'Planetary boundaries' set the limits of economic freedom

One of the most important developments in economics is something in which economists had no hand: the identification of the environmental limits which humans, busily producing and consuming, cross at their peril.

Earth has existed for about 4 billion years and humans have lived on Earth for about 200,000 years. For almost all of that time we were hunters and gatherers, but 10,000 to 12,000 years ago we settled down, to farm and create civilisation.

It’s probably no coincidence that, for about that time, Earth has enjoyed a stable climate, with no more ice ages nor period of great heat, in which palms grew in Antarctica. This is the geological epoch called the Holocene, in which we live – although it may be ruled that we’ve moved to the Anthropocene, a new epoch in which the human species has made major alterations to the planet.

In its modern form, economics can be dated to 1776, when Adam Smith published The Wealth of Nations. Beliefs about how the economy works were well-defined by the time Alfred Marshall published Principles of Economics in 1890.

The point is that all economic activity – all the efforts of humans to earn a living – both depends on the natural environment and adversely affects it. By 1900, there were only about 1.6 billion humans on the planet, not enough to do much damage.

If we wrecked some area, we could just move to somewhere that hadn’t been wrecked, while the first bit gradually recovered.

So, at the time conventional economics was established, it was perfectly sensible to assume that the environment’s role in economic activity could be taken for granted. It was just there and it always would be. It was, as economists say, a “free good”.

When, from the 1700s, we started burning fossil fuel – coal, oil and gas – for heat, light and energy, we had no reason to worry that one day it might run out. It certainly never occurred to us that this might end up having an effect on the climate.

It took many decades before scientists began telling us that all the things we were doing to improve our lives – cutting down forests, damming rivers, drilling for water, ploughing, fertilising crops, fishing with nets – were damaging the soil, causing erosion, killing species, lowering the water table, and damaging the environment in other ways.

However, in just the past century or so, the world’s population has gone from 1.6 billion to 8 billion. Every extra human does a bit more damage to the environment. But that’s not the main thing. The main thing that’s changed is our use of advances in technology to hugely increase our standard of living and, in the process, massively increase the damage we’re doing to the environment.

Which brings us to “planetary boundaries”. In 2009, the Swedish scientist Johan Rockstrom and a scientist from the Australian National University, the late Will Steffen, with many helpers, established a framework listing the key categories of environmental damage, and estimating the amount of damage that could be done to each before the risk increased that “the Earth system” could no longer recover.

A second update of these estimates, led by an American oceanographer based in Copenhagen, Katherine Richardson, was released last month. With the ANU’s Professor Xuemei Bai, Richardson has written an article explaining the planetary boundaries.

There are nine boundaries. Three of them cover what we take from the ecological system: loss of biodiversity (extinction of species), loss of fresh water (pumping too much water from rivers and aquifers) and land use (deforestation).

Something economists didn’t know – or didn’t realise affected them – is that the laws of physics say we can never truly get rid of anything that exists on Earth.

All we – or the ecosystem – can do is change the form of the thing. Water can evaporate, but it’s still up in the clouds, for instance. We can cut down a tree, but as it slowly sinks into the dirt, it releases the carbon dioxide it had previously taken up.

This means that all our economic activity leaves in its wake a lot of waste. Not just landfill, but in many other forms.

So, the remaining six boundaries concern the waste our activity greatly adds to what would have occurred naturally. They are: greenhouse gases which cause climate change, ocean acidification (carbon absorbed by the sea), emission of chemicals that deplete the Earth’s ozone layer, “novel entities” (synthetic chemicals such as plastics, DDT and concrete), aerosols, and nutrient overload (nitrogen and phosphorus from fertilisers that wash into rivers and the sea, causing algae blooms, killing fish and coral).

Crossing any of these boundaries doesn’t trigger immediate disaster. But it does mean we’ve moved from the safe zone into dangerous territory. And the nine boundaries are interrelated and interacting, in ways we don’t yet fully understand.

In 2009, the scientists found we’d already crossed three boundaries: biodiversity, climate change and nutrient overload. By the 2015 update, a fourth boundary had been crossed: land use.

And by this year’s update, only three boundaries hadn’t been crossed: ocean acidification (but only just), aerosol pollution, and stratospheric ozone depletion – where an international agreement banning CFCs is slowly reducing the ozone hole we created.

Richardson and Bai say we’re now well into the danger zone, “where we – as well as every other species – are now at risk”. “We are eating away at our own life support systems,” they say.

One thing to be said for economists is that, unlike some, they don’t try to tell scientists how to do their job. Very few economists dispute the scientists’ evidence that climate change has been caused by human activities.

It was economists who developed the best means to reduce carbon emissions – emission trading schemes – which other countries have adopted, but Australia rejected.

When our governments decide to act on the other planetary boundaries, it will be economists who work out the best way to do it.

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What's kept us from full employment is a bad idea that won't die

Lurking behind the employment white paper that Treasurer Jim Chalmers will release today is the ugly and ominous figure of NAIRU – the non-accelerating-inflation rate of unemployment. If the Albanese government can’t free itself and its econocrats from the grip of NAIRU, all its fine words about the joys of full employment won’t count for much.

The NAIRU is an idea whose time has passed. It made sense once, but not anymore. The story of how this conventional wisdom came to dominate the thinking of the rich world’s macroeconomists has been told by Queensland University’s Professor John Quiggin.

In the period after World War II, economists decided that the managers of the economy faced a simple choice between inflation and unemployment. Low unemployment came at the cost of high inflation, and vice versa.

This relationship was plotted on something called the Phillips curve, and the economic managers could choose which combination of inflation and unemployment they wanted.

It seemed to work well enough until the mid-1970s, when the developed economies found themselves with high unemployment and high inflation at the same time – “stagflation” – something the Phillips curve said couldn’t happen.

The economists turned to economist Milton Friedman, who’d been arguing that, if inflation persisted long enough, the expectations of workers and businesses would adjust. The inflation rate would become “baked in” as workers and suppliers increased their wages and prices by enough to compensate for inflation, whatever the unemployment rate.

So, after much debate, the economists moved to doing regular calculations of the NAIRU – the lowest rate to which unemployment could fall before shortages of labour pushed up wages and so caused price inflation to take off.

Since the early 1980s, the economic managers have tried to ensure the rate of unemployment stayed above the estimated NAIRU, so inflation would stay low. Should inflation start worsening, central bankers would jump on it quickly by whacking up interest rates.

Why? So that expectations about inflation would stay "anchored". Should they rise, the spiral of rising wages leading to rising prices would push up actual inflation. Then it would be the devil’s own job to get it back down.

If this sound familiar, it should. It’s what the Reserve Bank has been warning about for months.

Trouble is, the theory no longer fits the facts. Inflation has shot up, but because of supply disruptions, plus the pandemic-related budgetary stimulus, not excessive wage growth. And there’s been no sign of a worsening in inflation expectations.

Wages have risen in response to the higher cost of living, but have failed to rise by anything like the rise in prices. Why? Because, seemingly unnoticed by the econocrats, workers’ bargaining power against employers has declined hugely since the 1970s.

Meanwhile, the stimulus took us down to the lowest rate of unemployment in almost 50 years, where it’s stayed for more than a year. It’s well below estimates of the NAIRU, meaning wages should have taken off, but shortage-driven pay rises have been modest.

All of which suggest that the NAIRU is an artifact of a bygone age. As Quiggin says, the absence of a significant increase in wage growth is inconsistent with the NAIRU, which was built around the idea that inflation was driven by growth in wages, passed on as higher prices.

“As a general model of inflation and unemployment, it is woefully deficient,” Quiggin concludes.

Economists have fallen into the habit of using their calculations of an ever-changing NAIRU as their definition of full employment. But it’s now clear that, particularly in recent years, this has led us to accept a rate of unemployment higher than was needed to keep inflation low, thus tolerating a lot of misery for a lot of people.

So if today’s employment white paper is to be our road map back to continuing full employment – if our 3.5 per cent unemployment rate is to be more than a case of ships passing in the night – we must move on from the NAIRU.

A policy brief from the Australian Council of Social Service makes the case for new measures of full employment and for giving full employment equal status with the inflation target in the Reserve Bank’s policy objectives – as recommended by the Reserve Bank review.

The council quotes with approval new Reserve governor Michele Bullock’s definition that “full employment means that people who want a job can find one without having to search for too long”.

But it says another goal could be added, that “people who seek employment but have been excluded (including those unemployed long-term) have a fair chance of securing a job with the right help”.

And it argues that “since an unemployment rate of 3.5 per cent (and an underemployment rate of 6 per cent) has not triggered strong wages growth, this could be used as a full employment benchmark”.

One of the things wrong with the NAIRU was that it was a calculated measure, and it kept changing. As Quiggin notes, it tends to move in line with the actual rate of unemployment.

“When unemployment was high, estimates of NAIRU were high. As it fell, estimates of NAIRU fell, suggesting that how far unemployment could fall was determined by how far unemployment had fallen,” he says.

