Games show how economists lead us astray

In universities these days they play a lot of games - though when the economists play they prefer to call it "game theory". And game playing is one of the most potentially useful things academics do.

The most famous game played by social scientists is "the prisoner's dilemma". As described by Wikipedia, two suspects are arrested by the police. The police have insufficient evidence for a conviction, but they keep them separate and offer each the same deal.

If one testifies for the prosecution against the other (that is, "defects" from a position of solidarity with the other) and the other remains silent (that is, "co-operates" with the other), the defector goes free and the silent accomplice receives the full 10-year sentence.

If both remain silent, both are sentenced to only six months for a minor offence. If each betrays the other, each receives a five-year sentence. So each prisoner must choose whether to betray the other or remain silent.

Each is assured the other won't know about the betrayal before the end of the investigation. So how should the prisoners act?

As a group, the two prisoners are better off if they each stay silent - each gets only six months' jail.

As individuals, however, the risk of being betrayed by the other means the "rational" choice is always to dob in the other guy. If he stays silent, you get off while he gets 10 years. If he dobs you in too, you both get half the full sentence, whereas if you were to stay silent while he dobbed you in you'd cop the full 10 years. Barry Schwartz and Kenneth Sharpe, in their new book Practical Wisdom, observe that social scientists love the prisoner's dilemma game because it embodies many situations in life in which co-operation would make everyone better off, but choosing to co-operate makes you vulnerable to exploitation by people who choose not to co-operate.

It's noteworthy that, though the economists' model leads them to predict that everyone will make the "rational" choice to be unco-operative, when the once-only game is played with experimental subjects a significant minority of people choose to co-operate.

See what's happening? It turns out that the economists' conventional, neo-classical model is just one way of "framing" the economic problem - the problem of how to make a living.
The model frames the problem as a problem for individuals: how do I look after myself in a world composed of other individuals whose main aim is to look after themselves as individuals?

In other words, the model sees the economic world as fundamentally competitive. It highlights the risk that others will choose not to co-operate with me, and highlights the benefit to me of "free-riding" - taking advantage of those who do choose to co-operate.

The one thing it doesn't highlight is the opportunity cost - whether to me or to all of us - of our mutual failure to reap the benefits of co-operation.

So "the economists' way of thinking" is a way of framing the economic problem that's biased in favour of competition and against co-operation. But it's just one way of framing the problem; framing it another way could emphasise the benefits of co-operation and the costs of excessive competitiveness.

When we're taught to think about the economic problem the way economists conventionally think about it, our thinking becomes biased against recognising the benefits of co-operative solutions: "communitarian" or "collective" solutions, whether agreed between people informally or - to overcome the problem of free-riding - delivered by governments using compulsory mechanisms such as taxation.

Conventional economic analysis will always be biased against government intervention because it frames the economic problem as one to be solved by individuals, not by society.

A crude reading of evolution says it's all about competition - the survival of the fittest. A more modern, sophisticated reading says the supremacy of the human animal is as much the product of co-operation between humans as about competition between them. Both co-operation and competition are key components of our winning formula.

The fact is that a huge proportion of economic activity involves co-operation between people rather than competition in markets. There are all the goods and services produced within households.

And there's all the activity that occurs inside big companies, including trade between the different parts of national and trans-national corporations. Economists know surprisingly little about this activity.

To emphasise the point that conventional economics (and, indeed, all economics) involves framing, Schwartz and Sharpe note that the participants in one experiment were giving the same version of the prisoner's dilemma game, except that one group was told it was the Wall Street Game whereas the other group was told it was the Community Game.

You guessed it: people playing the Wall Street game were much more likely to defect. In a similar game, those told they were taking part in the Social Exchange Study were more likely to co-operate than those told they were taking part in the Business Transaction Study.

The latter researchers say the social-exchange frame induced a motivation for the players to do what was right, whereas the business-transaction frame induced the motivation to get as much money from playing the game as possible.

All this suggests the success economists have had in recent decades in propagating their way of framing the choices we face has subtly influenced our thinking and behaviour, making us more competitive and self-seeking and less co-operative and public-spirited.

If so, we're the poorer for it. We need to frame the economic problem more carefully.

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Its all in the frame (behavioural economics)

It's a long weekend, so let's play a game. Tell me this: are eagles large? And, next, are cabins small? If you said yes to both, congratulations - you're right. But if you said no to both, you're not wrong. In fact, you're just as right as the others are.

Relative to other birds, eagles are large. And relative to other buildings, cabins are small. But if you compare an eagle with a cabin, eagles are small and cabins are large.

Get it? Whether eagles and cabins are large or small depends on what you're comparing them with. Or, as they say in the classics, everything's relative.

And this, believe it or not, is one of the great discoveries of cognitive psychology.

Part of that discovery is that the way we react to situations or propositions is heavily dependent on the way they're framed, as psychologists say - the way they're packaged, the context in which they're put.

We can react differently to the same proposition depending on how it's framed. A classic example: even doctors say a 90 per cent success rate for operations is more acceptable than a 10 per cent failure rate.

The people who didn't need psychologists to tell them our reactions to things are influenced by the way they're framed are advertising and marketing types. They know that draping a girl in a bikini over a sports car can help sell more of them. What's the logical link between a good-looking young woman and a motor car? There's none - but the young bucks (and ageing baby boomers) who buy sports cars can imagine one.

Although it comforts economists to kid themselves that advertising is purely informational, in truth almost all advertising is about framing - drawing unspoken links between the product you're trying to flog and some attractive situation or emotion. Their not-so-subtle message is, buy my margarine (or sliced bread) and you'll have a happy, healthy family. In the advertisers' adage, you sell the sizzle, not the steak.

But framing goes far wider than advertising. It's the reason you should be sceptical of the results interest groups quote from the opinion polls they commission. It's too easy to influence the answers you get by the way you frame the questions you ask.

And don't forget that political spin is a form of framing. It's about portraying situations or decisions in ways that reflect more favourably on the pollies involved.

Their opponents, of course, try to frame the same situations or decisions in a more negative light.

But in Practical Wisdom, a new book by two academics at Swarthmore College, near Philadelphia, Barry Schwartz and Kenneth Sharpe, they observe that stories like these have given framing a bad name that's unwarranted.

Why? Because there's no alternative to framing. That's the great discovery of cognitive psychology: just about the only way we can get our minds around anything is to compare it with something we already know about.

Years ago an editor reminded me of the classical rule of rhetoric that argument by analogy is invalid. Sorry, it turns out that the only way we learn is by comparing things we don't understand with things we do understand.

This doesn't mean every analogy-based argument is correct, of course, just that there's no other way to argue.

The term frame is itself a metaphor. Schwartz and Sharpe say it's a wonderful one because it emphasises our capacity to take the chaos of the social world around us and organise it in an understandable way.

The capacity we have to frame enables us to do one of the most important things the exercise of practical wisdom demands: discern what's relevant about a particular context or event in regard to the decision we face.

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Looking to Aristotle for a guide on reform

How things have changed. When I was growing up Labor portrayed itself as the party of reform, out to fix an unjust world. The Liberals were conservatives, satisfied with the world as it was and trying to keep change to a minimum. Needless to say, the Libs kept winning.

These days, however, both sides portray themselves as parties of reform. And the faster the world changes the more certain both sides become of the need for further reform - even if, as with Work Choices, the new lot's reform is merely to reverse the reforms of the previous lot.

There is one small problem with all this reform: it's not always clear the changes actually make things better. The pollies see things that aren't working well, make changes intended to improve the situation, but often don't succeed. Then they, or their successors, do more in the same vein or try the opposite approach, with neither seeming to work.

When politicians see institutions they think aren't performing - the health system, the education system, the courts, the banks - they tend to apply one of two tools. The first is to toughen up the rules and regulations governing the institution; be more explicit about what people are required to do.

The second is to sharpen the incentives (and disincentives) faced by people in the institutions. With private-sector institutions - banking, for example - the approach is usually to reduce government regulation and then rely on competition and the profit motive to improve performance.
With public-sector institutions - health and education, say - the approach is to impose numerical tests and targets (''key performance indicators'') and maybe introduce monetary rewards for good performance.

As the international experience with banking indicates, the reformers sometimes alternate between the two approaches when they find the other hasn't worked. After the Great Depression we tightly regulated the banks, but in the 1980s we decided they weren't performing well and the answer was to deregulate them. Now, after the global financial crisis, the world has swung back to thinking tighter regulation is the key to better performance.

A long memory, however, suggests it won't be that simple. Why is it that neither rules nor incentives seem to do the trick? And what else can we do that stands a better chance of working? Well, while I was away on holiday in Italy I read a book that offers some answers. It's Practical Wisdom, by Barry Schwartz, a professor of psychology at Swarthmore College in Pennsylvania, and Kenneth Sharpe, a professor of political science at the same college.

It's noteworthy that both approaches proceed from a low opinion of the people working in these institutions: they don't really care about their work. The notion that tightening up the rules will improve the performance of practitioners assumes they are dumb (they don't know the right thing to do) and uncommitted to doing their job well. The notion that introducing numerical targets and monetary incentives will improve performance assumes practitioners are lazy and motivated only by self-interest. Both approaches are top-down: the politicians know what should be done to improve the performance of the courts or whatever, and seek to impose their judgment on the practitioners.

