Wednesday, October 29, 2014

Why federal-state relations are so hard to reform

There's been nothing like the death of Gough Whitlam to make me feel old. Was I on the job in the early 1970s watching the amazing scenes and taking note? Sure. Where was I when the Great Man was dismissed? In the building, where else? Later that night I was in a Canberra restaurant where Tom Uren wept from table to table.

But there's nothing to make me feel more disillusioned and cynical than the latest prime minister popping up to tell us his grand plans to revitalise federal-state relations. Really? That's what they all try. What makes Tony Abbott likely to succeed where his many predecessors - going right back to Whitlam - failed so dismally?

Since Abbott's plan raises the possibility of tax reforms - "including changes to the indirect tax base" - he'll be lucky if the "mature debate" and "rational discussion about who does what" he seeks doesn't erupt immediately into an Abbott-strength scare campaign about increasing the goods and services tax, led by a Labor Party with a long record of hypocrisy on the topic and a thirst for revenge.

In such a climate, the various premiers facing re-election in coming months are likely to swear total opposition to any change in the GST. These days our politicians excel in the Mexican standoff.

Whitlam was seen as the great centraliser, drawing furious attack from the premiers and a Coalition sworn to uphold "states' rights". But subsequent thought has been kind to his notion that the ideal model would be a strong central government dealing with many regional governments, closer to the ground than the present state governments and given flexibility to modify national rules to suit local conditions.

Forty years later it's obvious that ain't going to happen. However anachronistic, the state governments - within their own borders, just as centralist as any federal government - won't ever give up their rights and privileges.

Malcolm Fraser's "new federalism" involved making the states more self-sufficient by giving each the right to impose their own surcharge or discount on federal income tax. The premiers, always full of complaints about the inadequate money they're given, weren't the least bit attracted to new taxing powers.

The Hawke-Keating government continued the process of ever-increasing federal involvement in areas of state responsibility. It pioneered the practice of bribing the premiers to undertake desired reforms.

John Howard did little to conceal his centralist tendencies, dropping any pretence of favouring states' rights. More and more "specific-purpose payments" to the states came with detailed rules about how the money was to be spent.

Part of his reason for introducing a GST was the need to replace the revenue from various state taxes the High Court had ruled unconstitutional. His decision to give all the proceeds from the new tax to the states (and cut back other grants to fit) was an inspired move to neutralise the premiers' opposition to it.

His greatest act of centralisation came with Work Choices, which ended a century of (highly inefficient) shared federal-state responsibility for industrial relations.

Kevin Rudd tried to improve federal-state relations by greatly rationalising the thousands of conditions attached to federal grants. His efforts to reach federal-state agreement on removing regulatory inconsistencies ground to a halt as states dragged their heels. He lacked the resolve to carry out his threat of a full federal takeover of state public hospitals.

Now Abbott says he wants to reverse the creeping centralisation, reaching a rational division of roles that would make each level of government "sovereign in its own sphere". As part of this, he'd support a joint plan to increase collections from the (withering) GST and give all the proceeds to the states, taking it to the next federal election for voters' approval.

Trouble is, there's no suggestion this would leave the premiers with more money overall and, if this year's budget is any indication, no guarantee the feds wouldn't try to solve their own budget problems at the states' expense.

It's unlikely federal and state governments could ever reach a lasting division of responsibilities that would end the duplication, cost-shifting and blame-shifting. That's for a host of reasons.

Most of the economic arguments favour nationally uniform regulations. If the feds are to retain ultimate responsibility for the health of the economy, they need the ability to influence the building blocks of economic performance, such as schools and TAFE.

Federal Medicare and pharmaceutical benefits, and state public hospitals, are each parts of the same system, which must be co-ordinated.

The underlying problem of "vertical fiscal imbalance" - most tax revenue (including the GST) is raised by the feds, whereas most government spending is done by the states - is intractable, the product of history and constitutional law.

When the feds cop most of the opprobrium for extracting taxation, it's only human for them to want a say in how it's spent.

But when the premiers get used to spending lots of money without having to raise it, to demanding more from the miserly feds on behalf of their deserving constituents and to blaming any and all problems on those terrible incompetents in Canberra, it's only human for them to want to continue evading responsibility.

The premiers' "revealed preference", as economists say, is that they prefer the federal system as it is, including their right to complain bitterly about it and demand another handout.

Monday, October 27, 2014

Econocrats touch base with reality

As every small-business person knows, the econocrats who think they manage the economy sit in their offices without ever meeting real people. Instead, they pore over figures the Bureau of Statistics bods dream up without ever leaving their desks.

That last bit has always been wrong. Small business is run by people who think their sales this week equal the state of the national economy. If the official figures don't line up with their experience, some bureaucrat must be lying.

The first bit - that the macro managers look at stats without ever talking to business people - used to be true, but hasn't been since some time after the severe recession of the early 1990s.

That was when Treasury (and yours truly) was supremely confident the economy would have a "soft landing". For once, people who knew no economics but had heard the squeals coming from business were right and the supposed experts were wrong.

The econocrats' disdain for "anecdotal evidence" had led them badly astray. They learnt the obvious lesson: as well as studying the stats, they needed to keep their ears to the ground.

But what even many well-versed observers probably don't realise is just how much effort the Reserve Bank puts into its consultations with business and how seriously it takes the results. The workings of its "business liaison program" are described in an article in the Reserve's latest quarterly Bulletin.

The program was put on a highly systematic basis in 2001, so as to lift it above the level of anecdote. Specialised officers talk to up to 100 businesses a month. You try to speak to a range of businesses (or, failing that, industry associations) in each of the economy's industries. You speak to the same people each time, asking the same questions and seeking quantification where possible.

You stay conscious of the gaps in your industry coverage. Ensuring you speak to businesses across the nation means "liaison" is the main role of the Reserve's state branches. Ideally, this should alert you to differences between the state economies.

Some industries are dominated by few big companies, making them easier to cover. But others - particularly the service industries - are composed mainly of small businesses. This is much harder and it's where you may need to fall back on industry associations.

Firms are asked about the usual key variables: sales, investment spending, employment, wages, prices and margins.

The Reserve uses its liaison more to determine where the economy is now - and where particular industries are in their business cycle - than where it's headed.

Most of the intelligence it produces ends up fitting reasonably well with the official statistics, but in some cases it comes in earlier than the stats.

It's a reasonable fit also with the NAB survey of business conditions and confidence, which the Reserve always studies carefully.

The Reserve's well-established links with key businesses allow it to "hit the phones" at times of great uncertainty, such as the global financial crisis. Its liaison made it among the first to realise business was responding differently to the downturn in demand, preferring wage freezes and cuts in hours to mass layoffs.

Its contact with miners made it among the first to realise the biggest hangover from the Queensland cyclone in 2011 wouldn't be farming but the surprising delay in getting the water out of flooded coalmines.

Right now its resource contacts will help improve its guesses about the precise timing of the probably sharp fall-off in mining investment spending.

By now other central banks, including the Bank of Canada and the Bank of England, also conduct big business liaison programs, but our lot were early adopters.

Now you're better informed about the Reserve's use of liaison you're likely to be more conscious of the many references to its findings in the bank's pronouncements.

The Reserve regularly reviews the accuracy of its forecasts and publishes the sobering results. So does Treasury, for that matter. Neither institution pretends its forecasts are much more than educated guesses.

The central bankers haven't been able to detect that their liaison has done anything to improve the accuracy of their forecasts.

But it would a brave - or foolhardy - person who concluded from this that it was wasting its time. Managing the economy without major mishap is a bit trickier than getting forecasts spot on.

