Economists help cause gutless government

I hope I'm wrong, but I fear the all-in fight over the resource super profits tax will in time be seen to have brought the era of micro-economic reform to an end. If so, the economics profession will bear its share of the blame.

You could argue (as I did on Saturday) that, though the compromise deal Julia Gillard came up with is far from perfect, it still represents a net increase in economic efficiency relative to the present arrangements. But that ignores the psychological scars this dog fight will leave on the pollies.

You have to ask yourself what conclusions the politicians - of both sides; they're very similar animals - will draw, first from Kevin Rudd's palpable loss of credibility following his decision to dump the emissions trading scheme, and second from the government's near-death experience with the resource tax.

There is a host of useful lessons you'd hope the pollies would draw: don't over-promise and under-deliver, don't announce contentious reforms just before an election, don't take on too much, don't underestimate the attention and effort needed to sell unpopular reforms to a confused electorate, and more.

But the lesson the pollies are more likely to draw is much more damaging: don't let economists sell you complex reforms that are almost impossible to explain to mere mortals because the economists will fall to arguing among themselves and leave you in the lurch.

Think about it: what is reform? It's governments making changes that economic theory says will make us all better off, but in the process arousing intense resistance from those who fear their rents are threatened.

Governments then face the problem that the great number of modest winners stay mute while the small number of big losers scream blue murder. As we've just seen, the political problem is greatly compounded by the ease with which powerful vested interests can convince the public the interests' problem is actually the public's problem.

The antidote to this propaganda involves economic reasoning that's beyond most of the public's comprehension and which the pollies find almost impossible to explain without the help of economists capable of speaking plain English.

When people don't understand policy debates and don't know what to believe, they fall back on the opinions of presumed experts, such as prominent business people. But business people are either on the make or they're adhering to an honour-among-thieves ethic that you keep mum while fellow business people are trying it on (we've just seen the Business Council doing exactly this on the resource tax).

The other, better qualified authority source is the economics profession. But reforming pollies have learnt economists always let you down. You think you're fighting their good fight, but they're more inclined to attack you or muddy the water than support you. There are different kinds of economists, of course. The econocrats generally aren't free to speak publicly on policy.

Most market and private sector economists are prevented by their employers from joining the non-macro policy debate, prevented from offending clients or potential clients and sometimes required to spruik their firm's interests.

Then you have the self-employed economic consultants, whose arguments are for hire - sometimes by governments trying to side-step the econocrats, but usually by vested interests battling the government.

Apart from a handful of media economic commentators who are free to express their opinions (those working for Fairfax, anyway) that leaves only the academic economists free to take sides and speak out.

The great majority of academics don't say boo beyond the staff room. But the few who do are far more likely to argue the toss with government policies than support them.

(The 21 academic economists who issued a statement supporting the resource super profits tax are an honourable exception.) I have sympathy for the Treasury secretary's expression of the frustration ministers of both colours feel at the unsupportive contributions of academics.

Ken Henry acknowledged the value of the academic "contest of ideas", but said there were "occasions on which economists might, at least for a period, put down their weapons and join a consensus".

The reaction of the academics wasn't just defensive, it dripped with righteous indignation. Professor Warwick McKibbin, of the Australian National University, said Henry "can't believe you should have consensus because it is better to have bad policy that everyone agrees with than eventually get good policy that will work".

Note the assumptions in that remark: the policies governments advance are always bad and always in need of correction by that fount of wisdom, W. McKibbin. It tells you more about his personality than the state of public policy. I don't remember him ever doing anything but criticise. McKibbin was among the first economists to propose a detailed solution to climate change and is an expert of international rank. But no government has accepted his solution and now he tears down every proposal different from his own.

He's so negative the opponents of action see him as an ally.

Professor Joshua Gans, of Melbourne Business School, said "you have to believe Ken Henry really doesn't understand academics at all when he publicly says stuff like this". He had supported various government policies, but was never invited to help improve those policies ("something they could clearly use"). Failing that, he would "speak my mind from the sidelines".

It's a free country, and if academics are willing only to advocate (their personal version of) policy perfection and not support policies that inevitably and unavoidably are less than first-best, no one can make them.

But let's not hear any economists whose only contribution is a counsel of perfection complain governments lack the "political will" to implement economic reform policies even economists refuse to support.

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Henry's plan is for taxes based on hard evidence

What happens when you ask perhaps the foremost tax expert in the country to conduct a "root and branch" review of the tax system? He recommends things no prominent businessman or retired judge would dream of proposing.

Few if any taxes are popular, but in all the submissions to the Henry review there was little agreement on which were the really bad ones - or on why they were so bad.

A lot of the arguments we have about particular taxes - whether they're achieving their objectives, whether they're doing more harm than good - are based mainly on the vested interests, ideology or some economic theory, freefall rather than objective evidence.

Has it ever occurred to you that the decisions governments make about what taxes to levy and the rates at which to levy them ought to be a lot more scientific? Based more on hard evidence than judgment?

Though the primary purpose of taxes is to raise revenue, most have stated policy objectives behind them. If nothing more specific, they're supposedly designed to minimise the tax system's distortion of the choices we make, to spread the burden of taxation fairly, to treat people in similar circumstances similarly, and to do all this in ways that leave people certain of their rights and responsibilities and don't generate high costs to comply.

Then we have the growing tendency to use taxes to correct the spillovers that occur when people make decisions but don't take into account their impact on others.

Sometimes the tax is intended more to change behaviour than raise revenue; sometimes the revenue raised compensates the losers from the spillover. Emissions trading schemes and carbon taxes are the latest examples of this, as is the push for congestion taxes.

But let's consider taxes on tobacco and alcohol. Ideally, tax on alcohol is set at the relevant "marginal social cost" - the level that transfers to drinkers the costs their actions impose on the community, as well as compensating the community for those costs.

How do we know the right level for the tax? We don't - not without collecting a lot more empirical evidence than we have now. More generally, we need to monitor the performance of the tax system better.

Henry says that "where possible, the performance of specific taxes and transfers should be measured objectively to identify whether they are meeting their policy objectives.

"An objective evidence base can reinforce public and government support for successful economic reforms and helps to determine when existing policy settings are no longer appropriate."

The paucity of information on specific taxes or cash transfers means data designed for other purposes are often used for analytical purposes, but this can be unsatisfactory.

Unbiased and systematically collected data on the tax system, based on widely accepted methodology and appropriate for tax policy purposes, are rare and often not publicly available.

Because such information is a public good - that is, the producers of it can't stop it being used by people who haven't paid for it - and even though society would benefit through improved tax policy based on it, the incentive for individuals or businesses to produce it is weak.

In any case, the capacity of non-government players to generate such information is limited because much of the data needed for the analysis is held by government.

All this says it's primarily governments' responsibility to generate - and make public - the needed information.

Henry adds that we would benefit from a system-wide study of taxpayers' compliance costs to monitor, on a continuous basis, the costs of complexity.

