Economists do little to promote bank competition

The royal commission into banking, whose public hearings start on Monday, won't get a lot of help from the Productivity Commission's report on competition within the sector. It's very limp-wristed.

The report's inability to deny the obvious - that competition in banking is weak, that the big four banks have considerable pricing power, abuse the trust of their customers and are excessively profitable – won it an enthusiastic reception from the media.

Trouble is, its distorted explanation of why competitive pressure is so weak and its unconvincing suggestions for fixing the problem. It offered one good (but oversold) proposal, one fatuous proposal (to abolish the four pillars policy because other laws make it "redundant") and a lot of fiddling round the edges.

It placed most of the blame for weak competition on the Australian Prudential Regulation Authority, egged on by the Reserve Bank, for its ham-fisted implementation of international rules requiring banks to hold more capital, and for its use of "macro-prudential" measures to slow the housing boom by capping the banks' ability to issue interest-only loans on investment properties.

The banks had passed the costs of both measures straight on to their customers. It amounted to an overemphasis on financial stability (ensuring we avoid a financial crisis like the Americans and Europeans suffered) at the expense of reduced competitive pressure on the banks.

This argument is exaggerated. Even so, it's quite likely that, in their zeal to minimise the risk of a crisis, APRA and the Reserve don't worry as much as they should about keeping banking as competitive as possible.

The report's proposal that an outfit such as the Australian Competition and Consumer Commission be made the bureaucratic champion of banking competition, to act as a countervailing force on the committee that makes decisions about prudential supervision, is a good one.

The report's second most important explanation for weak competition is inadequacies in the information banks are required to provide to their customers. Really? That simple, eh?

See what's weird about this? It's blaming the banks' bad behaviour on the regulators, not the banks. If only the bureaucrats hadn't overregulated the banks, competition would be much stronger.

Why would the bureaucrats in the Productivity Commission be blaming other bureaucrats for the banks' misdeeds? Because this is the prejudiced, pseudo-economic ideology that has blighted the thinking of Canberra's "economic rationalist" econocrats for decades.

Whatever the problem in whatever market, it can never be blamed on business, because businesses merely respond rationally (that is, greedily) to whatever incentives they face. If those incentives produce bad outcomes, this can only be because market incentives have been distorted by faulty government intervention.

Market behaviour is always above criticism; government intervention in markets is always sus.

When the report asserted that the big banks had used the cap on interest-only loans as an excuse for raising interest rates, and would pass the new bank tax straight on to customers, there was no hint of criticism of them for doing so. They were merely doing what you'd expect.

In shifting the blame for these failures onto politicians and bureaucrats, the report fails to admit that the distortion that makes interest-only loans a worry in the first place is Australia's unusual tolerance of negative gearing and our excessive capital gains tax discount.

In criticising the bank tax, the report brushes aside the case for taxpayers' recouping from the banks the benefit the banks gain from their implicit government guarantee, and the case for taxing the big banks' super-normal profits (economic rent), doing so in a way that stops the impost being shunted from shareholders to customers.

Here we see a hint that the rationalists' private-good/public-bad prejudgement​ is only a step away from Treasury being "captured" by the bankers it's supposed to be regulating in the public's interest, in just the way it (rightly) accuses other departments of being captured.

The report's criticism of existing interventions would be music to the bankers' ears. Its fiddling-round-the-edges proposals for increasing competitive pressure have one thing in common: minimum annoyance to the bankers.

The Productivity Commission's rationalists can't admit that the fundamental reason for weak competition in banking comes from the market itself: as with many industries, the presence of huge economies of scale naturally (and sensibly) leads to markets dominated by a few big firms.

Market power and a studied ability to avoid price competition come with the territory of oligopoly. Have the rationalists spent much time thinking about sophisticated interventions to encourage price competition in oligopolies? Nope.

Have they learnt anything from 30 years of behavioural economics? Nope. When you've learnt the 101 textbook off by heart, what more do you need?

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Good could come from bank royal commission

The banks and other opponents of a royal commission into banking told us it would generate a lot of noise and expense without achieving anything of value. They'll probably still be claiming that when the just-announced inquiry has reported.

Well, maybe. By contrast, I think there's a good chance the commission's establishment will be seen as the most visible marker of the time when the two sides of politics turned their backs on the era of bizonomics – the doctrine that what's good for big business is good for the economy and the punters who make it up.

The litany of misconduct by the big four banks – the unscrupulous investment advice given, the mistreatment of people with legitimate life insurance claims, the charges that the bank-bill swap rate was being rigged, and allegations of extensive use of bank facilities for money laundering – has driven the public's growing insistence that the banks be brought to account.

This week Rod Sims, boss of the Australian Competition and Consumer Commission, confirmed what all of us know, that competition in banking is weak ("not vigorous") leaving the big four with great ability to protect their excessive profits by passing costs on to their customers ("the large banks each have considerable market power").

The arguments of the banks and the Turnbull government that an inquiry must be avoided because it would shake confidence in the integrity and strength of our financial system – including in offshore markets – were just as weak then as they are now when used by the banks and the government to justify holding an inquiry to end the "political uncertainty".

The plain truth is that a rebellion by its own backbenchers has robbed the government of its ability to stop an inquiry going ahead.

This is the best explanation for the banks' sudden reversal from opposing an inquiry to claiming one is now "imperative". Since the revolt makes one inevitable, they'd prefer its establishment to be controlled by their Liberal defenders, not their Nationals, Greens and Labor critics.

They say a smart prime minister never commissions a report unless he knows what it will find and recommend. But that's easier imagined than achieved.

Were the commission's report to be judged by voters as a whitewash, with no significant consequences, this would simply ensure the bad behaviour of the banks remained a hot issue favouring the government's opponents at the next election.

What's just as likely is that royal commissioner Kenneth Hayne will interpret his terms of reference as he sees fit and, in any event, uncover a lot more instances of misconduct.

Broadening the inquiry's scope to cover misconduct in wealth management, superannuation and insurance, as well as in banking proper, is unlikely to leave voters thinking the banks' behaviour hasn't been as bad as they first thought.

Polling shows high public support for a banking royal commission, including among Coalition voters.

But the way the government has been forced by public opinion to abandon its attempt to protect the banks is a sign of much deeper public disaffection with the long-dominant "neoliberal" doctrine – formerly accepted by both sides of politics – that governments should do as little as possible to prevent businesses doing just as they see fit.

That when business mistreats its customers or it employees, there's nothing the government could or would want to do.

That big businesses' generous donations to both sides' coffers mean they have the politicians in their pockets. That the Turnbull government's desire to cut the rate of company tax on foreign multinationals that already avoid paying much is proof the economy's run to please the big boys, not you and me.

I've been writing for months about the breakdown of the "neoliberal consensus". This is evident in the way the Labor side has promised a banking royal commission, opposed big business tax cuts, opposed reductions in penalty rates, and pressed for constraints on negative gearing and the capital gains tax discount.

But set aside his resistance to a banking inquiry and (impotent) advocacy of big business tax cuts, and you see Turnbull's already doing much to respond to voters' rejection of the fruits of neoliberalism – privatisation, the various economic reform stuff-ups – with his new tax on multinational tax avoiders and coercion of particular companies in his struggle to fix the stuffed-up national electricity market and the cornering of the eastern seaboard gas market by three big companies.

Remember too the way, as part of his efforts to stave off a banking inquiry, Turnbull has become ever tougher on the banks, making them pay for more surveillance by the Australian Securities and Investments Commission and imposing a new tax on the five biggest of them.

In his most recent attempt to head off pressure for an inquiry, a proposed arrangement to compensate victims of bank misbehaviour, the banks would have been paying.

When the political smarties look back on this saga, my guess is they'll conclude Turnbull was mad to lose so much political credit in his abortive attempt to protect the banks from the public's disapproval of their greed-driven misbehaviour.

He should have got, much earlier than he did, the message that the era of governments pandering to big business was over, killed off by voters' disaffection with the political mainstream and willingness to flirt with the populist fringe.

I'm not sure Australia's big business has yet got that message, particularly not the big banks – transfixed as they are by their inward-looking contest to increase their profits and chief executive remuneration package by more than their three rivals have.

I support the royal commission because another year or more of public dredging through all the moral (and sometimes legal) shortcuts the banks have taken on their way to higher profits and bonuses may finally get the message through that their way of doing business – and treating their customers – must change.

