if we were to fail in our attempt to get growth back up to trend, our prospects will stay a mighty lot better than those for the United States and Europe. Then there's our AAA sovereign credit rating and exposure to the fastest-growing region, Asia, to entice capital inflows.

Remember, exchange rates are relative prices, so if some countries are down, others must be up. We're not alone in the strong-currency boat: there's also Switzerland, Canada, New Zealand and Sweden.

So, what if the Aussie stays up and its contractionary effect on the economy remains undiminished? The Reserve would just keep cutting the official rate until it foresaw growth getting back up to trend.

In principle, the only thing that could deter it from this response is rising inflation pressure, but with growth below trend that's hardly likely.

Its goal wouldn't be to get the dollar down (though that would be welcome) so much as to stimulate the presently ailing, interest-sensitive parts of the domestic economy: home building and commercial (as opposed to mining-related) construction.

This would quite possibly get house prices growing reasonably strongly which, in turn, could perk up consumer confidence, particularly for people in or near retirement.

But that's actually the vulnerability in such an approach by the Reserve. Returning to a period of exceptionally low mortgage interest rates risks igniting another credit-fuelled boom in property prices, at a time when many households remain heavily indebted and most foreign economists can't understand why we haven't had a property bust.

The rich world spent most of the 1970s, '80s and '90s worrying about how to get inflation down to acceptable levels. We now know that, particularly since the advent of independent central banks and inflation targeting, the central bankers have got (goods-and-services price) inflation licked.

One small problem: as the global financial crisis so powerfully reminded us, in the process they've aggravated the problem of asset-price inflation, with its huge bubbles and terrible busts.

To date, the world's monetary economists are at a loss on how they can control goods-price inflation and asset-price inflation at the same time.


Saturday, October 13, 2012

Labour market can be flexibile as well as fair

If you listen to business, we still have big problems with the labour market. John Howard deregulated it, but then Julia Gillard re-regulated it and now we can't do a thing with it.

The business people are right to this extent: particularly at a time when the economy is under so many pressures for change in its structure - the rise of the emerging market economies and the resources boom it has produced, the digital revolution, the return of the prudent consumer, and more - we do need a labour market that's "flexible".

But what exactly does flexibility mean? Well, not what some bad employers think: unilateral freedom to change their staff's working arrangements without recompense or consultation. That's one-sided flexibility.

No, what flexibility should mean is the ability of the labour market to adjust to the shocks that hit the economy without generating excessive inflation or unemployment. You get some, but it doesn't linger for years.

Another word for it is "resilience" - the ability to take the punch, then bounce back.

So how are we doing on that score? A lot better than business's complaints may lead you to believe. In a speech this week, Philip Lowe, the deputy governor of the Reserve Bank, reeled off a host of respects in which the labour market is more flexible.

He started by noting that, despite all the gloominess - and notwithstanding its apparent rise to 5.4 per cent last month - the official unemployment rate is still very low by the standards of the past 30 years.

In that time there have been only four years in which the unemployment rate has averaged less than 5.25 per cent. (Note for sceptics: contrary to urban myth, the method of calculating the rate hasn't changed in that time.)

Lowe reminds us Australia has one of the lowest unemployment rates among the advanced economies - "an outcome that seemed improbable for much of my professional career".

Although the unemployment rate has been virtually unchanged for more than two years, this conceals a great deal of coming and going from jobs. The figures show that in February this year, about 2.3 million people - almost a fifth of the workforce - were newly employed, having been in their job for less than a year.

Whereas a little less than half of these people were starting work for the first time (or for the first time in a long time), 1.2 million people moved from one job to another. And this in a year when the net growth in employment was a mere 23,000.

In other words, a fraction more people gained jobs than lost them, even though the media trumpeted the job losses and said next to nothing about the job gains.

About three-quarters of the job changes were voluntary, including for personal reasons or to take advantage of new opportunities. The remaining quarter was involuntary, including because employers went out backwards or changed the nature of their business.

It's always true that far more people move around than we imagine when we see the small net changes from month to month. In the jargon, "gross flows" far exceed net change. But Lowe finds some evidence all the structural pressures affecting the economy at present have led to a higher rate of job turnover.

