Monday, March 30, 2015

Let's be more hard-nosed towards foreign miners

Joe Hockey and Competition and Consumer Commission boss Rod Sims must surely deserve a medal for their selfless devotion to the interests of foreigners, after their shocked reaction to Twiggy Forrest's suggestion that the world's big producers stop the plunge in iron ore prices by limiting their output.

And here was me thinking economics was about rational self-interest.

Hockey sniffed that the idea smacked of forming a cartel. Which was good of him when you remember the way the plunging price of iron ore is robbing his budget of company tax revenue and causing his deficits to be bigger than those Labor left.

We can't afford to give much money to the foreign poor, but if foreign-owned mining companies want to keep forcing down ore prices by expanding production at a time when world demand is weak, that's fine by Joe.

Sims proclaims that cartels are illegal and is investigating whether Twiggy should be prosecuted. It surely can't have escaped his notice that very little of Australia's iron ore production is used locally, meaning no Australian consumers or businesses would suffer from such an arrangement.

But that, apparently, is not the point. Cartels are morally wrong, even if they advance Australia's national interest. If big foreign-owned producers such as Rio Tinto and BHP Billiton want to use their lower costs per unit to keep expanding production, forcing down the world price and attempting to wipe out higher-cost Australian-owned producers such as Forrest's Fortescue Metals, good luck to them.

Fine by us. That's the way the global resources game has always been played – wild swings from excess demand and inadequate supply causing booms, to weak demand and excess supply causing busts – and so that's the way it must continue to be played.

No effort can or should be made to moderate this crazy game. That there is a lot of fallout on bystanding industries, workers and consumers in the countries where big mining chooses to play this contact sport, is just an unfortunate fact of economic life which it is our government's sacred duty to make us grin and bear.

But while we're being so noble and self-sacrificing, it's worth remembering it wasn't always thus. Consider the many decades in which our governments sought to stabilise the world price of wool, which ended badly only after misguided economic rationalists handed control of the scheme to the woolgrowers themselves.

And don't forget the old Australian Wheat Board's "single desk". We weren't big enough to control world wheat prices, but we did make sure our growers weren't bidding against each other.

While the punters talk xenophobic nonsense about Chinese state-owned corporations taking over NSW's electricity poles and wires, Australia's economists have a deeply ingrained ethic that it's a form of racism ever to acknowledge that a company is foreign-owned.

Now we're in the final throes of the decade-long mining resources boom, it's a good time to reflect on how much we got out of it (not all that much, remembering it's all our minerals) and how well we handled it.

We played it by letting the foreign mining companies do pretty much whatever they wanted, which was to build as many new mines and gas facilities as possible in minimum time. This insane rush came at the expense of all our other industries, but no one questioned its wisdom.

It was left to the Reserve Bank to ensure the miners' greedy stampede didn't cause a wages breakout and inflation surge, which it did by repressing the rest of the economy. To "make room" for the money-crazed miners, it held interest rates higher than they otherwise would have been, which may have caused the exchange rate to be even higher than otherwise.

Was any effort made to assess whether attempting to build 180 resource projects in three years was in the national interest? Yes, but the economists left it to the lawyers. Each of those projects would have been accompanied by an environmental assessment assuring some court that the project would create thousands of jobs and do wonders for the economy.

Evaluating each project separately, the lawyers bought it. You needed to be a macro-economist to see that, added together, those claims made no sense. There wasn't that much skilled labour available and, with the economy near full employment, it just isn't possible to create many extra jobs. All you'd do is move jobs around, bidding up wages and creating shortages in the process.

But the macro-economists were away at the time, probably busy explaining to politicians why it was our economic duty to allow foreign mining companies to use our economy as a doormat.


Sunday, March 29, 2015

State governments don't greatly affect the economy

With the election over, Sunday is the first day of the rest of the life of the NSW economy under the new Baird government. So how much has changed?

A lot less than the rhetoric of the election campaign may have led you to expect.

State elections are times when governments claim the credit for all the good things happening in the economy and get blamed by oppositions for all the bad things.

In truth, they should get only some of the credit or blame. That's because there is really no such animal as the NSW economy.

There are no barriers between NSW and the other states and territories, meaning it's just the NSW corner of the national economy.

So the government agencies with the most influence over our corner are the Reserve Bank and the federal government.

It is true the NSW economy has grown relatively strongly since the O'Farrell-Baird government took over four years ago. We were performing poorly compared with other states, but now we are doing best in various categories.

But that's mainly because market economies are cyclical: what goes up must come down, and what is down will go back up soon enough.

What came down was Western Australia and Queensland as the mining construction boom came to an end. What went back up was NSW and Victoria as things got back to normal.

Because NSW is by far the largest of the states, it is rarely far from the national average, and often a bit above it.

But the Coalition's economic policies have been good and it can take some of the credit for our improved performance.

Historically, NSW has had trouble building enough new housing to accommodate the state's growing population, a problem that does much to explain Sydney's exceptionally high house prices – and one the state government can do much to improve.

The undue regulation and high charges on developers have limited the supply of new homes on the outskirts of the city, and planning restrictions have permitted too little of the medium and high-density in-fill home buyers are demanding so as to be closer to jobs.

But a lot more homes are now being built, for which Mike Baird should get credit. This higher level of building is likely to continue.

State governments have no control over immigration and national population growth, but are responsible for solving the growing social and economic problem of traffic congestion and long commute times.

Both sides of politics have neglected the development of public transport. And road projects such as WestConnex are likely to offer only temporary relief.

The state's performance on employment has improved relative to the other states, but worsened with the national performance in recent years.

It will continue slowly worsening until the national economy picks up speed. Schemes offering payroll tax incentives to encourage businesses to increase employment are gimmicks to impress voters at election times.

Saturday, March 28, 2015

A rational analysis of Hockey's 'asset recycling'

I'm never sure who annoy me more, the business types who are certain every business is better run if privately owned, or the lefties who oppose every sale of government-owned businesses on principle.

