Wealth and happiness don't give meaning to our lives

Easter Monday’s a good a time to reflect on what we’re doing with our lives and why we’re doing it. I’ve been banging on about all things economic for more than 40 years, but if I’ve left you with the impression economics and economic growth is the be-all and end-all, let me apologise for misleading you.

The more I’ve learnt about economics, the more aware I’ve become of its limitations. Economics is the study of production and consumption, getting and spending. But as someone connected with Easter – not the Easter Bunny – once said, there’s more to life than bread alone.

Unfortunately, the conventional way of thinking about the economy has pretty much taken for granted the natural environment in which our economic activity occurs, and the use of natural resources and ecosystem services on which that activity depends.

We’re learning the hard way that this insouciance can’t continue. We’re damaging our environment in ways that can’t continue. I keep writing about the need for economic growth because, as the economy is presently organised, it’s pretty much the only way to provide sufficient jobs for our growing population.

But that just means we need to redefine economic growth to mean getting better, not bigger (and probably should do more to limit world population growth).

Conventional economics focuses on the material aspects of life: producing and consuming goods and services; buying and selling property. There’s no denying the inescapable importance of the material in our lives – “bread” – but conventional economics encourages our obsession with material accumulation at the expense of other important dimensions of our lives.

Some aspects of economic activity can damage our physical health – smoking, drinking, burning dirty fossil fuels, even eating fast foods – but we need to become more aware of the way the fast pace and competitive pressures of modern life also threaten our mental health. Too many people – particularly the young – suffer chronic stress, anxiety, depression and suicidal thoughts.

Too much emphasis on material success can also come at the expense of the social aspect of our lives – our relationships with family, friends and neighbours – which, when we’re thinking straight, we realise give us far more satisfaction than any new car or pay rise. Economists often advocate policies that will increase the efficiency of our use of resources without giving a moment’s thought to their effect on family life.

Nor should we allow our pursuit of material affluence to come at the expense of the moral and spiritual aspects of lives. I’ve just read social commentator Hugh Mackay’s book, Beyond Belief, which has done so much to clarify my thinking about Christianity, religion and spirituality that I’m sorry I didn’t get to it earlier.

Yet another thing that mars conventional economic thinking is its emphasis on the individual as opposed to the community, it’s effective sanctification of self-interest as the economy’s only relevant driving force, and its obsession with competition and neglect of the benefits of co-operation.

Mackay says that, if you ignore the doctrines and dogmas of the church – all the things you’re required to believe in – and focus on the teachings of Jesus, the first thing to strike you is that none of it was about the pursuit of personal happiness.

“The satisfactions offered or implied are all, at best, by-products of the good life,” he says. “The emphasis is on serving others and responding to their needs in the spirit of loving-kindness, the strong implication being that the pursuit of self-serving goals, like wealth or status, will be counterproductive.”

Jesus’ teachings “were all about how best to live: the consistent emphasis was on loving action, not belief. According to Jesus, the life of virtue – the life of goodness – is powered by faith in something greater than ourselves (love, actually), not by dogma.”

Mackay says we should “avoid the deadly trap of regarding faith as a pathway to personal happiness. The idea that you are entitled to happiness, or that the pursuit of personal happiness is a suitable goal for your life, is seriously misguided.

“If we know anything, we know that’s a fruitless, pointless quest – doomed to disappoint – because . . . our deepest satisfactions come from a sense of meaning in our lives, not from experiencing any particular emotional state like happiness or contentment.”

The self-absorbed mind’s entire focus is individualistic. It’s “the polar opposite of the moral mind. Its orientation is towards the self, not others; its currency is competition, not cooperation; it’s all about getting, not giving. Its goal is the feel-good achievement of personal gratification, however that might be achieved and regardless of any impact it might have on the wellbeing of ‘losers’.”

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How economics could get better at solving real world problems

The study of economics has lost its way because economists have laboured for decades to make their social science more mathematical and thus more like a physical science. They’ve failed to see that what they should have been doing is deepening their understanding of how the behaviour of “economic agents” (aka humans) is driven by them being social animals.

In short, to be of more use to humanity, economics should have become more of a social science, not less.

This is the conclusion I draw from the sweeping criticism of modern economics made by two leading British economics professors, John Kay and Mervyn King, in their book, Radical Uncertainty: Decision-making for an unknowable future.

But don’t hold your breath waiting for economists to see the error of their ways. There are two kinds of economist: academic economists and practising economists, who work for banks, businesses and particularly governments or, these days, are self-employed as “economic consultants”.

Whenever I criticise “economists” – which I see as part of the service I provide to readers – the academics always assume I’m talking about them. It rarely occurs to them that I’m usually talking about their former students, economic practitioners – the ones who matter more to readers because they have far more direct influence over the policies governments and businesses pursue.

You see from this just how inward-looking, self-referential and self-sustaining academic economics has become. The discipline’s almost impervious to criticism. Criticism from outside the profession (including “the popular press”) can usually be dismissed as coming from fools who know no economics. If you’re not an economist, how could anything you say have merit?

But Kay and King are insiders. As governor of the Bank of England, King was highly regarded internationally. Kay has had a long career as an academic, author, management consultant, Financial Times columnist and head of government inquiries.

So their criticism will just be ignored, as has been most of the informed criticism that came before them. Their arguments will be misrepresented – such as that they seem opposed to all use of maths and statistics in economics. They’re not. But there’ll be little face-to-face debate. Too discomforting.

Trouble is, the push to increase the “mathiness” of economics has gone for so long that all the people at the top of the world’s economics faculties got there by being better mathematicians than their rivals.

They don’t want to be told their greatest area of expertise was a wrong turn. Similarly, all the people at the bottom of the academic tree know promotion will come mainly by demonstrating how good they are at maths.

Kay and King complain that economics has become more about technique – how you do it – than about the importance of the problems it is (or isn’t) helping people grapple with in the real world. (This may help explain why, in many universities, economics is losing out to business faculties.)

In support of their case for economics needing to be more of a social science, Kay and King note there are three styles of reasoning: deductive, inductive and “abductive”. Deductive reasoning reaches logical conclusions from stated premises.

Inductive reasoning seeks to generalise from observations, and may be supported or refuted by later experience. Abductive reasoning seeks to provide the best explanation for a particular event. We do this all the time. When we say, for instance, “I think the bus is late because of congestion in Collins Street”.