That gives us a clue as to why neither approach is particularly effective. Both are demoralising - in both senses of the word. They reduce the practitioners' scope to exercise their discretion when objectives conflict (as they often do in this increasingly complex world) and the circumstances of individual cases differ.

This demotivates professionals as well as removing the moral element from their jobs. They become responsible for obeying rules or meeting targets, not ensuring the ultimate objectives are achieved.

Modern jobs are multi-faceted, with multiple objectives. Numerical targets and monetary incentive payments inevitably narrow practitioners' objectives and increase their focus on monetary rewards, driving out other motivations.

And when you eliminate the moral element you encourage people to try to beat the system. The more rules you make, the more you encourage demoralised workers to look for loopholes. The more you measure people's performance with numerical indicators, the more you encourage them to game the system. Whatever elements of their performance aren't covered by a performance indicator will be cannibalised to help achieve those you are measuring.

Under both approaches quantity improves at the expense of quality, partly because quantity is easy to measure and quality is hard.

So what's the answer? Schwartz and Sharpe say that, though we will always need rules and rewards in the running of institutions, increasing the emphasis on rules and incentives discourages and diminishes the third, more elusive element needed to make institutions work well: what Aristotle called phronesis and translates as practical wisdom.

People exercising practical wisdom use their skills and experience to achieve to the best of their ability the ''telos'' or true purpose of their activity. Practical wisdom involves finding the right way to do the right thing in the particular case you are dealing with.
People are motivated to exercise practical wisdom not to obey rules or increase their income but because they know it's the right thing to do, to benefit their students, patients, clients or customers and obtain personal satisfaction in the process. It's about intrinsic motivation - doing a good job for its own sake - rather than the extrinsic motivation of obeying rules or making more money.

Institutions would work better if, rather than discouraging practical wisdom by tighter rules and bigger incentives, they gave practitioners more flexibility to innovate, improvise and generally exercise their own judgment in doing the right thing by the individuals they help. Reformers haven't got far by assuming doctors, teachers, judges, public servants and the rest are dumb and lazy and must be compelled or bribed to do better. Why not assume the majority of these professionals want to do a good job and give them more scope to do the right thing in the right way?

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Economists part of Inside Job (Movie previews!)

It always takes the movie world a while to catch up with real life, but it's finally caught up with the global financial crisis. There's the Oscar-winning documentary Inside Job and a classic Hollywood job, The Company Men. I recommend both.

Inside Job deals with the origins of the crisis on Wall Street; The Company Men deals with consequences on Main Street from the resulting Great Recession. Let's start with the "real economy".

America's unemployment rate started rising in October 2008, reaching 10 per cent a year later. It's still about 9 per cent. Say it quickly and it doesn't sound too bad. People lose their jobs when the economy turns down - what else is new?

The great strength of The Company Men is the way it shows us what happens to the lives of three men who lose their jobs when their company decides to "rightsize". These aren't ordinary workers, they're executives close to the top of the tree, which gives them further to fall.

They are well-paid guys who seem to have committed themselves for almost all they earn. First is the humiliation of their lowly status at the outplacement agency and then the disillusionment as their repeated efforts to find another job get nowhere.

At first they attempt to conceal the shame of their unemployment from their children, neighbours and relations. Then comes the steady divestment of the big toys they can no longer afford. Marriages are strained by money worries. Their self-identity came from their job; their job is no more.

They were let go because their company's share price had fallen in the crash and something big must be done to restore it. But every company's share price fell, so what's the problem? The problem turns out to be the chief executive's need to raise the value of his share options. Whether on Main Street or Wall Street we see the new morality of corporate capitalism: look after No. 1 and don't feel any responsibility for the consequences of your actions for customers or colleagues.

In the words of one reviewer, Inside Job is the story of a crime without punishment. Wall Street's reckless behaviour caused the crisis and the huge damage it did to businesses, workers and retirement savings in America and Europe.

The banks were bailed out at great expense to the taxpayer, but so far almost no one has been punished for misconduct or negligence. Many of the perpetrators walked away with millions. The payment of outrageous bonuses hardly skipped a beat.

The film's graphics do a good job of explaining the central role - and the madness - of toxic derivatives such as collateralised debt obligations and credit default swaps.

Many of the docos you see on political and economic themes are acts of left-wing self-indulgence. Not this one. The sense of outrage it builds up in the audience is eminently justified. Indeed, it leaves you wondering how the American public has been so easily diverted from demanding Wall Street be brought to heel.

The outrage arises as you realise Wall Street is virtually a law unto itself. It was progressively deregulated at its own urging by congresses of both colours. Now its immense wealth and lobbying ability prevent it from being effectively reregulated.

For the most part, administrations' key economic regulators - Federal Reserve governors (Paul Volcker, Alan Greenspan) and Treasury secretaries (Robert Rubin, Hank Paulson, Tim Geithner) - come from the upper reaches of Wall Street.

When the big business-dominated Bush administration was replaced by the reformist Barack Obama, Republican-affiliated Wall Streeters were replaced by Democrat-affiliated Wall Streeters.

But it's not just the politicians who are compromised. The film's director, Charles Ferguson, shows how many of America's big-name academic economists are also on the Wall Street payroll. He outlined the case against economists in an article in The Chronicle of Higher Education. Ferguson's leading academic villain is Larry Summers of Harvard. He has long been a champion of privatisation and deregulation and as deputy secretary then secretary of the Treasury in the Clinton administration he oversaw the repeal of the Glass-Steagall Act, which had kept commercial banks separate from investment banks since the Depression.

Between 2001 and his entry into the Obama administration as director of the National Economic Council, Summers made more than $20 million through consulting and speaking engagements with financial firms.

Martin Feldstein, also of Harvard, a major architect of deregulation in the Reagan administration and president for 30 years of the non-government National Bureau of Economic Research, was on the board of the failed insurance giant, AIG, which paid him more than $6 million, and also on the board of the subsidiary whose dealings in credit default swaps brought the company down.

Feldstein's arrogant performance in the film was exceeded only by that of Glenn Hubbard, chairman of the Council of Economic Advisers in the Bush administration and dean of Columbia Business School. He's an adviser to many financial firms, resigning from the board of Capmark, a major commercial mortgage lender, shortly before its bankruptcy in 2009.

Frederic Mishkin, a professor at the Columbia Business School and a member of the Federal Reserve Board from 2006 to 2008, was paid $124,000 by the Icelandic Chamber of Commerce to write a paper praising its regulatory and banking systems, two years before Iceland blew up.

Laura Tyson, a professor at Berkeley and director of the National Economic Council in the Clinton administration, is on the board of Morgan Stanley, which pays her $350,000 a year.

Some of America's leading academic economists, from the most prestigious universities, make frequent pronouncements on public policy in the media, expecting to be venerated as disinterested experts. They rarely see a need to disclose their conflicts of interest.

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When the price is right you're on the right track

if economists wore T-shirts what they'd say is PRICES MAKE THE WORLD GO ROUND. Conventional economists are obsessed by prices. It took me ages to realise that economics isn't actually about the economy. It's about markets. So economists tend to ignore those parts of the economy that don't involve markets, such as the production and consumption of goods and services that go on inside households.

Economic sociologists also study markets and what they see is the way unwritten rules of social relationships influence the behaviour of producers and consumers, sellers and buyers.

Economists, however, don't see any of that. What they see is the way prices adjust until supply and demand are in balance ("equilibrium"). They see the price mechanism as the fulcrum on which the market economy rests.

Sometimes economists say economics is the study of incentives. That's just a fancy way of saying they study prices. Lower prices are an incentive to consumers to buy more, but an incentive to producers to produce less. Higher prices create the opposite incentives. Higher wages (which are a price) are an incentive to work more, and so forth.

But what fascinate economists are relative prices - the price of this item compared with the prices of other items. They think changes in relative prices have an almost magical ability to change people's behaviour.

Inflation involves rises in the level of prices generally. Economists disapprove of inflation mainly because when the prices of everything are rising this makes it harder for people to see and react to changes in the thing economists really care about: relative prices.

Last week an assistant governor of the Reserve Bank, Dr Philip Lowe, gave a speech in which he predicted the resources boom would cause a significant change in the structure of Australia's industries. What would bring this change about? Changes in relative prices, of course.

The most basic relative price in this story is our terms of trade - the prices we get for our exports relative to the prices we pay for our imports. The super-high prices we're getting for our coal and iron ore make our terms of trade possibly the most favourable they have ever been and about 90 per cent better than their average for the 1990s.

The change in this relative price is the main reason for the change in another key relative price: our exchange rate - the price of our dollar relative to the price of the US dollar, the yen or the euro.

But Lowe points to some relative price changes that are much less remarked. One is the price of manufactured goods (such as clothing, footwear, furniture and floor coverings, vehicles, audio, visual and computing equipment) relative to the price of other goods and services.

The prices of manufactures have been falling relative to the prices of services around the world for many years. This is because productivity in manufacturing has improved faster than productivity in services and because more of the world's manufacturing is being done in developing countries where labour is cheap.