On the question of privatisation, mindless prejudice is no substitute for rational analysis of the pros and cons. On the tricky question of the "asset recycling" being promoted by Joe Hockey to all state governments with businesses left to sell, careful analysis is essential.

Premier Mike Baird's hugely controversial proposal to sell most of NSW's electricity transmission and distribution network businesses – the "poles and wires" – and use the proceeds to finance $20 billion worth of public transport, road and other infrastructure is a classic example of asset recycling.

It offers a good case study in thinking through the issues, even to people who won't be voting in Saturday's state election.

You must cover all the relevant major considerations for and against, ignoring considerations that aren't relevant (or are common to both alternatives). You have to remember to take account of opportunity costs as well as actual costs and to avoid any double counting.

It will avoid confusion if we consider the two sides of the proposition separately. First, is it a good idea to sell the poles-and-wires businesses to private owners? Second, assuming the planned infrastructure projects are worthwhile, is privatising businesses the only way available to finance them?

The obvious starting point for consumers is: would selling the businesses lead to electricity prices being higher than they would be under continued public ownership? Or would there be a decline in the quality of service, such as blackouts?

In this particular case, the answers are more certain than usual: no and no. That's because, the networks being natural monopolies, the prices they charge are controlled by the Australian Energy Regulator, which believes they're already too high. Service quality is also tightly regulated.

The regulator's determination to get efficiency up and prices down suggests there will be job losses – in other states as well as NSW – whether or not the businesses are privatised.

This being so, the main issues of contention concern state government finances. The critics of privatisation stress that it's no magic pudding: sell these profitable businesses and you lose the dividends they were paying the government, along with the equivalent of the company tax they were paying to the state (because state-owned businesses don't pay tax to the federal government).

That's obviously true. But remember that, according to economic theory, the sale price of any business should be the "present value" of the stream of income it's expected to earn in coming years.

If so, the seller is perfectly compensated in the sale price for the loss of future dividends. Why else would they sell?

But does the theory work in practice? Not perfectly. For one thing, who can be sure what income will be earned in the future? The seller ought to have a better idea than the buyer, but if there aren't many potential buyers and the seller is anxious to sell, they may settle for less than they should.

Alternatively, if there are a lot of potential buyers, the seller may get more than the business is worth. Almost all buyers of established businesses are confident they can run it more profitably than the present owner.

Point is, provided the sale price is adequate, there's no financial reason to regret the loss of dividends. A complication is that a fair price would not compensate the state government for its loss of tax equivalent payments.

That's because a new private owner would be liable to pay real company tax to the federal government. This is part of the rationale for Hockey's scheme to give federal grants – $2 billion, in this case – to states that take part in his asset-recycling incentive scheme.

A factor having a bigger (downward) influence on the amount of the fair sale price is that the flow of annual profits from the network business in coming years is likely to be much lower than the recent $1.7 billion a year that Labor's Luke Foley keeps quoting.

That's partly because the regulator has signalled its intention to crack down on the excessive profits being earned by the nation's electricity network businesses, but also because the demand for electricity from the grid is falling and will fall further as people move to solar and the introduction of smart meters helps homes and businesses limit their demand for power.

(This demonstrates the economic truth that natural monopolies are a product of the existing technology. The network businesses' monopoly is being eroded by climate-change-driven technological advance.)

Some critics argue that selling profit-making assets and replacing them with roads and loss-making public transport reduces the state government's "net worth" and weakens its balance sheet.

This is true arithmetically, but is a strange argument. Governments aren't profit-seeking businesses. Their job is to meet the social and economic needs of their community by, among other things, ensuring the provision of adequate infrastructure – directly profitable or otherwise.

Turning to the predicated link between the sale of network businesses and the spending on needed infrastructure, it rests on an assumption it would be unthinkable for the state government to lose its AAA credit rating, which would happen if it simply borrowed another $20 billion.

For decades, federal and state treasuries have used credit ratings to beat off unworthy proposals for vote-buying capital works. But I think we have little to lose by causing the discredited rating agencies to lower our rating by a notch or two.

But though their limit on our debt level may be too low, there does have to be some safe limit. And the doctrine that state governments may acquire assets but, once acquired, they may never ever be sold off, strikes me as weird.

Friday, March 27, 2015

Poles and wires: who's misleading us about what

The politicians' decades of bad behaviour may have caused them to lose our trust, but not our mistrust - making us suckers for scare campaigns.

This election campaign has been dominated not by reasoned debate but by Labor and the power unions' almighty scare campaign over the sale of the state's electricity poles and wires.

It's the most successful scare-job since all the dishonest things Tony Abbott said about how the carbon tax would destroy the economy.

The truth is it doesn't matter much to electricity users whether the state's power transmission and distribution businesses stay government-owned or are sold off. That's because, being natural monopolies, the prices they charge are controlled by a national body, the Australian Energy Regulator.

The standard of service they deliver - blackouts, for instance - is also tightly regulated.

It is true that private owners would attempt to increase their profits by reducing overstaffing and other inefficiencies - which tells you what the power unions are so excited about - but the regulator has announced its intention to force all the nation's public and privately owned poles and wires businesses to raise their efficiency and to ensure the savings are passed on to consumers as lower prices.

It's clear that, whoever owns the poles and wires, those businesses will be doing it much tougher in coming years. That's because the demand for electricity from their grid will keep falling, with households and businesses moving to solar and the introduction of smart meters helping households cut their usage, especially at peak periods.

This is why the dividends the state government would lose by selling the businesses would be a lot lower than the present $1.7 billion a year Luke Foley keeps claiming. (A characteristic of scare campaigns is that you stick to your wrong claims even after you've been caught out.)

This is not to say we can believe everything Mike Baird has been saying, of course. He describes his plan as "the long-term lease of 49 per cent of the NSW electricity network". This is highly misleading, an attempt to fool us into believing he isn't really privatising the network.

There's little practical difference between a 99-year lease and an outright sale. And that figure of 49 per cent - making it seem the government would retain majority ownership of the network - is highly contrived.