Kay and King say all three forms of reasoning have a role to play in our efforts to understand the world. Physical scientists (and mathy economists) prefer to stick to deductive reasoning. But this is possible only when we study the “small world” where all the facts and probabilities are known – the world of the laws of physics and games of chance.

In the “large world”, where we must make decisions with far from complete knowledge, we have to rely more on inductive and abductive reasoning. “When events are essentially one-of-a-kind, which is often the case in the world of radical uncertainty, abductive reasoning is indispensable,” they say.

And, so far from thinking “as if” we were human calculating machines, “humans are social animals and communication plays an important role in decision-making. We frame our thinking in terms of narratives.”

Able leaders – whether in business, politics or everyday life – make decisions, both personal and collective, by talking with others and being open to challenge from them.

The Nobel prize-winning economist Professor Robert Schiller, of Yale, has cottoned on to the importance of narratives in explaining the behaviour of financial markets, but few others have seen it. Most academic economists just want to be left alone to play the mathematical games they find so fascinating.

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Humans beat computers at knowing when to leap into the unknown

Two leading British economists who’ve launched a scathing critique of the unrealistic assumptions their peers have added to conventional economics to make it more tractable mathematically have not spared one of my great favourites: “behavioural economics”. It has lost its way, too.

The economists are Professor John Kay of Oxford University and Professor Mervyn King, a former governor of Britain’s central bank, the Bank of England. Their criticism is in the book, Radical Uncertainty: Decision-making for an unknowable future.

As I wrote in this column last week, economists have been working for decades to make their discipline more academically “rigorous” by using mathematical techniques better suited to the “stationary” physical world – where everything that happens is governed by the unchanging laws of physics – or to games of chance, where the probability of something happening can be calculated easily and accurately.

Kay and King call this modelling “small worlds”, where the right and wrong answers are clearly identified, whereas the large worlds occupied by consumers, businesses and government policymakers are characterised by “radical uncertainty”. We must make decisions with so little of the information we need – about the present and the future – that we can never know whether we jumped the right way, even after the event.

Economists’ analysis and predictions are based on the assumption that everything individuals and businesses do is “rational” – a word to which they attach their own, highly technical meaning. They think it means the decision-maker was able to consider every possibility and think completely logically.

Behavioural economics – which has been a thing for at least 40 years – involves economists using the findings of psychology to help explain the way people actually behave when they make economic decisions. It takes the assumption that people always act “rationally” and subjects it to empirical testing. Where’s the hard evidence that people really behave that way?

It shouldn’t surprise you that behavioural economists have found much behaviour doesn’t fit the economists’ definition of rational. They’ve done many laboratory experiments asking people (usually their students) questions about whether they prefer A, B, C or D, and have put together a list of about 150 “biases” in the way people think.

These “biases” include that people suffer from optimism and overconfidence, overestimating the likelihood of favourable outcomes. We are guilty of “anchoring” – attaching too much weight to the limited information we hold when we start to think about a problem. We are victims of “loss aversion” – hating losses more that we love the equivalent gains. And much more.

But this is where Kay and King object. As has happened before in economics, some highly critical finding is taken by the profession and reinterpreted in a way that’s less threatening to the conventional wisdom.

Over the years, I’ve written about many of these findings, taking them to mean the economists’ theory is deficient and needs to be changed.

But Kay and King claim the profession has turned this on its head, seeing the findings as meaning that a lot of people behave irrationally and need to be shown how to be more sensible.

This is an old charge against conventional economists: they don’t want to change their model to fit the real world, they want to change the world so it fits their model.

Why? Because economists think they know what behaviour is right and what’s wrong. What’s rational and what’s irrational. There is, indeed, a popular book about behavioural economics called Predictably Irrational. (The economists love the “predictable” bit – it implies they can get their own predictions right with only minor modifications.)

Kay and King object that most (though not all) the listed “biases” are not the result of errors in beliefs or logic. Most are the product of a reality in which decisions must be made in the absence of a precise and complete description of the world in which people live.

“Real people do not optimise, calculate subjective probabilities and maximise expected utilities; not because they are lazy, or do not have the time, but because they know that they cannot conceivably have the information required to engage in such calculation,” they say.

They note that whereas the American behavioural economists led by the Nobel-prize-winning psychologist Daniel Kahneman have put a negative connotation on the “heuristics” – mental short-cuts – people take in making their decisions, a rival group led by the German psychologist Gerd Gigerenzer sees it as proof of how good humans are at coping with radical uncertainty. It’s amazing how often we get it right.

Kay and King agree, saying that if humans don’t make decisions in the computer-like way economists assume we do, “it is not because we are stupid but because we are smart. And it is because we are smart that humans have become the dominant species on Earth.

“Our intelligence is designed for large worlds, not small. Human intelligence is effective at understanding complex problems within an imperfectly defined context, and at finding courses of action which are good to get us through the remains of the day and the rest of our lives. [Which aren’t the best solutions, but are “good enough”.]

“The idea that our intelligence is defective because we are inferior to computers in solving certain kinds of routine mathematical puzzles fails to recognise that few real problems have the character of mathematical puzzles.

“The assertion that our cognition is defective by virtue of systematic ‘biases’ or ‘natural stupidity’ is implausible in the light of the evolutionary origins of that cognitive ability. If it were adaptive [in the survival-of-the-fittest sense] to be like computers we would have evolved to be more like computers than we are. . .

“Our knowledge of context and our ability to interpret it has been acquired over thousands of years. These capabilities are encoded in our genes, taught to us by our parents and teachers, enshrined in the social norms of our culture,” they conclude.

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Why economists get so many of their predictions wrong

Sometimes the study of economics – which has gone on for at least 250 years – can take a wrong turn. Many economists would like to believe their disciple is more advanced than ever, but in the most important economics book of 2020 two leading British economists argue that, in its efforts to become more “rigorous”, it’s gone seriously astray.

The book is Radical Uncertainty: Decision-making for an unknowable future, by Professor John Kay of Oxford University and Professor Mervyn King, a former governor of the Bank of England.

The great push in economics since World War II has been to make the subject more rigorous and scientific by expressing its arguments and reasoning in mathematical equations rather than words and diagrams.

The physical sciences have long been highly mathematical. Economists are sometimes accused of trying to distinguish their discipline from the other social sciences by making it more like physics.

Economics is now so dominated by maths it’s almost become a branch of applied mathematics. Sometimes I think that newly minted economics lecturers know more about maths than they do about the economy.

