AN ECONOMICS FIT FOR HUMANS

Ronald Henderson Oration, Melbourne
August 2004.

1. Introduction

The further I have strayed from my days as an undergraduate, the more convinced I have become of the importance of theory – not just to economics, but to any discipline. Theory is important because it is so pervasive in influencing the way we think, the way we analyse problems in our discipline and the nature of the solutions we favour. Often, we fall into ways of thinking about issues without fully appreciating the influence theory is having on us (Keynes 1936).

At a time when economic rationalists are so influential in government policy making, theory becomes highly relevant because economic rationalists can be defined as people who take conventional economic theory – the neoclassical model of markets, in its simplest form – and raise it to the status of religious doctrine.

In addition, I have become interested in some relatively recent developments in cognitive and social psychology. Psychology has become a lot more interesting to people interested in public policy since the advent of ‘positive psychology’, which has switched the focus from the study of mental illness to the study of people who are perfectly well (Seligman 2002; Kahneman et al. 1999: p. ix).

Two aspects of psychological research present significant challenges to conventional economics: the study of how people make decisions and the study of happiness or ‘subjective well-being’. I wish to draw out the respects in which these advances challenge various aspects of economic theory and the policy prescriptions conventionally flowing from the theory. The first challenge – concerning decision-making – is being taken quite seriously by the economics profession. The thriving school of economic thought it has given rise to is behavioural economics, and the psychologist who did most to inspire this school, Daniel Kahneman, was awarded the Nobel Prize in economics in 2002. The second challenge to conventional economics – from the burgeoning happiness research – is taking longer to win converts among economists. But I am enough of an optimist to hope that we are witnessing the early stages of another revolution in economics, one to match or even exceed the influence of the Keynesian revolution of the 1940s and 50s. Surprisingly, Keynes is now being hailed as one of the earliest behavioural economists (Akerlof 2002), though his contemporary followers largely ignored that aspect of his contribution.

2. Decision-making

2.1 Challenge to theory

Psychology’s first challenge to microeconomic theory strikes at one of its central elements: the assumption of Homo economicus. Economic man is assumed to be rational and self-interested. He or she always carefully evaluates all the options before making any decision, and always with the object of maximising his or her personal ‘utility’ or satisfaction. But cognitive psychologists have demonstrated that humans simply lack the neural processing power to make the carefully calculated decisions economists assume (Simon 1957). People are not rational, they are intuitive. And altruism is often an important consideration in their decision-making (Mullainathan and Thaler 2001; Frey and Meier 2002). People can’t chose correctly between three options where the best option is not immediately apparent (Simonson and Tversky 1992). Rather than carefully thinking through the pros and cons of every decision, people tend to rely on mental shortcuts (‘heuristics’) which often serve them well enough, but also lead them into systematic biases (Tversky and Kahneman 1974). People are often slow to learn from their mistakes (Mullainathan and Thaler 2001). They are frequently capable of reacting differently to choices that are essentially the same, just because the choices have been ‘framed’ (packaged) differently (Kahneman and Tversky 1979). This means that, rather than being coldly rational, people’s decisions are often influenced by emotional considerations.

All this means that Homo sapiens differs from Homo economicus in many important respects. He doesn’t conform to economists’ assumption of fungibility (one dollar is indistinguishable from another), he is often not bothered by opportunity cost and thus has a strong bias in favour of the status quo (Thaler 1980). He does not ignore sunk costs as he is supposed to (Thaler 1980) and often cannot order his preferences consistently (Tversky and Kahneman 1974; Kahneman and Tversky 1979). He is not averse to risks so much as averse to losses and he focuses more on changes in his wealth than on its absolute level (Tversky and Kahneman 1981).

Unlike Homo economicus, Homo sapiens cares deeply about fairness (Kahneman et al. 1986). Experiments show people will walk away from deals they consider treat them unfairly, even though those deals would leave them better off (Kahneman et al. 1986). People are prepared to pay a price to punish others they consider to have been behaving badly towards the group (Fehr and Gachter 2000). Often people are concerned about ‘procedural fairness’ – how things are done, not just how they end up (Tyler 2000).

2.2 Policy implications

I believe this has powerful implications for the aspect of the neoclassical model that economic rationalists (particularly right-wing rationalists) find so attractive: its elevation and celebration of individualism. The individual should be free to choose, and governments should be most circumspect in how they constrain individuals’ freedom, including by taxing them to pay for the public provision of services and to redistribute income. This elevation of the individual and, by implication, denigration of a more communitarian approach, turns out to rest heavily on the assumption that individuals are rational. If individuals are rational decision-makers then it follows, as the rationalists keep asserting, that governments can never know what is good for you better than you know yourself. Governments should therefore tax individuals as little as possible, and maximise the private provision of such things as education and health care. If individuals are not particularly rational in their decision-making, however, then there may well be a case for government paternalism in certain circumstances. Add to this the findings that people’s decisions are often influenced by altruism, their concerns about fairness, their willingness to punish people who act contrary to the interests of the group, and that their behaviour is often influenced by the behaviour of those around them (Ormerod 1998: chap. 2), and you get a further argument in support of communitarian interventions and income redistribution.

A second strand of policy implications also flows from abandoning the assumption that people are rational. It calls into question economists’ adherence to consumer sovereignty – their belief that consumers should and do determine what producers produce. When consumers’ decisions can be influenced by the way propositions are framed, and when decisions are frequently influenced by emotions, producers can use advertising and other marketing to manipulate consumer demand. This contravenes a basic tenet of market economics that, in Keynes’s phrase, consumption is ‘the sole end and object of all economic activity’ (1936: chap. 8). If producers can use advertising to increase as well as manipulate consumption, this puts the cart before the horse, it reverses the direction of causation in the economic system, turning means into ends.

Economists do not like talking about advertising. To make it fit their model they have to assume that it is purely informational, whereas we all know that smart advertisers sell the sizzle not the steak (Camerer 2003). Advertisers prey on our inadequacies and irrationalities (Layard 2005), subtly selling us propositions which become absurd as soon as someone puts them into words: that buying certain products will at last put us among the beautiful people or give us a healthy, happy family. But if advertising is antithetical to consumer sovereignty, why are economists usually so disapproving of proposals to limit or ban advertising?i

3. Happiness

3.1 Challenge to theory

There’s not a big difference between subjective well-being – happiness - and the economists’ goal of maximising utility or satisfaction (Easterlin 2001; Frey and Benz 2002; Frey and Stutzer 2002). So this is an area of research that ought to be of considerable relevance to economists. One common reservation they have, however, is that it is all so subjective – asking people to rate their satisfaction with life on a scale of one to 10. But psychologists have demonstrated that a person’s own assessment of their happiness has a high correlation with other people’s assessments of that person’s happiness and with physical measurements of brain electroencephalogram readings (Diener 1984; Veenhoven 1993; Davidson et al. 2000).

The most surprising finding of the happiness research, confirmed in an Australian study by Heady, Muffels and Wooden (2004), is that the link between life satisfaction and income and wealth is quite weak. It exists, but it is small. Once a nation’s income per person exceeds about $US15,000 a year (Inglehart and Klingman 2000; Helliwell 2003), the acquisition of further income is subject to rapidly diminishing returns. And, as was first pointed out 30 years ago by the economist Easterlin (1974), in the period since World War II the correlation between GDP and happiness has broken down in rich countries (Myers 1993). In America, for instance, real GDP per person has trebled while subjective well-being has been unchanged (Diener and Seligman 2004). Similar results are found for other developed countries where life satisfaction has been regularly measured (Blanchflower and Oswald 2000).

This is a devastating conclusion for economists – and particularly economic rationalists – whose whole practical motivation has been based on the assumption that helping the community raise its productivity and increase its production and consumption of goods and services will leave it unequivocally better off. There is no doubt that, materially, we are better off than we were even 10 years ago: our homes are bigger and better, our cars are better, our food and clothing are fancier and we have any number of wonderful new gadgets to save us labour or entertain us. But though we are better off, we do not feel better off. Why not? Why is it that the acquisition of income does so little to increase our satisfaction?

Psychologists (and a few economists) have proposed two main explanations. First, it’s a characteristic of humans that we adapt surprisingly quickly to our changed circumstances (Helson 1964; Frederick and Loewenstein 1999). We get a promotion, move into a better house or buy a new car and, for a while, we really feel better off. But all too soon we adapt to our new circumstances and absorb them into the status quo. People who win the lottery are no happier than normal within a few years but, by the same token, most accident victims who suffer paraplegia end up being no unhappier than normal (Brickman et al. 1978). The thing that is surprising about all this is our failure to learn from all the times the buzz from an acquisition has worn off so quickly (Schwartz 2004). We keep striving to acquire another new toy in the hope it will be the one that finally delivers nirvana. This amnesia – which, in terms of the economists’ model, constitutes a major information failure (Layard 2005) - is why psychologists describe us as being trapped on a ‘hedonic treadmill’ (Brickman and Campbell 1971).

The second part of the explanation for the diminishing marginal utility of money is rivalry (Duesenberry 1949; Hirsch 1976; Frank 1985, 1999; Solnick and Hemenway 1998; Easterlin 2001). The economic model assumes that what satisfies us is absolute increases in our income or wealth. This is because we’re all individualists, who not only don’t care about the well-being of others, but also don’t ever compare ourselves with others. In truth, we are highly social animals, obsessed by what those around us think of us and what we think of them. Remember Gore Vidal’s crack: when I see a friend succeed . . . a little part of me dies. Evolution has made us a species highly conscious of our social status. We care deeply about how we rank in the pecking order, and are always striving to advance our status – or avoid slipping back - by the promotions we get, the size of our incomes, the location and opulence of our homes, the newness and foreignness of our cars, the private schools we send our children to and the private hospitals we use when sick. In our mania for getting ahead of the Joneses, what we care about is not absolute increases in our income, but relative increases.

The trouble with this rivalry, however, is that it is a zero-sum game. To the extent that I succeed in making myself happy by moving up in the pecking order, those people I move ahead of suffer a loss of status that makes them unhappy. In economists’ language, my efforts to advance myself generate offsetting negative externalities for those I pass. And what is more, the whole leapfrogging game tends to leave us perpetually anxious about slipping back in the race for status.

3.2 Policy implications

There are many policy implications from this and I will only scratch the surface. Layard (2005) says that, beside adequate income, the research shows six main factors affect happiness: mental health, satisfying and secure work, a secure and loving private life, a secure community, freedom, and moral values.