"Well-designed system-wide surveys are expensive," Henry says, "but they would provide valuable information on where simplification would yield the greatest returns".

Another area where we'd benefit from more information is on the extent of non-compliance with tax laws. The Tax Office doesn't derive estimates of non-compliance for key income and deduction items, nor publish these estimates.

Where people do examine the performance of taxes they tend to consider taxes separately. But this makes it difficult to get a sense of the system's combined performance and effects, and to determine whether it's making a coherent contribution to our national objectives.

So Henry recommends that federal and state governments systematically collect data on aspects of existing taxes and cash transfers - including compliance costs - according to consistent and transparent classifications and concepts, and make this information freely available for analysis and research.

He further recommends that every five years the feds publish a "tax and transfer analysis statement" on the overall performance and impact of the system, including estimates of efficiency costs and distributional impacts.

Academics, tax practitioners and the public should be encouraged to contribute to - and contest - the analysis in the statement. All data used and a full description of methodologies should be available to the public and subject to peer review. The government should also support one or more institutions to undertake independent policy research relevant to the tax and transfer system.

Only a man as possessed by the need for good tax design as Henry is would dare recommend such an egg-headed and expensive program just to make tax policy more "evidence-based", as the medicos like to say. But that doesn't mean he's wrong.

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On sociology

Q&A for Economic Sociology newsletter
June 18, 2008

Question 1

In a recent roundtable address to the Productivity Commission, you described how two fundamental ideas of mainstream economics - the rational actor model and the idea of individual freedom - are scientifically outmoded ideas. You reminded the audience that these ideas originated in the 18th and 19th century ¡when we knew far less about human behavior than we do today.¢

Can you elaborate on this point and what caused your initial questioning of some of these mainstream economic laws?

When you examine conventional, neoclassical economics with a critical eye you soon realise it’s very much a product of the prevailing philosophical and scientific orthodoxy during its formative period, roughly between the publication of Adam Smith’s Wealth of Nations in 1776 and the publication of Alfred Marshall’s Principles of Economics in 1890. It’s thus a product of the Enlightenment, utilitarianism, the liberal philosophy of JS Mill, Newton’s physics and belief in the perfectibility of man. Since then economics has been following its own path, surprisingly little influenced by more recent philosophical inquiry and scientific discovery, except perhaps for developments in mathematics. So economics entered its tunnel when two disciplines highly relevant to the study of influences over human behaviour, psychology and sociology, were in their infancy. Had it branched off a lot later, I’m sure it would have had a more realistic model of behaviour in the economic domain.

The rational actor model probably seemed to make a lot of sense during the 19th century, but it takes no account of what psychology, sociology and neuroscience have taught us about the evolution of the brain, the tendency for instant instinctive responses to precede more considered responses and thus the key role played by intuition and emotion. Something I believe is a lot less widely recognised is the way the elevation of individualism over communitarianism - the barely disguised libertarianism - rests on the assumption of rationality - that is, on the belief that humans rarely make decisions they subsequent regret and rarely have trouble controlling their desires. Libertarians’ insistence that the state could never know what’s in my interests better than I know my self, thus making a case for minimal intervention in markets and minimal taxation, is unarguable - provided I’m always rational and rarely make mistakes or have trouble controlling myself. Once you accept that people often come to regret their actions and have trouble controlling themselves, you open up the possibility that governments may know better than the individual what’s in the individual’s best interests. More to the point, you open up the possibility that many of the restrictions governments impose on our behaviour are made with our tacit consent. We accept, for instance, that obliging cars to drive on the left, imposing speed limits, compulsory seatbelts and random breath tests are in our own interests as well as the community’s interests. There are huge areas of compulsion - of government restrictions on the liberty of the individual - that are utterly uncontroversial.

I came eventually to questioning these mainstream economic views partly as a result of getting older and wiser, but also as a result of the wider reading I’ve done in psychology - and, to a lesser extent, sociology - in more recent years.

Question 2

You have written several columns on alternative approaches to the study of economic phenomena, which orient themselves around the social dimensions that influence individuals¢ actions. For example, in your April 2005 article ¡No Woman (or man) is an Island in the Economy¢, you reviewed the key ideas of economic sociology and concluded that ¡economists may squirm under this critique from other social scientists but, in the end, it will do them a power of good.¢ Recent research by economic sociologists¢ suggest that mainstream economics has not yet engaged with alternative paradigms in any great capacity.

How do you view the future for mainstream economics if dialogue with other disciplines continues to be ignored?

I don’t imagine the vice is exclusive to economists, but I do accept the implication that economists generally avoid engaging with other disciplines. You might expect this isolationism to lead eventually to the decline of economics as it becomes increasingly irrelevant and isolated from the real world. But I would be loath to make such a fearless forecast for several reasons. The first is that economics is the dominant paradigm in the worlds of business and government policy-making. Its isolation from interaction with other social sciences has been the case for at least a century, but we have yet to see this leading to a decline in its influence. Because economics is the dominant paradigm, its precepts have a ring of credibility to them, even to people with no education in economics. Economics is the ideology that fits most easily with the interests of business, that tends to sanctify and the pursuit of profit, and this must surely help explain its longevity and dominance. A great intellectual attraction of economics is that it’s rigorously logical - even to the point of being capable of reduction to a set of equations - given its assumptions. When you’re good at playing mathematical games - as most academic economists are - why bother wondering about how realistic the assumptions are?

On a more positive note, the psychological critique of economics has been taking up by the behavioural economists; the psychologist founder of behavioural economics was awarded a Nobel prize in economics for his trouble, and papers on behavioural economics are appearing in many top journals. The brightest among its young devotees are setting their minds to finding ways it incorporate its insights into equations, and then its influence will be felt.

Question 3

Sociologist Michael Pusey¢s well-cited 1991 book ¡Economic Rationalism in
Canberra: A Nation-building State Changes Its Mind¢ describes how key policy makers in Canberra generally came to hold a tenacious (bordering on dogmatic) commitment to the philosophy of economic rationalism.

Do you agree with Pusey¢s argument in this respect? From your perspective, how could a consideration of alternative approaches offered by economic sociology or behavioral economics better inform and enrich public policy?

I might have a different reaction if I reread Pusey today, but at the time I wasn’t convinced by his exposition of the problem and its causes. I was annoyed by the claim - which may not have been his - that he discovered and named economic rationalism. That term had been part of my vocabulary for at least a decade before Pusey came along. I don’t believe he accurately captured the motives of the bureaucrat advocates of rationalism, nor the process by which rationalism - neoliberalism as it’s called overseas - came to have such an influence over policy. The econocrats didn’t suddenly convert to rationalism, they had always believed in it, often thinking of it as ‘the Treasury line’. It is after all, simply the taking of a missionary attitude towards the precepts of the neoclassical model.