Kay and King don’t object to the greater use of maths (and I think economists have done well in using advanced statistical techniques to go beyond finding mere correlations to identifying causal relationships).

But the authors do argue that, in their efforts to make conventional economic theory more amenable to mathematical reasoning, economists have added some further simplifying assumptions about the way people and businesses and economic policymakers are assumed to behave which take economic theory even further away from reality.

They note that when, in 2004, the scientists at NASA launched a rocket to orbit around Mercury, they calculated that it would travel 4.9 billion miles and enter the orbit in March 2011. They got it exactly right.

Why? Because the equations of planetary motion have been well understood since the 17th century. Because those equations describing the way the planets move are “stationary” – meaning they haven’t changed in millions of years. And because nothing that humans do or believe has any effect on the way the planets move.

Then there’s probability theory. You know that, in games of chance, the probability of throwing five heads in a row with an unbiased coin, or the probability that the next card you’re dealt is the ace of spades can be exactly calculated.

In 1921, Professor Frank Knight of Chicago University famously argued that a distinction should be drawn between “risk” and “uncertainty”. Risk applied to cases where the probability of something happening could be calculated with precision. Uncertainty applied to the far more common cases where no one could say with any certainty what would happen.

Kay and King argue that economics took a wrong turn when Knight’s successor at Chicago, a chap called Milton Friedman, announced this was a false distinction. As far as he was concerned, it could safely be assumed that you could attach a probability to each possible outcome and then multiply these together to get the “expected outcome”.

So economists were able to get on with reducing everything to equations and using them to make their predictions about what would happen in the economy.

The authors charge that, rather than facing up to all the uncertainty surrounding the economic decisions humans make, economics has fallen into the trap of using a couple of convenient but unwarranted assumptions to make economics more like a physical science and like a game of chance where the probability of things happening can be calculated accurately.

There’s a big element of self-delusion in this. If you accuse an economist of thinking they know what the future holds, they’ll vehemently deny it. No one could be so silly. But the truth is they go on analysing economic behaviour and making predictions in ways that implicitly assume it is possible to know the future.

Kay and King make three points in their book. First, the world of economics, business and finance is “non-stationary” – it’s not governed by unchanging scientific laws. “Different individuals and groups will make different assessments and arrive at different decisions, and often there will be no objectively right answer, either before or after the event,” they say.

Why not? Because we so often have to make decisions while not knowing all there is to know about the choices and consequences we face in the world right now, let alone what will happen in the future.

Second, the uncertainty that surrounds us means people cannot and do not “optimise”. Economics assumes that individuals seek to maximise their satisfaction or “utility”, businesses maximise shareholder value and public policymakers maximise social welfare – each within the various “constraints” they face.

But, in reality, no one makes decisions the way economic textbooks say they do. Economists know this, but have convinced themselves they can still make accurate predictions by assuming people behave “as if” they were following the textbook. That is, people do it unconsciously and so behave “rationally”.

Kay and King argue that people don’t behave rationally in the narrow way economists use that word to mean, but neither do they behave irrationally. Rather, people behave rationally in the common meaning of the word: they do the best they can with the limited information available.

Third, the authors say humans are social animals, which means communication with other people plays an important role in the way people make decisions. We develop our thinking by forming stories (“narratives”) which we use to convince others and to debate which way we should jump. We’ve built a market economy of extraordinary complexity by developing networks of trust, cooperation and coordination.

We live in a world that abounds in “radical” uncertainty – having to make decisions without all the information we need. Rather than imagining they can understand and predict how people behave by doing mathematical calculations, economists need to understand how humans press on with life and business despite the uncertainty - and usually don’t do too badly.

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Why much of what we're told about taxes is off beam

There are lots of ways to describe the subject matter of economics, but the ponciest way is to say it’s about “the study of incentives”. It’s true, but a less grandiose way to put it is that conventional economists are obsessed by prices and not much else.

If you’ve heard someone being accused of knowing “the price of everything, but the value of nothing”, that phrase could have been purpose-built for economists. Read on and you’ll see why economists so often make bad predictions and give bum advice.

The early weeks of most courses in economics are devoted to explaining the economists’ version of how markets work. How the demand for a particular good or service interacts with the supply of the particular item to determine its price.

Over time, movements in the price act as signals to both the buyers of the product and its sellers. A rise in the price tells buyers they should use the now more-expensive product less wastefully, and maybe start looking for some alternative product that’s almost as good but doesn’t cost as much. On the other hand, a fall in the price tells buyers to bog in.

To the sellers, however, the price signals sent by a price change are reversed. A price rise says: this product's now more profitable, produce more; a fall in the price signals that supply is now less profitable, so produce less.

You can see how changes in the price act as an incentive for buyers and sellers to change their behaviour.

You see too how, following some disturbance, this “price mechanism” acts to return the market for the product to “equilibrium” – balance between the supply of it and the demand for it. It sets off what real scientists call a “negative feedback loop”: when prices rise, it acts to bring them back down by reducing demand and increasing supply; when prices fall, it brings them back up by reducing supply and increasing demand.

Note that all this is about changes in relative prices – the price of one product relative to the prices of others. It ignores inflation, which is a rise in the level of prices generally.

The way economists think, taxes are just another price. And there’s no topic where people worry more about the effect of incentives than taxes – particularly the effect of income tax on the incentive to work.

Consider this experiment, conducted in 2018 by two (married) economists from the Massachusetts Institute of Technology, Esther Duflo and Abhijit Banerjee, with Stefanie Stantcheva of Harvard. Duflo and Banerjee were awarded the Nobel prize in economics in 2019.

The three surveyed 10,000 people from all over America, asking half of them questions about how people would react to several financial incentives. Half of these respondents said they expected at least some people to stop working in response to a rise in the tax rate, and 60 per cent expected people to work less.

Almost half of the 5000 respondents expected the introduction of a universal basic income of $US13,000 ($17,000) a year, with no strings attached, to lead people to stop working. And 60 per cent thought a Medicaid program (providing healthcare for people on low incomes) with no work requirement would discourage people from working.

But here’s the trick: the economists asked people in the other half of their 10,000 sample the same questions, but how they themselves would react, not how they thought other people would. Their responses were significantly different, with 72 per cent of them declaring that an increase in taxes would “not at all” lead them to stop working.

