Herd behaviour, fashion and status seeking

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Jobs market isn't nearly as bad as you think

Economists don't have a good record on forecasting what will happen to the economy, but here's a prediction I make with great confidence: whatever happens, it won't be as bad as you think it is. That applies particularly to the jobs market.

Consider this. One day you pick up a newspaper and on page five you read a small story saying employment grew by 10,000 last month, leaving the rate of unemployment unchanged at 5.2 per cent. A couple of days later, every time you turn on the car radio or look on the internet, then settle down at home to watch the evening news, you're told about the car company that's announced its intention to lay off 350 workers. The next day the big news is that a bank intends to lay off 1000 workers.

Question is, what conclusion do you come to about the state of the jobs market? You wouldn't be human if you didn't think things were in pretty bad shape.

You'd need the steel-trap mind of an economist to say to yourself: "These stories I'm hearing about layoffs here and there are sad news for the individuals involved, but they don't really prove anything. To make a balanced assessment of what's happening in the labour market I need aggregate statistics, not anecdotes - and the last stats I saw said that, overall, employment is growing sufficiently to hold the unemployment rate steady at 5.2 per cent."

The human mind isn't particularly good with statistics. Some people even have trouble pronouncing the word. Figures are too cold and impersonal. We're interested in other people, not numbers. So there's a sense in which we're moved more by a story of 350 people losing their jobs than by one saying 10,000 jobs had gone. Of course, what would really engage us is a story, with pictures, about the plight of just one sacked worker, worried about the mortgage and not at all sure where their next job was coming from.

But there's a distinction between fellow-feeling for someone who's struck hard times and assessing how worried we should be about the state of the world.

Already this year we've heard a lot of stories about people being laid off in manufacturing, retailing and now banking. It's a safe bet we'll be hearing a lot more, and that each announcement will get much attention.

How could this not leave most of us with the impression the economy's going to hell in a foreign-made handcart? Yet this impression will almost certainly be exaggerated, and may well disguise a position where, overall, the economy is holding its own.

One reason we're misled is that we're unduly impressed by very small figures. To put it another way, we don't appreciate just how big the economy is. There are 11,421,300 people in the labour force, either in a job or actively seeking one. So 350 people represent 0.003 per cent of the total.

The point is not that the fate of 350 people is unimportant, but that it makes a minuscule difference to the fate of workers generally. Make it 10,000 people and we're still only up to 0.09 per cent.

Another reason we're unduly impressed by news of people losing jobs is we don't realise how much turnover there is in the labour market. Julia Gillard keeps saying that every year about a million workers change jobs - with about a quarter of them also changing the industry they work in. When I checked that surprisingly large figure with an expert, he said it was too low.

(Gillard emphasises the remarkable degree of change in the economy by adding that, every year, about 300,000 businesses close - and 300,000 new ones start up.)

So every month many thousands of people leave their jobs - voluntarily or involuntarily - and many thousands move into jobs. What's another 350?

By now you may have realised we get told about only the tiniest fraction of all the coming and going. In fact, we get told when a big company announces it's decided to get rid of a block of workers. It makes an announcement because it wants to impress the sharemarket or pressure the government for assistance.

But we don't get told when big companies decide to hire a block of workers or, more usually, to hire people in dribs and drabs. And we're told virtually nothing about the hiring and firing by small business. Get the feeling we're being given a biased impression?

There is, however, another, more fundamental reason we'll be getting a distorted impression of what's happening in the economy this year. We're getting the idea the high dollar is causing the economy to slow down and shed jobs.

In truth, the high dollar and the factors that brought it about aren't destroying jobs so much as shifting jobs from one industry to another. That's painful for the contracting industries - and we're hearing their cries loud and clear - but, predictably, we're not hearing much from the expanding industries.

While jobs are being lost in manufacturing and elsewhere, employment will be growing in mining and the construction industry, pretty obviously, but also in the services sector, including in health, education and training, public administration, the science professions and arts and recreation.

I'll be surprised if, overall, we don't see continuing growth in employment. Whether this growth will be sufficient to cope with the natural growth in the labour force and thus hold unemployment steady, I'm not as sure.

But I do know this: with inflation under control, if the Reserve Bank sees unemployment drifting up it will cut interest rates further to encourage borrowing and spending and thus foster faster growth in employment.

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TALK TO FAIRFAX MEDIA SENIOR MANAGEMENT FORUM

Sydney, Monday, February 13, 2012

Greg has asked me to talk to you about the state of the world economy we find ourselves coping with, particularly the problems in the euro zone. But before I do I have to issue a standard consumer warning: economists have a very bad record in forecasting what will happen in the economy, so you’d be wise not to take a blind bit of notice of anything I say.

I can say that confident you will take an interest in what I say because everyone already knows economists aren’t good at forecasting but it’s never stopped them asking for another forecast. That’s because the human animal has an insatiable curiosity about the future - an incurable belief that it’s possible to know about the future and the more we know about it the better our chance of controlling it. John Kenneth Galbraith said economists were created to make astrologers look good, but I prefer to say that if people don’t have economists to ask about the future, they’ll settle for asking witchdoctors.

Perhaps economists are modern-day witchdoctors. But I draw a distinction between understanding what’s going on in the economy and predicting what will happen next, so I’m going to focus more on what and why things are happening rather than what will happen next.

I’ll say a bit about China eventually, but I’m sure you realise the big problem area in the world economy at present is the North Atlantic economies, the United States and Europe (including Britain). Most people automatically assume that if these big economies are in trouble that spells trouble for us, but I think it’s important understand the various ‘channels’ by which developments in other countries flow through to us. The first and most obvious channel is via trade: if they reduce their demand for our exports that’s bad for us, of course. But these days the EU accounts for less than 10 pc of our export income and the US for only 5 pc, so direct trade with the North Atlantic shouldn’t be greatly affected. A second channel is via the global financial markets. We know that worries about worries about major problems in the world can push our sharemarket down. And now compulsory superannuation has made a lot more Australians conscious of sharemarket falls. We also know problems with banks can cause some international funds markets to freeze or can push up the cost of overseas funding to our banks, as is happening to a small extent at present. The third channel thru which adverse developments in other economies can adversely affect our economy is via confidence. Consumers and business people hear all the bad news and it tends to make them less confident and more uncertain about the future. Consumers tighten their belts, increase their saving and pay down debts and avoid making new commitments. Businesses put expansion plans on hold, try to improve their gearing, cut non-essential spending such as advertising and maybe lay off staff.

It’s clear this third, psychological channel is the main channel by which worrying developments in the North Atlantic economies become a worrying development in our economy. The more I see of the ups and downs of the business cycle, the more convinced I become that ‘confidence’ - and particularly our collective swings from excessive optimism to excessive pessimism - is the biggest single factor determining the swings in the economy. There are ‘real’ factors at work, of course, but they are greatly amplified by the way business people and consumers are feeling at the time. The trick is that when the way we feel affects the way we act, the merely emotional becomes real. To take an example close to home, when I decide to cut my advertising budget because I’m uncertain about the future, the effect on businesses that sell advertising is very real. And when negative sentiment takes hold, it tends to feed on itself, becoming self-fulfilling and self-reinforcing. This is why, as you may have noticed, in my writing I’m putting a lot more emphasis on ensuring I give our readers a reasonably balanced assessment of how good or bad things are, even tho it’s a lot more fun to scare the pants off them.

Two factors do most to explain why the North Atlantic economies have been in so much bother since the global financial crisis reached its peak with the collapse of Lehman Brothers in 2008, and why they’re unlikely to be completely out of bother for many years. The first is ‘debt’ and the second is the euro. The crisis in 2008 brought an end to a debt-fuelled boom in the developed economies that lasted - with interruptions from mild recessions - for about 20 years. In the US it’s clear households borrowed too much, for housing and to maintain lifestyle; in their efforts to maximise profits banks became too highly leveraged, and the US government ran too many annual deficits and racked up too much debt. In Europe, the banks became far too highly geared and governments were far too undisciplined in their budgeting. When the crisis peaked, governments in the US and Europe borrowed heavily to rescue their banks, then borrowed again to get their economies moving. Coming on top of the already high debts acquired during the long boom, this took most governments to quite unsustainable levels.