No, the real question is why, after decades of limited success in persuading their political masters to implement rationalist policies, the Hawke-Keating government start acting on their advice with such vigour. The answer is, because the old protectionist and interventionist policies were no long working, the economy was in a state of significant malfunction - with double-digit inflation and unemployment - the politicians had to try something different and they were persuaded to implement the neoliberal policies being tried in most of the other English-speaking countries following the breakdown of the Bretton Woods fixed exchange-rate regime in the early 1970s.

The view that everything in the economy was going fine until a bunch of econocrats took it into their heads to persuade their political masters to make changes that stuffed everything up is a nostalgic rewriting of history. It remembers the halcyon 50s and 60s, but blanks out the descent into dysfunction in mid-70s to early 80s. The post-war Golden Age was brought to an end throughout the developed world by the advent of stagflation, the product of decades of naive Keynesianism and endless intervention in markets. In Australia the malfunctioning of the old policy regime was greatly compounded by the economic mismanagement of the inexperienced Whitlam government.

The adoption of rationalist policies didn’t cause the economic dysfunction, it was a later reaction to it. It’s important to acknowledge that, given its blinkered objectives, economic rationalism works. When you remove government interventions that inhibit the pursuit of economic growth, you do get more growth. A quarter of a century later we can say it has largely succeeded in restoring low inflation and low unemployment, though this has been accompanied by huge growth in household and foreign debt and some worsening in the distribution of income and wealth (though much less than is widely believed).

I don’t believe our circumstances - plus changes in the rest of the world - left us much choice but to make most of the changes we did. My regret is that, as with most reform movements, in our zeal we swept away a lot of institutions whose contribution to our wellbeing we weren’t aware of at the time.

Question 4

What particular aspects of economic sociology do you see as useful/important?

I have to be careful here not to reveal my limited knowledge of all that economic sociology has to offer. With its rational actor model, its barely concealed libertarianism, its assumption that the individual has fixed tastes and preferences utterly uninfluenced by social relationships, its preoccupation with the material, its inability to come to grips with non-monetary values and its intense focus on the price mechanism, economics - which influences the perceptions of many politicians and business people, not just professional economists - is blind to many important aspects of economic life, not to mention being blind to non-material objectives. Economists simply don’t see many of the institutions sociologists study. They often take insufficient account of the role of formal institutions such as laws; norms of behaviour they are usually oblivious to. And yet those norms affect the vigour with which firms pursue profits and the choices consumers make.

I think it’s fairly common for economic reformers to want to sweep away government interventions their model tells them are inefficient in the pursuit of economic growth, but which unknown to them are serving to reinforce institutions the community values. An example close to my heart is the deregulation of shopping hours and the push to get rid of penalty payments for work at unsociable hours. Economists saw these simply as impediments to higher productivity - which they are. It never occurred to economists that these interventions were there to ensure most of us could socialise at the weekend, an arrangement very important to us.

Another example is economists’ emphasis on the virtue of having a highly geographically mobile workforce. There’s no denying that economic growth is enhanced when employers in expanding industries in one part of the country can easily attract workers from parts of the country where industries are contracting. What simply never occurs to economists is the implication of this mobility for family relationships - for young families needing help from parents now in another city or state, or for middle-aged couples needing to assist ageing parents. When such ramifications are drawn to economists’ attention, they’re usual reaction is to say they have no expertise in this area, which is a matter for others. But this attitude doesn’t fit with the missionary attitude of economic rationalists and their unspoken proposition that economic efficiency is the only thing governments need worry about.

Then there’s the belated discovery of social capital and the truth that ‘trust’ is a valuable economic commodity which greases the wheels of a capitalist economy. In the years following financial deregulation, the banks happily exploited the loyalty (or inertia) of their customers, quietly offering new customers better deals than they were giving existing customers. Later they recoiled in amazed horror when they discovered how much their customers hated them. I’m sure they didn’t really understand the game they’d been playing. Too often, economists, politicians and business people wake up to the value of these institutions only after they’ve been damaged or destroyed.

There is a valuable role for economic sociologists to point out beforehand to policy-makers and the community generally the existence of institutions few people can see, but which are actually highly valued. Sociologists can also contribute to the public debate by pointing to the range of powerful non-monetary motivations helping to drive economic behaviour, motivations the economic model has led economists, politicians, business people and the media to disregard.

The economists’ dominance in the provision of public policy advice needs to be contested by other social scientists, who have much of value to contribute. I’m confident the politicians would soon see the value of that advice were they exposed to it. There is, however, a price to be paid if economic sociologists want to make such a contribution. There are few formal academic rewards for doing so (though sociologists should be the first to discern the unacknowledged occupational rewards as well as the personal non-monetary rewards). Sociology deals with such intangible and unfamiliar issues that all you say has to be illustrated with relevant, concrete examples. The public’s inability to see the practical applications of sociologists’ airy-fairy theorising is a major stumbling block to be overcome. And the public is so unfamiliar with sociology’s terminology and way of thinking that all you say to a lay audience must be expressed in the simplest, clearest English possible. The public suspects that all social scientists seek to conceal the prosaic nature of their findings by using a lot of jargon. If this isn’t true, you have nothing to fear by making your message as clear as possible.

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TALK TO TREASURY MACROECONOMIC GROUP’S PLANNING DAY

Old Parliament House, Canberra
July 18, 2007

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

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

Thinking about a change of government

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

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

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

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

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

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

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

Thinking about the next recession

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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AN OUTSIDER’S CRITIQUE OF THE PERFORMANCE OF TREASURIES

Talk to Australasian Treasury Officers’ Conference, Hobart
November 3, 2006

I’m pleased to be here to talk to you and offer an outsider’s view of the performance of Treasuries - when I say Treasury, please take that to include finance departments where they’re separate from treasury and to refer to the ‘purse-string departments’ at both federal and state level. It’s not my practice in speaking to any group to tell them how wonderful I think that are, so my critique will be fairly critical. Of course, as an outsider it’s quite possible I’m misinformed - but, if so, I’m sure you’ll set me straight. Before I launch into any criticism, however, I should make it clear that I have a great deal of sympathy for treasuries and the vital role they perform in controlling public spending. It’s not a popular job, but someone has to do it and it may be that my original training as a chartered accountant gives me sympathy with those whose lot in life is to be that someone. Any fool can make themselves popular by spending money; it takes character to be the one who often says no. Or it may be my knowledge of economics gives me an acceptance that, despite the unwillingness of so many to accept it, there is a budget constraint, which will make its presence felt one way or another, and it’s much smarter to learn to live within it.

My basic claim, however, is that treasuries could be doing that job a lot better than they are. That, too often, they’re going through the motions using old fashioned budget restrictions to limit the growth in spending, using instruments that either aren’t very effective or that do a lot of collateral damage, whereas they need to be using newer techniques that are a lot more effective, imaginative or, as I like to say, scientific. And in that respect I think we need more than just the latest accounting fad.