Which is why, to the extent that econocrats persist with their NAIRU estimates – or the government sets a more fixed target – the council is smart to suggest a test-and-see approach.

Rather than continuing to treat a fallible estimate as though it’s an electrified fence – to be avoided at all cost – you allow actual unemployment to go below the magic number, and see if wages take off. Only when they do, do you gently apply the brakes.

The council reminds us that it’s not enough to merely aspire to full employment, or even specify a number for it. It’s clear that, apart from the ups and downs of the business cycle, what keeps unemployment higher than it should be is long-term unemployment.

Committing to full employment should involve committing to give people who have “had to search too long” special help just as soon as their difficulties become apparent.

This would be a change from paying for-profit providers of government-funded “employment services” to punish them for their moral failings.

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Productivity debate descends into damned lies and statistics mode

Last week we got a big hint that the economics profession is in the early stages of its own little civil war, as some decide their conventional wisdom about how the economy works no longer fits the facts, while others fly to the defence of orthodoxy. Warning: if so, they could be at it for a decade before it’s resolved.

Economists want outsiders to believe they’re involved in an objective, scientific search for the truth and are, in fact, very close to possessing it. In reality, they’ve long been divided by ideology – views about how the world works, and should work – which is usually aligned with partisan interests: capital versus labour.

You see this more clearly in America, where big-name “saltwater” (coastal) academic economists only ever work for Democrat administrations, while “freshwater” (inland) academics only work for the Republicans.

In the 1970s, the world’s economists argued over the causes and cures for “stagflation” – high inflation and high unemployment at the same time. Then, in the 1980s, we had a smaller, Australian debate over how worried we should be about huge current account deficits and mounting foreign debt, won convincingly by the academics, who told the econocrats to forget it – which they did.

Now, the debate is over the causes of the latest global surge in inflation. At a time when organised labour has lost its bargaining power, while growing industry “concentration” (more industries dominated by an ever-smaller number of big companies) has reduced the pressure from competition and increased the pricing power of big firms, is a lot of the recent rise in prices explained by businesses using the chance to increase their profit margins?

A related question is whether it remains true that – as business leaders, politicians and econocrats assure us almost every day – all improvement in the productivity of labour (output per hour worked) is automatically reflected in higher real wages.

And that’s the clue we got last week. The Productivity Commission issued a study, Productivity growth and wages – a forensic look, that concluded that “over the long term, for most workers, productivity growth and real wages have grown together in Australia”.

So, all the worrying that silly people (such as me) have been doing – that the workers are no longer getting their cut of what little productivity improvement we’ve seen in recent years – has been proved to be a “myth”.

For the national masthead that prides itself on being read by the nation’s chief executives, this was a page one screamer. Apparently, even though real wages are 4 per cent lower than they were 11 years ago, workers are getting “their fair share of pie”.

When workers’ real wages rise by less than the improvement in labour productivity, the study calls this “wage decoupling”. It says “it is important to get the facts right on wage decoupling. Unfortunately, debates about the extent of wage decoupling, its sources and its implications are often dogged by differences in the methods and data”.

“This is because analysts can pick and choose among a wide range of measures of real wage growth, and their choices can lead to different, sometimes misleading conclusions.”

This is very, very true. Trouble is, sauce for the goose is sauce for the gander. The clear inference is that “the commission’s preferred measure” is the single correct way of measuring it, whereas all those who get different results to us are just picking the methodology that gives them the results they were hoping for.

Get it? I speak the objective truth; you are just fudging up figures to defend your preconceived beliefs about how the world works. Yeah, sure.

I hate to disillusion you, gentle reader, but this is what always happens in economics whenever some group says, “I think we’re getting it wrong.” They produce calculations to support their case, but some don’t like the idea, so they produce different calculations intended to refute it.

Because economics is factionalised, most debates degenerate into arguments about why my methodology is better than yours. That’s why a change in the profession’s conventional wisdom can take up to a decade to resolve. But intellectual fashions do change.

The study finds that the mining and agriculture industries – which account for only 5 per cent of workers – have experienced major wage decoupling over the past 27 years, but for the remaining 95 per cent of workers, in 17 other industries, the difference between productivity growth and real wage growth has been “relatively low”.

Sorry, but that’s my first objection. It’s not relevant to compare productivity growth by industry with real wage growth by industry. Some industries have high productivity, some have low productivity and, in much of the public sector, productivity can’t be measured.

Despite the things it suits the employer groups to claim, the reward held out to workers for at least the past 50 years has never been that their real wages should rise in line with their own industry’s productivity.

For reasons that ought to be obvious to anyone who understands how markets work, it’s never been promised that, say, carpenters who work in mining or farming should have rates of pay hugely higher than those who work in the building industry, while the real wages of carpenters working in general government should never have changed over the decades because their (measured) productivity has never changed.

It’s an absurd notion that could work only if we could enforce a rule that no one could ever change jobs in search of a pay rise.

No, as someone somewhere in the Productivity Commission should know, the promise held out to the nation’s employees has always been that economy-wide average real wages should and will rise in line with the trend economy-wide average improvement in the productivity of labour.

When you exclude the two industries that contribute most to the nation’s productivity improvement, it’s hardly surprising that what’s left is so small you can claim it wasn’t much bigger than the growth in most workers’ real wages.

Then you tell the punters that, over 27 years, they are less than 1 percentage point behind – a mere $3000 – where they were assured they would be.

The report finds – but plays down – that the national average real wage fell behind the national average rate of productivity improvement by an average of 0.6 percentage points a year – for 27 years.

That’s if you measure wages from the boss’s point of view (which is economic orthodoxy) rather than the wage-earner’s point of view. But I can’t remember hearing that fine print explained in the thousands of times I’ve heard heavies telling people that productivity improvement automatically flows through to real wages.

View wages from the consumer’s perspective, however, and the national average shortfall increases to 0.8 percentage points a year. And nor did anyone ever tell the punters that it may take up to 27 years for their money to arrive.

You guys have got to be kidding.

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Don't let an economist run your business, or bosses run the economy

A lot of people think the chief executives of big companies – say, one of the four big banks - would be highly qualified to tell them how high interest rates should go and what higher rates will do to the economy over the next year or two.

Don’t believe it. What a big boss could tell you with authority is how to run a big company – their own, in particular. Except they wouldn’t be sharing their trade secrets.

No, in my experience, when bosses step away from their day job to give Treasurer Jim Chalmers free advice, their primary objective is to tell him how to run the economy in ways that better suit the interests of their business (and so help increase their annual bonus).

But when it comes to keeping our banks highly profitable, our treasurers and central bankers are doing an excellent job already.

Of course, it’s just as true the other way around: don’t ask an economist to tell you how to run a business. It’s not something they know much about.

Running big businesses and running economies may seem closely related, but it’s not. They’re very different skills.

One of the ways the rich economies have got rich over the past 200 years is by what the father of economics, Adam Smith, called “the division of labour” – dividing all the work into ever-more specialised occupations. By now, managing businesses and managing economies are a world apart.

But as Free Exchange, the economics column in my favourite magazine, The Economist, explains in its latest issue, there’s more to it than that.

Conventional economic theory sees the economy as composed of a large collection of markets. Producers use resources – labour, physical capital, and land and raw materials – to produce goods and services, which they sell to consumers in markets.

Producers supply goods and services; consumers demand goods and services. How do producers know what to supply and consumers what to demand? They’re guided by the ever-changing prices being demanded and paid in the market.

So economists see economics as being all about markets using the “price mechanism” to ensure the available resources are “allocated” to the particular combination of goods and services that yields consumers the most satisfaction of their needs and wants.

It wasn’t until 1937 that a British-American economist, Ronald Coase, pointed to the glaring omission in this happy description of how economies work: much of the allocation of resources happens not in markets but inside firms, many of them huge firms, with multiple divisions and thousands of employees.

Inside these firms, the decisions are made by employees, and what they do is determined not by price signals, but by what the hierarchy of bosses tells them to do. A key decision when something new is wanted is whether to buy it in from the market, or make it yourself.

The Economist says another gap between economic theory and the world of business is the economists’ assumption that firms are profit-maximising. Well, they would be if they could be.

Trouble is, contrary to standard theory, they simply don’t have the information to know how much they could get away with. Gathering a lot more information would be expensive and, even then, they couldn’t get all they need.

As the American Herbert Simon – not really an economist, which didn’t stop him winning a Nobel Prize – realised, businesses live in a world of “bounded rationality” – they make the best decision they can with the information available, seeking profits that are satisfactory rather than ideal. They are “satisficers” rather than maximisers.

It took decades before other economists took up Coase’s challenge to think more about how companies actually go about turning economic resources into goods and services.

The Economist says a key idea is that the firm is “a co-ordinator of team production, where each team member’s contribution cannot be separated from the others.