But this brings us to a paradox: for individual households or businesses or banks, the best way to get on top of your debts is to tighten your belt; for whole economies, however, the best way is to grow your way out of them. The ideal for governments is to keep growing, while slowly mending your ways. The trouble for governments with lax budgeting records, however, is that markets, German governments and others don’t trust their promises to be good boys tomorrow but not today. This does much to explain the flirtation with policies of austerity which, by making economies even weaker, can make it even harder to reduce budget deficits. Then markets react badly when they see economies weakening. Of course, when a government reaches the point where people are no longer willing to lend to it - as with Greece - it has no choice but to accept austerity.

A point to note is that, because of this debt overhang, it’s idle to imagine (as I suspect some people still do imagine) there’s some way Europe - or even America - can get back to normal rates of growth within a year or two. For a start, the rates of growth we came to regard as normal in the 90s and the noughties turned out to be debt-propelled. It will be a long time before we see its like again. For another thing, the process of ‘deleveraging’ is always protracted. So the only options available to the North Atlantic economies are weak growth for the rest of the decade, or economic disaster for the rest of the decade.

Starting with the US, its households are likely to be preoccupied with getting on top of their debts for many years yet, which will constrain the growth of consumption spending. It has unsustainably high levels of government deficit and debt, but its ‘debt crisis’ is political rather than economic. The two sides in Congress can’t agree on how and when to get its budget under control but, in marked contrast to the Europeans, global financial markets remain so willing to continue financing its deficit that the yield on US Treasury bonds has fallen to 2 pc.

One point I want to leave you with is that the outlook for the North Atlantic economies has improved markedly since late last year. In the case of the US, its recovery faltered in the middle of last year, but has improved a lot since then. The economy grew at an annualised rate of 2.8 pc in the December quarter and the unemployment rate has been falling slowly for the past five months. The US sharemarket is up about 20 pc on its low point in October. Growth isn’t likely to continue at that healthy rate, but all the talk of a double dip has evaporated.

What makes Europe’s story much more worrying that America’s is the euro. The rationale for the single currency area was more political than economic. Even without the addition of the former communist countries, the economies of the foundation members of the area were at far too disparate states of development for this to be a sensible arrangement. The interest rate and exchange rate levels appropriate for Germany and France were never likely to be appropriate for Portugal, Ireland, Greece and Spain - even for Italy. The removal of currency barriers between the 17 members of the euro does increase trade between them and, for a time, the governments of the less developed and less fiscally disciplined members did benefit from being able to borrow in euros at much lower interest rates then they’d been paying.

But, as is now all too painfully evident, all that did was lure Greece and others into borrowing far more than was good for them. And now they’re having difficulty servicing that excessive sovereign debt, the drawbacks of the currency union are painfully apparent: no ability to regain lost competitiveness with the rest of Europe by devaluing your exchange rate rather than cutting nominal wage rates; no ability to set interest rates at levels appropriate to your own needs. And, indeed, no easy way to escape the straitjacket of the currency area. Greek firms that had borrowed in euro would find their debt levels greatly increased when expressed in new drachmas.

The founders of the Euro understood that budgetary indiscipline was the greatest threat to the single currency’s survival, and established deficit and debt limits and targets accordingly. But they failed to live up to or enforce those limits, and now they’re chained together whether they like it or not.

It’s by no means certain the Europeans can make the euro work. And it’s hard to imagine a way it could break up that wouldn’t turn the mild recession they’re already in, into a deep and prolonged recession that worsened the US recovery and made life a lot tougher for us as well. They’re having a lot of trouble agreeing on what they need to do, and the longer they dither the greater the risk of some unexpected but damaging accident.

But having conceded that, I have to remind you of my point that, even with Europe, the situation is now looking a lot less on-the-brink than looked late last year. Under a more pragmatic president, the European Central Bank has provided its banks with huge amounts of cheap three-year liquidity, which has calmed market concerns about the banks. They’ve used much of that liquidity to buy the bonds of euro governments, which has significantly lowered the rates those governments face when they borrow. The euro governments are moving towards a new fiscal responsibility treaty which, at least, seems to have mollified the Germans somewhat. And the Greeks have passed another milestone.

The IMF, the Reserve Bank and Treasury base their forecasts for growth in Europe on the assumption the euro leaders manage to ‘muddle through’ without a disaster occurring. That’s the only sensible basis on which a forecast could be based and, thankfully, it’s easier to see it coming to pass than it was three months’ ago.

I haven’t left myself enough time to talk about China and the rest of developing Asia, but let me make a few quick points. The adverse effect on trade from the North Atlantic economies comes to us mainly via China. So China is the economy whose health we need to be most concerned about. Fortunately the news from the orient is a lot less worrying. It’s true its exports to the North Atlantic have been hit, but many people overestimate its continuing reliance on export-led growth. It’s true the Chinese authorities have been acting to slow their growth and reduce inflation pressure, but they and other emerging Asian economies retain plenty of scope to stimulate domestic demand should the rest of the world slow by more than we’re expecting at present.

The IMF is forecasting world growth of 3.3 pc this year, which is below the average rate of about 4pc, but well above the 2 pc level regarded as a world recession. When you weight that 3.3 pc to take account of the countries to which we send most of our exports, you add 1 percentage point.

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What happens now on interest rates

Until last week, the financial markets and most business economists thought the Reserve Bank had several rate cuts up its sleeve and would start doling them out this month. The smarter ones don't think that any more.

When the Reserve failed to cut the official interest rate last week, some observers swung to the opposite view of expecting no further cuts for the foreseeable. And with all the fuss about the banks' small "unofficial" increases in mortgage rates, you can bet the punters are now convinced rates are heading back up.

Needless to say, the official rate is unlikely to rise. With luck, it won't need to be cut further. But if the outlook for the economy deteriorates, it will be.

Since the Reserve cares most about the rates households and businesses actually pay, and has no desire to tighten the interest-rate screws, the tiny unofficial increase will be one factor - but only one - favouring another cut in the official rate sooner rather than later.

Why didn't the Reserve cut last week? Because you may have convinced yourself the economy's in trouble, but the Reserve hasn't.

For the markets and business economists to have been so sure the Reserve would cut, it was necessary for them to be convinced of the truth of one or both of two propositions.

First, that the outlook for the world economy is now worse than it was late last year. It's true that, in recent times, the Reserve has judged the state of the rest of the world to be the greatest single threat to the continuing growth of our economy.

But almost all the news we've received from abroad so far this year has been reassuring. Things have calmed down a lot in the euro zone, with the actions of the European Central Bank making people a lot less worried about the European banks than they were, with sovereign bond yields falling back to more sensible levels, with banks able to raise funds with new bond issues, with Greece looking like it may reach a deal with its saviours, and with world sharemarkets looking up.

None of this implies the Europeans don't have a lot more to do, nor that there's little chance of something somewhere suddenly going badly wrong. The continuing risk that things could deteriorate in Europe remains the greatest single reason the Reserve could cut rates again this year.

But you do have to say the improvement in conditions in Europe so far this year makes it easier to believe the Europeans will muddle through.

As for the United States, its economy isn't roaring, but it is doing better than it was, growing fast enough to slowly reduce unemployment. For China, it's slowed a bit, but is still growing strongly.

The second proposition you'd need to believe to have been so confident the Reserve would cut last week is that the domestic economy is clearly slowing.

The tribulations of particular parts of the economy - notably manufacturing and retailing - have generated so many negative headlines I've no doubt many people are convinced the economy's in trouble.

Certainly, the belief the economy is slowing is widely held. But that's what happens when the news is mixed, with the bad bits trumpeted and the good bits played down. Just why the commercial media regard misinforming the public in this way as good for business I'm blowed if I know.

Do they imagine only the Labor government will suffer if they succeed in talking the economy down? Do they think it's like "a Martian ate my baby"? It's just entertainment and no one actually believes them?

The unrecognised truth is, the economy's speeding up a little, not slowing down. That's because we're recovering from the effects of the bad weather this time last year. Abstract from the weather effect and the economy's been travelling at about its medium-term trend annual rate of 3.25 per cent for the past two years or so, and is expected to grow at that rate this year.

With the unemployment rate steady at just 5.2 per cent and underlying inflation in the centre of the target range and expected to stay there for the next two years, you'd have to conclude the economy is right on normal.

In which case, the present level of interest rates - close to their own trend rate - must surely be pretty right. But it's clear from the Reserve's rhetoric that it retains a weak "bias to ease" (cut rates further): "the current [favourable] inflation outlook would, however, provide scope for easier monetary policy should demand conditions weaken materially".

