The RBA is spooked by pay rises. It should relax

By MILLIE MUROI, Economics Writer

When the Reserve Bank meets next week, it will probably cut interest rates. But it will be some time before it is comfortable enough to lower them to a level that isn’t grinding down economic growth.

Already, some economists have slammed the bank for being slow to cut rates, saying it’s causing more cost-of-living pain than necessary for people with home loans.

Now that the bank’s preferred measure of inflation is within its 2 per cent to 3 per cent target range and the economy has slowed to a crawl (with the risk of a further slowdown as US President Donald Trump’s tariffs hit home), those criticisms are growing louder.

So, why is the Reserve Bank still determined to keep the economy growing below its potential? A lot of it comes down to the bank’s phobia of pay rises – which, like many modern-day fears, served us well in the past but aren’t so useful today.

One of the first rules we learn in economics is that the prices we pay are determined by the balance between supply and demand: when supply of a good or service outstrips demand for it, prices fall, and when demand exceeds supply, prices rise.

Then, we learn all the reasons why this rule isn’t that simple. For example, if a business has a lot of power (maybe it has few competitors), it can charge more for its goods and services.

On the other hand, when customers hold more power, they can drive prices down. How do you think the Australian government manages to negotiate cheaper prices for medicines it buys from other countries? By acting as a single buyer, representing millions of Australians, which gives it a lot more bargaining power than if you or me, individually, tried to negotiate with the pharmaceutical giants. This is what’s called a “monopsony”.

Put simply: prices are determined by the balance of supply and demand – but also the power balance between buyers and sellers.

Our wages are determined in a similar way, which is what the Reserve Bank has been worried about. At almost every interest rate decision in the past couple of years, the bank has mentioned the strong labour market as a reason for its reluctance to cut rates.

Think of your wage as the price of the work you supply. Workers sell their labour to companies which buy – or employ labour. This is called the labour market.

When there’s more demand for workers than there is supply, we have a labour shortage and unemployment tends to be low. This is the position we’ve been in for the past few years, when unemployment dropped to a record low of 3.4 per cent and has remained historically low at roughly 4 per cent.

While this might seem like a good thing, the Reserve Bank is worried.

Its biggest concern is inflation, which it’s worried could follow the same path it did in the 1970s. That is, prices could spike back up if unemployment stays low and businesses give us big wage rises which, in turn, could feed into higher prices.

How do we know the bank is biting its nails? Because of how carefully it’s treading. While inflation hit nearly 8 per cent in 2022, that figure has fallen a lot over the past two years. Yet in that time, the central bank has cut interest rates only once (and raised them six times).

To be fair, employment is growing robustly (a huge 89,000 additional Australians were employed in April compared with March) and job vacancy data shows there’s still a big worker shortage.

But a “wage explosion” is unlikely given the labour market has changed radically since the 1970s.

Wages have finally started growing faster than inflation, but it’s been at a relatively modest pace of 3.4 per cent over the year – and following a year-and-a-half in which wage growth fell short of price rises.

So, what explains the Reserve Bank’s worries of excessive wage growth?

For one thing, the bank relies on a relatively neoclassical view of how the economy works, one in which demand and supply (in this case, of labour) determine price levels, including wages, with individual firms having little control over how much to pay their workers. It’s why the bank is constantly surprised by the strength of the labour market – and waiting (with little avail) for wages to spring up out of it like a jack in a box.

Meanwhile, this lack of a wage explosion comes as no surprise to a lot of labour economists, including Professor Emeritus David Peetz from the Carmichael Centre.

That’s because the neoclassical view of economics tends to assume everyone has roughly equal bargaining power, while many labour economists acknowledge that isn’t the case – especially in recent years.

Peetz argues that real wages – that is, wages adjusted for inflation – have been held back in Australia in recent decades because workers’ power to negotiate has been persistently eaten away.

“Workers have lost a lot of power since the last wages explosion in the 1970s,” he says, noting that from 2014 to 2022, government policies such as WorkChoices have taken away workers’ bargaining power.