If you take all the people who left their job over the year to February and compare it with the all people employed at some time during the year, this was the highest in two decades.

That's true for both voluntary and involuntary "separations" - meaning it's a sign of greater flexibility in the labour market. It suggests that, while a lot of jobs ceased to exist, at the same time a lot of new job opportunities opened up in other parts of the economy and many displaced workers were able to find new jobs without much drama.

Another indication some parts of the labour market are expanding while others are contracting is that the official measure of the number of job vacancies has remained relatively high, even though the growth in employment overall has been so small.

Consider this: since 2007, about 300,000 net additional jobs have been created in the health care sector, 200,000 in professional and scientific services, and about 130,000 each in mining and education.

So where's the downside? Employment in manufacturing has fallen by about 70, 000 and the number of jobs in retailing has stopped growing.

Despite this significant variation in employment growth by industry, there hasn't been any widening of the rates of unemployment among the nation's 68 local regions. Compared with 10 years ago, the average unemployment rate is lower and the variation between regions is lower, not higher.

About half the regions have unemployment rates below 5 per cent and almost three-quarters have rates below 6 per cent. In only three regions is the rate above 8 per cent, compared with 13 regions a decade ago. That's lovely, but what about wages? Here there has been increased dispersion. Since 2004, average wages in mining have risen by about 10 per cent relative to the economy-wide average. Workers in professional services have also experienced faster-than-average increases, Lowe says.

Conversely, relative wages have declined in the manufacturing, retail and the accommodation industries, each of which has experienced difficult trading conditions in recent times.

Sounds pretty flexible to me. This adjustment of relative wages has help move workers around the changing economy so shortages of skilled workers in some areas have been fairly limited.

Lowe observes the adjustment of relative wages has occurred "without igniting the type of economy-wide wages blowout that contributed to the derailment of previous mining booms".

He declares the industrial relations system is more flexible than it was two decades ago and says it's essential the labour market retains its flexibility. But though industrial relations laws and practices are important in this, "they are by no means the full story".

"Flexibility also comes from having an adaptable [my emphasis] workforce - one that has the right general skills, the right training and the right mindset," he concludes.

"Whether or not Australia fully capitalises on the opportunities that the growth of Asia presents depends critically upon the ability of both workers and business to adapt, and to build and use our human capital."

Wednesday, October 10, 2012

The Asia boom is just getting going

Have you noticed how joyfully the media trumpet the bad news they seek out so assiduously? The latest is that the resources boom is finally busting. O frabjous day! Callooh! Callay!

It's true the prices we're getting for our exports of coal and iron ore, having lifted the terms on which we trade with the rest of the world to their most advantageous level in 200 years in the September quarter of last year, have been falling ever since and have further to go.

It's true China's economy has slowed markedly in recent times and this, combined with the fall in export prices, has prompted some of our smaller mining companies to shelve their plans for new mines.

And last week the Reserve Bank warned the peak in mining investment spending was likely to occur next year and reach a lower level than earlier expected. Fearing a slowdown in the economy, it cut the official interest rate another notch.

So, is this the dumper many people have feared? Is the much ballyhooed resources boom about to disappear into the history books?

Don't be misled. As the secretary to the Treasury, Dr Martin Parkinson, argued last week, it was always misleading to think the resources boom, being just another boom, would soon bust, leaving us in the lurch with nothing to show but holes in the ground.

For a start, it's a bit previous to be kissing the boom goodbye. Spending on the building of new mines and liquefied gas plants is expected to keep growing strongly for another year before it starts to fall back. Even then it will stay way above what we normally see for several more years.

Coal and iron ore prices may be falling, but don't imagine they'll return to anything like what they were. At their best, our terms of trade - the prices we get for our exports relative to the prices we pay for our imports - were almost 80 per cent better than their average throughout the 20th century.

The econocrats now expect that, by 2019, they will have collapsed to a mere 50 per cent above that 100-year average. Nothing to show for it? This means we'll remain wealthier than we were (our exports will continue buying far more on world markets than they used to).