Baird plans to sell 100 per cent of TransGrid, the state-wide high-voltage transmission business, and 50.4 per cent each of Ausgrid and Endeavour Energy - which distribute power locally to about 70 per cent of the state's population living between Ulladulla and Newcastle, and inland to Scone, Lithgow and Bowral.

How does that add up just 49 per cent? By taking account of the plan not  to sell any of Essential Energy, which distributes power to the state's backblocks. Convinced?

A separate question is: is selling the electricity network the only way we would be able to fund the $20 billion in new public transport, road and other infrastructure Baird promises?

Yes - if you think it matters that the state keeps its triple-A credit rating. No - if you don't. I don't.

Wednesday, March 25, 2015

Should taxpayers develop properties for churches?

Election campaigns are busy times for interest groups. They turn up the pressure on governments and oppositions to give them written promises to grant them particular benefits, or not do things the groups don't fancy, during the next term.

It's surprising how often the pollies give in to such tactics. They do so for fear the interest groups will campaign against them if they don't sign on the line.

In the last federal election, for instance, the banks and other financial institutions got the Labor government to promise not to make any more adverse changes to the taxation of superannuation for five years, then persuaded the Coalition to match Labor's promise during its first term. A lot of promises have been broken since then, but not this one.

Historically, few groups have pursued this tactic more successfully than the Catholic systemic schools. If you were a pollie, which would you choose: risk being preached against on the Sunday before election day, or be photographed beside a beaming archbishop as you sign the deal?

Recognising the Catholics' superior bargaining power, the other religious and independent schools tend to ride on their coat-tails.

Late last month the Catholic Education Commission announced that in the NSW election campaign it would "play an advocacy role in the interests of students, parents and teachers in the Catholic education sector".

Its "key policy issue" is that, in the light of the expected growth in the number of schoolchildren, the state government "must increase its capital funding to Catholic schools to help Catholic schools enrol their share of this growth".

Last year, we're told, the state's 584 Catholic schools educated 21 per cent of the state's students, but received only 2 per cent of the NSW government's capital funding for schools.

"The NSW Government must first reverse its 2012 decision to cap capital funding to non-government schools at $11 million per year and put in place a sustainable, long-term funding framework that grows as enrolments increase", the commission's executive director, Brian Croke, said.

The Catholic schools' share of the $11 million was $7.6 million, equivalent to about $30 per student, while government schools received more than $399 million, or $524 per student.

The state government's forecast is that all NSW schools will need to accommodate an extra 267,000 students by 2031. For the proportion of students in Catholic schools to remain unchanged, Catholic schools would need to create places for a further 58,000 students, the equivalent of more than 2300 new classrooms.

Sorry, but this argument needs thinking about. For one thing, the campaigners don't mention that non-government schools also receive capital funding from the federal government, which is a lot more generous than state grants.

For another, it's hardly surprising the state government spends a lot more on building and equipping its own schools than it does on subsidising other people's schools.

Where do taxpayers' obligations to Catholic and other non-government schools end? Governments have an obligation to provide for a growing student population, but do they have an obligation to ensure Catholic or any other non-government group's share of the school population doesn't decline as the population grows?

For religious or other groups to say they have school facilities they wish to make available for the education of kids - kids of their own choosing in locations of their own choosing - is one thing. For those groups to argue governments have an obligation to subsidise their provision of additional facilities so their share of the overall school population doesn't drop is quite another.

Who's to say those non-government groups will want to build their additional facilities in those locations where the population growth occurs? If the groups want to build in areas other than those of fastest growth - which these days would include the inner city - are taxpayers obliged still to cough up subsidies while also building the new schools where they're actually needed?

And is it reasonable to demand that taxpayers provide big subsidies towards the building of new facilities that remain the property of the churches or other groups involved?

The Catholics argue that their building of new facilities has been, and will continue to be, largely funded by parents. So the church itself doesn't put up much, but gets to retain ownership of the schools while the parents move on. When it comes to real estate, I wouldn't have thought the mainstream churches were all that property poor.

Federal grants come with a proviso that, should the subsidised school facilities be sold or used for another purpose within the first 20 years, the government may ask for its grants to be repaid. How often this provision is enforced I don't know.

We've long been asked to believe the non-government schools are doing taxpayers a favour, providing education to kids that taxpayers would otherwise have to pay for. But this demand for capital grants is aimed at reducing the size of the favour.

And when it comes to recurrent funding, the favour isn't all that great. Federal and state grants covered almost three-quarters of the costs of running Catholic schools in 2012. Fees charged to parents covered another 22 per cent.

With the election just a few days away, I'm hoping whichever side wins will get through without promising more funds to non-government schools. But we may not know whether they have until after it's over.

Monday, March 23, 2015

Budget needs more efficiency, less deficit repression

Joe Hockey's intergenerational report says something I really agree with: "to ensure government expenditure is sustainable and better targeted . . . governments need to focus their efforts on achieving the efficient provision of services".

At last, Hockey is acknowledging that we need to reduce the rate of growth in government spending in ways that increase the efficiency of the government's delivery of services.

To me – but no one else, it seems – the pet shop galahs' call for "more micro reform" points directly at two of our biggest industries, healthcare and education, which happen to be mainly in the public sector.

The intergenerational report projects that federal healthcare spending will rise only modestly over the next 40 years from 4.2 per cent of gross domestic product to 5.5 per cent, while federal education spending actually falls from 1.7 per cent to 1 per cent.

Believe that and you'll believe anything. These implausible projections rest on assumptions that the unsustainable cuts in the indexation of federal grants for state hospitals and schools plus the deregulation of uni fees proposed in last year's budget will roll on untouched for four decades.

Truth is, both healthcare and education are "superior goods", meaning they make up an ever growing proportion of consumption as real incomes rise over time. They account for such a large proportion of federal and state government spending that they expose the fiscal monoculists' goal of cutting spending to the point where taxation stops increasing and even falls, for the pipe dream it is.