As Duflo and Banerjee summed it up in their book, Good Economics for Hard Times, and in an excerpt in the New York Times, “Everyone else responds to incentives, but I don’t”.

It’s possible those people could be deluding themselves – after all, most people believe they’re not influenced by advertising, when it’s clear advertising works – but in this case the hard evidence shows financial incentives aren’t nearly as influential as is widely assumed.

The first place to see this is among the rich. “No one seriously believes that salary caps lead top athletes to work less hard in the United States than they do in Europe, where there is no cap. Research shows that when top tax rates go up, tax evasion increases . . . but the rich don’t work less,” they say.

And we see it among the poor. “Notwithstanding all the talk about ‘welfare queens,’ [and the use our Morrison government has made of similar talk to justify keeping the JobSeeker dole payment low] 40 years of evidence shows that the poor do not stop working when welfare becomes more generous,” they say.

“When members of the Cherokee tribe started getting dividends from the casino on their land, which made them 50 per cent richer on average, there was no evidence that they worked less.”

It’s true that in many circumstances – but not something as deeply consequential as decisions about how much work to do – differences in prices will influence the choices people make. In a supermarket, for instance, many shoppers will reach for the cheaper jar of peanut butter.

But when we’re making decisions about bigger and more consequential issues – such as whether to work and how much of it to do – monetary incentives such as the rate of tax on it, go into the mix with a multitude of other, non-monetary incentives.

Such as? “Something we know in our guts: status, dignity, social connections. Chief executives and top athletes are driven by the desire to win and be the best. The poor will walk away from social benefits if they come with being treated like a criminal. And among the middle class, the fear of losing their sense of who they are,” Duflo and Banerjee conclude.

Why do economists so often make bad predictions and give bum advice? Because they keep forgetting that a model of economic behaviour that focuses so heavily on prices leaves out many other powerful incentives.

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Budget warning: more rent-seeking won't create jobs

While we wait to see next week’s budget, think about this: economists must shoulder much of the blame for past "reforms" that ended up doing more harm than good. But more of the blame should go to the politicians who allowed lobbying by generous industries to subvert reform and turn it into rent-seeking, or worse.

Lefty academics who bang on about the evils of what they love calling "neoliberalism" seem to see it as some kind of conspiracy between the economics profession and big business.

There’s some truth to this – after all, many economic practitioners work for or produce "independent" consultant reports for big business. But the old rule from politics applies: what may look like a conspiracy is more likely to be just a stuff-up.

The term neoliberalism – a pompous, hipster word only a "problematic" academic could love – conceals more truth than it reveals. The words we used in Australia when this way of thinking became dominant in the 1980s were "economic rationalism" in pursuit of "micro-economic reform" – the very thing Productivity Commission boss Michael Brennan advocated a return to in a speech last week.

The more revealing label, however, is the one preferred by two leading British economics professors, Paul Collier and John Kay, in their new and enlightening book, Greed is Dead: "market fundamentalism".

The economic rationalist thinking that drove extensive economic policy change in the ‘80s and ‘90s took the profession’s ubiquitous neo-classical, demand-and-supply model of how markets work and assumed it was all you needed to know about how the economy worked.

It thus overemphasised the role of competition between "self-interested" (selfish, greedy) individuals, but underestimated the role of co-operation and community spirit and the importance of touchy-feely things such as job security, loyalty and our trust in economic and political institutions in making the economy work well.

The simple model’s assumption that all individuals and firms unfailingly act with full foresight of their best interests implies that government intervention is unnecessary and may well make things worse.

So the greatest crime of the rationalists (including, until far too late, yours truly) was naivety. They saw reforms that worked well in theory and assumed they’d work just as well in practice. In many cases they did work well enough, but in too many others they failed badly.

Unintended consequences abounded, the greatest of which was what I call "the sanctification of selfishness". When the econocrats were planning the removal of import protection they confidently predicted a benefit would be to discourage "rent-seeking" – businesses incessantly lobbying the government for favours when they should be getting on with running their businesses more efficiently.

In reality, rent-seeking has become rife. Since the mid-80s, the Canberra-based lobbying industry must surely have been one of our fastest growing and most lucrative. The economists’ greatest naivety has been their assumption that successive governments would faithfully implement their reform plans while resisting the temptation to do favours for generous mates.

Which brings us to next week’s budget. Recent days have seen big business campaigning for tax breaks, a further shift in the industrial relations power balance in favour of employers, and the removal of "burdensome regulations", all to create jobs.

Trouble is, years of bitter experience have taught us to recognise rent-seeking when we see it. Because economic rationalists have left people with the notion that economic progress is driven solely by self-interest, the rich and powerful now see themselves as justified in demanding that the economy be re-organised in ways that facilitate their efforts to get richer and more powerful.

Among the various micro-economic reforms advocated last week by the Productivity Commission’s Brennan as ways of speeding up the recovery were: removing rigidities in the labour market, streamlining the approvals process for new businesses and improving the “culture” of regulators.

I have no doubt there are plenty of anachronistic, pettifogging, cumbersome provisions of industrial relations law that both sides could readily agree to remove. But I doubt that’s what the employers are seeking. They want their quid without any quo.

Equally, I don’t doubt that much could be done to minimise the time-wasting involved in the regulation of business, without compromising other public policy goals. But too often removing "green tape" is code for sacrificing long-term protection of our environmental assets in favour of letting a few developers temporarily create a few hundred jobs while they build some highly automated mining project.

And while the culture of pushing people around at Centrelink or the local council should definitely be corrected, the last time the pollies went down this road they left the banking and corporate regulators with the clear impression that what they wanted was a buddy-buddy culture. The banks concluded that, for them, obeying the law was optional, and we all remember what happened next.

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How economists got it wrong for so long

Most economists are great believers in the need for "reform" – for other people, not themselves. Over the past 30 or 40 years, no profession has had more influence over the policies governments have pursued, but the results have hardly been flash.

Even the lightning speed at which an epidemic in part of China became a pandemic reaching every corner of the globe can be blamed in large part on the globalisation that economists long championed.

After the unmitigated disaster of the global financial crisis of 2008 – which the economists not only failed to foresee, but did much to help bring about by their advocacy of deregulated financial markets – many people assumed this would force the economists, shamefaced, back to the drawing board.

It didn't happen. But the poor performance of economies in the decade following the Great Recession hasn't allowed the more intellectually honest among the world's economists to delude themselves that all's well with their theories and policy prescriptions.