How would such a weakening be manifest? Well, obviously by a deterioration in the world economy. Were Europe to implode, the flow-on to the rest of the world would be considerable - even for us. In this case we know how the Reserve would react: by slashing interest rates in a few big, bold steps.

But the requisite material weakening could also be brought about by a deterioration in essentially domestic factors.

The way the Reserve sees it, the economy is being hit by two powerful but opposing shocks: the expansionary effect of the once-in-a-century mining construction boom and, against that, the contractionary effect of the high exchange rate, which has reduced the international price competitiveness of our export and import-competing industries.

At present, the two conflicting forces are roughly offsetting each other, leaving the economy travelling at its trend rate. Should it become clear the high exchange rate is doing more restricting than the construction boom is doing expanding, which would show itself in slowly but steadily rising unemployment, the Reserve will cut rates further.

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How fiscal policy does and doesn't work

It's remarkable that the politicians of Europe and America are making things much worse for themselves and their people because they've unlearnt the economic lessons of the past 70 years.

Economists spent many years studying what policymakers did wrong in the Great Depression of the 1930s, making it much worse than it needed to be. One well-understood lesson was not to try to get the government budget back into balance too quickly.

This is counter-intuitive to many people. The government's tax revenues have collapsed, its spending has increased, it has a yawning budget deficit and government debt is piling up. Surely it's obviously right to get spending and your income back into line as quickly as you can.

Not if you're a national government. Why not? Because governments are so big that what they do affects the rest of the economy. Remember, governments can borrow more for longer than the richest individual or corporation, since they represent the whole community and have the power to pay their bills by levying taxes.

Economic downturns, recessions or depressions almost always manifest themselves in consumers and businesses cutting their spending. The more they cut, the more people lose their jobs and their businesses and the greater the decline in spending.

In such circumstances, it's not possible for the private sector to lift itself up by its bootstraps. Clearly, the government needs to do something that helps the private sector get back on its feet.

One thing the central bank can do is cut interest rates to encourage borrowing and spending. In normal times this is usually effective, but in really bad times a lot of people are too uncertain about the future to want to borrow and expand, no matter how low rates are. And if interest rates are already very low - as they are in the advanced economies at present - you can't cut them below zero.

The next tool available to help the private sector is "fiscal policy" - the budget. The first way to help is do nothing: when fewer people paying tax and more people on the dole cause the budget deficit to blow out, don't do anything to counter it.

This process happens automatically when the private sector turns down, and the fact that some people are paying out less money to the government while others are getting more money from it means the government is helping to cushion the private sector's fall, stopping it from falling further. Thus economists say budgets contain "automatic stabilisers".

If you try to counter the effect of these stabilisers by cutting spending or increasing taxes, you'll push the private sector down further and, because of that, probably won't succeed in getting the budget closer to balance in any case.

The second way to help is more active: stimulate the private sector by cutting taxes or increasing spending. If you were to do this when the economy was strong, you'd just worsen inflation. But if you do it when the economy is flat on its back, it will probably be effective, particularly if you increase spending rather than cutting taxes (which would allow some people to save their tax cuts).

Once you get the economy growing again, tax collections will improve and people will go off the dole, thus causing the deficit to reduce. This is the automatic stabilisers working the other way. Keep it up and the budget balance will turn to surplus, which you can then use to repay government debt.

See the point? Exercise enough discipline and patience and eventually the budget problem will fix itself.

All this had been well understood by economists and politicians for many years. It was how governments responded to the global financial crisis in 2008. But governments in Britain and the euro zone, and the US Congress, are now doing pretty much the opposite.

Their economies are still quite weak but they want to increase taxes or - more commonly - slash government spending to get their big budget deficits down in a hurry. In consequence of this policy of "austerity", the European economies are heading back into recession and their deficits getting worse.

Why are they doing something so counter-productive? Because their stock of government debt is so unsustainably high. Whereas sensible policy involves running surpluses and reducing debt during the good years, they kept running deficits and piling it up in the noughties.

When the global financial crisis struck in 2008, many had to borrow heavily to rescue their banks and then borrow even more to kick-start their economies. Their debt is now so high the financial markets have started wondering whether they'll be able to repay it.

But the flighty financial markets are an unreliable guide to good policy: though they seemed to approve when governments announced their austerity programs, they started disapproving when they saw those programs were causing economies to weaken.

Of course, when a country's sovereign debt gets so high that markets will soon refuse to lend more to it at any price, it has no choice but austerity. You can renege on your debts, but you can't run a deficit if no one will finance it.

Even if some international institution bails you out, it will punish you for your profligacy by insisting on austerity. Will this make things worse long before it makes them better? Inevitably.

That's the case of Greece. But most of the European countries aren't in those dire straits, so why are they slashing spending?

What they should be doing is promising and laying plans to reduce their spending down the track, as their economies recover and can take it in their stride.

Why don't they? Because, after decades of fiscal indiscipline, they don't have much credibility when making promises to be good tomorrow.

But that doesn't change economic reality: cut when the economy's weak and you make it weaker. The answer is to find ways of making their promises more credible.

As for the Americans, they too have years of fiscal indiscipline and a way-too-high level of debt. But though it suits President Obama's critics to claim the US has a "debt crisis", it doesn't. The world is still so anxious to lend to the US government that the yield (effective interest rate) on its long-term debt is down to 2 per cent.

It has plenty of time to get its budgetary house in order but, at present, a hostile Congress has the budget set up to crunch the US economy next year. These guys have learnt nothing.

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Propping up private heath insurance unfair, inefficient

Despite the untiring efforts of Julia Gillard and Tony Abbott to make themselves seem poles apart in their policies - he/she is hopeless, I'm really good - the ideological gap between the two sides has never been narrower.

If you look carefully, that's true even in one of the few remaining points of ideological difference: the funding of healthcare, particularly private health insurance.

When John Howard resumed leadership of the Liberals in 1995, he abandoned their long-standing opposition to Labor's Medicare (and Medibank before it). But that didn't stop him using a succession of carrots and sticks to get people back into private health insurance.

When Labor returned to power in 2007, it lost no time in seeking to water down those incentives. In its first budget it raised the income thresholds at which middle- and high-income earners became liable for the additional, 1 per cent Medicare levy surcharge if they didn't have private insurance.

In its second budget it sought to means test the 30 per cent health insurance rebate, reducing it for higher-income earners and removing it for those even higher up. Labor seems to have wanted this as part of its efforts to pare back all the middle-class welfare Howard introduced to health and social security payments.

But the measure was knocked back by the Senate, mainly because of the implacable opposition of the Libs. Labor has sent the bill back to the Senate every year since then, only to have it rejected.

This week the newish Minister for Health, Tanya Plibersek, is conducting discussions with the independents and the Greens in the hope of having more success this year. Strangely, if the Greens join forces with the Libs to block the bill one more time, it will be because they profess to believe it doesn't go far enough.

Plibersek has sought to demonstrate the unfairness of the rebate with figures showing that while just 12 per cent of couple taxpayers earn more than $160,000 a year between them, they account for 21 per cent of the couples benefiting from the rebate - worth, typically, about $1000 a year. For single taxpayers, the 14 per cent earning more than $80,000 a year account for 28 per cent of the singles getting the rebate. It's a concession for the well-off.

The health funds and the Liberals oppose the means test because, they claim, it would lead many people to abandon private insurance.

Leaving aside the question of why that would be such a bad thing, this is a weak argument.

Treasury's calculations show that only about 0.3 per cent of the 10 million people with insurance would quit. And it's not hard to see why. Higher earners are essentially compelled to hold private insurance by the Medicare surcharge. And Labor's plan actually involves increasing the size of that stick.

It's clear Labor's motives are to make the system a little less unfair and save the budget a little money (its means test would reduce the $3 billion annual cost of the rebate by about $700 million) without harming private insurance.

So, just as the Libs now accept the legitimacy of Medicare, so Labor now accepts the legitimacy of taxpayer-subsidised and enforced private health insurance. One of the few remaining ideological gaps has greatly narrowed.

The pity is that, as John Menadue and Ian McAuley explain in a new paper published by the Centre for Policy Development, subsidising private health insurance doesn't only advantage the better-off (including yours truly), it makes healthcare more expensive than it needs to be.

Healthcare costs to the community - whether funded by the taxpayer or privately - are already growing rapidly and are set to keep outpacing most other costs, becoming by far the greatest pressure on government budgets.