Saturday, October 25, 2014

Economic chaos of Whitlam years not all his fault

Gough Whitlam was a giant among men who changed Australia forever - and did it in just three years. No argument. The question is whether the benefits of his many reforms exceeded their considerable economic costs.

The answers we've had this week have veered from one extreme to the other. To Whitlam's legion of adoring fans - many of whom, like many members of his ministry, have never managed to generate much understanding or interest in economics - any economic issues at the time aren't worth remembering.

To his bitter, unforgiving critics - led by former Treasury secretary John Stone - his changes were of dubious benefit, in no way making up for the economic chaos he brought down upon us.

The truth is somewhere in the middle.

To his many social reforms must be added a few of lasting economic benefit: diplomatic and trading relations with China, the Trade Practices Act with its first serious attack on anti-competitive business practices and - the one so many forget - the Industries Assistance Commission, whose efforts over many years led eventually to the end of protection against imports, removed by the next Labor government.

Not all of his many social reforms have survived. The Hawke-Keating government removed remaining vestiges of his non-means-tested age pension and ended the failed experiment with free university education, which did little to raise the proportion of poor kids going to university, but cost a fortune and delivered a windfall to the middle class at the expense of many workers.

The best modern assessment of the Big Man's economic performance comes in the chapter by John O'Mahony, of Deloitte Access Economics, in The Whitlam Legacy, edited by Troy Bramston.

O'Mahony's review of the economic statistics tells part of the story: "The years of the Whitlam government saw the economic growth rate halve, unemployment double and inflation triple".

But that conceals a wild ride. By mid-1975, inflation hit 17.6 per cent and wage rises hit 32.9 per cent. The economy boomed in 1973 and the first half of '74, but then suffered a severe recession.

From an economic perspective, Whitlam did two main things. He hugely increased government spending - and, hence, the size of government - by an amazing 6 percentage points of gross domestic product in just three years.

Some have assumed this led to huge budget deficits. It didn't. Most of the increased spending was covered by massive bracket creep as prices and wages exploded.

Many of Whitlam's new spending programs should have come under his predecessors and would have happened eventually. Some can be defended as adding to the economy's human capital and productive infrastructure, others were no more than a recognition that our private affluence needn't be accompanied by public squalor.

From this distance it's hard to believe that in 1972 large parts of our capital cities were unsewered. That's the kind of backwardness Whitlam inherited.

The Whitlam government's second key economic action was to pile on top of high inflation huge additional costs to employers through equal pay, a fourth week of annual leave, a 17.5 per cent annual leave loading and much else.

Clyde Cameron, Whitlam's minister for labour, simply refused to accept that the cost of labour could possibly influence employers' decisions about how much labour they used.

From today's perspective, there's nothing radical about equal pay or four weeks' leave. But to do it all so quickly and in such an inflationary environment was disastrous.

When the inevitable happened and Treasury and the Reserve Bank jammed on the brakes and precipitated a recession, Labor's rabble of a 27-person cabinet concluded the econocrats had stabbed them in the back, panicked and began reflating like mad.

What Labor's True Believers don't want to accept is that the inexperience, impatience and indiscipline with which the Whitlam government changed Australia forever, and for the better, cost a lot of ordinary workers their jobs. Many would have spent months, even a year or more without employment.

But what the Whitlam haters forget is that Labor had the misfortune to inherit government just as all the developed economies were about to cross a fault-line dividing the postwar Golden Age of automatic growth and full employment from today's world of always high unemployment and obsession with economic stabilisation.

Thirty years of simple Keynesian policies and unceasing intervention in markets were about to bring to the developed world the previously impossible problem of "stagflation" - simultaneous high inflation and high unemployment - that no economist knew how to fix, not even the omniscient and infallible John Stone.

It was 30 years in the making, but it was precipitated by the Americans' use of inflation to pay for the Vietnam war, the consequent breakdown of the postwar Bretton Woods system of fixed exchange rates, the worldwide rural commodities boom and the first OPEC oil shock, which worsened both inflation and unemployment.

The developed world was plunged into dysfunction. The economics profession took years to figure out what had gone wrong and what policies would restore stability. Money supply targeting was tried and abandoned.

The innocents in the Whitlam government had no idea what had hit them; that all the rules of the economic game had changed. The point is that any government would have emerged from the 1970s with a bad economic record.

Malcolm Fraser had no idea the rules had changed, either. His economic record over the following seven years was equally unimpressive.

It took the rest of the developed world about a decade to get back to low inflation and lower unemployment. It took us about two decades. I blame the Whitlam government's inexperience, impatience and indiscipline for a fair bit of that extra decade.

My strongest feeling is that when the electorate leaves one side of politics in the wilderness for 23 years it's asking for trouble. It's Time to give the others a turn after no more than a decade.

Wednesday, October 22, 2014

Health spending is quite sustainable

Oh dear, what an embarrassment. Thank heavens so few journalists noticed. Last month, one of the federal government's official bean-counters, the Australian Institute of Health and Welfare, issued its report on total spending on health in 2012-13. It didn't exactly fit with what the government has been telling us.

As you recall, Health Minister Peter Dutton got an early start this year, warning that health spending was growing "unsustainably". (Blame it all on Gough Whitlam, whose supposedly too-expensive Medibank Malcolm Fraser dismantled, only to have Bob Hawke restore it as Medicare.)

The report of the Commission of Audit soon confirmed that health was prominent among the various classes of government spending growing - and projected to continue growing - "unsustainably".

Something would have to be done.

In the budget, we found out what the something was. A new "co-payment" of $7 a pop on visits to the GP and on each test the GP orders. The general co-payment on prescriptions to rise by $5 to $42.70 each.

And the previous government's funding agreement with the states to be torn up, with grants for public hospitals to rise only in line with inflation and population growth.

Sorry, but it was all growing "unsustainably".

So how unsustainable was growth in 2012-13? Total spending on health goods and services was $147 billion, up a frightening 1.5 per cent on the previous year, after allowing for inflation.

This was the lowest growth since the institute's records began in the mid-1980s, and less than a third of the average annual growth in the past decade.

Allow for growth in the population, and average annual health spending of $6430 per person was actually down a touch in real terms.

It gets better (or worse if you've been one of the panic merchants).

That $147 billion is the combined spending on health by the federal government, state governments, private health funds and other insurers, plus you and me in direct, out-of-pocket payments on co-payments and such like.

So, total spending may not have grown much, but the federal government's share of the tab rose faster than the rest, right? Err ... no. The opposite, actually.

The feds' health spending in 2012-13 actually fell by 2.4 per cent in real terms. The states' spending rose by 1.5 per cent, but that left the combined government spend falling by 0.9 per cent.

So it was actually the private sector (including you and me) that accounted for more than all of the overall increase in spending. This is a big problem for the government?

By my reckoning, out-of-pocket payments by individuals rose by 6.9 per cent in real terms. The pollies seem to have been doing a good job of shunting health costs off onto us even before the latest onslaught.

So, all very embarrassing for the three-word-slogan brigade. Or would have been had the government's spin doctors not had the media off chasing foreign will-o-the-wisps at the time. Easily diverted, the media.

But let's be reasonable about this. One year of surprisingly weak growth in total health spending - and falling federal spending - doesn't prove there isn't longer-term problem.

Government health spending has grown pretty strongly in previous years, and the latest year's moderation may be the product of one-off factors rather than the start of a new moderate trend.

Actually, the real fall in federal spending seems to be largely the product of savings measures taken by the previous government, particularly its tightening of rules for the private health insurance rebate - which the Coalition fought so hard to stop happening.

Even so, when you look at the trend of spending in recent years revealed by the institute's figures, it does suggest that health spending may not grow as strongly in coming years as we've long been told to expect.