But in recent years that process has been accelerated in Australia by the appreciation of the dollar. So much so that the Australian retail prices of manufactured goods (many of which are imported) have not only been falling relative to the prices of other goods and services, but also falling in absolute terms.

Looking at the consumer price index over 2010, the prices of other goods and services rose by about 7 percentage points more than the prices of manufactured goods.

The next important change in relative prices is the price of "investment goods" (machinery and equipment) relative to the price of "output" (all goods and services produced in Australia). When the price of new machines is low relative to the price of the goods and services produced using those investment goods, investment in new machines tends to be high - which is just what we've seen over the past decade.

The relative price of investment goods tends to be cyclical, but there is also a clear downward trend over time. This secular decline is driven largely by technological improvements lowering the price of computing power. But, again, the decline over the past decade has been particularly large because of the high dollar (much machinery is imported).

The final key change in relative prices is the price of labour. For workers, what matters is their wage relative to the price of the goods and services they buy with that wage. Economists call this the "real consumption wage".

For firms, what matters is the wages they pay relative to the prices they get for the goods and services they produce and sell. This is the "real producer wage". Usually, these two relative wages should be pretty similar because the goods and services people buy are much the same as the goods firms produce.

In recent years, however, this correspondence has broken down because of the improvement in the terms of trade. By definition, Australian firms produce exports but not imports, but Australian consumers buy imports but not exports.

Since 2000, the economy-wide ("aggregate") real consumption wage has risen by about 25 per cent (great news for workers), whereas the aggregate real producer wage has risen by only about 10 per cent (good news for firms).

But these aggregate figures conceal big differences between industries.

In industries where productivity is improving quickly - such as manufacturing - the real producer wage tends to rise because competition passes the benefits of the higher productivity through to customers in the form of lower prices.

By contrast, in many service industries real producer wages have been pretty flat. And in mining the real producer wage has fallen significantly: although miners' wages have grown very strongly, the prices the mining companies have been getting for their coal and iron ore have risen infinitely faster.

See where this is leading? All the relative price changes we've discussed will be working to change the allocation of resources within the economy in the same direction: away from manufacturing (and other export or import-competing industries, such as tourism) and towards mining and those parts of the manufacturing and services sectors that hang off it.

Mining's share of total annual private and public sector investment spending has reached almost 20 per cent - roughly double its usual share - and may rise as high as

25 per cent before long.

However, the great bulk of the economy - the services sector, accounting for more than three-quarters of total employment - will be little affected.

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We are watching our pennies, at last

Not so long ago people used to scandalise over the rate at which we were racking up credit card debt. Not any more. These days a new frugality is gripping us and credit card and other personal debt is growing at a snail's pace.

Starting in the mid-1990s, our return to low inflation caused interest rates to fall sharply and oscillate around a much lower level - remember when the mortgage rate was up at 17 per cent? - and this coincided with the banks becoming much keener to lend to ordinary mortals.

They pushed their credit cards, offering reward schemes as a new incentive, and inventing home loans that allowed you to redraw without fuss money you had paid off the principal. Whereas for decades people had tried to pay off their mortgage as quickly as possible, now they were seizing the opportunity to add to it.

The great bulk of the borrowing was for housing - including investment housing - but we also borrowed enthusiastically for cars and other durables, as well as hitting the credit card. Over the year to June 2007, outstanding credit card debt grew by more than 11 per cent. Add in personal loans and total personal debt (excluding housing debt) grew by 19 per cent.

Over the year to this January, however, total personal debt grew by less than 2 per cent. And over the year to February, the average credit card debt rose by less than 1 per cent - way below the rate of inflation - and the number of new cash advances fell by almost 2 per cent.

So what has changed? Probably a couple of things. The first is that we've adjusted to life in a world of easily obtained credit. We've borrowed hugely in the competition to obtain a better home, pushing the price of housing to unknown heights. Housing has now become much less affordable and it has occurred to us that house prices can mark time or even fall as well as rise inexorably.

After an uncharacteristic period of allowing the proportion of our collective equity in our homes to decline, we've returned to our accustomed position of increasing our equity by keeping ahead of our repayment schedule wherever possible.

Similarly, we seem to have gained a little more self-control when it comes to wielding our credit cards.

A second factor may be the lingering effect of the global financial crisis. Many Australian households may well have realised they were carrying far too much debt, which would leave them vulnerable (or, if you prefer, vonnerable) should they ever lose their jobs. (This is certainly what's happening with a vengeance in the United States and Britain.) If so, many people would be trying to avoid new commitments and repay old ones.

Another suggestion is that it's particularly the baby boomers who have changed their behaviour. In 2008 they witnessed the sharemarket crash slash the value of retirement savings - with share prices still not fully recovered - and now they've realised they need to knuckle down and start saving while there is still time.

Whatever the reasons, the figures say that whereas in the early noughties households had "negative saving" - their consumption spending exceeded their incomes - now they are saving almost 10 per cent of their disposable incomes. That's the highest our rate of saving has been since the mid-1980s.

Saving and borrowing are closely linked, of course - roughly, opposite sides of the same coin. So it shouldn't surprise that much of the money we're saving is being used to reduce our debts. (Nor should it surprise that, while many people are reducing their credit card balance, others are adding to it, so that total debt is still rising fractionally.)

We save by limiting our consumption relative to our income, but much of our spending - on rent or mortgage interest, council rates and electricity, for instance - isn't particularly discretionary. Where we have most discretion is in our spending at discount and department stores and it's these stores (plus newspapers dependent on retail advertising) that are feeling the pinch of our new frugality.

What goes with department stores? Credit cards. Why do so many people have trouble with credit cards? Professor Joshua Gans, of the Melbourne Business School, says many poor consumer decisions have two dimensions: sophisticated versus naive, and disciplined versus undisciplined.Sophisticated consumers are adequately informed about the products they are purchasing and about the mental biases which, if unchecked, may influence their decisions. Disciplined consumers are able to overcome their own biases, even if they aren't always well informed.

Ian McAuley, of the University of Canberra, has applied this matrix to credit cards. A sophisticated and disciplined consumer uses a credit card in the interest-free period and pays it off before the monthly deadline. Sophisticated but undisciplined consumers use the credit card, intending to pay it off, but when the time to do so arrives they suffer the bias of short-sightedness and go into high-interest debt.

Naive and undisciplined consumers use the credit card, perhaps to the limit, without even considering the opportunity to pay it off in the interest-free period.

Naive but disciplined consumers may refuse to use a credit card at all.

I doubt we've become much more sophisticated, but we do seem to have become more disciplined. Certainly, the figures say more of us - about 65 per cent - are paying off our accounts in full each month.

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No one's trying to reduce government waste

Government waste is like the weather: everyone disapproves, but no one does anything about it. Oppositions accuse governments of creating it, but governments don't seem to try too hard to eliminate it.

And this doesn't seem to worry you and me too much because our main use for government waste is as an excuse to oppose every suggestion that we pay more tax - and, indeed, to resent the extortionate amount we pay already (always conveniently forgetting what we read time and again: that Australia's total tax burden is quite low compared with other advanced economies).

Were someone to magically eliminate all government waste, would we then be willing to pay more tax? Somehow, I doubt it.

This makes it likely we have an exaggerated view of the extent of waste. It suits us to believe waste is endemic. The sums we hear about seem huge - they are huge relative to our household budgets - but we're bad at putting them into the context of the billions of dollars our governments play with. We have no conception of how big Australia is when you add up its 8 million households and more than 1 million businesses.

That's my guess - that we have an exaggerated view of the extent of waste - but I can't prove it. I doubt if anyone has surveyed our impressions on the topic. Nor do we have any figures on the actual size of government waste, whether it's getting better or worse, or which side of politics has the worse record.

I guess no one's game to spend money measuring the extent of waste for fear of the talkback know-alls who'd say this was itself a waste of money.

And, of course, measuring waste wouldn't be nearly as easy as many of the sidewalk supervisors imagine. Waste is deceptively easy to allege, not so easy to prove and very hard to eliminate.

I've no doubt waste exists, and will always exist. There's plenty of waste in our own homes - the excess food we buy, the expensive gadgets we rarely use, the empty bedrooms, the kids who don't take advantage of the expensive educations we've provided, the holiday houses that are rarely occupied, the boats that rarely enter the water or leave their mooring - so why do we imagine governments could ever conduct their affairs without waste?

Because some degree of waste is inevitable it would nice to have some measure that allowed us to say whether its present level was excessive. And there are different types of waste. Often what the casual observer regards as waste merely reflects their lack of knowledge of all the circumstances.

Often there's a lot of subjective judgment involved. Is it wasteful to have bedrooms that are rarely occupied? Is it wasteful not to bother trying to rent out your holiday house when you're not using it? Or is it just the way you choose to enjoy your affluence?

At the government level, there's undoubted waste but there's also debatable waste. I may consider paying the family tax benefit to someone on your income a case of wasteful spending, but you probably disagree.

Tony Abbott and his colleagues are always accusing the Rudd-Gillard government of wasting money - as though waste was a recent invention - but when they're obliged to come up with their own list of spending cuts they're pretty light on. Too many possibilities that could cost votes.