That makes healthcare the greatest source of pressure for rising taxes. Nothing wrong with that - provided we get value for money. But that's just where private insurance lets us down.

Howard's subsidy of health fund premiums was really a vote-buying election promise and a gift to the well-insured Liberal heartland. He tried to justify it by claiming that getting more people into private insurance would relieve the pressure on public hospitals.

As all the experts predicted at the time, it didn't work. It shifted patients from public to private, but it also shifted doctors from public to private, leaving public queues little changed. It did, however, subsidise the better-off in their efforts to jump the queue.

As anyone who's done high school economics could tell you, the benefit from a government subsidy of the price of something is shared between the buyer and the seller. The health funds have become a lot more profitable than they used to be.

All arrangements that separate the true cost of something from what you appear to pay for it at the counter encourage overconsumption, overservicing and overcharging. That's true of Medicare as well as private insurance.

But unlike private insurance, Medicare has countervailing advantages. Being a single national payer, it has lower administrative costs and, more to the point, greater ability to counter the market power of healthcare providers.

Our many private health funds have little ability - and little incentive - to counter overservicing and overcharging. It's a well established principle in health economics that those countries with the greatest reliance on private insurance to finance healthcare have the most expensive healthcare - without a commensurate improvement in their health. The United States is the classic case.

Using carrots and sticks to prop up private insurance not only subsidises a two-class health system, it delivers its greatest benefit to the incomes of medical specialists. Great idea.

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Asia well-placed to withstand global slowdown

Perhaps it's our natural eurocentricity, but we've been hearing a lot more about recession and the risk of worse in Europe than about the resilience of our own region. Fortunately, the International Monetary Fund set the record straight last week.

At a briefing in Washington, the director of the fund's Asia and Pacific department, Anoop Singh, focused on the counter-weight to the weakness in the North Atlantic economies.

If the euro zone is expected to contract by 0.5 per cent this year and the United States to grow by only 1.8 per cent, how come the world is still expected to grow by a not-so-terrible 3.3 per cent? Mainly because "developing Asia" is forecast to grow by a buoyant 7.3 per cent.

Singh made four main points. First, while growth in Asia has slowed, Asian economies have generally proved resilient to the increased turbulence in global financial markets and are helping to support global growth.

Second, there's certainly a risk of contagion to Asia from any further deterioration in global financial conditions.

But, third, the fund believes that, in the event of further slowdown in the global economy, most economies in Asia have room for "a strong policy response" - that is, room to stimulate their economies to offset the effects from abroad.

And fourth, the recent decline in the current account surpluses of China and many other Asian economies is very welcome. Sustained efforts to continue this decline in the medium term will reduce Asia's exposure to the external risks it's experiencing now, thereby maintaining its support for global growth.

"So, in both the short term and medium term, there are positive factors coming from Asia," Singh said.

On his first point, economic activity in Asia has slowed mainly because the growth in its exports has lost momentum, thanks to weaker growth in regional as well as global trading partners. But robust growth in domestic demand is helping offset this drag from external demand.

In China, the two main components of domestic demand - investment spending and consumption spending - have remained resilient, supported by strong corporate profits and rising household income.

And Asian banks have so far used their strong balance sheets to step in and ensure a continued flow of credit and trade finance in the face of the reduction in lending growth by European banks. As growth has slowed in Asia, inflation pressures have waned. So it's not surprising governments have paused the pace of tightening macro policies, or in some cases reversed it. The fund expects inflation to recede further this year.

The fund expects growth in the overall Asia-Pacific region to remain closed to 6 per cent this year, recovering to 6.5 per cent next year. Within this, emerging Asia will remain the fastest-growing region in the world, led by China and India. In China, growth will remain in the 8 to 8.5 per cent range this year, returning close to 9 per cent next year. In India, growth will stay about 7 per cent.

On his second point, these are just the fund's central forecasts. There's a clear risk an escalation of Europe's debt crisis could cause global growth to be 2 percentage points lower than the central forecast of 3.3 per cent.

Were this to happen, Asia would be greatly affected because the usual effect on its exports would be compounded by an adverse effect on business and consumer confidence, as well as by contagion in the financial sector. So there would be a knock-on effect from external demand to domestic demand.

Moving to his third point, were such a deterioration to occur, policy responses by Asia would be needed, without which the impact on Asia's growth would be substantial. But the fund believes many countries have the room to respond.

For many, the room is greater on the fiscal (budgetary) side than the monetary (interest rate) side. The pace at which countries are reducing their budget deficits could certainly be slowed, particularly in those with low levels of public debt, such as China. More than that, some countries could undertake another round of fiscal stimulus.

"Indeed, many Asian countries could advance their plans, which they already have over the medium term, to boost social safety nets and increase consumption and investment," Singh said.

These policies would have long-term positive effects on "rebalancing" - increasing domestic demand and thus reducing reliance on external demand - and growth, as well as reducing income inequality, which remains an issue in many Asian countries.

As for monetary policy, monetary tightening has appropriately been paused in many Asian economies, with some beginning to reverse this tightening. But the room for further easing is limited in economies where underlying inflation pressures remain, such as India. China has little room because it's still absorbing the stimulus from its previous credit expansion of the past two years.

As usual on these occasions, Australia hardly rated a mention. Except for this: "The authorities have certainly committed to return to [budget] surplus by 2012-13, and we have supported that. The authorities have believed that an exit from fiscal deficits is needed to rebuild fiscal buffers and support monetary policy," Singh said.

"Having said that, it is also the case that were downside risks to materialise, with a further slowing of the global economy, in Australia the authorities probably have more policy flexibility than almost any other advanced economy.

"Why? It currently has probably one of the highest policy interest rates, and it probably has the lowest net public debt-to-GDP ratio.

"So, clearly, Australia has the ability to take actions if there were to be a further external deterioration."

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Why economic modelling is so tricky

When I was studying economics at university in the mid-1960s, I wasn't quite sure what a "model" was. These days, politicians and business people are always using the word, and most of us think we know what they mean.

In case you're not sure, here's an explanation I would love to have seen at uni, provided by Dr Richard Denniss, executive director of the Australia Institute, in his new paper, The Use and Abuse of Economic Modelling.

"A model, be it a model car or an economic model, is a simplified representation of a more complex mechanism. A model is typically smaller, simpler and easier to build than a full-scale replica. A model sheds light on the main features of the reality it seeks to represent," Denniss writes.

"An economic 'model' is not a physical thing, like a model car. Rather, it is a mathematical representation of the linkages between selected elements of the economy."

Thus an economic model is, unavoidably, a simplified version of the economy, or an aspect of the economy. It includes those aspects of reality the model-builder regards as most important in explaining what happens, and leaves out all those aspects that don't seem to make a big difference.

So the results you get from a model are only as good as the modeller's choice of what to include and what to leave out. In practice, the model's predictions will often prove astray because some factor the modeller assumed wouldn't be important turned out to be.

Different types of economic models are used for different purposes. Earlier this week I used Denniss's paper to discuss the input-output model that industry lobbies use to make their industry sound bigger than it is.

Today let's discuss the most sophisticated models economists have developed; "computable general equilibrium" models. These are often used to shed light on the effect of a major policy change on the economy over the next 10 or 20 years.

Economists often analyse only a part of the economy, called a "partial equilibrium analysis", while assuming ceteris paribus (all other things remain equal) in the rest of the economy. This is unrealistic because, in the economy, everything is connected to everything else. Changes in one bit lead to changes in other bits, which then feed back on the first bit. So general equilibrium models attempt to capture all these interactions between different industries and markets. (In practice they can't capture all of them, so they still rely on the ceteris paribus assumption to cover those they leave out.)

If you remember nothing else about models, remember this: their weakness is they are built on a host of assumptions, and therefore are only as good as the assumptions on which they are built. Some assumptions are obviously unrealistic and couldn't possibly hold; some happen to be overtaken by events.

Models are sets of equations with dependent and independent variables. The modeller decides the values of the independent (or "exogenous") variables and the model calculates the values of the dependent ("endogenous") variables. So, if the modeller puts in the wrong independent variables (usually assumptions or guesses about the future), the dependent variables will be wrong, too.

The model-builder also specifies the "elasticity" (sensitivity) of the relationships between the variables. For instance, when the exchange rate rises will the reduction in exports be big or small? Elasticities are partly based on empirical evidence, but they also reflect the model-builder's beliefs about how the economy works. Should that belief be wrong, the model's results will be wrong.