So my first policy implication is that reducing unemployment should be given a much higher priority by the economic policy-makers. Research shows that being unemployed makes people particularly unhappy (Clark and Oswald 1994), a lot more unhappy than can be explained by the loss of income they suffer by not having a job (Di Tella et al. 2001). What people miss is the sense of identity and self-worth that comes from a job, and also, no doubt, the social contact. Economists may protest that they are already giving high priority to reducing unemployment but, in truth, their pursuit of this goal is conditional. Their concern with the efficient allocation of resources means they frown on any solutions (job sharing, job-creation schemes, public sector employment, for instance) that involve modest inefficiencies. The truth is that the overwhelming goal of economists is to hasten the growth in the economy’s production of goods and services, and the jobs generated in this process are just a fortunate by-product.

My second policy implication is that governments and employers could do a lot to raise subjective well-being if they put more emphasis on the enrichment of jobs – increasing job satisfaction by giving workers more personal control, opportunity to use their skills, variety in tasks, respect and status, and contact with others. Taken literally, the economists’ model assumes that all work is unpleasant – a disutility – and is undertaken purely to gain the money to buy the things that bring utility. Like the rest of us, economists know that, in reality, work carries much intrinsic satisfaction. But they don’t follow this realisation through to their policy prescriptions. They are perpetually advocating labour market reform aimed at ensuring labour is used more efficiently, treating labour as though it were just another inanimate economic resource, and ignoring the feelings of the human beings attached to the labour. Various of the ways labour can be used more efficiently make life unpleasant and even unhealthy for the workers involved: ever-changing casual hours, rolling shift work, split shifts and firms continually moving their staff to different cities. When we pursue efficiency at the expense of people, economists have got things round the wrong way, trashing ends so as to advance means.

A third implication is that economic policy-makers should recognise the benefit of stability. People like stability – it makes them feel secure and happy. What’s more, it breeds a highly valuable commodity: trust. People don’t like continuous change. Macroeconomic management is aimed a stabilising the rate of growth in demand, and that’s good. But microeconomists perpetually advocate change (‘reform’) aimed at increasing efficiency, raising productivity and quickening the production of goods and services – the very objective we now know doesn’t make people any happier. Often, micro reform involves ‘displacing’ workers from the reformed industries where their labour wasn’t being used efficiently. This is a process that causes no heart searching among economists because their model: first, assumes alternative employment will be readily forthcoming; second, ignores the intrinsic satisfaction from work and, third, assumes unemployed workers will have a whale of a time enjoying all their new-found leisure.

A fourth policy implication is that the thing economists celebrate as ‘competition’ and are always trying to encourage because it acts as a spur to efficiency and growth, is actually ‘rivalry’ that creates losers as well as winners and thus generates roughly as much unhappiness as happiness. Rivalry is hardwired into our brains, but a case can be made that social comparison is not something we should be encouraging (Layard 2005). Seen in this light, we should think twice about the unceasing calls for us to do this or do that to preserve or improve the economy’s international competitiveness. But why? It is just rivalry on a global scale. It is saying, we must make sure foreigners do not get richer at a faster rate than we are, or even, God forbid, overtake us on the league table.

Fifth, instead of merely unquestioningly promoting consumption, economists should be doing something they rarely do: studying it (Scitovsky 1976). They need to see whether there are some forms of consumption that that yield more satisfaction than others. It may be that, in our striving for social status, we are devoting too much of our time and income to the purchase of ‘positional goods’ (Hirsch 1976) - conspicuous consumption – and too little to activities empirical research now tells us would yield greater satisfaction. Frank (1999) says the ‘gains that endure’ are more likely to include social life, time with our children, less travel time to work, more job security and better health care. Layard (2005) says we should be spending a lot more on fighting glaring evils – and sources of profound unhappiness - such as depression.

Sixth, the evidence that income is subject to diminishing marginal utility strengthens the case for redistributing income from rich to poor, since such transfers should increase total happiness. As yet, however, there is mixed evidence on the question of whether people who live in countries with a narrower gap between rich and poor are happier. Alesina et al. (2001) find that income inequality has a large negative effect on happiness in Europe, but not in the United States.

Finally, we should look sceptically at the incessant calls for lower tax rates to encourage people to work harder. By its very nature, the economists’ model assumes away all non-monetary motives for work. We do it only for the money. But the reminder of the intrinsic satisfaction we derive from work also reminds that higher income-earners in particular have powerful non-monetary motives for working long and hard: job satisfaction and the pursuit of power and status. Reducing tax rates would merely allow us to run faster on the hedonic treadmill, whereas I think we should slowdown. The drive for reduced government spending and lower taxes would leave people with more disposable income they could use to purchase education and health care privately, in the hope that these positional goods would enhance their social standing. Layard (2005) warns we should worry lest leisure, public goods and inconspicuous consumption (consumption that is not compared with the consumption of others) are under-produced because people focus so much on conspicuous consumption.

4. Conclusion

My conclusion is not that economics should be abolished but that it, rather than the economy, is what is in desperate need of radical reform. Neoclassical economics is a product of the state of man’s knowledge during the 18th and 19th centuries, and has actually lost some of its human subtleties since then as it has been made more mathematical (Frey and Benz 2002). It needs to assimilate our now vastly superior understanding of human decision-making and motivations. The community will always need the advice of people who specialise in studying the economic aspects of our lives, but those specialists need to rebuild their models using more realistic assumptions about human behaviour. This would give us an economics fit for humans.


References

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POLITICS AND POLICY – THE OUTLOOK IN AUSTRALIA 2003

Australian Business Economists Annual Forecasting Conference, December 4, 2002

I’ve been working up to it for some years in these talks, but today I think I’m finally in a
position to pronounce the Death of Economics. Last week’s decision to postpone
indefinitely the privatisation of Telstra has removed the fig leaf covering the Howard
Government’s loss of commitment to further micro-economic reform. It’s equally true
that the satisfactory state of the economy has allowed concerns about macro-economics
to recede. The economy is now on automatic pilot and it won’t return to top priority until
the next recession – which I’m not expecting any time soon. The most significant
development for politics and policy this year – and thus the most significant influence
over the outlook for politics and policy in the coming year – is the way the events of
October 12 have moved concerns about defence and domestic security to the forefront of
the public’s mind and to the top of the Howard Government’s agenda. The public was
greatly disturbed by the Bali bombings and is very worried about the possibility of a
terrorist attack on our shores. You and I may not be terribly conscious of this growing
crisis atmosphere, but the politicians are in no doubt about it.

The chief political consequence of the terrorist threat has been to complete John
Howard’s personal dominance of the political scene. All incumbent governments around
the world have benefited from the post-September 11 climate of uncertainty, but John
Winston Howard has shown himself particularly well suited to the role of ‘wartime
leader’. He won many plaudits for the way he comforted the Bali bereaved; in general,
he’s said all the right things and rarely said the wrong thing.

The chief policy consequence of the terrorist threat has been to shift defence and
domestic security to the top of the Government’s preoccupations and thereby complete
the eclipse of micro-economic reform. Howard made that crystal clear in his recent
CEDA speech: ‘Mounting a strong, focused and resolute defence of Australia and our
national interests is the most critical continuing challenge that we face. Not since the
early 1960s have we faced a more complex and uncertain region. Some trends,
particularly the emergence of terrorism, clearly run deeply counter to our interests. And
Australia’s national security will therefore require the highest priority and continuous
review by the Government.’ So the dominance of economics in the political debate has
passed and, for the first time in about 30 years, defence and foreign affairs are the main
game.

Now, before we move on, I want to be clear that to freely acknowledge John Howard’s
political success is not to approve of the way he has come by it. To say that he’s the most
successful politician of his generation is also to say he’s the most cynical politician of his
generation. Howard is a walking political calculator. He couldn’t kiss his granny without
the political implications of the act flashing across his mind as he did so. And it’s a long
times since we’ve had a prime minister more uninhibited by ethical concerns in his
efforts to garner the xenophobic vote. We were reminded of that when, in response to
Fred Nile’s bigoted and idiotic suggestion about preventing women from wearing the
chador, he failed to immediately dissociate himself, but slipped into his old Pauline
Hanson soft-shoe shuffle, observing that Nile ‘speaks for the views of a lot of people’.
That was a dog-whistle to people who hate the ‘towel-heads’.

The Liberal leadership

John Howard now has almost total, personal dominance of the federal political scene. He
has the electorate eating out of his hand and is reigning, like a head of state, above the
political fray. He has completely wrong-footed, overawed and demoralised the Labor
Opposition. And he has total dominance over his own party. You’d never imagine this
was the same man who, not so long ago, so many punters were contemptuously referring
to as Little Johnny. I should add that he’s also enjoying a media that’s unquestioning and
complacent, where it isn’t belligerently defensive of his every move. So after he reaches
his 64th birthday in July, it would be the perfect time for him to retire.

I’m not really joking. All former prime ministers are obsessed by just one thing: how
they’ll be remembered by history. And Howard knows that all political leaders are
remembered by the manner of their going. History is littered with prime ministers who
clung on past their time, had to be pushed out and so diminished their reputations. But
quit while you’re riding high and your good reputation is assured. This is why I believe
Howard fully intended to retire next year, just as soon as he’d pipped Malcolm Fraser’s
seven year term as PM.

There’s just one thing wrong with this analysis, however: if you’re riding high, why on
earth would you quit? The kind of person who has what it takes to climb the greasy pole
as far as prime minister, and cling tenaciously to the job despite all the blows, is simply
not the kind of person who knows when to call it quits. That’s why so few PMs have left
at a time of their own choosing. So, though they say Howard is tireder than he looks, I
won’t be surprised if he decides to stay on after all. The temptation to stay on and enjoy
the adulation would be huge. Howard will have many self-serving people around him
urging him to stay on – he even has callers on talkback radio urging him to stay. And he
has the perfect excuse: I promised the people I’d see them through the crisis and I just
couldn’t desert my post at my country’s hour of need (cue the violins).

But note this: should Howard decide to stay, it means he has to stay for another three
years ie until he’s 67. Why? Because he couldn’t get through another election campaign
without making another commitment to stay for the best part of two years into the new
term before handing over to his successor. And what would Peter Costello do about all
this? Nothing. He’d be deeply unhappy, of course, but he’d be a long way from having
the numbers in the party room and he lacks the courage to make an issue of it.

