Money is created by the banks, not the government

Just for a change, let’s talk about money. What? Don’t economists always talk about money? Well, yes, in the sense that almost all the things they talk about are valued in monetary terms. But otherwise, no, they rare talk about money as such.

Sometimes I think economics is about finding a host of synonyms for the word "money". Why do you go to work? To make money, of course. But economists prefer to say you earn a wage. Or, if you’re a big shot, a salary.

Businesses sell us things to get money, but economists prefer to say they make sales to generate turnover which, after they’ve paid out a lot of money on wages and rent and many other expenses, leaves them with money called income or profit.

Economists do talk specifically about money, but they define it much more narrowly. Consider this: how would you like to live in a barter economy, where you’re paid with some of whatever it is you’ve helped produce, then have to exchange those things with other people for some of the things they’d help produce?

It would be a hugely cumbersome and time-consuming business. Which is why, a long time ago, someone invented money. We get paid with money, which we use to buy the things we need. Much simpler and easier.

That’s what economists mean by money – a means of paying for things; a "medium of exchange". To an economist, money has little intrinsic value. It’s the things it buys that are valuable.

Economists mainly focus on those valuable things – what’s happening to them and how they work - and ignore the money used to buy and sell them.

It’s true, of course, that economists and the rest of us put dollar values on all those things – prices of the goods and services we buy, the value of the houses and other assets we sell.

Expressing the value of so many and varied things in dollars makes it easier to compare them, add and subtract them. So another part of economists’ definition of money is that it’s used as a "unit of account".

(This, however, exposes a big limitation of economics. There are a lot of important things in life and the economy whose value or cost can’t be reduced to a dollar figure. Things like love, trust, honesty, anxiety and stress. Economists are always forgetting to take account of factors than can’t be measured in dollars.)

Of course, not all the money than comes our way is spent immediately. Some of it we save to spend later – sometimes much later. Which means the third requirement money must fulfil is to be a good "store of value".

That’s why we need to keep the rate of inflation low and steady (and why Bitcoin doesn’t rate as money).

But now we’re clear on what money is, the big question is: where does it come from? How is it created?

Well, we know that coins and banknotes come from the government. Notes are printed in Melbourne by the Reserve Bank; coins are made in Canberra by the Royal Australian Mint. The Reserve sells to the banks all the notes and coins they want.

But notes and coins account for less than 4 per cent of all the money in circulation. Most of us hold most of our money on deposit with the banks.

In principle, the Australian dollar is a creation of the Australian government. Like almost every currency these days, it’s a "fiat" currency – meaning it has no intrinsic value: notes are just pieces of paper, and the metal used to make a $2 coin is worth a small fraction of $2. An Australian $50 note is worth $A50 purely because the government says it is.

This also means the government could print – or credit to people’s bank accounts – as many dollars as it wanted to (though not without ramifications).

But here’s the trick: although that is true in principle, in practice money is created by the banks. As Emma Doherty, Ben Jackman and Emily Perry explained in the Reserve Bank’s Bulletin last year, money is created when banks make loans.

The bank either puts the loan money directly into its customer’s deposit account, or pays it into the account of the business selling whatever it is its customer needed the loan to buy. Either way, since money is notes and coins ("currency") plus bank deposits, the amount of money in circulation has just increased.

Amazing, eh? But before you run away with the idea that a bank could create as much money as it wanted to, there are two further points to understand.

First, there are obvious limits on how much money the banks can create. For a start, they’re not giving it way, they’re lending it. They must have a customer wanting to borrow at the interest rate charged, and likely to be able to repay it.

And the banks also need to be in a position to make the loan. They must keep a sufficient share of their assets in liquid form (cash) to be able to meet any withdrawals the new borrower makes from their account, as well as to meet any withdrawals by existing borrowers.

This pretty much means they need to attract more cash deposits to support the loan they just made. The banks’ loans need to be backed up by enough capital, supplied by shareholders, in case borrowers can’t repay their loans or other bank assets fall in value.

All this is necessary to ensure the banks don’t collapse. So these factors imply that creating money comes at a cost to the banks, which limits the extent to which they can increase their loans.

Second, an individual bank can’t create money in this way, only the banking system as a whole can. That’s because the bank that initiates the loan can’t be sure that all the loan money spent comes back to it as deposits. Some of it will, but most may go to other banks.

Next week it’s back to talking about the things we do with money.

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ABBA was right: Rockonomics shows the winner takes it all

Why do we live in the era of superstars – whether people or businesses? Why is there such a thing as winner-take-all markets? Why do the top 1 per cent of households get an ever-bigger slice of the pie?

Short answer: because the digital revolution is disrupting far more of the economy than we realise.

It’s explained in the new book, Rockonomics: What the music industry can teach us about economics and life, by Alan Krueger, and summarised in his article in the New York Times, from which I’ll quote. Krueger, an economics professor at Princeton University, died in March at the age of 58.

Krueger says the first economist to explain the growing income gap between superstar businessmen and everyone else was the great English economist Alfred Marshall, in the late 1800s.

Marshall argued that a remarkable development in communications technology, the undersea telegraph, allowed top entrepreneurs “to apply their constructive or speculative genius to undertakings vaster, and extending over a wider area, than ever before”.

Ironically, Marshall used the music profession as his counterexample. Because the number of people who could be reached by a human voice was so limited, it was unlikely that any singer could better the £10,000 that the great soprano Elizabeth Billington was said to have earnt in a season.

What the superstar businessmen had, but Billington and her rivals lacked, was the ability to scale up at no prohibitive cost. Of course, Krueger notes, the other thing you need to become a superstar is what economists call “imperfect substitutes”. In English, you must have your own unique style and skills.

Today, of course, music is a most extreme and obvious example of superstars and winner-take-all markets. Why? Because technological advance has provided the economies of scale lacking in Marshall’s day.

Start with amplification of the human voice and then musical instruments. Then, the advent of enhanced recording technology. Finally, the internet and digital streaming of individual tracks anywhere in the world.

“Scale magnifies the effect of small, often imperceptible differences in talent. With the ability of scale, the rewards at the top can be much greater for someone who is slightly more talented than his or her next-best competitor, because the most talented person’s genius can reach a much greater audience or market, in turn generating much greater revenue and profit,” Krueger says.

Album sales and digital streaming clearly reflect the superstar phenomenon, he says. In 2017, the top 0.1 per cent of artists accounted for more than half of all album sales. Song streams and downloads are similarly lopsided.

But a strange thing has happened. Because digital recording has made it so easy to copy and share recordings, the revenue earned by artists and record labels has collapsed. These days, musicians make most of their income from live performances – from nobodies playing in pubs to superstars touring the world’s major venues.

Krueger says that, in 2017, the top 1 per cent of artists increased their proportion of total concert revenue to 60 per cent, compared with 26 per cent in 1982.

Another funny thing: it's now so cheap and easy to record your performance and get it onto the internet, where it’s available to the whole world, that anyone can do it. But does that make you famous? No way. The amount of music available on the net is so vast that the chances of your genius being discovered are tiny.

If you’re already famous, it’s easy to become more so. We hear of some unknown’s YouTube video getting a million clicks, but these are the exceptions. And if that happens it does so because something about the video is exceptional, and because a cascading network of people hear about it and recommend it to their friends. Do you make any money out of it? Probably not.

What happens is not a normal, “bell-shaped” distribution of listens – or dollars – but a “power-law” distribution in which a small number of people get huge scores, which quickly fall off until you get to everyone else getting next to nothing.