Fiscal monoculists are those who take a one-eyed view of the budget. If it's in deficit, this can only be caused by excessive spending, never by inadequate taxation, even when the lack of revenue arises from choice-distorting sectional tax breaks, blatant multinational tax avoidance or irresponsible Reagan-style tax cuts.

Brushing aside the more obvious objections to last year's budget, another was its dearth of what Paul Keating called "quality cuts". These are cuts that aim to improve the efficiency of the provision of services.

By contrast, most of the savings came from nothing more virtuous than cost-shifting – to the young unemployed, university graduates, the aged, the sick and, above all, the state governments. This is why so many of the measures, even if they'd got through the Senate, were unsustainable.

You could argue that the GP co-payment, with its introduction of a price signal, and the deregulation of uni fees were genuine, cost-saving reforms, aimed at increasing efficiency in healthcare and higher education.

But such an argument stands up only if you make the most cursory examination of the economics involved. A co-payment price signal improves efficiency only if it deters unnecessary consultations, not if it deters low-income patients from reporting serious problems to their GP before they get worse. Too many of the latter and your "reform" becomes a false economy, storing up higher costs for later.

Deregulating uni fees and expecting market forces to prevent over-charging is a case of magical thinking when you remember the unis remain government-owned and highly regulated, are possessors of market power, and would be selling a service still heavily subsidised by taxpayers via HECS's income-contingent, real-interest-free loans.

There are ways to cut costs in healthcare and education – or, at least, slow their rate of growth – without reducing quality, but they require a lot more thought and effort than was put into last year's GP co-payment and uni fee deregulation proposals.

If you accept that governments ought to be assisting the victims of homelessness, domestic violence, people who can't possibly afford legal representation, dispossessed Indigenous people, the working poor and so forth, it's not efficient to make savings by cutting grants to charities, whose non-profit benevolence is a free good being offered to the taxpayer.

Echoing economists' strictures against "repressed inflation" in days past, the prominent American economist Lawrence Summers is warning against the prevalence of "repressed deficits", where governments engage in accounting tricks and false economies to hide the true costs and make budget deficits and debt look better than they really are.

Such as? Failing to properly maintain public assets, deferring the replacement of infrastructure beyond the end of its useful life, effectively paying higher interest rates to persuade private firms to hide government-initiated debt on their own balance sheets or, with similar effect, engaging in the sale and leaseback of government offices.

On the latter, the Howard government wasted millions of taxpayers' dollars doing that in its first budget. And now, I hear, Hockey is planning the same thing for the Treasury building. Not smart, Joe.

Saturday, March 21, 2015

Why fiscal policy may be making a comeback

For four decades, fiscal policy has been the poor relation among the tools available for countries to use to stabilise demand as their economies move through the ups and downs of the business cycle. Monetary policy has been the preferred instrument. But this may be about to change.

Monetary policy refers to the central bank's manipulation of interest rates, whereas fiscal policy refers to the government's manipulation of taxation and government spending in the budget.

Of course, in those four decades fiscal policy hasn't been completely friendless. In times of recession, politicians have almost always resorted to budgetary stimulus, sometimes against the advice of their econocrats.

In the policy response to the global financial crisis in late 2008, aimed at preventing it turning into a worldwide depression to rival the depression of the 1930s, there was an instinctive resort to budget spending in addition to the sharp easing of monetary policy.

The fiscal response was partly because the North Atlantic economies needed to lend money to their banks, but also because demand needed bolstering at a time when households and businesses, conscious of their high levels of debt and the diminished value of their assets, were in no mood to spend no matter how low interest rates were.

Urged on by the International Monetary Fund, all the major economies engaged in huge fiscal stimulus at the same time. This succeeded in averting depression and getting their economies on a path to recovery.

But by then the North Atlantic economies had high levels of public debt, and the ideological opponents of fiscal activism fought back, persuading Britain and the rest of Europe to abandon fiscal stimulus and instead cut government spending and raise taxes, even while their economies were still very weak.

Unsurprisingly, the result was to prolong their recessions and force them to resort to ever more unorthodox ways of trying to stimulate their economies with monetary policy.

In this column last Saturday we saw Dr Philip Lowe, deputy governor of the Reserve Bank, accepting that monetary policy had become a lot less effective around the developed world, but arguing this would cease to be so after the major advanced economies had finally shaken off the Great Recession in about a decade's time.

But a leading American economist, Professor Lawrence Summers, of Harvard, a former US Treasury secretary, argues that monetary policy's reduced effectiveness could last for the next quarter of a century.

This is because he sees world interest rates staying very low for at least that period. In all the recessions since World War II, the US Federal Reserve has had to cut its official interest rate by an average of 4 percentage points to get the economy moving again.

If interest rates stay low, the Fed (and other central banks) won't have room to cut the official rate to the necessary extent before hitting the "zero lower bound". This will make economic managers more dependent on fiscal policy to provide stimulus.

Why does he expect interest rates to stay low for so long? Because, at base, interest rates are the price that brings the supply of saving into balance with the demand for funds for investment.

And, in the developed economies, Summers sees less investment occurring because of weak or falling population growth, because capital equipment gets ever cheaper and possibly because of slower technological advance.

On the other hand, he sees higher rates of saving because more of the growth in income will be captured by high-income earners, with their higher propensity to save.

So if the supply of saving increases while the demand for funds decreases, real interest rates will be very low, even after all the quantitative easing (money creation) is unwound. Continuing low inflation will keep nominal interest rates low.

Summers argues that, over the decades, the popularity of fiscal policy has fluctuated with economists' changing views about the size of the fiscal "multiplier" – the size of the increase in national income brought about by a discretionary increase in government spending.

The latest view, coming from the IMF, is that the fiscal multipliers are much higher than previously believed (particularly for spending on infrastructure, less so for tax cuts). This is mainly because the reduced effectiveness of monetary policy has caused a change in central banks' "policy reaction function".

Whereas in earlier times the central bank would have increased interest rates if it feared fiscal stimulus threatened to worsen inflation (thereby reducing the fiscal multiplier), these days the central bank would be less worried about inflation and pleased to see fiscal policy helping it get the economy growing at an acceptable pace.