The Labor leadership

Turning to the Opposition, it’s been completely outmanoeuvred by Howard and lives in
fear of him. He can make his criticisms of it stick with the electorate, but it can’t make its
criticisms of him stick. Part of its problem is that the media have no enthusiasm for
holding the government to account. Howard has stolen much of Labor’s foreigner-fearing
blue-collar base. It’s efforts to retain that base by saying ‘me too’ to his populist policies
on asylum seekers don’t have much effect – except to alienate Labor’s educated, middleclass,
socially progressive base – which is switching its first-preferences to the Greens to
register its disapproval of Labor’s pandering to redneck intolerance.

Labor is convinced it could do a lot better with Costello as PM so, should Howard decide
to stay on, it will be a further blow to Simon Crean – assuming he survives long enough
to be hit. Crean’s case is terminal. The recent outbreak of muttering and manoeuvring
against him is no media beat-up – it never is. In such cases the gallery is always reacting
to what it’s being told off-the-record by plotters and disaffected backbenchers. In this
case, the rumblings were prompted by the Newspoll finding that, even among Labor
voters, only 26 per cent preferred Crean as leader, while 44 per cent still hankered after a
proven loser like Kim Beazley. But here’s the point: it’s hard to think of a previous
occasion when a leader has suffered such public destabilisation and yet survived. No,
Crean will be out of the job before next year is over – probably long before it’s over.

He’ll be succeeded by Wayne Swan – who’ll be no better. Mark Latham has little support
within the caucus and is considered unstable. Which is a pity because (apart from the
Left’s Lindsay Tanner – who doesn’t have the numbers) Latham is one of the few
contenders who has what I consider to be the bedrock qualification for high office: he
wants the job because he has policies he deeply believes in and wants to implement
because he’s convinced they’d make the world a better place. All the rest of them are men
who want the job because they want the job, and don’t have a deeply held belief to bless
themselves with. That’s Crean’s problem and it’s also Swan’s problem.

The remarkable federal/state dichotomy

It’s important not to overlook the present remarkable federal/state dichotomy. At the
federal level, the Libs are all-conquering and Labor is in utter, hopeless disarray. At the
state level, however, Labor holds all eight state and territory governments and most of the
Liberal oppositions are in terrible shape. Amazing. You can imagine how much the
federal Libs would like to break that drought, and how anxious Labor is to hold the state
line. And with the Libs so hopelessly routed in Victoria, the focus now turns to the NSW
election in late March. Here the Carr Government will be trying to jump the hurdle Jeff
Kennett couldn’t make: to win a third term - with its various weaknesses and failures well
known to the electorate and an accumulation of niggles on 101 issues. I’m told Labor is
quite worried about the possibility of losing, while the Libs are hopeful of progress with
such a young, intelligent and attractive candidate as John Brogden. And here’s the point:
federally, nether side will be rocking the boat before the NSW election. So, Crean is safe
from challenge until after the NSW election. And that election was one of the factors in
the Howard Government suddenly going cold on the sale of Telstra – Brogden and his
National Party mates don’t need any further problems with country seats, thank you.

Howard’s policy agenda

That’s enough about politics; let’s move on to policy matters and let’s look at the items
the Howard Government has on its agenda. The big point of Howard’s recent CEDA
speech was to demonstrate how busy he is on the policy front by laying out the cabinet’s
recently determined list of ‘longer-term strategic objectives’. There were no fewer than
nine of them. Let’s go through them quickly and see what they add up to. Howard
stressed that, apart from the first, they were in no particular order – ‘they all have a
special importance of their own’ ie no particular importance.

First is, as you’d expect, ‘the twin dangers of rising international terrorism and the
proliferation of weapons of mass destruction’ and these are ‘clearly . . . more fundamental
than any of the others’.

Second is ‘balancing work and family life’. It’s clear Howard has a quite narrow
conception of this issue: he thinks it’s all about mothers having ‘choice’ over whether or
not to stay at home full-time with their young children. He seems to be working on a rejig
of the Government’s many and various family payments. This could be announced in
association with the next election – which is probably the only context in which the
Government would be likely to pick up the moderately expensive proposal for taxpayerfunded
paid maternity leave.

Third is ‘demography’ and the ageing of the population. On this Mr Howard will
continue preaching about the need for people to avoid early retirement – he may get
around to taking measures to affect the incentives and disincentives. There’s little sign of
any policies aimed at raising fertility.

The fourth ‘strategic objective’ is ‘science and innovation’. All very worthy – doesn’t
seem to amount to much.

Fifth is education. Here Brendan Nelson is working on further reforms to university
funding, and has won the vice-chancellors’ agreement to a scheme which will allow them
to take in more full-fee paying students and also charge fees in excess of HECS if they
think the market will bear it. Problem eased with little or no extra cost to the budget.
Sixth is ‘sustainable environment’. This means pressing on with water reform, with the
Commonwealth’s incentive payments to the states under national competition policy
being diverted to this purpose. Also under this heading is Mr Howard’s remarkable policy
of insisting that our greenhouse gas emissions target under Kyoto will be met easily and
at no cost to the economy, while also insisting that actually to sign the Kyoto agreement
would do our economy incalculable economic damage.

Seventh is ‘energy’ where Mr Howard is developing ‘a strategic plan for Australia’s
long-term energy policy’. Wow.

Eighth is ‘rural and regional policy’ where the Government has ‘important and enduring
priorities’ including a national response to the drought. Obviously, no post-Hanson
government could have a list of priorities that didn’t include the magic word RARA.
Ninth is ‘transport policy’ – which also doesn’t seem to amount to much.

Looking at this agenda you’d have to say it’s not wildly impressive. This is not a
government with a host of major reforms it’s bursting to get on with. This list is not one
of ‘longer-term strategic objectives’ as Mr Howard so grandly puts it, it’s just an ordinary
old to-do list that any government could rustle up at any time. It’s not about Reform with
a capital R so much as running repairs and the oiling of squeaky wheels. It’s the agenda
of a government that knows it’s expected to look busy. You’ll note that, though many
items on the list are matters a reformist government would want to do big things about,
few are the sort of matters you’d think of as ‘micro-economic reform’. There’s little that
involves reducing government intervention or increasing competition. Indeed, it’s clear
the National Competition Council is being wound up and Graeme Samuel moved on to
the ACCC. The era of micro reform has finished.

You’ll notice that one glaring omission from the nine-point agenda is health. Clearly,
there’s no sign of any grand plan for the reform of health-care funding. But the present
funding arrangements aren’t working well and Mr Howard won’t be able to avoid more
patch-ups. He’ll have to do something next year to try to turn around the decline in bulk
billing – which I’m sure is annoying GPs and patients in equal measure – particularly in
RARAland. Less acute but more chronic is the problem the recent IMF staff report drew
attention to: the moral hazard arising from the elimination of out-of-pocket payments for
many people with private health insurance. There’s simply too much scope for overservicing
by specialists – in an area that’s even more heavily subsidised by the taxpayer
than it was.

Telstra and the bond market

You wouldn’t forgive me if I failed to say something about Telstra and the end of the
bond market. A lot of business economists have been reluctant to be seen coming out in
support of the retention of government intervention that contributes to their own
livelihoods. But I think I’ve found the right form of words to overcome the problem: we
could certainly live without a bond market if there was a good reason to, but there isn’t.

So what’s to be gained by killing it off? Nothing. Australia doesn’t have, and never has
had, a problem with an excessive public debt to GDP ratio. Last week I heard the
Chancellor of the Exchequer boasting that Britain had one of the lowest public debt ratios
in the world: 31 per cent. With our federal ratio already a mere 5 per cent, there is simply
no economic reason to want to get it to zero. It’s obvious that Peter Costello’s ambitions
are purely political: he wants to be able to boast that he’s paid off ‘every last cent’ of
‘Labor’s debt’. He dreams of being able to use this as the ultimate proof of the Libs’
impeccable economic management and a reminder of Labor’s appalling mismanagement.

The more spotty his record becomes on the maintenance of budget surpluses, the more he
emphasises debt reduction. It’s become clear, however, that the goal of literally paying
off ‘every last cent’ is unattainable. Telstra isn’t worth that much and the foreseeable
underlying cash surpluses won’t be big enough. With the indefinite deferral of the
Government’s plans to sell the rest of Telstra, the threat of the bond market being wiped
out has passed, but a subtler threat remains: that further smaller-scale debt redemptions
will fatally wound the bond market (in terms of critical mass) without actually killing it
off. Were this to happen it would be a great pity because it would mean that, for no good
reason, we’d incurred many of the losses canvassed in the debate. Presumably, the market
would become moribund. To me, the strongest argument in favour of preserving an active
market is that, sooner or later, the budget will return to deficit and the government will
need to issue bonds to cover it. It would be galling to find we had to run to the expense of
reviving a bond market we’d allowed to expire purely through lack of foresight.
Costello’s blinkers may prevent him from seeing this – just as the Bush Administration
and its Republican supporters’ lust for income-tax cuts blinded them to the obvious
implausibility of those happy projections showing the US budget remaining in surplus for
as far as the eye could see – but it should be clear enough to the rest of us. I wouldn’t be
surprised to see the federal budget return to modest deficit within the next year or two.

The notion that we’ve entered an era of permanent surplus is the product of ignorance or
hubris.

Let me just say something about the deferral of the Telstra sale. One point to note is that,
though the notional sale has been pushed back to the 2004-05 financial year, the next
election is due in November/December 2004 and it’s hard to see the Government wanting
to stir up controversy about Telstra’s ownership before the election. So we’re talking
about the actual sale of the first tranche some time in late 2005 at the earliest. Even by
then I wouldn’t be confident Telstra’s share price would be much higher than it is today.
It certainly could take many years to get back to anything like $7.40 – you only get one
dot.com bubble in your life. I believe Howard, Costello and the Government generally
have had a lot of ego riding on completing the privatisation of Telstra. So I’m not
convinced they’ve indefinitely deferred the sale primarily because they believe the
company is worth infinitely more than its present share price. No, I think they’ve decided
that proceeding with the sale is all too hard politically – getting it past the Nats, getting
the numbers in the Senate, wearing the flack in rural electorates. And, because they see
privatising Telstra as a major micro reform – up there with the GST – I see their decision
to put Telstra on the backburner as strong confirmation of their loss of interest in micro
reform. John Howard has simply moved on.