In 2016, Krueger says, the most popular artist, Drake, was streamed 6.1 billion times, followed by Rihanna (3.3 billion streams), Twenty One Pilots (2.7 billion) and The Weeknd (2.6 billion). Move down just 100 places and you get to Los Tigres del Norte (0.5 billion).

See how quickly it falls away? That’s a power-law distribution. So is the “80/20 rule”.

Krueger says that the whole United States economy has moved in the direction of a superstar, winner-take-all market. Since 1980, more than 100 per cent of the total growth in income has gone to the top 10 per cent of households, with two-thirds of that going to the top 1 per cent, while the share of the remaining 90 per cent has shrunk.

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Rates of tax tell us nothing about economic success

When Leigh Sales of 7.30 asked Scott Morrison what evidence he had to support his claim that the economy would be weaker under Labor because it would impose higher taxes, he replied “I think it’s just fundamental economics 101”. Sorry, don’t think so.

The belief that an increase in taxes must, of necessity, discourage work effort, saving and investing is regarded as a self-evident truth by the well-paid. Similarly with the converse: a decrease in taxes must, of necessity, encourage work effort, saving and investing.

But since no one particularly enjoys paying taxes – and some people really hate it – they would think that, wouldn’t they.

It’s a simple, all-purpose, no-need-to-explain argument against me being asked to pay more tax and in favour of me paying less. What’s not to like?

Just that it misrepresents what economics teaches.

It’s true that some economists emphasise the “deadweight loss” involved in imposing taxes. In principle, a tax distorts an individual’s choices, causing them to do things they otherwise wouldn’t.

This distortion of choices is said to be “economically inefficient”, in that it fails to produce the allocation of economic resources – land, labour and capital – that maximises the “utility” (satisfaction) the community derives.

The degree of allocative inefficiency differs for different taxes, with some said to involve greater deadweight loss than others.

By this logic, one of the worst taxes is conveyancing duty (which discourages people from moving house) and the best is a poll tax (everyone pays the same dollar amount each year which, being impossible to avoid, doesn’t change behaviour).

One thing often not mentioned in economics 101 is that tax on the unimproved value of land (such as council rates) and inheritance taxes score well.

But these calculations are based on theory and assumptions. The first of their limitations is that they ignore the benefits that flow when the taxes are spent. When they’re spent on government provision of “public goods” (goods or services that would be undersupplied if their provision was left to the private sector) they increase allocative efficiency.

You shouldn’t have to go beyond first year economics to learn that changes in the price of something have two effects: an “income effect” and a “substitution effect”.

People who believe an increase in income tax (which is a price) discourages work, and a cut in income tax encourages it, are focusing on the substitution effect and ignoring the income effect.

It’s true that a higher rate of income tax should discourage work by reducing the monetary benefit you get from it, relative to the benefit you get from not working. That is, from enjoying more “leisure”. It thus should encourage you to substitute leisure for work – that is, work less.

 By contrast, lowering the tax on work should encourage people to substitute work for leisure – work more.

Trouble is, the income effect works the opposite way. Increasing income tax reduces your after-tax income. If you don’t want your income to fall, you have to do more work, not less. Similarly, cutting income tax increases your after-tax income, encouraging you to work less.

The fact that the income effect and the substitution effect pull in opposite directions means economic theory can’t tell us whether or not tax increases discourage work. To answer that question you have seek out empirical evidence from the real world.

In doing so you’ll make up for theory’s implicit assumption that money is the only factor motivating people to work. If that’s what you think, you’ve got a lot to learn about human nature.

The empirical evidence says changes in the rate of income tax for “primary earners” – the main person a family relies on for income, who’s usually working full-time – aren’t great.

It’s only “secondary earners” - often women working part-time – whose hours of work are much influenced by increases or decreases in income tax.

This is pretty obvious when you think about it. The number of hours worked by full-time employees is set by their boss, whereas part-timers have some degree of control over the hours they work. Certainly, they decide whether they want to move from part-time to full-time.

Let me tell you: politicians’ motive for tax cuts is almost always more political than economic. If Morrison was really on about encouraging more work, his tax cuts would be aimed at working mothers, not the highly paid full-timers they are aimed at.

But there’s another empirical test of his confident assertion that high rates of tax discourage economic growth and low rates encourage it.

If that were true it should also be true that countries with high tax rates have low living standards, whereas countries with low tax rates have high living standards.

Try as they might, however, economists have never been able to find an inverse correlation between the level of taxes and a country’s rate of growth.

For a start, the poor countries have much lower rates of total taxation than the rich ones. Rich countries have high tax rates so they can enjoy the many benefits of being rich: the welfare state, good public infrastructure, good health care, good education and much else.

The Organisation for Economic Co-operation and Development regularly publishes figures for their 35 member-countries’ rates of total taxation (federal and state) as a percentage of gross domestic product.

Its latest figures, for 2017, show its rich-country members ranging from 46 per cent for France and Denmark to 23 per cent for Ireland. Sweden is on 44 per cent, Germany on 37.5 per cent.

The average for the whole OECD is 34 per cent, with us on about 28 per cent and the United States on 27 per cent (but with a much bigger budget deficit).

If they don’t tell you all that in economics 101, ask for your money back.

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Give economists a PC and they start making more sense

Economies turn down and back up, but one of the biggest, long-running economic stories of our time is the way the digital revolution is disrupting one industry after another. So let me tell you how it’s changing the academic study of economics.

You probably imagine the economic research carried out in universities is terribly theoretical and impractical. It used to be, but not anymore.

You can trace the progress of academic economics by looking at who’s been awarded the Nobel memorial prize in economic sciences from about 2001 onwards, and what they did to deserve it. Of course, there’s usually a long delay between when you make your seminal contribution and when you get your gong.

Until the turn of the century, the prize usually went to people elaborating on orthodox neo-classical theory, particularly by shifting to mathematical reasoning.

It may surprise you that the man who wrote the most popular introductory textbook of the post-war years, Paul Samuelson, was also the individual who did most to turn economic reasoning from words and diagrams to equations.

The development of the first mathematical “econometric” models of the macro economy was another important advance.

It was about 30 years ago that the frontier of economic research took a more realistic turn by shifting to the study of “imperfect competition”, where the idealised assumptions of the simple neo-classical model of markets were critically examined.

In 2001, for instance, the prize was shared by three American economists – George Akerlof, Michael Spence and Joseph Stiglitz – for their demonstration that, rather than being perfectly shared by everyone in a market, information is usually asymmetric – with sellers knowing more than buyers – and, rather than being costless, is expensive to acquire.

Another example: Paul Krugman got his gong in 2008 for demonstrating that there’s more to international trade than just each country pursuing its “comparative advantage”, as mainstream theory assumes.

It was about 40 years ago that the psychologist Daniel Kahneman (gonged in 2002) and the rebellious economist Richard Thaler (2017) began formulating behavioural economics, an advance on the neo-classical assumption that all decision-making is rational. Robert Shiller got his in 2013 for his study of non-rational behaviour in financial markets.

But recent studies of articles in the world’s top economic journals (mainly American) have shown that, since about the turn of the century, theoretical papers have largely been replaced by empirical studies of particular relationships in particular markets (competition between male and female drivers in Japanese speedboat races, for instance).

This shift from deducing conclusions from assumption-based theory to examining the relationships between real-world variables, to see how the theory measures up, is a big improvement. But why has it happened?

I give most credit to the information revolution. Computerisation has hugely increased that number of “data sets” of business information waiting to be discovered and subjected to statistical tests by academic economists checking hypotheses or just looking for interesting relationships.