But Summers has another point. Lasting low real interest rates not only make monetary policy less effective and fiscal policy more effective, they also mean that lower debt servicing costs allow governments to carry more public debt.

His oversimplified calculation is that if the interest rate on public borrowing halves from 2 per cent to 1 per cent, a government can now carry twice as much debt for the same interest bill.

Let's put this interesting discussion into an immediate, Australian context. We know from the latest national accounts that, at a time when the economy's growth is too weak to stop unemployment continuing to creep up, public sector spending is acting as a drag.

This isn't because of federal government cuts in recurrent spending, but because the states have allowed their annual capital works programs to fall back at a time when private construction activity is falling through the floor and yields (interest rates) on government bonds are the lowest in living memory.

If the Feds had any sense they'd be borrowing big for well-chosen infrastructure projects, thereby reducing the pressure on the Reserve Bank to keep cutting interest rates and risking a house price bubble. The Reserve would love a bit of help from fiscal policy.

Thursday, March 19, 2015


Talk to Federal Court judges’ continuing education day, Brisbane, March 19, 2015

It’s normal for economists in my position to give you a happy chat about the state of the economy - or the world economy - full of forecasts about how things will turn out and warnings about what the economic managers need to do to ensure everything turns out well. But we all know many of my predictions would turn out to be wrong, and those that were right would probably be right for reasons I hadn’t foreseen. It’s one of the great mysteries of modern life that economists can be so bad at forecasting without the public ever tiring of asking them for more.

But such talks are usually accompanied by a PowerPoint presentation with copious graphs, and I’ve never got the hang of PowerPoint. In any case, though I have three years of economics in my commerce degree, I don’t regard myself as an economist, but rather as a journalist who writes about economics. I’m not a member of the economists’ union. This allows me to act as a kind of interpreter and go-between, standing between the economists and the public. I see my role as providing my readers with a critique of economics and economists, much as our theatre critics provide our readers with a critique of the latest plays. My goal is to explain and demystify economics, advising my readers on when they ought to accept the advice of economists and when they shouldn’t.

So today I want to talk about economics and economists, with special reference to that mystifying animal, economic modelling. The world is full of experts but, particularly in the area of public policy, few experts’ advice gets taken as seriously as economists’ advice. I imagine the economic aspects of the matters that come before you aren’t often kept in the background; that you often have people mounting economic arguments - or arguments that seem economic to the unqualified mind - and that some of you even have economists appearing before you as expert witnesses.

I find it interesting to speculate about why economics and the advice of economists get taken so much more seriously these days than they were in years past. My theory is that it’s because we live in an age of heightened materialism. There’s nothing new about materialism, of course, we’re all materialistic to a greater or lesser extent, and those who never spare a thought for the material aspect of their lives will be lucky if they don’t starve. But I think we’ve become more materialistic than we were - you can see that in the way the aspirations of entrants to American colleges have changed over the years - and this leaves us as a community more inclined to listen to and act on the advice of economists. But, I suspect, it’s a two-process: the more we listen to economists, the more materialist our attitudes become. So, if I’m right, the dominance of economic advice is both an effect and a cause of our era of heightened materialism.

Economics is the study of how market economies organise the production and consumption of goods and services. In other words, it deals with a very important aspect of life - all of us are consumers and most of us are producers - but only one aspect. It’s preoccupied with the practical, material aspect of life.

But there are lots of ways to define economics and another way is to say it’s the study of ‘the economic problem’, which is the problem of scarcity. Scarcity arises because our resources - of land, labour and capital - are finite, whereas our wants are infinite. Scarcity in this context doesn’t mean as scarce as hen’s teeth, just that things aren’t free - they can be acquired only at a price. So economists advise the community on ways to use our finite resources to satisfy as many of our wants as possible. This explains economists’ preoccupation with efficiency: the more efficiently we use our resources, the more wants we can satisfy, the more bang we can get for our buck.

The conventional economist’s first piece of advice to the community is that the most efficient - or least inefficient - way for a community to organise production and consumption is via markets. Governments will need to ‘hold the ring’ in a market economy, conferring and enforcing private property rights, enforcing the law of contract, providing bankruptcy laws, providing companies with limited liability, imposing adequate standards of financial reporting and auditing, and the like. There will be other instances of significant ‘market failure’ but, for the most part, most conventional economists believe that government regulation of markets, or intervention in markets, should be kept as limited as possible so the ‘invisible hand’ of market forces can play its semi-miraculous role of causing all things to work together for good.

If that sounds sarcastic, it’s not intended to be. There are two mistakes you can make about market forces: to underestimate their power or to conclude they’re near infallible. I’m about to bring to your attention the limitations and weaknesses of conventional economics and economists and their advice, but I’d hate to leave you with the impression I regard economics as little more than a hoax. I certainly don’t. The world would be much poorer without the contribution of economists and their discipline. They may not be much chop at forecasting, but that doesn’t mean they don’t know more about the workings of markets and the macro economy than the rest of us. If had more time I’d be happy to give you a list of their most valuable insights, but I think it’s more important for you to understand their limitations.

I want to make five points about economics and the economists’ art, before making five points about economic modelling.

The first point about economics is that it’s narrower than many people realise. We assume that economists are experts on the economy, but it’s truer to say they’re experts on the markets that help to make up the economy. Their basic model - known as the neo-classical model - is a model of how markets work through the interaction of supply on the one hand and demand on the other. This interaction determines the price of the good or service in question and it’s the market price that that brings demand and supply into balance (‘equilibrium’). This means that economists are obsessed by prices. If economists wore tee-shirts they’d say: Prices make the world go round. Economists believe the key to the efficient allocation of resources - to making our finite resources satisfy as many of our infinite wants as possible - is to get the price right which, for the most part, you do by leaving market forces free to determine that price.