Monetary policy

I should now turn to fiscal policy, but I know you’re not interested in it, so let’s go
straight to monetary policy. I want to start the way Ian Macfarlane starts his
parliamentary testimony: by reviewing the forecasts he made last time. This time last year
I observed that the Fed might have more easing to come and, if it did, the Reserve would
ease a little more, too. This was much more pessimistic than the markets’ thinking at the
time, so I predicted that ‘most of you guys will spend most of next year anticipating a rise
in rates that never eventuates’. Now, as most of you would remember, once it became
clear that the Reserve intended to begin tightening in May, I wrote a Monday column in
which I ate humble pie and admitted I’d got that forecast wrong. At this late stage,
however, I’d like to regurgitate some of that pie and say that, by the end of the year, I’m
not as wrong as I thought I was in May. I was out on the Reserve, but only to the tune of
50 basis points. And I was right in thinking the Fed was more likely to cut than to tighten,
even if the easing came at the opposite end of the year to what I thought. So, in a different
way to what I was expecting, I think I was reasonably right in predicting that most of you
would spend most of this year expecting rate rises that didn’t happen. Certainly, it took
people like John Edwards (to whom I’d apologised in May) a long time after June to
realise there were no more tightenings to come. In fact, the Reserve lost its appetite for
tightenings as soon as it realised there was a growing chance the Fed would resume
easing.

What does this post mortem prove? Nothing – other than that I can wriggle on the hook
as well as the best of them. But I do think that, looking back over the year, the Reserve
has been consistently more worried about the state of the US and world economies than
most business economists have. And that’s true even though there was that period in
April-May-June when the Reserve said it was pleasantly surprised by the stronger state of
the world economy. It soon changed its mind back again – sooner than a lot of you guys.

Over the past two years – going back to Greenspan’s first, surprise easing on January 3
last year – the US financial markets have been consistently over-optimistic, and that’s
rubbed off on our markets and our economists. It’s true that the net fall in share prices
and bond yields over that period reveals the US markets to be a lot less optimistic today
than they were at the start. But, as the Reserve argued in the November SOMP, it seems
pretty clear that the US markets remain more optimistic than they should be – ie that Wall
Street may have further to fall. The one bloke who merits an honourable exception to all
this is, of course, Rory the Wonderboy. I rehash all this to make my first substantive
point: I believe we’re likely to see the same phenomenon in the coming year: markets and
economists in the US and here being consistently more optimistic about the outlook for
the US and world economies than both the Fed and the Reserve. Every time you’re
tempted by the thought that the US is looking up, remember two things. First, Europe is
in worse state than the Yanks. It has a debilitating structural problem: the euro and its
policy regime is seriously flawed and is slowly squeezing the life out of the German
economy. Second, if, as seems possible, the Japanese are finally stirring themselves to
tackle their structural (banking) problems, that will make their economy weaker before it
makes it stronger. I repeat: the most likely second-guessers’ error I foresee in the coming
year is to be more optimistic about the strength of the world economy than the policy
makers.

The other useful lesson I think we can draw from this year’s experience is that, these
days, central banks in general and ours in particular change the direction of policy a lot
sooner and more often than they used to. Consider the record: we had our Reserve
tightening four or five times through 2000, then, last year, after a pause of just six
months, easing six times between February and December. It then paused just five
months before starting to tighten again, telegraphing its intention to raise rates by 125 to
175 basis points - but, in the event, halting after just 50. It’s now done nothing for six
months. It may be that this yoyo-like behaviour is a product of times in which currents
and crosscurrents are especially hard to read, but I suspect it has a fair bit to do with the
present extremely pre-emptive approach to the conduct of policy. The pre-emptive
approach makes central banks more dependent on forecasts and, as we all know, our
forecasts frequently prove astray.

Which brings me to my call. Starting with the Fed, I think it could end up doing more.
Certainly – and as I said last year – it will regard the whole of the remaining 125 basis
points as available to be used if necessary. With some small possibility of deflation, I
don’t expect it to be erring on the side of overconfidence. Turning to the Reserve, I don’t
believe that, at this stage, it has any clear expectation of what it will do with rates over
the coming year – except that it expects to be doing nothing for quite a few months yet. If
rates are shifted some time next year, it could be in either direction: up if it’s clear the US
and world economies are recovering satisfactorily and it’s clear the domestic economy
still has a lot of steam left in it; but down if the outlook for the world economy has
deteriorated further and the domestic economy is losing momentum. Of course, should
the world economy get weaker while we stayed strong, I’d expect the Reserve to continue
sitting on its hands. If this call doesn’t strike you as particularly courageous I’m sorry, but
it’s about as definite as I think it’s sensible to be.

POLITICS AND POLICY – THE OUTLOOK IN AUSTRALIA

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THE POLITICAL AND POLICY OUTLOOK IN AUSTRALIA 2002

Australian Business Economists Annual Forecasting Conference, Sydney, December 6, 2001

With the federal election not far behind us, this isn’t a bad time to be examining the
political and policy outlook, though I have to warn you up-front that it’s not a particularly
cheery outlook for people with the policy preferences I suspect you have. The first bad
sign is that this was the first election in many years (since the Vietnam-war election in
1966, I think) where economic issues - the state of the economy and micro reform –
weren’t dominant. Rather, the dominant issues were the boatpeople and ‘security’ –
which suited John Howard down to the ground. He may now be ashamed of the way he
stooped to pressing xenophobic and possibly racist buttons, but there is simply no
denying the overwhelming emphasis on the boatpeople issue in his advertising –
particularly in the final week – and even in the signs his people strung up around polling
places. It suited Howard to promote this mighty distraction from the public’s economic
discontents: the high price of petrol (until the last month or two), all the complaints from
people who perceive themselves to be losers from globalisation or national competition
policy, and, above all, all the lingering whinges about the GST package.

The Labor Party chose not to fight on macro issues, adopting the Government’s policies
on the inflation target and the independence of the Reserve Bank, and on the mediumterm
fiscal strategy. It even matched Howard and Costello’s stupid – but clearly
premeditated – promise to keep the budget in surplus throughout the next term. Both
sides chose not to mention unemployment, even though it’s risen by a percentage point
over the past year. The Government tried to hide its stated intention to sell the rest of
Telstra. In the end the parties were not far apart on Labor’s preferred issues of education
and health (neither side was promising the kind of sweeping changes to funding
arrangements – and funding sources – that are needed to bring genuine improvement to
these areas). And, most surprising of all, in the one policy area where the parties did have
significant, ideologically driven differences – industrial relations – both sides had their
own reasons for not wanting to raise it. The conclusion is inescapable: neither side
wanted to talk about economic issues in this campaign. And that fact does not augur well
for further economic reform in the Government’s third term.

How Howard won

It’s important to understand how Howard won the election and why Labor lost. Early this
year, after the West Australian and Queensland state elections and the Ryan federal byelection,
Howard had been written off by everyone but himself. His back-to-the-wall
survival strategy had two stages. The first stage was to remove all the negatives – all the
reasons people wanted to vote against him; the second stage was to find a positive reason
for them to vote for him. The first stage involved, in particular, doing something to
mollify each of the various interest groups with gripes about the GST. Thus we had: the
changes to the BAS, the cut in petrol excise and the abolition of indexation, the cut in the
beer excise, the temporary increase in the first-home owners grant, the $300 handout to
pensioners, the extra tax rebate for the self-funded retirees and the backdowns on various
unpopular aspects of business tax reform, such as taxing family trusts as companies and
the abuse of personal service income. As you well know, this Rollback and various
spending programs appropriated most of the prospective budget surpluses for this and the
next three financial years. The second stage of Howard’s strategy involved seizing on the
Tampa incident and exploiting it for all it was worth. In that sense, this issue involved
less good luck than ‘good’ political manipulation. Howard well knew how unpopular the
boatpeople were with most Australians, he was on the look out for an issue to use as a
diversion from the public’s economic discontents and he had the quick wittedness to see
the Tampa’s potential and exploit it shamelessly. Howard’s use of the boatpeople was an
example of the timeless effectiveness of the oldest trick in the leaders’ handbook: using a
threat from outside to unite your team. But it also had something else: whereas Howard’s
own version of GST Rollback had been about the removal of negatives, Tampa gave
people a positive reason for voting for him. They’d been reminded of an issue they really
cared about – the need to repel the alien interlopers – and been shown the perfect man for
the job.

What role did September 11 play in the election result? Did it make people feel insecure
and anxious about what the future might hold, and thereby force them back into the arms
of the incumbent? Yes, I guess it did to some extent and Howard was certainly quite
blatant in the way he sought to fan uncertainty. But I don’t think it was nearly as big an
issue as the boatpeople. And, by its depiction of alien and threatening Arabs and
Muslims, it served to reinforce the boatpeople threat. What’s more, first Peter Reith and
then Howard himself sought to link the two issues with the disingenuous statement that
he couldn’t be sure there were no terrorists among the boatpeople.

In their efforts to minimise retrospectively the central role played by the Tampa issue,
Liberal functionaries have argued that the Government’s good economy management and
the good state of the economy were major factors in its win. It’s true the public perceived
the Libs to be much better economic managers than Labor (with a strength of belief few
economists would share) and that Howard and Costello exploited this perception
brilliantly in their strategy of keeping Labor boxed in. But, even so, it’s important that
economists don’t fall for this line. The aphorism to remember is that no-one votes out of
gratitude – as Jeff Kennett, Winston Churchill and many other politicians have
discovered. The politics of economic management isn’t symmetrical: bad management
can get you tossed out, but good management can’t, by itself, get you re-elected. At best,
it’s the removal of a negative. To me, the proof that the state of the economy didn’t figure
largely in Howard’s re-election is that it wasn’t a lot different between March (when
Howard had been written off) and November (when he won). Interest rates were a bit
lower; unemployment was a bit higher. Back in March, the good state of the economy
wasn’t sufficient to outweigh the whole range of people’s economic complaints – about
petrol, globalisation, competition policy and the GST – but by November petrol prices
had fallen, much had been done to mollify the GST whingers and, above all, Howard had
managed to divert everyone’s attention to a (perceived) non-economic issue.

Why Beazley lost

Why did Labor lose? Because, once Howard had played his masterstroke, the whole
emptiness of Labor’s election strategy, its policies and its leadership was revealed. Kim
Beazley tried to get himself elected the same way Howard got elected: by making himself
a small target so that all the focus was on the public’s dissatisfactions with the Prime
Minister as a person and with his policies, notably the GST. Unfortunately for Kimbo,
Howard was no Paul Keating. It was an appropriate strategy for Beazley, a man with no
particularly strong convictions about economics, no personal reform agenda, and no
burning desire run the country much differently from Howard. Labor hit on two
genuinely important issues for the positive centrepiece of its campaign – education and
health – but it revealed little understanding of the structural problems involved, nor any
desire to tackle them. It just wanted to exploit public discontent about education and
health by promising to spend more money on them. But the real rock on which Labor’s
strategy was built was the unpopularity of the GST. It thought it was on to a winner but,
as things turned out, the GST proved a fatal distraction. As we’ve seen, Howard had
mollified much of the unhappiness with the tax package and then powerfully diverted
attention to the treat from terrorist boatpeople. In the process, however, he’d done
something else important in defusing the GST as an election issue: he’d emptied the till.