“Team output requires a hierarchy to delegate tasks, monitor effort and to reward people accordingly.”

But this requires a different arrangement. In market transactions, you buy what you need and that’s pretty much the end of it. But, because a business can’t think of all the things that could possibly go wrong, a firm’s contracts with its employees are unavoidably “incomplete”.

Without these legal protections, what keeps the business going is trust between employer and employee, and the risk to both sides if things fall apart.

Another problem that arises within companies is ensuring employees act in the best interests of the firm, and are team players, rather than acting in their own interests. Economists call this the principal-agent problem.

In law, and in economic theory, businesses are owned by their shareholders, with everyone employed in the business - from the chief executive down – acting merely as agents for the owners. Who, of course, aren’t present to ensure everyone acts in the owners’ interests, not their own.

Economists came up with the idea of ensuring the executives’ interests aligned with the owners’ interests by paying them with bonuses and share options.

Trouble is, these crude monetary incentives too often encouraged executives to find ways to game the system. Ramp the company’s shares just before you sell your options and let the future look after itself.

Elsewhere, linking teachers pay to exam results encourages too many of them to “teach to the test”.

More recently, economists have decided it’s better to pay a fixed salary and avoid tying rewards to any particular task – which could be achieved by neglecting other tasks.

But whatever economists learn about how to manage businesses, it’s hard to see them supplanting management experts any time soon.

As The Economist observes, when a business hires a chief economist, it’s usually for their understanding of the macroeconomy or the ways of the central bank, not for advice on corporate strategy.

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Why economists keep getting it wrong, but never stop doing sums

Why are economists’ forecasts so often wrong, and why do they so often fail to see the freight train heading our way? Short answer: because economists don’t know as much about how the economy works as they like to think they do – and as they like us to think they do.

What happens next in the economy is hard to predict because the economy is a beehive of humans running around doing different things for different reasons, and it’s hard to predict which way they’ll run.

It’s true we’re subject to herd behaviour, but it’s devilishly hard to predict when the herd will turn. Humans are also prone to fads and fashions and joining bandwagons – a truth straightlaced economists prefer to assume away.

I think it embarrasses economists that their discipline’s a social science, not a hard science. Their basic model of how the economy works became entrenched long before other social sciences – notably, psychology – had got very far.

They dealt with the human problem by assuming it away. Let’s assume everyone always acts in a rational, calculating way to advance their self-interest. Problem solved. And then you wonder why your predictions of what “economic agents” will do next are so often astray.

Actually, the economists don’t wonder why they’re so often wrong – we do. They prefer not to think about it. Anyway, there’s this month’s round of forecasts we need to get on with.

The economists’ great mission over the past 80 years has been to make economics more “rigorous” – more like physics – by expressing economic relationships in equations rather than diagrams or words.

These days, you don’t get far in economics unless you’re good at maths. And the better you are at it, the further up the tree you get. The academic profession is dominated by those best at maths.

Trouble is, although using maths can ensure that every conclusion you draw from your assumptions is rigorously logical, you’ll still get wrong answers if your assumptions are unrealistic.

In the latest issue of the International Monetary Fund’s magazine, the ripping read named Finance and Development, a former governor of the Bank of Japan reminds his peers about the embarrassing time in 2008, after the global financial crisis had turned into the great recession, when Queen Elizabeth II, visiting the London School of Economics, asked the wise ones why none of them had seen it coming.

With frankness uncharacteristic of the Japanese, the former governor observed that King Charles could go back and ask the same question: why did no one foresee that the economic managers’ response to the pandemic would lead to our worst inflation outbreak in decades?

One answer would be: because all our efforts to use computerised mathematical modelling to make our discipline more rigorous have done little to make us wiser. The paradox of econometric modelling is that, though only the very smart can do it, the economy they model is childishly primitive, like a stick-figure drawing.

The best response some of the world’s economists came up with, long after the Queen had gone back to her palace, was that academic economists had largely stopped teaching economic history.

These days, economists can’t do anything much without sets of “data” to run through their models. And before computerisation, there were precious few data sets. But those who forget history are condemned to . . .

The great temptation economists face is the one faced by every occupation: to believe your own bulldust. To be so impressed by the wonderful model you’ve built, and so familiar with the conclusions it leads you to, you forget all its limitations – all the debatable assumptions it’s built on, and all the excluded variables it isn’t.

As part of the academic economists’ campaign for an inquiry into the Reserve Bank, some genius estimated that the Reserve’s reluctance to cut its already exceptionally low official interest rate even lower in the years before the pandemic had caused employment to be 250,000 less than it could have been.

Only someone mesmerised by their model could believe something so implausible. Someone who, now they’ve got a model, can happily turn off their overtaxed brain. There’s no simple linear, immutable relationship between the level of interest rates and the strength of economic growth and the demand for labour.

At the time, it was obvious to anyone turning their head away from the screen to look out the window that, with households already loaded with debt, cutting rates a little lower wouldn’t induce them to rush out and load up with more – the exception being first-home buyers with access to the Bank of Mum and Dad, who as yet only aspired to be loaded up.

To be fair to the Reserve in this open season for criticism, it’s far more prone to admitting the fallibility of its modelling exercises than most modellers are – especially those “independent consultants” selling their services to vested interests trying to pressure the government.

In its latest statement on monetary policy, the Reserve explains how its modelling finds that supply-side factors explain about half the rise in the consumer price index over the year to September 2022.

But then it used a more sophisticated “dynamic stochastic general equilibrium model” which found that supply factors accounted for about three-quarters of the pick-up in inflation.

The Reserve’s assistant governor (economic), Dr Luci Ellis, told a parliamentary committee last month that this “triangulation” left her very confident that the demand side accounted for at least a quarter and probably up to a third of the inflation we’ve seen.

(Remembering the debate about the extent to which the present inflation surge reflects businesses sneaking up their profit margins – their “mark-ups,” in econospeak – note that this second model includes “mark-up” as part of the supply side’s three-quarters. Always pays to read the footnotes.)

One of the tricks to economics is that many of the economic concepts central to the way economists think are “unobserved” – the official statisticians can’t measure them directly. So you need to produce a model to estimate their size.

A case in point is the economists’ supposed measure of full employment, the NAIRU – non-accelerating-inflation rate of unemployment – the lowest the rate of unemployment can fall to before this causes wage and price inflation to take off.

Some of those business economists who believe the Reserve hasn’t raised interest rates nearly enough to get inflation down justify this judgment by saying our present unemployment rate of 3.7 per cent is way, way below what conventional modelling tells us the NAIRU is: about 5 per cent.

But Ellis told the parliamentary committee that the Reserve had rejected this estimate. The “staff view” was that the NAIRU had moved from “the high threes to the low fours”, and this was what its forecasts were based on.

So why dismiss the conventional model? Because, Ellis explained, it’s driven solely by demand-side factors. It’s “not designed to handle the supply shocks that we have seen over COVID”.

Oh. Really. Didn’t think of that. Mustn’t have had my brain turned on.

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Never ask an economist to tell you a story

Tell me, are you planning to read any good books over the break? Maybe go to the movies? Certainly, watch a fair bit of streaming video? I bet you are. And I bet most of what you read or watch will be fiction.

If it’s non-fiction, it’s most likely to be a biography – the story of someone’s life.

How can I be so sure? Because, though it’s taken economists far longer than anyone else to realise – and many of them still haven’t read the memo – humans are a story-telling animal.

It’s something psychologists and other social scientists have long understood – although, being academics, they prefer to use the more high-sounding “narratives”.

Humans have been telling themselves stories since we lived in caves and sat around campfires. The eminent American biologist, E.O. Wilson, said storytelling was a fundamental human instinct. Evolution has wired our brains for storytelling.

Jonathan Gottschall, author of The Storytelling Animal, says we are, as a species, addicted to stories.

“Even when the body goes to sleep, the mind stays up all night telling itself stories,” he says.

You can say we like telling and listening to stories because we enjoy them and find them entertaining. Sure. But why has our evolution programmed us to enjoy stories so much?

Because stories add to our “fitness” to survive and prosper as a species. Because stories are the way humans make meaning out of the seeming chaos of life.

Gottschall says storytelling “allows us to experience our lives as coherent, orderly and meaningful”. Another author, Peter Guber, says stories have helped us share information long before we had a written language.

We turn facts we want to remember into stories, and we remember facts embedded in stories better than facts that aren’t.

Stories engage our emotions, not just our intellect, which is what makes them so powerful. We don’t remember much of the key figures and facts summarising the seriousness of the latest famine in Africa, but we do remember the story about a little girl, all skin and bones.

So, what have stories got to do with economics, especially when economics is more about impersonal concepts than about particular people? More than many economists want to admit.

Just as stories are our way of making meaning out of the seeming chaos of life, so the economists’ “models” – whether the ones they carry in their heads or the sets of equations they program into a computer – aren’t as scientific as economists like to think.