Taken by itself, this lasting improvement in our terms of trade suggests another thing we'll have to show is a dollar that stays well above the US70? or so it averaged in the decades following its float. That means a dollar that remains uncomfortably high for our manufacturers and tourism operators.

All this ignores a further benefit from the resources boom which, though it's already started, is largely still to come: vastly increased quantities of coal, iron ore and natural gas for export. This, too, adds to our wealth.

Before the start of this supposed here-today-gone-tomorrow "boom" - which began almost a decade ago - mining accounted for less than 5 per cent of the nation's total production of goods and services. Its share is now well on the way to 10 or 12 per cent.

At the same time, manufacturing's share will continue its decline from about 15 per cent in 1990 to 12 per cent at the start of the boom and 8 per cent today to maybe 6 per cent by the end of this decade. (Much of this decline, however, is explained by the faster growth of the services sector as we, like the rest of the rich world, move to a knowledge-based economy.)

So yet another lasting effect of this fly-by-night boom is a marked and lasting change in the structure of our economy. To the consternation of some, the non-services part of our economy is becoming less secondary and more primary.

The underlying reason for this shift is the same reason it was always mistaken to imagine this is a transitory commodity price boom like all those we've seen before: the economic emergence of the developing world, led by Asia.

With the industrialisation of China and India, the globe's centre of economic gravity is shifting from the North Atlantic to the Indian and Pacific oceans. It's happening so fast it's visible to the naked eye. All the economic troubles of the Europeans and Americans are speeding it up, not slowing it down.

Remember how the world's richest 20 per cent owned 80 per cent of the wealth? Forget it. The poor countries already account for half the world's annual production of goods and services. Over the next five years, they'll account for three-quarters of the growth in world production.

So we're witnessing a tremendous change in the structure of the world economy, something so big economic historians will still be talking about it in 200 years' time. Is it surprising the effects on our economy are so big and so lasting?

We're greatly affected because of our proximity but also because our economy is so complementary to the emerging Asian ones. We have in abundance what they need in abundance: primary commodities. Their need for our raw materials will roll on for decades, including as Indonesia transforms itself from the world's fourth most populous country to its fourth richest.

This raises the final reason the mining boom shouldn't be lightly dismissed. As Parkinson reminded us, it's just the first wave of change arising from the Asian century. Next comes the rural boom as global demand for agricultural produce surges.

The third wave is the global growth in the middle class - from half a billion to more than 3 billion souls - with its growing demand for better services, goods and experiences. Just another passing boom?

Monday, October 8, 2012

We need to talk about the budget

I have a terrible fear that just as the rest of the developed world is demonstrating how much better off our three decades of budgetary discipline have left us, we're in the early stages of letting it slip.

Australians have drawn many (usually disheartening) conclusions from the tribulations of the Europeans and Americans since the global financial crisis, but they don't seem to be getting the most obvious message: thank god we've kept our nose clean on the budget.

You can look at the Europeans' problems and say the key to them is the unsound basis on which they built their common currency, but the euro wouldn't be in trouble were it not for the decades of fiscal (budgetary) indiscipline of so many of its member countries.

They've gone for 30 years or more not bothering to balance their budgets and, as a consequence, building up huge levels of government debt. Add the crisis and its need to bail out banks and stimulate economies, and debt levels jump to the point where a banking crisis morphs into a sovereign debt crisis.

This story of laxity is matched in the United States (not to mention Britain). Although America's long-term bond rates are extraordinarily low - evidencing little sign of concern by the bond market - it's clear the Americans face considerable difficulty getting their growing deficit and debt levels under control.

In marked contrast, Australian governments - federal and state - have been obsessed by the need to restrain deficits and debt since the early 1980s, notwithstanding the ups and downs of the business cycle in that time.

The development of a suitably responsible but cyclically flexible "framework" for the conduct of fiscal policy began with the Hawke government's budget "trilogy" and culminated in Peter Costello's charter of budget honesty and medium-term fiscal strategy, requiring the budget to be balanced "on average over the medium term".

What makes our performance so remarkable isn't our early start in the design of budgetary commitments, but that successive governments have stuck to them.