The Reserve Bank isn’t totally blind to this. Their economists have written about bargaining power and its relationship with wages. But their justification of interest rate decisions suggests they don’t give much weight to it.

While the bank might worry the current skills shortage could lead to a wage spike and further inflation as in the 1970s, Peetz points out employers now rarely feel compelled to hand out pay rises in response to skills shortages.

In 2023, Jobs and Skills Australia, a federal government agency, asked employers what they do in response to a skills shortage. Only 1 per cent said they would adjust how much they paid their workers.

Why? Because there’s not as much pressure to do so when only one in seven Australian workers are part of a union (it was one in two during the 1970s). The threat of industrial action such as strikes is much smaller. Only 100,000 working days were lost in 2021 compared with 6.3 million working days lost to industrial action in 1974.

While workers in 1974-75 managed to win wage rises of 10 per cent accounting for inflation, workers went backwards by 3 per cent in 2021-22.

This is because of several changes including legal changes in recent decades which have made collective bargaining (in which workers across an entire industry band together to negotiate) less common than enterprise bargaining, in which workers negotiate directly with their employer.

Wage increases won through enterprise bargaining apply only to workers at a specific business or site, limiting those workers’ negotiating power as well as how far the wage rise, if won, can spread. While a wage rise at one company might put some pressure on another company to do the same, in practice, this kind of flow-on impact is limited.

While changes under the Albanese Labor government such as its same job, same pay policy have started to hand more power back to workers, rampant wage rises – and a resurgence in inflation – are far from a big threat to the economy. The Reserve Bank can, and probably should, relax a bit, too.

Read more >>

Maths or no maths? Ross Gittins and Richard Holden have it wrong

By MILLIE MUROI, Economics Writer

We’ve heard the old(er) boys argue over the optimal level of maths in economics, but they’ve delivered some imperfect information. Don’t know what I’m talking about?

Seven years after sitting my final high school economics exam, four years after farewelling university economics, and three years since exiting the economics profession (almost) entirely, I’ve been reflecting.

The reason? A clash between our economics editor Ross Gittins and UNSW economics professor Richard Holden. In the words of Dr Ray Da Silva Rosa, finance professor at the University of Western Australia, it’s the academic equivalent of the “beef” between rappers Drake and Kendrick.

Gittins last week ruffled some feathers when he said economists had lost the plot, becoming obsessed with maths and driving students away from the discipline. Holden’s response? “Shocker …even legends [like Gittins] can be wrong.” Maths, he said, is crucial to economics – and students shouldn’t be intimidated by it.

But let’s go back to why we’re talking about this in the first place: a proposed change to the NSW economics syllabus which would increase to about 35 the number of calculations a student is required to be able to perform.

And more importantly, Reserve Bank research by economist Emma Chow laying out the benefits and ways of boosting the size and diversity of the economics student population, which has plunged since the early 1990s.

Holden doesn’t think the size part is much of an issue (or at least not at crisis levels yet).

And Da Silva Rosa says it’s probably not: “Oddly, as experts who study markets, neither [Gittins nor Holden] considers that we may have about the right number of economists.” It is, he argues, simply a matter of the market allocating the optimal number through the incentive we know of as price: finance and commerce jobs tend to pay better.

But markets are far from perfect. We know – from economic theory – that prices aren’t always a good reflection of the value a good or service might provide to the wider community. That’s why, for example, the government subsidises things such as education and vaccinations (things which economics students might recognise as a “positive externality”).

Similarly, having greater economic literacy across the population comes with big benefits for society more broadly. We may not all become economists (or, in my case, stay one), but having a population with better understanding of economics leads to better policy debates and day-to-day decision-making.

There’s some merit, then, as to why we might want to boost economics student enrolments – just as we have for STEM (science, technology, engineering, maths) subjects in recent years.

I also have some doubts that financial prospects are as big a driver for students’ desire to study certain subjects in high school compared to university. In school, the focus tends to be on maximising marks or choosing the subjects that are easier or more enjoyable.