Labor could have won plenty of votes with a big program of Rollback, but the money just
wasn’t there for anything more than a laughably token effort. So, for Labor, the GST
ended up being a distraction, and the distraction proved fatal. Without the GST issue,
Labor was reveal as having few feathers to fly with. I have to say that, on this, Labor got
its just deserts – from Day 1, its position on the GST was cynical, opportunist and devoid
of principle. It’s also worth noting that it was a good thing for the long-term future of
reform in general, and tax reform in particular, to have the Government comfortably reelected.
Had it lost, tax reform would have got the blame – from both sides. This isn’t a
huge amount of comfort, however, because the Libs’ conclusion from the episode would
be that the GST brought them a mighty lot closer to the abyss than they ever want to be
again, and they’ll make sure they never take on any reform even half so unpopular.

Labor under Crean

Before we move from politics to policy, I should say a little about the new Labor leader,
Simon Crean. Crean is unelectable and everyone knows it – his party knows it and the
talkback callers know it. He got the job because there was no-one remotely better, but this
won’t protect him from recurring leadership rumblings whenever he’s judged to be
faltering. Fortunately, Crean is under no illusion that he’s regarded as unelectable and
that he’ll get only one crack at the prime ministership – if that. This is why he’s trying so
hard to be the new broom and everything that Beazley wasn’t. Labor will have plenty of
well-developed, alternative policies this time around. Like his deputy, Jenny Macklin,
Crean has an economics degree. But he’s no economist. The Canberra press gallery keeps
marvelling at how ‘dry’ he’s become since he became shadow treasurer, but this doesn’t
prove much. The gallery wouldn’t know a genuine dry if it saw one. One thing it means is
that Crean saw no alternative but to wear the fiscal straitjacket that Peter Costello so
cunningly fashioned for him with all his silly talk of perpetual surpluses. But that was
mainly about being seen to have politically correct views on fiscal issues. The other thing
it means is that Crean is what Labor politicians call ‘pro-business’. He wants business –
big as well as small – to see him as pro-business and he really is pro-business in the sense
that, when business lobbyists are on the make for a new tax break or handout, Crean will
be very keen to talk turkey. He was dead keen for Labor to be seen to be co-operating
with Costello to get the Ralph business tax reforms through the Senate. Unlike many of
his colleagues, he had no problem going along with the halving of capital gains tax, only
requiring that the Government ensure the total package was revenue neutral by including
some anti-avoidance measures (most of which it subsequently dropped when the going
got tough). What Crean is and always will be is a full-on believer in industry policy:
special deals for manufacturing, tarted up by reference to the latest fashionable
enthusiasm – R&D, IT, the New Economy, whatever. At the centre of his industry policy
is always a tripartite deal between government, unions and business. And at the centre of
the tripartite deal is always the great deal-maker and ringmaster, Captain Handout
himself, Simon Crean.

Two points about the Government before we leave politics for policy. There will be two
recurring political themes in the Government’s third term. First, after the new Senate is
installed in July and for as long as the Libs look strong in the polls, we’ll have the
Government trying to get its way with a recalcitrant Senate by threatening a double
dissolution – something that would be guaranteed to reduce the Democrats numbers.

Second, Howard is supposed to be retiring two years into this term, but he’s made no firm
promises (public or private) and the ability to quit while you’re ahead seems incompatible
with the ego required to be a successful prime minister. Knowing all this, Costello and,
just as importantly, his parliamentary supporters, will be as twitchy as hell until the
changeover is effected. You may know that there is no love lost between the two men. So
the welling of tensions to the surface will be a recurring theme and the gallery will be on
the lookout for them. Since such reports are usually unsourced and often formally denied
by the parties, there’s a temptation for Liberal sympathisers back in Sydney to see them
as products of the gallery’s overactive imagination. Not so. Stories of leadership tensions
have a high ratio of signal to noise and are often borne out by a subsequent formal
challenge. They’re usually well-founded because the journalists have politicians
whispering in their ears.

Howard’s third-term agenda

As everyone realised as soon as the election was over, John Howard had managed to get
himself re-elected without a third-term agenda of any consequence. This is typical of
politicians. When you’ve got your back to the wall, you fight to preserve your political
life and only once you’ve succeeded do you worry about what you’ll do next. By now,
however, Howard does see the need for an agenda. Quote: ‘It would be a terrible mistake
if in this term we thought everything had been accomplished and no more reform was
necessary because we a need to have an activist reform agenda’. And now his cabinet has
been appointed, he’s told them their first job is to think up a list of things that need doing.
But despite his fine words, I don’t hold much hope for genuine economic reform, for five
reasons. First, campaigning on the slogan ‘Keep Australia in safe hands’ doesn’t get you
off to a very daring start. Second, Howard’s long-held personal ‘conviction’ agenda –
which was set in concrete while he was Treasurer in the Fraser Government – has only
two major items, both of which have been ticked off (even if they haven’t been finished
properly): reform industrial relations and introduce GST. Third, what Howard really
meant by that quote is that governments are expected to keep busy. They can’t be seen to
be resting on their laurels, but must always have some big new projects on the go. It
doesn’t follow, however, that all the big new projects have to be economic. I suspect that,
from now on, a lot more of the Government’s appearance of busyness will come from
non-economic endeavours such as defence and ‘security’ and a federal government’s
version of the law-and-order agenda, such the war on drugs. Fourth, if the economic
downturn proves deeper and longer than all of you guys expect – as I suspect it may – the
public’s economic focus (and, hence, the Government’s focus) will switch back from
micro reform issues to all the old issues of macro stabilisation: what’s the Government
doing about creating jobs to reduce unemployment and, much later, what’s the
Government doing to rein in the Budget deficit?

Fifth, I fear there’s a micro-reform price to be paid for the cleverness of the boatpeople
ploy. John Edwards (in my opinion the only business economist with a good feel for
politics) reminded us during the campaign that no party was running in support of
globalisation. Not a good start towards a courageous third-term agenda, but I fear it’s
worse than that. Part of the cleverness of the boatpeople issue was that it diverted
people’s attention away from their discontents about globalisation, the effects of national
competition policy on the regions, and suchlike. People were so stirred up by the threat
posed by the boatpeople that they forgot their worries about globalisation etc. You could
argue that this is a good thing: the Libs managed to get re-elected without being punished
for the perceived evils of globalisation. But I fear it works the other way. There’d be a
close overlap between the people stirred up about globalisation and the people stirred up
about boatpeople. Why? Because the boatpeople issue is merely a novel dimension of
globalisation. Like the opposition to globalisation, the boatpeople issue is about
resistance to change, fear of foreigners, protectionism (build up border barriers to keep
the threatening world at bay) and about mercantilism (it’s OK for us to plunder other
countries’ skilled workers, but it’s a terrible loss for our brains to go abroad). Shifting the
focus from scientists to ordinary workers, it’s a fair bet that much of the fear of invading
boatpeople arises from a fear they will ‘take our jobs’.

Part of the genius of Howard’s identification of the potency of the boatpeople issue is that
it redefined the globalisation issue in a way that allowed him to get out in front of the
mob as the leading opponent of globalisation – to provide the very kind of leadership that
people in the regions and One Nation voters had been craving – without incurring the ire
of the business and economic supporters of globalisation. He found the one exception to
the globalisers’ rule: countries should be open to the free flow of all goods, services,
ideas, technology, capital and executive and highly skilled labour, but tightly limiting the
inflow of common-or-garden labour is AOK.

But what’s the opportunity cost of this cleverness? Now the Libs have experienced the
huge political benefits of setting themselves at the head of the anti-globalisation crowd,
are they really going to want to alienate that crowd by returning to a pro-globalisation
agenda? What price the business community’s push for a much bigger immigration
program? And what about the remaining islands of tariff protection? In its first term, the
Howard Government reviewed the post-2000 arrangements for the tariffs on motor
vehicles and textiles, clothing and footwear. It decided to freeze the 2000 rates for four
years, but then to catch up with the deferred reductions on the day after the freeze. In this
term, the Government’s challenge is to stick with its rather daring back-end loading,
resisting industry pressure to review the post-2004 arrangements and further postpone the
reduction. What do you reckon are the chances of it going to the barricades in defence of
free trade?

The unfinished agenda

The one area where Howard has made clear his determination to push on with reform is
industrial relations: exempting small business from the unfair dismissal law, further
limiting union access to workplaces, tightening the prohibition on secondary boycotts,
requiring secret ballots before strikes and banning unions from charging non-union
freeriders a fee for negotiating a collective agreement in their workplace. Most of these
measures have been blocked frequently in the Senate by Labor and the Democrats. The
chances of them changing their minds in this term are slim. So what’s Howard on about?
He’s playing politics, trying to knacker Crean from the start in the same way he so
successfully knackered Beazley. Howard and Costello made so much fuss about
Beazley’s $10 billion budget black hole that he was branded for all time as a bad
economic manager. Labor developed an inferiority complex about macro management, it
lived in fear of being asked ‘where’s the money coming from?’ and was never really
game to take the fight up to the Libs on the weaknesses in their economic performance.

This is why, once the Libs had raided the fiscal cookie jar, Labor was snookered. It could
see no alternative to standing up in the campaign and promising to splash out sixpence on
Rollback, sixpence on education and sixpence on health. Howard believes Crean’s
Achilles’ heel is his union background. So he’s bowling up the IR legislation as a (quote)
‘test of whether Mr Crean has really freed himself from union domination’. Crean being
Crean, he will try to find some compromise on which they can do a deal. But Howard
won’t be buying. He’s not on about getting whatever IR reform he can, he’s on about
stigmatising Crean in the eyes of the public and getting the drop over him from the off.

I believe Howard will add few if any new items to the reform agenda. There are many
unfinished items on the agenda, but I fear little progress will be made.

Telstra: has reached stalemate. Much as Howard and Costello would like to complete its
privatisation, this is unlikely. Labor and the Democrats retain control of the Senate and
their opposition is implacable. In any case, even the National Party is unlikely ever to
agree to it; the bush would never understand. For all intents and purposes, the era of
privatisation – federal and state – has come to an end.