That's true even of our budgetary response to the financial crisis. Kevin Rudd was able to unleash huge budgetary stimulus because net federal debt had been eliminated. But the medium-term strategy effectively required the increased spending to be temporary, and so it was.

Many Australians probably don't realise the Europeans' and Americans' budgets face enormously increased pressure over the next decade and more as the baby boomers retire. Why? Because governments long ago set up highly generous public pension schemes that haven't been adequately funded by employee contributions.

Yet again, we're in the clear. The cost of our low, flat-rate, means-tested age pension will not blow out much as the baby boomers retire. (Admittedly, the tax concessions attached to superannuation are far too expensive, though that's not a baby-boomer problem. And the Rudd-Gillard government is taking steps to wind them back.)

The depth of Australians' aversion to deficits and debt is well demonstrated by the opposition's success in frightening the punters over the modest rise in public debt following the financial crisis, and the government's manic determination to get back to surplus in 2012-13 come hell or high water.

So why my fear that, in terms of our commitment to fiscal rectitude, this is as good as it gets? That, just when we're witnessing the huge trouble we've avoided by being so disciplined, we're preparing to lurch into indiscipline?

Because both sides of politics are gearing up for next year's federal election with wildly expensive commitments they'll have enormous trouble fitting into a balanced budget. And because, though neither side wants to admit it, the revenue side of the budget is in so much trouble.

Each side is leading us down a different garden path. Labor is trying to buy the election with promises of vastly increased spending on a disability insurance scheme, grants for schools and much else. It's given us absolutely no indication of how it will pay for this spending "going forward".

For his part, Tony Abbott is trying to buy the election with promises to abolish the two new taxes that raise about $10 billion a year, the proceeds from which are already fully committed. For good measure, he's promising to lower the tax burden generally.

It's hard to believe either side would have sufficient discipline - sufficient willingness to impose deeply unpopular spending cuts - to pay for their promises and leave the budget bottom line heading ever further into surplus as we steadily eliminate the net public debt both sides profess to be so concerned about.

And that's before you take account of the two complications the Treasury secretary, Dr Martin Parkinson, reminded us of in a major speech on Friday. First is that economic growth - and hence, tax collections - in coming decades will be slower for demographic reasons (more on that another day).

Second, the serious structural problems on the budget's revenue side: income tax's loss of bracket-creeping power thanks to eight years of tax cuts; company tax's problems with the miners' huge depreciation deductions and the evaporation of capital gains, and the goods and services tax's problems with the return to normal growth in consumption and the changing pattern of consumer spending.

All these weaknesses say it will be a long time before tax revenue returns to its earlier proportion of gross domestic product, if it ever does.

"Combined," Parkinson says, "the slowing economic growth, rising expectations of government, and a constrained revenue base, are likely to force an explicit debate about the size and scope of government."

Bring it on.

Saturday, October 6, 2012

How the financial system works

It’s amazing to think the mighty, mysterious, overawing edifice of high finance - run by people much smarter and infinitely better-paid than us - is built on a pathetically simple, often fickle emotion: trust.

This is something economists and bankers understand in theory but, in their world of high-falutin’ mathematical models, keep forgetting in practice - to everyone’s cost. In this they exhibit the very human fallibility they so often assume away in their fancy calculations.

It’s also so elemental - and so humbling - they rarely talk about it. So when someone in authority spells it out for the benefit of mere mortals, it’s work taking note. An assistant governor of the Reserve Bank, Dr Guy Debelle, did so in a speech last week.

He started by explaining what banks and the financial sector do. They act as ‘intermediaries’ between savers and borrowers, taking the funds they raise from savers - through deposits, for instance - and lending them to those who wish to borrow, whether they’re businesses, governments or householders.

The financial sector is an intermediate sector, Debelle says. It’s not at the end of a production chain producing something that directly generates satisfaction. Rather, it’s a critical link along the way; the oil that keeps the economy ticking over. ‘When the oil dries up,’ he says, ‘the economic engine starts to malfunction and can ultimately grind to a halt.’

So the financial sector is different from other parts of the economy and its central role in keeping the rest of the economy functioning explains why it’s subject to considerably more government regulation and oversight than other industries (something many governments forgot in the years before the global financial crisis).