I don’t completely accept Holden’s view that students shouldn’t be intimidated by maths, either. It’s easy to say, but not always the reality. To his credit, he doesn’t necessarily think there should be more maths mixed into the high school economics curriculum.

The thing that drew me to economics for so many years – despite my lukewarm enthusiasm for maths – is just how relevant it can be to daily life (sunk cost fallacy, anyone?) and understanding the world around us (a certain US president could do with a refresher on tariffs).

Don’t get me wrong. Basic maths is a must-have for understanding economics. And I don’t buy Gittins’ argument that maths-obsessed academic economists have little regard for – or understanding of – how the economy works. As Holden points out, there’s been plenty of great research built on mathematical rigour.

But whether we need dozens of additional equations at a high school level is less certain. For me, being spared from memorising more complex formulas until second year university (and getting the choice at that point to focus more on the less maths-heavy units that interested me) kept me motivated and allowed me to specialise in areas I cared about and was good at.

And my fellow economics students who revelled in maths? They went further down the econometrics path. Economics is one of those disciplines where everyone from mathematicians to philosophers and historians can and do play a crucial role.

Would more maths in the high school economics curriculum have turned me off completely? Well, it certainly wouldn’t have had me jumping for joy.

And here’s something crucial neither Gittins nor Holden touched on. One of the key drivers of the fall in economics enrolments is the drop-off in female enrolments. I’ve spoken about why this is important last year: women economists think differently, and diverse teams simply perform better.

Maybe the quality of the economics discipline – often dismissed as the dismal science – is determined less by how much maths there is, and more by the people and perspectives missing from it. But we can’t separate that completely from the debate on the role of maths in economics.

Given the Reserve Bank’s observation that female high school economics students (who are under-represented in university economics enrolments and in the economics profession) tend to go on to preference disciplines like arts, health and law in university, there’s an argument that a heavier maths focus in high school could push more women away.

Women perform well in maths, yet tend to study it at lower rates than men. The bank suggests advocacy to females could emphasise that economists work on a breadth of social problems that are also seen in arts and social science.

One of the things I loved most was when my arts subjects would intertwine with my business ones. We can integrate economics with other disciplines, not just the obvious ones like finance, tying it more to those subjects that women have tended to favour.

Still think there should be more maths in economics? Why not turn the tables and include more economic principles in the maths curriculum?

Then there’s the need to continue to make economics – both as a career pathway and a discipline – more concrete. Among the biggest threats to high school economics enrolments is not “more maths versus less”, but the rise of business studies, which has increasingly eaten into the pool of possible economics students.

Why? The Reserve Bank says it’s partly the perception that business studies is easier to learn and teach than economics, has a lower workload and has clearer career pathways.

We need to better link economic theories, existing equations and the economics curriculum to the real world: current policy debates, trade wars and day-to-day life. Simply adding more maths at high school level risks plunging the discipline further into abstraction.

There also needs to be more connection between students and those using economics in their professional life. Through high school (and most of university) I had virtually no contact with the mythical creature I now know to be “the economist”.

Breaking down that barrier would bolster the confidence of could-be economists, inspire them to consider a career in economics, and keep economists in touch with younger generations which are often bursting with novel ideas.

I’m no longer an economist, but the things I’ve learnt – and continue to learn – have been invaluable. I’m hopeful we can find better ways to revive the discipline and attract the diversity needed to make it better. More maths wouldn’t have excited a younger me, but more connection to the real world – and to other disciplines – certainly would have.

Read more >>

In 50 years, Trump will be remembered as just a puzzling footnote

I know I’m a bit late, but welcome to 2025. Before we get on with a year of absolutely gratuitous economic angst courtesy of a great American conman’s second coming, let’s take a breath and realise we’re already a quarter of the way through what many still think of as the “new” century.