Models are an economist’s way of making sense of the seeming chaos of the economy, which makes them just another (less entertaining) form of story. As their name implies, models aren’t the economy, they’re just models of the economy, which don’t reproduce all the complexity of the actual economy.

Modellers select just a few of the economy’s moving parts – the ones they believe do most to drive the economy – and ignore the many hundreds of parts that usually don’t play a big part in moving the economy along.

Models that don’t simplify the story of how the economy works are of no use to anyone because they don’t reduce the seeming chaos.

All of which is true of the stories we tell each other of what motivates people to behave the way they do in particular circumstances, and of what are the main things that matter in our efforts to get rich or have a successful marriage or live a satisfying life. Like models, our stories cut to the chase.

Nobel laureate Robert Shiller, a pioneering behavioural economist, was among the first to explain “how stories go viral and drive major economic events” in his book, Narrative Economics.

He shows how simple economic stories, when widely believed, can shape economic policy decisions, as politicians and their advisers face pressure to act according to the public narrative.

Whether the results are good or bad depends on whether the narrative is true. His insights are particularly relevant to explaining financial crises, housing cycles and sharemarket bubbles.

If you haven’t decided what you think about globalisation and the latest push to roll it back, a good book to read is Six Faces of Globalisation, by Anthea Roberts, of the Australian National University, and Nicolas Lamp, of Queen’s University in Ontario.

One review says it’s not just a book about globalisation, but also “the power and importance of narrative: how it is constructed and how it can contribute to a far more nuanced and complex understanding of the forces of change”.

What the authors did is take all the conflicting arguments for and against globalisation and boil them down to six contesting “narratives”. Why? To make it easier for us to understand the debate and the differing perspectives.

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Treasury thinks the unthinkable: yes, intervene in the gas market

If you think economists say crazy things, you’re not alone. Speaking about our soaring cost of living this week, Treasury Secretary Dr Steven Kennedy told a Senate committee that “the solution to high prices is high prices”. But then he said this didn’t apply to the prices of coal and gas.

How could anyone smart enough to get a PhD say such nonsense? He even said – in a speech actually read out by one of his deputies – that this piece of crazy-speak was something economists were “fond of saying”.

It’s true, they are. If they were children, we’d call it attention-seeking behaviour. But when you unpick their little riddle, you learn a lot about why economists are in love with markets and “market forces”, why they’re always banging on about supply and demand, and why (as I’ve said once or twice before) if economists wore T-shirts, what they’d say is “Prices make the world go round”.

At the heart of conventional economics – aka the “neo-classical model” – lies the “price mechanism”. Understand this, and you understand why the thinking of early economists such as Adam Smith and Alfred Marshall is still influential a century or two after their death, and why, of all the people seeking the ears of our politicians, economists get more notice taken of their advice than other professions do.

The secret sauce economists sell is their understanding of how a lot of seemingly big problems go away if you just give the price mechanism time to solve them.

A market is a place or a shop or cyberspace where people come to sell things to other people. The sellers are supplying the item; the buyers are demanding it. The seller sets the price; the buyer accepts it – or sometimes they haggle or hold an auction.

If the price of some item rises, this draws a response from the price mechanism, which is driven by market forces – the interaction of supply on one side and demand on the other.

The price rise sends a signal to buyers and a signal to sellers. The message buyers get is: this stuff’s more expensive, so make sure you’re not wasting any of it.

And see if you can find a substitute for it that’s almost as good but doesn’t cost as much. If you’ve been buying the deluxe, big-brand version, try the house brand.

On the other side, the message to sellers is: since people are paying more for this stuff, produce more of it. “I’m not in this business, but maybe now the price is higher, I should be.” If the price has risen because the firm’s costs have risen, maybe we could find a way to cut those costs, not put our price up and so pinch customers from our competitors.

See where this is going? If customers react to the higher price by buying less, while sellers react by producing more, what’s likely to happen to the price?

If demand for the item falls, and the supply of the item increases, the higher price should come back down.

Saying the solution to high prices is high prices is a tricky way of saying market forces will react to the price rise in a way that, after a while, brings it back down again.

When demand and supply get out of balance, market forces adjust the price up or down until demand and supply are back in balance. The price mechanism has fixed the problem, returning the market to “equilibrium”.

This is the origin of the old economists’ motto: laissez-faire. Leave things alone. Don’t interfere. Interfering with the mechanism will stop it working properly and probably make things worse rather than better.

There’s a huge degree of truth to this simple analysis. At this moment there are thousands of firms and millions of consumers reacting to price changes in the way I’ve just described.

Kennedy admits that “there are many conditions that underpin” this do-nothing policy, but “in most circumstances Treasury would support such an approach”.

There certainly are many simplifying assumptions behind that oversimplified theory. It assumes all buyers and sellers are so small they have no power by themselves to influence the price.

It assumes all buyers and all sellers know all they need to know about the characteristics of the product and the prices at which it’s available. It assumes competition in the market is fierce. And that’s just for openers.

However, Kennedy said, the circumstances of the price shocks caused by the Ukraine war are “different and outside the frame” of Treasury’s usual approach. Such shocks bring government intervention in the coal and gas markets “into scope”. That is, just do it.

“The current gas and thermal coal price increases are leading to unusually high prices and profits for some companies,” he said. “Prices and profits well beyond the usual bounds of investment and profit cycles.

“The same price increases are leading to a reduction in the real incomes of many people, with the most severely affected being lower-income working households.

“The energy price increases are also significantly reducing the profits of many [energy-using] businesses and raising questions about their viability.”

In summary, Kennedy said, the effects of the Ukraine war are leading to a redistribution of income and wealth, and disrupting markets. “The national-interest case for this redistribution is weak, and it is not likely to lead to a more efficient allocation of resources in the longer term,” he said.

(The efficient allocation of resources – land, labour and capital – is the main reason economists usually oppose government intervention in the price mechanism. Markets usually allocate resources most efficiently.)

The government’s policy response to the problem could take many forms, Kennedy said, but with inflation already so high, policymakers “need to be mindful of not contributing further to inflation”.

This suggests that intervening to directly reduce coal and gas prices is more likely to be the best way to go, he concluded.

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How human psychology helps explain the resurgence of inflation

The beginning of wisdom in economics is to realise that models are models – an oversimplified version of a complicated reality. A picture of reality from a particular perspective.

I keep criticising economists for their excessive reliance on their basic, “neoclassical” model – in which everything turns on price, and prices are set by the rather mechanical interaction of supply and demand.

It’s not that the model doesn’t convey valuable insights – it does – but they’re often too simplified to explain the full story.

Sometimes I think Reserve Bank governor Dr Philip Lowe is like someone whose brain has been locked up in a neoclassical prison. But in his major speech on inflation two weeks ago, he showed he’d been thinking well outside the bars, looking at various models for a comprehensive explanation of how inflation could shoot up so quickly and unexpectedly.

He observed that another “element in the workhorse models of inflation is inflation expectations.” This relatively recent, more psychological addition to mainstream economics says that what businesses and unionised workers expect to happen to inflation tends to be self-fulfilling because they act on their expectations.

We’ve heard much about the risk of worsening inflation expectations, including from Lowe. It’s been the main justification offered for jacking up interest rates so high, so fast. But Lowe admitted it’s a weak argument.

“Inflation expectations have picked up a little, but...there is a high degree of confidence that inflation will return to target. This suggests that a pick-up in inflation expectations is not a primary driver of the sharp rise in inflation,” he said.

As Professor Ross Garnaut has observed - and recent Reserve research has confirmed – “the spectre of a virulent wage-price spiral comes from our memories and not current conditions”.

But, Lowe said, there’s something here that’s not easily captured in our standard models. That’s “the general inflation psychology in the community. By this, I mean the general willingness of businesses to see price increases and the willingness of the community to accept price increases.

“Prior to the pandemic, it was very difficult for a business person to stand in the public square and say they were putting their prices up. And a common theme from our liaison [regular interviews with business people] was that because most businesses had trouble putting their prices up, wage increases had to be kept modest. That was the mindset.”

Mindset? Mindset? That’s not a word you’ll find in any economics textbook. There’s no equation or diagram for mindsets.

Today, however, “business people are able to stand in the public square and say they are putting their prices up, and they can point to a number of reasons why.

"The community doesn’t like it, but there is a begrudging acceptance. And with prices rising, it is harder to resist bigger wage increases, especially in a tight labour market,” Lowe said.

“So, the psychology shifts. Or as the Bank for International Settlements put it in its recent annual report: when inflation is high, it becomes a coordinating mechanism for pricing decisions.

"In other words, people really start to pay attention to changes in costs and prices. The result can be faster and fuller pass-through of cost shocks and more frequent price and wage adjustments.

“There is some evidence that is already occurring, which is contributing to the strength of the pick-up in inflation,” Lowe added in his speech earlier this month.

To be fair, this is just the latest version of a thesis – a “model” – Lowe has been developing for years. And I think he’s on to a phenomenon which, when added to all the mechanistic, mathematised rules of the standard model, takes us a lot further in understanding what the hell’s been happening to the economy.