At present, politicians and policymakers are preoccupied with suppressing the virus and countering the coronacession this effort has led to. Economists are worried about the depth of this recession, and are warning politicians that they'll need to spend (and borrow) unprecedented sums to bring about a sustainable recovery.

A big part of the economists' concern arises from their knowledge that deep, structural problems had caused the rich economies to be in a weak state before the arrival of the virus. This suggests that, without an extraordinary effort by governments, the recovery is likely to be slow, with unemployment staying high.

Worse, the "normal" to which we return after the virus has been fully vanquished isn't likely to be nearly as good as the normal we remember. Not only will material living standards be improving at a glacial pace, but there'll be continuing, maybe worsening, social conflict (not to mention a worsening climate).

The good news, however, is that leading thinkers among the world's economists are still grappling with the embarrassing question of why their profession's advice over many decades seems to have made our lives worse rather than better.

I'm just back from a couple of weeks catching up on my reading. I noticed several books by well-known economists coming to similar conclusions about how the ideas of "neoliberalism", which dominated economic advice to governments for so long, led us astray.

In their book Greed is Dead, two leading British economics professors, Paul Collier and John Kay, both from Oxford, argue that the problem with what they (and I) prefer to call "market fundamentalism" – which oversimplifies and takes too literally the basic model of how markets work – is its overemphasis on the role of competition between self-interested individuals in generating economic progress.

By sanctifying selfishness, it has undermined community-mindedness and the role of co-operation in advancing our mutual interests. Voting has become a simple matter of "what's in it for me and mine", while businesses and industries have been licensed to lobby for preferment at the expense of everyone else.

"In recent decades the balance between these instincts [of competition and co-operation] has become dangerously skewed: mutuality has been undermined by an extreme individualism which has weakened co-operation and polarised our politics," they say.

In his book, The Third Pillar, Raghuram Rajan – a US-based Indian economist who did foresee the global financial crisis, but was told by his elders and betters not to be so stupid – argues that society is supported by two obvious pillars, the state and markets, but also by a neglected third pillar: the community. That is, the social aspects of society.

"Many of the economic and political concerns today across the world, including the rise of populist nationalism and radical movements of the Left, can be traced to the diminution of the community," he says.

"The state and markets have expanded their powers and reach in tandem, and left the community relatively powerless to face the full and uneven brunt of technological change. Importantly, the solutions to many of our problems are to be found in bringing dysfunctional communities back to health."

In his book, The Common Good, Robert Reich defines his subject as "our shared values about what we owe one another as citizens who are bound together in the same society – the norms we voluntarily abide by, and the ideals we seek to achieve".

Since the late 1970s, however, Americans have talked less about the common good and more about self-aggrandisement; less "we're all in it together" and more "you're on your own". There's been "growing cynicism and distrust toward all the basic institutions of American society – governments, the media, corporations" and more.

But the last, more hopeful words go to Collier and Kay: "We see no inherent tension between community and market: markets can function effectively only when embedded in a network of social relations.

"Humans are not selfish, maximising individuals, pursuing their conception of happiness; they seek fulfilment which arises largely from their interaction with others – in families, in streets and villages, at work."

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Lucky Country has lost its dynamism and can't find where it is

Do you know what economists mean when they talk about the nation’s “economic fundamentals”? I thought I did until I heard what Reserve Bank governor Dr Philip Lowe said they were.

When Lowe had a meeting with Treasurer Josh Frydenberg after last year’s election, I was puzzled by him saying that the economy’s fundamentals were “sound”. How could he say that when the economy had grown by an exceptionally weak 1.8 per cent over the year to March?

But at his appearance before the House of Reps economics committee last week, he had to respond to a challenging description of the state of the economy by Labor’s Dr Andrew Leigh, a former economics professor.

“We have seen declines in labour productivity for the first time on record, the slowest wage growth on record, declining household spending per capita, record household debt, record government debt, below average consumer confidence, retail suffering its worst downturn since 1990 and construction shrinking at its fastest rate since 1999,” Leigh said.

“The economy is in a pretty bad way at the moment, isn’t it?” he asked.

“That wouldn’t be my characterisation,” Lowe responded. “One thing you left out of that list is that a higher share of Australians has jobs than ever before in our history ... ultimately what matters is that people have jobs and employment and security.”

What’s more, “our fundamentals are fantastic”, Lowe went on – but this time he spelt out what he meant.

“We enjoy a standard of living in this country that very few countries in the world enjoy. More of us have jobs than ever before. We live in a fantastic, prosperous wealthy country, and I think we should remember that.”

Well, if that’s what he thinks our fundamentals mean, who could argue? Even if Leigh thought the weaknesses he was outlining were a description of our fundamentals. Maybe Lowe’s fundamentals are more fundamental fundamentals than other people’s are.

Under further questioning from Leigh, however, Lowe said he didn’t want to deny that “we have very significant issues, and the one that worries me most is weak productivity growth ... We’ve had four or five years now where productivity growth has been very weak ... in my own view it’s linked to very low levels of investment relative to gross domestic product.”

This is an important point. As former top econocrat Dr Mike Keating has been saying for some years, you can take a neo-classical, supply-side view that weak productivity improvement explains why the economy’s growth has been so weak (a view that assumes productivity improvement is “exogenous” – it drops on the economy from outside), or you can take a more Keynesian, demand-side view that weak economic growth explains why productivity improvement has been so weak (that is, productivity is “endogenous” – it’s produced inside the economy).

Keating keeps saying that it’s when businesses upgrade their equipment and processes by replacing the old models with the latest, whiz-bang models that improving innovations are diffused throughout the economy, making our industries more productive.

Why is it that our businesses (particularly those other than mining) haven’t been investing much in expanding and improving their businesses? The simple, demand-side answer is that they haven’t been seeing much growth in the demand for their products.

But Lowe sees something deeper. “I fear that our economy is becoming less dynamic [continuously changing and developing],” he told the economics committee. “We’re seeing lower rates of investment, lower rates of business formation, lower rates of people switching jobs, and in some areas lower rates of research-and-development expenditure.

“So right across those metrics it feels like we’re becoming a bit less dynamic. I worry about that for the longer term.

“Public investment is not particularly low at the moment. What is low is private investment. Firms don’t seem to be investing at the same rate that they used to, and I think this is adding to the sense I have that the economy is just less dynamic ...