How time flies while you’re preoccupied with one crisis – one damn thing – after another. I hate to undercut the media’s business model, but old age has taught me that most of the things we find so momentous at the time don’t leave much of a mark on the course of history.

In the heat of battle, we imagine the distant future having been irreversibly shaped by the latest unexpected excitement. A global trade war, for instance. Sorry, a beginner’s error.

Late last year I learnt that, in 1975, “15 leading Australians” had produced a book titled Australia 2025, which examined “the changing face of their country 50 years from now”. It was published by Electrolux, maker of vacuum cleaners.

What a great way to kick off another year of columns, I thought as I asked our library to disinter this gem from the archives. To be honest, I expected it would be great fun. All those fearless predictions about how, by 2025, we’d be flying to work in our spaceships. Or maybe by then computers would mean everyone was working from home.

Wrong. The chapter on the economy was written by someone I dimly remember, BHP’s chief economist at the time, John Brunner. He was far too smart to get caught making fanciful predictions about spaceships or anything else much. He devoted most of his 10 pages to explaining why anything he predicted was likely to be wrong.

He listed all the country’s recent problems, which many more impetuous observers could be tempted to foresee changing our future, while then expressing his doubts. For example, at that time, and still under the Whitlam government, we had a big problem with double-digit inflation. Would this problem be with us for another 50 years?

Brunner recorded all the reasons for thinking it might: “the increasing power of the unions, more generous unemployment benefits, vulnerability of capital-intensive industry to strikes” and “perhaps most potent of all, the commitment of governments to full employment”.

Even so, Brunner doubted it. And he was right. “What?” you say. “We’ve had a problem with high inflation in just the past few years.”

True. But much of the reason we’ve found it so disconcerting is that we’ve become so unused to high inflation. This latest, pandemic-caused surge in prices ended a period of about 30 years in which inflation stayed low, in Australia and all other rich countries.

Why is it so rare for the problem of the moment to be the thing that shapes the next 50 years? Because, as Brunner well understood, when big problems emerge, ordinary businesses and consumers look for ways around them, while governments look for ways to fix them. Action leads inevitably to reaction. And market economies like ours are adept at finding solutions to problems.

Consider Brunner’s list of reasons for predicting eternal high inflation. Powerful unions? Globalisation stopped that. So did the deregulation of wage-fixing. Generous unemployment benefits? Tell that to the Australian Council of Social Service. These days, every sensible person thinks the dole is too low.

As for “the commitment of governments to full employment”, it became a commitment in name only just a few years after Brunner was writing. Overseas economists invented an escape clause they called the “non-accelerating inflation” rate of unemployment, or NAIRU, and naturally, our government and its econocrats jumped at it.

For about the first 30 years after World War II, our rate of unemployment rarely got above 2 per cent. Allow for the workers who happened to be between jobs at any given time and that really was full employment.

But by 1975, inflation was in double digits and the unemployment rate had jumped to 4.6 per cent. The governments of the rich economies dumped the full-employment objective and turned every effort towards getting inflation down.

Thanks mainly to all the extra money the Morrison government spent during the pandemic, our unemployment rate fell to 3.5 per cent early in the Albanese government’s term. As I hope you remember hearing, this was the lowest unemployment had fallen to “in about 50 years”.

Quite accidentally, we’d got back to something like full employment. But get this. If you wonder why the Reserve Bank is so reluctant to cut interest rates, it’s because its battered old NAIRU machine keeps telling it unemployment is still too low.

This brings me to a bit of Brunner wisdom worth repeating 50 years later. “One of the superstitions to which modern man is particularly susceptible is the idea that what comes out of the computer must represent the law and the prophets [the Old Testament].”

“But of course what comes out of a computer depends on what goes into it and if you feed in neo-Malthusian assumptions you will get gloomy answers.” (Thomas Malthus was a notoriously pessimistic English economist from the 18th century.)

Finally, this: “Probably no profession spends more time contemplating the future than the economics profession and yet few are worse equipped for the task. For whatever facility they may have for manipulating economic variables, economists really know very little indeed about what determines economic magnitudes, particularly in the long run.