Second, like all professions, economists suffer from what I call ‘model blindness’.  Just like model trains or model planes, economic models consciously simplify complex reality. They’d be of no use if they didn’t. The idea is to include and highlight the key factors and get rid of the unimportant issues that merely cloud the workings, thereby capturing the essence of what causes what. The neo-classical model strips away other commercial considerations so it can get to what economists regard as the heart of the matter, price. The question to ask of a model is not whether it’s left things out, but whether what it’s left out is important. And the test of that is how good it is at predicting how people (‘economic agents’) will behave in given circumstances. I believe that, in many circumstances, the standard model’s prediction record is poor. That is, it leaves out a lot of factors that do turn out to be important.

To put it another way, the motivations for human behaviour are simply too complex to be adequate captured by any model. It’s fashionable to say that economics is ‘the study of incentives’, but that’s just a sexy way of saying economics is the study of prices. To an economist, prices and the changes in them are the one great incentive - to produce more or buy less, or to produce less or buy more, depending on whether the price has risen or fallen and on whether you’re a producer or a consumer. One major limitation of economic analysis is that it can’t take account of any factor that can’t be not just quantified, but also valued in dollars. Sometimes when a relevant factor doesn’t have a market price because it’s not traded in a market, economists will try to estimate a ‘shadow’ price for it but, for the most part, factors than can’t be monetised are simply ignored. So economists end up tacitly assuming people are motivated solely by monetary considerations. No one does anything out of the goodness of their heart, because of a sense of duty, because they simply enjoy doing a good job or because they’re seeking power and influence. Little wonder economists aren’t much good at predicting people’s behaviour.

The economists’ model has many other limitations but, as with all professions, economists tend to lose sight of the factors that have been excluded from their model. Just as lawyers tend to view every problem from a legal perspective and doctors see all problems as medical, so economists suffer from their own ‘model blindness’ - a tendency to view the world and to analyse problems exclusively through the prism of their model; to focus on those variables their model focuses on and to ignore all those factors from which their model abstracts.

It’s the job of their hearers - including judges - to quiz them about which factors they haven’t taken into account and what their relevance might be. On that score, it’s important to be aware that most economic estimates of the extra income (economic growth) that this or that action would bring about take no account of the ‘distribution’ of that extra income between high, middle and low-income families. In other words, one of the factors from which the model abstracts is questions of fairness. Although a few economists specialise in studying distributional questions, most economists’ analyses ignore it. When pressed, they’ll tell you perceptions of fairness are subjective and so outside their field of competence. So they leave them for others to judge - politicians, for instance. Their specialty is efficiency, not ‘equity’. Trouble is, if you don’t press them they probably won’t mention this limitation to their advice. By contrast, the public tends to regard questions of fairness - who wins, who loses - as highly relevant to the decision-making process.

Third, though it’s fashionable to bang on about the need for decisions to be evidence based, economics is more faith-based than evidence-based. Actually it’s better to say economic analysis is theory-based, with only a secondary appeal to empirical evidence. Whereas the hard sciences collect empirical evidence then try to think of theories that best explain that evidence, economics works the other way. It starts with theories (models) based on assumptions - assumptions which, in the basic neo-classical model, have changed little since the second half of the 19th century - then looks for empirical evidence that supports the theory.

This is not to imply there’s been little advance in the economics profession’s thinking since the 19th century. There has been. Most of the Nobel prizes in economics awarded in recent decades have gone to economists exploring the limitations of the basic model’s assumptions - advances such as information economics and behavioural economics. But most of these advances have been too hard to express mathematically, or too hard to measure, for them to have made much impact on either ‘the economic way of thinking’ or the formal mathematical models used to make forecasts about the economy or about the effects of a particular policy change.

One important but only implicit assumption built into economists’ thinking and their formal models is that the parties to a transaction - say, Woolworths and one of its suppliers, Coles and one of its customers, or any employer and one of its workers - are of roughly equal bargaining power. The inappropriateness of such an assumption does much to explain the government intervention embodied in many of the acts you deal with, including the Competition and Consumer Act.

Fourth, economists and, more particularly, economic rationalists, tend to be missionary or imperialistic in their attitudes. Notwithstanding the narrowness of their model - its focus on the material dimension of our lives and abstraction from the relational, social, cultural and spiritual dimensions; its abstraction from considerations of fairness and significantly unequal bargaining power - economists of a more fundamentalist disposition want us to think like economists think and make economic growth and efficiency in the allocation of resources our overwhelming priority.

Significant parts of our community life have not been part of any market. We don’t allow people to buy and sell blood or body parts, for instance, much of our sport is amateur, many speeches are still given for no recompense other than a bottle of wine and there is much volunteering. But many economic rationalists are so convinced of the benefits of increasing efficiency, and so enamoured of markets as a way of allocating resources efficiently, that they want to see more and more aspects of our lives given over to the market. They want to commercialise and privatise government-owned businesses, and contract out the provision of government services such as job search assistance and childcare. They want to raise more revenue from user charges and less from general taxation. The de facto privatisation of our universities has been proceeding for several decades. Rationalists want to complete the commercialisation of the weekend by completing the deregulation of shopping hours and removing penalty rates. What effect would this have on family life? It’s literally of no consideration; it’s not in the model.

Economic advice is often so missionary, while being so one-dimensional, that it ought to come with a product warning: here’s a list of all the factors I haven’t taken into account in proffering you this advice; you should probably consult a social psychologist or sociologist or cleric before acting on my recommendations. But it rarely comes with any qualification: I’m an expert and here’s what you should do.

Finally, economists have no professional association - no law society or bar council - and so have no expressed or enforced standards of ethical behaviour. The Economic Society is essentially a discussion group that the unqualified are welcome to join. So these days the many firms of economic consultants or the economists undertaking similar work for the big accounting firms, such as KPMG and Deloitte, are under no external ethical constraint when they provide supposedly independent economic advice to paying customers advocating or opposing government policies, or when they appear as expert witnesses.

Which brings us neatly to economic modelling exercises. I make no profession of a deep understanding econometrics, but I’ve quizzed modellers about their models for so long that their limitations are clear enough to me to allow me to make five points.