It’s taking the standard model but, contrary to its assumptions, accepting that, as the social animals that humans are, economic “agents” – whether consumers, bosses, workers or union secretaries – have a tendency to herding behaviour.

You can observe that in financial markets any day of the week. We feel comfortable when we’re doing what everyone else’s is doing; we feel uncomfortable when we’re running against the herd.

Anyone knows who has worked in business for a while – as many econocrats and academic economists haven’t – business behaviour is heavily influenced by fads and fashions. One role of sharemarket analysts is to punish companies that don’t conform to the fad of the moment.

The world’s economists spent much time between the global financial crisis and the pandemic trying to explain why all the rich economies had spent more than a decade caught in “secular stagnation” – a low-growth trap.

I think Lowe’s found a big piece of that puzzle. Business went through this weird period of years, when because no one else was putting up their prices, no one wanted to put up their prices.

The inflation rate fell below the Reserve’s target range, and stayed there for years. Businesses had no reason to invest much, so productivity improvement fell away, and economic growth was weak.

But then, along came the pandemic, lockdowns, huge budgetary and monetary stimulus, borders closed to immigrants, and finally a massive supply shock from the pandemic and the Ukraine war.

Suddenly, some big price rises are announced, the dam bursts and everyone – from big business to corner milk bars – starts putting up their prices. The spell has broken, and I doubt we’ll go back to the weird world we were in.

But the other side of the no-price-rises world was an obsession with using all means possible – legal or illegal – to cut labour costs. This greatly reinforced the low-growth trap we were caught in. But it was made possible also by the various developments that have robbed workers of their bargaining power.

It’s not yet clear whether the end of the self-imposed ban on price rises will be matched by an end to the ban on decent pay rises. If it isn’t, we’ll still be lost in the woods.

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Don't expect great productivity if we give business an easy ride

An unwritten rule in the economic debate is that you can say whatever you like about the failures of governments – Labor or Liberal; federal or state – but you must never, ever criticise the performance of business. Maybe that’s one reason we’re getting so little productivity improvement these days.

One reason it’s unwise to criticise big business is that it’s got a lot of power and money. It can well defend itself but, in any case, but there’s never any shortage of experts happy to fly to its defence, in hope of a reward.

But the other reason is the pro-business bias built into the standard demand-and-supply, “neoclassical” model burnt into the brains of economists. It rests on the assumption that market economies are self-correcting – “equilibrating” - and so work best when you follow the maxim “laissez-faire” – leave things alone.

So if markets don’t seem to be going well, the likeliest explanation is that intervention by governments has stuffed them up. Business people always respond rationally to the incentives that governments create, so if what business is doing isn’t helpful, it must be the government’s fault.

In theory, economists know about the possibility of “market failure”, but many believe that, in practice, such failures are rare, or of little consequence.

All this explains why almost all discussion of our poor productivity performance assumes it must be something the government’s doing wrong, which needs “reforming”. You’ll see this mentality on display at next week’s jobs and skills summit.

Which is surprising when you remember that, for the most part, productivity improvement – producing more outputs of goods and services from the same or fewer inputs of raw materials, labour and physical capital – occurs inside the premises of businesses, big or small.

Fortunately, one person who understands this is the new assistant treasurer, Dr Andrew Leigh, a former economics professor, who this week used the Fred Gruen lecture at the Australian National University to outline recent Treasury research on the “dynamism” of Australian businesses – how good they are at improving their performance over time.

The news is not encouraging. One indicator of dynamism is job mobility. When workers switch from low-productivity to high-productivity firms, they earn a higher wage and make the economy more efficient.

The proportion of workers who started a new job in the past quarter fell from 8.7 per cent in the early 2000s to 7.3 per cent in the decade to the end of 2019.

Another indicator of dynamism is the “start-up rate” – the number of new companies being set up each year. It’s gone from 13 per cent in 2006 to 11 per cent in 2019.

Over the same period, the number of old companies closing fell from 10 per cent to 8 per cent. So our firms are living longer and getting older.

The neoclassical model assumes a high degree of competition between firms. It’s the pressure from competition that encourages firms to improve the quality of their products and offer an attractive price. It spurs firms to develop new products.

Competition encourages firms to think of new ways to produce their products, run their businesses and use their staff more effectively, Leigh says.

“In competitive industries, companies are forced to ask themselves what they need to do to win market share from their rivals. That might lead to more research and development, the importation of good ideas from overseas, or adopting clever approaches from other industries.

“Customers benefit from this, but so too does the whole economy. Competition creates the incentive for companies to boost productivity,” he says.

As Leigh notes, the opposite to competition, monopoly, is far less attractive. “Monopolists tend to charge higher prices and offer worse products and services. They might opt to cut back on research, preferring to invest in ‘moats’ to keep the competition out.

“If they have plenty of cash on hand, they might figure that, if a rival does emerge, they can simply buy them out and maintain their market dominance. Monopoly [economic] rents lead to higher profits – and higher prices.”

Taken literally, “monopoly” means just one seller, but economists use the word more broadly to refer to just a few big firms - “duopoly” or, more commonly, “oligopoly”.

One indicator of the degree of “market power” – aka pricing power – is how much of a market is controlled by a few big firms. At the start of this century, the market share of the largest four firms in an industry averaged 41 per cent. By 2018-19, it had risen to 43 per cent. So across the economy, from baby food to beer, the top four firms hold a high and growing share of the market.

And the problem’s even greater when you remember that the rival firms often have large shareholders in common. For instance, the largest shareholders of the Commonwealth Bank are Vanguard and Blackrock, which are also the largest shareholders of the three other big banks.

But the strongest sign of lack of competition is the size of a company’s “mark-up” – the price it charges for its product, relative to its marginal cost of production. In the textbook, these mark-ups are wafer thin.

Treasury estimates that the average mark-up increased by about 6 per cent over the 13 years to 2016-17. This fits with the trend in other rich economies. And the increase in mark-ups has occurred across entire industries, not just the market leaders.

It seems that rising market power has reduced the rate at which labour flows to its most productive use, which in turn has lowered the rate of growth in the productivity of labour by 0.1 percentage points a year, according to Leigh’s rough calculations.

If so, this would explain about a fifth of the slowdown in productivity improvement since 2012. Lax regulation of mergers and takeovers has allowed too many of our big businesses to get fat and lazy, even while raising their prices and profits. But don’t tell anyone I said so.

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Why the political duopoly is losing market-share

If you hadn’t noticed, economic policy and politics are closely entwined. And economic journalism is a just specialty within political journalism. But some parts of economics – agency theory and industrial organisation, for instance – are surprisingly useful in understanding how politics works.

The big surprises in this election weren’t the election of Labor, but the steep decline in the two major parties’ share of the primary vote, and the emergence of climate action as the big vote-shifting issue, even though it got little attention in the campaign, especially compared with the focus on the cost of living.

Some decades ago, the two big parties’ share of the primary vote was 90 per cent. By the last election, the non-mainstream vote had risen to a quarter. But this time it jumped to a third, leaving the big guys sharing roughly a third each.

Despite its win, Labor’s third was its lowest since the 1930s, and amazingly low for the winning party. Though the Coalition’s share was bigger than Labor’s, it fell far more this time.

Why are fewer and fewer people prepared to vote for either of the two majors? Why is the two-party system in decline? The economists’ basic neoclassical model of markets assumes intense price competition between a large number of small firms.

In real life, many markets are characterised by “oligopoly” – they’re dominated by a small number of large firms. Many decades of firms pursuing economies of scale do a lot to explain why we see so many oligopolistic markets.

In the sub-discipline of “industrial organisation”, economists seek to explain why oligopolistic markets differ from that basic model of “perfect competition”. They’ve found that the few big firms are not so much competitors as rivals. Their huge size gives each of them “market power” – more control over the prices they’re able to charge – but they watch each other like hawks, and never make a move without considering what the other big firms might do in reaction to their move.

They live in fear of losing market-share. With only two huge firms – a duopoly – the rivalry is that much more intense.

Few people realise that, though our political duopolists paint themselves as poles apart ideologically, the main thing that influences the choices they make is what the other side’s doing. Governments are constrained by oppositions; oppositions are constrained by governments.

See what this does? It makes the rival parties more alike. When I see you behaving badly but getting away with it, I decide I’ll do the same. And if you’re not sticking your neck out on climate action, I decide I’d better not risk it either.

That’s why so many people complain the parties are “all the same”. An economist called Harold Hotelling formulated a rule that two firms serving an area – ice cream sellers on a beach, for instance – will tend to gravitate to the same central location. Why? Because they want to reduce the chance of the other side getting a bigger share of the market than they do.

This, of course, reduces the choice available to customers. So, does it surprise you that, as the two sides of politics become more similar – as they crowd around the political centre – more people set up fringe parties, and more people vote for them?