“There’s something deeper going on, and it’s not just in Australia: it’s everywhere. At the meetings I go to with other central bank governors, this is the kind of thing we talk about. Something’s going on in our economies that means the same dynamism that used to be there isn’t there.”

Asked later by another MP what was causing this loss of dynamism, Low replied, “I wish I knew the answer to that ... My sense is, as an Australian and looking at what’s going on in our economy, that we’re becoming very risk-averse.” (A sentiment I know other top econocrats share.)

“It’s a global thing that happens – I think it probably happens partly when you’re a wealthy country. The standard of living here is fantastic. It’s hardly matched anywhere in the world, so we’ve got something important to protect,” he said.

“But I think in that environment you become more risk-averse. Probably with the ageing of the population, we become more risk-averse. When people have a lot of debt, they’re probably more risk-averse.

Risk-aversion seems to help explain the slow wage growth we’ve had “for six or seven years” now. “It’s the sense of uncertainty and competition that people have, and this is kind of global. Most businesses are worried about competition from globalisation and from technology, and many workers feel that same pressure.

“There are many white-collar jobs in Sydney and Melbourne and Canberra that can be done somewhere else in the world at a lower rate of pay, and many people understand that ...,"Lowe said.

“So the bargaining dynamics ... for workers is less than it used to be. And firms are less inclined to bid up wages to attract workers because they’re worried about their cost base and competition,” he said.

Doesn’t sound too wonderful to me. But not to worry. Just remember, our fundamentals are fabulous.

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Economics isn't as highfalutin' as the jargon makes it sound

If you’ve ever had the feeling you ought to know a lot more about economics than you do – even if only to make it harder for economists to bamboozle you – here’s my long-weekend special offer: the key concepts of the discipline explained in one article. As many as I can fit, anyway.

More than a year ago, the boss of the Australian Competition and Consumer Commission, Rod Sims – surely the most experienced senior econocrat evading retirement in Canberra – began a speech by saying economics had become too mathematical and that to be a good economist all you needed was a deep intuitive feel for 10 or 15 concepts.

He then rattled off what he regarded as the 15 most important concepts, “in no particular order”. From those I’ll explain, in order, the five I consider to be most significant.

1. Opportunity cost

The first is one you should have heard of: opportunity cost.

Many economists consider “opp cost” to be the single most important and fundamental concept in economics, and the discipline’s most useful contribution to the betterment of mankind. Indeed, that’s the view Professor John Quiggin, of the University of Queensland, takes in his book Economics in Two Lessons, which I recommend as the best book to introduce you to economics.

Quiggin says “the opportunity cost of anything of value is what you must give up to get it”. Our wants are almost infinite, but our resources are limited, so we have to make choices. Economists’ eternal message to individuals and to the community is: think carefully before you spend your money, make sure you’re spending it on what you really want because you can’t spend it twice.

Really? That complicated, huh? Quiggin says “the lesson of opportunity cost is easy to state but hard to learn”. We keep forgetting to apply it. For instance, Prime Minister Scott Morrison is saying he’s not going to reduce our greenhouse gas emissions if the opportunity cost is to endanger jobs in the coal industry.

Sounds fair enough until you realise he’s saying jobs in a particular industry matter more to him than us doing all we can to help reduce global warming (which will destroy jobs in many industries).

We live in a market economy. We sell our labour in the jobs market, then use the money we earn to buy the goods and services we need in 101 product markets. Economics is the study of markets and, in particular, of how the prices set in markets work to bring supply and demand, sellers and buyers, into agreement (aka “equilibrium” or balance).

2. Invisible hand

The first of Quiggin’s two lessons is “market prices reflect and [also] determine the opportunity costs faced by consumers and producers” – which brings us to Sims’ next key concept, “the invisible hand”.

In a market-based economy (as opposed to a feudal economy or a planned economy), the differing objectives of workers, employers, consumers and producers are co-ordinated (brought together) not by the government issuing orders to people, but by the “price mechanism” (prices going up or down until both sides are satisfied).

That’s the invisible hand. And what motivates this invisible hand is the self-interest of workers, bosses, consumers and businesses. In the famous words of the father of modern economics, Adam Smith, in 1776, “it is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest”.

It’s amazing to think of, but it holds much truth: the invisible hand of markets and prices takes the self-interest of all those competing players and turns it into a situation where most of us have our wants satisfied most of the time.

3. Imperfect competition

But if that sounds a bit too pat – a bit too perfect – it is. It is, in fact, a description of what economists call “perfect markets” and “perfect competition”. And in real life, nothing’s ever perfect. The greatest female economist, Joan Robinson, was the first to formalise Sims’ third key concept, “imperfect competition” – the study of why markets and the price mechanism don’t always work as perfectly as the oversimplified “neo-classical” model of markets assumes they do.

4. Market failure

From the subtitle of Quiggin’s book you see that lesson one is “why markets work so well”, but lesson two is “and why they can fail so badly”. This takes us straight to Sims’ fourth key concept “market failure”. Markets are said to fail when they deliver results that aren’t “allocatively efficient” – when they don’t lead to the particular allocation of economic resources that yields the maximum satisfaction of people’s wants.

Economists have spent much time studying the various categories of factors that cause markets to fail. More recently they have turned to studying “government failure”, which is when governments’ attempts to correct market failures end up making things worse.

5. Externalities

Sims’ final key concept is “externalities” – a major category of market failure. These occur when transactions between sellers and buyers generate costs (or benefits) for third parties – known as “social” costs or benefits – that aren’t reflected in the market or “private” prices paid and received by the buyers and sellers.

These social costs or benefits are thus “external” to the private transaction and the private price mechanism. They constitute market failure because the market generates more costs (or fewer benefits) than is in the public’s interest.

One example of an external benefit is the gain to the wider community (not just the particular individual) when a student graduates from university (which is why uni fees are set at only about half the cost of the course, so as to “internalise” the positive externality).

As for external costs (“negative externalities”), Quiggin notes that the leading British economist Lord Nicholas Stern has described climate change as “the biggest market failure in history”. So now you know why so many of the nation’s economists are appalled by Morrison’s dereliction.

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Populist revolt around the world making economists rethink

It’s often said that the failure of conventional economics revealed by the global financial crisis has prompted no serious effort to find a new economic theory that actually works. Look closer, however, and you see economists stirring themselves to lift their game.