But before we get on to all that, first we need to be clear about why we want to control spending and about the challenge that lies ahead. I’m not a believer that everything private is good and everything public is bad, so government needs to be kept as small as possible. Rather, government needs to be efficient and effective whatever its size. Why? Because of nothing more profound than opportunity cost. Because money doesn’t grow on trees and there’s a limit to how much tax people are prepared to pay. And because, to make the high levels of tax we must pay more politically palatable, we need to do more to counter the widespread perception that a much government spending is wasteful.

I don’t think we’ll ever reach a time when most voters have a realistic acceptance that, at least in the long run, budgets must balance, thus producing a clear link between how much governments spend and how much they raise in taxation. Most people remain hopeful that governments will increase their spending - because there are so many worthwhile things the government could be doing - without that requiring them to pay higher taxes.

You’ve probably been labouring under that tension for as long as you’ve been in treasury, but I think it’s clear that tension is likely to intensify rather than abate. We’ve now been through a large number of exercises examining future fiscal pressures, starting with federal Treasury’s Intergenerational Report in 2002, then the Productivity Commission’s report and then studies by most if not all state treasuries, including the NZ dept of finance.

All those studies tell us much the same thing: if you look out over the next 40 years or so, yes, you do see considerable pressure for increased government spending. But only some of this pressure will be coming from the ageing of the population. If it were just population-related it would be quite manageable. According to all the studies, most of the pressure will be coming from spending on health - from the ever-more-expensive advances in medical technology and the public’s demand that it be given access to the benefits of that advance as fully and quickly as possible. It’s paying for health that will present the greatest single challenge to the treasury officers of the next 40 years.

Now, before I go on, I want to make it clear that I do see a bit of treasury propagandising at work here. When before have we had this amazing rash of studies of future fiscal pressures in every jurisdiction? I don’t think it’s been purely because of concerns about ageing. I think it’s also because of treasury concerns about living in an age of strongly growing revenue, budget surpluses and a record length expansion phase in the economy (with resources boom). With spending demands so easily accommodated, with no deficit problem to hold over politicians, where does the discipline come from? It doesn’t. So you have to manufacture it, fashion yourself a stick to wave around people’s heads. I suppose that’s fair enough.

In the process, however, we’ve managed to highlight an important point: many if not most forms of government spending are what I call ‘superior goods’, otherwise known as merit goods and bearing similar characteristics to luxury goods. That is, as our income increases, our spending on them increases at an ever faster rate. The classic example of a superior good is health care spending - and that makes all the sense in the world. As we get richer, why wouldn’t we want to devote a significant proportion of the increase to staving off death and staying hale and hearty for as long as possible? So be clear that the unrelenting pressure for increased health spending is fundamentally a good thing, not a bad thing. It’s a trend to be accommodated, not resisted. And, since we choose for good reasons (mainly to do with equity) to deliver health care mainly through the public sector, there’s no reason we should be unduly concerned about the likely increase in taxation needed to accommodate the community’s desire to live longer.

The wider point, however, is that health care is just one of the superior goods delivered by governments. Education is another obvious example - which is why it will be difficult to realise in practice the savings theoretically made possible by the lower birth rate. Take health and education and you’ve covered at least half of a state government’s recurrent spending. But the superior goods don’t stop there. Think about it and you realise that even something as mundane as law and order is a superior good: the richer I get, the more susceptible I become to worries about my personal safety and to fears that my wealth will be stolen from me.

The point is that, if so much of what governments do is deliver superior goods, then as incomes rise the pressure for increased government spending will be irresistible, and so will be the pressure for higher taxation. All governments have been reluctant to admit the obvious: that the primary solution to the future fiscal pressures their studies have identified will be higher taxation. (Treasuries haven’t wanted to admit it either because it counteracts their use of these studies as a weapon for enforcing discipline on the spending side.) It’s clear, however, that as our real incomes rise over the coming decades and our desire for spending on publicly-provided superior goods grows accordingly, the result will be a steady increase in the share of our incomes devoted to tax.

In principle, there’s no reason for that to be regarded as a bad thing. You’re the people who’ll be responsible for helping the politicians bring about that rise in taxation - or, perhaps, for persuading them that, since they’ve happily acceded to electoral pressure to bring the higher spending about, they must raise taxes to finance it responsibly.

I must concede, however, that while an increase in spending on superior goods is inevitable as incomes rise over time, there are extra risks of inefficient and wasteful spending where those superior goods are delivered through the public sector. Sometimes superior goods are delivered through the public sector because of their public-goods characteristics, but mainly I suspect it’s because of equity considerations. So a major responsibility for treasury officers over the next 40 years will be not simply trying to keep the lid on government spending, but continually searching for better trade-offs between equity and efficiency. If you try simply to impose increased efficiency at the expense of equity you’ll have limited success in getting your proposals adopted and persisted with (because equity considerations are so powerful politically). So, much better to be working on the much more intellectually demanding task of finding a better trade-off between the two.

Before I leave that outline of the likely outlook for both sides of the budget in coming decades, let me make one further point. I think it vitally important for treasury people to become more conscious of Fred Hirsch’s concept of ‘positional goods’. Positional goods or services are those which, along with doing whatever it is they’re supposed to do, are purchased also with the hope that they’ll demonstrate to the world our superior position in the social pecking order. In other words, it’s about conspicuous consumption and keeping up with the Jones. When you think about it you realise that, the more our incomes rise and the cost of necessities accounts for an ever-declining proportion of that income, the higher the proportion we’re likely to devote to the pursuit of social status via the purchase of positional goods - remembering that, when you choose to buy a BMW over a Toyota, the price of the Toyota is the cost of the transport vehicle you bought and the extra you shelled out to get the BMW is the cost of the positional good. Our private spending abounds in the payment of premiums intended to demonstrate our status. You can see it in the clothes we buy for ourselves and our children, the cars we buy, the homes and suburbs we choose to live in, the private schools we send our kids to, the private hospitals we insure for, the restaurants we eat at, the holidays we take and much, much more.

Why am I telling you this? Partly because I believe much of the pressure on governments to keep taxes down comes from the public’s desire to be left with as much disposable income as possible, to be spent on the pursuit of social status. But the pursuit of status, like an arms race, is a zero sum game. I can advance my place in the pecking order only at the expense of those I pass. So I wouldn’t have thought it an important public policy objective to leave people with as much positional spending money as possible. And yet, if you examine the descent into middle-class welfare by the Howard Government, for instance, I believe you can find examples of Howard providing public subsidies for positional goods: the 30 pc private health insurance rebate is one example, the increased grants to undeserving private schools is another.