It's no doubt a good thing oppositions carry on about waste - there'd probably more of it if they didn't. Even so, you don't get the feeling governments put much effort into hunting it down. They're always boasting about cracking down on petty welfare fraud, but not much else.

And when you consider how little publicity the media give to auditor-general certified waste, you get the feeling the public isn't all that worried about waste beyond using it to justify their objection to higher taxes.

One class of waste is ineffectiveness: government spending that doesn't achieve its stated objectives, or doesn't achieve them as well as some other program might. You'd think that, in this day and age, governments would put a lot of effort into assessing the effectiveness of their spending programs, but in this we lag well behind the Americans.

Perhaps because of the crowing they know the Opposition might do, ministers and their department heads have little enthusiasm for reviewing the effectiveness of their programs. They don't want the auditor-general poking his nose in and what evaluation occurs is usually pretty Mickey Mouse.

In the US, by contrast, it's common for Congress, when passing spending bills, to earmark a small proportion of the funds for program evaluation and to specify the rigorous methodology to be used. They've even got to the point where they're using randomised controlled trials. You have a treatment group and a (non-treatment) control group and you allocate participants between the groups by the toss of a coin.

Provided both groups are big enough, this approach makes it more likely the differences in outcomes between the two groups are the result of the treatment rather than extraneous factors.

Such an approach, which is widely used in medical trials, could be used to evaluate many - but not all - social spending programs.

And Dr Andrew Leigh, a federal Labor backbencher and former economics professor, has moved a private member's bill proposing we do just that. I'd like to see Abbott and the soon-to-be-elected O'Farrell government promising rigorous evaluation of spending programs. That would test their sincerity. And the Baillieu government in Victoria could get right in and do it now.

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A way to tackle carbon and keep everybody happy

As if we needed any reminding, the latest flare-up of politicking over putting a price on carbon shows just how difficult it will be to gain sufficient community agreement to take effective action against climate change.

With a government lacking the numbers in both houses, the Greens demanding a sackcloth-and-ashes scheme and an opposition determinedly putting short-term partisan advantage ahead of the national interest, how are we to reach agreement?

Well, Dr Frank Jotzo, of the centre for climate economics and policy at the Australian National University, thinks he's found a way. In a forthcoming paper he proposes a strategy that would respond to each of the conflicting interest groups' key concerns while still producing a scheme that stacks up economically and environmentally.

He starts by ignoring the political parties and identifying four key constituencies. First are environmentally concerned citizens and groups. These are deeply concerned about climate change and convinced of the need to reduce domestic emissions of carbon dioxide and other greenhouse gases. They'd like to see Australia making a constructive contribution to global action.

Second are the general citizens, who accept that more needs to be done about climate change, but are concerned about the possible effect on their cost of living, thus making them vulnerable to scare campaigns.

Third is the general business community, which is only weakly engaged in the public debate because it doesn't see climate change as a core concern. But it accepts that something must be done and sees an effective government response as a sign of commitment to reform and good government.

Fourth are emissions-intensive industries, which now seem to have accepted some form of emissions reduction policy is inevitable, but are focused on minimising the financial impacts on major emitters. The success of their lobbying resulted in the Rudd government's emissions trading scheme granting them many free emission permits and much permit revenue.

While some of these businesses would be happy to see policy action delayed, more of them want to reduce the effect of uncertainty about policy on electricity generators' decisions on new investments. The present hiatus creates a risk of disruption in electricity supply over coming years.

How could you come up with an arrangement that offered enough to each of those groups to achieve their support for action? Jotzo thinks the key to it is the leeway provided by a little-understood feature of the Rudd government's scheme, or any other plausible scheme.

Australia is a relatively small open economy whose carbon reduction scheme would be part of a global collection of national schemes which, collectively, would significantly reduce global emissions. It's the level of global emissions, not the efforts of any particular small country, which influences climate change.

Because the problem and the solution are global, the Kyoto Protocol and, no doubt, its eventual successor provide for the trading of emission permits between countries. This helps to minimise the economic cost of reducing emissions by allowing emissions to be reduced in those parts of the world where the cost of doing so is lowest.

If it's more expensive for me to reduce my emissions than it is for you to reduce yours, let me meet my obligation by paying you to reduce yours on my behalf.

Under the Rudd government's scheme it was always intended that Australian producers who needed permits to cover their emissions would be free to meet their obligations by purchasing emissions permits from overseas. This means the international price of emissions permits would set a ceiling for the market price of permits in our scheme.

It also means that, until the domestic price of permits reaches the international price, the domestic price and the rate at which it's set to rise can be detached from the achievement of the target for Australia's contribution to the reduction in global emissions.

Should the reduction in domestic emissions fall short of the target, the government can simply buy sufficient overseas permits to ensure the target is met. This decoupling allows us to phase in the carbon price - thus making it easier for firms and households to adjust to it - while still setting and achieving an ambitious target.

And this allows Jotzo to propose a strategy that "has the potential to deliver a worthwhile long-run policy outcome while working within the major concerns and interests of the four interest groups".

The strategy builds on last month's agreement between the government and the Greens to set a government-determined carbon price from next July, with provision to shift to a trading-determined price over the medium to long term as international uncertainties are resolved.

The first step is to ensure that, wherever the initial carbon price is set, it should be increased over time so that the price in the medium term (from 2015 to 2020) is high enough to create confidence that Australia's domestic emissions will begin to trend downwards within the next few years.

Remember, the expected future price of carbon is the major driver of present new investments in the assets - such as power plants, business machinery, transport infrastructure and vehicles, buildings and household appliances - that will shape future energy use and emissions.

The simplest way to achieve this is to legislate the path of the fixed price and then, once the switch is made to an emissions trading scheme, legislate the path of a minimum price below which the market price won't be allowed to fall.

The second step is to set the initial price at a level low enough to give people confidence the short-run effects on the economy will be manageable and to give households and businesses time to adjust.

This would reassure general citizens and the two business constituencies, demonstrating that a carbon price won't cause major economic disruption.

The third step is to ensure any assistance to emitters is tightly limited, determined by transparent rules, subject to sunset provisions and, above all, doesn't reduce their incentive to cut their emissions.

In using the proceeds from the sale of permits, the highest priority should be compensating households - particularly low- to middle-income households - for the rise in their cost of living but, again, this must be done in a way that doesn't reduce their incentive to cut emissions.

Finally, the scheme should include provision for the government to steepen the path of the carbon price, and lift the target to a 25 per cent reduction in emissions by 2020, in response to any increase in global ambition beyond what individual countries promised to achieve following the meeting in Copenhagen.

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Money can ease the pain of disability

Did you know there's an expensive policy proposal Tony Abbott isn't opposed to? When it lobbed last week both sides made supportive noises about it so, thanks to the perversity of politics, it slipped past without getting the attention it deserves. It's the Productivity Commission's draft report on the government's desire to establish a national disability insurance scheme.

The scheme would cover people with severe disabilities present at birth or acquired through an accident or health problem, but not due to ageing.

It's estimated that about 680,000 people under 65 suffer a severe or profound limitation in their ability to engage in core human activities. Just under half of these have at least a daily need for help with mobility, self-care or communicating with others. But only about 170,000 are using disability services.

Among those with a profound inability to engage in core activities, about 40 per cent suffer from mental and behavioural disorders such as autism, Asperger's syndrome and intellectual disability. The next biggest groups suffer from diseases of the nervous system, such as multiple sclerosis, of the circulatory, respiratory or digestive systems, and of the musculoskeletal system.

It's easy to look at that list and think none of it applies to me and mine, thank God. That's the political problem: it's not that we have no sympathy for these people, it's that we prefer not to think about such unpleasant topics. But all of us are just a car or household accident away from joining their number.

My interest in the topic comes via my belief that governments should be seeking to maximise our subjective wellbeing - our happiness - not just our material standard of living. One of the best ways to increase national happiness is to reduce the deep unhappiness suffered by many of the disabled and their carers.

People with disabilities are able to adjust to their circumstances and find happiness - but not if the community's neglect allows their lives to be a hellish struggle. The report quotes a psychiatrist saying members of the profession regularly meet parents considering murder-suicide because of their inability to find adequate help for their child.

The present system - or lack of system - for helping people with disabilities has many deficiencies. The most obvious is that in all states there are insufficient resources and gaps in services, so that people with disabilities and their family carers bear too much of the cost.

People with similar levels of impairment get quite different levels of support, depending on the state they live in, whether they live in the city or the country and even the origin of their disability.

The present arrangements are "provider-centric" - organised for the convenience of the providers of assistance - which reduces the ability of people with disabilities and their carers to choose which services they use.

Services are generally narrowly prescribed and don't have the goal of increasing the person's ability to take part in normal life. There are too few opportunities for people to work or participate in the community if they're able to.

People with disabilities and their families often don't have a reasonable level of certainty about the future. In particular, the parents of children with profound disability often worry about how their child will be supported when they get too tired or sick, or they die.

There's a lack of co-ordination between agencies, seen in duplicated and inconsistent methods for assessing people and allocating services, and inadequate links between services provided by different governments.

Services often aren't portable between states, penalising people who move. And there are other injustices and inefficiencies, such as caring for young people with disabilities in aged care homes and keeping people in hospitals - thus blocking beds - because of insufficient funds for minor modifications to their homes.