That’s the view of a noted American economist and critic of his profession, Professor Dani Rodrik, of Harvard, in an article published this week by Project Syndicate.

Rodrik says the populist backlash sweeping the advanced economies in recent years – think Trump, Brexit and Pauline Hanson – has produced some soul searching in the discipline. It is, after all, a backlash against the austerity policies, free-trade deals, financial deregulation and labour market deregulation that economists urged on the politicians (and only in retrospect realised how naive they’d been and how misused by pollies with other agendas).

In consequence of this rethink, “the economics profession is gradually changing for the better”, according to Rodrik. But the transformation extends beyond thinking about economic policy.

Within the discipline there’s finally a reckoning with the hierarchical practices (reverence for seniority and high-status universities) and the macho seminar culture (where anyone who says something silly or unorthodox is brutally shot down) that have produced an inhospitable environment for women and minorities.

According to a survey of its members conducted last year by the American Economic Association, nearly half of female economists felt discriminated against or treated unfairly on account of their gender. Nearly a third of non-white economists felt they’d been treated unfairly because of their ethnicity.

Rodrik, an Egyptian American, thinks the bad policy advice and the inhospitality towards anyone not an old white male may be related. “A profession that is less diverse and less open to different identities is more likely to exhibit groupthink and hubris,” he says.

“If it is to generate ideas to help society achieve inclusive prosperity [and so not push outsiders into the arms of populist politicians with no real answers to the problems being reacted against] it will have to start by becoming more inclusive itself.”

The new face of the discipline was on display at its annual meeting in San Diego early this month. The sessions that attracted the greatest attention were the more than a dozen focusing on gender and diversity.

Also discussed was a new book by the Nobel laureate Angus Deaton and Anne Case, Deaths of Despair. Their research shows how a particular set of economic ideas privileging the supposed “free market”, along with an obsession with material indicators such as aggregate productivity and gross domestic product, have fuelled an epidemic of suicide, drug overdose and alcoholism among America’s (often jobless) working class.

Capitalism is no longer delivering for these people (many of whom switched their votes to get Trump over the line) and economics is, at the very least, complicit, Rodrik observes.

In a panel session at the annual meeting that Rodrik helped organise, Economics for Inclusive Prosperity (note that buzzword inclusive), several new strands of thinking were discussed that are, he claims, “taking over the discipline”.

One was the need to expand economists’ focus from average levels of prosperity (which often look okay) to the distribution of that increased income between top, middle and bottom (which often doesn’t).

Another strand of thought was the non-economic dimensions that are equally fundamental to wellbeing – such as dignity, autonomy, health and political rights – damage to which economists have tended to ignore.

“How economists talk about, say, trade agreements or deregulation may well change when they take such additional considerations seriously,” he says.

“This will require new economic indicators. One proposal that goes part of the way is for government agencies to produce distributional national accounts [something our Australian Bureau of Statistics has been working on].”

Mainstream economists have long claimed their theories and models to be “value-free”. This is self-delusion on a grand scale. In a paper presented to the panel session by Professor Samuel Bowles, of the Santa Fe Institute, and Professor Wendy Carlin, of University College, London, they boldly stated the bleeding obvious.

They argued that every policy paradigm has embedded within it not just a theory about how the economy works, but also a set of ethical values about what the good life entails. Neo-liberalism, for instance, presumes individualistic, amoral individuals and a free market that delivers efficiency, thanks to “complete contracts” (those that leave the other party no room to cheat you, but such contracts don’t exist) and few instances of “market failure” (where, for various reasons, the market fails to work the way the theory says it will).

Clearly, such assumptions go a long way towards explaining why economists failed to foresee that deregulation of the financial system and permissive supervision of it would lead eventually to collapse and deep recession.

Bowles and Carlin said what we needed was a new theory that integrates egalitarian, democratic and sustainability “norms” of acceptable behaviour (the ethical side) with a model of the economy as is really operates today (that is, which would incorporate the insights of behavioural economics).

Such a paradigm would place the community alongside the economists’ conventional dichotomy between the market and the government. And it would include policies such as wealth taxes, broader access to insurance to reduce people’s exposure to risks, workplace rights, reform of corporate governance (none of the convenient fiction that shareholders’ rights trump all others), and a substantial weakening of intellectual property rights (which have devolved from a device to encourage innovation to a prime source of big business rent-seeking).

Professor Luigi Zingales, of Chicago University’s business school, criticised economists for foisting their own preferences on the public. They tended to place greater value on certain outcomes (such as economic efficiency) rather than others (such as the distribution of income) and they fall prey to groupthink and to fetishising particular economic models over others.

I can’t say I’m convinced a revolution in economists’ thinking is imminent, but it’s a start.

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Why we don't get more joy out of our super

When one of our top econocrats gives a speech about behavioural economics, you know we’re making progress. Take the ever-present problem of income in retirement. “BE” explains both why it’s a major area of government intervention in our lives and how that intervention can be made more effective.

One of the greatest limitations of conventional economics – based on the “neo-classical” model, which focuses on how prices are determined by the interaction of supply and demand – is its assumption that people are unfailingly “rational” – calculatingly self-interested – in their response to the prices they face.

Behavioural economics accepts that we’re not the financial automatons the model assumes us to be, and uses insights from the more empirical sciences of psychology and sociology to gain a much more realistic picture of the many non-monetary factors that also affect our behaviour in economic matters.

Behavioural economists draw on the long list of “heuristics” – mental shortcuts or biases in the way we think – developed by cognitive psychologists. In a recent speech, Dr David Gruen, top economics guy in the Department of Prime Minister and Cabinet, outlined the cognitive biases that limit many people’s ability to make adequate provisions for the income they’ll need in retirement.

For more than a century the government has provided the age pension, of course. But in the 1990s people began to worry that it wouldn’t be sufficient to meet the aspirations of the rising generation. So the Keating government introduced compulsory employee superannuation.

In those days before the spread of BE, most economists accepted the imposition of compulsory saving as a correction to the “market failure” of “myopia” – most of us are too short-sighted to save enough towards our retirement.

The BE way of putting it is that we suffer from “present bias” – we overvalue the present relative to the future. Gruen takes the idea further, noting that “while choosing a retirement plan is likely to influence literally decades of our lives, many of us spend little time – sometimes less than an hour – choosing our plan”.