It's common for general equilibrium models to be Keynesian in the short run (up to 10 years) but neoclassical in the long run (20 years or more). That is, key variables such as inflation, unemployment and economic growth are determined by the strength of aggregate (total) demand in the short run, but by the strength of aggregate supply in the long run.

This means the economy is assumed to be at full employment in the long run, and economic growth over the period is assumed to be determined solely by the growth in the labour force (the population of working age and its rate of participation in the labour force) plus the rate of improvement in the productivity of labour.

How do you know what the average rates of growth in population and productivity will be over the next 20 years? You take an educated guess, then plug them in. But here's the trick: once you've done that, you've predetermined where the model's results will end up, regardless of whatever policy changes you simulate happening to the economy in the meantime.

No matter how much some change knocks the economy off its assumed long-run course, the model's specifications assume it will not only get back on course but also catch up to where it would have been.

The economy can take up to 10 years to return to its "steady state".

So, the bigger the initial departure from the long-run trend, the bigger the ultimate bounce back - by design. And, by design, nothing can ever happen that changes our destiny.

Thus the model assumes away "path dependency" - the idea that where we end up is determined by what happens to us on the way; that some developments leave us permanently better off, while some leave us permanently worse off. This is clearly unrealistic.

But see what it means? It means the policy change you're purporting to be testing doesn't stand a chance of making much lasting difference, for good or ill. And that means your test is a sham. You give the appearance of testing some proposition, but the outcome is essentially predetermined.

I think such models should be used only in private by consenting economists. They have a good understanding of the assumptions on which the model's results are built and they know whether they share the modeller's faith that the economy works the way her model assumes it does.

When the results of these models are paraded before the public - by governments and treasuries, as well as interest groups - they can't help but mislead. They appear to be proving some policy change would be good or bad but, in truth, they're coming to predetermined conclusions.

The sign that the sponsors and modellers are out to mislead is shown by their failure to highlight their model's key assumptions in some sort of comprehensible product disclosure statement.

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Talk to Fairfax employment group, Sydney, 6.2.12

I want to say a few words about the outlook for the economy in general and employment in particular, but before I do I have to issue a standard consumer warning: economists have a very bad record in forecasting what will happen in the economy, so you’d be wise not to take a blind bit of notice of anything I say.

But let me give you my prediction: the economy’s performance this year is likely to be just a fraction below average, but it will feel a lot worse than average - particularly when it comes to employment. Why? Because the media will be making it sound worse than it is.

Let’s start by talking briefly about the overseas situation. We’ve heard a lot about the troubles of the euro area - and those troubles are very real - but the forecast I’m about to give and all the forecasts we’ve been hearing lately are based on the assumption the Europeans muddle thru: they go through a period of significant weakness, where they’re a drag on the rest of the world economy, but they don’t implode and become a major restraint on world growth. In recent days the situation in Europe has been looking a bit better - a bit less like it’s about to implode - which is nice, and may it continue. Even so, the risk of things in Europe turning really bad is still uncomfortably high.

Around the middle of last year there was a lot of concern about the weakness of the US economy, but it’s been looking a bit better in recent times - not brilliant, but growing fast enough to slowly reduce unemployment. So that’s good.

In such a world - but, of course, with China and the rest of developing Asia still growing quite strongly - the outlook for us, which the Reserve Bank is likely to announce later this week, is for the economy - real gross domestic product - to grow by 3.25 per cent this year. This is the economy’s long-run rate of growth. Where will the growth come from? Particularly from the huge surge in business investment spending on the construction of new mines and, especially, natural gas facilities. But also - and contrary to anything you might have heard - from reasonably strong consumer spending. It used to be true that households were increasing their rate of saving, but it hasn’t been true for some time. The rate of household saving has been steady at 10 pc of disposable income for about a year, meaning consumer spending must being growing at the same rate as disposable income is growing. If you find that surprising, it may be because you’re confusing consumer spending with retail sales. Retail sales have been very weak, but they account for only about a third of consumer spending.

The labour force grows by a percent or so every year thanks to natural increase and immigration, so employment has to grow by that much just to hold unemployment steady. Normally growth at the average rate of 3.25 per cent a year would be sufficient to hold unemployment steady, but employment grew unusually strongly in 2010, and since then a lot of employers seem to have been holding off hiring more workers, allowing their existing workers to work more hours, but waiting to see what happens to the economy. If they keep thinking this way it seems likely the unemployment rate will slowly creep up, from its present 5.2 pc to about 5.5 pc in June and maybe 6 pc by December. That wouldn’t be good, but remember that an unemployment rate of between 5 and 6 pc is still a lot better than we experienced for most of the past 20 years. And 5 pc is getting towards the lowest point the Reserve Bank will allow unemployment to fall to because of its concern to keep inflation under control. As the unemployment rate falls close to 5 pc or lower, the Reserve starts to raise interest rates; if it starts rising towards 6 pc the Reserve starts cutting interest rates. It did that twice towards the end of last year, and if it doesn’t cut them again tomorrow, most economists are confident we’ll get more cuts this year.

Just because unemployment is likely to rise a bit doesn’t mean no new jobs will be created. For a start, and as we’ve just seen, total employment can still grow modestly even though unemployment is drifting up. Only if unemployment is shooting up is it likely that total employment is unchanged or falling. But, in any case, there’s a further point to understand - one that’s very important to the job you guys are doing. The figures the media quote each month for employment and unemployment are figures for the net change between this month and last month. If total employment around Australia is up by, say, 35,000, it’s easy to jump to the conclusion that only 35,000 positions were filled during the month; every existing worker stayed in their job, and they were joined by 35,000 more workers, presumably coming from being unemployed. Fortunately, it’s not like that. The truth is that, on average, every month about 370,000 people leave their employers and about the same number take up jobs with a new employer. So when the figures tell you employment rose by 35,000 last month, what this actually means is that the number of people taking up new jobs exceeded the number leaving jobs by 35,000. In other words, there’s huge turnover in the job market every month - even in the depths of a recession - even if the net change in total employment isn’t very big - in either direction. If you think that figure of 370,000 is so huge it’s hard to believe, you’re forgetting how big the workforce is. It’s almost 11.5 million, meaning about 3 per cent of workers leave their jobs every month - to get a better one, to have a baby, to retire, to go on an extended overseas trip, or whatever. My point is, don’t think just because employment is likely to be growing only slowly and unemployment to be creeping up, there won’t be many potential customers for you. There should be.

Finally, I said the economy wouldn’t be too bad this year, but the media will be making it sound worse than it is. Why do I say that? Because the media, knowing we regard bad news as a lot more interesting than good news, will be doing what it always does: emphasising the bad news about the economy and not saying much about things that are going OK. But I suspect there’ll be a special reason this year. The very high dollar is making life particularly tough for manufacturers, the tourist industry and overseas-student education. Some employers have been laying off workers, and it’s a safe there’ll be more. It’s an equally safe bet those lay-offs will be highly publicised by the media. This is likely to create the impression in people’s minds that the jobs market is a lot weaker than it actually is - for three reasons. First, people don’t realise how big our economy is, so they’re more impressed by relatively small numbers than they should be. Last week Toyota announced its intention to reduce its numbers by 350. That seems a lot, but beside the third of a million workers who leave their jobs every month it’s a fleabite. Second, you wouldn’t know it from the way the media talk, but the high dollar isn’t destroying Australian jobs so much as reducing them in some industries and increasing them in others. People may be losing jobs in manufacturing, but employment will be rising in other industries. Such as? Mining and construction, as the obvious ones, but also many parts of the services sector: health care, finance and insurance, public administration, various professions and arts and recreation. Finally, people tend to lose their jobs in bulk, whereas employment tends to increase in dribs and drabs. We get to hear about the big layoffs, but not the individuals being taken on.

All up, it should be too bad this year.

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Damned lies and economic modelling

One of my resolutions this year is to spend more time trying to prevent lobby groups from using dodgy economic "modelling" to mislead my readers. Canberra has developed a bad case of modelling mania, but most of it is dubious. The less you know about modelling, the more it impresses you.

Any day of the week you can hear politicians demanding to see the modelling behind some figure the government has produced (even if Treasury did a quick calculation on the back of an envelope).

But the worst offenders are business interests, which pay big money to Canberra economic consultants to produce supposedly independent reports aimed at persuading governments to give them something, or at persuading the public to stop the government taking something from them.