The report proposes a new national scheme providing insurance cover for all Australians in the event of a significant disability. The scheme would fund long-term, high-quality care and support (such as accommodation, mechanical aids, transport, respite, day programs and participation in the community), but would not overlap with Medicare, social security benefits or aged care arrangements.

Each individual's needs would be assessed and they would be provided with a "support package" portable across state borders. People with a package would be able to choose their own service providers, ask a non-government support organisation to assemble the best package on their behalf and even cash out their allocation of funds and direct them to areas of need they thought more important.

There would be a strong emphasis on helping people participate in education, training and employment where possible. People would be given more opportunity to choose mainstream services rather than those from specialist providers.

A separate national injury insurance scheme would be established for people requiring lifetime care and support for catastrophic injuries, such as major brain or spinal cord injuries. It would be a no-fault scheme and would catch people whose injuries were covered neither by worker's comp or compulsory third-party motor insurance.

The agency overseeing the two schemes would be created by, and report to, federal and state governments. It would have a high degree of protection from political interference. By "insurance" is meant social insurance - the risk of disability is removed from the individual and shared by the group which, because of its sheer size, is most able to bear it without great pain: all taxpayers.

At present, governments - mainly state governments - are spending about $6.2 billion a year. The report estimates the new schemes would cost as much again.

The extra $6.3 billion a year could be covered by increasing the present Medicare levy from 1.5 per cent to 2.3 per cent of income but, rather than start another "great big new tax on everything" outcry, the report recommends just funding it out of consolidated revenue, leaving the government to worry about how it will balance its budget. Funding problem safely swept under carpet.

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No more ignorant talk of a two-speed economy

The more economists examine it, the more they explode the seemingly self-evident truth that we're living in a two-speed economy.

Why do people keep saying this? I think they're saying that whoever's benefiting from all the talk of a boom, it ain't my state or my industry. In short: I see no evidence of any boom around me and I'm certainly not getting any benefit from it.

If there is a boom, they seem to be saying, it's limited to the mining industry while the rest of the economy is struggling. Similarly, Western Australia and Queensland may be doing OK, but the other states and territories aren't.

There's just one small problem with all this: the facts don't back it up. Consider, for openers, the figures we got last week for "state final demand" (an imperfect interim substitute for gross state product).

Growth in this measure over the year to December averaged 2.7 per cent across Australia, but varied from 4.3 per cent to 1.5 per cent. The three fastest growing areas were the Northern Territory, the ACT and Tasmania.

Western Australia came fourth on 3.1 per cent and Queensland came eighth and last on 1.5 per cent.

As Saul Eslake of the Grattan Institute has reminded us, it's not arithmetically possible for all the states to be above average like the kids in Garrison Keillor's Lake Wobegon. There'll always be some above the average and some below it. There'll always be a multitude of reasons why, at any moment, some states are doing relatively well and others relatively badly.

Eslake has had a good look at the figures and found that, in the past two decades, there's never been a gap of less than 2 percentage points between the annual rates of growth in gross state product of the fastest and slowest growing states and territories.

But that gap is narrower in recent years than it used to be. Over the past five years it's averaged 3.7 percentage points, which is 1.5 percentage points narrower than it averaged over the previous 15 years.

Eslake adds that there's much less divergence in the performance of our states and territories than there is in comparable federations. Over the past four years our divergence has been half what it is for the American states and about a third of what it is for Canada's provinces.

But now Kieran Davies and Felicity Emmett, of the Royal Bank of Scotland, have examined the two-speed economy proposition using labour market figures for almost 70 regions around the nation.

In particular, they test the contention that the resources boom and the high dollar that goes with it are making the economy too dependent on mining and hollowing out the rest of the economy, thus making us more vulnerable to external shocks.

They find that at the height of the first stage of the resources boom in 2008, when national unemployment fell just below 4 per cent, unemployment was low across the country. There was a gap of only about 6 percentage points between the lowest regional unemployment rate of 2 per cent and the highest of 8 per cent.

Then, at the time when the mild recession caused by the global financial crisis led to national unemployment peaking at close to 6 per cent, the gap between the lowest regional unemployment rate of 1 per cent and the highest regional rate of 20 per cent was a massive 19 percentage points.

But now, as unemployment has continued to fall back from that peak, the gap has narrowed sharply. At the start of this year it stood at 14 percentage points, with the lowest regional unemployment rate still at 1 per cent and the highest falling to 15 per cent.

And get this: many of the regions with the lowest unemployment rates are in the non-resource-rich states. The regions with rates between 1 per cent and 2 per cent are in NSW (the Hunter Valley excluding Newcastle, and some parts of Sydney) and the Northern Territory. WA doesn't feature in the top 10, though rural WA comes in at No. 13.

In 2008, before the onset of the crisis, more than 90 per cent of the regions had unemployment of 6 per cent or less. Now, with the economy yet to return to that height, 70 per cent of regions are at 6 per cent or less. If that doesn't prove the benefits of the resources boom are being spread right around the economy, nothing will.

It's true the retailers are doing it tough at present (mainly for reasons that have little to do with the resources boom), but it's just sloppy thinking to see this as more evidence of the two-speed economy.

Why is it not a two-speed economy? Because about three-quarters of us work in industries that are neither great direct beneficiaries of the resources boom, nor great victims of the high exchange rate it has brought about.

And also because we live in one national economy, not eight isolated economies. There is a high degree of trade between the states and territories. They are subject to the same exchange rate, interest rate and federal budgetary policy.

A fair bit of the cream from the resources boom goes to the federal government. And all the mining royalties gained by the WA and Queensland governments are shared with the other state and territory governments via the formula by which the proceeds from the goods and services tax are divided between them.

The rise in the dollar is actually one mechanism by which part of the earnings of the miners is redistributed to all other industries and all consumers, in the form of cheaper imports.

If you think you've got nothing to show for the resources boom, all you're showing is your economic ignorance.

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Glimmering lights help dispel the gloom and doom

Peering through the statistical mist, the national accounts we saw this week tell us that, contrary to some messages we have been getting, the economy is on track and growing quite strongly. For the foreseeable future, growth will be coming more from business investment spending than from consumption.

Bureau of Statistics figures show real gross domestic product grew by 0.7 per cent in the December quarter. But Treasury estimates that the early days of the Queensland floods cut production, mainly coal production, by about 0.4 percentage points during the quarter.

So the ''underlying'' growth in GDP was probably nearer 1.1 per cent. If we take the actual growth over the year to December of 2.7 per cent and add back the 0.4 percentage points, we get underlying growth for the year of 3.1 per cent.

(Why is it OK to keep adding back the effect of the floods? Because the loss of production is expected to be temporary. After the full effect of the disruption is felt in the present quarter - maybe reducing GDP by a further 1 percentage point - growth will be higher than otherwise as the miners catch up and much money is spent repairing and replacing damaged homes, businesses and public infrastructure. The authorities expect the floods' effect on GDP to have largely been offset by the end of this year.)

The figures for growth in the December quarter continue the recent pattern of very strong growth in one quarter followed by a quarter of very weak growth and then back to strong growth again.

So let's abstract from the volatility by focusing on the figures for the year to December. They show consumer spending growing by 2.8 per cent - below the trend rate of growth, but not by a lot.

If that's stronger than you were expecting, the reason is that, yet again, the monthly figures for retail sales have proved an unreliable guide to the quarterly figures for total household consumption (which is more comprehensive). In real terms, retail sales grew by only 1.1 per cent over the year to December.

The sub-par growth in consumer spending is not the product of any weakness in the growth of household disposable income. It rose by 6.4 per cent in nominal terms.

No, consumer spending is moderate because households are saving more of their incomes, to pay down debt rather than add to it. The household saving rate averaged more than 9 per cent over the year to December, much higher than it's been for ages.

Spending on new homes and renovations grew by a weak 2.2 per cent over the year, which means we are not building enough homes to accommodate the growth in the population. Taken by itself, this puts pressure on house prices and rents.

Turning to business investment, spending on new machinery and equipment fell by 8.2 per cent over the year. That's probably because a lot of businesses brought forward purchases they would have made this year to take advantage of a tax break that was part of Kevin Rudd's stimulus package.

But spending on new equipment actually grew by 4.7 per cent in the December quarter, which suggest the hiatus may now be over.

The other major component of business investment is ''non-dwelling construction'' - the building of office blocks, shopping centres and mines. It has not been doing too well lately, with the exception of ''engineering construction'', which is mainly the mines.

New engineering construction grew by a massive 12.4 per cent over the year to December. And we know from what businesses have told the Bureau of Statistics about their intentions that there's a lot more spending to come this year and next.

Over the year to December, the volume (quantity) of our exports increased by 5.1 per cent, but the volume of imports increased by 8.4 per cent, with the effect that ''net exports'' (exports minus imports) subtracted 0.7 percentage points from the overall growth in GDP.

Turning from export and import volumes to export and import prices, our terms of trade - export prices relative to import prices - improved a little further in the December quarter, to be 22 per cent better over the whole year.