All of which is easily done using programs on your personal computer, rather than waiting your turn for time on the main-frame. And it fits with economists’ modern addiction to using stats and maths for “academic rigour”.

As part of their greater interest in empirical evidence rather than what theory tells us should be the case, economists have started doing something they long believed was impossible: economic experiments – including searching out “natural experiments”, such as the famous study of two nearby cities in different US states, where one state raised the minimum wage and the other didn’t.

By the standards of real mathematicians, economists’ maths isn’t that fancy, but it’s more advanced than used by others in the social sciences. Economists have made more progress in moving from finding correlations to establishing causal relationships than the psychologists have – which probably means they get more research funding.

It also means there’s less resistance from international journals to publishing research about that uninteresting and unimportant place called Australia. I’m told doctoral students come to Oz because they’ve heard we have good data sets.

The risk, however, is that research projects are chosen because good data are available, rather than because the questions being answered are important to our understanding of how the economy works and to finding better solutions to our economic problems.

We don’t want academic economists losing interest in their theory, we want them using their empirical evidence to improve it. Making it more realistic and thus more reliable in its predictions about what happens if you do X, or whether policy A or policy B is more likely to improve things.

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Does gift-giving make sense? Silly question

It’s the season of the year when the bylaws of the economists’ union require me to issue the stern admonition that the medieval practice of gift-giving should cease and desist forthwith. And the fact that I’m a bit late won’t stop me.

Perhaps more people - recipients of socks and handkerchiefs and other wondrous surprises - will be receptive to the profession’s utterly disinterested (look it up) advice and see the wisdom of my words.

Gift-giving is an irrational act, one where sentiment and emotion triumph over good sense. Since it’s hardly possible for the giftor better to know what the giftee would like to be given than the giftee themself, the success rate of the practice is abysmally low.

So low, in fact, as to justify economists using one of their worst pejoratives to brand the practice as involving a “deadweight loss” – one where the benefit to the giver and the benefit to the receiver are insufficient to justify the cost of the transaction, thereby creating a loss to the community.

(And please, please don’t ruin my Boxing Day by arguing that the commercialisation of Christmas at least creates jobs. The economists’ union’s Christmastide message is that any mug can create jobs, all you have to do is spend money – your own or someone else’s. The whole point of economics is to help the community spend money in ways that yield it greater benefit than other ways.)

But fear not. Go back to eating your leftovers in peace (and goodwill). I’m not actually a member of the economists’ union, but an adherent to a dissident sect known as behavioural economists (people who, too late in life, realised psychology made more sense than economics).

This bunch of heretics delights in pointing to the glaring weaknesses in the oversimplified model conventional economists carry in their heads.

But you need only to have gone to Sunday school to see the weakness in all the nonsense about the deadweight loss of Christmas. I think it was the little chap himself who said it was more blessed to give than receive.

And there is, in fact, plenty of what a deranged economist would call “giver’s surplus”. How do I know? Because psychological experiments have demonstrated it – many of them conducted by Professor Elizabeth Dunn, a psychologist at the University of British Columbia.

But just last week came new research by Ed O’Brien, of the University of Chicago Booth School of Business, and Samantha Kassirer, of Northwestern University Kellogg School of Management, showing that “the joy of giving lasts longer than the joy of getting”.

One of the great limitations of human nature is “hedonic adaptation”. The happiness we feel after a particular activity or event diminishes each time it’s repeated. It’s likely this phenomenon is “adaptive” – we’ve evolved to react that way because it increases our ability to survive and reproduce; it keeps us striving.

But the researchers find that giving to others may be an exception to the rule. In two studies they found that participants’ happiness did not decline, or declined more slowly, if they repeatedly bestowed gifts on others versus repeatedly receiving those same gifts themselves.

Separate research by Dr Vera te Velde, a lecturer in economics at the University of Queensland, has found evidence for the existence of “beliefs-based altruism” – concern about other people’s emotions and other psychological experiences, beyond any material measure of their wellbeing.

This means “we don’t give gifts only because we want people to have something that they want; we also give gifts because we want them to feel cared about, experience joy or a pleasant surprise when receiving it. Or to prevent them from feeling disappointed if we fail to give anything,” she says.

This kind of altruism can apply in many other situations. “When girl guides come to our doors to sell cookies, we buy them not only to support the group and because we like cookies, but also because we want the girls to feel successful and valued,” she says.

But how can we be sure that a pure concern for others’ feelings is the motivation for these behaviours, instead of – or maybe, as well as – concern about our own reputations? After all, I may not only want girl guides to feel good, I may also want to be known as someone who supports them.

To help answer this question Velde experimented with a sharing game. One person is asked to share $10 with another person. But the bank handling the transfer occasionally makes a mistake and transfers exactly $1 to the other person. So if that person receives $1, they don’t know if it’s a bank mistake or the first person’s selfishness.

Asked whether they thought the recipients would prefer to know about giver’s true intentions, many participants thought they would. Even so, when they played the game themselves, the participants were more likely to give either exactly $1 (thereby hiding their selfishness) or exactly $5 (thereby revealing themselves to be perfectly fair).

But get this: even the people who tried to hide their selfishness were demonstrating their concern about the emotions of the other person. Economics makes a lot more sense with a bit of psychology thrown in.

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Why so many businesses are behaving badly

While we digest the royal commission’s evidence of shocking misconduct by the banks and insurance companies, there’s another unpalatable truth to swallow: they have no monopoly on bad behaviour.

It seems almost everywhere you look you see examples of companies behaving badly. In a major speech he gave a few months ago, the chairman of the Australian Competition and Consumer Commission, Rod Sims, offered a remarkable list of business household names the commission was taking proceedings against, as I noted at the time.


Commissioner Kenneth Hayne has given us a lawyer’s explanation of why the banks misbehave, but Sims’ speech offers an economist’s explanation.

It’s an important, though sensitive, question for economists since their simple “neo-classical” model of markets predicts firms won’t mistreat their customers because, if they did, they’d lose them to a competitor.

Sims offers seven reasons for this evident “market failure” – a term economists use to acknowledge when real world markets fail to deliver the benefits the textbook model promises.

First, he says, meeting customer needs may not be the main way companies succeed.

On the supply side, markets and economies are driven by the desire of firms to earn and grow profits. (On the demand side, markets are driven by the self-interest of consumers seeking the best deal they can get.)

Nothing wrong with that. Indeed, it often means that those businesses best at meeting the needs of consumers over the longer term do best and survive longest.

“However”, Sims concedes, “being the best at meeting the needs of consumers is not the only, or even the dominant, way firms succeed. Staying ahead of rivals through continual improvement is a difficult task for most companies; eventually, someone [else] works out how to do things better and cheaper.”

“Commercial strategy therefore is largely about building defences against the forces of competition. To make it more difficult for other firms to develop a better product. Or, if they do, to limit their access to customers.” Much of this is perfectly legal.

Michael Porter, the doyen of corporate strategists, from Harvard Business School, demonstrated that firms can best attain commercial success by reducing the number of competitors, by erecting high barriers to new firms entering the market, by keeping suppliers dispersed and weak, by using brands or the bundling of products to create strong consumer loyalty, and by reducing the likelihood of other firms being able to offer your customers products those customers see as substitutable for your product (that is, by “product differentiation”).

Sims’ second reason customers may not get treated well is that executives are under considerable sharemarket pressure to increase short-term profits, so as to increase share prices. Executives’ bonuses are often geared to achieving this.