Business taxation: many loose ends remain but, after all the angst of the past two years,
there’ll be little enthusiasm for tying them up, either from the Government or business.
Howard has promised to examine company tax arrangements affecting Australian
multinationals and is sure to do something. This could come under the heading of tax
reform, but is more likely to involve a few grudging, piecemeal concessions intended to
shut the Business Council up till next time. On another matter, if you’re still dreaming of
a cut in the top tax rate, dream on.

National competition policy: this is the progressive review of all anti-competitive state
and federal legislation. It’s meant to be micro reform on automatic pilot. But it’s grinding
along very slowly, without that fact disturbing the Howard Government or any other. The
Nats made various promises to throw further sand in the gears.

Review of Trade Practices Act and the ACCC: This election promise was intended to
look anti-Fels, but whether it ends up clipping his wings or adding to his feathers remains
an open question. The Prof gets up a lot earlier than his big-business detractors. Howard
made no bones about the purpose of the review: ‘It’s time we had another look at whether
the competition laws of this country preserve the right balance between large and small
within our community but, equally, allow for the development of sufficient critical mass
amongst our larger corporations that they can fully participate in a globalised economic
environment.’ Doesn’t sound like reform to me – more like special rates for business
mates. We’ll see how much eventuates. But there’s no doubt about the future of the Four
Pillars policy – it will still be standing inviolate in three years time.

Ageing policy: a nice, post-election idea to take this issue more seriously, but unlikely to
lead to any controversial policy measures. Howard may yield to the financial services
lobby’s pressure for a thorough review of superannuation – its adequacy and tax
arrangements – but I doubt it. His election promises on super would actually add to the
mess and amount to little more than the introduction of super tax concessions for rich
single-income families.

Fiscal policy

Turning now to fiscal policy, it won’t surprise you to hear that I’m not much impressed
with the way it’s been conducted in recent years. A key element in the Government’s reelection
strategy was to spend virtually all of the prospective budget surpluses, so as to
win votes by doing so and, just as important, so as to deny Labor the chance to do so.

Particularly in the latter objective, it succeeded brilliantly. Despite all the warning it had,
Labor was totally wrong-footed. With little to spend it had little policy to offer and little
to say about anything economic. If you fear, as I do, that the economy may be a lot
weaker next financial year than the Government’s forecasts imply, then a case can be
made for a discretionary increase in government spending, even to the point where it
takes the budget into deficit. But that case wasn’t made – either by the Government or by
Labor – and the new spending measures weren’t of an appropriately immediate, finite,
pump-priming nature.

We’ve been through five fat years in which the budget outcome has invariably come in
above budget – often well above. But I suspect that, between the raid on the surplus and
the economy’s move into what could be several years of slower growth, we may be
entering a period of lean years where budget outcomes come in below budget. In other
words, the underlying cash balance may well drop into deficit, as the fiscal balance
already has, to the turn this financial year of more than $3 billion.

But both Howard and Costello kept promising to keep the budget in surplus throughout
their new term. So, does this say we’re in for a tough, post-election budget next May to
haul the balance back into surplus? Not a snowball’s chance in hell. There’s a far higher
chance that, by then, the Government will see a need to supplement easy monetary policy
with further discretionary fiscal stimulus. But, even if we don’t reach that point, I reckon
it won’t be long before Costello has to do a lot of climbing down about the importance of
keeping the budget in perpetual surplus.

John Howard is inordinately proud of his achievement in ‘bringing the budget back to
surplus’. But Paul Keating used to be just as proud of his own, similar achievement. What
Keating discovered, however – much to his disillusionment - is that ‘bringing the budget
back to surplus’ isn’t a ‘reform’ – it isn’t something that needs to be fixed and then, once
fixed, stays fixed. It’s a chore to be repeated once-a-cycle. By the time he realised that,
despite his earlier labours, the budget had unfixed itself and needed to be ‘brought back
to surplus’ a second time, Keating had little stomach for the task. His interests had moved
on; been there, done that. It was his failure to re-apply his shoulder to the budgetary
wheel that left such a damaging inheritance for Beazley as Labor’s next leader. The
Beazley black hole crippled Labor for 5 years, robbing it of economic credibility and
budgetary flexibility. But the point is that the ultimate test of fiscal heroism is the second time-around test. We’ve yet to see whether Howard does any better on that test than
Keating did.

We know already, however, that the Government’s fiscal performance isn’t nearly as
impressive as it pretends. It’s much-trumpeted Charter of Budget Honesty has fallen well
short of expectations. It’s a flawed document, open to manipulation for political purposes,
which Costello has not hesitated to do. Despite its efforts to obfuscate the facts, we know
from John Edwards’s calculations that this Government’s levels of spending and taxation
as a proportion of GDP are remarkably high, and give the lie to its small government/low
tax pretensions. Nor does its much-boasted ‘fiscal framework’ live up to its billing. Its
medium-term fiscal strategy (to balance the budget on average over the cycle) is
admirable in principle but, since the Government’s reversal of its decision to publish
estimates of the structural budget balance, is unmeasurable in practice. We now have a
fiscal framework that is honoured by nothing more than bald assertion.

Finally, we have the Government introducing accrual accounting, converting its measures
and targets to an accrual basis (which, it assured us, was the superior measure), then
quietly switching them back to underlying cash when the going got tough. Even more
remarkable, it’s done so virtually without a peep from business economists who, if
they’ve even noticed, don’t seem to care. The fact that this year’s premature MYEFO
revealed a fiscal deficit of $3.1 billion for this financial year and $1.3 billion for next year
prompted no-one to cast aspersions on the whole bipartisan election-campaign farce of
manfully struggling to ensure that promises didn’t push the underlying cash balance into
even a million of deficit. It’s clear that business economists, as well as being weak on
politics, are weak on accounting. Someone in Treasury told them the cash measure is
more apposite for macroeconomic purposes, and they inquired no further. What that
someone didn’t both to tell them is that the cash measure is much easier to falsify than the
accrual measure. Few business economists realise the truth that the budget is already in
deficit.

Monetary policy

The market is still having a fair bit of trouble reading signals from the Reserve Bank. The
reason for that is simple: the Reserve is not very good at signalling. A big part of the
trouble is that the two institutions – the Reserve and the market – have quite different
objectives and don’t make adequate allowance for the other side’s different approach. So
there’s a lot of failed communication and, as every (successful) journalist understands,
that has to be the Reserve’s fault, not the market’s. Why? Because it’s the Reserve that’s
initiating the communication. If I write a column that’s misunderstood by thousands, it’s
idle for me to tell myself I’m surrounded by idiots. I attempted to communicate, but
failed. If I don’t like it, the only alternative is to lift my game.

The market assumes that every formal announcement from the Reserve – every statement
accompanying a policy move, every quarterly statement on monetary policy (SOMP) –
contains a signal about the Reserve’s future intentions. Sorry, it’s not that easy. The
confusing thing is that sometimes SOMPs contain a signal and sometimes they don’t.
Sometimes it suits the Reserve to signal and sometimes it doesn’t. When it doesn’t suit to
signal, the Reserve doesn’t bother. On those occasions, all the signal-like remarks in the
statement are merely backward-looking justifications of past decisions. The market is so
fanatically forward-looking that it’s incapable of recognising a backward-looking
statement when it sees one. What it forgets is that central bankers are bureaucrats, and
bureaucrats are obsessed by justifying their actions. They’re highly defensive animals. So
that’s our first culture clash.

Why would the Reserve not want to signal? Because it’s common for statements to be
issued at times when it doesn’t know what it plans to do at the next meeting. It will be
awaiting developments and reacting to them. When you break down the conduct of
monetary policy to its meeting-to-meeting moves, it’s a highly subjective business; it’s
artistry, not science. Should we go now or wait a month? Should we do 25 or make it 50?
Such decisions are the stuff of the monthly meeting, but they’ll be made on the flimsiest
of grounds. They’re not strategy, merely tactics. Often, the tactical decision will be based
on the question: which alternative would have the more helpful effect on confidence?
Often, the answer to that question will come from the governor’s gut-feel. Certainly, such
decisions will be made very late in the peace. And, without wishing to shock you too
deeply, it’s always possible that such tactical decisions will be finally determined in the
board meeting itself. (Which raises another issue: how would the board feel if the
outcome of its deliberations was regularly and clearly signalled a month before hand?)
So, while the Reserve has no desire to catch the market out, it simply can’t clearly signal
its detailed intentions in every formal statement because it doesn’t know what they are.

And here’s another major culture clash to be aware of. The Reserve is well aware that,
whether it waits a week or a month or even a few months to make its next move –
whether it does two 25s in a row or one 50 up-front – makes no discernable difference to
ultimate macro outcomes. In contrast, those distinctions mean everything to the markets. I
fear this difference of interest means the Reserve will never feel a need to keep the
market as well signalled as it would like to be.

A reality with which the Reserve needs to grapple more successfully, however, is this.
Though the Reserve may have times when it wants to send a signal and times when it
doesn’t, both the media and the markets have vested interests in receiving a signal every
time. So they’ll always find a signal, whether or not one’s been sent. That being the case,
it behoves the Reserve to do more to ensure that at least they don’t walk away with a
wrong signal. When the Reserve has no message to send and is merely boring away
justifying past actions, it should try harder to ensure it doesn’t inadvertently mislead
people as to its future intentions. It should at least leave people with the right impression
as to whether it retains a bias to tighten/loosen.
To get down to practicalities (and at the risk of st
ating the obvious), when you’re
scrutinising a statement in search of signals, there should be two items on your checklist:
one, what does it say about the balance of risks on inflation and, two, what does it say
about the balance of risks on activity? The answers to those two questions should tell you
as much as is being signalled about the Reserve’s intentions.

If we take last month’s SOMP as a case study, it did carry two signals. The first came in
the way the Reserve laid it on so thick about international conditions being ‘at their
weakest for many years’, with synchronicity being ‘all the more cause for concern’ and
how global growth had ‘turned out to be a good deal weaker than previously thought’.
Got that – or would you like some more? The second signal came with the announcement
that, at its November meeting, the board had ‘elected not to change the stance of policy
for the present’. This, I suspect, is the first time the Reserve has announced a nondecision.

What you had to work out was why. Taken a face value (and ignoring the extent
of the carry-on about the world economy), you could conclude that the Reserve was
pretty happy with the stance of policy by November 6, and only if there were more bad
news between then and now would it be likely to cut at its December meeting. But you
had to be able to supply a word that would never cross an independent central banker’s
lips – a word that started with ‘e’ and ended with ‘lection’. You had to know Ian
Macfarlane is too proud to admit that only in the most extreme circumstances would the
Reserve risk getting itself embroiled in the political fray by adjusting rates during an
election campaign. Most market participants knew that, but some – being so weak on
politics – hadn’t followed the logic through properly and wondered if the board had made
a decision at its November meeting and was waiting til after the election to announce it.