The spectre of ever more rapid growth in public spending on healthcare - to the point where health spending comes to dominate the federal budget - is one the federal Treasury has been warning of in each of its three "intergenerational reports" since 2002.

The state treasury versions of this exercise portray health spending positively overrunning state budgets, crowding out all other spending.

Federal Treasury has explained its dramatic projections in terms of the ageing of the population, developments in medical technology that invariably are much more expensive than the technology they replace, and the public's insatiable demand for immediate access to whatever advances medical science has come up with.

But Treasury's figures are essentially mechanical projections of past growth trends over the coming 40 years, meaning just a small reduction in the assumed annual rate of growth can make a big difference.

The institute's latest figures show the federal government's real spending on health grew at an annual rate of 4.8 per cent over the five years to 2007-08, but by just 4.1 per cent over the five years to 2012-13.

Perhaps more significantly, they show that whereas the prices of health goods and services rose faster than the prices of all domestic goods and services by 0.7 per cent a year during the first five-year period, during the second period they rose by 0.2 per cent a year more slowly than other prices.

In other words, the long-feared problem of "excess health inflation" seems to be going away.

It will be interesting to see Treasury's latest prognostications in next year's intergenerational report.

Monday, October 20, 2014

Abbott's choice: competition v cronies

It's still too soon to tell whether Tony Abbott's government is pro-market or pro-business, but so far the evidence for the latter stacks higher than that for the former.

The difference turns on whether the pollies want markets where effective competition ensures benefits to consumers are maximised and excessive profits minimised, or markets where government intervenes to limit competition - often under the cover of claiming to be protecting jobs - and makes life easier for favoured businesses.

Will we see more rent-seeking or less under Abbott, more of what The Economist calls "crony capitalism"?

Will firms or industries with rival interests do better from government regulation if they're more generous donors to party coffers?

Abbott and his ministers' intemperate attacks on the Australian National University for its decision to "divest" itself of a few million mining company shares for environmental or ethical reasons are a worrying sign.

Investors shouldn't enjoy freedom to choose where they invest, regardless of their reasons? ANU is different from the rest of us even though its investment funds come largely from private donations and bequests? This from a government keen to complete the de facto privatisation of universities?

What is ANU's offence? Bringing ethical considerations into investment? Or sounding like it believes climate change is real and we should be doing something real about it?

Abbott attacked ANU's decision as "stupid" and believes "coal is good for humanity, coal is good for prosperity, coal is an essential part of our economic future".

If ever there was an industry whose early decline could be confidently predicted - as it is being by hard-headed investors and bankers the world over - it's steaming coal.

Yet Abbott seems keen to change the rules of the formerly supposed bipartisan renewable energy target in ways that, by breaking long-standing commitments to the renewables industry, would cost it billions and blight the future of its employees, all to provide the government's coal and electricity industry mates with temporary relief from the inevitable.

The biggest problem with governments "picking winners" is that they quickly regress to picking losers, helping industries against which technology and other forces have shifted to resist the market's pressure for change that would - almost invariably - make consumers and the economy better off.

The proposals of the recent draft report of Professor Ian Harper's competition policy review could do much to strengthen the market's ability to deliver benefits to consumers and roll back decades of accumulated rent-seeking and crony capitalism.

The enthusiasm with which the Abbott government takes up those proposals will tell us much about its choice between being pro market forces or pro certain generous business donors to party funds.

A particular area where sound competitive principles have been secondary to special pleading from various interests is the regulation of intellectual property, such as patents, copyright, trademarks and plant breeder rights. Harper says our intellectual property regime is a priority for review.

IP isn't God-given, it's a government intervention in the market to limit competition with owners of the patents and so forth for a limited period. It's a response to market failure where the "public goods" characteristics of IP would otherwise generate too little monetary incentive for people to come up with the new knowledge and ideas that benefit us all.

In other words, it's a delicate trade-off between government-granted monopolies to encourage innovation, and competition to keep prices and excess profits down.

This makes it ripe for rent-seeking: pressuring politicians to extend the monopoly periods retrospectively (despite the lack of public benefit), to allow loopholes that permit phoney "ever-greening" of drug patents that would otherwise expire, to limit poor countries' access to life-saving drugs at realistic prices and to ignore blatant gaming of IP laws by two-bit operators that have never created anything.

Most of these excesses are at their worst in the United States with its easily bought legislature. The information revolution has made IP one of America's chief export earners. And the free-trade preaching Yanks have made advancing the interest of their IP exporters their chief priority in trade negotiations such as the present Trans Pacific Partnership deal.

As always, we have a tendency to give the Yanks whatever they want. Trouble is, as Harper points out, Australia is and always will be (and should be, given our comparative advantage in world trade) a net importer of intellectual property.

Abbott has a further temptation to be less than vigilant in pursuing Team Australia's best interests: his chief media cheerleader, News Corp, happens to be the twin brother of a primary beneficiary of the Yanks' efforts to advance the interests of their IP exporters, 21st Century Fox.

Saturday, October 18, 2014

Re-writing the re-write of the GFC fiscal stimulus

Economists may be bad at forecasting - even at foreseeing something as momentous as the global financial crisis - but that doesn't stop them arguing about events long after the rest of us have moved on.

That's good. Economists need to be sure they understand why disasters occurred so we can avoid repeating mistakes. They need to check the usefulness of their various models and whether they need modifying.

One thing that causes these debates to go for so long is that economics - particularly academic economics - is based more on theories than evidence. Some theories clash, so empirical evidence ought to be used to determine which hold water.

But economists aren't true scientists. They pick the rival theories they like best and become more attached to them as they get older. They will try to talk their way around evidence that seems to contradict the predictions of their model.

This leaves plenty of room for ideology, for individuals to pick those theories that fit more easily with their political philosophy.

There's been much mythologising of our experience with the GFC. Many punters' memory is that we thought there'd be a bad recession, the Rudd government spent a lot of money, but no recession materialised so the money was obviously wasted.

This isn't logical. You have to consider what economists call "the counterfactual": what would have happened had Kevin Rudd not spent all that money? Maybe it was the spending that averted the recession.

One Australian newspaper has worked assiduously to inculcate the memory that pretty much all Rudd's "fiscal stimulus" spending was wasteful. It went for months reporting every complaint against the school-building program, while ignoring the great majority of schools saying they didn't have a problem, then misrepresented the inquiry findings that the degree of waste was small.

What got the economy growing again so soon after the big contraction in gross domestic product in the December quarter of 2008, we were told, was the return of the resources boom as China's demand for our commodities ballooned. (This ignores that China's economy was hit for six by the GFC, but bounced back after it applied massive fiscal stimulus.)

To bolster the line it was pushing, the paper did much to publicise the views of Professor Tony Makin, of Griffith University. Makin adheres to a minority school of thought among macro-economists that fiscal stimulus never works. He repeated his long-held views when assessing Rudd's efforts.

Early last month, the Minerals Council published a monograph it had commissioned from Makin on Australia's declining competitiveness. Guess what? All the subsequent events have confirmed the wisdom of his earlier forebodings.

Makin used "the classic textbook macro-economic model" to argue that, even during recessions, fiscal policy is ineffective in adding to economic growth in an open economy with a floating exchange rate because it "crowds out" net exports (exports minus imports).

Borrowing to cover the extra government spending tends to push up domestic interest rates, which attracts foreign capital inflow. This, in turn, pushes up the exchange rate. Then the higher dollar reduces the price competitiveness of our export and import-competing industries, thus increasing imports and reducing exports. Any increase in domestic demand is thus offset by reduced net external demand.

Next Makin examined the national accounts showing a strong rebound in growth in the March quarter of 2009 (thus silencing the two-quarters-of-negative-growth brigade) and found the turnaround was explained not by increased domestic spending but by an improvement in net exports.