Many companies set a sales or profit target higher than the growth in nominal gross domestic product, meaning not all of them can achieve it. This can induce some executives to push the boundaries and ignore the risk of reputational damage over the longer term.

Third, in some markets poor firm behaviour goes unpunished by customers. This can be so because customers don’t see what’s been done to them – that they’re being misled, or that firms have formed an (illegal) cartel to keep prices high.

Or it can happen because customers don’t have viable alternative products to turn to. Or switching to another provider may be too difficult or costly. Firms may deliberately make it hard to compare their product with their competitors’.

Fourth, competition can become a race to the bottom rather than the top if firms gain a competitive edge through poor behaviour that goes undetected and unpunished. Stay pure and you lose business. A firm can know it’s bad practice, but not be game to be the first to stop doing it.

Fifth, companies may give their staff financial incentives without adequate safeguards to prevent mistreatment of customers.

Companies can establish poor business models, such as arrangements that leave franchisees little room to achieve a return on their investment while paying their workers award wages.

Sixth, customers can consider themselves badly treated when firms (including banks and power companies) engage in “price dispersion” – charging new customers a lower price than existing customers – which is a common practice and perfectly legal.

Economists have often judged this to be a good thing - “welfare enhancing”. But Sims notes that such behaviour imposes extra search costs (spending leisure time checking to see that companies you deal with aren’t taking advantage of you) which are a loss to society.

(He could have added than the economists’ simple model assumes away all search costs – an example of “model blindness”, by which economists mislead themselves.)

Finally, customers can suffer if executives’ loyalty to their company leads them to sail closer to the edge of what’s legal than they would in their private lives. If some lawyer tells you it’s not illegal, does that make it honest?

Not surprisingly, the economist’s explanation of why businesses behave badly is very different to the judge’s. But when it comes to what we can do about it, Sims and Hayne aren’t far apart.

Commissioner Hayne’s answer is not to pass new laws outlawing conduct that’s already illegal, but to increase penalties so as to make them a realistic deterrent to big businesses whose size means their misconduct in just one area can earn them huge sums, and then police the law with far more vigour and diligence that so far shown by the financial regulators, including Treasury.

Sims has several suggestions. Increase the "private cost" of bad behaviour by identifying and shining a light on bad behaviour, increasing penalties and continually looking for new ways to increase regulators’ ability to identify and pursue bad behaviour.

Markets will never be as competitive as the textbook model assumes, but Sims says governments should ensure they’re as competitive as possible.

And they should bolster competition on the consumer side by taking measures to lower customers’ search costs – the time and effort needed to find the best deal.

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Economists: male, upper class, out of touch

Could there ever be a shortage of economists? And if there were, would that be a bad thing?

At the risk of being drummed out of the economists’ union, it wouldn’t be a big worry of mine.

What I do find of concern is the decline in the number of students studying economics at school and university, as outlined by the Reserve Bank’s Dr  Jacqui Dwyer in a recent speech.

Why should people study economics? Well, as the world’s greatest female economist, Joan Robinson – a contemporary of Keynes – famously said, “the purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.”

Too true. But Dwyer offers a more positive sales pitch: “Economics is relevant to us all. Every day our lives are affected by economic decisions – ones we make personally and ones that are made by others.

“Economics is about how individuals and societies choose to allocate their limited resources to meet their needs and wants. It’s about how we respond to incentives, make trade-offs, weigh up costs and benefits – and how we decide what is efficient and [sometimes] what is fair.”

I’ve been known to find fault with the performance of economists on the odd occasion, but Dwyer is dead right to say economics “contains some powerful concepts and useful frameworks”.

At its best, economics “can help us better understand the choices involved in many personal decisions we make, and better understand the economic conditions and policies that affect our lives”.

If economics is relevant to daily life, and economic literacy brings benefits to society, how widely is it studied at school and university? Short answer: much less than it was.

Dwyer says that year 12 enrolments in economics have fallen by about 70 per cent over the past 25 years. In NSW the decline has been greater, beginning in the early 1990s when economics was displaced by the introduction of business studies, a subject Dwyer diplomatically refers to as “less analytically demanding”. The name of a Disney character comes to mind.

In 1991, economics was the third most popular subject choice in NSW, surpassed only by English and maths. It was taught in nearly all high schools. These days, it’s taught in less than a third of NSW government schools (many of them selective schools) and a little over half of non-government schools (particularly independent schools).

Back in the day, there were roughly equal numbers of males and females, whereas today males outnumber females roughly two to one. Dwyer says this gender imbalance is worse even than for the STEM subjects – science, technology, engineering and maths.

“So over the course of a generation, there has been a pronounced fall in the size and diversity of the economics student population at Australian high schools,” Dwyer says.

At university, Dwyer’s figures are, on their face, better news: the number of economics enrolments have been fairly constant since the early 1990s, falling only slightly since 2001.

But this isn’t so reassuring when you remember that, over the 15 years to 2016, total under-grad and post-graduate enrolments have grown at the average rate of more than 3 per cent a year.


The average annual rate of growth in enrolments has been about 3.6 per cent for banking and finance, 2.75 per cent for management and commerce, and even about 2.5 per cent for STEM, but a small negative for economics.

It’s not known whether this decline represents reduced demand for economists in the job market. But for those who are economically literate, a clue is that graduate starting salaries are higher for economics students than for those taking business-oriented subjects.

I wonder if the apparent decline in economics is partly just the unis’ greater marketing emphasis in naming their degrees. “Finance”, for instance, is actually a specialisation within economics. And banking, management, commerce and accounting are so theory-light that many such degrees would be beefed up intellectually with a fair bit of economics (as was my own commerce degree).

One strange fact is that of the many fewer unis still offering economics, more than half of those that do are in NSW and the ACT.

But the biggest cause for concern are the signs of diminishing diversity among uni students of economics. The proportion of females has fallen to about a third. And well over half of uni economics students are in the top quarter of socio-economic status, with only about 10 per cent in the bottom quarter. It’s similar, but not quite so extreme, for high school economics students.

If you rank the relevant uni degrees according to the proportion of students from high socio-economic status families, economics comes well ahead of banking and finance, then management and commerce, which is well ahead of STEM.

Oh, dearie me. This may explain a lot.

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Competition isn't always as good as we're told

The banking royal commission has many sub-plots. Did you notice the one where a couple of the banks blamed their decisions to keep doing things they knew were dodgy on the pressure of competition?

A chap from Westpac didn’t argue when one of the inquiry’s barristers criticised it for paying “flex commissions” to car dealers arranging loans for people buying cars. The higher the interest rate the dealers could get their customers to accept, the higher the (undisclosed) commission Westpac paid them.

The Australian Securities and Investments Commission has decided to prohibit this practice from November. So why was Westpac persisting with it until then? Because, if it simply stopped doing it off its own bat, it would lose most of its business to competitors.

Another chap, from the Commonwealth Bank, gave a similar explanation for it continuing to base its commissions to mortgage brokers on the size of the loans they organised. If it stopped doing the wrong thing, he said, its brokers would switch to dealing with other banks.

But since it’s a relaxing long weekend, let’s not persist with such a blood-pressure raising subject as the behaviour of our lovely banks. No, let’s just have a calming philosophical discussion about the complications of competition in markets.

Economists like to give us the impression competition is a fabulous thing in any market, all upside and no downside. Competition is something you can never have enough of, they imply.

Don’t believe it. It’s certainly true that a market with no competition – a monopoly – isn’t a great place. Prices are high, service is bad, and when you complain to the company, no one gives a rat’s.

