THE ECONOMIC CASE FOR A MORE EQUITABLE AUSTRALIA

October, 2014

I want to talk about the economic case for a more equitable Australia. But before I do I want to enter a major caveat. Why should we seek a more equitable Australia in which income and wealth and opportunity are shared more fairly between the top and the bottom? For no better reason than that it’s the ethical, moral, right thing to do. If it’s the moral thing to do - the thing that Christians and most other religions and humanist ethical codes tell us we should do - we don’t need any supporting arguments. I’ve often heard the ethicist Simon Longstaff say that if you’re ethical in your business practices because you believe it’s good for business, you’re not being ethical at all. Ethics as a profit-making strategy isn’t ethics. One of the things I’ve learnt from my reading of psychology is that it’s always better to do things from intrinsic rather than extrinsic motives. It’s better to do things for their own sake - because you enjoy doing them or believe it’s your duty to do them - than because doing them brings you some sort of external reward - money, power, fame or status.

I’m often sorry when I hear people in noble occupations defending what they do with instrumental arguments. I’d like to hear more vice chancellors say they believe in increasing and spreading knowledge for its own sake, that a rich country like ours can afford to spend a far bit of its wealth on satisfying our insatiable human curiosity, that the better educated people are the more they can get out of life, even if they never put that education to use in the workforce, rather than arguing that investing in education is good for the economy. I’m sorry when I hear people in the arts arguing that the arts create many jobs. When we do this we’re giving in to the hyper-materialism of our age.

But having said that, and as an economic journalist it’s more appropriate for me to make the economic case for greater equity. So it may seem that I’m about to do what I just said other people shouldn’t do: argue that we should be more equitable because this would make the community better off materially. I actually believe that to be true - just as it’s true that spending more on education would make us all better off materially - but actually I’m going to make the mirror image argument: that making Australia more equitable wouldn’t make us worse off.

Why am I mounting such a negative argument? Because there’s a widespread belief among economists and their fellow travellers that making Australia more equitable would leave the community worse off materially, that it would come at the cost of a lower material standard of living overall.

 The longstanding conventional wisdom among mainstream economists is that ‘equity’ is in conflict with ‘efficiency’ - that is, the efficient allocation of resources so as to maximise the community’s material standard of living and foster economic growth. Economists are comfortable with objectives being in conflict because a key part of their expertise is knowing how such conflicts are resolved: by trading off one unit of equity for one for one unit of efficiency (or vice versa) and continuing to do this until you’ve achieved the particular combination of equity and efficiency that gives you maximum satisfaction overall. Once you’ve achieved that ideal trade-off you’ve achieved economic nirvana: equilibrium.

In practice, however, it’s worse than that. Economists specialise in efficiency, but not in equity. Their contribution to society is to explain to the community how to organise the economy in ways that maximise our utility or satisfaction from the production and consumption of goods and services, and how to keep our material standard of living improving every year. If you believe that efficiency and equity are always in conflict, so anything you do to improve equity will always be at the expense of efficiency, but you, as an economist, happen to specialise in efficiency, it’s easy to decide to focus on efficiency and ignore equity. After all, we live in an age of ever-increasing specialisation - which is actually a primary source of productivity improvement and thus our ever-rising material affluence. So you focus on efficiency and growth, and leave equity for others to worry about.

You bolster this decision by observing that, whereas efficiency is objective and measurable, equity is highly subjective; fairness is in the eye of the beholder. So you tell yourself - and anyone who asks - that you stick to the science and leave the value judgments to those more qualified, such as the politicians. (This would be fair enough, were it not for the fact that, in proffering their advice, economists rarely attach product warnings. Though the advertisers of patent medicines warn people to see a doctor ‘if problems persist’, economists don’t warn politicians to check with sociologists or prelates before they act on the economists’ advice.)

The problem is, if it’s not true that efficiency and equity are in conflict - or not always true - then the economists will be failing to advise politicians of cases where equity can be improved without any loss of efficiency - that is, failing to advise the community when there’s a free lunch to be had. And if, because of their lack of interest in equity as an objective, economists fail to draw attention to those cases where improving equity can lead also to improved efficiency, then economists are failing in their own specified role to maximise efficiency and failing to point out cases where we can kill two birds with one stone.

I’m sure there are plenty of cases where equity and efficiency really are in conflict. But I’m equally sure there are many cases - far more than we realise - where they aren’t; that there are delicious free lunches going begging and opportunities to increase efficiency that the efficiency experts themselves haven’t noticed because of this kink in their thinking.