First, economic models are highly sophisticated and quite primitive at the same time. They’re sophisticated in that they’re a mathematical representation of the linkages between selected elements of the economy. The links are represented by a large number of algebraic equations with numerous variables. The modeller decides the values of the independent (or ‘exogenous’) variables and the model calculates the values of the dependent (‘endogenous’) variables. So if the modeller slots in the wrong independent variables - they’ll usually be assumptions (guesses) about the future - the dependent variables will be wrong, too.

Models are primitive because they’re a hugely oversimplified version of the economy, which often can’t adequately represent the subtleties of the policy changes whose effects they’re purporting to estimate. This lack of subtlety, or a lack of empirical data, means they often make extensive use of ‘proxy’ indicators, a euphemism for ‘the nearest we could find’.

Second, like economic theory itself, economic models are built on a host of assumptions. Indeed, many of those assumptions come from the modeller’s preferred theory about how the economy works. It’s common for ‘computable general equilibrium’ models to have Keynesian assumptions in the short run (up to 10 years) but neo-classical assumptions in the long run (20 years or more). That is, key variables such as inflation, unemployment and economic growth are determined by the strength of aggregate (total) demand in the short run, but by the strength of aggregate supply in the long run.

This means the economy is assumed to be at full employment in the long run, and economic growth over the period is assumed to be determined solely by the growth in the labour force and the rate of improvement in the productivity of labour. Both of those are independent variables, plugged in by the modeller on the basis of some assumption.

So the results you get from such models are largely predetermined by the assumed structure of the economy and the chosen values of the independent variables. Worse, it would be an incompetent modeller who couldn’t tweak the assumptions to ensure the results they got were consistent with what their paying customer was hoping for.

Third, most commercial modellers keep the workings of their models largely hidden. They’ll have some impenetrable qualifications and explanations up the back of their report, but they don’t go out of their way to warn lay users about their model’s assumptions and limitations. Even university economics courses don’t labour the limitations of the theoretical model, and practitioners become so familiar with the way their econometric models work that they can forget about their limitations until they’re challenged. Then, when the results of the modelling are being quoted by the interest group that paid for it - or by politicians on the same side - any remaining restraint is lost and the results are invested with about the same authority and certainty as the Ten Commandments.

Fourth, disinterested parties to whom modelling results are presented should arm themselves with caution and scepticism. All modelling results are rough estimates. Estimates that are expressed too precisely exhibit ‘spurious accuracy’ and are a sign the modeller may be more interest in impressing the punters than enlightening them. Modellers should be asked to outline the key assumptions that are driving the models results and then asked for ‘sensitivity analysis’ of the key variables. That is, if this variable was increased or decreased by 1 percentage point, what difference would it make to the results? Don’t assume that if one economist says an effect is big and another says it’s small, the truth is probably somewhere in the middle.

Finally, be particularly wary of claims about jobs. Businesses are motivated by profits, not a desire to provide employment to people. Economists are on about achieving faster growth in GDP and GDP per person - a crude measure of our improving material standard of living. They know that where there’s growth in GDP there’ll also be growth in employment, but increasing employment is not their primary concern.

But both business people and economists know that when you’re trying to persuade the community to let you undertake a project that will cause economic disruption and environmental damage, there’s just one, killer argument: all the jobs you’ll create. The public have it deeply ingrained in their brain that there’s a permanent excess of unemployed workers and an eternal shortage of jobs, so that you can never have enough jobs. So promise lots of jobs and no further questions will be asked.

This presents businesses and their modellers with an enormous temptation to exaggerate estimates of the number of jobs the project will ‘create’. They’ll focus on the many jobs created in the construction phase, not the much smaller number of permanent jobs. They’ll misuse the multipliers in the Bureau of Statistics’ ‘input-output tables’ to exaggerate the number of jobs to be created ‘indirectly’ in other industries. They’ll forget to remind you that if the jobs to be created are skilled jobs, skilled workers are usually in short supply, so that the jobs won’t be filled by the unemployed but already-employed workers will have to be paid sufficiently highly to attract them away from other employers or from overseas. They won’t mention that if the economy’s growing at a full-employment rate (these days judged by the econocrats to be an unemployment rate of about 5 per cent), it’s just not possible to ‘create’ any additional jobs, merely to move existing jobs from one location to another. Disinterested economists never cease to be amazed by some of the claims made about how many jobs will be created - or, with other lobbying propositions, lost.