One trick they often pull is trying to make their industry sound bigger and better for the economy than it is. Just last week the Minister for Manufacturing, Kim Carr, was defending the government's grants to the car industry by claiming it provides employment to 46,000 workers and "more than 200,000 in associated jobs".

But the industry that's been trying hardest to bolster its economic importance lately is mining. According to a press release issued by the Australian Mines and Metals Association, "213,200 people are directly employed in mining, oil and gas operations in Australia, with an additional 639,600 indirect jobs created by the resource industry".

Did you notice how the second of those suspiciously precise figures was precisely three times the first? "Spurious accuracy" is one of the signs a con job is in progress.

I'm sure you've seen the ads sponsored by the Minerals Council of Australia and others telling "Our Story" about what a wonderful, caring industry it is. The related website says that "across the nation, mining employs 187,400 people directly, and a further 599,680 in support industries". So for every mining job, another 3.2 are created elsewhere.

According to a report funded by Peabody Energy, "the Australian coal industry employs over 32,000 people and indirectly creates an additional 126,000 jobs in Queensland and New South Wales". So that's an employment "multiplier" of 3.9.

Where do these figures come from? Knowing how many people are employed in a particular industry isn't hard. Every month the Bureau of Statistics conducts a giant sample survey of households, asking them about their experience in the labour market. That's where our monthly figures for employment and unemployment come from. Every third month the bureau asks people what industry they work for.

It's obvious that all industries buy materials and other "inputs" from other industries, to which they then apply a lot of labour and equipment to produce whatever goods or services are their "output". So every industry can justly claim its purchases from other industries create jobs in those industries. Many could claim to create more jobs indirectly than directly.

But how do they know how many? They pay an economic consultant to do a report that tells them. How do the consultants know? They look up the industry's multiplier in a model-based document produced by the bureau called the input-output tables.

Trouble is, the tables are subject to significant limitations, which make it easy for them to be misused. All is explained in a paper by Dr Richard Denniss, of the Australia Institute, to be released today, The Use and Abuse of Economic Modelling in Australia: Users' Guide to Tricks of the Trade.

Like all models, the bureau's input-output model is built on a host of assumptions, as the bureau acknowledges in its accompanying documents. This reliance on assumptions shouldn't surprise you. Were you to work out a household budget for the year, you'd have to make many assumptions, including about what will happen to prices in the future.

Denniss reminds us of the key assumptions: that the relationships between inputs and outputs are fixed and so unaffected by changes in technology or changes in the relative prices of inputs; that all the output of an industry is identical, with no differences in quality or features; and that increasing the quantity of the industry's output would yield no economies of scale.

These unrealistic - but unavoidable - assumptions greatly limit the use you can make of employment multipliers without misleading yourself or others. You can't assume that doubling the size of an industry (such as mining) would also double the number of jobs it created directly and indirectly. Nor can you assume that a significant reduction in the size of an industry (such as car making) would mean the same reduction in total employment.

Another problem is that the employment multipliers involve double counting - more than one industry taking the credit for "creating" a job in some other industry. Denniss finds that if you used the multipliers to calculate the jobs directly and indirectly created by each Australian industry, then added them up, the total would be 187 per cent of all the jobs in the nation.

Yet another problem is the implication that the significant expansion of an industry would do nothing but add to employment in the industry and elsewhere. This assumes such an expansion would have no effect on wage rates, skill shortages, the exchange rate and much else.

Denniss quotes the results of some quite different modelling commissioned by the proponents of what would be one of the world's largest mines, the China First mine in Queensland. It found that, though the mine would lead to 6000 new jobs, it would also lead to the loss of about 3000 jobs, most of them in manufacturing.

We should be highly sceptical about claims made by interest groups on the basis of reports

from "independent" consultants with no acknowledgment of all the hidden assumptions.

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Europe has serious troubles, but we don’t

The economic news from Europe in recent days hasn’t been good. And it could get worse as the year progresses. Those guys have big problems. But let’s not spook ourselves by imagining it to be any worse than it is.

Unfortunately, there’s been a tendency in parts of the media to convey an exaggerated impression of how bad things are and of the extent to which Europe’s problems translate into problems for us.

Take last week’s downwardly revised forecast for the world economy in 2012 from the International Monetary Fund. We heard a lot about the fund’s dire warnings of what could happen if the Europeans didn’t get their act together, but what wasn’t made clear was that the fund’s actual forecast was for global recession to be avoided.

Though the forecast for growth in the world economy this year WAS cut significantly from the forecast in September, at 3.3 per cent it’s below the long-run average rate of about 4 per cent, but still comfortably above the 2 per cent level generally regarded as representing a world recession.

No one thought it necessary to tell us - even though Wayne Swan reminded journalists of it at his press conference - that, from our perspective, the fund’s revisions were old news. They were surprisingly similar to the revised forecasts the government adopted in its mid-year budget review last November.

The fund has the United States growing by 1.8 per cent this year; Treasury had it at 2 per cent. The fund has the euro area contracting by 0.5 per cent; Treasury had it contracting by 0.25 per cent. For China, the fund has growth of 8.2 per cent, whereas Treasury had 8.25 per cent. For India it’s the fund’s 7 per cent versus Treasury’s 6.5 per cent.

Bottom line? The fund has the world growing by 3.3 per cent, whereas Treasury had it at 3.5 per cent.

Journalists are always criticising politicians for repeatedly re-announcing new spending programs, thus leaving the public with an inflated impression of how much is being spent. But journos aren’t above doing much the same thing.

We get a fuss when the government revises down its forecasts in November, then another fuss when the fund announces essentially the same revisions. And in between we get a fuss when the World Bank announces its revisions. Three for the price of one.

Actually, you can understand why the uninitiated got excited about the bank’s revisions. Whereas Treasury had forecast world growth of 3.5 per cent, the bank revised its forecast down to just 2.5 per cent. But no one remarked on that, just as they didn’t seem to notice when, only a week later, the fund put its prediction at a seemingly healthier 3.3 per cent.

So which one is right? They all are. That’s to say, they’re all saying the same thing. I find it hard to understand how anyone who knew their business could bang on about how low the bank’s forecast was without pointing out that it does its forecasts on a different and inferior basis to everyone else.

Whereas our Reserve Bank and Treasury, and the fund, add each country’s gross domestic product together using exchange rates that take account of the US dollar’s widely differing purchasing power in each country, the World Bank doesn’t bother. It uses market exchange rates.

So it perpetually understates the rate of growth in the emerging economies of Asia, thereby understating world growth, since most of it has for quite some years come from Asia. But not to worry. If you took the fund’s country-by-country forecasts and added them together the same misleading way the bank does, what would you get? Growth of 2.5 per cent. Same forecast on either basis.

The trouble with all these forecasts and pronouncements from international agencies is it’s hard for the public to assess what they amount to by the time they reach our shores. These pronouncements rarely mention Australia. And shock waves from Europe have to come to us via China, India and the rest of Asia.

I think the media could try harder to bridge this gap rather than leaving us with the vague impression disaster for Europe means disaster for Australia. Actually, what matters for us is not world growth so much as the growth in our major trading partners, with each partner’s contribution weighted according to its share of our exports.

When Treasury did this sum in the mid-year review, growth in the world economy of 3.5 per cent translated to growth in our major trading partners of 4.25 per cent. All this despite Europe’s recession.

Fran Kelly of Radio Nation Breakfast did go to the trouble of asking the lead author of the fund’s World Economic Outlook, Jorg Decressin, what the revised forecasts meant for us. His reply deflated most of the hype we’ve been subjected to.

‘Australia will be affected by these downgrades only to a limited extent,’ he said. Oh. ‘At this stage, growth in output for Australia is still reasonably strong.

‘Growth in Australia is importantly driven by major investment projects that are in the pipeline and these are funded by strong multinationals that don’t have problems assessing funding.’ Oh.

‘There is no advanced economy - or maybe there are one or two - that is as well placed as Australia in order to combat a deeper slow down, were such a slowdown to materialise and that’s because, well, you still have room to cut interest rates if that was necessary and you also have a very strong fiscal [budgetary] position,’ he said.

Do you get the feeling you’ve heard all this before? Maybe it’s true.

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All hail mighty Aussie dollar, as it's here to stay

This year we'll see more painful evidence of Australian businesses accepting the new reality: our dollar is likely to stay uncomfortably high for years, even decades.