But it doesn’t follow that all competition is wonderful, nor that more is always better. Far from it.

The simple “neo-classical” model of markets assumes a large number of small sellers. The competition between them is so fierce that none of them dares charge a price that’s a cent more than the minimum needed to cover their costs (including the cost of the capital invested in the business, aka profit).

All sellers charge the same price, and if you try selling for a bit more, you sell nothing and go bankrupt.

In the real world, it ain’t so simple. There are various reasons for this, but a big one is the presence of economies of scale – the more you produce, the lower the average cost of what you’re producing.

This allows you to lower your price – which is good for buyers – but, as a consequence, sell a lot more, which is also good for you.

It’s scale economies that explain why so many of our real-world markets are the opposite of what textbooks assume: a small number of large sellers – known as oligopoly. The big four banks are a good example.

When you look at the behaviour of oligopolies you see competition isn’t as wonderful as it’s cracked up to be. Oligopolists compete fiercely against each other, but they compete mainly for market share, and try to avoid competing on price.

According to the economists’ basic model, however, low prices are the key benefit competition brings us. In reality, oligopolists prefer to keep prices and profit margins high by competing via marketing and advertising, including by “differentiating” their products.

Occasionally a firm tries to steal a march on its competitors by innovation – coming up with a product that’s clearly better than the others. Mainly, however, product differentiation involves superficial differences.

Economists preach the virtues of competition because they assume it gives consumers a wider range of products to choose from, which must be a good thing.

But with only a few sellers, competition tends to do the reverse, limiting the choice available. Each firm will have a product range remarkably similar to the others.

This is because the few big firms focus on each other, not the customers. Their goal is not so much to find the magic product the punters will love, as to make sure their competitors don’t get ahead of them. So product ranges tend to be the same.

But how do we explain those two bankers claiming competition prevented them from ceasing dodgy practices? Why wouldn’t a bank want to get itself a reputation for being square with its customers?

Because of another weakness in the economists’ basic model: its assumption that both buyers and sellers know all they need to know about market conditions - an implicit assumption that gaining the knowledge you need to make good choices is easy and costless.

In reality, it costs time and money to be well-informed, which gives sellers (who tend always to be in the market) an inbuilt advantage over buyers, who tend to buy a new car, or change houses, only occasionally.

The first economists to starting thinking such thoughts just a few decades ago ended up winning Nobel prizes for realising that information is “asymmetric”, with sellers usually knowing a lot more than buyers.

In the two cases from the royal commission, the banks and their car dealers and mortgage brokers know about the conflicts of interest caused by their commission arrangements, but customers don’t.

Should one bank decide to stop playing that game, many of its dealers or brokers would have taken their business elsewhere long before the nation’s customers realised it was more trustworthy than its competitors.

Up-to-date economists see this as a class of “market failure” called a “collective action problem”: all the firms in a market realise they’re doing something wrong, or even profit-reducing, but no one’s game to be the first to stop.

The obvious solution is for the government to intervene and ban the practice, letting everyone off the hook at the same time - just as ASIC has decided to do in the case of flex commissions for car dealers. Sometimes competition needs help from a visible hand.

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Free-trade agreements aren't about freer trade

You may think spin-doctoring and economics are worlds apart, but they combine in that relatively modern invention the "free-trade agreement" – the granddaddy of which, the Trans-Pacific Partnership, is presently receiving CPR from the lips of our own heroic lifesaver, Malcolm Turnbull.

It's not surprising many punters assume something called a "free-trade agreement" must be a Good Thing. Economists have been preaching the virtues of free trade ever since David Ricardo discovered the magic of "comparative advantage" in 1815.

Nor is it surprising the governments that put much work into negotiating free-trade agreements – and the business lobbyists who use them to win concessions for their industry clients – want us to believe they'll do wonders for "jobs and growth".

What is surprising is that so many economists – even the otherwise-smart The Economist magazine - assume something called a free-trade agreement is a cause they should be supporting.

Why's that surprising? Because you can't make something virtuous just by giving it a holy name. When you look behind the spin doctors' label you find "free trade" is covering up a lot of special deals that may or may not be good for the economy.

This is the conclusion I draw from the paper, What Do Trade Agreements Really Do? by a leading US expert on trade and globalisation, Professor Dani Rodrik, of Harvard, written for America's National Bureau of Economic Research.

Rodrik quotes a survey of 37 leading American economists, in which almost all agreed that freer trade was better than protection against imports, and were in equal agreement that the North American Free-Trade Agreement (NAFTA) to eliminate tariff (import duty) barriers between the United States, Canada and Mexico, begun in 1994, had left US citizens better off on average.

Their strong support for freer trade is no surprise. One of the economics profession's greatest contributions to human wellbeing is its demonstration that protection leaves us worse off, even though common sense tells us the reverse.

And that, just as we all benefit from specialising in a particular occupation we're good at, then exchanging goods and services with people in other specialties, so further "gains from trade" can be reaped by extending specialisation and exchange beyond our borders to producers in other countries.

What surprised and appalled Rodrik was the economists' equal certainty that NAFTA – a 2000-page document with numerous exceptions and qualifications negotiated between three countries and their business lobby groups – had been a great success.

He says recent research suggests the deal "produced minute net efficiency gains for the US economy while severely depressing wages of those groups and communities most directly affected by Mexican competition".

So there's a huge gap between what economic theory tells us about the benefits of free trade and the consequences of highly flawed, politically compromised deals between a few countries.

Rodrik says trade agreements, like free trade itself, create winners and losers. How can economists be so certain the gains to the winners far exceed the losses to the losers - and that the winners have compensated the losers?

He thinks economists automatically support trade agreements because they assume such deals are about reducing protection and making trade freer, which must be a good thing overall.

What many economists don't realise is that the international battle to eliminate tariffs and import quotas has largely been won (though less so for the agricultural products of interest to our farmers).

This means so-called free-trade agreements are much more about issues that aren't the focus of economists' simple trade theory: "regulatory standards, health and safety rules, investment, banking and finance, intellectual property, labour, the environment and many other subjects besides".

International agreements in such new areas produce economic consequences that are far more ambiguous than is the case of lowering traditional border barriers, Rodrik says, naming four components of agreements that are worrying.

First, intellectual property. Since the early 1990s, the US has been pushing for its laws protecting patents, copyrights and trademarks to be copied and policed by other governments (including ours). The US just happens to be a huge exporter of intellectual property – in the form of pharmaceuticals, software, hardware, music, movies and much else.

Tighter policing of US IP monopoly restrictions pits rich countries against poor countries. And though free trade is supposed to benefit both sides, with IP the rich countries' gains are largely the poor countries' losses. (Rich Australia, however, is a huge net importer of IP).

Second, restrictions on a country's ability to manage cross-border capital flows. The US, which has world-dominating financial markets, always pushes for unrestricted inflows and outflows of financial capital, even though a string of financial crises has convinced economists it's a good thing for less-developed economies to retain some controls.

Third, "investor-state dispute settlement procedures". These were first developed to protect US multinationals from having their businesses expropriated by tin-pot governments.

Now, however, they allow foreign investors – but not local investors – to sue host governments in special arbitration tribunals and seek damages for regulatory, tax and other policy changes merely because those changes reduced their profits.

How, exactly, is this good for economic efficiency, jobs and growth?

Finally, harmonisation of regulations. Here the notion is that ensuring countries have the same regulations governing protection of the environment, working conditions, food, health and safety, and so forth makes it easier for foreign investment and trade to grow.