For many years, the Liberals used climate change as a stick to beat Labor over the head, making Labor more cautious in what it proposed. For years that’s mean Labor’s lost many first-preference votes to the Greens. But this time the Libs lost votes to the teal independents in Sydney, Melbourne and Perth, and both sides lost votes to the Greens in Brisbane.

Yet, just as commercial firms have become bigger over the decades, so politicians and their parties have changed. Economies of scale are one reason for fewer, bigger firms, but another technique we’ve used to get richer is “specialisation and exchange”. The more we specialise, the more efficient we get at doing whatever it is we do.

By now, we have specialties within specialties. We have experts who know more and more about less and less. Politics used to be a game for amateurs. People who’d done well in their careers, switched to politics to “give something back”.

These days, politics has become more professionalised, more a lifetime career where, upon graduating, you start at the bottom as a research assistant for a union or a minister, and work your way up, becoming an MP, then a minister, then who knows?

The more professional politicians become, the more they focus on advancing in the political game, and less on the things they got into politics to fix. They used to have to guess at what the voters wanted; now the majors spend a fortune on polling and focus groups. They’re more inclined to give the voters what they now know they want, and tell them what they know they want to hear.

Voters have shown less loyalty to a particular party the more they suspect the pollies are advancing their own cause, not the public’s. The minor parties and independents are more like the amateur politicians of old: they turned to politics after a career elsewhere and they did so because they cared about a few particular issues. A growing number of voters find these issue-driven politicians more attractive.

The main political parties have changed, too. They used to be grassroots, bottom-up movements with many members. Now, they have few members and those they retain tend to be a lot more hard-line than the people who just vote for the party.

With the professionalisation of politics, the two majors have become more top-down. Just as the interests of executives don’t always align with those of their shareholders and supposed masters, so it is with political parties. Economists see this as a principal-and-agent problem.

The two majors have become more like franchise operations. All the big decisions are made at the centre by the professional managers, leaving the franchisees to just flog the product. These days, the party’s policies are made at the top, with party members getting little say.

In the old days, the branches’ main right and function was to preselect the candidates who would represent them in parliament. They tend to favour candidates who are well-known and well-liked in the district – maybe a former mayor – who’ll work hard attending school fetes and advancing the electorate’s interests.

As we’ve seen in this election, leaders and people at the centre increasingly insist on parachuting in someone with a higher profile and greater leadership potential. The party faithful increasing resent this.

The people at the top must wonder why they still need branches at all. Short answer: they still need enough volunteers to door-knock and man the booths on election day.

We saw that Labor’s attempt to foist Kristina Keneally on some electorate cost it the seat. In the Liberals’ leafy heartland, I suspect the locals’ thought that they might see a lot more of an independent member contributed significantly to the teals’ success.

It’s not at all clear the teals will be one-term wonders. And it maybe the days of either major party ruling with a comfortable parliamentary majority are gone.

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Digital revolution is leaving economists scratching their heads

There should be a law against holding election campaigns while people are trying to enjoy their Easter break. So let’s forget politics and think about the strange ways the economy is changing as the old industrial era gives way to the post-industrial, digital era.

The revolution in information and communications technology is working its way through the economy, changing the way it works. The markets for digital products now work very differently from the markets for conventional products.

So a growing part of the economy consists of markets that don’t fit the assumptions economists make in their basic model of markets, as Diane Coyle, an economics professor at Cambridge University, explains in her book, Cogs and Monsters.

And the way we measure the industrial economy – using the “national accounts” and gross domestic product – isn’t designed to capture the new range of benefits that flow from digital markets.

Starting at the beginning, the great attraction of the capitalist, market economy is its almost magical ability to increase its productivity – its ability to produce an increased quantity of goods and services from an unchanged quantity of raw materials, capital equipment and human labour.

It’s this increased productivity – not so much the increase in resources used – that explains most of the improvement in our standard of living over the past two centuries.

Where did the greater productivity come from? From advances in technology. From bigger and better machines, and more efficiently organised factories, mines, farms, offices and shops, not to mention better educated and skilled workers.

Particularly in the past 70 years, we benefited hugely from the advent of mass-produced consumer goods on production lines. Economists call this “economies of scale” – the bigger the factory and the more you could produce, the lower the cost of each item.

Although each extra unit produced added marginally to raw material and labour costs, the more you produced, the more the “fixed cost” of building and equipping the factory was averaged over a larger number of items, thus reducing the “average cost” per item.

Decades of exploiting the benefit of economies of scale explain why so many of our industries are dominated by just a few big firms.

But the new economy of digital production has put scale economies on steroids. Coyle says software – and movies, news mastheads and much, much else – is costly to write (high fixed cost) but virtually costless to reproduce and distribute (no marginal cost).

So, production of digital products involves “increasing returns to scale”, which is good news for both producers and consumers - everyone except economists because their standard model assumes returns are either constant or declining.

But another thing that makes the digital economy different is “network effects”, starting with the greatest network, the network of networks, the internet. The basic network effect is that the more users of the network there are, the greater the benefit to the individual user. More increasing returns to scale.

Then, Coyle says, there are indirect network effects. Many digital markets involve “matching” suppliers with consumers – such as Airbnb, Uber and Amazon Marketplace. For consumers, the more suppliers the network attracts, the better the chance of quickly finding what you want. But, equally, for suppliers, the more customers the network attracts, the easier it is to make a sale. Economists call these digital networks “two-sided platforms”. The owner of the platform sits in the middle, dealing with both sides.

So, yet more benefits from bigness. And that’s before you get to the benefits of building, mining and sharing large collections of data.

All these benefits being so great, it’s not hard to see why you could end up with only a couple – maybe just one – giant network dominating a market. Welcome to the world of Google, Facebook, Apple, Amazon and Microsoft.

In their forthcoming book, From Free to Fair Markets, Richard Holden, an economics professor at the University of NSW, and Rosalind Dixon, a law professor at the same place, note that a number of leading lights have proposed breaking up these huge tech companies, in the same way America’s big telephone monopoly and interlocking oil companies were broken up last century.

But, the authors object, in most of these markets the power of these giants stems from the “network externalities” we’ve just discussed.

“Unlike traditional markets, when the source of market power is also the source of consumer harm, in these markets the source of market power is also what consumers (and producers, in the case of two-sided platforms) value – being connected with other consumers and producers,” they write.

“The key driver of the value that these firms create is precisely the network externalities that they bring about. Facebook is valuable to users because lots of other users are on Facebook . . .

“Google is a superior search engine because in performing so many searches, machine learning allows its algorithm to get better and better, making it a more desirable search engine.”

So, the driving force that leads to these markets having one dominant player is also the force that creates economic value. “Breaking up the large players will stop there being just a few large players, but it will also stop there being nearly as much economic value created,” they say.

Research by Holden, Professor Luis Rayo and the Nobel laureate Robert Akerlof has found that markets with network externalities tend to have three features. First, the firm that wins the initial competition in the market ends up with most of the market.

Second, it’s difficult to become a winning firm, and success is fragile. For instance, Microsoft has had little success getting its search engine Bing to take business from Google. And Netscape was once dominant in the browser market, but suddenly got supplanted.

Third, winners can’t go to sleep. They must constantly innovate and seek to raise their quality.

This makes the tech markets quite different from conventional markets like oil or even old-style networks like railways.

Economists’ efforts to get a handle on the new economy continue.

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How to help the well-off: make their taxpayer assistance invisible

There’s a key principle of economics that’s not widely realised. Economists believe anything that looks like a duck and quacks like a duck must be a duck. Q: When is something that isn’t government spending still government spending? A: when it’s a tax break.

A government can impose taxes and spend the proceeds on achieving some objective – say, helping the retired with their living expenses – or it can achieve the same objective by charging those people less tax than they’d otherwise pay.

Whichever way the government chooses to do it, the effect on the budget balance is the same. And the effect on the people the government’s trying to help should be the same.

The only difference is that the two ways of assisting people appear on opposite sides of the budget. One adds to government spending while the other subtracts from government tax revenue. But, reason economists, this is a distinction without a difference. In principle, it doesn’t really matter.

Which is why economists have long sought to highlight the lack of difference between the two ways of assisting particular people or businesses by referring to special tax concessions as “tax expenditures”.

But though there may be no difference between the two in principle, in practice there’s an important difference. Government spending – on the age pension, for instance – is highly visible. It’s “salient” as psychologists and behavioural economists say.

By contrast, tax concessions – such as those applying to income that’s saved in a superannuation scheme, for instance – are much harder to see.

The practical consequence of this big difference in visibility is that actual government spending is examined carefully each year by the bureaucrats and by the Expenditure Review Committee of Cabinet, whereas all the spending on tax concessions tends to be ignored until someone decides to play around with a few of them.

This relative lack of attention paid to our many tax breaks prompted Treasury many years ago to begin estimating the value of the most important of them and publishing an annual Tax Expenditures Statement.