As John Edwards pointed out, you only have to think about that proposition for a minute
to realise that such behaviour would get the Reserve into at least as much trouble with the
pollies as changing rates during the campaign. But that was all the Reserve’s second
signal amounted to: if you were one of the mugs expecting a cut a day or two after the
election, forget it. There are some matters so sensitive that they’re written in invisible ink,
and you have write them in yourself. One was the Reserve’s attitude to elections, another
was the role of the GST in the Reserve’s decisions to tighten policy in the run up to July
2000.

Now for my call, which comes in five points. First, the Fed may have further to go than
the markets imagine. It will be prepared to cut further if it’s not confident that recovery is
on the way. It will regard the whole 200 basis points as available to be used and, as we
learnt last week, sees no need to keep its power dry.

Second, if the Fed eases more, the Reserve will ease more – though, as we’ve seen, not to
the same extent.

Third, our economy can’t go into recession unless consumer spending actually falls,
which isn’t likely. The downside risk that could produce such a fall is a savage bout of
cost-cutting and layoffs by big business as propitiation to the god of Shareholder Value.

Fourth, the big test for our economy should come mid-year, when housing has finished its
run. Will the US cavalry have perked up in time to rescue us? That’s the base-case hope,
but I have my doubts. Even if we are left in the lurch, however, that should mean weak
growth rather than negative growth. By the time the non-arrival of the US recovery had
become apparent, the Reserve would presumably have been easing further in anticipation
(as the Fed would have, too). By then there would be more serious consideration of the
need to supplement monetary stimulus with discretionary fiscal action.

Fifth, unless we’re very unlucky, at some point in the first half of next year both the Fed
and the Reserve will reach the end of what they need to do (though uncertainty means
they’re unlikely to signal clearly that this point has been reached). What happens then?

This is where our last culture clash arises. Central banks are perfectly happy to live with
protracted periods of inactivity, but the market (and the media) has a vested interest in
movement. So the easing phase isn’t over for five minutes before markets are bracing
themselves for the tightening phase. To rationalise this compulsive behaviour, the market
has already started telling itself how worried the central bankers will soon be about
rampant inflation. This conveniently overlooks the evident structural change in inflation
and productivity, as well as the central bankers’ track record in the sitting-on-their-hands
department. Consider our Reserve’s record. It held the cash rate steady at 4.75 per cent
for more than a year between July 1993 and August 1994, then held it at 5 per cent for 16
months between July 1997 and December 1998 and at 4.75 per cent for a further 11
months to November 1999.

So here’s my call: most of you guys will spend most of next year anticipating a rise in
rates that never eventuates.


The Political and Policy Outlook in Australia 2002

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WHAT IS TREASURY’S ROLE?

Talk to Treasury seminar, Canberra
September 17, 2001

I suspect that, when Martin and Ken invited me to talk to you today, their intention was to put before you a speaker you’d find a bit thought-provoking and challenging – someone who’d give you a bit of an intellectual workout. (Maybe someone you could easily dispose of before lunch.) So, to that end, I’m going to take a round-about approach to my topic of what Treasury’s role should be. I’ll be sneaking up on the topic, dividing my talk into three parts. The first part will be a bit theoretical, the second a bit philosophical and the last very down to earth. When I finally get round to talking about Treasury’s role, I’ll throw a few friendly punches in Treasury’s direction.

But let’s start with a little challenge on the theoretical side. If you’ve read my stuff over recent years you may have noticed that I’m much influenced by the insights of ‘behavioural economics’. This is a relatively new school of economic thought which is led by Richard Thaler – formerly of Cornell, but now ‘promoted’ to Chicago – and draws heavily on the work of two cognitive psychologists, Daniel Kahneman of Princeton and the late Amos Tversky of Stanford. If you’re not familiar with behavioural economics, you may have had more exposure to its sister discipline, behavioural finance, which is devoted to challenging and improving upon the efficient markets hypothesis. One of the leaders of behavioural finance is Robert Shiller of Yale, author of Irrational Exuberance.

Behavioural economics challenges two basic premises of the neoclassical model, rational choice and, under conditions of uncertainty, expected utility theory. These theories are both normative and positive – they specify not only how economic agents should act, but also how they do act. Behavioural economics subjects these theories to empirical testing, mainly by means of laboratory experiments, and finds that they fail as positive theories: they are poor predictors of how people actually behave. Let me summarise some of the key findings:

1. Money is not fungible. One dollar is not the same as another. In the minds of most people, a dollar’s value varies with circumstances. For instance, people will go out of their way to achieve a saving of $5 on the purchase of a tranny worth $25, but won’t go to the same trouble to save $5 on the purchase of a TV worth $500. People fail to treat all dollars equally because they engage in a system of metal accounting, where certain sums are allocated to certain purposes and can’t be drawn on for other purposes. They engage in this seemingly irrational behaviour because it helps them keep their total spending within their budget constraint. One key finding under the heading of fungibility is that a dollar of loss gets a higher weight than a dollar of gain.

2. People aren’t risk averse so much as loss averse. It’s true that people are risk averse when it comes to gains, but their dislike of losses is so great that many are willing to accept gambles in the hope of avoiding them.

3. People are more concerned about the change in their wealth than about its ultimate level. I offer you the choice between starting the day with $150 and suffering a loss of $50, or starting and ending the day with $100. Theory predicts you’ll be indifferent between the two but, in fact, most people would much prefer to avoid the loss by starting and ending with $100.

4. People simply can’t see why they should ignore sunk costs. This is something politicians understand much more readily than their econocrat advisers. It occurs, I suspect, because of people’s misconceived desire to avoid losses.

5. People often ignore opportunity costs. They commonly have a wide gap between willingness to pay and willingness to sell. I may not be willing to pay much for a particular item, but once I own it, you’d have to offer me a lot more before I was willing to sell it to you. This is a bias towards preserving the status quo.

6. People often fail to order their preferences consistently and have difficulty making comparisons between three or more things. As part of this, people’s choices are often influenced by the way those choices are presented to them – the way they’re ‘framed’ – which is why, for instance, we know not necessarily to believe the results of opinion polls conducted by vested interests.

What all this amounts to is an exploration of the specifics of Herbert Simon’s notion of ‘bounded rationality’. The point is not that people are wilfully irrational or capricious, but that the human mind simply has limited capacity to store and process information. We are physiologically incapable of being as coldly rational in our decision-making as the neoclassical model assumes we are. We rely on simple rules of thumb (or ‘heuristics’) which generally serve us well – they’re mentally cost-effective – but nonetheless lead us into consistent errors.

The fact that the leading proponent of this stuff has now won a chair at Chicago suggests it’s starting to gain some respectability in academic circles. My motive in drawing it to your attention is partly to give you something to think about and certainly to challenge any complacency you may have about the adequacy of the neoclassical model. The great stumbling block to the wider acceptance of the insights of behavioural economics is the difficulty in incorporating it in a mathematical model. If a truth can’t be turned into an equation then a mighty lot of academic economists would prefer not to know about it. But that’s not a good enough excuse for someone engaged in policy advising to elected politicians. Their advice needs to be tempered by the knowledge that the model’s assumption of rational choice is unrealistic and unreliable. Advisers need to understand and, where possible, anticipate the misconceptions that bind the minds of ministers and their constituents. They should appreciate the great extent to which rational responses need to be explained and justified. And it’s not enough to convince the minister; you then have to provide him with the explanations he can pass on to the public. The insights of behavioural economics are also useful in helping advisers realise when they’re pushing their luck too far – when the propositions they’re advancing are just too counterintuitive for any politician to sell.

By way of illustration, I’ve argued before that these insights do a lot to explain the political difficulties of selling tax reform. Once the politicians committed the fatal design error of making the reform of indirect taxation revenue positive rather than revenue neutral, the basic proposition they had to sell was along the lines: the net effect of the GST is to raise your cost of living by $10 a week, but don’t worry, we’re going to cut your income tax by $20 a week, so you’ll be $10 a week better off. To any economist, that sounds a pretty attractive offer. But to many voters it sounded most unattractive. Why? Because they gave the $10 of loss a higher weight than the $20 of gain.

In the outworking of the tax package, many voters believe their personal cost of living has risen by far more than the 3 per cent or so that the CPI seems to be suggesting. Behavioural economics’ exploration of the various heuristics that affect people’s thinking – such as that they find it easier to call to mind unusual or outstanding events – does much to explain why the CPI people carry around in their heads gives such radically different answers to the one the Statistician so carefully calculates.

OK, now let’s move on to the second part of my remarks, the vaguely philosophical bit. In his speech to the Fin Review’s chief finance officers’ summit in June, Martin repeated an argument often advanced by Treasury and others that the significant and sustained increase in productivity growth during the 90s can be attributed to the beneficial effects of 15 years of microeconomic reform. Though it can’t be proved, I have no difficulty accepting this argument. But it prompts what I regard as a key question: if we’re so rich, why aren’t we happy? If income per capita grew faster in the 90s than at any time since the 60s – and it did – why is there so much dissent in the ranks? Why so much support for outfits like One Nation; why so much abuse of economic rationalism, such carry-on about globalisation and such vehement criticism of national competition policy? Why do we all know that, no matter who wins the election, little further reform is likely to be undertaken?

Treasury’s standard answer – of which there were hints in Martin’s speech – comes in two parts. First, the opposition is coming from vested interests defending their privileges. Second, to the extent that this doesn’t explain the discontents of ordinary mortals not being whipped up by lobby groups, the punters are simply too dumb to understand what’s good for them. It’s usually put a bit more politely than that: the policies haven’t been ‘sold’ properly. I have to say the line that the public is woefully illiterate in economic matters – that it just can’t trace through causes and effects – doesn’t come well from economists whose advice is based on a model that assumes agents’ decision-making is relentlessly rational at all times. But, apart from that, the standard defence isn’t sufficiently convincing. It’s too self-serving, for one thing. And the line that the punters don’t know what’s good for them, so the pollies should just press on with good policies because, in due time, the results of those policies will convince people that father knew best – well, time’s run out on that argument. The benefits are in, they’re in line with the economists’ predictions, but the public’s still not happy with the outcomes.

The standard response from Treasury’s critics within the profession – from people such as Bob Gregory, let’s say – is that the reason higher income per capita hasn’t satisfied the electorate is distributional. Sure micro reform has increased national income as promised, but – not surprisingly – too much of that extra income has gone to the top 10 or 20 per cent of the distribution, and too little to the battlers. It’s no wonder the battlers are in revolt – and justifiably so. Now, you won’t be surprised to hear that I have a lot of sympathy with this standard criticism – and I’ll have more to say on it later.