There you go: proof positive that his long-held views were spot on. He attacked the claim that the fiscal stimulus saved 200,000 jobs, saying "this assertion is based on spurious Treasury modelling of the long-run relationship between GDP and employment". He criticised Treasury's estimates using dubious Keynesian "multipliers" of the addition to GDP caused by the fiscal stimulus.

Treasury quickly released a response to Makin's criticism. His theoretical argument was based on the Mundell-Fleming model (from as long ago as the early 1960s), which assumes unilateral fiscal action, a high degree of openness to trade and perfect mobility of financial capital between countries. (It could have added the assumption that the central bank controls the supply of money rather than the level of short-term interest rates, as ours has long done.)

In reality, all the major economies applied fiscal stimulus in concert, trade accounts for much less of our GDP than it does for most developed countries, and the turmoil of the GFC meant capital mobility was far from perfect at the time (I'd say all the time).

As for his empirical checking, Makin's use of the national accounts failed to consider the counterfactual. It's likely imports fell in that March quarter not so much because the dollar fell heavily (and didn't shoot back up for about a year, once commodity prices had reversed and were on their way to new heights) as because the fear unleashed by the GFC prompted people to postpone planned purchases of imported items. If so, their spending would also have fallen, offsetting to boost from net exports.

Makin's claim that Treasury used multiplier estimates that were long-term rather than short-term is wrong. The whole idea of the stimulus was to boost spending (and confidence) quickly to counter the collapse in confidence. Since the spending measures were always intended to be temporary (and were, despite the mythology) it was always known that the effect on GDP growth would be negative before long.

The short-term multipliers Treasury used were based on the conservative end of the range of estimates calculated for our economy by the International Monetary Fund and the Organisation for Economic Co-operation and Development.

Makin is entitled to his opinions, but he's in a small minority among economists, even the academics. The two international agencies were full of praise for our fiscal stimulus and in no doubt about its effectiveness.

Wednesday, October 15, 2014

Competition is a wonderful thing - up to a point

The older I get the more sceptical I become. Goes with being a journo, I guess. I've become ever-more aware that no one and nothing is perfect. Not political leaders, not parties, not any -isms, not even motherhood.

Take competition. Economists portray it as the magic answer to almost everything, but the more I see of it, the more conscious I become of its drawbacks and limitations.

Which is not to say I don't believe in it. Far from it. We could use a lot more competition than we've got. But only in the right places and for the right reasons.

The recent draft report of the review of competition policy, chaired by emeritus professor Ian Harper, argues that we need to step up the degree of competition in the economy if we're to cope with three big sets of challenges and opportunities that we face: the rise of Asia, our ageing population and the advent of disruptive digital technologies.

Dead right - up to a point.

We need more competition in the economy because it's what keeps the capitalist system working in the interests of the populace, not the capitalists. But that doesn't mean it makes obvious sense to take areas of our lives that have been outside the realm of the market and turn them over to the capitalists.

Economics is about efficient materialism; making sure the natural, man-made and human resources available to us are used in ways that yield maximum satisfaction of our material wants. It argues that economies based on private ownership and freely operating markets - "capitalist" economies - are the most efficient.

What's to stop the capitalists using markets to exploit us and further aggrandise themselves? Competition. Competition between themselves, but also between us (the consumers) and them (the producers).

Get this: the ideology of conventional economics holds that the chief beneficiaries of market economies should be, and will be, the consumers, not the capitalists.

Market economies are seen as almost a con trick on capitalists: they scheme away trying to maximise their profits at our expense, but the system always defeats them, shifting the benefits to consumers (in the form of better products and lower prices) and leaving the capitalists with profits no higher than is necessary to keep them in the game.

What it is that performs this miracle? Competition. It's not nearly as fanciful as it sounds. Since the industrial revolution, the history of capitalism is the history of capitalists latching on to one new technology after another, hoping for the killing that never materialises.

Take the latest, digital technology and its effect on my industry, news. Who's losing? The formerly mighty producers of the soon to be superseded newspaper technology, including many of their journalists and other workers. Who's winning? People wanting access to as much news as possible as cheaply as possible.

For good measure, the cost of advertising - reflected in the prices of most things we buy - is now a fraction of what it was. Tough luck for producers, good luck for consumers. Competition at work.

But, amazing though this process is, it's far from perfect. Competition doesn't work as well in practice as it does in theory, for many reasons. A big one is "information asymmetry" - producers know far more about products than consumers do. Another is the presence of economies of scale, which has led to most markets being dominated by a handful of big companies.

Perhaps most pernicious, however, is the success of some producers in persuading governments to protect them from the full rigours of competition. Some industry lobbies are particularly powerful, and the ever-rising cost of the election arms race has made the two big parties susceptible to the viewpoints of generous donors.

The report produced by Harper, a former economics professor, emphasises that competitive pressure needs to be enhanced for the ultimate benefit of consumers. With so many big companies enjoying so much power in their markets, we need laws against anti-competitive practices. He proposes refinements to make these laws more effective.

He points to industries where governments need to reform laws that limit competition at the expense of customers: retail pharmacies, taxis and coastal shipping. He advocates "cost-reflective road pricing" and an end to restrictions on "parallel imports" of books, recordings, software and so on (fear not, the internet's doing it for us) and local zoning laws that implicitly favour incumbents (Woolies and Coles, for instance) at the expense of new entrants (Aldi and Costco).

But, predictably, there's little acknowledgement that competition has costs as well as benefits. It's assumed that if some choice is good, more must be better. And competition-caused efficiency outweighs all social considerations.

So the report advocates liberalising liquor licensing, and deregulation of shopping hours on all but three holy days a year (the holiest being Anzac Day), without any serious consideration of the effects on sobriety and crime in the first case or family life, relationships and what I like to call re-creation in the second.

Similarly, it sees nothing but benefit in maximising choice and competition between schools, and wants much more outsourcing of the delivery of government-funded services to profit-motivated providers.

The inquiry we need is one to check how well previous experiments in mixing government funding with the profit motive - in childcare, for instance, or training courses for international students - have worked in practice. We need more evaluation and fewer happy economist assumptions.

Monday, October 13, 2014

Interest rates to stay low, but lending curbs loom

With the Reserve Bank worried by fast-rising house prices, but the dollar coming down and the unemployment rate now said to be steady, can a rise in the official interest rate be far off? Yes it can.

On the face of it, last week's revised jobs figures have clarified the picture of how the economy is travelling. The national accounts for the March and June quarters show the economy growing at about its trend rate of 3 per cent over the previous year, which says unemployment should be steady.

And now the jobs figures are telling us the unemployment rate has been much steadier than we were previously told, at about 6 per cent.

If economic growth is back up at trend, we need only a little more acceleration to get unemployment falling. The Reserve is clearly uncomfortable about keeping interest rates at 50-year lows while rapidly rising house prices tempt an already heavily indebted household sector to add to its debt.

So, surely it's itching to remind us that rates can go up as well as down and, in the process, let some air out of any possible house-price bubble.

Well, in its dreams, perhaps, but not in life. Even if hindsight confirms the latest reading that the economy grew at about trend in 2013-14, the Reserve knows it can't last. Its central forecast of growth averaging just 2.5 per cent in the present financial year is looking safer, maybe even a little high.

The sad fact is that a host of factors are pointing to slower rather than faster growth in 2014-15, implying a resumption of slowly rising unemployment and no scope for even just one upward click in interest rates.

The biggest likely downer is the long-feared sharp fall in mining investment spending. To this you can add weak growth consumer spending, held back by weak growth in employment and unusually low wage rises.