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We're a long way from getting bank regulation right

The movie version of The Big Short is so good you probably don't need to read the best-selling book by my far-and-away favourite finance writer, Michael Lewis.

If you want to go deeper than the events culminating in the global financial crisis of 2008 to a more systemic analysis of why we've had so much trouble with the financial system and will continue to unless we change the rules more radically than we have, I recommend you read Other People's Money, by a leading British economist, Professor John Kay.

It's required reading for the nation's economists but, although it's very thorough, it's eminently readable by ordinary mortals. Similarly, although it doesn't deal specifically with Australia's financial system, its analysis is more readily applied to Oz than a book more focused on Wall Street.

Kay was in Australia this week, and when I spoke to him he left me in little doubt that he wasn't wildly impressed by our financial system inquiry, conducted by a panel dominated by people from the industry and led by former Commonwealth Bank boss, David Murray.

Not much there to ruffle the industry's feathers.

The Murray report does little to contradict the conventional wisdom that the huge expansion of the "financial services" industry over the past 30 years has been a great boon to the wider economy.

We've benefited from much financial innovation, deeper financial markets and a revolution in the management of financial risks.

But have we? We've certainly enjoyed much greater access to credit and much more convenient banking thanks to automatic tellers, direct debits and credits, and bill-paying on the internet.

But much of this is owed to advances in information processing and telecommunications rather than banking expertise.

Much of the "innovation" in the development of new financial products has been motivated by a desire to get around government taxes and regulations.

We're often told that all the trading of financial claims the banks and other market participants do between each other has made financial markets deeper and more liquid, thus making it possible for bank customers – individuals or businesses – to buy or sell a large block of shares or currencies without their transaction having a big, adverse effect on the market price.

Kay counters that all the trading of claims between financial institutions has, in fact, made financial markets far deeper than is required by users from the "real economy". Their need to buy and sell securities without moving the price could be met by opening the markets for a quarter of an hour a week.

But surely all that trading – in conventional securities, but also in ever-more exotic "derivatives" that get ever-more removed from the physical assets they are supposedly derived from – is aimed at helping customers manage the financial risks they face.

Well, that's what bank bosses and economists told us for years. Kay recalled the now-infamous incident in 2005, where a young Indian upstart from the International Monetary Fund attending the US Federal Reserve's annual conference at Jackson Hole, Wyoming, queried the value of recent innovation in financial markets and warned of troubles ahead.

The young fool was quickly put back in his box. One heavy defended the innovations, claiming that "by allowing institutions to diversify risk, to choose their risk profiles more precisely, and to improve the management of the risks they take on, they have made institutions more robust".

"These developments have also made the financial system more resilient and flexible – better able to absorb shocks without increasing the effects of such shocks on the real economy," he went on.

Later, another heavy agreed: "Financial institutions are able to measure and manage risk much more effectively. Risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries."

You've guessed how this story ends. Within two or three years, the global financial crisis revealed all that as the opposite of the truth – to the great cost of taxpayers who had to bail out banks in the US and Europe and all the people in the real economy who lost their jobs or businesses.

It turns out the financial markets weren't managing risk by spreading it thinly across many people – as happens with an insurance policy, for instance – but were multiplying it (by gearing up and by creating derivatives of derivatives) and concentrating it in the hands of a relatively small number of big banks. Nobody knew how much risk particular banks had taken on.

The other way to "manage" risk is to find someone whose particular circumstances give them the opposite "risk profile" to yours. Do a deal and the problem is solved at each end.

In practice, however, such perfect matches are very hard to find. The best you can do is find a partner who's "risk seeking" – they want to take on the risk because there's a chance they'll clean up if you've jumped the wrong way.

In other words, they're willing to speculate. Turns out that's the main thing our bigger financial system is doing: not managing risk in any genuine sense, just making bets with each other.

These days, no central banker makes speeches extolling our bigger financial sector and much better ability to handle risk.

Trouble is, Kay says, all the tightening of regulation – including the requirement for banks to hold higher levels of capital, which the Murray report so strongly supported – hasn't done enough to ensure we don't have another crisis.

We have loads of regulation, all of it acceptable to the banks, whatever their grumbles. We could have less regulation if we regulated the right things the right way.

We could leave speculative trading between financial institutions largely unregulated provided it was separated from the normal banking activity than must always be effectively government-guaranteed. But the banks mightn't like that.

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Good reason to be angry about the banks

Are you angry about the banks? A lot of Australians are. And a lot of people in the United States and Europe are a lot angrier than we are, with good cause.

In Oz, we're annoyed mainly by the banks' very big profits and the way they never seem to miss a trick in keeping those profits high.

In other countries, people are angry about the way the banks and other financial institutions, having stuffed up their affairs to the point where they almost brought the global economy to its knees, were promptly bailed out at taxpayers' expense, so that few went bust, with almost no executives going to jail and many not even being fired.

By now, however, you're probably used to bankers and economists saying you don't understand and are quite unreasonable in your criticisms.

That's why you need to know about the book, Other People's Money, by John Kay. Kay, who's visiting Australia and this week spoke to a meeting organised by the Grattan Institute, says he wrote the book to help ordinary people understand "what it is they're angry about".

You want the dirt on the banks? No one's better qualified to spill the beans than Kay, an economics professor from Oxford and columnist for the Financial Times, who was commissioned to write a report on the sharemarket for the British government.

He starts by noting that over the past 30 or 40 years, each of the developed economies has experienced "financialisation" – huge growth in the size of what these days is called their "financial services sector" to the point where it's among their biggest industries.

For years, we've been told this is a wonderful thing, a sign of our economy's growing sophistication and ability to manage risk. Kay doesn't believe it.

We've always had a financial sector composed of banks, insurance companies and other institutions, and we've always needed one.

We've needed it to help us make payments to each other, to bring people wanting to save together with homeowners and businesses wanting to borrow, to help us save for retirement and to help individuals and businesses manage the risks associated with daily life and economic activity (insurance policies being the obvious example).

We need a financial sector to service the needs of the "real economy" of households and businesses producing and consuming goods and services. But none of this justifies the huge growth in the financial sector we've seen.

Most of that growth has come in the form of massively increased trading between the banks themselves in "financial claims", such as shares and bonds and foreign currencies and "derivatives" (claims on claims, and even – if you've seen The Big Short – claims on claims on claims).

If you add together all the financial assets ("claims") owned by all the banks and other financial outfits, they exceed by many times the value of the physical assets – such as houses and business buildings and equipment – which are the ultimate basis for all those claims.

The value of foreign currencies changing hands each day vastly exceeds the value of currencies needed by businesses and tourists paying for exports and imports. Similarly, the value of shares changing hands each day vastly exceeds companies' needs to raise new share capital and end-investors' needs to buy into the market or sell out.

Kay says that, in Britain, bank lending to firms and individuals in the real economy amounts to only about 3 per cent of their total lending.

All the rest is lending to other banks and institutions busy buying and selling bits of paper to each other – making bets with each other that the prices of those bits of paper will rise or fall in coming days.

Kay makes what, for an economist, is the very strong condemnation that almost all this speculative activity is "socially unproductive". It might or might not benefit the people doing the trading, but it's of no benefit to the rest of the economy.

He observes something I've noticed, too: economists have put little effort into explaining why all this trading in claims is so hugely profitable, allowing people near the top of the banks (but not their many foot soldiers) to be paid such amazing salaries.

If all they're doing is making bets with each other, why aren't the gains of the winners exactly cancelled out by the losses of the losers?

His answer is that the claims-trading parts of banks have found ways to exaggerate the profits they make by counting expected future profits they haven't actually captured – "paper profits" – but delaying recognition of expected "paper losses" until they're realised.

This game can continue for as long as everything's on the up and the bubble's getting bigger. Once it bursts, of course, former supposed profits become present, unavoidable losses. Many banks teeter on bankruptcy, but the government bails them out and they live to gamble another day.

Kay says the answer is to rigidly separate the old-fashioned parts of banking – the facilitation of payments, and lending to households and businesses; the bits that must be kept going through recessions – from all the speculative trading in claims.

It's a free country and "investment" banks should remain free to bet against each other, but there should be no taxpayer bailouts or other government protection for those that do their dough.

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Timid financial changes get Turnbull started on reform

Since the election of the Coalition government we've heard a lot more talk about the need for micro-economic reform than we've had actual reform.