In 2019, however, the statement’s name was changed to the snappier, more enticing and informative Tax Benchmarks and Variations Statement. What a page-turner.

When the latest statement, for 2021, was published a few weeks ago, Dr John Hawkins, of the University of Canberra – in an earlier life, a senior Treasury official – used an article on the universities’ The Conversation website to explain that the name change reflects the truth that the amount of tax the government forgoes by granting a certain tax concession isn’t necessarily the same as the amount of tax it would regain if it abolished the concession.

Why not? Because when you make certain actions “tax-preferred”, people become more likely to take those actions, whereas when those actions cease to be tax-preferred people become less likely to take them.

But there’s another, less-defensible reason for switching to a title that will make tax expenditures even less visible than they already are. In the main, when governments want to help people in the bottom half of the distribution of incomes, they pay them money or buy things for them. But when governments want to help people in the top half of the distribution, they give them tax breaks.

(Hawkins points to one exception to that rule: the exemption of fresh food from the goods and services tax favours the poor over the rich because fresh food accounts for a higher proportion of the spending of the poor.)

If you’re well-off, and so have to pay proportionately more tax to support government spending to help those not doing as well as you are, it suits you for government spending to be highly visible and regularly scrutinised by politicians looking for ways to save money.

Conversely, it suits you for the support you get from the government to come in the form of tax concessions and thus be hidden from the public’s and the politicians’ view.

Hawkins notes that the biggest annual tax expenditures are: $64 billion because private homes are exempt from tax on any capital gain when they’re sold; $23 billion because the earnings on money in superannuation funds are taxed at a concessional rate; $21 billion because contributions to super funds are taxed at a concessional rate; and $12 billion because capital gains are taxed at only half the rate that income from “personal exertion” (work) is taxed.

Last financial year, the top 10 tax expenditures totalled just under $120 billion, which compares with total actual tax collections by the federal government of $460 billion. This year, 2021-22, the cost’s expected to be $150 billion. That increase of almost a quarter is explained mainly by the boom in house prices and share prices.

While tax expenditures primarily benefit the individual taxpayers who receive them, there’s a flow-on benefit to the industries conducting the economic activity that’s getting favourable tax treatment.

One stand-out is the property industry – developers, builders and real estate agents – which sees itself as benefiting from negative gearing and the 50 per cent discount on capital gains tax.

Another stand-out is the superannuation industry. It’s selling a product that’s heavily subsidised by the government – apart from the small fact that the government compels employers to buy its product on behalf of their employees.

The super industry has led claims that Treasury’s estimates of the value of tax expenditures are overstated. But Hawkins notes that its estimates of the revenue gained by canning a tax break don’t differ greatly from its estimates of revenue forgone.

A final “benefit” from the near invisibility of tax expenditures is that it allows recipients to delude themselves – and others – that they’re not dependent on government handouts.

John Roskam, boss of the Institute of Public Affairs, has written to correct my memory of an exchange between us more than a decade ago, as recounted in earlier editions of this column. I had written that the institute was “taxpayer-subsidised”. He wrote denying my claim. I replied that, since its donations were tax-deductible, this amounted to a subsidy from the taxpayer. He objected that I didn’t describe other government-supported organisations in this way.

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It's the holidays, so let's have some fun with economic puzzles

So it’s holiday season, when (almost) everyone takes a break, chills out and tries not to think about workaday worries. So let’s have some fun. Let’s do a few economic puzzles.

There’s an old joke in economics that says, “it may work in practice, but does it work in theory?” If you take that to mean economists care more about getting their theory right than about its usefulness then, yes, too many of them do.

But an empirical revolution is happening in economics, where economists test their standard theory to see how well it explains the real world. A big part of this is the rise of “behavioural economics” which, rather than simply making the conventional assumption that everyone acts “rationally” – with carefully considered self-interest – in the economic decisions they make, studies the many reasons people often make decisions that aren’t rational.

So, first puzzle. When, in 2012, prime minister Julia Gillard introduced what she called a “price on carbon” and opposition leader Tony Abbott correctly labelled a “carbon tax”, which increased the price of electricity, she took care to cut income tax and increase pensions in a way designed to leave households on average incomes no worse off.

Among Abbott’s many criticisms, he claimed the move would fail to reduce electricity consumption because people would simply use their tax cut to allow them to keep buying the same amount of power. Puzzle: conventional economics says Abbott was wrong, but behavioural economics suggests he may have had a point.

In compensating most people for the cost of her carbon tax, Gillard was doing just as economists advised. They were confident people would still reduce their electricity use because theory says a change in the price of some item has two, conflicting effects: the income effect and the substitution effect.

The income effect reduces the consumer’s real (after-inflation) income, whereas the higher price relative to the prices of similar items encourages the consumer to substitute other items for the now-dearer item, at least to some extent.

So even though Gillard’s compensating tax cut eliminated the income effect, economists were confident the remaining substitution effect would still encourage people to use less electricity and use what was left of their tax cut on something else they wanted more of.

But behavioural economics says maybe it’s not that simple. One of its early and major findings is that many people are “loss averse” – they hate losing money from the increase in the price of electricity more than they like getting the money back as a tax cut.

So, contrary to theory, many people wouldn’t have felt the tax cut left them no worse off. If so, they may well have chosen to use all their tax cut to keep buying the same amount of electricity.

For the record – and for whatever reason or reasons (remember, this wasn’t an experiment where all else was held equal) – electricity sales and emissions of carbon dioxide fell sharply during the two years before the Abbott government abolished the “carbon pricing mechanism”.

Then they rose again. History will not be kind to that man.

Second puzzle. An ABC series called How to Live Younger presented scientific evidence showing that regular exercise throughout life can rewind the clock on cognitive (mental) decline, fight cancer, prevent disease, beat depression and even enhance our lives by making us smarter and more creative.

So people who’ve exercised throughout their lives generally do much better in old age. It’s also true that people who aren’t used to exercising find it harder to start working out and so don’t get as much “utility” - enjoyment and benefit – from exercising.

The economists’ convention model of “rational decision-making” predicts that knowledge of all this will lead parents to encourage their children to exercise and lead kids to keep it up as young adults and in middle age, thus setting themselves up for a healthy, happy old age.

Doesn’t always happen that way, you say? True. By why not?

Because, as behavioural economists recognise, many people, even those who fully understand how keeping fit will benefit them in old age, still have trouble making themselves exercise regularly. If they get out of the habit, it’s hard to get back into it.

A finding of behavioural economics is that this is partly explained by the “projection bias” that affects the thinking of many people. They mistakenly believe that the benefit they enjoy from exercise at this stage of their life will be the same in later stages. Actually, they’ll benefit more in later stages if they keep exercising now; if they give up exercise now they’ll find it harder to take it up again later.

So, whereas conventional economics can’t see there’s a problem – also with adverse consequences for the health system and the taxpayer – behavioural economics can see it. It can see the case for a government education campaign to help people overcome their projection bias, for instance.

And there are techniques individuals use to overcome their projection bias, short-sightedness and lack of willpower. Psychologists call such techniques "commitment devices". I did little exercise until, in my late 40s, a diabetes doctor ordered me to start.

I’ve been able to keep going to the gym two or three times a week since then, and I enjoy it. The tricks I’ve used to keep it up are to have a highly qualified trainer and go at set times with a bunch of gym buddies who’ve become good friends.

A couple of times last year I criticised academic economists for not doing enough to make their theories more realistic – and more useful to the students they teach.

The two “puzzles” we’ve just looked at are derived from a university exam paper in behavioural economics, sent to me in response to my criticisms by Professor Simon Grant, of the Australian National University.

It seems that, at least at our better universities, economists don’t just bang on with conventional theory oblivious to its limitations.

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Nobel winners make economics more useful, not a parlour game

It turns out that, in economics, maths – like technology and much else – can be used for good or ill. The three academic economists (and one ghost) who won this year’s Nobel Prize in “economic science” used mathematics to make economics more realistic and thus more useful to society.

The reason economics has become dominant among the social sciences – has had so much influence over the thinking and actions of governments - is the belief that understanding how and why people behave the way they do in the economic dimension of their lives – their producing and consuming – will help our leaders solve problems with the economy and make us happier and more prosperous.

But sometimes I suspect that the bulk of academic economists – whose beaverings won’t go anywhere near winning any prize – have lost sight of the goal of improving economists’ understanding of how the economy works and being more useful to the community and its leaders in improving our lives.

I worry that academic economists have become more inward-looking and more concerned with impressing each other than in serving the mugs who ultimately pay their wages. (I make the same criticism of journalists, by the way.)

In the years since World War II, the greatest project in academic economics has been to make it more scientifically “rigorous” by making it more mathematical. To express economic reasoning not in words or diagrams, but in equations.

These days, you shouldn’t do economics at university if you’re no good at maths (which may help explain why student numbers are down). No one gets to be an academic economist unless they’re good at maths. No one gets to be an economics professor unless they’re really good at maths.