But why do we need financial intermediaries? Why don’t savers lend to borrowers directly? Mainly because of ‘asymmetric information’. This just means I know more about my affairs than you do. It’s hard for a saver to know whether the person or business to which they’re going to lend money will use the money wisely and be in a position to repay the loan when it falls due.

In contrast, a bank is practiced at making such an assessment of credit-worthiness and so can reduce (but never eliminate) the degree of asymmetry. The size of the interest rate charged by the bank should reflect its assessment of the degree risk of not being repaid.

The other main advantage of lending via intermediaries is their scope for ‘diversification’ - making a range of different loans to people or firms in different circumstances means the bank should not be overly exposed to a particular loan going bad.

So banks are able to ‘mutualise’ risk in a way individual savers can’t. ‘If there is a problem with one loan, the lender should be earning sufficient interest on the rest of its loan portfolio to cover the loss,’ Debelle says.

Now we see where trust comes into it. Largely because of the problem of asymmetric information, there has to be trust between depositors and the bank that their funds are safe. And there is trust between the bank and its borrower that the borrower has provided accurate information and will act in good faith.

Trust is needed to cover the asymmetry that remains despite the ‘due diligence’ of the depositor in assessing the riskiness of the bank and of the bank in assessing the riskiness of the borrower.

Trust is particularly important because banks engage in ‘maturity transformation’ - in the jargon, they ‘borrow short and lend long’. Banks will let you deposit your money ‘at call’ (you can withdraw it at any time) but, on the other hand, will lend this money for periods up to 30 years.

Were too many depositors to lose trust in their bank at the same time, it would not be able to call in all its loans and so would not be able to return the depositors’ money. To prevent such a thing occurring, central banks stand ready to lend to banks if they need it. The trust in these arrangements is almost always enough for them not to be needed, Debelle says.

Banks don’t always hold on their own books all the risk (debt) they’ve taken on, but use devices such as ‘securitisation’ (bundling many consumer loans into a bond, which is then sold to investors) to distribute the risk around the financial system.

This means the process of financial intermediation often has a number of links in the chain. This, in turn, means trust needs to be present at every stage in the chain. ‘One breakdown in this chain of trust between ‘counterparties’ can throw a spanner in the works of the whole process,’ he says.

Guess what? The global financial crisis can be explained as a consequence of the breakdown of trust.

The years leading up to the crisis were a period of what Debelle calls ‘lazy trust’. Things were going along fine, so too many people relaxed their due diligence. Too many borrowers were taken at their word, without checking.

‘Moreover, with long chains of intermediation involved, there was often too much distance between the ultimate holder of the risk and the source of the risk. Too many links means that details get lost or misheard. If the due diligence is necessarily incomplete by the very nature of financial transactions, then that incompleteness is likely to get magnified, the more chains there are in the transaction.

‘The due diligence gets dissipated along the chain. There is a presumption that someone further up the chain did the due diligence.’

Such behaviour was anything but rational. As Debelle concedes, ‘good times beget complacency’. ‘It does seem to be a trait of human behaviour that has been evidenced many times in financial history.’

Lazy trust evaporated. The financial system switched rapidly from complacency to deep mistrust. In particular, trust broke down between financial institutions. Knowing they had a lot of bad loans on their own books, institutions assumed the same was true of their competitors, though to an unknown extent.

Institutions stopped lending to each other, so intermediation broke down. Central banks had to step in and provide banks with the funds they needed. This is still true in Europe, and a lack of trust in the longevity of the euro has made people unwilling to lend even to some governments.

The trouble now is that trust can be quickly and easily shattered, but takes a long time to rebuild.

Wednesday, October 3, 2012

The psychological roots of morality (and politics)

Paul Keating still quotes his early mentor, Jack Lang: "In the race of life, always back self-interest - at least you know it's trying". This may be why, as treasurer, Keating so readily embraced economic rationalism. The economists' working model assumes the self-interest of the individual is the sole force that makes the world turn.

Fortunately, the latest research tells us it's not that simple.

I can't go on a sight-seeing holiday without taking a few good books for a little intellectual sustenance at the end of the day. One book I took this time was a ripper, The Righteous Mind: Why good people are divided by politics and religion, by Jonathan Haidt, a moral psychologist at the University of Virginia.