An improvement in our terms of trade makes us richer. This explains why our real gross domestic income rose by 7.7 per cent over the year, compared with the rise in real gross domestic product of 2.7 per cent. As this extra income is spent in coming months, GDP will accelerate.

Because they're so volatile, it's always good to cross-check the quarterly national accounts by comparing them with what we know is happening in the labour market. Over the year to January, total employment grew by a rapid 3 per cent, with 80 per cent of the 330,000 jobs created being full-time. Unemployment fell by 0.3 percentage points to 5 per cent.

This is a healthy economy notwithstanding the caution consumers are showing and the temporary effects of floods and cyclones. The strength is coming from investment in the expansion of our mining industry, and there's a lot more of it to come.

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Bitter pill when politicians swallow big pharma's spin

Politicians always profess great sympathy for people struggling to keep up with the cost of living but often fail to put that sympathy into practice. Economists like to divide the economy into consumers on one side and producers on the other. They believe the economy should be run for the benefit of consumers, not producers. The consumer is supposed to be king.

Ostensibly, pollies think the same. But they're always doing deals with producers that allow them to charge higher prices at their customers' expense.

Why would politicians do such a thing? Because the producers are usually better organised. They have more to gain from a higher price - or lose from a lower price - than individual consumers have to lose or gain. Consumers are amateurs; producers are professionals and they put a lot of effort into lobbying governments.

But there's another factor. Every voter with a job is a producer as well as a consumer. Politicians care about jobs. And when producers offer to create new jobs - or, more likely, threaten to sack workers if they don't get what they want - the pollies usually play ball. They're easily conned.

Consider the case of pharmaceuticals. When a drug company - usually a big American or European corporation - discovers and develops a new medicine, it is granted a patent that amounts to a 20-year monopoly on the production of the medicine. If the medicine is highly effective, the monopoly allows the company to charge a very high price.

The standard justification for patents is that, by holding off competitors, they allow the company a period of grace in which to recover its research and development costs and make a big profit, thus encouraging more invention, to the benefit of society.

This explains why pharmaceuticals are so expensive in the United States. But the companies are prevented from charging such high prices in Australia by the operation of our pharmaceutical benefits scheme.

Under the scheme most drugs are, in effect, bought by the federal government, then sold to patients at heavily subsidised prices. This makes the government a "monopsonist" - a single buyer - and so gives it the ability to beat down the prices the drug companies are able to charge.

This explains why patented pharmaceuticals are so much cheaper in places such as Australia and Canada than they are in the US. The Aussie taxpayer benefits, as does the patient required to pay a smaller out-of-pocket contribution towards the cost of the drug.

Great stuff. But here's where the story gets bad. When a drug's patent expires, any drug company is allowed to start producing that drug in competition with the former patent holder. They can't appropriate the drug's trade name, of course, so they're known as generics. Generics are tightly regulated to ensure they're just as effective as the drug being copied.

So when a drug comes off patent and a lot of cheaper generics come onto the market, you'd expect the price of the trade-name drug to fall sharply. That's what happens in the US and in many other countries, but not in Australia. Why not? Because our pharmaceutical benefits scheme goes easy on the former patent holders. It drops the price by a bit, not a lot.

And it leaves it up to the prescribing doctor - and sometimes the patient talking to the chemist - to say whether a generic may be substituted. Many doctors and patients have an irrational attachment to the brand name, even though it's a lot dearer.

Last year the Rudd government proudly announced it had cut a new and tougher deal with the drug companies, represented by Medicines Australia, which would save the taxpayer $1.9 billion over five years.

The patents of a lot of expensive drugs will expire in the next few years. The deal involved cutting the prices of these drugs by 16 per cent and cutting the prices of generic drugs by 2 or 5 per cent from the start of this year.

But a health economist at the University of Sydney, associate professor Philip Clarke, and his colleague Edmund Fitzgerald, argue the deal still leaves our off-patent and generic drug prices much higher than they are in most developed countries. They quote the example of statins, the cholesterol-lowering drugs, where the patents of the various types have expired or soon will. Statins account for about 16 per cent of the total cost of the pharmaceutical benefits scheme.

They surveyed the wholesale price of Simvastatin 40mg in 10 developed countries and found our price was the highest: 50 per cent more than the next highest country and more than four times greater than the average price.

The lowest price was in New Zealand, which stages competitive tenders between the drug companies. Its price is just a fraction of our wholesale price of $1 a tablet. And even in the US, chains such as Kmart Pharmacy sell that statin for $15 for 90 tablets.

Clarke and Fitzgerald estimate that, compared with prices in England and Canada, the Rudd government's deal with the industry lobby will cost taxpayers and consumers $1.7 billion more over its five-year term. And that's just for the statin group of drugs.

The saving would be even greater, no doubt, if the government were game to take a firmer line on the prescribing habits of doctors.

Why would a government that professes to care so much about our cost of living cut such an expensive deal with the drug producers? Because, in practice, it gives a higher priority to maintaining an industry that makes the actual pills in Australia.

And the largely foreign-owned drug companies have conned it into believing that, unless it forces Australian consumers to paying much higher prices for off-patent drugs than people in other countries pay, the local industry will curl up and die.

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Carbon courage, and for Gillard, no going back

Maybe Julia Gillard will make a good prime minister after all. Her decisions of late - culminating in her commitment to impose a price on carbon from July next year - suggest she has learnt from Labor's mistakes and understands what she must do to stay in office.

Kevin Rudd's biggest mistake was to abandon his carbon-pollution reduction scheme after the going got tough, rather than seeking to get it passed after a double dissolution election. Urged on by Gillard and Wayne Swan, he thought abandoning the threat of "a great big new tax on everything" would help preserve his popularity.

Instead, it convinced voters he was lacking in courage and conviction. That was when his sharp slide in the polls began. His funk over climate change contributed to the mishandling of the resource super profits tax, while emboldening BHP Billiton and the other big miners to attempt to knock off the tax by knocking off the government. It's clear that, when Gillard replaced Rudd and rushed to an early election, she had no idea why Labor was in trouble. Rather than taking a different tack on the emissions trading scheme, she made matters worse by promising not to impose a price on carbon during her next term.

The result was that Labor voters abandoned the party in droves, while few if any swinging voters were attracted to such a chameleon party. She'd tried to "govern from the centre" and been caught between two stools. At last, however, Gillard seems to have realised leaders have to stand for something if they're to retain the loyalty of their heartland and impress the rest of the electorate.

She's starting to show signs of courage in imposing the eminently avoidable flood levy, in attacking rather than aping Tony Abbott's latest attempt to capitalise on popular resentment of boat people, and in restating Labor's support for multiculturalism.

For weeks she's been making speeches about her belief in economic reform and now she's given that some substance by announcing a firm objective of introducing a price on carbon well before the next election, not after it. No going back now.

Not long after Rudd followed John Howard's example in committing to using an emissions trading scheme as the means of imposing a cost on emissions of carbon dioxide and other greenhouse gases, many economists decided they favoured using a carbon tax.

In theory, the two are mirror images of themselves. Trading schemes limit the quantity of emissions directly, in the process pushing up their cost. Carbon taxes raise the cost of emissions directly, in the process discouraging people from emitting them. In practice, the two approaches have differing practical and political pros and cons. And now Gillard's agreement with the Greens commits her to a hybrid of the two. An emissions trading scheme will be established, but for the first three to five years the price of permits will be fixed and no trading allowed. After that trading will be permitted and this will cause the price of permits to vary with the balance of supply and demand.

This idea was originally proposed by Professor Ross Garnaut and later taken up by the Greens. Of course, most of the details of how the scheme would work remain to be negotiated with the Greens and sufficient independents in the House of Representatives.

But in his review of Gillard's statement, Dr Richard Denniss, the director of the Australia Institute, says the initial price is unlikely to be lower than the $26 a tonne initially used by Treasury in its modelling of the carbon pollution reduction scheme. The annual increase in the price is likely to be the inflation rate plus a few percentage points. Denniss says that if the eventual move to a trading scheme led to a rapid fall in the carbon price this would harm many businesses. So he suggests setting a price floor to prevent that from happening (as it did happen in the European Union's trading scheme).

Perhaps the greatest area of political vulnerability is the scheme's addition to households' electricity bills, given these have already risen by 40 per cent or so in recent times for other reasons. Here Denniss has an unorthodox and second-best suggestion.

Since it's all higher prices rather than just higher carbon prices that are expected to change our habits in the use of power, why not shield consumers from any further price increases?

The power generators could be made to pay for their emissions, but the higher costs could be offset by direct payments to the retail distributors. This would leave the price incentive for generators to invest in less emissions-intensive production methods, while removing the need to raise household electricity costs but then compensate people for the rise in their cost of living.

As Denniss reminds us, behavioural economics explains why the punters hate being taxed with one hand and compensated with the other. Partly it's distrust - the pollies may welsh on the deal - but mainly it's because most people are "loss averse": they dislike losing money more than they enjoy receiving money.

The very use of the word "compensation" is a reminder to people there must be pain involved.

Because it's so hard to adequately compensate every last person with unusual circumstances, governments commonly end up overcompensating a lot of people. So if you sent the compensation direct to the electricity retailers you could avoid wasting the proceeds from the tax on overcompensation, leaving more available for subsidising research and development of alternative energy sources.