To me, this is all the wrong way round. If you’ve got a situation where people are dead keen to spend money on private health and private schools - on things that are superior goods and publicly provided - you shouldn’t be subsidising them you should be exploiting them. In other words, the more we can make people pay privately for their pursuit of status-linked superior goods, the better off we are. Treasury officers forever searching for relatively politically painless ways of increasing taxation should never forget the device I call the ‘voluntary tax’. Private health insurance was a voluntary tax (you didn’t have to take it but, if you did, your public subsidy diminished), sending kids to private schools was a voluntary tax, gambling taxes are voluntary in a sense (though with risks of social costs if their pursuit is overdone) and tobacco tax is, too, in a sense. You should be looking for ways to increase voluntary taxation - which includes ‘taxing’ people pursuing social status - and perhaps it would help if this way of looking at things were explained to politicians tempted to go the other way.

OK, now let’s turn to my critique on the spending side. The conventional means used to try to limit spending - by imposing cuts or caps on agencies - has various disadvantages. It tends to favour existing programs over new programs, even though some older programs could be abandoned or turned over to private provision. It tends to favour cures over prevention - fixing problems after they’ve happened rather than stopping them happening. It often fails to motivate agencies to co-operate in identifying the fat and making sure it gets chopped rather than the bone. Indeed, it can leave governments vulnerable to passive resistance, where cuts are directed to those areas the government is likely to find most politically embarrassing, in the hope of forcing it to relent. I guess many of the new accounting approaches are aimed at overcoming these limitations, but I think we can do better.

One of the great temptations facing treasuries is to get so locked into the annual budget round that they end up focusing on cost containment in the short term rather than cost effectiveness in the longer term. When treasuries’ behaviour becomes too hand-to-mouth - too focused on getting this year’s budget balance looking OK - they can resist spending on the evaluation of programs that could be most informative in subsequent budget rounds, they can resist spending on health prevention and promotion simply because the costs are up front and the savings down the track. In other words, there’s a great temptation to be a short-term maximiser, with the result that you commit the greatest treasury sin: false economy. Public servants tell me of the crazy things agencies do in the name of efficiency - so much so that, to them, efficiency is synonymous with inefficiency. If something done in the name of efficiency is counterproductive or short-sighted, it’s not efficient by definition. I think the public sector abounds with false economy. Sometimes this won’t be the direct result of treasury decisions, it will be a damaging response by the agency to perverse incentives created by treasury.

When we lift our sights beyond this year’s magic budget-balance figure, we’re able to pay greater attention to the quality of government spending. Quality goes to the effectiveness of spending programs, but also to the thing the top-flight treasury officer should be perpetually in search of: the program which, though it’s classed as an expense, is actually an investment - an investment in future cost containment.

It’s important to remember that the spending agencies often have very little vested interest in measures that offer high value for taxpayers’ money. What departments are genuinely keen to have their programs rigorously evaluated? How many doctors would support spending on health promotion and prevention when that money could be spent on their own curative specialty? How many agencies want to do rigorous cost-benefit analysis of their capital works projects? In other words, if treasury isn’t pushing for these improvements, who will be? Now, you may say that if treasury were mad enough, it could support the spending of millions on dubious health promotion advertising campaigns. True - but all the more reason treasury should be pressing for - and paying for - rigorous assessment of what prevention programs work and what don’t.

I don’t know a lot about all the various accounting reforms - I won’t call them fads - I think the latest is performance budgeting. They may carry the answer to some of my criticisms. I have a feeling, however, that what we need is not so much better accounting as more economics. When I say we need a more scientific approach to spending control, the examples I have in mind come from economists, not accountants.

I’m thinking of such innovations as case-mix funding of hospitals. This is where, rather than giving a hospital funding based on an adjustment to what it got last year, it gets a flexible amount based on the known cost of efficiently dealing with particular types of cases, multiplied by the particular mix of cases the hospital encounters. Health economists put an enormous amount of research into developing the cost data needed for such a funding system. I’m not sure how much of the encouragement and funding of this research came from treasuries.

Another example is the advent of income-contingent loans. Australia has been a world leader in this area, with Professor Bruce Chapman’s application of the concept to university fees being the finest example of applied economic rationalism. As is easily seen in the case of HECS, the beauty of income-contingent loans is the superior trade-off they offer between equity and efficiency. You can require students to make a higher contribution towards the private benefits they receive from a university education, without fear of making uni education too expensive for kids from poor families. If Treasury and Finance had been doing their job, the idea would have been developed by them. Now Professor Chapman and his colleagues are elaborating on the many other ways - such as drought assistance - in which savings could be made by replacing grants with income-contingent loans. But it’s not clear the purse-string departments are pursuing this opportunity with any enthusiasm.

To me, however, the cost-effectiveness potential of these ideas is dwarfed by the scope for long-term savings arising from the neuroscientists’ discovery of the crucial importance of an infant’s early years in determining both its IQ and its EQ - its intellectual ability and its emotional ability to fit in socially, apply itself to work or study and generally lead a successful life. I suspect that many of our politicians are better versed on this remarkable research than the econocrats are. But there’s no excuse for the purse-string controllers: the whole thing’s been checked out by the Nobel-winning economist James Heckman, who’s given it a rave review.

Heckman’s studies demonstrate that spending programs aimed at early childhood development (that is, long before school-age) have far higher cost-benefit scores than remediation programs for students, prisoners or the unemployed in later life. If you leave it that late, you’ll be lucky if the benefits exceed the costs. Heckman makes a killer point for economists: spending on early childhood development involves no conflict between equity and efficiency. That is, the things you might do to promote equality of opportunity are just as effective in promoting productivity and human capital formation, and vice versa. In other words, improving on early childhood development is as close as we come to a free lunch.

The implication of this body of research for spending on social programs is profound. It says that, in neglecting babies and spending money trying to help or punish young people and adults once their educational or behavioural problems come to the attention of the authorities, we’re getting it exactly the wrong way round. Whether you care about economic efficiency or about fairness, we ought to be massively re-orienting our social spending in favour of the very young. In fact, the only remaining justification for trying to help non-infants is simply the ethical point of not abandoning people who are victims of our earlier neurological ignorance.

At an intellectual level, many of our political leaders know this. The trouble with modern politicians, however, is that they’re more interested in being seen to be responding to problems than in actually solving them. So they spread their spending too widely and thinly. Explain to them about how babies’ brains develop and they ‘respond’ by initiating a few new early childhood programs, but they never spend anything like enough. Why not? Because they have other interest groups to keep happy and so they’re not prepared to divert funds from social programs where, though we now know the money is largely wasted, the profile is higher and the political pressure greater.

The people who should be throwing their weight behind the neuroscientists, social workers and early childhood educators in helping persuade the pollies to reform their spending priorities are the purse-string controllers. But are they? I doubt it. Why not? Because they’re not applying their brains and they’re not trying hard enough.

I want to finish by adding something different: I believe every up-and-coming treasury officer needs to be familiar with the relatively new school of economic thought known as behavioural economics. BE draws heavily on the findings of psychologists - including the psychologist Daniel Kahneman who won the Nobel Prize in economics in 2002 for founding the school - to study the way people actually make economic decisions in contrast to the conventional assumption of rational self-interest. It finds that most people don’t act on opportunity cost, don’t ignore sunk costs, dislike losses more than they like gains of equivalent size, are more loss averse than risk averse, practice mental accounting which breaks the assumption of fungibility, have big self-control problems and much more.