Indeed, the main "reform" we've had so far has been abolition of the previous government's chief reforms: the carbon tax and the mining tax.

But all that changed this week, with the announcement of the Turnbull government's response to the recommendations of the Murray inquiry into the financial system.

Next will come the government's response to the Harper inquiry into competition policy, then its proposals for tax reform – and possibly for changes to industrial relations – both to be taken to next year's federal election for approval by voters.

There's no doubting the importance of the financial system and the need to ensure it's performing well.

According to the Australian Centre for Financial Studies, our financial services industry is a cornerstone of the economy – the largest industry, the largest payer of company tax, a major employer of highly skilled workers and a large source of service exports.

The finance industry carries out all the payments made by households, businesses and governments. Its banks act as "intermediaries", taking the money of savers and lending it to investors, in the process affecting "maturity transformation" by borrowing for short periods (say, "at call") but lending for long periods (say, 30 years).

The industry – particularly its insurance companies – helps the community manage risk (say, that your house burns down, or that the person to whom your savings have been lent goes broke). It also manages our financial assets, such as our superannuation savings.

Of course, to say the finance industry is vital to the functioning of the economy is not to say it may not be a lot bigger than it needs to be, nor that all the trading in financial assets it engages in is necessary and productive, nor that its top people should be paid the eye-popping salaries they are.

But that's a story for another day. Today's story is that though the financial sector is a key part of the economy, the reforms announced this week aren't terribly major. There are a few reasons for this.

For one thing, you can only deregulate the industry once. We did that in the 1980s, and the few rounds of reform since then have been progressively less sweeping and more in the nature of fine-tuning.

For another thing, the global financial crisis in 2008 was a harsh reminder that deregulation can go too far, that banks and other financial institutions can do stupid, short-sighted things in their search for profit, that some degree of regulation is essential and that regulators who only pretend to be regulating can end up allowing great damage to be done to the real economy.

Of course, we in Australia did keep our banks under tight supervision and did prohibit our big four from merging any further, which stood us in good stead when the Americans and Europeans were getting themselves into so much trouble.

So regular fine-tuning of our regulatory arrangements is about all we need. Even so, this week's decisions do err on the timid side. They were worked up before the ascension of Malcolm Turnbull, and the previous administration seemed keenly aware of the power of the big banks and their many lobbyists.

The government accepted almost all the inquiry's 44 recommendations and added half a dozen of its own. The main proposal it rejected was that it ban self-managed super funds from borrowing to buy property. A courageous decision, minister. Hope we don't live to regret it.

The government says its response to the inquiry covers five "strategic priorities". The first is to strengthen the financial system's resilience by reducing the impact of potential financial crises. We need to be better able to weather them and to lessen their cost to taxpayers and the economy.

Australia is a capital-importing country, which makes us more reliant on foreign capital markets than some other economies are. To account for this, the main measure is the Australian Prudential Regulation Authority's requirement that the banks – particularly the big four – hold more shareholders' capital (the cost of which they're now busy passing on to their mortgage customers).

The second priority is to improve the efficiency of the superannuation system. The government will ask the Productivity Commission to develop measures of the rival super funds' efficiency and propose ways of making funds compete for the right to be "default" funds (when employees express no preference for a particular fund).

The government has already moved to require the boards of funds to have at least a third of their members as independent directors (that is, more retired business people and fewer union secretaries).

It would be nice to believe these "reforms" were aimed at getting fund members a better deal rather than getting super funds out of the orbit of the Liberals' long-hated class enemies and into the hands of the banks and other mates.

The third priority is to stimulate innovation to "facilitate competition and reduce costs for consumers". Which is fine, provided it doesn't involve wasteful product differentiation and advertising campaigns, or new products aimed at avoiding taxation or getting around the regulation.

Fourth, to support consumers of financial products being treated fairly. The standards of financial advice will be lifted by improving the training and ethical standards required of advisers.

The Australian Securities and Investments Commission will be given power to ban or order modification of harmful financial products, but only after the government has "consulted widely" with lobby groups.

The government's final priority is to strengthen the capabilities and accountability of the prudential regulator and the securities regulator.

The absence of industry complaint about all this reform is a sign it's not ruffling many feathers (and that the lobby groups remain hopeful of being able to water down the changes before they're applied).

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Libs deserve share of reform credit

I am a career-long admirer of Paul Keating. He opened our economy to the world, dragging us into the era of globalisation. Of the 13 treasurers I've observed in my career, I judge him to be far and away the best – though he did have his failings.

But last week Keating came out fighting when John Howard argued that the Coalition opposition of the time also deserved praise "because it gave bipartisan support to so many of [Keating's] reforms".

Keating objected to "a creeping part of the orthodoxy of late that the reformation of Australia's financial, product and labour markets . . . was not executed by the Hawke and Keating governments but was some kind of project undertaken with the active co-operation of the then Liberal-National opposition".

"Nothing could be further from the truth."

Sorry, but Howard has a point.

It's true there was no overt co-operation between Labor and the Coalition, nor any atmosphere of sweetness and light. The Liberals never said anything good about Labor and always found plenty to criticise and oppose. To the casual observer, it was adversarial politics as usual.

In particular, the Libs vigorously opposed almost all of Labor's tax reforms, particularly the taxes on fringe benefits and capital gains, the compulsory superannuation levy and even the restoration of the assets test for the age pension.

They also vigorously opposed Medicare and Labor's Accord with the union movement.

Howard may be happy to praise the Hawke and Keating reforms at this late stage, but he didn't at the time, nor during the almost 12 years he was prime minister. This is an old trick: praising long departed opponents as a way of criticising the present incumbents.

I don't doubt that, had a Howard-led government been elected in 1983, it wouldn't have instigated all the reforms Keating made in the following 13 years. It would have lacked the vision, drive, courage and sense of urgency Keating had – not to mention the support of its Labor opposition.

Keating is no doubt right in saying his biggest problem in pushing reform was getting the Labor caucus and the unions lined up behind him. In this the Accord was a great help, meaning ACTU secretary Bill Kelty deserves his share of the reform credit.

The Labor faithful may regard Keating as a saint up there with Whitlam today, but at the time they thought of him as a turncoat.

But the fact is Howard is right in listing all the reforms the Coalition, under the influence particularly of him and his former adviser, Professor John Hewson, did not oppose: privatisation of Qantas and the Commonwealth Bank, deregulation of bank lending rates, floating the dollar, admitting foreign banks, ending import quotas and virtual phasing out of tariffs, and introducing the HECS scheme for university fees.

Urged on by Hewson, Howard instigated the whole financial deregulation project by commissioning the Campbell report. He implemented as many of its recommendations as Malcolm Fraser would let him, before the Fraser government was swept from office.

It's noteworthy that nothing Keating went on to do was mentioned in the 1983 election campaign. In opposition, Keating joined the rest of Labor in vigorously attacking financial deregulation.

In office, he changed his tune, used a quickie report by the banker Vic Martin to sanctify the Campbell proposals, and proceeded to implement them all.

Howard is right in saying the most politically courageous reform was ending the protection of manufacturing. Until then, protectionism had been a bipartisan policy for decades, strongly supported by business and the unions. It remains supported by the public to this day.

It was usual for protection to be stepped up during recessions. But in the depths of the recession of the early '90s – our worst since the Depression – Keating actually instigated the second stage of its removal.

Never was there a better opportunity for the Libs to rally the nation against this monstrous act of folly. By then they were being led by Hewson and his criticism remains burnt on my brain: Labor should have gone further.

Keating says he never worried about the Libs, never even spoke to them about things. I believe him. What I don't believe is his implication that, had they opposed his reforms, nothing would have been any different.

In the key areas Howard listed, Keating knew his opponents would not attempt to score points against him, that the interest groups and voters adversely affected would have no political flag to rally under. This hugely strengthened his hand.

It was a unique period in our economic history, for which the Libs deserve their share of credit.

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Jesus the great debt-eliminator

At this time of our greatest Christian holy-days, what does the Bible have to say about economics? A lot more than you may think.

That's according to the Czech economist Tomas Sedlacek, whose book, Economics of Good and Evil, I'll be heavily relying on in this column.

When God expelled Adam and Eve from the Garden of Eden after they had disobeyed him, part of their punishment was that "by the sweat of your brow you will eat your food" – they'd have to work for their living.

But Jesus said, "Man does not live on bread alone". So we have to be concerned about making our living, but we also have to be concerned about more than that.