“The long-term rate of economic growth, for instance, will be determined by a host of political, technological and cultural factors which no economist has any special claims to be able to predict.”

Ah. They don’t make business economists like him any more.

Read more >>

Want more economics students? Drop the obsession with maths

The Reserve Bank is worried. The number of students wanting to study economics has been falling over the years, and it’s worried this will lead to a fall in the electorate’s economic literacy, which could end up worsening government policy.

And the Reserve, being by far our biggest single employer of economists, may be worried its choice of potential recruits will deteriorate.

An article by the Reserve’s Emma Chow, published last week, told us a truth the nation’s academic economists have often been loath to admit: the main recruiting sergeant for university economics degrees is high school economics.

Because it’s based so heavily on current affairs – “be sure you watch the treasurer delivering the budget speech on TV tonight, kids” – high school economics gives students the impression economics is interesting and important. Only after they’ve signed up at uni do they discover that, in the hands of a lecturer who’d rather be doing research, it can be deadly dull.

But the proportion of students studying economics at high school has fallen markedly since the early 1990s, mainly because of the introduction of business studies, a more descriptive course that requires much less intellectual effort for both students and teachers.

Now, however, Chow tells us that not only are fewer students studying economics at high school, few of those who do go on to a dedicated economics course at uni. Most prefer to major in commerce or finance.

The limitations of her data allow Chow to tell us little about why economics has become so unpopular. It certainly can’t be because the management of our economy has become so boringly smooth and uneventful.

But I think I know the biggest reason: the economists have lost the plot. Since not long after the end of World War II, academic economists have been engaged in an all-consuming quest to make their discipline more intellectually “rigorous” by making it more mathematical.

Their concepts of how the economy works must be expressed in algebraic equations, not diagrams of demand and supply curves nor – heaven forfend – mere words.

They must build ever-more “elegant” econometric models of the economy which could at last spit out reliable forecasts of where the economy was headed. Except they’ve proved just as unreliable as economists’ predictions have always been.

When some kid tells me proudly that they’ll be doing economics at uni, I warn them they’d better like maths. If they talk to a friend who’s already doing the uni course, they’re told the same thing. I reckon too many young people are getting the message that uni economics ain’t much fun.

It’s true that when you express propositions as equations, any logical faults in your reasoning are exposed. But this greater “rigor” comes with a big proviso: the reasoning is completely logical given the assumptions on which it’s based.

If your assumptions are hopelessly unrealistic, however, your fancy mathematics is logical but sadly astray. Whether your prediction came off the top or your head or from a model whose maths is beyond the comprehension of almost all of us, it’s still a case of garbage in, garbage out.

The remarkable thing is that the failure of mathematisation to improve the economists’ understanding of how the economy works has done nothing to dampen their enthusiasm for more maths.

Once, when I reminded a well-known academic economist of some finding of behavioural economics that contradicted the conventional model, he replied: “You maybe right, Ross, but unless you can get it into an equation, I’m not interested.”

Get it? The academics are now doing maths for its own sake. They stick with their stick-men model of the economy because anything more sophisticated can’t be mathematised. These days, you can’t work in a uni economics department unless you’re a whizz at maths. Nor can you get promoted.

Academic economics is becoming a branch of applied mathematics. It’s dominated by people who got where they are because they’re good at maths, not because they know a lot, or care a lot, about how the economy really works.

But if the Reserve Bank bosses are worried now, I have more bad news: the NSW Education Department’s draft revised economics syllabus shows the maths disease is spreading to high schools.

The syllabus – which would be little different from that for the Victorian Certificate of Education – is already absurdly overcrowded. You take a 17-year-old and, in two years, while they’re studying various other subjects, expect them to get their head around everything a professional economist understands about what their profession thinks it knows about the workings of the economy.

If they really did understand all that, why would they need to go to uni and learn it all again? But, to give high school economics greater rigor, the proposed new syllabus seeks to – you guessed it – make it more mathematical. It increases to about 35 the number of calculations a student is required to be able to perform.