Now add the point made by Saul Eslake, of Bank of America Merrill Lynch, that real income is growing a lot more slowly than production, thanks to mining commodity prices that have been falling since 2011.

Weak growth in income eventually leads to weaker growth in production, which, in turn, is the chief driver of employment. With the Chinese and European economies' prospects looking so poor, it's easy to see our export prices falling even faster than the authorities are forecasting.

Real gross domestic income actually fell in the June quarter, and Eslake sees it falling again in the September quarter.

Apart from the recovery in home building, pretty much the only plus factor going for the economy is the recent fall in the dollar, bringing relief to manufacturers, tourist operators and others.

But measured on the trade-weighted index, the Aussie is back down only to where it was in February, and since then export prices have fallen further, implying the exchange rate is still higher - and thus more contractionary - than it should be.

In other words, the usually strong correlation between the dollar and our terms of trade has yet to be restored. Why hasn't it been in evidence? Because our exchange rate is a relative price, affected not just by what's happening in Oz but also by what's happening in the economy of the country whose currency we're comparing ours with.

The Aussie has stayed too high relative to the greenback not because our interest rates have been too high relative to US rates, as some imagine, but because one of the chief effects of all the Americans' "quantitative easing" has been to push their exchange rate down.

As the US economy strengthens and the end of quantitative easing draws near - and, after that, rises in their official interest rate loom - the greenback has begun going back up. The prospects of it going up a lot further in coming months are good.

That's something to look forward to. But our exchange rate would have to fall a long way before it caused the Reserve to reconsider its judgment that "the most prudent course is likely to be a period of stability in interest rates".

But that still leaves the real risk of low rates fostering further rises in house prices, particularly in Sydney and Melbourne.

What to do? Resort to a tightening of "macro-prudential" direct controls over lending for housing. The restrictions may be announced soon, be aimed at lending for investment and even limited to borrowers in the two cities.

But though they'd come at the urging of the Reserve, they'd be imposed by the outfit that now has that power, the Australian Prudential Regulation Authority.

Saturday, October 11, 2014

At present GDP is more misleading that usual

I could attempt to explain to you why the Bureau of Statistics is having such embarrassing trouble with its monthly estimate of employment, but I won't bother. It's horribly complicated and at a level of statistical intricacy no normal person needs to worry about.

What this week's labour force figures now tell us is that, though the rate of unemployment has been slowly drifting up since mid-2011 - when it was 5 per cent - it seems to have steadied this year and, using the smoothed figures, has stayed stuck at 6 per cent for the past three months.

This is reasonably consistent with what we know about other labour-market indicators, such as job advertisements and vacancies, claims for unemployment benefits and employers' answers to questions about hiring in the National Australia Bank's survey of business confidence.

It also fits roughly with what the national accounts have been telling us about the strength of growth in the economy. We know that when the economy is growing at its trend rate of about 3 per cent a year, this should be sufficient to hold the rate of unemployment steady.

The accounts told us real gross domestic product grew by 3.4 per cent over the year to March, and by 3.1 per cent over the year to June.

But now let me tell you something that, while a bit technical, is much more worth knowing than the gruesome details of the bureau's problem with the labour force survey.

One of our smartest business economists, Saul Eslake, of Bank of America Merrill Lynch, has reminded us that GDP is only one of various summary indicators of overall economic activity provided by the national accounts. And the economy's peculiar circumstances over the past decade and for some years to come mean GDP is not the least misleading of the various measures.

Eslake says real GDP measures the volume (quantity) of goods and services produced within a country's borders during a particular period. (Actually, it doesn't include the many goods and services produced within households, which never change hands in a market.)

To estimate real GDP the bureau takes the nominal, dollar value of the goods and services produced, then "deflates" this figure by the prices of those goods and services relative to what those prices were in the base period.

We commonly take the value of the goods and services we produce during a period to be equivalent to the nation's income during that period. This easy assumption works for most developed economies most of the time.

But Eslake reminds us that "for an economy like Australia's, the prices of whose exports are much more volatile than those of other 'advanced' economies, abstracting from swings in the prices of exports (and imports) obscures a significant source of fluctuations in real incomes".

We've experienced a series of sharp swings in our "terms of trade" - export prices relative to import prices - over the past decade of the resources boom, which was interrupted by the global financial crisis in 2008-09. For the past three years, of course, mining commodity prices have been falling.

Trouble is, real GDP doesn't capture the effects of these swings. So the values of our production and our income have parted company, as they do every time our terms of trade change significantly. An improvement in our terms of trade causes our income to grow faster than our production, whereas a deterioration has the opposite effect.

This matters because of the chicken-and-egg relationship between production and income: we use the income we earn from our part in the production process to buy things and thus induce more production.

So if our real income slows or falls, soon enough this dampens our production.

However, the national accounts include a measure of overall economic activity that does capture the effects of movements in our terms of trade: real gross domestic income, GDI. It grew a lot faster than real GDP for most of the time between 2002 and 2011, but since then has grown much more slowly than real GDP (a big reason for our slowly rising unemployment).

Next Eslake says that as the resources boom moves into its third and final phase - with mining investment winding down and exports ramping up - real GDP growth will be an even less useful guide to what's happening to domestic income and employment.

This is because maybe 80 per cent of the income generated by resources exports will be paid to the foreigners who own most of our mining companies and who financed most of the new investment.

It's also because the depreciation of Australia's greatly enlarged stock of capital equipment and structures as a result of all the mining investment spending will now absorb a greater share of our gross income.

(A separate issue Eslake doesn't mention is that the highly capital-intensive nature of mining means the increased production of mineral exports will create far fewer jobs than you'd normally expect.)

If you've ever wondered about the difference between gross national product and gross domestic product it's that the former excludes all the income earned on Australian production that's owed to the foreign suppliers of our debt and equity financial capital, making it a more appropriate measure for us given our huge foreign debt and foreign investment in our companies.

If you've ever wondered what the "gross" in GDP, GNP, GNI etc means, it's short for "before allowing for the depreciation of our stock of physical capital".

So gross national income (GNI) is a better measure than gross domestic income (GDI), and net national disposable income (NNDI) is a better measure than GNI.

Which, by the way, explains why real NNDI is used as the base for all the further non-national-accounts-based modifications included in Fairfax Media's attempt to calculate a broader measure of economic welfare, the Fairfax-Lateral Economics wellbeing index, released each quarter soon after the publication of GDP.

Wednesday, October 8, 2014


Economic Society, Sydney, Wednesday, October 8, 2014

Economists - and economic journalists like me - are used to being reminded by science-types that the Nobel prize in “economic sciences” is not a real Nobel. It’s true. Alfred Nobel, said to have had a low opinion of economists, did not include provision for an economics price in his will. Rather, almost 70 years after the real prizes began, a Swedish bank decided to sponsor an economic prize “in honour of Alfred Nobel”. And since it’s the Swedish central bank, able to print its own money, its continued sponsorship has never been in doubt.

So I’m not sure I agree with Paul Oslington that the Nobel is a symbol of the economics professions’ “scientific status”. Only economists delude themselves that economics is a genuine science. In any case, I read that the reference to “economic sciences” is intended as an allusion to the other “sciences” included in the prize, political science and psychology.

Even so, I’m a great supporter of the Nobel in economics, because I suspect it’s one of the few things offering economists an incentive to broaden their horizons beyond the usual mundane preoccupations of the vast majority of academic economists. Economists are so obsessed by competition - both in theory and in practice - I have no doubt that when the prize is awarded to people who’ve ventured into genuinely new areas of economic inquiry, a lot of younger economists are both licenced and incentivated to take up pursuit of that new area. For instance, I don’t doubt that a lot of young economists were motivated to take up the study of behavioural economics after the prize was awarded to Daniel Kahneman in 2002. Similarly, the award to the inventor of experimental economics, Vernon Smith, in the same year, would have done wonders to legitimise experimental economics and encourage young PhDs to take it up. The search for “natural experiments” in economics hasn’t looked back.