Trouble is, there's no natural benchmark that allows us to judge whether the regulatory standard you're harmonising with – probably America's - is inadequate, excessive or protectionist.

Rodrik concludes that "trade agreements are the result of rent-seeking, self-interested behaviour on the part of politically well-connected firms – international banks, pharmaceutical companies, multinational firms" (not to mention our farm lobby).

They may result in greater mutually beneficial trade, but they're just as likely to redistribute income from the poor to the rich under the guise of "free trade".

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How Keynesianism came to Australia

Whenever you meet someone who uses the words Keynes or Keynesian as a swear word – or as synonyms for socialist – know that their adherence to neoliberal dogma far exceeds their understanding of mainstream economics.

Though John Maynard Keynes' (rhymes with gains) magnum opus, The General Theory of Employment, Interest and Money, was published in 1936, and he died 10 years later at 62, most economists – including many who wouldn't want to be called Keynesians – acknowledge him as the greatest economist of the 20th century.

It's true that the "monetarist" counter-attack on Keynesian orthodoxy led by Milton Friedman in the 1970s and early 1980s led to lasting changes in prevailing views about how the macro economy should be managed – mainly, that the primary instrument used to stabilise demand should be monetary policy (interest rates) rather than fiscal policy (the budget).

But the monetarists' advocacy of using control of the money supply to limit inflation was soon abandoned as unworkable, and these days few economists would want to be called monetarist.

What remains is a host of fundamentally Keynesian ideas. First is the distinction between micro-economics (study of particular markets) and macro-economics, study of the economy as a whole.

Then there's the idea that governments should seek to stabilise the fluctuations in aggregate (total) demand as the economy moves through the business cycle, a notion rejected by some "new classical" academic economists, but daily practised by the world's central banks and treasuries.

Macro-economists' obsession with fluctuations in gross domestic product is a product of Keynesian thinking, made possible by the development of "national income accounting" by Keynes' followers.

The General Theory was Keynes' attempt to explain how the Great Depression of the 1930s occurred – when the prevailing "neo-classical" orthodoxy said it couldn't occur – and how the world could return to healthy economic growth.

Eventually, it led to a revolution in the way economists thought about the macro economy. Neo-classical theory was out, Keynesian theory was in. Usually, radically different ideas can take years to be accepted – but this time, not so much in Australia.

In his book published earlier this year, A History of Australasian Economic Thought, Alex Millmow, an associate professor at Federation University in Ballarat, explains how Keynesianism​ came to Oz.

Although The General Theory laid out Keynes' new approach in all its exciting but confusing glory, the thinking of Keynes and his associates at Cambridge University in England had been developing since the start of the Depression in late 1929, and expressed in several of his earlier books and papers.

Australian academic economists had also been puzzling over the causes and cure of the international slump. They'd been closely involved in our initial policy response, to devalue the Australian pound, cut wages by 10 per cent and try to balance the budget.

Only slowly did the evolving thinking of Keynes and his circle in Cambridge cause them to doubt the wisdom of this deflationary approach, which made things worse, and shift to the opposite tack of using government spending on capital works to stimulate economic activity and create jobs at a time of mass unemployment.

Cambridge was then the Mecca of economics – especially for Australians – meaning our academics had plenty of contact. Our leading economist of the era was Lyndhurst Falkiner Giblin, a Tasmanian based at the University of Melbourne.

Anther leader was Douglas Copland, a Kiwi also at Melbourne Uni. They were early and influential, if cautious and qualified, supporters of the Keynesian approach.

Among the Australians who studied at Cambridge and brought back Keynesian thinking was E. Ronald Walker (later Sir Edward Walker; several of these people ended up as knights), based at the University of Sydney.

Over the years, Walker did most to inculcate Keynesian macro-economics among Australian academics and students. Another Aussie who returned from Cambridge as a convert was Syd Butlin, also at Sydney, who became our greatest economic historian.

Keynes was interested in how Australia had been hit by the Depression. Among his colleagues and students who made extended visits to Australia in the 1930s was Colin Clark, who stayed on after accepting an invitation to become a top bureaucrat in the Queensland government.

Clark was a brilliant economic statistician, who played a leading part in the development of what these days are known in every country as the national accounts.

When a Labor federal treasurer, Edward "Red Ted" Theodore, proposed a program of reflation in 1931, to counter the effects of the earlier deflationary measures, he quoted Keynes in his support. His plan was blocked by the Senate.

All this explains why Keynesian ideas were widely accepted by Australian economists even before the publication of The General Theory in 1936.

Publication came just as our first royal commission into "the monetary and banking systems" was getting under way. Many economists gave evidence, making a more influential contribution than the bankers, who defended the status quo.

The leading member of the commission, who wrote most of its report, was Richard Mills, an economics professor from Sydney University. Its other member of note was Ben Chifley, future Labor treasurer and prime minister, whose part in the commission caused his biographer to call him "a Keynesian of the first hour".

It's key finding was that "the Commonwealth Bank [then Australia's central bank, as well as a government-owned trading bank] should make its chief consideration the reduction of fluctuations in general economic activity in Australia".

The commission's recommendations shaped the regulation of Australian banking – including establishment of the Reserve Bank of Australia in 1959 – until the advent of financial deregulation in the mid-1980s.

As Millmow has observed elsewhere, the latest banking royal commission is unlikely to be nearly as influential as the first.

The federal government's national mobilisation following the outbreak of war in 1939, then the preparations for "postwar reconstruction and development", saw the full acceptance of Keynesian economics.

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Who's ripping it off? Competition theory and reality

Puzzling over the rich economies' poor productivity improvement and weak wage growth (but healthy profits), American economists are pointing the finger at reduced competition between firms. But can this explain Australia's similar story?

Jim Minifie, of the Grattan Institute, set out to answer this in his report, Competition in Australia.

Economists regard strong competition between businesses as essential to ensuring market economies function well, to the benefit of consumers and workers.

Competition is what economic theory says stops us being ripped off by the capitalists. Firms that overcharge for their products lose business to firms that undercut them.

So competition pushes prices down towards costs (which economists – but not accountants – define as including the "cost of capital", or "normal profit", the minimum rate of profit needed to induce firms to stay in the market).

Competition helps ensure that economic resources - land, labour and (physical) capital – move to the uses most valued by consumers.

Competition also encourages firms to come up with new or better products – or less costly ways of producing a product – in the hope of higher profits. But those that succeed in this soon find their competitors copying their ideas, and bidding down the price to get a bigger slice of the action.

The innovations improve the economy's productivity (output per unit of input), but competition soon takes away the higher profits, delivering them into the hands of consumers, who often get better products for lower prices.

That's the theory. Question is, to what extent does it hold in practice? And does it hold less in recent years than it used to?

The simple theory assumes any market has a large number of sellers, each too small to be able to influence the market price. In practice, however, many of our markets are dominated by two, three or four big firms.

Why? Mainly because of the presence of economies of scale. It's very common that the more you produce of something – up to a point – the less each unit costs.

So, it makes great sense to have a small number of big firms doing much of the production – provided competition ensures most of the cost saving is passed on to customers in lower prices. Which, as a general rule, it has been over the decades.

Trouble is, big firms do have some degree of control over prices. And it's common for the few big firms in an industry to come to an unspoken agreement to compete using advertising or product differentiation, but not price.

Firms can increase their pricing power by taking over their competitors to get a bigger share of the market. It's the role of "competition policy" – run in our case by the Australian Competition and Consumer Commission – to prevent overt collusion between firms, and takeovers intended to increase market power. But how well is that working?