Can you imagine how much students’ time that should be spent thinking about how it all hangs together would be devoted to memorising formulas and practising sums? Don’t think about how oligopolies work and why market power harms consumers, just learn to calculate the Herfindahl-Hirschman industry concentration index.

Or, how about using Laffer curves to calculate optimal tax rates? (I’m not making this up.) To make room for all these new calculations, the new syllabus would drop such minor matters the case study of the Chinese economy and the impacts of globalisation on the world.

Of course, the move to greater rigor would have its advantages. Much more of the exam would involve asking questions with answers that could be exactly right or wrong. This makes exam papers much easier and cheaper to mark. It could be done by a machine, not a teacher on overtime at the marking centre.

I reckon that if each state reformed their syllabus in this way, they’d end all the Reserve’s worries about the declining popularity of high school economics. Few if any kids would want to do the course. Problem solved.

Read more >>

Oligopolists gouge power and gas prices, Albanese cops the blame

If, as seems likely, Anthony Albanese and his government lose seats at next year’s federal election, one thing we can be certain of is that the nation’s economists and econocrats won’t be admitting to their not insignificant contribution to Labor’s setback.

Economists have such a limited understanding of how the behaviour of the real-world economy differs from the economy described in their textbooks and measured in their econometric models, and are so woefully bad at predicting where the economy is headed, that their profession has become hugely defensive. And so, like Peter Dutton, they never ever admit to getting anything wrong.

It seems a safe bet that, should Labor’s vote be down, it will be for one overwhelming reason: the voters’ ire at what they call the “cost-of-living crisis” – the sudden surge in retail prices in the aftermath of the pandemic.

Many factors have contributed to that surge, but the Reserve Bank attributes much of the responsibility to the authorities’ excessive stimulus of the economy during the lockdowns. This, by causing the demand for goods and services to outstrip the economy’s ability to supply them, allowed businesses everywhere to get away with whacking up their prices.

Economists regard such price rises as completely normal and unexceptional, part of the God-ordained mechanism by which market forces return the economy to equilibrium. The public, however, sees such rises as utterly opportunistic and illegitimate, condemning them as “price gouging”.

But while the Reserve has frequently offered this “demand-pull” explanation as justification for its protracted increase in interest rates, it’s been much less willing to acknowledge that it was among the “authorities” who stuffed up.

Of course, the retail prices of some goods and services have made a much bigger contribution to the higher inflation rate than others have. And a prominent role has been played by the prices of electricity and gas. Over the three years to June this year, electricity prices rose by 20 per cent and gas prices by more than 30 per cent.

We’ve been told the leap in energy prices has been caused by Russia’s invasion of Ukraine in February 2022. But as new research by the Australia Institute’s David Richardson reveals, that’s just a tiny part of the story.

The truth is that electricity and gas prices have been rising much faster than the overall consumer price index since at least the end of 2007, with prices really shooting up over the past four years.

Richardson has used the latest annual reports of AGL and Origin Energy to derive some astonishing figures for what consumers are paying for electricity and gas. On average, he calculates, AGL’s electricity costs households $377 a megawatt hour, while Origin households pay $343 a MWh.

So what are the costs that cause those electricity prices to be so high? He says the total retail price consists of five components. First is the cost of the generation of electricity by power stations, including the cost of the coal and a bit of gas used to power the generators.

Second are the “network costs” of moving the electricity from the power stations to homes, businesses and offices, first transmitted across the countryside by high-voltage power lines, then distributed by “poles and wires” at the local level.

The third component is an annual allowance for the depreciation of all the equipment, which must eventually be replaced. Fourth is “other costs” incurred by the electricity retail companies – most of it being the cost of advertising – and fifth is the retailers’ profit before interest payments and tax.

Now get this. Richardson calculates that, for every $100 paid by a retail customer of AGL, a mere $12 goes on generating the electricity. So much for the evil Russian invaders being the cause of the problem.