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Surge in savings masks current account rise

One little-noticed consequence of the resources boom has been a big rise in the current account deficit on our balance of payments with the rest of the world. But when we get the latest figures on Tuesday we're unlikely to see any evidence of that. Why not? Because of the surge in household saving.

The current account deficit occurs because our imports and payments of interest and dividends to the rest of the world almost always exceed our exports and receipts of interest and dividends from the rest of the world.

Over the past 30 years the current account deficit has averaged about 4 per cent of gross domestic product. Since the start of the resources boom in 2003-04, however, the current account deficit has been nearer 5 or 6 per cent of GDP.

You might expect that, with the resources boom meaning the world is paying us much higher prices for our exports of coal and iron ore, the current account deficit would be smaller rather than larger. But it hasn't worked out that way.

Why not? Because the higher export prices represent an increase in the nation's real income, and when that extra income is spent by individuals and firms, much of the additional spending goes on imports.

But it's always easier to see the factors driving the current account deficit if we explain it in terms of saving and investment rather than exports and imports.

How is it possible for us to go on year after year having our recurrent payments to the rest of the world exceeding our recurrent receipts? It's possible only if we can cover the difference by having someone in the rest of the world lend us that difference (or by accepting foreign ''equity'' investment in Australian businesses).

These capital transactions are recorded in the capital account on the balance of payments. So it turns out that if we're running a deficit on the current account this has to be exactly matched by a surplus on the capital account.

And the capital account surplus represents the amount by which the nation's investment in new housing, business plant and structures, and public infrastructure during a period exceeds the nation's saving during that period.

Households save by spending less than all their income on consumption. Companies save by retaining some of their after-tax profits rather than paying them all out as dividends. And governments save when they raise more in taxes than is needed to cover their recurrent spending.

The amount we save pays for the amount we invest. So when a nation's physical investment spending during a period exceeds the amount it has saved during that period - as it always does in Australia - it has to cover the gap by calling on the savings of foreigners.

Looked at this way, the resources boom increases the current account deficit because it leads the mining companies - many of which are foreign-owned - to greatly increase their investment in the construction of new mines, natural gas facilities and so forth.

In the first stage of the resources boom - before the global financial crisis interrupted - there was an increase in national saving, but a greater increase in national investment, thus causing the current account deficit to be 1 or 2 percentage points of GDP higher.

Then there was the period of the crisis - particularly in 2009 - when national saving increased but national investment fell, thus causing the current account deficit to narrow to about 3 per cent.

But now we've got the economy recovering from the mild recession induced by the crisis. We have seen a bit of growth in investment in new housing, stronger growth in companies' investment in ''non-dwelling construction'' (mainly continuing construction of new mines), though no growth in companies' investment in new machinery and equipment, and very strong growth in governments' investment in infrastructure, particularly the state governments.

So national investment spending is up on the crisis period. But national saving is up by more. As we saw in this column last week, the household saving ratio has shot up to 10 per cent of household disposable income (equivalent to about 6 per cent of GDP).

Corporate saving is quite high, as companies use retained earnings to repay debt and improve their gearing. Yet governments have gone from saving to dissaving as their revenues have been hit by the delayed effect of the downturn while their recurrent spending has been swollen by stimulus measures.

Putting these three components together, national saving is well up on what it was before the crisis struck. Whereas gross national saving had coasted along each year at about 20 per cent of GDP (here, ''gross'' means before making a deduction for the annual depreciation in the value of the stock of the nation's physical capital), now it is up to about 25 per cent.

So, though national investment is up a bit on what it was during the crisis, national saving is up a lot - mainly thanks to the remarkable increase in household saving. This suggests the current account deficit, which got down to 3 per cent of GDP during the crisis, has taken a step lower to 2 per cent. It averaged 2 per cent in the June and September quarters of last year and, when we see the balance-of-payments figures on Tuesday and the national accounts on Wednesday, they're likely to show the current account deficit stayed at about 2 per cent in the December quarter.

Two conclusions. First, the fact that the increase in the current account deficit during the noughties occurred because of higher investment rather than reduced saving (which actually increased a bit), suggests that the foreign debt we are racking up is financially sustainable. In the main, we're borrowing from foreigners to expand our capacity to sell more coal, iron ore and natural gas to foreigners.

Second, the expectation that the resumption of the resources boom will lead to many more years of outsized current account deficits arises because we know there's a huge amount of investment in mining construction to come, with much of the funding for that investment coming from foreigners.

But this expectation assumes no change in the nation's saving habits. So to the extent that our households continue saving a lot more of their incomes than they used to, we can have the mining construction boom with lower-than-expected current account deficits and less increase in our foreign debt.

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Hard to hear angels above the racist heartbeat

Scientists used to think chimpanzees - our close relatives - were a gentle, peace-loving species, until they observed their behaviour in the wild and found they could be quite murderous in the treatment of other chimps.

And what was it that caused them to become so vicious? The arrival of chimps from a different troop in the part of the forest they considered to be their territory.

I remembered this one day after failing to persuade a friend who took a dim view of boat people that her objections were unfounded. Whenever I knocked down one argument she'd just switch to another.

Our evolutionary history has left us with an instinctive fear of outsiders - people who are different, people who invade our territory to steal our food and our women or, in the contemporary context, to jump the queue and steal our jobs, overcrowd our schools (and win most of the prizes), overwhelm our culture, crowd out the rellos we're trying to get into the country, push up house prices and add to congestion on the roads.

You can call it racism or religious intolerance - the nation that invented the White Australia Policy can hardly object to that charge, except to say we're no worse than most nationalities and better than some.

But it's best thought of as xenophobia - a fear of foreigners, people who are different, who aren't one of us.

And it's so deeply ingrained in us - so visceral - it's not susceptible to rational argument. It would be nice if a greater effort by the media to expose the many myths surrounding attitudes towards asylum seekers could dispel the fear and resentment, but it would make little difference.

Our politicians have long understood that widespread dislike of newcomers, especially those of darker skin or strange religious practices, lay just beneath the surface and could be easily aroused. The politician or party that tapped this vein would draw much support.

For decades there was an unspoken agreement between the major parties to keep such tactics off limits. Their role was to avoid bringing out the worst in the Australian psyche.

But maybe 20 years ago that bipartisan approach began breaking down. Perhaps it was the rise of Asian immigration, perhaps the era of so many people arriving uninvited by boat.

It may be true we have a bigger problem with visitors arriving by plane and overstaying visas, but the more visible arrival of scruffy people on an overcrowded, leaky boat - the footage of which can be replayed many times, leaving an exaggerated impression of the numbers involved - seems far more threatening.

Perhaps it was the huge rise in the levels of sanctioned immigration in recent years, for which governments have failed to provide sufficient housing and public infrastructure.

Another factor was the advent of talkback radio, which gave greater currency to the disaffection of individuals, and then the rise of shock jocks who, in pursuit of ratings and commercial gain, where prepared to incite their listeners' resentments.

Pauline Hanson brought the issue crashing onto the stage of federal politics, forcing the major parties to respond. But politicians had begun walking away from their commitment to avoid politicising the issue much earlier.

Perhaps they couldn't avoid responding to public concerns; perhaps in the heightened contest between the parties they could no longer resist the temptation to gain an advantage over their opponents.

Some people blame it all on John Howard, but the harsh treatment of boat people began under his Labor predecessors. And whoever started it, once the embargo had been breached both sides got down and dirty.

Julia Gillard took the debate to a lower level before the election when she invited people to give their prejudices free rein. "People should feel free to say what they feel," she said. "For people to say they're anxious about border security doesn't make them intolerant. It certainly doesn't make them a racist."

To acknowledge we have an evolutionary predisposition to fear and resent outsiders is not to condone such attitudes. The process of civilisation involves gaining mastery over our base emotions which, if they once contributed to our biological "fitness", are now antisocial and counter-productive.

But if such attitudes are instinctive and impervious to rational argument, what's to be done now the pollies have let their standards fall?

I was at a loss to answer that until last week and the arrival in Sydney of that poor distressed orphan boy for the funeral of his father. Suddenly a crack appeared in the wall of prejudice against boat people. Tony Abbott and his immigration spokesman, Scott Morrison, got caught going beyond the pale in their pursuit of electoral advantage. It emerged that Morrison had earlier proposed exploiting the popular resentment of Muslims, but had been rebuffed by colleagues insisting the Liberals' long-standing commitment to a non-discriminatory immigration policy remain inviolate.

The minister, Chris Bowen, was widely criticised for his bureaucratic and insensitive treatment of the boy and his relatives. And it seems the episode has prompted Gillard to find the courage to lead.

"People easily fear change. People easily fear difference," she said. "It is the job of national leadership to reassure in the face of that fear, to explain to people that there is ultimately nothing to be afraid of."

What changed? Here's a clue: in their efforts to gratify and exploit public resentment of "illegals", governments of both colours have given the highest priority to preventing individual boat people from telling their stories to the media. They must continue to be seen as monstrous invaders, never as flesh and blood.

Our attitudes towards asylum seekers may be impervious to rational argument, but they're not to rival emotions - particularly the positive emotion of empathy.