Impressing the other academics with your great maths is the way you get on in academic economics. Maths is just so logical, so beautiful, so “elegant”. But sometimes I think these people love maths for its own sake and are turning economics into a branch of applied mathematics.

In an infamous study economists prefer to forget, economists attending the American Economics Association’s annual meeting were asked to answer a question about opportunity cost. Eighty per cent of them got it wrong. Opp cost is the foundation on which most economics rests. Makes you think all these PhDs know more maths than basic economics.

It’s true that expressing an argument in mathematical equations exposes any flaws in your logic – given the assumptions the argument is built on. That’s why the results of modelling – including the epidemiological variety – should be viewed with caution until you know and accept as plausible the key assumptions on which the modelling’s based.

The other day I wrote that economics’ greatest weakness is its primitive model of human behaviour, based on the mere assumption that people always behave “rationally” – which I defined as acting with carefully considered self-interest.

A couple of economics professors took me to task on Twitter. Oh no, not that old canard. “Rational” is just one of the many words in economics that are used to mean something other than their meaning in common speech.

No, what we mean by “rational” is not that people always think logically, but that we look at people’s “revealed preference” – what they actually do, not just what they say. This, I was assured, had long been part of mainstream economics.

Sorry, not convinced. It’s a circular definition: what people actually do (as measured by the statistical data available) is rational behaviour. Why? Because people are always rational. It’s getting around an implausible assumption by making it even more implausible. By defining non-rational behaviour out of existence.

Why would you do that? To make the assumptions of the neo-classical model mathematically “tractable”. That contrived meaning of “rational” may be longstanding mainstream econometrics, but it ain’t mainstream economics. That’s unconsciously assuming economics is now just maths.

When people were going crazy buying toilet paper last year, Australia’s brightest young economist export, Professor Justin Wolfers, argued it was “rational fear” to join the queue because, if you didn’t, toilet paper might all be gone when yours ran out. That was using “rational” to mean what everyone thinks it means.

You can say the same about former Federal Reserve chairman Alan Greenspan’s famous admission in 2008, after the global financial crisis, that he was mistaken to assume the banks’ “self-interest” would protect them from doing risky things that ended up damaging their shareholders.

The commentator Ian McAuley has observed that both engineers and economists use equations and mathematical models, but engineers check their maths against reality and modify their equations accordingly. Economists? Not so much.

To be fair, predicting the behaviour of bridges and suchlike is a lot easier than predicting the behaviour of human beans. This has led many academic economists not to worry about the plausibility of the assumptions on which their model rest.

Just make whatever nips and tucks are need to mathematise the mainstream model and think of all the fun games you’ll be able to play running different “data sets” through it. Other academic economists will be impressed.

Fortunately, not all academic economists are content with their work having such a tenuous link to real-world problems. Nor are the people who decide who gets the Nobel Prize in economics. The various founders of behavioural economics – which my critics contend isn’t real economics - have received awards, including a psychologist.

And the three academic economists sharing last week’s awards were about trying to make economics more realistic and therefore useful to economic policymakers.

Professor David Card, of the University of California, Berkeley, sought to test the straight-from-theory belief - then almost universally accepted by mainstream economists – that raising the minimum wage would increase unemployment, by searching for empirical evidence to support or refute neo-classical theory.

Until relatively recently, economists believed there was no way they could use experiments to test their theories. But a previous Nobel laureate showed some laboratory experiments were possible. And Card showed how theory could be tested by finding a “natural experiment” – a circumstance where the real world had created a test group and a control group, such as two nearby cities in different states, where one state had raised the minimum wage and one hadn’t.

Professors Joshua Angrist and Guido Imbens have done natural experiments too, and have also developed statistical methodologies for going beyond finding correlations between two variables to being able to demonstrate which caused which – showing other social scientists how it could be done.

The point is that the three honoured economists (plus the ghost of Professor Alan Krueger, who was a co-author with two of the three, but died in 2019) did reams of maths – or, more specifically, statistics – but put it to much more productive purposes. There’s hope for economics yet.

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The economy can self-correct, but only up to a point

As you’ve no doubt noticed, the crippling lockdowns in Sydney and Melbourne turn out to have one important side-benefit: NSW and Victoria have the highest rates of vaccination, which offers those states a path out of lockdown.

By contrast, the other states – which sensibly closed their borders to people coming from the two highly infected states – have the advantage of not needing to lock down, but the disadvantage of low rates of vaccination.

The two states that built the highest walls against the coronavirus - Queensland and Western Australia – have the lowest vaccination rates. (Which suggests they may not be feeling quite so superior once the lockdowns end and the virus’s chances of penetrating their borders are greatly increased.)

You don’t need me to tell you the two sides of the coin are connected. The incentive to get vaccinated has been greatest in the most infected states and least in the least infected states.

What you may need me to tell you is that this offsetting outcome is just what an economist is trained to expect. One of the most important and useful insights of economics is that market economies possess an inbuilt self-correction mechanism, a negative feedback loop.

Positive feedback causes a variable that’s going up to keep going up and a variable that’s going down to keep going down, whereas negative feedback causes a variable that’s going up to start going down, and a variable that’s going down to start going up.

Don’t take this the wrong way, but economists love negative feedback. Why? Because it returns a market and, by extension, the whole economy, to “equilibrium”.

Equilibrium means a state where everything’s in balance and thus at rest. There is – until the next “shock” to the system comes a long - no pressure for things to change.

What is it that always pushes markets back to equilibrium? “Market forces”.

This refers to the interaction between the demand from consumers for some product on one side and the willingness to supply that product on the other. What brings demand and supply into balance is the “price mechanism” – the price keeps changing until demand and supply are equal and the price is stable.

Say there’s some shock that causes the quantity demanded to exceed the supply available. This will cause the market price to rise, and the rise will send a “price signal” to both buyers and sellers.

The signal to buyers is: buy less. Be less wasteful in your use of the product, or look for similar products that are cheaper. The signal to sellers is the reverse: sell more. Now the product has become more profitable, produce more of it.

So, the price mechanism has caused a fall in the demand for the product and a rise in its supply. This will push the price back down until demand and supply are equal again. The market will have “cleared,” leaving nothing unsold, and the price will be back to about where it was before the shock. Equilibrium will have been restored.

Simple, eh? Neat, eh? And that’s a big part of the reason the economists’ way of thinking about how markets and market-based economies work hasn’t changed much in 150 years.

You see, too, why economists believe that prices – particularly changes in them – are the great incentive for people to change their behaviour. You want to decarbonise the economy? Put a price on carbon emissions.

Another instance of the equilibrating effect of prices is the existence of “arbitrage”, particularly in the markets for shares and other securities. Any difference in the price of the same security in different markets won’t last because the actions of people seeking to profit by buying in the cheaper market and then selling in the dearer market will soon eliminate the discrepancy. Economists call this “the law of one price”.

Putting all this another way, economists have long understood that markets and market economies are, in the modern idiom, “interactive”. Any new action always leads to a reaction, as the people affected change their behaviour to cope with the new development.

This understanding is why economists don’t worry about some developments as much as normal people do. Normal people say: look what’s just happened - it’s terrible. Economists say: yes, but then what happens? They call this the “second-round effect” and their model is supposed to predict what it will be.

For example, economists have never been impressed by all those reports warning that, by 2030, there’ll be a massive national shortage of teachers/nurses/other skilled occupation as all the baby boomers retire. No, there won’t. Why not? Because employers will take evasive action and other employees will take advantage of the opportunities presented.

But the notion of equilibrium can be taken too far. The doctrine of “laissez-faire” (leave it alone) – which lurks just below the surface of what lefty academics call neo-liberalism, but I prefer to call market fundamentalism – says that, since market economies have an inherent ability to return themselves to equilibrium after any shock, government intervention to correct the problem will only make things worse.

This is the old case of taking an element of truth and raising it to the status of a magic answer. The economists’ theory of how markets work is grossly oversimplified. In the real world there are lots of problems that can’t be solved just by leaving it to market forces.

Wait for market forces to stop global warming, and you’ll wait forever, decimating the economy in the process.

Or cases where waiting for the market to solve the problem would take too long or extract an unacceptable price in human suffering. Do nothing about the pandemic and waiting for all of us to get the virus and thus achieve herd immunity would cost too many lives.

The econometric models that economists use to forecast the macroeconomy or predict the effects of some policy proposal rely heavily on the assumption that, over the (unspecified) long term, the economy always returns to where it would otherwise have been. Yeah, sure.

The opposing theory to certain return to equilibrium – which comes from the physical sciences - is “path dependence”. That where you end up after equilibrium is disturbed depends on what else happens to the economy while it’s supposed to be on its way back to where it was. It could be knocked off course and never return to the previous path it was following.

The notion of equilibrium contains a lot of truth. Trouble is, so does the notion of path dependence. As always, the whole truth is somewhere in the middle.

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