Next come network transmission and distribution costs of $34, $4 for depreciation and $15 for advertising and other retailing costs. Which leaves AGL’s retail company with a profit before interest and tax of a measly $35.

What! About 35 per cent of our bill goes on profit to the retailer? Woolies and Coles eat your heart out. Qantas – you’re not really trying.

According to Richardson’s calculations, Origin’s retail profit share is a bit lower at 29 per cent. Turning from electricity to gas, he puts AGL’s retail profit margin at 36 per cent, and Origin’s probably a bit higher.

Richardson’s conclusion that consumers are being gouged in the electricity market is consistent with the findings of Professor Allan Fels in his report for the ACTU earlier this year. Fels made the economists’ point that every company’s electricity is identical. It’s also something that every home must have.

So why do retailers need to spend so much on advertising, “inappropriate door-to-door marketing activities” and other forms of “obfuscation”, Fels asked.

And Richardson’s figuring reveals something else. The overcharging of household customers of electricity and gas involves requiring them to cross-subsidise AGL and Origin’s business customers. They pay prices for electricity and gas that are about half what household customers pay. And the profit margins extracted from business customers are tiny.

But why should economists and econocrats share the blame for all the inflationary price gouging that’s helped make the Albanese government so unpopular? Because all the malfunctioning we’re seeing has occurred under the National Electricity Market that the econocrats designed and still regulate, and assured us would be a great reform.

The wonder-working NEM has turned five state-government-owned monopolies into a national oligopoly dominated by just three huge operators – AGL, Origin Energy and the foreign-owned and tight-lipped EnergyAustralia. The three are highly “vertically integrated”, meaning they each own big slabs of the market’s three levels: generation, transmission network and retail provision.

The NEM is owned by the five state governments plus the feds – that is, by everyone and no one – and regulated by two separate government authorities using a rule book running to thousands of pages. But it seems to have been captured by the oligopolists.

The economists have done little to stop consumers across the nation from being grossly overcharged for electricity and gas. But not to worry. It’s only some politician that will be left carrying the can.

Read more >>

When funding healthcare, don't forget the caring bit

 It’s Easter, and we’ve got the day off. So let’s think about something different. As a community, we spend a fortune each year on health, mainly through governments. What has economics got to tell us about healthcare? And, since it’s Easter, what light has Christianity got to shed on how we fund healthcare?

One man who’s thought deeply on these questions is Dr Stephen Duckett, Australia’s leading health economist, whose career has included academia, running government health departments, and the Grattan Institute think tank. He’s now back in academia, at the University of Melbourne.

Duckett has long been a lay reader in the Anglican Church. He’s recently completed a doctorate in theology, awarded by the Archbishop of Canterbury. He’s turned his thesis into a book, Healthcare Funding and Christian Ethics, published by Cambridge University Press.

One way to run a hospital is to let the doctors and nurses do as they see fit until the money runs out but, for several decades, health economists’ advice has reshaped the health system, helping to ensure that the money available is spent in ways that do the most good to patients.

One definition of economics is that it’s the study of scarcity. We have infinite wants, but limited resources of land, labour and physical capital to achieve those wants. So we must carefully weigh the costs and benefits of the many things we’d like, so we end up choosing the particular combination of things that yields us the greatest “utility” (benefit) available.

Since there’s never enough money to spend on healthcare, hard decisions have to be made about what can be done and what can’t, what drugs should be subsidised and what can’t, who should be helped and who turned away.

Health economists analyse the cost-effectiveness of the various options to help governments and hospitals make their choices, working out the number of “quality-adjusted life years” each option would add.

The Scotsman called the father of modern economics, Adam Smith, saw it as a moral science but, as economists have striven to be more “rigorous” (which mainly means more mathematical) this touchy-feely stuff has fallen away.

Most economists see economics as amoral, that is, neither moral nor immoral; having nothing to say about moral issues. When it comes to means and ends, economists see themselves as sticking to means.