"We were endowed with both body and soul, and we are both spiritual and material beings . . . Without the material, we die; without the spiritual, we stop being people," Sedlacek says.

Christianity doesn't condemn the material, but it does condemn materialism. It's not money that's the problem, it's the love of money. Keep too much of it for yourself and you've probably crossed the line.

It's true Jesus chased from the temple "men selling cattle, sheep and doves, and others sitting at tables exchanging money", but he didn't chase them any further. His problem was not with their commerce but with their mixture of the sacred with the profane.

Jesus's teaching is often based on paradox, we're told. Jesus considers more valuable two mites that a poor widow drops on to the collection plate than the golden gifts of the rich.

Implicitly, this legitimises the role of money. But, to economists, it also shows Jesus understood the concept of marginal disutility. The widow's mite involved much greater sacrifice than the rich person's gold.

Sedlacek notes the New Testament's extensive use of economic metaphors. Of Jesus's 30 parables, 19 are set in an economic or social context: the parable of the lost coin; of talents (money), where Jesus rebukes a servant who didn't "put my money on deposit with the bankers"; of the unjust steward; of the workers in the vineyard; of the two debtors; of the rich fool, and so forth.

But get this: the most central concept in the Easter story of Christ's death and resurrection – redemption – originally had a purely economic meaning. You need to know that, in New Testament Greek, sin and debt were the same word.

People who were unable to pay their debts became debt slaves. Once you fell into slavery, the only escape was for someone to ransom you, to pay your bail. Jesus's role was to redeem us, purchase us at a price, buying us out of our debt of sins. The price was the shedding of his blood on the cross, just as the sacrificial lamb's blood was shed at Passover.

"In him we have redemption through his blood, the forgiveness of sins, in accordance with the riches of God's grace," St Paul said.

Western civilisation has been shaped by Christianity and Christian values, which means Christianity has also shaped economics. Sedlacek says the prayer "forgive us our sins", meaning "cancel our debts", could be heard from the West's leading banks in the global financial crisis.

Our modern economy cannot function without institutions that deliver the unfair forgiveness of debt. Bankrupts, for instance, are discharged even though they've paid back only a fraction of what they owe. When a company goes bust owing millions, the liability of its shareholders is limited to the face-value of their shares, paid long before by the original purchaser of the shares.

As for the GFC, Sedlacek says, "It would be hard to imagine the financial Armageddon that would follow if the government actually did not pay the ransom and redeem banks and some large companies".

"This, of course, goes against all principles of sound reason and of basic fairness. We also breached many rules of competition on which capitalism is built. Why did the most indebted banks and companies, which did not compete very well, receive the largest forgiveness?"

Why? It had to be done, in order to redeem not only these particular troubled and highly indebted companies, but also others that would fail if these few were not saved.

You've heard of "positive discrimination", but Sedlacek says Christian thought emphasises the concept of "positive unfairness": the more you've sinned, the bigger dollop of forgiveness you get.

"It doesn't matter how hard you try – everyone gets the same reward" (something the prodigal son's brother had trouble accepting).

"Christianity thus largely abolishes the accounting of good and evil. God forgives, which is positively unfair," he concludes.

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Why we're still not free of the GFC

Almost six years since the global financial crisis reached its height, it's easy to forget just how close to the brink the world economy came. To someone like Reserve Bank governor Glenn Stevens, however, those events are burnt on his brain.

Which explains why he thought them worth recalling in a speech this week. And also why, so many years later, the major developed economies of the North Atlantic are still so weak and showing little sign of returning to normal growth any time soon.

When those key decision-makers who lived through 2008 and 2009 say that there was the potential for an outcome every bit as disastrous as the Great Depression of the 1930s, "I don't think that is an exaggeration", he says.

"Any account of the events of September and October 2008 reminds one of what an extraordinary couple of months they were. Virtually every day would bring news of major financial institutions in distress, markets gyrating wildly or closing altogether, rapid international spillovers and public interventions on an unprecedented scale in an attempt to stabilise the situation.

"It was a global panic. The accounts of some of the key decision-makers that have been published give even more sense of how desperately close to the edge they thought the system came and how difficult the task was of stopping it going over."

But, despite the inevitable "mistakes and misjudgments", the authorities did stop it going over. Stevens attributes this to their having learnt the lessons of the monumental mistakes and misjudgments that that turned the Great (sharemarket) Crash of 1929 into the Great Depression.

Economic historians (including one Ben Bernanke) spent decades studying the Depression and, in Stevens' summation, they came up with five key lessons: be prepared to add liquidity – if necessary, a lot of it – to financial systems that are under stress; don't let bank failures and a massive credit crunch reinforce a contraction in economic activity that is already occurring – try to break that feedback loop; be prepared to use macro-economic policy aggressively.

So far as possible, maintain dialogue and co-operation between countries and keep markets open, meaning don't resort to trade protectionism or "beggar-thy-neighbour" exchange rate policies. And act in ways that promote confidence – have a plan.

There was a lot of action and a lot of international co-operation, and it worked. As a result, we talk about the Great Recession, not the Great Depression Mark II.

"We may not like the politics or the optics of it all – all the 'bailouts', the sense that some people who behaved irresponsibly got away with it, the recriminations, the second-guessing after the event and so on," he says. "But the alternative was worse."

With collapse averted, the next step was to fix the broken banks. Their bad debts had to be written off and their share capital replenished, either by them raising capital from the markets or accepting it from the government.

Fixing the banks' balance sheets was necessary for recovery, but not sufficient. A sound financial system isn't the initiating force for growth, so stimulatory macro-economic policies were needed to get things moving.

On top of all the government spending to recapitalise the banks came a huge amount fiscal (budgetary) stimulus spending. Stevens says a financial crisis and a deep recession can easily add 20 or 30 percentage points to the ratio of public debt to gross domestic product.

Then you've got the weak economic growth leading to far weaker than normal levels of tax collections. Add to all that the various North Atlantic economies that had been running annual budget deficits for years before the crisis happened.

"So fiscal policy has not had as much scope to continue supporting recovery as might have been hoped," Stevens says. "Policymakers in some instances have felt they had little choice but to move into consolidation mode [spending cuts and tax increases] early in the recovery."

He doesn't say, but I will: this crazy, counterproductive policy of "austerity" has helped to prolong the agony.

With fiscal policy judged to have used up its scope for stimulus, that leaves monetary policy. Central banks cut short-term interest rates hard, but were prevented from doing more because they soon hit the "zero lower bound" (you can't go lower than 0 per cent).

But long-term interest rates were still well above zero and, in the US and the euro area, long-term rates play a more central role in the economy than they do in Oz. Hence the resort to "quantitative easing".

Under QE, the central bank buys long-term government bonds or even private bonds and pays for them merely by crediting the accounts of the banks it bought from. Adding to the demand for bonds forces their price up and yield (interest rate) down. And reducing long-term rates is intended to stimulate borrowing and spending.

Has it worked? It's intended to encourage risk-taking, but are these risks taken by genuine entrepreneurs producing in the real economy, or are they financial risk-taking through such devices as increased leverage?

Stevens' judgment is that it always takes time for an economy to heal after a financial crisis [because it takes so long for banks, businesses and households to get their balance sheets back in order - they've borrowed heavily to buy assets now worth much less than they paid] so it's too soon to draw strong conclusions.

For Stevens, the lesson is that there are limits to how much monetary policy can do to get economies back to healthy growth after financial crises. "If people simply don't wish to take on new business risks, monetary policy can't make them," he says.

Perhaps the answer is simply subdued "animal spirits" – low levels of confidence, he thinks. But, at some stage, sharemarket analysts and the investor community will ask fewer questions about risk reduction and more about the company's growth strategy.

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We need less fancy financial footwork, not more

Attention conspiracy theorists: see if you can detect a pattern in this. Tony Abbott wants to review the renewable energy target, so he appoints self-professed climate change "sceptic" Dick Warburton, who feels qualified to explain to the scientists where they're going wrong.

Abbott wants to review the financial system, so he appoints a former boss of a big four bank, David Murray, who feels qualified to explain to economists where they're going wrong.

So, which industry sector stands the better chance of getting what it wants from its review?

Can you imagine how many proposals Murray's committee will receive aimed at making the financial system bigger and better - and all in return for just a little more help from taxpayers?