It has suited a lot of people to believe that just as the resources boom would be a relatively brief affair, so the high dollar it has brought about wouldn't last.

If there were no more to the resources boom than the skyrocketing of world prices for coal and iron ore, that might have been a reasonable expectation. But the extraordinary boom in the construction of new mining facilities makes it a very different story.

The construction boom is likely to run until at least the end of this decade, maybe a lot longer. The pipeline of projects isn't likely to be greatly reduced by any major setback in the world economy. That's particularly because so much of the pipeline is accounted for by the expansion of our capacity to export natural gas. The world's demand for gas is unlikely to diminish.

Last time I looked, the dollar was worth US105?, compared with its post-float average of about US75?. But that's not the full extent of its strength. At about 81 euro cents and 67 British pence it's the highest it's been against those currencies for at least the past 20 years.

In the context of the resources boom, the high exchange rate performs three economic functions. First, it helps to make the boom less inflationary, both directly by reducing the prices of imported goods and services and indirectly by lowering the international price competitiveness of our export- and import-competing industries.

Second, by lowering the prices of imports, it spreads some of the benefit from the miners' higher export prices throughout the economy. In effect, it transfers income from the miners to all those consumers and businesses that buy imports, which is all of them. So don't say you haven't had your cut.

Third, by reducing the price competitiveness of our export- and import-competing industries, it creates pressure for resources - capital and labour - to shift from manufacturing and service export industries to the expanding mining sector.

That is, it helps change the industry structure of the economy in response to Australia's changed "comparative advantage" - the things we do best among ourselves compared with the things other countries do best.

As businesses recognise the rise in the dollar is more structural than temporary and start adjusting to it, painful changes occur, including laying off workers. Paradoxically, this adjustment is likely to raise flagging productivity performance.

Economists have long understood that the exchange rate tends to move up or down according to movement in the terms of trade (the prices we receive for exports relative to the prices we pay for imports). This explains why the $A has been so strong, for most of the time, since the boom began in 2003.

But here's an interesting thing. In the December quarter of last year, our terms of trade deteriorated by about 5 per cent as the problems in Europe caused iron ore and other commodity prices to fall. They probably fell further this month.

This being so, you might have expected the $A to fall back a bit, but it's stayed strong and even strengthened a little. Why? Because when the terms of trade weakened, other factors strengthened. The main factor that's changed is the rest of the world's desire to acquire Australian dollars and use them to buy Australian government bonds.

Indeed, the desire to hold Australian bonds was so strong it more than fully financed the deficit on the current account of the balance of payments in the September quarter. It may have done the same in the December quarter. Among the foreigners more desirous of holding our bonds are various central banks.

Remember that, at the most basic level, what causes the value of the $A to rise on any day is that people want to buy more of them than other people want to sell. The price rises until supply increases and demand falls sufficiently to make the two forces equal.

So economists' theories about what drives the value of the $A are just after-the-fact attempts to explain why the currency moved the way it did. We know from long observation that there's a close correlation between our terms of trade and the $A.

But we also know this correlation is far from perfect. There have been times when the two parted company for a while. It's apparent the dollar is driven by different factors at different times.

And it now seems apparent that our relatively superior economic performance and prospects are taking over as the main factor driving the dollar higher (even though our terms of trade would have to deteriorate a mighty lot further before they were back to their long-term average).

There are various reasons why foreign investors (including central banks with currency reserves that have to be parked somewhere) would like to increase their holdings of Australian government bonds.

For a start, we're now one of the few "sovereigns" (national governments) still with a AAA credit rating. For another, the yield (effective interest rate) on Australian 10-year government bonds is almost 4 per cent, compared with about 2 per cent on US Treasury bonds or German bunds.

And the present and prospective state of our economy is a lot healthier than that of the North Atlantic and Japanese economies. Why are our prospects so much brighter and our interest rates higher? In short: the mining construction boom, of course.

It seems clear the world's financial investors are shifting their portfolios in favour of $A-denominated financial assets. And remember, because they're so much bigger than we are, what's only a small shift for them is a big deal for us.

All this suggests the Aussie will stay strong, even as our terms of trade fall back. Remember, too, the huge spending on mining construction over the years will require a lot of foreign financial capital to flow into Australia, helping keep upward pressure on the exchange rate.

This doesn't say the $A has become a safe-haven currency. Were some sudden disaster to occur in Europe it would probably take a dive as frightened investors rushed to the safe haven of US Treasury bonds.

But it probably wouldn't take long for the Aussie to recover - just as it didn't take long after the sudden disaster of the collapse of Lehman Brothers in 2008.

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Economic fixes must offer a fair go for all

When you listen to street interviews with people in the troubled countries of the euro zone, a common complaint emerges: whereas some people waxed fat in the boom that preceded the crisis, it's ordinary workers who suffer most in the bust, and they and even poorer people who bear the brunt of government austerity campaigns intended to fix the problem.

In other words, achieving a well-functioning economy is one thing; achieving an economy that also treats people fairly is another. Economists and business people tend to focus mainly on economic efficiency; the public tends to focus on the fairness of it all.

Fail to fix the economy and almost everyone suffers. But offend people's perceptions of fairness and you're left with a dissatisfied, confused electorate that could react unpredictably.

The trick for governments is to try to achieve a reasonable combination of both economic efficiency and fairness. Fortunately, but a bit surprisingly, the need for this dual approach has penetrated the consciousness of the Organisation for Economic Co-operation and Development - the rich nations' club which is expanding its membership to include the soon-to-be-rich countries.

New research from the organisation deals with ways governments can get their budgets back under control without simply penalising the vulnerable and ways they can improve the economy's functioning and increase fairness at the same time.

Much of the concern about fairness in the hard-hit countries of the North Atlantic has focused on bankers. In the boom these people made themselves obscenely rich by their reckless, greedy behaviour, eventually bringing the economy down and causing many people to lose their businesses and millions to lose their jobs.

But their banks were bailed out at taxpayers' expense - adding to the huge levels of government debt the financial markets now find so unacceptable - and few bankers seem to have been punished. Some have even gone back to paying themselves huge bonuses.

It's a mistake, however, to focus discontent on the treatment of a relative handful of bankers. The fairness problem goes much wider. In most developed countries, the long boom of the preceding two decades saw an ever-widening gap between rich and poor.

In the United States, almost all the growth in real income over the period has been captured by the richest 10 per cent of households (much of it going to the top 1 per cent), so that most Americans' real income hasn't increased in decades.

It hasn't been nearly as bad in Australia. Low and middle household incomes have almost always risen in real terms, even though high incomes have grown a lot faster.

Looking globally, a lot of the widening in incomes has come from the effects of globalisation and, more particularly, technological change, which has increased the wages of the highly skilled relative to the less skilled. But a lot of the widening is explained by government policy changes, such as more generous tax cuts for the well-off.

The euro zone countries need not only to get on top of their budgets and government debt, but also to get their economies growing more vigorously. So the organisation has proposed structural reforms - we'd say microeconomic reforms - which can foster economic growth and fairness at the same time.

One area offering a "double dividend" is education. Policies that increase graduation rates from secondary and tertiary education hasten economic growth by adding to the workforce's accumulation of human capital while also increasing the lifetime income of young people who would otherwise do much less well.

Promoting equal access to education helps reduce inequality, as do policies that foster the integration of immigrants and fight all forms of discrimination. Making female participation in the workforce easier should also bring a double dividend.

Surprisingly - and of relevance to our debate about Julia Gillard's Fair Work Act - the organisation acknowledges the role of minimum wage rates, laws that strengthen trade unions, and unfair dismissal provisions in ensuring a more equal distribution of wage income.

It warns, however, that if minimum wages are set too high they may reduce employment, which counters their effect in reducing inequality. And reforms to job protection that reduce the gap between permanent and temporary workers can reduce wage dispersion and possibly also lead to higher employment.

Systems of taxation and payments of government benefits play a key role in lowering the inequality of household incomes. Across the membership of the organisation, three-quarters of the average reduction in inequality achieved by the tax and payments system come from payments. Means-tested benefits are more redistributive than universal benefits.

Reductions in the rates of income tax to encourage work, saving and investment need not diminish the inequality-reducing effect of income tax, provided their cost is covered by the elimination of tax concessions that benefit mainly high income earners - such as those for investment in housing or the reduction in the tax on capital gains. Getting rid of these would also reduce tax avoidance opportunities for top income earners.