"Natural monopolies" – where it simply wouldn't make economic sense for more than one firm to serve a particular market, such as rival sets of power lines running down a street, or two service stations in a small town - are another common departure from the theoretical model.

So, what did Minifie find in his study of competition in practice? He found evidence it had lessened in the United States, but not here.

He found plenty of markets where a few firms did most of the business. But "the market shares of large firms in concentrated sectors are not much higher in Australia than in other countries [of comparable size], and they have not grown much lately," he says.

Nor have their revenues (sales) grown faster than gross domestic product. The profitability of firms – profits relative to funds invested - hasn't risen much since 2000.

Minifie identifies eight industries characterised by natural monopoly (in descending order of size): electricity transmission and distribution, wired telecom, rail freight, airports, toll roads, water transport terminals, ports and pipelines.

Then there are nine industries where large economies of scale mean they're dominated by a few firms: supermarkets, wireless telecom, domestic airlines, then (of roughly equal size) internet service providers, pathology services, newspapers, petrol retailing, liquor retailing and diagnostic imaging.

Next are eight industries subject to heavy regulation by government: banks, residential aged care, general insurance, life insurance, taxis, pharmacies, health insurance and casinos.

(Often, these industries are heavily regulated for sound public policy reasons, but the regulation often acts as a barrier to new firms entering the market, thus allowing them to be dominated by a few firms.)

But note this: by Minifie's calculations, natural monopolies account for only about 3 per cent of "gross value added" (a variant of GDP), while high scale-economies industries account for 5 per cent and heavily regulated industries for 7 per cent.

So that means the parts of the economy where "barriers to entry" limit competitive pressure make up about 15 per cent of the economy. Then there are 29 industries with low barriers to entry making up the rest of the "non-tradables" private sector, and about half the whole economy.

That leaves the tradables sector (export and import-competing industries) accounting for 14 per cent of the economy and the public sector making up the last 20 per cent.

Even so, Minifie confirms that, in industries dominated by a few firms, many firms make "super-normal" profits – those in excess of what's needed to keep them in the industry.

By his estimates, up to half the total profits in the supermarket industry are super-normal. In banking it's about 17 per cent.

Other companies and sectors with substantial super profits include Telstra, some big-city airports, liquor retailers, internet service providers, sports betting agencies and private health insurers.

Comparing this last list with the lists of natural monopolies and heavily regulated industries suggests governments could be doing a much better job of ensuring the regulators haven't been captured by the companies being regulated.

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We should rescue economics from the folly of neoliberalism

There's no swear word in politics today worse than "neoliberalism". It's badly on the nose, and the reaction against it has a long way to run. But what is it, exactly? Where does mainstream economics stop and neoliberalism begin?

The term means different things to different people. Professor Dani Rodrik, of Harvard, says in the Boston Review the term is used as a catchall for anything that smacks of deregulation, liberalisation, privatisation or fiscal (budgetary) austerity.

I've always thought of it as a fundamentalist, oversimplified, dogmatic version of conventional economics, one from an elementary textbook, not a third-year text that adds the complications of market power, externalities​ (costs or benefits not captured in market prices), economies of scale, incomplete and asymmetric (lop-sided) information, and irrational behaviour.

Rodrik's conception of the term isn't very different. He thinks mainstream economics needs to be rescued from neoliberalism because, as people heap scorn on it, we risk throwing out some of economics' useful ideas.

Which are? That the efficiency with which an economy's resources are allocated is a critical determinant of its performance. That efficiency, in turn, requires aligning the incentives of households and businesses with "social" costs and benefits (so as to internalise the externalities).


That the incentives faced by entrepreneurs, investors and producers are particularly important when it comes to economic growth. Growth needs a system of property rights and contract enforcement that will ensure those who invest can retain the returns on their investments.

And that the economy must be open to ideas and innovations from the rest of the world. Of course, economies also need the macro-economic stability produced by sound monetary policy (low inflation) and budgetary sustainability (manageable levels of public debt).

Does all that smack more of neoliberalism than mainstream economics to you? If it does it's because mainstream economics shades too easily into ideology, constraining the choices that we appear to have and providing cookie-cutter solutions.

"A proper understanding of the economics that lies behind neoliberalism would allow us to identify – and to reject – ideology when it masquerades as economic science. Most importantly, it would help us develop the institutional imagination we badly need to redesign capitalism for the 21st century."

There's nothing wrong with markets, private entrepreneurship, or incentives, Rodrik says, provided they're deployed appropriately. Their creative use lies behind the most significant economic achievements of our time.

The central conceit and fatal flaw of neoliberalism is "the belief that first-order economic principles map onto a unique set of policies, approximated by a Thatcher-Reagan-style agenda" – also known as the "Washington consensus".

Take intellectual property rights. They're good when they protect innovators from free-riders, but bad when they protect them from competition (as they often do when the US Congress has finished with 'em).

Consider China's phenomenal economic success. It's largely due to its orthodoxy-defying tinkering with economic institutions. "China turned to markets, but did not copy Western practices in property rights. Its reforms produced market-based incentives through a series of unusual institutional arrangements that were better adapted to local context," Rodrik says.

Some may say China's institutional innovations are purely transitional. Soon enough it will have to converge on Western-style institutions if it's to maintain its economic progress. Well, maybe, maybe not.

What neoliberal proponents of the single route to economic prosperity keep forgetting is that none of the economic miracles that preceded China's – in South Korea, Taiwan and Japan – followed the Western formula. And each did it differently.

Even among the rich countries we see much variance from the neoliberal cookie cutter. The size of the public sector, for instance, varies from a third of the economy in Korea, to nearly 60 per cent in Finland.

In Iceland, 86 per cent of workers are in a trade union; in Switzerland it's 16 per cent. In America firms can fire workers almost at will; in France they must jump through many hoops.

Rodrik repeats an old economists' saying, one forgotten by the neoliberal oversimplifiers. "Good economists know that the correct answer to any question in economics is: it depends."

It depends on the particular circumstances, on how well your economic "institutions" (laws, official bodies, norms of behaviour) fit with those the model assumes to exist, on what you're trying to achieve, on your priorities, and on the political constraints you face.

As the Chief Scientist, Dr Alan Finkel, said when asked if he preferred his own emissions intensity scheme to Malcolm Turnbull's national energy guarantee: "There are a lot of ways to skin a cat."

Economics has many useful insights to offer the community. It must be rescued from neoliberalism because neoliberalism is simply bad economics.

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Unis should never be allowed to set their own fees

The Productivity Commission has changed its ideological tune, shifting away from the slavish adherence to an idealised version of the "neoclassical" model of the economy for which it and its predecessors became notorious.

It's moved to a more nuanced approach, recognising the many respects in which real-world markets differ from those described in elementary textbooks.

This shift has been underway since the present chairman of the commission, Peter Harris, succeeded Gary Banks in 2012.

You could see it in the commission's 2015 report on the Workplace Relations Framework, which acknowledged, readily and in detail, the factors that made the simple neoclassical, demand-and-supply model unsuitable for analysing the labour market.

But it's even more apparent in the commission's blueprint for a very different approach to economic reform, Shifting the Dial. Consider this.

Remember the plan in the Abbott government's first budget, of 2014, to deregulate the fees universities are allowed to charge students doing undergraduate degrees?

It was a logical next step following the Gillard government's decision some years earlier to deregulate the number of undergraduate places each university was permitted to offer.