Haidt (pronounced Height) says decades of research by political scientists have concluded that self-interest is a weak predictor of voters' policy preferences.

Why? Because people care about the groups they belong to - whether they be racial, regional, religious or political. They seem to be asking themselves not "what's in it for me?" but "what's in it for my group?". Political opinions function as "badges of social membership".

Whereas the old view was that natural selection had caused us to evolve into self-seeking competitors, Haidt argues we're more accurately thought of as "homo duplex" - a creature who exists at two levels: as an individual and as part of the larger society.

Human nature is mostly selfish: our minds contain a variety of mental mechanisms that make us adept at promoting our own interests, in competition with our peers, he says. But human nature is also "groupish": our minds contain a variety of mental mechanisms that make us adept at promoting our group's interests, in competition with other groups.

"We evolved to live in groups. Our minds were designed not only to help us win the competition within our groups, but also to help us unite with those in our group to win competitions across groups," he says. "We are not saints, but we are sometimes good team players."

All this goes a long way towards explaining the psychological roots of morality. Haidt defines moral systems as interlocking sets of values, norms, practices and institutions that work together to suppress or regulate self-interest and make co-operative societies possible.

His research leads him to believe moral intuitions arise automatically and almost instantaneously in our minds, long before moral reasoning has a chance to get started. Moral reasoning is not something we do to figure out the truth. Rather, it's a skill we evolved to further our social agendas - to justify our own actions and defend the teams we belong to.

Human nature is intrinsically moral, but it's also intrinsically moralistic, critical and judgmental.

"Our righteous minds made it possible for human beings - but no other animals - to produce large co-operative groups, tribes and nations without the glue of kinship," he says. "But at the same time, our righteous minds guarantee that our co-operative groups will always be cursed by moralistic strife."

We're much more aware of other people's moral shortcomings than our own, often making us "selfish hypocrites so skilled at putting

on a show of virtue that we fool even ourselves".

Haidt says one of the hardest problems humans face is co-operation without kinship. We instinctively co-operate with people to whom we're directly related, but co-operation within wider groups carries the ever-present temptation to "free-ride" - to enjoy the benefits co-operation brings while avoiding pulling our weight.

The more people free-ride, and the more we see others failing to pull their weight, the more co-operation breaks down and we all forgo the benefits it could bring.

Haidt argues morality is, in large part, an evolved solution to the free-rider problem. We develop norms of acceptable, co-operative behaviour and find ways to sanction people who aren't co-operating.

His empirical research into the moral sentiments of people from around the world leads him to identify six dimensions to people's moral concerns. First is care/harm; we are sensitive to signs of suffering and need, and despise cruelty. Second is liberty/oppression; we resent attempts to dominate us. Third is fairness/cheating; people should be rewarded or punished in proportion to their deeds.

Then there's loyalty/betrayal; we trust and reward team players, but want to sanction those who betray the group. Next is authority/subversion; we recognise rank or status and disapprove of those not behaving properly, given their position. Finally there's sanctity/degradation; we care about what we do with our bodies and what we put into them.

Haidt believes these moral concerns are shared by people regardless of their culture, nationality or wealth. But, of course, people interpret them differently and put more weight on some than others.

Our differing moral emphases are reflected in our differing political sympathies. So the unending battle between small-L liberal and conservative policies is a manifestation of "deeply conflicting but equally heartfelt visions of the good society".

Haidt finds that small-L liberals' moral concerns are limited to just the first three dimensions: they care deeply about the harm suffered by minorities and the needs of the poor, about oppression and about fairness.

Conservatives, on the other hand, care about all six dimensions. Their most sacred value is to "preserve the institutions and traditions that sustain a moral community". So they worry also about maintaining loyalty, acceptance of authority and the sanctity of our bodies.

The conservatives' broader range of moral concerns means they understand the motivations of liberals better than liberals understand the motives of conservatives.

Haidt argues the community benefits from the ever-present tension between the two sides - each emphasises important aspects of maintaining a good society - if only we could restore a greater degree of civility between the contending parties.