What I like about the economics Nobel is that some kink in the selection process - perhaps the participation of members of the Royal Swedish Academy of Sciences, including some non-economists, on the selection committee - means it’s always awarding the prize to people whom most academic economists wouldn’t have dreamt of including on their list of likely recipients and, in some cases, have never even heard off. That no economist had heard of Elinor Ostrom - the first woman to win the prize, in 2009, is an indictment of the inward-looking narrowness of the economics profession. Ostrom studied a distinctly economic topic, the tragedy of the commons. Her problem was that she was a political scientist. And she compounded that moral failing by collecting extensive empirical evidence refuting the conventional economists’ conclusion that the obvious answer to the degradation of the commons was to award property rights. Ostrom found numerous examples of people around the world solving the problem by co-operative arrangements and social sanctions. So obsessed are economists by competition and prices that they can’t see the co-operation that’s in front of their noses.

The other thing I like about the economics Nobel is that the committee keeps overlooking all the people economists are convinced will win it, and giving the prize to non-economists. Ostrom wasn’t the first political scientist to win it; Herb Simon was in 1978. Then there was the mathematician John Nash in 1994 and the psychologist Kahneman in 2002. Oliver Williamson, who shared the prize with Ostrom in 2009, is more sociologist than economist.

Eugene Farma, perpetrator of the great hoax known as the efficient markets hypothesis, was top of the staff-room tipping competitions for decades before his name finally came up last year, but the committee redeemed itself by having him share it with Robert Schiller, the behavioural finance guru who has been saying pretty much the opposite to Farma. That’s almost as big a joke as making Hayek share with the Swedish socialist Gunnar Myrdal in 1974.

How will win this year? I have no advance to offer on Paul’s intelligence. Who should win it? Not the makers of some relatively minor advance in econometric technique, nor the elaborators of the conventional wisdom - such as Farma - but those who’ve made advances with what the profession euphemistically refers to as “market imperfections” - that is, all the unrealistic assumptions on which the neo-classical model rests.

Does any Australian stand a chance? I’ve thought Paul Frijters at the University of Queensland was our only hope - the only Aussie doing genuinely insightful research - ever since I read his path-breaking book, An Economic Theory of Greed, Love, Groups and Networks.


Why we care about morality - apparently

The good thing about holidays is getting time to read books. I' ll look at all the museos, oratorios, cappellas and duomos in Italy provided I can go back to my book when day is done. On this trip one book I read was Moral Tribes, by Joshua Greene, a young professor of psychology at Harvard.

One of the hottest areas of psychology these days is moral psychology - the science of moral cognition - which seeks to explain why we have moral sentiments and what use they are to us. It' s pretty coldly scientific and evolutionary, which may be disconcerting to readers of a religious disposition.

According to Greene and his confreres - another leading thinker in the area is Jonathan Haight, author of The Righteous Mind, which I' ve written about before - humans are fairly selfish individuals, but we are also highly social animals who like to be part of groups.

Groups, however, require co-operative behaviour, so we evolved moral attitudes to enable us to get along together in groups.

Biologists (and economists) have long stressed the importance of competition between us - survival of the fittest and all that - but it s not hard to see that humans' domination of the planet arises from our unmatched ability to co-operate with each other to overcome problems.

So humans are about competition and co-operation. Economists have schooled us to think of markets as all about competition - between sellers, between buyers and between buyers and sellers - but psychologists see markets as a prime example of human co-operation.

Co-operation through markets allows us to use specialisation - I produce what I' m good at, you do the same and we use the medium of money to exchange the things we ve produced - to increase our combined efficiency in production, leaving us all better off.

Studies have shown that people' s performance in well-known psychology games giving them a choice between selfish or altruistic responses can differ markedly between cultures. Turns out that people from cultures with more developed market systems tend to be less selfish and more co-operative.

So to these scientists, morality is a set of psychological adaptations that allow otherwise selfish individuals to reap the benefits of co-operation within groups.

But why do we want to co-operate within groups? So our group can compete more effectively against other groups.

" Our moral machinery evolved to strike a biologically advantageous balance between selfishness (Me) and within-group co-operation (Us), without concern for people who are more likely to be competitors than allies (Them), " Greene says. This moral machinery includes our capacities for empathy, vengefulness, honour, guilt, embarrassment and righteous indignation, he adds.

The fact is that each of us belongs to a whole host of groups: our family, neighbourhood, workplace, occupation, nationality, ethnicity, religious affiliation, sporting interest, political party and more.

The groups we belong to are the tribes we belong to. We feel a great loyalty to our groups, and greatly favour their interests over those of rival groups. This group selfishness and tendency to see the world as Us versus Them is tribalism.

So, much of the conflict we see around us - both within our country and, as we' ve become more conscious of in recent days, between countries and the groups within them - arises from tribalism.

Much of the conflict between tribes is simple self-interest - I favour my interests ahead of yours, and see them much more clearly than I see yours - but there are also genuine differences in values and disagreements about the proper terms of co-operation. One major source of disagreement in political life is between individual and collective responsibility.

Some disagreement arises from tribes' differing allegiances to what Greene calls " proper nouns" - gods, leaders, holy scriptures and holy places.

Obviously, tribally based morality gets us only so far. What Greene seeks is a "meta-morality" , which can help reduce conflict between tribes rather than just within them. To this end he reaches back to an old idea now out of favour with philosophers: utilitarianism.

(This is of relevance to economists because, though they 've spent the past 80 years trying to play it down, utilitarianism forms part of the bedrock on which the conventional economic model is built.)

According to Greene, utilitarianism answers two basic questions: what really matters and who really matters. What matters most is the quality of our experience. Economists call this " utility" and the rest of us call it "happiness" .

Who matters most is all of us, equally - otherwise known as the Golden Rule.

Thus Greene summarises utilitarianism as " happiness is what matters and everyone' s happiness counts the same. This doesn 't mean that everyone gets to be equally happy, but it does means than no one' s happiness is inherently more valuable than anyone else' s ."

He claims this meta-morality involves a moral system that can acknowledge moral trade-offs and adjudicate among them, and can do so in a way that makes sense to members of all tribes.

It s a nice thought. Somehow I think it will be a while before we measure up to that ideal. But it s always good to have a vision of what we should be aiming for and how we can move towards it.

Monday, October 6, 2014

Science runs ahead of economists' model

The failings of economists - the bum forecasts and less-than-wise advice they give us about the choices we face - can usually be traced back to the limitations of the basic model that tends to dominate the way they think, the neo-classical model.

The thinking of economists began to ossify in the second half of the 19th century, at a time when the science of psychology was in its infancy. The model was thus consolidated at a time when our understanding of human behaviour was quite primitive.

Unfortunately, the past century of progress in psychology has revealed just how far astray are many of the economic model's assumptions about how humans tick. Although a minority of economists - "behavioural economists" - have sought to incorporate these findings into their thinking, the majority have ploughed on regardless. It keeps the maths simpler.

The model is often criticised, not least by me, for its key assumption that we are always "rational" - carefully calculating and self-interested - and never instinctive or emotional in the decisions we make, but there's another assumption that's equally unrealistic and likely to lead to wrong predictions about how we'll behave.

It's that consumers and businesses always act as isolated individuals in making their decisions, uninfluenced by the decisions those around them are making, except to the extent that the combined behaviour of others affects the prices the individual faces. In other words, the model's "unit of analysis" is the individual - the "representative consumer" or "representative firm".