They’re saying: tell me what you want to do, and I’ll tell you the best way to achieve it. That’s what they say; it’s not always what they do.

Economics is based on utilitarianism: seeking the greatest good for the greatest number. But this ignores the question of “equity”: how fairly the benefits are shared. Are some getting a lot while others miss out?

Duckett says: “Economics’ assumption that humans are simply individual units, de-emphasising community, and [economics’] ubiquitous use in policymaking, comes at a cost, as Homo economicus [the self-interested, rational calculator that economists assume us to be] crowds out other manifestations of what it is to be human.”

Economists often say they have no expertise on equity and the community, so they leave that to others – such as the politicians. Economists often claim that economics is “objective” and “value-free”.

But Duckett says it’s not simple. By ignoring issues you’re implying that they don’t matter. And you’re making implicit assumptions that are value-laden.

For instance, if a cost-effectiveness study does not explicitly highlight the distribution of costs and benefits [how unequally they are shared between people], it is implicitly conveying the message that the distribution is not a relevant issue.

If nursing home funding allows money ostensibly allocated for care to be leached out as extra returns to the owners, then quality is assumed to be not a concern of those doing the funding.

If a system design places a higher monetary reward on cosmetic surgery intended solely to improve appearance compared to the monetary reward for caring for older patients and people with mental illness, this sends a signal about the value placed on care for the marginalised.

Duckett says that, because decisions about public policy inherently involve value choices, health economics becomes a “moral science” whether economists like it or not. What’s true, however, is that economics is not well-equipped to determine issues such as what should be society’s priorities, what value should be place on unfettered choice, and the value to place on ensuring no one is left behind.

This is where Christian ethics has a contribution to make, a contribution that, except on matters of sexual morality, doesn’t differ much from the views of the aggressively secular philosopher Professor Peter Singer and, no doubt, many other Western ethicists.

Duckett offers a “theology of healthcare funding” based on Christ’s parable of the Good Samaritan. As I hope you remember, a man was travelling to Jericho when he was set upon by robbers, who left him naked and bleeding by the road.

Two separate religious figures passed by him on the road without stopping to help. But a Samaritan saw him and “was moved with pity”. He bandaged his wounds, put him on his donkey and took him to an inn, where he paid the innkeeper in advance to look after him, promising to come back and pay for any extra expense.

From this parable Duckett derives three principles that should guide health economists in the advice they give on healthcare funding.

The three are: compassion (shown by the behaviour of the Samaritan), social justice (everyone included and treated equally; shown by the identity of the Samaritan, a race despised by the Jews) and stewardship (shown by the innkeeper, who was trusted to care for the traveller and to spend the Samaritan’s money wisely).

Compassion must involve feeling leading to doing. It must involve helping people other than yourself. So health economics must be less impersonal, remembering the flesh and blood behind the statistics and calculations. Any funding arrangement must allow time for workers to care for patients in a compassionate way.

The Christian ethic is that social justice is not simply about fairness for atomised individuals, but also the person as part of a community, something economists tend to forget. Archbishop Desmond Tutu has said “a person is a person through other people . . . I am human because I belong. I participate, I share.”

“Christian contributions to the public square need to challenge policy ‘solutions’ that rely on individuals pulling themselves up by their own bootstraps, victim-blaming approaches, and a narrow definition of [who is my] ‘neighbour’,” Duckett says.

As for stewardship, it’s the easy bit. It’s the Christian word for what economists already know about: making sure that other people’s money is spent carefully, and their property is looked after. It’s being efficient.

But the Christian contribution to what health economists do is to make sure stewardship is kept in tension with the other two principles. “Austerity does not mean that compassion and social justice can be ignored, or distributional consequences [for the rich and the poor] can be erased from consideration.

Read more >>

'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.

Read more >>

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.

Read more >>

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.

Read more >>

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.

Read more >>

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.

Read more >>

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.

Read more >>

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.

Read more >>

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.

Read more >>

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.

Read more >>