I read that the Australian Bankers Association's submission proposes abolition of interest withholding tax, so as to support offshore fund-raising by local banks and to encourage overseas banks to lend more in Australia. It also calls for the removal of "tax disincentives" on bank deposits. All to increase this financial sector's contribution to economic growth and jobs, naturally.

The government's terms of reference say "the inquiry is charged with examining how the financial system could be positioned to best meet Australia's evolving needs and support Australia's economic growth".

Fine. But if it's to be more than just an industry sales pitch, the inquiry needs rigorously to examine the industry's convenient assumption that the bigger it gets the more it benefits the rest of us.

In a brief submission that deserves more attention than it's likely to get, Professor Ron Bird and Dr Jack Gray, of the Paul Woolley centre at the University of Technology, Sydney, summarise the growing evidence that the developed economies' much expanded financial systems have been a bad investment from the perspective of the wider economy. (Both are former fund managers.)

The growth in America's financial sector has been amazing, with its share of gross domestic product rising from less than 3 per cent in 1950 to about 5 per cent in 1980 and more than 8 per cent in 2006. Its share of total corporate profits grew from 14 per cent in 1980 to almost 40 per cent by 2003.

Salaries in US financial services were similar to other industries until 1980, but are now on average 70 per cent higher than those elsewhere. This remarkable growth is referred to as the "financialisation" of the economy. One test of the inquiry's thoroughness will be whether it works out comparable figures for Oz.

The first warning that this growth might be making economies more risky came from Professor Raghuram Rajan, of the University of Chicago, at a central bankers' conference in 2005. They told him not to worry. He has since argued that the financial system's big rewards for risk-taking (with other people's money) result in the economy proceeding from bubble to bubble.

Since the mid-2000s, an increasing amount of analysis has questioned whether the growth of the financial system has worked to the betterment of anybody other than those working in the industry, Bird and Gray say.

One study for the Bank for International Settlements concludes that "big and fast-growing financial sectors can be very costly for the rest of the economy ... drawing essential resources in a way that is detrimental to growth at the aggregate level". A British minister has said: "We need more real engineers and fewer financial engineers."

Other research has found that real (physical) investment is being crowded out by the increasing size and profitability of financial investment. Even our Reserve Bank governor, Glenn Stevens, has questioned "whether all this growth [in finance] was actually a good idea; maybe finance had become too big (and too risky)".

The huge advances in information technology could have been expected to result in lower costs for financial services, but unit costs have actually increased over the past 30 years.

All the trading on financial markets is supposed to lead to better "price discovery" and thus improved efficiency in the allocation of resources, but a study found no evidence of financial market prices becoming more "informationally efficient".

Adair Turner, former chairman of Britain's Financial Services Authority, sees "no clear evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last 20 or 30 years has driven increased growth or stability".

Bird and Grey conclude that the starting point of the Murray inquiry's analysis should be to assess the financial system's effectiveness and highlight where it is falling short and why.

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Your guide to business entitlement

With the Abbott government's close relations with big business, we're still to see whether its reign will be one of greater or less rent-seeking by particular industries. So far we have evidence going both ways.

We've seen knockbacks for the car makers, fruit canners and Qantas, but wins for farmers opposing the foreign takeover of GrainCorp and seeking more drought assistance, as well as a stay on the big banks' attempt to water down consumer protection on financial advice.

The next test will be the budget. Will the end of the Age of Entitlement apply just to welfare recipients (especially the politically weak, e.g. the unemployed and sole parents, rather than politically powerful age pensioners) or will it extend to "business welfare"?

With Joe Hockey searching for all the budget savings he can find, there's a lot of business welfare or, euphemistically, "industry assistance" to look at. The Productivity Commission measures it every year in its Trade and Assistance Review.

Government assistance to industry is provided in four main ways: through tariffs (restrictions on imports), government spending, tax concessions and regulatory restrictions on competition. Although much rent-seeking takes the form of persuading governments to regulate markets in ways that advantage your industry, the benefit you gain is hard to measure, so it's not included in the commission's figuring.

Assistance through tariffs is far less than in the bad old days before micro-economic reform, but there's still some left. However, its cost is borne directly by consumers in the form of higher prices. So it's not relevant to Hockey's search for budget savings. Even so, I'll give you a quick tour.

The commission estimates that, in 2011-12, tariffs allowed manufacturing industries (plus the odd rural industry) to sell their goods for $7.9 billion a year more than they otherwise would have.

In the process, however, this forced up the cost of goods used by manufacturers and other industries as inputs to their production of goods and services by $6.8 billion a year. About 30 per cent of this cost to inputs was borne by the manufacturers themselves, leaving about 70 per cent borne by other industries, largely the service industries.

(This, by the way, shows why import protection doesn't help employment as non-economists imagine it does. It may prop up manufacturing jobs, but it's at the expense of jobs everywhere else in the economy.)

So now we get to budgetary assistance to industry. On the spending side of the budget it can take the form of direct subsidies, grants, bounties, loans at concessional interest rates, loan guarantees, insurance arrangements or even equity (capital) injections.

On the revenue side of the budget it can take the form of concessional tax deductions, rebates or exemptions, preferential tax rates or the deferral of taxation. In 2011-12, the total value of budgetary assistance was $9.4 billion, with just over half that coming from spending and the rest from tax concessions.

Often people will virtuously assure you their outfit doesn't receive a cent of subsidy from the government, but omit to mention the special tax breaks they're entitled to. Think-tanks that rail against government intervention and the Nanny State, hate admitting they're sucking at the teat because the donations they receive are tax deductible (causing them to be higher than otherwise, but at a cost to other taxpayers).

This is why economists call tax concessions "tax expenditures" - to recognise that, from the perspective of the budget balance and of other taxpayers, it doesn't matter much whether the assistance comes via a cheque from the government or via the right to pay less tax than you otherwise would.

Of the total budgetary assistance in 2011-12 of $9.4 billion, 15 per cent went to agriculture, 7 per cent to mining, 19 per cent to manufacturing and 45 per cent to the services sector (leaving 14 per cent that can't be allocated to particular industries).

To put that in context, remember that agriculture's share of gross domestic product (value-added) is about 3 per cent, mining's is 10 per cent and manufacturing's is 8 per cent, leaving services contributing about 79 per cent.

Within manufacturing, the recipients of the most business welfare are motor vehicles and parts, $620 million, metal and metal fabrication, $270 million, petroleum and chemicals, $220 million, and food and beverage processors, $110 million.

Within services, the big ones are finance and insurance, $910 million, property and professional services, $610 million, and arts and recreation, $350 million.

But if you combine tariff and budgetary assistance, then compare it with the industry's value-added (share of GDP), you get a different perspective on which industries' snouts are deepest in the trough. The "effective rate of combined assistance" is 9.4 per cent for motor vehicles and parts, 7.3 per cent for textiles, clothing and footwear, and 4.7 per cent for metal and metal fabrication.

Get this: outside manufacturing, the most heavily assisted goods industry relative to the size of its contribution to the economy is forestry and logging on 7.2 per cent. We pay a huge price to destroy our native forests.

Within services, the most heavily assisted industry is the one where incomes are so much higher than anywhere else: financial services. Virtually all the assistance picked up in the commission's calculations comes via special tax breaks, such as the tax concession for offshore banking units and the reduced withholding tax on foreigners receiving distributions from managed investment trusts.

But that ain't the half of it. These calculations don't pick up two big free kicks: the benefit to the industry because the government forces almost all workers to hand over 9.25 per cent of their pay to be "managed" by it, and the benefit it gains from having one of its main products, superannuation, so heavily subsidised by other taxpayers.

Cut these fat cats? Naah, screwing people on the dole would be much easier.

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Compulsory super without protections is a rip off

A few weeks ago, when I offered my list of our top 10 economic reforms of the past 40 years, I was surprised by the number of people arguing I should have included compulsory employee superannuation in the list. Really? I can't agree.

It is, after all, merely a way of compelling people to save for their retirement. That's probably no bad thing in principle, countering our all too human tendency to worry excessively about the here and now and too little about adequate provision for our old age.

But compulsory saving hardly counts as a major reform. I suspect some of my correspondents see it as a boon for workers because it extracts a benefit from employers over and above the wages they're paid.

If so, they've been misled by appearances. Economists are in no doubt it all comes out in the wash: that when the government obliges employers to contribute to workers' retirement savings, the employers eventually make up for it by granting smaller wage rises than they otherwise would have.