In truth, humans are highly social animals and our behaviour is hugely influenced by those around us. We evolved to live in small groups, which has left us with a powerful - if often unconscious - motivation to fit in with the group and avoid being ostracised.

We feel most comfortable when we're doing what everyone else is doing; we feel distinctly uncomfortable when we're doing the opposite to everyone else. We feel great loyalty to the groups we belong to, and rivalry and suspicion towards groups we don't belong to.

This means humans - "economic agents" as economists say - are prone to herd behaviour. At the most innocuous level, this makes us heavily influenced by fashion. We like to wear what others are wearing, read what others are reading and watch the movies and TV shows that others are watching.

It's remarkable that the business world could be so conscious of the need to accommodate and, indeed, exploit our susceptibility to fashion while the economists seek to analyse our behaviour using a model that assumes it away.

More significantly, our tendency to herd behaviour affects the behaviour of markets - particularly financial markets - in ways that, though we've seen it happen many times before, almost invariably catch economists unawares.

It's our propensity for "group-think" that does most to explain booms and busts in the sharemarket, but also the upswings and downswings in the economy. We swing from overly optimistic to overly pessimistic, then back again, and we tend to all do it together.

A separate aspect of the model's exclusive focus on the individual is its overemphasis on competition and underemphasis on co-operation. It's actually the human animal's unmatched ability to co-operate in solving problems that has given our species its mastery over the planet.

Human behaviour is composed of competition and co-operation. We form co-operative groups so as to enhance their ability to compete with other groups. But the economists' model captures only one dimension of the process.

The classic example of group co-operation to facilitate competition is, of course, that bedrock of modern economies, the company. Companies - often very large, multinational companies - dominate our economy, but the model tells us nothing about what goes on inside them and economists don't have much to tell us about how the existence of big companies affects the behaviour of markets.

The final and perhaps most important twist that the economic model's focus on individuals imposes on economists' thinking is an inbuilt bias against intervention in markets by co-operation at its highest level, government.

The market of individual consumers and individual (tiny) firms is assumed to be self-sufficient and self-correcting, thus making intervention by government something alien and more likely to make things worse than better.

The reality, of course, is that governments not only need to "hold the ring" - provide the protection of property rights and legal enforcement of contracts - they also need to impose rules that protect the market, and the rest of us, from the consequences of its own herd-driven excesses.

Saturday, October 4, 2014

How mental biases expose us to exploitation

So, you're a regular reader of the business pages and you reckon you're smarter than the average bear when it comes to financial matters. Well, here are some common "biases" to which people fall victim when making decisions about financial products. See if you can put hand on heart and swear you've never made any of these mistakes. If you can, you're a lot smarter than me.

Have you ever overspent on your credit card, or paid off less of it than you know you should? And if you pass that one, try this one: are you confident you're saving enough to ensure your retirement is as comfortable as you'd like it to be?

If you fall short on any of those, you've been affect by what psychologists call "present bias" and behavioural economists call "time-inconsistent preferences" (so in the competition to make your discipline sound smarter than it is, the economists win).

People often succumb to the urge for immediate gratification, thinking too little about the problems this will create for them down the track. It's natural - economists would say "rational" - to value the present more highly than the future. But if you go too far in that direction and end up regretting the choices you made, you've overvalued the present and undervalued the future, making your preferences inconsistent over time.

Most of us have a self-control problem in some field or other. People who are overconfident about their ability to control themselves in the future - to, say, manage heavy repayments - will make their lives more of a pain than they need to be.

Those who are more realistic often use "commitment devices" to impose self-control on themselves. The most extreme example is to cut up your credit card. Compulsory superannuation contributions for employees are a kind of government-imposed commitment device to help us save for retirement - which may be why so few people object.

Businesses exploit our self-control problems by, say, designing a gym subscription that seems cheap, but only if we keep using it for the length of the contract. Or by starting a credit card or home loan with a low interest rate (known in the trade as a "teaser" rate) but then jumping to an overly high rate.

Have you ever delayed moving to a better bank account, or putting some of your savings in a term deposit paying a higher interest rate? The experts call this "procrastination" (now that's a surprise) and class it as a version of present bias.

Examples are legion: deciding to cancel something but not getting around to it, not checking to see if the accounts and the loans and phone contracts you have are still the best available, or not putting much work into searching for the best deal in the first place.

This, too, leaves you open to exploitation by businesses. Some offer a "free trial" while knowing few people will cancel the deal when the paying period begins. Even requiring cancellation by post exploits our inertia.

Have you ever driven a hard bargain to buy a new car, but then gone overboard buying extras like rust-proofing, window-tinting or an improved security system? Have you ever bought a new TV or computer, then been sold extended warranty insurance?

Have you ever hung on to shares now worth less than you paid for them, hoping they will come good and you won't have to accept you made a bad decision to buy them?

If so, you've fallen victim to the biases of "reference dependence" in the first case and "loss aversion" in the second.

It's virtually impossible to look at something and decide what you think about it without consciously or unconsciously comparing it with something else. When buying a car, we compare and contrast all the ones we could buy. Failing that, we compare the one we're thinking of buying with our old one. If we don't have an old car to compare with, we compare having one with going by bus.

Comparisons are almost unavoidable. But we're so dependent on having something else to compare with - use as a point of reference - that if a sensible comparison isn't available we'll use one that makes no sense at all.

An old experiment asks people to estimate how many African countries are members of the United Nations. Most people have no idea. But if, before or while asking the question I mention 60, many people will seize on that number. Do I reckon the number of countries is more or less than 60? How much more, or how much less? That's an easier question to answer.

This way of making decisions is known as "anchor and adjust" and all of us use it all the time, consciously and unconsciously. Trouble is, 60 was a number plucked from the air. Experiments show that if you mention 100 rather than 60 before asking the question you get higher answers.

Point is that our reference dependence makes us easy meat for clever salespeople. We go overboard buying extras for our new car because they all seem so cheap relative to the huge sum we've just forked out to buy the car.

Likewise with extended warranties, which are notoriously overpriced for what little you get back. Anyone wanting to buy "peace of mind" is usually overcharged.

It's an empirical fact that most of us hate making losses much more than we love making gains. By about two to one, they say.

This explains why we do silly things like hanging on to dud shares we should sell - and then should put the proceeds into something with better prospects of gain.

These examples come from a report on behavioural economics prepared by Britain's new Financial Conduct Authority, which has been charged with finding ways to prevent businesses taking advantage of our lack of rational thinking. Good idea.

Wednesday, October 1, 2014


October, 2014

I want to talk about the economic case for a more equitable Australia. But before I do I want to enter a major caveat. Why should we seek a more equitable Australia in which income and wealth and opportunity are shared more fairly between the top and the bottom? For no better reason than that it’s the ethical, moral, right thing to do. If it’s the moral thing to do - the thing that Christians and most other religions and humanist ethical codes tell us we should do - we don’t need any supporting arguments. I’ve often heard the ethicist Simon Longstaff say that if you’re ethical in your business practices because you believe it’s good for business, you’re not being ethical at all. Ethics as a profit-making strategy isn’t ethics. One of the things I’ve learnt from my reading of psychology is that it’s always better to do things from intrinsic rather than extrinsic motives. It’s better to do things for their own sake - because you enjoy doing them or believe it’s your duty to do them - than because doing them brings you some sort of external reward - money, power, fame or status.