So it's not inevitable that the best-off benefit most during booms and the worst-off suffer most in the clean-up operations after the boom busts. It's a matter of the policies governments choose to implement in either phase of the cycle.

You, however, may think it's inevitable that governments choose policies that benefit the rich and powerful in both phases.

But we're talking about the government of democracies, where the votes of the rich are vastly outnumbered by the votes of the non-rich. So if governments pursue policies that persistently disadvantage the rest of us, it must be because we aren't paying enough attention - aren't doing enough homework - and are too easily gulled by the vested interests' slick TV advertising campaigns.

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WHAT MAKES A GOOD LIFE?

January, 2012

Mainstream economics is about enabling people to lead a prosperous life; it’s about telling the community how to be more efficient in its use of scarce resources, with the objective of raising our material standard of living. But is a prosperous life a good life? Not necessarily. So what’s the relationship between prosperity and a good life? Or, to put the question in its classic form, does money buy happiness? The answer from the rapidly growing body of research into happiness, by a lot of psychologists and a few economists, is: yes it does - but only up to a point. I guess it must be possible to be poor but happy, but surveys suggest most people living below some minimum level of income aren’t particularly happy. Poverty doesn’t have a lot to recommend it.

But once people in affluent countries such as Australia reach an adequate but reasonably frugal standard of living, the surveys show that the ability of an extra $1000 of annual income to make people happier falls away surprisingly rapidly. For those of us who aren’t poor, acquiring extra money yields progressively less and less value for money.

Why does more money do so little to make us happier? Psychologists offer two main explanations. First, because humans adapt so readily to their changed circumstances. A new car, a new house, a new dress or a promotion does make us happier - as we expected it would - but usually within a few weeks the new thing becomes part of the status quo, leaving us little happier than we were. Second, it seems clear that what makes us happier is not having more money so much as having more money than other people, particularly those people you usually compare yourself with. It’s not absolute increases in our income that matter to us but relative increases. And relative increases are harder to come by, as well as leaving those whose incomes we overtake feeling less happy.

But if acquiring more money is such an ineffective way to improve our happiness, why do so many of us keep pursuing money? Partly because research shows we’re quite bad a predicting the extent to which events we hope for - or events we dread - will make us feel good or bad. We’re like a donkey chasing a carrot - we don’t have much in the way of a learning curve. Some scientists suggest our evolution as a species has programmed us to believe a little more money will finally make us happy because there must have been some point in our evolution where working hard contributed to our survival as a species. Whether or not that’s true, many of us do seem to have an inbuilt tendency to pursue money at the expense of things that actually contribute a lot more to our happiness - our relationships being the prime example - so there is a need for many of us to put more conscious effort into controlling our materialist urges.

We’re supposed to be talking about the good life, but I’ve switched to talking about happiness. Is pursuing happiness - or even achieving happiness - the same as living a good life? That depends on what you take happiness to mean. I usually talk about happiness because, as a journalist, I know it’s an attention-getting word, but it’s quite an ambiguous word. I suspect that much of the debate about whether the modern preoccupation with happiness is a good or bad thing arises from people attaching different meanings to the word.

If by happiness you mean hedonism - the pursuit of pleasure and the avoidance of pain - then, no, happiness is not synonymous with a good life. What I mean by happiness is not the pursuit of pleasure, nor even contentment (except in the sense that we’re content with our present level of material affluence). A word that comes closer to it is fulfilment - living a life we can look back on with a degree of satisfaction, and without too many regrets. To some people’s minds happiness is associated with smugness - I’m alright, Jack. But, to me the highest level of happiness - which I’m happy to label the good life - is a life with a lot of concern for others, starting with our nearest and dearest but going further to the less fortunate. Happiness isn’t a euphemism for selfishness, and preoccupation ourselves and our own needs is a bad way to achieve happiness.

Unless you’re old or bedridden, the good life is active rather than passive. There is plenty of room for ambition and striving in the good life - depending on your motive for all the ambition and striving. A good life will have its share of setbacks and sadness and even anger - not to mention its share of hard work.

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Moneyball shows competition isn’t always a winner

One of my favourite films for this year was Moneyball. Ostensibly, it's the story of how the real-life Billy Beane (Brad Pitt), general manager of the Oakland As baseball team, took the second-poorest team in the comp almost to the top.

At a deeper level, it's about how the super-cool guys of professional baseball got beat by the nerds.

It's about how the science of statistics can tell us things we didn't know about our world.

It's about the ultimate make-or-buy decision facing businesses: do you select and train up your own people, or go out and poach someone whenever you need a new heavy-hitter.

But, above all, it's about how competition in markets can fail to live up to its advertising. (If you didn't catch all those levels, read the book by Michael Lewis - much better than the movie.)

Professional baseball in America is a market. All the teams are privately owned businesses, the owners of which are out to maximise profits.

(That's in theory. In practice, many of the owners probably treat their team as an indulgence - a way to enjoy their fortune - as much as a way to increase their fortune; an end as much as a means.)

Beane was so short of money he turned to a bunch of highly educated baseball tragics, who thought studying a potential player's statistical record through high school and college baseball was a better way of predicting his success in the big league than relying on the judgment of talent scouts.

Much to the amazement and disapproval of the traditionalists - and despite their opposition - Beane and the nerds were proved right. Eventually, other teams started copying their methods.

This says to me that, contrary to the assumption of the economists' conventional model, all the guys running all the teams weren't playing for keeps until Beane and his nerds came along.

They wanted to win the comp, but they wanted to win while playing by the unwritten rules - the game's long-established social norms - of how you should go about winning.

To them, picking players by resort to a laptop full of statistics was almost as unsporting as using performance-enhancing drugs.

Here's the point: they didn't want to win for the money - as the model assumes - they wanted to win to impress the other guys in the comp. They were playing a game, not profit-maximising.

Economists portray competition as the foolproof path to efficiency and affluence. And the idea of living in an economy without competition - where everything was supplied by monopolies, whether privately or publicly owned - has zero appeal. Competition does help keep people on their toes.

But competition isn't the unmitigated blessing economists often assume it to be. As I discussed on Saturday, Robert Frank, in his latest book, The Darwin Economy, elucidates the case where competition leads to socially wasteful arms races, where what's good for the individual isn't good for the group.

The conventional model assumes we seek to maximise absolute values: businesses maximise profits, consumers maximise utility.

In real life, however, we're often more concerned about relative values: with how our salary compares with other people's, with whether our firm has the biggest market share. We care most about how we rank.

A related competitive failure occurs when firms (and the individuals who make them up) break (Hugh) Mackay's Law of competition: focus on the customer, not your competitor.

Thanks to their defective model of human behaviour, economists assume we compete only in response to monetary incentives. They forget the urge to compete is hardwired in the brain of the human animal.

We compete because we enjoy competing. We compete because we want to see how we rank in the comp - and we're confident we'll rank well. This, much more than greed, is what motivates the world's billionaire entrepreneurs.

We compete to impress the other players in the game. But when we do, we break Mackay's Law and our efforts don't benefit the community the way the model predicts.

Speaking of misguided competition, consider this from The Economist's Schumpeter column: "The vast majority of American universities are obsessed by rising up the academic hierarchy, becoming a bit less like Yokel-U and a bit more like Yale.

"Ivy League envy leads to an obsession with research. This can be a problem even in the best universities: students feel short-changed by professors fixated on crawling along the frontiers of knowledge with a magnifying glass.

"At lower-level universities it causes dysfunction. American professors of literature crank out 70,000 scholarly publications a year, compared with 13,757 in 1959.

"Most of these simply moulder: Mark Bauerlein of Emory University points out that, of the 16 research papers produced in 2004 by the University of Vermont's literature department, a fairly representative institution, 11 have since received between zero and two citations.

"The time wasted writing articles that will never be read cannot be spent teaching.

"In Academically Adrift, Richard Arum and Josipa Roksa argue that over a third of America's students show no improvement in critical thinking or analytical reasoning after four years in college."

Clearly, and despite all its virtues, competition can sometimes do more harm than good. But don't be so sure the American unis' misguided motivations could easily be corrected by applying some KPIs - key performance indicators.

It's a safe bet those universities have already been using KPIs to reinforce their academics' obsession with publishing or perishing.

In Australia, our governments have long allowed academic-dominated research councils to hand out research grants in ways that discourage our academics - certainly the economists - from researching Australian issues.

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