The unis had responded by hugely increasing the number of government-funded places, at greatly increased cost to the federal budget, after successive governments had spent decades trying to quietly privatise the unis and get them off the budget.

The economic rationale was that "market forces" – competition between the unis – would prevent them for using their new fee-setting power to overcharge students.

It was a reform that all right-thinking people should support, and those terrible popularity-seekers in the Senate should never have blocked.

Get this: as part of its plan to improve the teaching of uni students, and in the course of explaining how some students are being charged higher fees than they should be, the commission also shows why deregulating fees would have been a crazy idea.

At the same time as it allowed unis to set their own fees, the government's intention had been to cut its funding of places by 20 per cent. It wasn't hard to see that, as unis continued to raise their fees each year, the government would keep cutting its own funding contribution until it was no more.

The commission argues (on page 109) that government "regulation" of the maximum fees unis may charge for particular undergrad courses "is necessary because price competition [between universities] is difficult to establish in the domestic university market.

"This is primarily because the vast majority of domestic students have access to income-contingent HELP loans and consequently have a low price sensitivity, which was a necessary by-product of enabling university access on merit, rather than family income."

Get it? The elementary model's promise that "market forces" – competition between sellers, plus the self-interest of buyers – will stop firms overcharging rests on an assumption that customers have to pay the price upfront.

In the case of uni fees, however, the upfront price is paid by the government, and students incur a debt to the government, which they don't have to start repaying until their income reaches a certain level at some uncertain time in the future.

How long they'll be given to repay the debt is also uncertain, though it's certain their repayments will be geared to their ability to pay, and the only interest they'll pay is the rate of inflation. Cushiest loan you'll ever get.

With the cost of university tuition to a student so far into the future and so uncertain, it's unrealistic to assume students will shop around to find the lowest-charging uni. (Actually, they all charge the maximum allowed.)

Remember, too, that the fee is less than the full cost of the tuition, meaning the unis are "selling" a product whose retail price has been heavily subsidised by the government.

The commission notes that price competition is further limited by the geographic immobility of students. Because more than 80 per cent of commencing students live at home, and moving out would add greatly to their costs, you might get competition between the unis in a particular capital city, but that's all.

But even that's unlikely. The elementary model assumes "perfect knowledge" – both buyers and sellers know all they need to know about the prices and qualities of the products on offer.

In reality, knowledge is far from complete, and is often "asymmetric" – sellers know far more than buyers, usually because the sellers are professionals, whereas the buyers are amateurs.

The commission explains why all unis – big-name or bad-name, city or country – charge the maximum fees allowed.

"In the absence of good information, lower prices may undermine the prestige of a university and its capacity to attract good students," the commission says.

This is an admission of a weakness in the elementary model that affects far more than uni fees. The assumption of perfect knowledge leads to the further assumption that the prices market forces allow a firm to charge fully reflect the quality of its products relative to the quality of rival products.

As behavioural economists have pointed out, however, quality is something that's often very hard for buyers to know in advance. Only after they've bought it and tried it will they know. Think bottles of wine.

So whereas economists assume buyers' foreknowledge of differences in quality is what determines differences in the prices of similar products, buyers who don't know the differences in quality assume they can use prices as a quality indicator. Higher price equals higher quality.

So why don't lesser unis seek to attract more students by charging lower fees than the big boys? Because it would be taken as an admission of their inferior quality, and could lose as many customers as it attracted, maybe more.

The assumption that market forces would prevent unis from abusing their freedom to set fees as they chose was extraordinarily naive, as the commission is now happy to explain.

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Politicised Treasury bites own tail, covers for Turnbull

Shadow treasurer Chris Bowen is right: One of the Abbott-Turnbull government's various acts of economic vandalism is its politicisation of the once-proud federal Treasury.

Among Tony Abbott's first acts upon becoming prime minister in 2013 was to sack the secretary to Treasury, Dr Martin Parkinson.

Even so, Parkinson was left in place for more than a year before being replaced by John Fraser, a retired funds manager, hand-picked by Abbott.

Fraser had risen through the ranks of Treasury under the formative influence of the legendary John Stone, until he left in the early 1990s to make his fortune in the money market.

When Fraser returned in triumph to take the top job, singing the praises of Margaret Thatcher, Ronald Reagan and David Cameron's austerity policy in Britain, it seemed clear he hadn't spent the intervening decades keeping up with developments in thinking about fiscal (budgetary) policy.

The Abbott government's next act of politicisation came a few months later with the publication of Treasury's fourth five-yearly intergenerational report.

It had been turned into a partisan propaganda rag, full of dubious figuring intended to prove the Abbott government's failure to return the budget to surplus as promised was all the fault of the previous Labor government. The media tossed the report aside.

The latest stage in the politicisation of Treasury came last week with its publication of a report on The Effectiveness of Federal Fiscal Policy, commissioned from Professor Tony Makin, of Griffith University.

If you've never heard of Makin's work, you'll be surprised to learn he regards fiscal policy as utterly ineffective and probably counterproductive.

If you have heard of it, you won't be. Makin's views on the ineffectiveness of fiscal "activism" – using budgetary stimulus to assist recovery during recessions – are well known, unchanged and unchanging.

He's the go-to guy for anyone who'd like an independent report asserting that fiscal policy doesn't work – never has and never could.

In all the decades since Makin made up his mind on this question, all the academic theorising and empirical evidence from the real world have served only to confirm the wisdom of that decision.

His paper's "review" starts by rubbishing that deluded fool John Maynard Keynes – who, presumably, will never attain the intellectual heights reached by Makin and his mates – and praising such giants of the profession as Robert Mundell, Marcus Fleming, Robert Lucas and Thomas Sargent.

It then reprises Makin's well-rehearsed argument that the Rudd government's budgetary stimulus – undertaken at the urging of the then Treasury secretary, Dr Ken Henry – was unnecessary and unhelpful.

And finally it does a lot of hand-wringing about the rapid growth in the public debt (especially when you exaggerate the size of the debt by quoting gross rather than net, a trick Makin seems to have learnt from Barnaby Joyce), the burden being left to our children, and the need to make reducing recurrent government spending our top fiscal priority.

One small problem – the last time Makin ran his anti-activism line, in a paper commissioned by the Minerals Council, Treasury issued a detailed refutation. Makin seems to have taken none of its substantive criticisms into account in his Treasury-commissioned version.

This is a measure of the extent to which politicisation has changed Treasury's tune.

Apart from correcting various factual errors, old Treasury noted that the 1960s-era Mundell-Fleming open economy model Makin uses relies on extreme assumptions that don't hold in Australia's case, and certainly didn't hold during the global financial crisis.

Makin is unimpressed that, at that time, such lightweights as the International Monetary Fund and the Organisation for Economic Co-operation and Development heaped praise on the Rudd government's budgetary stimulus.

So why has new Treasury chosen now to pay one of its former critics to repeat his ill-founded criticisms?

One reason is that Fraser left Treasury not long after it had advised the Hawke government not to use fiscal policy to respond to the severe recession of the early 1990s, but to rely solely on monetary policy (lower interest rates).

Henry and others in Treasury eventually realised how bad that advice had been. Indeed, Henry's advice to Rudd was influenced by a determination not to repeat the mistake. But Fraser had left the building by then and didn't read the memo.

Another reason is that, now, both the IMF and the OECD are urging the Turnbull government to help strengthen the economy by increasing its spending on worthwhile infrastructure.

What's more, some guy called Dr Philip Lowe has been saying the same thing. Forcefully.

Makin has been hired to tell these idiots they don't know what they're talking about.

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