Wednesday, March 18, 2015

Our kids need social skills, not just high marks

My father raised me to be contemptuous of fashion in all its forms, and I try not to be overawed by the rich and powerful. But, like my mum, there's one thing I am impressed by: brains.
My job brings me into regular contact with the econocrats at the top of the Reserve Bank, Treasury and other departments. Let me tell you, they're the brightest of the bright. I have to keep telling myself this as I struggle to keep up with them. All of them could hold down jobs as professors, or earn a lot more money in business.
These days, most have PhDs - though it's disturbing that, so far in his time as Prime Minister, Tony Abbott has relinquished the services of five economist department secretaries: Dr Martin Parkinson, Dr Don Russell, Blair Comley, Dr Ian Watt and now Dr Paul Grimes. Not sure we have that many brains to spare.
In recent years, however, I've realised that being super-bright ain't enough. To be really successful you also need "people skills". I've decided an extra unit of EQ - emotional intelligence - is worth a lot more than an extra unit of IQ. And if a genie appears from a bottle, that's what I'll ask for.
Most of our politicians have heard that the development of children's brains is hugely significant in influencing their success throughout the rest of their lives. Hence governments' increasing attention to early childhood education and care.
What people may not realise is that brain development doesn't matter just because of its effect on kids' intellect. As a new report from the Organisation for Economic Co-operation and Development, The Power of Social and Emotional Skills, makes clear, it matters also for children's social development.
We don't need telling about the importance of "cognitive" skills. These days, governments conduct periodic tests of children's literacy, numeracy and scientific literacy as they progress through the school system.
They make the results available directly to parents, but also put them on websites so the whole world can compare the academic performance of particular schools. Teachers object that good teaching involves a lot more than the three Rs and that the emphasis on competition via "metrics" encourages schools to "teach to the test" and spend much time drilling for coming tests.
The OECD's PISA exercise now compares our cognitive tests with those undertaken in other countries, so that every year or so we agonise because we've slipped back in the international comp on this cognitive measure or that.
The point of this latest report is to agree with the teachers: there is a lot more to the adequate development of our kids than just nurturing their IQs. It finds that children and adolescents need a balanced set of cognitive and social and emotional skills in order to succeed in modern life.
Cognitive skills - as measured by achievement tests and academic grades - have been show to influence the likelihood of individuals' success in education and the jobs market. They also predict broader outcomes such as our self-perceived health, social and political participation, and trust.
But social and emotional skills - such as perseverance, sociability and self-esteem - have been shown to influence numerous measures of social outcomes, including better health, improved subjective wellbeing (aka happiness) and reduced odds of antisocial behaviour.
If that doesn't impress you, try this: cognitive skills and social and emotional skills interact and cross-fertilise each other, empowering children to succeed both in school and out of school.
For instance, social and emotional skills may help children translate intentions into actions, and thereby improve their likelihood of graduating from university, sticking to healthy lifestyles and avoiding aggressive behaviours, the report says.
For children who are talented, motivated, goal-driven and collegial, and thus more likely to weather the storms of life, cognitive skills aren't enough. They need to be combined with social and emotional skills, which include conscientiousness and emotional stability.
The report stresses that "skills beget skills". They build on each other, and the earlier kids start acquiring them and the firmer their foundation the more skills are gained and the better the kids do in life.
You may say that children from "good" homes will acquire social skills from their parents without any fuss. That's fairly true and it's why, apart from making attendance at preschool universal, early intervention programs are best targeted at disadvantaged families, offering parents training and mentoring.
But though an early start is best, children's acquired skills remain malleable through adolescence. Programs aimed at older children emphasise teachers' professional development. Among adolescents, mentoring seems to work well, while hands-on experiences in the workplace can instil skills such as teamwork, self-efficacy (strong belief in your ability to reach goals) and motivation.
Improvements in social skills don't necessarily require major reforms or resources but can be incorporated into existing curricular and extracurricular activities, the report says. A lot of social and emotional skills can be gained from sport, arts clubs, student councils and voluntary work.
The report finds that recent developments allow us to measure social and emotional skills reliably within a particular culture and language. I reckon that as long as we retain our obsession with measuring and comparing academic performance we need to balance this with regular measurement of progress in acquiring social skills.
Surely our econocrats are bright enough to see that.

Monday, March 16, 2015

We're not taking productivity seriously

Given our obsession with materialism, productivity "isn't everything, but in the long run it is almost everything," as Paul Krugman famously said. If so, the intergenerational report's consideration of the topic is quite inadequate.

It's partial in both senses. It mentions most of the key factors that influence productivity improvement - defined as increased goods and services produced per hour worked - but doesn't do justice to many, including climate change.

That's partly because, though the report purports to be about the future of the economy, its real target is Treasury's eternal top priority, the future of the budget balance.

But it's also because the econocrats are leading us towards their preferred policy response to our alleged productivity problem and away from those responses their "priors" - preconceived beliefs about how the world works - cause them to disapprove of.

There are two broad approaches to government efforts to improve productivity: one which involves more intervention and spending and one which involves less intervention and little change in spending. Guess which one Treasury's priors lead it to favour?

For the past 200 hundred years, most of the world's productivity improvement has come from technological advance - people inventing better machines and thinking of better ways to do things.

But the other fish Treasury wants to fry prompt it to embrace an extreme view held by a few American economists that we've entered a period of much less rapid technological change.

When you consider all the disruption the digital revolution is unleashing on so many industries this is hard to believe.

In the era of the knowledge economy, you'd expect much long and earnest discussion about what governments should and shouldn't be doing to encourage acquisition of the "human capital" that comes from education and training.

Should we be cutting budgetary support for science and research and development? Is now the right time to be pushing university funding off the budget and on to students and universities' money-making schemes?

Why would a government that professes to believe in "equality of opportunity" welch on its professed support for the Gonski reforms to school funding? Why would it view Gonski as about private versus public rather than about lifting the future participation and productivity of kids at the bottom of the distribution?

Instead, the issue of human capital is airily dismissed with the line that "there is little evidence that slower productivity growth has been the result of inadequate investment in skills, education and innovation more broadly".

Maybe. But it's probably equally true there's little evidence it hasn't been. All you're really saying is that there's little evidence - because we've never been willing to run to the expense of adequately measuring such a vital ingredient in our future wellbeing.

The other key element of productivity improvement that gets short shrift is public infrastructure spending. To what extent are its inadequacies limiting the productivity of businesses and adding to commuting times (an important part of our wellbeing that doesn't show up in gross domestic product)? But do workers who spend an hour getting to work arrive at their productive best?

No discussion of our present and future productivity performance is adequate without assessment of the role being played by our policy of high immigration. But all we get is the throwaway line that "there is some evidence that" high levels of migration increase productivity because our focus on skilled migration raises the workforce's average skill level and because "migrants can be highly motivated".

This is true and quite dishonest at the same time. It minutely examines the dog in the room while studiously ignoring the elephant. What economists know but try not to think about - and never ever mention in front of the children - is that immigration carries a huge threat to our productivity.

The unthinkable truth is that unless we invest in enough additional housing, business equipment and public infrastructure to accommodate the extra workers and their families, this lack of "capital widening" reduces our physical capital per person and so reduces our productivity.

Think of it: the very report announcing that our population is projected to grow by 16 million to 40 million over the next 40 years doesn't say a word about the huge increase in infrastructure spending this will require if our productivity isn't to fall, nor discuss how its cost should be shared between present and future taxpayers.

No, none of that. Just another repetition of that peculiarly Australian doctrine that pretty much the only way to improve productivity is to engage in unceasing micro-economic reform.