Why do ambitious treasury officers need to be familiar with this stuff? Various reasons. Because it helps them understand why the conventional model often mispredicts. Because it teaches them to respect and accommodate the electorate’s inescapable concerns about fairness, particularly procedural fairness - economists can abstract from fairness considerations, but the people to whom politicians answer never can. But also because the two professions with an instinctive understanding of BE are the marketers and the politicians. BE helps economists convince themselves of the truth and relevance of propositions politicians simply know to be true. So BE is a counter to the old treasury line that there are always only two policy choices: good economics (ie conventional economics) and political expediency. It turns out the pollies often have good reason to reject advice based on conventional economic assumptions that are normative (how people should behave) but not positive (how they do behave). The point is that when econocrats’ understanding of BE allows them to break out of the good-v-expedient mindset, they’re better equipped to find a better trade-off between what would be ideal in an ideal world and what politicians are likely to accept as doable.

There is much scope to elaborate on this point - to draw out the practical lessons for policy advisers from BE - but let me highlight just one: when you understand BE you realise that hypothecation should be embraced rather than opposed. Treasuries traditionally oppose hypothecation because it’s either a con on the public (it doesn’t actually lead to increased spending in the area in question) or it distorts spending choices (it does oblige more spending in the area than would otherwise occur). The trouble with this logic is that it’s too rational by half. In an era when people’s demands for increased spending are insatiable but their willingness to pay higher tax is limited, hypothecation is a useful tool. At the moment when public demand for new spending is at its height, the politician steps in and says sure I’d like to spend the money but I’d need to cover it by introducing this small levy or surcharge. The public invariably agrees. Why? Because it wants to see what normally is concealed from it: the link between what you pay and what you get. The Howard Government has made extensive use of the hypothecated surcharge. Why? Because it’s unconscious understanding of BE gives it better policy judgement than many econocrats, who’ve been blinded by the unrealistic assumptions of conventional economics.

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WHAT IS TREASURY’S ROLE?

Talk to Treasury seminar, Canberra
September 17, 2001

I suspect that, when Martin and Ken invited me to talk to you today, their intention was to put before you a speaker you’d find a bit thought-provoking and challenging – someone who’d give you a bit of an intellectual workout. (Maybe someone you could easily dispose of before lunch.) So, to that end, I’m going to take a round-about approach to my topic of what Treasury’s role should be. I’ll be sneaking up on the topic, dividing my talk into three parts. The first part will be a bit theoretical, the second a bit philosophical and the last very down to earth. When I finally get round to talking about Treasury’s role, I’ll throw a few friendly punches in Treasury’s direction.

But let’s start with a little challenge on the theoretical side. If you’ve read my stuff over recent years you may have noticed that I’m much influenced by the insights of ‘behavioural economics’. This is a relatively new school of economic thought which is led by Richard Thaler – formerly of Cornell, but now ‘promoted’ to Chicago – and draws heavily on the work of two cognitive psychologists, Daniel Kahneman of Princeton and the late Amos Tversky of Stanford. If you’re not familiar with behavioural economics, you may have had more exposure to its sister discipline, behavioural finance, which is devoted to challenging and improving upon the efficient markets hypothesis. One of the leaders of behavioural finance is Robert Shiller of Yale, author of Irrational Exuberance.

Behavioural economics challenges two basic premises of the neoclassical model, rational choice and, under conditions of uncertainty, expected utility theory. These theories are both normative and positive – they specify not only how economic agents should act, but also how they do act. Behavioural economics subjects these theories to empirical testing, mainly by means of laboratory experiments, and finds that they fail as positive theories: they are poor predictors of how people actually behave. Let me summarise some of the key findings:

1. Money is not fungible. One dollar is not the same as another. In the minds of most people, a dollar’s value varies with circumstances. For instance, people will go out of their way to achieve a saving of $5 on the purchase of a tranny worth $25, but won’t go to the same trouble to save $5 on the purchase of a TV worth $500. People fail to treat all dollars equally because they engage in a system of metal accounting, where certain sums are allocated to certain purposes and can’t be drawn on for other purposes. They engage in this seemingly irrational behaviour because it helps them keep their total spending within their budget constraint. One key finding under the heading of fungibility is that a dollar of loss gets a higher weight than a dollar of gain.

2. People aren’t risk averse so much as loss averse. It’s true that people are risk averse when it comes to gains, but their dislike of losses is so great that many are willing to accept gambles in the hope of avoiding them.

3. People are more concerned about the change in their wealth than about its ultimate level. I offer you the choice between starting the day with $150 and suffering a loss of $50, or starting and ending the day with $100. Theory predicts you’ll be indifferent between the two but, in fact, most people would much prefer to avoid the loss by starting and ending with $100.

4. People simply can’t see why they should ignore sunk costs. This is something politicians understand much more readily than their econocrat advisers. It occurs, I suspect, because of people’s misconceived desire to avoid losses.

5. People often ignore opportunity costs. They commonly have a wide gap between willingness to pay and willingness to sell. I may not be willing to pay much for a particular item, but once I own it, you’d have to offer me a lot more before I was willing to sell it to you. This is a bias towards preserving the status quo.

6. People often fail to order their preferences consistently and have difficulty making comparisons between three or more things. As part of this, people’s choices are often influenced by the way those choices are presented to them – the way they’re ‘framed’ – which is why, for instance, we know not necessarily to believe the results of opinion polls conducted by vested interests.

What all this amounts to is an exploration of the specifics of Herbert Simon’s notion of ‘bounded rationality’. The point is not that people are wilfully irrational or capricious, but that the human mind simply has limited capacity to store and process information. We are physiologically incapable of being as coldly rational in our decision-making as the neoclassical model assumes we are. We rely on simple rules of thumb (or ‘heuristics’) which generally serve us well – they’re mentally cost-effective – but nonetheless lead us into consistent errors.

The fact that the leading proponent of this stuff has now won a chair at Chicago suggests it’s starting to gain some respectability in academic circles. My motive in drawing it to your attention is partly to give you something to think about and certainly to challenge any complacency you may have about the adequacy of the neoclassical model. The great stumbling block to the wider acceptance of the insights of behavioural economics is the difficulty in incorporating it in a mathematical model. If a truth can’t be turned into an equation then a mighty lot of academic economists would prefer not to know about it. But that’s not a good enough excuse for someone engaged in policy advising to elected politicians. Their advice needs to be tempered by the knowledge that the model’s assumption of rational choice is unrealistic and unreliable. Advisers need to understand and, where possible, anticipate the misconceptions that bind the minds of ministers and their constituents. They should appreciate the great extent to which rational responses need to be explained and justified. And it’s not enough to convince the minister; you then have to provide him with the explanations he can pass on to the public. The insights of behavioural economics are also useful in helping advisers realise when they’re pushing their luck too far – when the propositions they’re advancing are just too counterintuitive for any politician to sell.