It's true that compulsory super contributions - and the subsequent earnings on them - attract tax concessions, being taxed at a flat rate of just 15 cents in the dollar. But while upper income-earners do disgracefully well out of these concessions, people on incomes around the average gain little advantage, and those earning less than $37,000 a year gain nothing. Hardly sounds fair to me.

My other reservation about compulsory super is the way it compels employees to become the victims of the most shamelessly grasping, overpaid industry of them all: financial services. These are the people who made top executives and medical specialists feel they were underpaid.

Compulsory super delivers a huge captive market for the providers of investment services to make an easy living from and for the less scrupulous among them to prey upon. The pot of money the government compels us to give these people to manage on our behalf has now reached $1.6 trillion.

Most of us have little idea how much these people appropriate from our life savings each year to reward themselves for the services we're compelled to let them provide to us - and little desire to find out.

We should be less complacent. For many workers it's more than we pay for electricity each year. Think of it: we put so much energy and passion into carrying on about the rising price of power - and Tony Abbott used our resentment to get himself elected - while the men in flash suits dip into our savings without most of us knowing or caring.

To be fair, industry super funds dip into our savings far more sparingly than the profit-driven "retail" funds backed by the big banks, insurance companies and firms of actuaries. Since most workers do have a choice, you'd need a very good reason not to have your money with an industry fund.

But even this worries me. It means the union movement - the people whose job is to protect workers by being full bottle on the tricks the finance industry gets up to - has divided loyalties. Those who should be holding the industry to account are also part of it.

For years the industry campaigned for an increase in the super levy of 9 per cent of salary, arguing it was insufficient to provide people with an adequate income in retirement. This is a dubious argument, rejected by the Henry taxation review.

But look at it another way: here is a hugely profitable industry arguing the government should increase the proportion of all employees' wages diverted to the industry for it to take annual bites out of before giving us access to our money at age 60 or later.

This is classic rent-seeking. The Howard government was never tempted to yield, but as part of the Labor government's mining-tax reform package, it agreed to boost compulsory super contributions to 12 per cent by 2019. Why? I don't doubt Labor was got at by the union end of the financial services industry.

Contributions increased to 9.25 per cent last July, but the Abbott government came to power promising to defer the phase-up for two years. I'd lay a small bet this deferral will become permanent - though probably not before contributions rise to 9.5 per cent on July 1.

I wouldn't be sorry to see the phase-up abandoned. The Henry report recommended against it, arguing that action to reduce the industry's fees could produce a similar increase in ultimate super payouts. And it's doubtful that low income earners are better off being compelled to save rather than spend their meagre earnings.

The government's policy of compelling workers to hand so much of their wages over to the finance industry surely leaves the government with a greater-than-normal obligation to ensure the industry doesn't exploit this monopoly by misadvising and overcharging its often uninformed customers.

This - along with the millions lost by investors in Storm Financial and other dodgy outfits - prompted Labor's Future of Financial Advice reforms, which focused on prohibiting or highlighting hidden commissions and requiring advisers to put their clients' interests ahead of their own.

But now Senator Arthur Sinodinos is seeking to water down these consumer protections in the name of reducing "red tape". The financial fat cats live to rip us off another day.

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The four business gangs that run America

IF YOU'VE ever suspected politics is increasingly being run in the interests of big business, I have news: Jeffrey Sachs, a highly respected economist from Columbia University, agrees with you - at least in respect of the United States.

In his book, The Price of Civilisation, he says the US economy is caught in a feedback loop. "Corporate wealth translates into political power through campaign financing, corporate lobbying and the revolving door of jobs between government and industry; and political power translates into further wealth through tax cuts, deregulation and sweetheart contracts between government and industry. Wealth begets power, and power begets wealth," he says.

Sachs says four key sectors of US business exemplify this feedback loop and the takeover of political power in America by the "corporatocracy".

First is the well-known military-industrial complex. "As [President] Eisenhower famously warned in his farewell address in January 1961, the linkage of the military and private industry created a political power so pervasive that America has been condemned to militarisation, useless wars and fiscal waste on a scale of many tens of trillions of dollars since then," he says.

Second is the Wall Street-Washington complex, which has steered the financial system towards control by a few politically powerful Wall Street firms, notably Goldman Sachs, JPMorgan Chase, Citigroup, Morgan Stanley and a handful of other financial firms.

These days, almost every US Treasury secretary - Republican or Democrat - comes from Wall Street and goes back there when his term ends. The close ties between Wall Street and Washington "paved the way for the 2008 financial crisis and the mega-bailouts that followed, through reckless deregulation followed by an almost complete lack of oversight by government".

Third is the Big Oil-transport-military complex, which has put the US on the trajectory of heavy oil-imports dependence and a deepening military trap in the Middle East, he says.

"Since the days of John D. Rockefeller and the Standard Oil Trust a century ago, Big Oil has loomed large in American politics and foreign policy. Big Oil teamed up with the automobile industry to steer America away from mass transit and towards gas-guzzling vehicles driving on a nationally financed highway system."

Big Oil has consistently and successfully fought the intrusion of competition from non-oil energy sources, including nuclear, wind and solar power.

It has been at the side of the Pentagon in making sure that America defends the sea-lanes to the Persian Gulf, in effect ensuring a $US100 billion-plus annual subsidy for a fuel that is otherwise dangerous for national security, Sachs says.

"And Big Oil has played a notorious role in the fight to keep climate change off the US agenda. Exxon-Mobil, Koch Industries and others in the sector have underwritten a generation of anti-scientific propaganda to confuse the American people."

Fourth is the healthcare industry, America's largest industry, absorbing no less than 17 per cent of US gross domestic product.

"The key to understanding this sector is to note that the government partners with industry to reimburse costs with little systematic oversight and control," Sachs says. "Pharmaceutical firms set sky-high prices protected by patent rights; Medicare [for the aged] and Medicaid [for the poor] and private insurers reimburse doctors and hospitals on a cost-plus basis; and the American Medical Association restricts the supply of new doctors through the control of placements at medical schools.

"The result of this pseudo-market system is sky-high costs, large profits for the private healthcare sector, and no political will to reform."

Now do you see why the industry put so much effort into persuading America's punters that Obamacare was rank socialism? They didn't succeed in blocking it, but the compromised program doesn't do enough to stop the US being the last rich country in the world without universal healthcare.

It's worth noting that, despite its front-running cost, America's healthcare system doesn't leave Americans with particularly good health - not as good as ours, for instance. This conundrum is easily explained: America has the highest-paid doctors.

Sachs says the main thing to remember about the corporatocracy is that it looks after its own. "There is absolutely no economic crisis in corporate America.

"Consider the pulse of the corporate sector as opposed to the pulse of the employees working in it: corporate profits in 2010 were at an all-time high, chief executive salaries in 2010 rebounded strongly from the financial crisis, Wall Street compensation in 2010 was at an all-time high, several Wall Street firms paid civil penalties for financial abuses, but no senior banker faced any criminal charges, and there were no adverse regulatory measures that would lead to a loss of profits in finance, health care, military supplies and energy," he says.

The 30-year achievement of the corporatocracy has been the creation of America's rich and super-rich classes, he says. And we can now see their tools of trade.

"It began with globalisation, which pushed up capital income while pushing down wages. These changes were magnified by the tax cuts at the top, which left more take-home pay and the ability to accumulate greater wealth through higher net-of-tax returns to saving."

Chief executives then helped themselves to their own slice of the corporate sector ownership through outlandish awards of stock options by friendly and often handpicked compensation committees, while the Securities and Exchange Commission looked the other way. It's not all that hard to do when both political parties are standing in line to do your bidding, Sachs concludes.

Fortunately, things aren't nearly so bad in Australia. But it will require vigilance to stop them sliding further in that direction.

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Reserve turns spotlight on dark side of innovation

There are few words in the business bible more holy than "innovation". And I'm a believer in its great virtue. But, like many things in economics, sometimes what's usually a good thing can be a bad thing - even a terrible thing.

In a speech on banking, the deputy governor of the Reserve Bank, Dr Philip Lowe, drew attention to the dark side of innovation in the financial sector and advocated closer regulation of it. Here's what he said, with my interpolations.

"Over many decades, our societies have benefited greatly from innovation in the financial system. Financial innovation has delivered lower cost and more flexible loans and better deposit products."

It has provided new and more efficient ways of managing risk, he says, helped our economies to grow and our living standards to rise.