I’m often sorry when I hear people in noble occupations defending what they do with instrumental arguments. I’d like to hear more vice chancellors say they believe in increasing and spreading knowledge for its own sake, that a rich country like ours can afford to spend a far bit of its wealth on satisfying our insatiable human curiosity, that the better educated people are the more they can get out of life, even if they never put that education to use in the workforce, rather than arguing that investing in education is good for the economy. I’m sorry when I hear people in the arts arguing that the arts create many jobs. When we do this we’re giving in to the hyper-materialism of our age.

But having said that, and as an economic journalist it’s more appropriate for me to make the economic case for greater equity. So it may seem that I’m about to do what I just said other people shouldn’t do: argue that we should be more equitable because this would make the community better off materially. I actually believe that to be true - just as it’s true that spending more on education would make us all better off materially - but actually I’m going to make the mirror image argument: that making Australia more equitable wouldn’t make us worse off.

Why am I mounting such a negative argument? Because there’s a widespread belief among economists and their fellow travellers that making Australia more equitable would leave the community worse off materially, that it would come at the cost of a lower material standard of living overall.

 The longstanding conventional wisdom among mainstream economists is that ‘equity’ is in conflict with ‘efficiency’ - that is, the efficient allocation of resources so as to maximise the community’s material standard of living and foster economic growth. Economists are comfortable with objectives being in conflict because a key part of their expertise is knowing how such conflicts are resolved: by trading off one unit of equity for one for one unit of efficiency (or vice versa) and continuing to do this until you’ve achieved the particular combination of equity and efficiency that gives you maximum satisfaction overall. Once you’ve achieved that ideal trade-off you’ve achieved economic nirvana: equilibrium.

In practice, however, it’s worse than that. Economists specialise in efficiency, but not in equity. Their contribution to society is to explain to the community how to organise the economy in ways that maximise our utility or satisfaction from the production and consumption of goods and services, and how to keep our material standard of living improving every year. If you believe that efficiency and equity are always in conflict, so anything you do to improve equity will always be at the expense of efficiency, but you, as an economist, happen to specialise in efficiency, it’s easy to decide to focus on efficiency and ignore equity. After all, we live in an age of ever-increasing specialisation - which is actually a primary source of productivity improvement and thus our ever-rising material affluence. So you focus on efficiency and growth, and leave equity for others to worry about.

You bolster this decision by observing that, whereas efficiency is objective and measurable, equity is highly subjective; fairness is in the eye of the beholder. So you tell yourself - and anyone who asks - that you stick to the science and leave the value judgments to those more qualified, such as the politicians. (This would be fair enough, were it not for the fact that, in proffering their advice, economists rarely attach product warnings. Though the advertisers of patent medicines warn people to see a doctor ‘if problems persist’, economists don’t warn politicians to check with sociologists or prelates before they act on the economists’ advice.)

The problem is, if it’s not true that efficiency and equity are in conflict - or not always true - then the economists will be failing to advise politicians of cases where equity can be improved without any loss of efficiency - that is, failing to advise the community when there’s a free lunch to be had. And if, because of their lack of interest in equity as an objective, economists fail to draw attention to those cases where improving equity can lead also to improved efficiency, then economists are failing in their own specified role to maximise efficiency and failing to point out cases where we can kill two birds with one stone.

I’m sure there are plenty of cases where equity and efficiency really are in conflict. But I’m equally sure there are many cases - far more than we realise - where they aren’t; that there are delicious free lunches going begging and opportunities to increase efficiency that the efficiency experts themselves haven’t noticed because of this kink in their thinking.

Let’s start by looking at the limited case: where is the evidence that greater equity damages efficiency? The opponents of government intervention have been searching for years for cross-country or other evidence that developed economies with a bigger public sector (and thus a more redistributive tax and transfer system) have inferior records on economic growth. They haven’t found it. Nor have they found evidence that countries with a less unequal distribution of income between households have inferior economic growth. In his book, The Price of Inequality, the Nobel Prize- winning economist Joe Stiglitz observes that various European countries enjoy a standard of living much the same as America’s while doing much more to reduce income inequality than America does. So there’s little evidence we have to accept a highly unequal society to preserve an efficient, growing economy. Studies show the US has surprisingly low social mobility: few people with poor parents go on to have high incomes and, conversely, few people suffer a decline in income between generations. If you can stay rich in America without trying, and stay poor despite trying, it’s hard to believe this won’t lead to a long-term decline in the dynamism of the US economy.

So let’s move on to the evidence for the more positive case: that equity and efficiency can pull together, that reduced inequality can actually enhance efficiency and growth. There’s a growing amount of such evidence. First is what health economists and public health medicos call ‘the social gradient’ or ‘the social determinants of health’. There is much evidence that the health of people with low socio-economic status is much worse than that of people with high socio-economic status. The obvious response to this evidence is to say that measures to improve the health of people on the bottom ought to lead to a very real improvement in their wellbeing. That’s the equity objective. But health, like education, is one of those things that are both a means and an end in themselves, an instrument as well as an objective. The better educated a population is, the more its labour is worth and the richer we can expect it to be. Similarly, the healthier a population is the more able it is to work and the richer we can expect it to be. So the more we do to improve the health of the bottom half, the more efficient the economy should be and the faster it should grow.

Stiglitz cites an IMF study finding that the less unequal a country’s income distribution is, the further apart its recessions are likely to be - that is, the less macroeconomic instability it’s likely to suffer. His book contains much similar evidence and arguments, but I want to refer to the work of one other American Nobel laureate, James Heckman, before I move my argument closer to home. Heckman’s work demonstrates the almost magical power that attending to the early childhood development of at-risk children has in reducing the likelihood of them getting into trouble with the police, dropping out of school, being in and out of employment and in and out of jail. It’s obvious that the success of such a program would do much to improve equality of opportunity, and it’s not hard to see it would also greatly improve the beneficiaries’ contribution to the paid labour force (not to mention the pressure on government spending).

The most obvious case of increasing equity also increasing efficiency is unemployment. We think it’s unfair to have people who want to work unable to find a job, not just because it leaves them with less to spend but also because we know the unemployed are particularly unhappy. Sure. But it’s also glaringly inefficient to have people who’re able to work lying around idle and not contributing to national production. Finding ways to get those people back to work would often make a far greater contribution to efficiency than many of the micro-economic reforms economists hanker after.

Two prominent policies in the last federal campaign are seen as primarily about equity, but nonetheless should bring significant efficiency benefits. The first is the Gonski reforms to school funding, which are intended to increase the assistance able to be given to students suffering one form of disadvantage or another, regardless of which school system they’re in. If this results in more young people gaining a better education, the value of their labour is increased as well as their degree of participation in the labour force. It’s a similar situation with the national disability insurance scheme. It can be expected to increase workforce participation and the acquisition of skills. And where unpaid carers with high skills are able to return to the workforce after being replaced by paid carers with lesser skills there’s obviously some increase in the skills of the workforce. According to the estimates of no less an authority than the Productivity Commission, the disability scheme could be expected to lead to an annual increase in real GDP reaching 1 percentage point by 2050.

Finally, in an issue that’s dear to my heart, there is growing evidence that organising work in the workplace in ways designed to increase the satisfaction workers derive from their work - by making sure you put round pegs in round holes, or having them work in teams, or giving them greater personal autonomy or a say in the way things are run - leads them to make a better contribution to the success of the firm. Since most of us are doomed to spend 40 hours a week working for most of our lives, it amazes me the populous hasn’t long ago insisted that work be made as satisfying as possible. The growing evidence that doing so would also increase efficiency makes it even more amazing.

The case for greater equity in Australia is fundamentally a moral one: we should do it because it’s the right thing to do. But the economic efficiency case for not making Australia more equitable is weaker than many economists assume. There is evidence we can increase equity in ways that don’t reduce efficiency. And if we look for them there are many ways we can reduce inequality and increase efficiency at the same time. Let’s do it.