But I want to give you my own, non-standard response – the philosophical bit. Bob Hawke once said something to the effect that the role of economists was to increase happiness. It struck the public – and even some economists – as a weird thing to say, but I think it’s right. I don’t see much distinction between ‘utility’, ‘satisfaction’, ‘welfare’ and ‘happiness’ (or, as the psychologists usually put it, ‘subjective well-being’). So, to me, increasing happiness is the stated objective of economics, and the question is: how well does it do in achieving that objective? As you may know, there’s a growing body of empirical literature about the relationship between income and happiness, and I believe it sheds a fair bit of light on that key question raised by the success of micro reform: if we’re so rich, why aren’t we happy?

A host of studies have shown that, though rising per-capita incomes have been associated with rising measures of subjective well-being in developing countries, in developed countries the steady rise in incomes over the past 30 or 40 years has not been associated with a measured improvement in subjective well-being. So we’ve been producing and consuming more goods and services but, contrary to the most basic assumption of economics, it doesn’t seem to have led to any increase in aggregate utility.

Why not? The literature offers various explanations. One is what Kahneman calls the ‘hedonic treadmill’. As our income rises, our expectations quickly adjust, leaving us feeling no better off. This is consistent with the findings of Richard Easterlin of USC in a recent study: ‘income growth does not . . . cause well-being to rise, either for higher or lower income persons, because it generates equivalent growth in material aspirations, and the negative effect of the latter on subjective well-being undercuts the positive effect of the former.’ People continually expect a rise in their income to make them happier, but it never does. They fail to anticipate the rise in their aspirations that comes with their higher income.

A second explanation of why higher national income fails to increase aggregate utility comes from the empirical observation that – contrary to the assumptions of the model – what people strive for is not an absolute increase in their income but a relative increase. What they’re seeking is socio-economic status – a higher place in the pecking order. So they’re keeping up with the Joneses – or rather, trying to get ahead of them. In consequence – and as Robert Frank of Cornell argues in his book Luxury Fever – the more affluent societies become, the more consumer spending is devoted to Fred Hirsch’s ‘positional goods’. If so, it’s obvious why we’re no happier: we’re engaged in a zero-sum game. Any increase in my relative income generates a negative externality for others.

If there’s anything in these arguments, they suggest that micro reform is pursuing an intermediate target – higher national income – which doesn’t lead to the ultimate objective: greater welfare. They also suggest that materialism is the great delusion – the great carrot on a stick – of our age. I suspect that when the punters carry on with arguments about how ‘people are more important than The Economy’, what they’re expressing, in their own inarticulate way, is their disillusionment with materialism.

In recent times I’ve become more conscious of the narrowness of economics. That it deals with just one, important but narrow dimension of our lives: the material. The limitations of the neoclassical model narrow it further. Like all professions, economists are highly specialised in their interests and they run the occupational risk of developing tunnel vision in the advice they give their clients. I’ve decided I don’t want to devote what remains of my career to trying to ram materialism down people’s throats. And I’ve become more conscious of my obligation as a journalistic commentator to warn my readers not to be unduly influenced by one-dimensional advice from economists – by what, to coin a phrase, is ‘partial-equilibrium analysis’. Voters have to stand up to economists in the same way an HSC student has to stand up to a French teacher who lays on the homework as though French was the only subject the student was studying. So the first thing I’d say about Treasury’s role is that, in proffering its advice, Treasury must guard against the unconscious assumption that the material objective should be maximised at the expense of all other objectives. I suspect Treasury also needs to be more conscious of the analytical limitations of its discipline.

So at last we reach the final part of my talk where I actually address the topic and say something about Treasury’s role. I’m not going to bother telling you what a great job I think you’re doing – there’d be little point in that. No, I’m going to offer some criticism. But please note this: I’m a person who earns his living by expressing his criticisms in public, but these are being offered in private. And though I’m paid to find fault, I have no reason to be anti-Treasury. In fact, I’ve always had in my makeup an instinctive sympathy for those people charged with the daunting task of holding the show together and moving it on in pursuit of the community’s betterment.

To that end, I’ve always accepted, for instance, that the Treasurer’s role is to talk up the economy – that he does so in our corporate interests, not just his own political interests. I’ve always accepted that it’s not Treasury’s role to be the first to forecast a recession, for fear of the self-fulfilling prophecy. I’ve been sympathetic to Treasury when its Budget-time forecasts have been subject to cheap shots from smart-alec business economists who enjoy the luxury of being able to change their forecasts as often as they change their underpants. (And I almost always remember to pin the forecasts on the Government rather than Treasury.)

Hitherto, I’ve always accepted the need for Treasury – and more, these days, Finance – to play the institutional role of Dr No. I think of it as the role of the cricket club treasurer. She’s facing a committee of 12, each of whom can think of fabulous ways of spending every cent in the club’s bank account – and more besides. Facing such odds, if she adopts a position of automatically opposing all spending proposals, there’s a fair chance that no more will get through than the club’s finances can stand. There’s never any shortage of people with good ideas to spend money. Every institution needs a least one person – the treasurer - who knows her role is to be a perpetual wet blanket in the interests of the institution’s longevity.

And, hitherto, I’ve always accepted the need for Treasury – and Tax, of course – to ‘protect the revenue’. If you don’t do it, who will? Well, it was my own concern to protect the revenue that helped to bring me into journalism almost 30 years ago. I was a young chartered accountant bored with auditing. I decided the only really interesting part of accounting was tax advice, but I also decided that I didn’t want to devote my life to helping the well-off avoid their responsibilities to the community. I trust you’ve seen this ‘prior’ evident in my work. I’ve often been happy to defend unpopular tax measures – I even went to the defence of the super surcharge, despite considerable reservations about its design features.

But – and now we get to the but – of late I’ve formed the view that Treasury needs to perform its roles of opposing new spending and defending the revenue with a lot more forethought, discernment and subtlety. With more guile, if you like. Let’s start with the spending side.

In Martin’s speech to the CFOs, he argued that ‘these real GDP per capita gains [from micro reform] are not just materialistic gains for the lucky few, but a real improvement in Australia’s capacity to sustain whatever economic and social improvements its people want’. I responded to that by email, and I’ll tell you my response. I said that, coming from Treasury, it was a bit rich. It was, in fact, no more than ex-post rationalisation. We both know, I said, that, first, when Treasury and other economic rationalists were urging governments to make these reforms in the first instance, they did little to urge governments to introduce (quote) ‘policies that help sections of the community adjust to change’ (unquote). In fact, Treasury hoped to be able to get away without them. Second, when other people wanted such adjustment assistance/compensation for the losers, Treasury oftentimes opposed it. The third thing we both know, I said, was that when the political shite eventually hits the fan, the pollies go behind Treasury’s back and do things that are really stupid. In which case, Treasury’s badly overplayed its hand.

Consider the case of the revolt in the bush. We’ve been through a period of at least a decade where, as a result of a range of micro reforms – from banking to railways to telephones – people have been busily dismantling a whole range of long-standing cross-subsidies in favour of RARAland. It seems to have occurred to no-one in any of the alleged co-ordinating departments that these disparate federal and state initiatives were starting to add up, and might soon provoke a counter-reaction. It occurred to no-one that there is deeply ingrained community support for the notion that the city should prop up the bush – support not just in the bush, but also in the city. When the inevitable backlash came, what did we get? We got petrified politicians running everywhere reversing policies and oiling squeaky wheels. What we didn’t have was any pre-emptive thinking by the PC or anyone else about second-best solutions. Thinking that, proceeding from the position that the public would always want some degree of subsidy for the bush, studied the costs and benefits of rival subsidies and came up with a program saying, if you insist on wasting your money, these are the least-worst subsidies to waste it on.

Martin always expected what I’d say today was that micro reform should have done more to help people adjust to change and more to redistribute the proceeds of reform from the winners to the losers. Well, I am saying it. I’m saying it’s not enough that the winners could compensate the losers; you actually have to do it. I’m also saying that if you want to know why economic rationalism and globalisation and competition policy are on the nose – and why the prospects for further reform are so dismal – you need look for no fancier answer than this. The punters have discerned that, whoever’s making a killing from micro reform, it ain’t them. And they’re right, it ain’t. The final ain’t is that they ain’t gonna take it anymore. Treasury and its fellow travellers sought to drive too hard a bargain on the opening up of our economy, and they’ve brought to whole game unstuck.

Next I want to say something about protecting the revenue. Alan Mitchell has a saying that the main task of the bureaucracy is to keep the crazy decisions to a minimum. On the tax front, I don’t think Treasury and Tax have been doing too well lately on that criterion. They seem to have been working on the theory that if you look after the pennies the pounds will look after themselves – and they seem to have come badly unstuck.

Consider the petrol excise. I assume that Treasury urged the Government to do the 1.5 cents a litre chisel on its promise to prevent petrol prices rising, and that it urged the Government to include the special GST price effect in the regular indexation of excises. These penny-pinching decisions were taken or confirmed after the price of petrol had skyrocketed and motorists’ extreme displeasure was apparent. Presumably, the logic was that, with OPEC and the Aussie dollar doing their worst, no-one would notice a little chiselling by the Government. But the Government was robbed of the ability to claim its hands were completely clean in the matter, and the motoring lobbies were incited to launch a major campaign. In the inevitable backdown, the Government not merely gave up the ill-gotten 1.5 cents a litre, it abandoned the indexation of petrol excise for good and all. That’s protecting the revenue? Well done.

Next, consider the alleged self-funded retirees. My mail says that a lot of the complaints Government backbenchers were getting about GST paperwork came not from small businesspeople complaining about the BAS, but from retirees complaining about the IAS. And why wouldn’t they? When the backdown came, you could have knocked me over with a Payment Summary – Individual Non Business when I heard Costello say that people likely to owe less than $250 a year no longer needed to complete a quarterly IAS. If having the elderly submit five returns a year to pay less than $250 isn’t administrative incompetence (ie they didn’t have to, but were allowed to think they did), it’s appalling penny-pinching. And the ultimate penalty to the revenue? The even more appalling measures to square away the self-righteous retirees in this year’s Budget – measures that are like a time-bomb ticking away as the population ages and Generation X buckles under the weight of carrying the babyboomers.

What is Treasury’s role? Well, one role is that, in its efforts to control government spending and to protect the revenue, it should avoid being too smart by half.

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