"But financial innovation can also have a dark side," he says. "This is particularly so where it is driven by distorted remuneration structures within financial institutions, or by regulatory, tax or accounting considerations."

Ain't that the truth. Distorted remuneration structures go a long way to explain the origins of the global financial crisis. People paid commissions to give home loans to people who couldn't possibly pay them off. People on Wall Street hugely rewarded when their bets pay off, but suffering no great personal loss when their bets blow up.

People who invent toxic products and flog them to their own clients. Credit rating agencies paid handsomely to give toxic products triple-A ratings.

Because (for reasons I'm yet to fully understand - or meet anyone who does) remuneration in the financial sector is so eye-wateringly gargantuan - enough to make chief executives envious - it attracts many of our brightest minds, who could be advancing the frontiers of science or managing the economy, but instead spend their days finding ways around financial regulations, tax law and accounting conventions.

I suppose you'd have to be hugely rewarded to devote your life to making such an antisocial contribution.

Lowe says problems can also arise where the new products are not well understood by those who develop and sell them, or by those who buy and trade them.

"Over recent times, much of the innovation that we have seen has been driven by advances in finance theory and computing power, which have allowed institutions to slice up risk into smaller and smaller pieces and allow each of those pieces to be separately priced," he says.

"One supposed benefit of this was that financial products could be engineered to closely match the risk appetite of each investor. But much of the financial engineering was very complicated and its net benefit to society is debatable."

Many of the products were not well understood, he says, and many of the underlying assumptions used in pricing turned out to be wrong. Even sophisticated financial institutions with all their resources [all those highly paid, super-bright people] didn't understand the risks at a micro-economic nor a system-wide level.

"As a result, they took more risk than they realised and created vulnerabilities for the entire global financial system."

Just so. We live in an era when it's the height of fashion to see much of the management task as managing the many and varied "risks" to which businesses are subject. It's a useful way of thinking.

One way to manage risk is to spread it very thinly between a large number of people. All insurance policies are longstanding examples of this approach. Another approach is to join together people facing opposite risks. For instance, a contract between someone who stands to lose if the dollar falls and someone who stands to lose if it rises.

The market has developed lots of "plain vanilla" derivatives that allow firms to swap their interest-rate or foreign-exchange risks in this way. This is socially beneficial innovation.

But when derivative contracts become far more complicated than that, there can be problems. Risk management can itself be risky. It's hard to escape the risk of human fallibility in all its forms: the risk that people (even professionals, let alone punters) don't really understand the risks they're taking on; the risk of people's judgment being clouded by greed or hubris (nothing's gone wrong so far and that's because I'm so smart).

Then there are all the previously non-existent risks you create when you invent assets for which there's no market price, but for which you calculate a price using a fancy mathematical formula. All such synthetic prices are built on a host of explicit and hidden assumptions.

Forget that small fact and you can come horribly unstuck, as we've already discovered in the global financial crisis to our huge and far-from-over cost - as witness, Europe.

The question is, how can society obtain the benefits that financial innovation delivers while reducing the risks it entails? Lowe concedes this won't be easy, but sees a way forward in greater public sector oversight of areas where innovation is occurring.

"I suspect that the answer is not more rules, for it is difficult to write rules for new products, especially if we do not know what those new products will be, and the rules themselves can breed distortions," he says.

But one concrete approach is for supervisors [such as our Australian Prudential Regulation Authority] and central banks to pay very close attention to areas where innovation is occurring: to make sure they understand what's going on and to test and probe institutions about their management of risks in new areas and new products.

"Ultimately, supervisors need to be prepared to take action to limit certain types of activities, or to slow their growth, if the risks are not well understood or not well managed," he concludes.

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Herd behaviour, fashion and status seeking

Think for more than a moment about the causes of the global financial crisis - the fallout from which is still hurting the US and Europe - and you realise herd behaviour had a lot to do with it.

People paid extraordinarily high prices for houses because they felt they were trailing the Joneses. Brokers sold unsound mortgages because they had to keep up with rival brokers. Funds managers - remunerated according to their relative performance against other managers - traded shares with the same motive.

So, the study of herd behaviour must be a pretty important part of economics, right? Wrong. Between 1970 and the onset of the crisis only nine out of 11,500 articles in three esteemed economic journals discussed herd behaviour. And when they did discuss it they usually viewed it as "informational learning" - learning what I should do from your behaviour. If you hear a fire bell and see people running for the exit, you don't inquire further, you just join them.

Yeah, sure. That explains it. Fortunately, one economist who's taken a great interest in herding is Professor Andrew Oswald, of the University of Warwick, in Britain, and the IZA research institute, in Bonn. Oswald spoke about herd behaviour and keeping up with the Joneses at a conference this week to celebrate the contribution of Professor Ian McDonald, of Melbourne University.

Unlike his peers, Oswald has spent his career crossing the boundaries between economics and the other social sciences. Now he's forging links with the physical sciences and is on the board of editors of the journal Science.

On herding, Oswald took his lead from a seminal zoological paper written in 1971. "Before that article, the standard theory in biology was that herds had some inexplicable communitarian instinct," Oswald says. But the article argued that an animal clusters with others because its relative position is what matters. When you're being threatened by a predator, clustering with others reduces the chance it will pick you as its prey.

What has this to do with humans? Just our preoccupation with our position relative to others. Our desire to be in fashion - to wear what our peers are wearing - is motivated subconsciously by our strong desire to keep up.

And falling back worries us because it involves dropping down the status ladder. So, our often demonstrated desire to do what other people are doing seems to show a deep, though unconscious, concern to defend or advance our status (or rank) relative to others.

Economists have long been suspicious of survey evidence, of asking people what they think about things or why they do things. It's too subjective; how can you be sure they're telling you the truth? This is one of the profession's reservations about the study of happiness (of which Oswald has been a leader among economists).

So, Oswald has been interested in finding more objective ways to measure feelings such as happiness. When I compare your rating of your satisfaction with life with your spouse's or your friend's rating of your satisfaction, do they line up? (Yes, they do.)

He's done a lot of work using the British medical profession's system for rating people's mental health, rather than just asking people how they feel about their lives.

Another approach is to use magnetic resonance imaging (MRI scanning) to see what happens inside people's brains when they have certain feelings or encounter certain ideas.

Yet another approach Oswald is pursuing is the use of "biomarkers": can changes in a person's physiology - their heart rate or blood pressure, say - tell us about what they're thinking and feeling?

Oswald quotes the results of a study by German economists who put pairs of people in adjacent brain scanners and asked them puzzle questions, with money rewards for correct answers. They found that outperforming the other guy had a positive effect on the reward-related parts of the brain. People compare themselves with others and enjoy feeling they're winning.

You reckon that's pretty obvious? Not to an economist. Their standard model assumes away all interpersonal comparison. My likes and dislikes ("preferences") are unaffected by other people's preferences and never change over time.

Raise my income by $10 and my satisfaction ("utility") increases. Raise my income by

$20 and there's a commensurately greater increase in my utility. Raise my income by

$10 while you increase my mate's income by $20 and I won't mind a bit.

Actually, we know from happiness research that relative income (how my income compares with yours) has a big effect on how satisfied people feel with their lives.

Oswald asks whether our satisfaction from social status accelerates or decelerates as we increase in status. That is, does our pursuit of status bring increasing marginal utility or decreasing marginal utility?

This question is still being researched empirically. Oswald quotes the case of top tennis players. The gain in utility from going from being third in the world to second is likely to be much bigger than the gain from going from eighth to seventh.

But increasing marginal utility is probably limited to the very top of the status ladder, with diminishing utility applying to most of us.

We know, for instance, that though people with high incomes are happier than those with low incomes successive increases in income buy progressively smaller and smaller increases in satisfaction with life.

Another thing we know is that the rising average real incomes the developed economies have achieved over the decades haven't led to any increase in average levels of satisfaction.

This raises what Oswald calls a "disturbing possibility". "Maybe modern society is stuck," he says. "Individually, we chase higher income and 'rank', but for society as a whole this cannot be achieved."

Here's another worry: "Herd behaviour is often very natural and individually rational. But it has the potential to be disastrous for the group," he says.

"When rewards depend on your relative position it will routinely be dangerous to question whether the whole group's activity is flawed, and be rational simply to compete hard within the rules that govern success."

In the dotcom bubble a decade ago - where the shares of internet companies that had never made a dollar of profit traded for ever more ridiculous prices - those analysts who said it made no sense got fired.