Like all nationalities, Australians are neither good nor bad, they're both. Our leaders can play up to our darker side, or appeal to the better angels of our nature.

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The economy is a lion disguised as a lamb

The big divide in economists' views on the outlook for the economy - and hence, for interest rates - is whether they regard the present weakness in consumer spending as worrying or welcome. And that turns on how forward-looking they are.

I suspect it's also affected by what psychologists call "salience" - the tendency for our judgments to be most affected by those events that are highly visible and memorable, those that make the biggest impression on us. Looking at the economy now, what stands out is the weakness of consumer spending, including quite anaemic growth in retail sales. Tourism - whether inbound or domestic - is another area of weakness, badly affected by the high dollar.

So weak is consumer spending that it's putting downward pressure on a lot of retail prices. As Dr Philip Lowe, of the Reserve Bank, pointed out last week, over the past year the Bureau of Statistics' price index for clothing has fallen by 6 per cent (assisted by a fall in import duty on footwear, clothing and textiles at the beginning of last year).

The various indexes have fallen by 4 per cent for major household appliances, 1.5 per cent for furniture and furnishings and by 18 per cent for audio, visual and computing equipment. Indeed, apart from processed food, the prices of very few manufactured goods rose during the past year.

Lowe suspects the weak consumer spending has led to a faster than usual pass-through to retail prices of the substantial appreciation of the dollar, which has lowered the cost of imported goods and services (and also put downward pressure on the prices of locally made goods and services that compete against imports in the domestic market). His suspicions are confirmed by the research of Kieran Davies, of Royal Bank of Scotland, who found the weakness of retail prices was more likely to be the result of pass-through of the higher exchange rate than the compression of retailers' margins.

Davies notes that, unless the dollar appreciates further (not something I'd wish for), the exchange rate's dampening effect on inflation will soon start to wane.

All this spells tough times for the retailers, and their lamentations have had much publicity. So it's easy to see the economy as going through quite a weak patch. This impression will be compounded when we see the way the Queensland floods and cyclone Yasi have taken a bite out of the growth in gross domestic product in the December and, more particularly, March quarters.

Little wonder the financial markets aren't expecting any further increases in the official interest rate until quite late this year, and the governor of the Reserve Bank, Glenn Stevens, thinks rates are "about right for the medium-term outlook". But I think there's a lot more strength behind the economy than all the surface noise would suggest. If I'm right, the rate rises will resume earlier than the markets presently expect.

For a start, the blow from the extreme weather events largely represents the displacement of activity from the March quarter to the June and later quarters. The Reserve is expecting the level of GDP to be no lower by the end of this year than was expected before the floods happened.

For another thing, the weakness in consumer spending is occurring because of a reversion to our earlier saving habits and a (presumably temporary) bout of caution. In other words, consumers aren't short of a bob, they're choosing not to spend.

It's not the sort of thing the media shout about, but household disposable income grew by 6.4 per cent over the year to September in nominal terms. It's being boosted by two major sources of present and future growth: our most favourable terms of trade in 140 years and strong growth in employment. The Reserve's index of commodity prices has risen by almost half over the past year. This doesn't add to GDP directly, but it does add to the nation's real income which, when spent, becomes more visible.

Another less salient factor is the strength of the labour market. Over the year to January, total employment grew by 3 per cent. Within that, full-time employment grew by 3.4 per cent. The unemployment rate is down to 5 per cent, while the rate of participation in the labour force is at a near record high of 65.9 per cent.

This is not the hallmark of a weak economy - quite the reverse. It also gives the lie to the silly talk of a two-speed economy. You may object that the labour market's yet to register the effect of the weak retail sector but, in fact, the various forward indicators suggest employment will continue growing strongly.

And to top off all that there's the least salient factor of all: the looming wall of mining construction spending. Consider this quote from the latest statement on monetary policy: "For some time, the [Reserve] has been expecting very strong growth in resources sector investment.

"The information received over recent months has provided greater confidence in this forecast, with announced plans to date at least as strong as had been expected."

All this is what you see when you lift your eyes from hard-pressed retailers and look at what's in the pipeline. When you do you see that, from a wider perspective, the fact we're not yet adding a consumption boom to a business investment boom is more welcome than worrying.

The economy's potential rate of economic growth is only about 3.25 per cent a year and, with unemployment already down to 5 per cent, we have little spare production capacity.

Even so, the Reserve is forecasting growth of about 4.25 per cent over this year, with growth of 3.75 to 4 per cent in the following years.

Sounds like a recipe for higher interest rates to me.

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Urge to splurge fades as savers born again

The punters, pollies and shock jocks who tell us we're groaning under the weight of the rapidly rising cost of living need to answer a question: if so, how come households are managing to save 10 per cent of their disposable income?

It has drawn remarkably little comment, but the household saving ratio - saving as a proportion of household disposable (that is, after-tax) income - is the highest it has been in more than 20 years.

You wonder why the retailers are doing it so tough? That's why. With wage rates increasing and more people in jobs, household income has been growing quite strongly. But in recent years we've been much less inclined to rush out and spend every cent that comes our way.

That's what saving is: the bit that's left over when you don't spend all your income on consumption. In fact, economists define saving as ''deferred consumption''.

Most of us think of saving as putting money in bank accounts. We've been doing more of that lately, but it's not the main way we save. Historically, the main way Australians have saved is by borrowing a shed-load of money to buy a house, then paying it off over the next 25 years. Your savings are embodied in the proportion of the house that's owned by you rather than the bank - your ''equity'' in the house.

The household saving ratio was at 15 per cent in the early 1980s, but then it fell for more than two decades to reach a low point of minus 2 per cent in the early noughties. We were ''dissaving'' - consuming more than we earnt.

How's that possible? By running down past savings or by borrowing.

Since the mid-noughties, however, the saving ratio has shot up to 10 per cent. You could be forgiven for not knowing this because much of the increase has suddenly appeared as a result of the Bureau of Statistics' revisions to the national accounts.

The bureau doesn't measure saving independently, just takes it as the residual when it compares two huge numbers: for household income and for household consumption. So any errors in measuring those two big numbers will be reflected in the figure for saving, making it volatile and subject to revision as better information comes to hand.

Since 2004 household disposable income has grown strongly, averaging 7.3 per cent a year in nominal terms (that is, before allowing for inflation). Over the same period, household consumption has grown by 5.4 per cent a year.

Dr Philip Lowe, an assistant governor of the Reserve Bank, expressed the figures differently in a speech he gave this week. In quite a few of the years during the decade and a half to 2005, household consumption increased by more than a dollar for every extra dollar of household disposable income received.

Since then, however, only about 65¢ in every extra dollar of income has been spent. (Small prize if you realised this measure is that old Keynesian workhorse, the ''marginal propensity to consume''.)

The evidence that something has changed in our attitude to saving can be seen in other indicators. One example comes from the annual survey of Household, Income and Labour Dynamics in Australia.

In the surveys between 2000 and 2005, there was a clear trend of fewer and fewer households with mortgages reporting they were ahead of schedule in their repayments (a way of saving). But this downtrend slowed in about 2005 and then in 2009 - the most recent year for which results are available - there was a marked increase in the share of people saying they were ahead of schedule.

Similarly, over the past couple of years there has been an increase in the proportion of households who say they pay their credit card balance in full each month. It has gone from about 60 per cent to almost 65 per cent.

Then if you look at the Westpac-Melbourne Institute monthly survey of consumers you find there has been a marked increase in the number of households saying the wisest thing to do with their savings is to pay down debt or build up bank deposits.

Correspondingly, there has been a decline in the perceived attractiveness of more risky investments.

A final bit of evidence comes from the estimates of how much equity households are adding to the housing stock. Until the late 1990s, it was normal for the value of newly constructed homes each year to be significantly greater than the increase in the amount we all owed on our housing.

Why? Because, while the people buying the newly-built homes would usually borrow most of the cost of the home, other, established home owners would be trying to pay back their mortgages as quickly as they could (mainly by keeping their monthly mortgage payments higher than the bank's minimum requirement).

In other words, the proportion of the nation's total amount of housing that wasn't owed to banks would increase each year. Economists call this ''equity injection''.

But during the early part of the noughties this changed and the household sector was withdrawing equity. Now here's the point: in recent years things have changed again and we've returned to the usual pattern of increasing equity.

So what's going on? Why did we stop saving and why have we started again? Over the decade to 2005, there was a large run-up in household debt and a related rise in the (gross) value of household assets such as homes and shares, while our rate of saving declined.

This seems to have been a period of adjustment to the fall in nominal interest rates (caused by our return to low inflation) and financial innovation (banks keener to lend for housing, with new products such as home-equity loans and reverse mortgages).

Lower nominal mortgage rates allowed us to borrow more, which many of us did at much the same time, thus bidding up house prices in the process. Some of us even increased our mortgage to pay for an overseas trip.

But it seems this period of adjustment to new possibilities was largely completed by the mid-noughties and we've gone back to our usual preference for paying off the mortgage as soon as we can.

And then this episode of ''structural adjustment'' seems to have been reinforced by the global financial crisis, which has led some households to rethink their spending and borrowing decisions. Some people are a lot more cautious and a lot less sure that house and share prices can only ever go up.

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