Then there’s “confirmation bias” – we tend to remember events that confirm our existing views, but forget developments that cast doubt on those views. Gruen uses this to explain why many of us spend what little time we have set aside to choose a retirement plan looking for one with an investment strategy that supports our existing investing approach.

And “cognitive overload”. This occurs when people find it too hard to process a mass of information in order to make decisions. In the context of planning for retirement, it leads many of us to stick with choices we have arrived at by default.

“Together, these cognitive biases create a big gap between our intentions and our actions: although people intend to save for their retirement, they often don’t translate that into action. For most people, how much to save, and in what form, are difficult cognitive problems – because of both our limited calculation powers and the apparent enormity of the task,” Gruen says.

When the compulsory super system was first set up, the government adopted the conventional economics view that savers were rational economic agents who knew their own business best. So all it had to do was require the super funds to reveal relevant information about their investment options, and diligent savers would do the rest, ensuring they picked the option that best suited their circumstances.

Yeah sure. At the time of a review of super in 2009, 80 per cent of super fund members were invested in the default fund chosen by their employer. Of that 80 per cent, anecdotal evidence suggested that only about 20 per cent explicitly chose the default option, with the rest making no active choice whatsoever.

“When complicated decisions are required, people often stick with the status quo and take no decision at all. In that case, the default option becomes very important,” Gruen says. (This is actually one of the key “insights” of BE.)

So the review panel recommended creating a default option – called MySuper - with features that would promote the wellbeing of those who didn’t actively choose another option. MySuper funds must be simple and cost-effective, with a diversified portfolio of investment.

Of course, there are remaining challenges in the compulsory super system, which the latest review of retirement incomes, instigated by Treasurer Josh Frydenberg, will consider. Let’s hope it takes full advantage of the behavioural insights available to it.

As Gruen says, BE allows all government policymaking to be improved by starting with a richer understanding of human behaviour and building this into the design of measures.

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Governments are learning to nudge us down better paths

The world is a complicated place – partly because humans are complicated animals. One of the many things this means is that when governments try to influence our behaviour, their chances of stuffing up are surprisingly high.

Consider this. Say I’m an investment adviser telling you (or your parents or grandparents) where to invest your retirement savings. I warn you that, should you take my advice, I’ll be paid a commission by the managers of the investments I put you into.

How do you react?

Well, you should react by becoming a lot more cautious about following my advice. It’s clear I have a conflict of interest. Is my advice aimed at doing the best I can for you, or at maximising the commissions I earn?

When governments require investment advisers to disclose any conflict of interest to their clients, that’s how the pollies expect you’ll react. They also expect that this requirement will prompt advisers to eliminate or reduce any conflict so their advice is more likely to be trusted.

But research by Dr Sunita Sah, a psychologist at Cornell University in upstate New York, has found it often doesn’t work like that. Although such disclosures do indeed cause clients to have less trust, they can often lead people to feel social pressure to act on the advice anyway.

Clients may be concerned that refusing to follow the advice would be a signal of their distrust in the adviser, with whom they’ve often formed a personal bond. They may even interpret the disclosure as a request that the advice be taken, as a favour to the adviser who, after all, needs to earn a living like the rest of us.

Sah found that clients given advice they knew to be conflicted were twice as likely to follow that advice as were clients where no disclosure was made.

The lesson is not that we should stop requiring advisers to disclose their conflicts, but that government policymakers need to think carefully about the specific design of their policies.

It turns out you can reduce the undesirable effects of disclosure if they come from a third party – that is, someone other than the adviser. It also helps if clients’ decisions are made in private, or if there’s a cooling-off period before the decision is finalised.

Have you guessed where this is leading? It’s a plug for a relatively new tool that’s been added to the bureaucrats’ policy toolkit – “behavioural insights”.

In a speech he gave in Canada last week, Dr David Gruen, a deputy secretary in our Department of Prime Minister and Cabinet, explained that behavioural insights is an approach to policymaking that draws from psychology, cognitive sciences and economics to better understand human behaviour, help people make good choices more easily, and help improve the effectiveness of public policy interventions.

As the case of conflict-of-interest disclosures illustrates, people’s responses to government policy measures can be surprising. Politicians and bureaucrats need to be more conscious of the insights of behavioural insights when designing policies to fix problems.

And the behavioural insights tool can also be used for real-world testing of how policy measures are working – or not working – in practice.

The first government to establish a behavioural insights team was Britain in 2010, at the initiative of prime minister David Cameron, Gruen says. It’s since become a partly privatised joint venture.

By now, according to the Organisation for Economic Co-operation and Development, there are more than 200 public sector organisations around the world that have applied behavioural insights to their work.

In Australia, the federal government’s behavioural economics team – BETA – was set up to apply behavioural insights to public policy and to build behavioural-insights capability across the public service. It’s at the centre of a network of 10 behavioural insight teams across the federal government and alongside several state government teams.

These teams are also known as “nudge” units because they’re often trying to give individuals a nudge in the direction of making more sensible decisions, while leaving them free to do something else should they choose. You’re not forced, just nudged.

Gruen offered several examples of what the feds have been doing. BERT, the behavioural economics research team in the Department of Health, looked at the ballooning cost of reimbursements to doctors for providing after-hours care.

After-hours care considered urgent was remunerated at about twice the rate of that judged a non-urgent visit. Who judged whether the care was urgent? The doctor.

The department identified the 1200 doctors with the highest urgent after-hours claims, and ran a randomised control trial, sending each of them one of three alternative letters, with the letter a doctor received chosen at random.

One letter compared the doctor’s billing practices with their peers, showing they were claiming the urgent category far more often than others were. This drew on the behavioural insight that individuals are often motivated to change their behaviour when they are out of step with their peers.

The second letter emphasised the consequences of non-compliance, including the penalties and legal action. This letter drew on the behavioural insight that people tend to avoid losses more than they seek the equivalent gains.

The third letter was the control – the standard bureaucratic compliance letter, running to three pages.

All three letters were successful in reducing claims, but the peer-comparison one was far more effective than either the standard compliance letter or the loss-framing letter. The peer-comparison letter reduced claims by 24 per cent.

And it was just a nudge, not a threat of punishment for dishonestly claiming cases to be urgent when they weren’t.

In the six months after the letters were sent, the 1200 high-claiming doctors reduced their claims by more than $11 million (across all three letters), and 18 doctors voluntarily owned up to more than $1 million in previous incorrect claims.

So, as Gruen concludes, a simple and cheap nudge can yield big dividends.

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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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