By way of illustration, I’ve argued before that these insights do a lot to explain the political difficulties of selling tax reform. Once the politicians committed the fatal design error of making the reform of indirect taxation revenue positive rather than revenue neutral, the basic proposition they had to sell was along the lines: the net effect of the GST is to raise your cost of living by $10 a week, but don’t worry, we’re going to cut your income tax by $20 a week, so you’ll be $10 a week better off. To any economist, that sounds a pretty attractive offer. But to many voters it sounded most unattractive. Why? Because they gave the $10 of loss a higher weight than the $20 of gain.

In the outworking of the tax package, many voters believe their personal cost of living has risen by far more than the 3 per cent or so that the CPI seems to be suggesting. Behavioural economics’ exploration of the various heuristics that affect people’s thinking – such as that they find it easier to call to mind unusual or outstanding events – does much to explain why the CPI people carry around in their heads gives such radically different answers to the one the Statistician so carefully calculates.

OK, now let’s move on to the second part of my remarks, the vaguely philosophical bit. In his speech to the Fin Review’s chief finance officers’ summit in June, Martin repeated an argument often advanced by Treasury and others that the significant and sustained increase in productivity growth during the 90s can be attributed to the beneficial effects of 15 years of microeconomic reform. Though it can’t be proved, I have no difficulty accepting this argument. But it prompts what I regard as a key question: if we’re so rich, why aren’t we happy? If income per capita grew faster in the 90s than at any time since the 60s – and it did – why is there so much dissent in the ranks? Why so much support for outfits like One Nation; why so much abuse of economic rationalism, such carry-on about globalisation and such vehement criticism of national competition policy? Why do we all know that, no matter who wins the election, little further reform is likely to be undertaken?

Treasury’s standard answer – of which there were hints in Martin’s speech – comes in two parts. First, the opposition is coming from vested interests defending their privileges. Second, to the extent that this doesn’t explain the discontents of ordinary mortals not being whipped up by lobby groups, the punters are simply too dumb to understand what’s good for them. It’s usually put a bit more politely than that: the policies haven’t been ‘sold’ properly. I have to say the line that the public is woefully illiterate in economic matters – that it just can’t trace through causes and effects – doesn’t come well from economists whose advice is based on a model that assumes agents’ decision-making is relentlessly rational at all times. But, apart from that, the standard defence isn’t sufficiently convincing. It’s too self-serving, for one thing. And the line that the punters don’t know what’s good for them, so the pollies should just press on with good policies because, in due time, the results of those policies will convince people that father knew best – well, time’s run out on that argument. The benefits are in, they’re in line with the economists’ predictions, but the public’s still not happy with the outcomes.

The standard response from Treasury’s critics within the profession – from people such as Bob Gregory, let’s say – is that the reason higher income per capita hasn’t satisfied the electorate is distributional. Sure micro reform has increased national income as promised, but – not surprisingly – too much of that extra income has gone to the top 10 or 20 per cent of the distribution, and too little to the battlers. It’s no wonder the battlers are in revolt – and justifiably so. Now, you won’t be surprised to hear that I have a lot of sympathy with this standard criticism – and I’ll have more to say on it later.

But I want to give you my own, non-standard response – the philosophical bit. Bob Hawke once said something to the effect that the role of economists was to increase happiness. It struck the public – and even some economists – as a weird thing to say, but I think it’s right. I don’t see much distinction between ‘utility’, ‘satisfaction’, ‘welfare’ and ‘happiness’ (or, as the psychologists usually put it, ‘subjective well-being’). So, to me, increasing happiness is the stated objective of economics, and the question is: how well does it do in achieving that objective? As you may know, there’s a growing body of empirical literature about the relationship between income and happiness, and I believe it sheds a fair bit of light on that key question raised by the success of micro reform: if we’re so rich, why aren’t we happy?

A host of studies have shown that, though rising per-capita incomes have been associated with rising measures of subjective well-being in developing countries, in developed countries the steady rise in incomes over the past 30 or 40 years has not been associated with a measured improvement in subjective well-being. So we’ve been producing and consuming more goods and services but, contrary to the most basic assumption of economics, it doesn’t seem to have led to any increase in aggregate utility.

Why not? The literature offers various explanations. One is what Kahneman calls the ‘hedonic treadmill’. As our income rises, our expectations quickly adjust, leaving us feeling no better off. This is consistent with the findings of Richard Easterlin of USC in a recent study: ‘income growth does not . . . cause well-being to rise, either for higher or lower income persons, because it generates equivalent growth in material aspirations, and the negative effect of the latter on subjective well-being undercuts the positive effect of the former.’ People continually expect a rise in their income to make them happier, but it never does. They fail to anticipate the rise in their aspirations that comes with their higher income.

A second explanation of why higher national income fails to increase aggregate utility comes from the empirical observation that – contrary to the assumptions of the model – what people strive for is not an absolute increase in their income but a relative increase. What they’re seeking is socio-economic status – a higher place in the pecking order. So they’re keeping up with the Joneses – or rather, trying to get ahead of them. In consequence – and as Robert Frank of Cornell argues in his book Luxury Fever – the more affluent societies become, the more consumer spending is devoted to Fred Hirsch’s ‘positional goods’. If so, it’s obvious why we’re no happier: we’re engaged in a zero-sum game. Any increase in my relative income generates a negative externality for others.

If there’s anything in these arguments, they suggest that micro reform is pursuing an intermediate target – higher national income – which doesn’t lead to the ultimate objective: greater welfare. They also suggest that materialism is the great delusion – the great carrot on a stick – of our age. I suspect that when the punters carry on with arguments about how ‘people are more important than The Economy’, what they’re expressing, in their own inarticulate way, is their disillusionment with materialism.

In recent times I’ve become more conscious of the narrowness of economics. That it deals with just one, important but narrow dimension of our lives: the material. The limitations of the neoclassical model narrow it further. Like all professions, economists are highly specialised in their interests and they run the occupational risk of developing tunnel vision in the advice they give their clients. I’ve decided I don’t want to devote what remains of my career to trying to ram materialism down people’s throats. And I’ve become more conscious of my obligation as a journalistic commentator to warn my readers not to be unduly influenced by one-dimensional advice from economists – by what, to coin a phrase, is ‘partial-equilibrium analysis’. Voters have to stand up to economists in the same way an HSC student has to stand up to a French teacher who lays on the homework as though French was the only subject the student was studying. So the first thing I’d say about Treasury’s role is that, in proffering its advice, Treasury must guard against the unconscious assumption that the material objective should be maximised at the expense of all other objectives. I suspect Treasury also needs to be more conscious of the analytical limitations of its discipline.