"In financial markets, people are now routinely rewarded in a way that depends on their relative performance" - whether they're in the top quartile, second quartile or whatever. "That's dangerous," he concludes.

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Sorry to be so sober. World not ending

At times like these, much of the media tends to cater to people who enjoy a good panic. The sky is falling and the proof is that billions have been wiped off the value of shares in just the past few days. Which makes me wonder how I've survived in the media for so many years. I hate panicking. So I'm always looking for contrary evidence. I just have hope there's a niche market of readers who prefer a sober assessment.

A bane of my working life is the way people imagine the state of the sharemarket to be far more important than it is in the workings of the economy. Our response to big falls in the sharemarket is based more on superstition than logical analysis, and a lot of people who should know better are happy to pander to the public's incomprehension.

We have a kind of race memory - a relic from the 1930s - that tells us a sharemarket crash is invariably followed by an economic slump. It ain't. As the Nobel-prize winning economist Paul Samuelson once quipped, ''the stockmarket has predicted nine of the past five recessions''.

Do you remember the crash of October 1987? No, probably not. There's no great reason to. It was the biggest fall on Wall Street since the Great Crash of 1929. People were panicking on that day in 1987 much as they are now.

A commentator senior to me predicted on page 1 it would lead to a global depression. In my comment - which was relegated to an inside page - I predicted no worse than a world recession. Fortunately, my thoughts were billed as ''The End Is Not Nigh''.

Turned out we were both way too pessimistic. What transpired? Precisely nothing. Neither in America nor here. In Australia the economy motored on for more than another two years before a combination of the subsequent commercial property boom and many more increases in the official interest rate finally brought us the recession we had to have.

The trouble with taking the sharemarket as your infallible guide to the economy's future is that the market itself is prone to panic. As its practitioners admit, its mood swings between greed and fear. Like all financial markets - and like the media - it acts in haste and repents at leisure. You can panic today because you can always change your mind tomorrow.

That's fine when onlookers don't take the market's antics too seriously. When they take its mood swings as authoritative, however, their reactions can cause those antics to have adverse effects on the ''real'' economy of spending and jobs that we inhabit.

In other words, what's important is not the ups and downs of the sharemarket, but the way we react to them.

In 1987, a lot of ordinary people who'd bought shares during the boom rushed out and sold them - thus buying high and selling low, precisely the opposite behaviour to the way you make money from shares. But the public soon shrugged off its anxiety and it wasn't long before the market recovered its lost ground.

Of course, a lot of things have changed since that great non-event of 1987. In those days, the link between the sharemarket and our daily lives was quite tenuous. These days, the link is much stronger thanks to the advent of compulsory superannuation - which has given most of us a fair stake in the sharemarket - and the baby boomers' proximity to retirement.

These days a sustained fall in share prices knocks a noticeable hole in people's retirement savings. That hole will refill in time, but who's to say how long it will take? Another difference with 1987 is that, this time, the sharemarkets in Wall Street and Europe really do have things worth worrying about. The American economy is quite weak and, although it's unlikely to drop back into recession unless Americans will it to, it's likely to stay pretty weak for the rest of the decade.

It's the Europeans who have by far the most to worry about, with so many heavily indebted governments locked into the euro and banks that are still in bad shape.

But yet another thing that's changed since 1987 is our economy's reorientation away from America and Europe towards China and the rest of Asia. Much of the fear that rises in our breasts on hearing of crashing sharemarkets is our unthinking conviction that what's bad for them must be bad for us.

It ain't so - not unless we unwittingly make it so. There never was a time when our economy was less dependent on the US and Europe than it is today. Well over half our exports go to Asia, with surprisingly small proportions going to the US and Europe.

It's true we're quite heavily dependent on China, but its problems are all in the opposite direction to those of the North Atlantic economies: it's growing too strongly and could use a bit of a slowdown. There never was a time when China was less dependent on the US and Europe than it is today. The notion that the world's second-largest economy lives or dies by its exports to the North Atlantic is silly.

But if all this is true, why does our sharemarket still take its lead from Wall Street? Because of its tendency to herd behaviour. By tacit agreement, what Wall Street's done overnight acts as a signal to all Australian players of the direction in which our market will be travelling.

What holds in the short term, however, shouldn't hold forever. Eventually, the price of a BHP Billiton share will reflect the profit-making prospects of BHP - and they're still very good.

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West heads to a Greek tragedy, too

To boil it down, the reason Greece is in so much trouble is that every Greek wanted a government that did all the expensive things governments do, but none wanted to pay tax.

Greece's politicians did not have the courage to tell their people that, in the end, you cannot have one without the other.

The Greek government ran budget deficits for year after year, racking up more and more government debt, eventually doing dodgy deals to disguise the amount of that debt until - surprise, surprise - the day of reckoning arrived.

Greece is now in the hands of its bank manager and - another surprise - he is not inclined to be gentle or reasonable.

The ostensible reason the rest of Europe is more worried than sympathetic is Greece's membership of the euro currency group and the knowledge that a lot of their own banks have lent to its government. That, plus the fact that Ireland and Portugal are in similar dire straits.

Were Greece to default on its sovereign (government) debt, it could touch off a financial tsunami - driven as much by fear as logic - that swept up the whole of Europe and even reached across the Atlantic to America.

But, really, why should the major advanced economies of the world be so worried about the fate of a piddling country like Greece? Because their own noses are not clean. They are not as far down the track as Greece and the others, but they, too, have been running big budget deficits year after year, building ever-increasing government debt.

They, too, have not had the courage to tell their voters that government benefits have to be paid for with higher taxes.

Australia used the long boom before the global financial crisis to run successive budget surpluses and so pay off all our net federal government debt, but the United States, Japan, Britain, Italy and various other European countries continued building up big government debts.

Then, when the financial crisis struck, they borrowed huge sums to bail out their teetering banks and, to a lesser extent, to stimulate their deeply recessed economies. Put that on top of their existing high levels of debt and even the mightiest economies of the world are in too deep.

In most of the leading economies, the ratio of government debt to gross domestic product will have risen by 2014 to the region of 100 per cent of GDP, compared with 60 to 70 per cent before the crisis. Japan, which started with a high government debt ratio because of its 1990s economic crisis, will end up with a figure of about 240 per cent by 2014.

This explains the stern warning the Bank for International Settlements, the central banks' central bank, issued at the weekend. The major advanced economies should not just be worried about Greece, it said, they should be worried about themselves. If the huge debt levels of the major economies prompt the world financial markets to wonder if those debts will be honoured, so that the markets take a set against sovereign debt in general, the majors, too, will be in big trouble.

But as the British economist Dr Diane Coyle reminds us in her new book, The Economics of Enough, it is worse than that.

We have known for years that the major advanced economies are facing immense pressure on their budgets from the ageing of their populations. They are committed to generous pension payments and healthcare spending for their retiring baby boomers at a time when, for many countries, their populations will be falling.

The Organisation for Economic Co-operation and Development has estimated that, within a decade, the government of the average member country will need to borrow 5 per cent of gross domestic product a year more than it does at present.

The ideal way to get on top of your debts is to trade your way out. Keep the income coming in, hold down your expenses and use the difference to pay down the principal. What makes it hard is the continuing big interest payments you have to meet before you can reduce the principal. Once your bankers lose faith in you, they may well increase the interest rate you are paying to cover their heightened risk.

For governments it is even harder. If they start from a position of annual deficit, they have to slash spending and raise taxes just to return the budget to balance and so stop adding to the principal. To get the budget into surplus - and so have money to reduce the principal - they have to cut spending and raise taxes even further.

But the more governments cut their spending and raise taxes, the more they slow the growth of their economies. And the more slowly their economies grow, the more slowly their tax revenue grows and the higher is their spending on dole payments, making it that much harder to get back to surplus.

The trouble with bank managers is that when finally they lose patience with you, they become quite unreasonable, imposing requirements and restrictions that actually make it harder for you to repay your debt. And when the "bank manager" takes the form of a herd of anonymous traders in global financial markets, their actions can be destructive and even self-defeating.

No matter how deep the problems of the developed world, it will survive. But these seemingly prosperous countries - which have gone for many years falsely inflating their prosperity by borrowing from the future - are reaching their day of reckoning.

Even if they avoid another financial crisis, they are set for a protracted period of austerity and relative penury, with their economies growing only slowly for many years. They have not woken up to this yet, but they will.

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