So at last we reach the final part of my talk where I actually address the topic and say something about Treasury’s role. I’m not going to bother telling you what a great job I think you’re doing – there’d be little point in that. No, I’m going to offer some criticism. But please note this: I’m a person who earns his living by expressing his criticisms in public, but these are being offered in private. And though I’m paid to find fault, I have no reason to be anti-Treasury. In fact, I’ve always had in my makeup an instinctive sympathy for those people charged with the daunting task of holding the show together and moving it on in pursuit of the community’s betterment.

To that end, I’ve always accepted, for instance, that the Treasurer’s role is to talk up the economy – that he does so in our corporate interests, not just his own political interests. I’ve always accepted that it’s not Treasury’s role to be the first to forecast a recession, for fear of the self-fulfilling prophecy. I’ve been sympathetic to Treasury when its Budget-time forecasts have been subject to cheap shots from smart-alec business economists who enjoy the luxury of being able to change their forecasts as often as they change their underpants. (And I almost always remember to pin the forecasts on the Government rather than Treasury.)

Hitherto, I’ve always accepted the need for Treasury – and more, these days, Finance – to play the institutional role of Dr No. I think of it as the role of the cricket club treasurer. She’s facing a committee of 12, each of whom can think of fabulous ways of spending every cent in the club’s bank account – and more besides. Facing such odds, if she adopts a position of automatically opposing all spending proposals, there’s a fair chance that no more will get through than the club’s finances can stand. There’s never any shortage of people with good ideas to spend money. Every institution needs a least one person – the treasurer - who knows her role is to be a perpetual wet blanket in the interests of the institution’s longevity.

And, hitherto, I’ve always accepted the need for Treasury – and Tax, of course – to ‘protect the revenue’. If you don’t do it, who will? Well, it was my own concern to protect the revenue that helped to bring me into journalism almost 30 years ago. I was a young chartered accountant bored with auditing. I decided the only really interesting part of accounting was tax advice, but I also decided that I didn’t want to devote my life to helping the well-off avoid their responsibilities to the community. I trust you’ve seen this ‘prior’ evident in my work. I’ve often been happy to defend unpopular tax measures – I even went to the defence of the super surcharge, despite considerable reservations about its design features.

But – and now we get to the but – of late I’ve formed the view that Treasury needs to perform its roles of opposing new spending and defending the revenue with a lot more forethought, discernment and subtlety. With more guile, if you like. Let’s start with the spending side.

In Martin’s speech to the CFOs, he argued that ‘these real GDP per capita gains [from micro reform] are not just materialistic gains for the lucky few, but a real improvement in Australia’s capacity to sustain whatever economic and social improvements its people want’. I responded to that by email, and I’ll tell you my response. I said that, coming from Treasury, it was a bit rich. It was, in fact, no more than ex-post rationalisation. We both know, I said, that, first, when Treasury and other economic rationalists were urging governments to make these reforms in the first instance, they did little to urge governments to introduce (quote) ‘policies that help sections of the community adjust to change’ (unquote). In fact, Treasury hoped to be able to get away without them. Second, when other people wanted such adjustment assistance/compensation for the losers, Treasury oftentimes opposed it. The third thing we both know, I said, was that when the political shite eventually hits the fan, the pollies go behind Treasury’s back and do things that are really stupid. In which case, Treasury’s badly overplayed its hand.

Consider the case of the revolt in the bush. We’ve been through a period of at least a decade where, as a result of a range of micro reforms – from banking to railways to telephones – people have been busily dismantling a whole range of long-standing cross-subsidies in favour of RARAland. It seems to have occurred to no-one in any of the alleged co-ordinating departments that these disparate federal and state initiatives were starting to add up, and might soon provoke a counter-reaction. It occurred to no-one that there is deeply ingrained community support for the notion that the city should prop up the bush – support not just in the bush, but also in the city. When the inevitable backlash came, what did we get? We got petrified politicians running everywhere reversing policies and oiling squeaky wheels. What we didn’t have was any pre-emptive thinking by the PC or anyone else about second-best solutions. Thinking that, proceeding from the position that the public would always want some degree of subsidy for the bush, studied the costs and benefits of rival subsidies and came up with a program saying, if you insist on wasting your money, these are the least-worst subsidies to waste it on.

Martin always expected what I’d say today was that micro reform should have done more to help people adjust to change and more to redistribute the proceeds of reform from the winners to the losers. Well, I am saying it. I’m saying it’s not enough that the winners could compensate the losers; you actually have to do it. I’m also saying that if you want to know why economic rationalism and globalisation and competition policy are on the nose – and why the prospects for further reform are so dismal – you need look for no fancier answer than this. The punters have discerned that, whoever’s making a killing from micro reform, it ain’t them. And they’re right, it ain’t. The final ain’t is that they ain’t gonna take it anymore. Treasury and its fellow travellers sought to drive too hard a bargain on the opening up of our economy, and they’ve brought to whole game unstuck.

Next I want to say something about protecting the revenue. Alan Mitchell has a saying that the main task of the bureaucracy is to keep the crazy decisions to a minimum. On the tax front, I don’t think Treasury and Tax have been doing too well lately on that criterion. They seem to have been working on the theory that if you look after the pennies the pounds will look after themselves – and they seem to have come badly unstuck.

Consider the petrol excise. I assume that Treasury urged the Government to do the 1.5 cents a litre chisel on its promise to prevent petrol prices rising, and that it urged the Government to include the special GST price effect in the regular indexation of excises. These penny-pinching decisions were taken or confirmed after the price of petrol had skyrocketed and motorists’ extreme displeasure was apparent. Presumably, the logic was that, with OPEC and the Aussie dollar doing their worst, no-one would notice a little chiselling by the Government. But the Government was robbed of the ability to claim its hands were completely clean in the matter, and the motoring lobbies were incited to launch a major campaign. In the inevitable backdown, the Government not merely gave up the ill-gotten 1.5 cents a litre, it abandoned the indexation of petrol excise for good and all. That’s protecting the revenue? Well done.

Next, consider the alleged self-funded retirees. My mail says that a lot of the complaints Government backbenchers were getting about GST paperwork came not from small businesspeople complaining about the BAS, but from retirees complaining about the IAS. And why wouldn’t they? When the backdown came, you could have knocked me over with a Payment Summary – Individual Non Business when I heard Costello say that people likely to owe less than $250 a year no longer needed to complete a quarterly IAS. If having the elderly submit five returns a year to pay less than $250 isn’t administrative incompetence (ie they didn’t have to, but were allowed to think they did), it’s appalling penny-pinching. And the ultimate penalty to the revenue? The even more appalling measures to square away the self-righteous retirees in this year’s Budget – measures that are like a time-bomb ticking away as the population ages and Generation X buckles under the weight of carrying the babyboomers.

What is Treasury’s role? Well, one role is that, in its efforts to control government spending and to protect the revenue, it should avoid being too smart by half.

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