Let’s start by looking at the limited case: where is the evidence that greater equity damages efficiency? The opponents of government intervention have been searching for years for cross-country or other evidence that developed economies with a bigger public sector (and thus a more redistributive tax and transfer system) have inferior records on economic growth. They haven’t found it. Nor have they found evidence that countries with a less unequal distribution of income between households have inferior economic growth. In his book, The Price of Inequality, the Nobel Prize- winning economist Joe Stiglitz observes that various European countries enjoy a standard of living much the same as America’s while doing much more to reduce income inequality than America does. So there’s little evidence we have to accept a highly unequal society to preserve an efficient, growing economy. Studies show the US has surprisingly low social mobility: few people with poor parents go on to have high incomes and, conversely, few people suffer a decline in income between generations. If you can stay rich in America without trying, and stay poor despite trying, it’s hard to believe this won’t lead to a long-term decline in the dynamism of the US economy.

So let’s move on to the evidence for the more positive case: that equity and efficiency can pull together, that reduced inequality can actually enhance efficiency and growth. There’s a growing amount of such evidence. First is what health economists and public health medicos call ‘the social gradient’ or ‘the social determinants of health’. There is much evidence that the health of people with low socio-economic status is much worse than that of people with high socio-economic status. The obvious response to this evidence is to say that measures to improve the health of people on the bottom ought to lead to a very real improvement in their wellbeing. That’s the equity objective. But health, like education, is one of those things that are both a means and an end in themselves, an instrument as well as an objective. The better educated a population is, the more its labour is worth and the richer we can expect it to be. Similarly, the healthier a population is the more able it is to work and the richer we can expect it to be. So the more we do to improve the health of the bottom half, the more efficient the economy should be and the faster it should grow.

Stiglitz cites an IMF study finding that the less unequal a country’s income distribution is, the further apart its recessions are likely to be - that is, the less macroeconomic instability it’s likely to suffer. His book contains much similar evidence and arguments, but I want to refer to the work of one other American Nobel laureate, James Heckman, before I move my argument closer to home. Heckman’s work demonstrates the almost magical power that attending to the early childhood development of at-risk children has in reducing the likelihood of them getting into trouble with the police, dropping out of school, being in and out of employment and in and out of jail. It’s obvious that the success of such a program would do much to improve equality of opportunity, and it’s not hard to see it would also greatly improve the beneficiaries’ contribution to the paid labour force (not to mention the pressure on government spending).

The most obvious case of increasing equity also increasing efficiency is unemployment. We think it’s unfair to have people who want to work unable to find a job, not just because it leaves them with less to spend but also because we know the unemployed are particularly unhappy. Sure. But it’s also glaringly inefficient to have people who’re able to work lying around idle and not contributing to national production. Finding ways to get those people back to work would often make a far greater contribution to efficiency than many of the micro-economic reforms economists hanker after.

Two prominent policies in the last federal campaign are seen as primarily about equity, but nonetheless should bring significant efficiency benefits. The first is the Gonski reforms to school funding, which are intended to increase the assistance able to be given to students suffering one form of disadvantage or another, regardless of which school system they’re in. If this results in more young people gaining a better education, the value of their labour is increased as well as their degree of participation in the labour force. It’s a similar situation with the national disability insurance scheme. It can be expected to increase workforce participation and the acquisition of skills. And where unpaid carers with high skills are able to return to the workforce after being replaced by paid carers with lesser skills there’s obviously some increase in the skills of the workforce. According to the estimates of no less an authority than the Productivity Commission, the disability scheme could be expected to lead to an annual increase in real GDP reaching 1 percentage point by 2050.

Finally, in an issue that’s dear to my heart, there is growing evidence that organising work in the workplace in ways designed to increase the satisfaction workers derive from their work - by making sure you put round pegs in round holes, or having them work in teams, or giving them greater personal autonomy or a say in the way things are run - leads them to make a better contribution to the success of the firm. Since most of us are doomed to spend 40 hours a week working for most of our lives, it amazes me the populous hasn’t long ago insisted that work be made as satisfying as possible. The growing evidence that doing so would also increase efficiency makes it even more amazing.

The case for greater equity in Australia is fundamentally a moral one: we should do it because it’s the right thing to do. But the economic efficiency case for not making Australia more equitable is weaker than many economists assume. There is evidence we can increase equity in ways that don’t reduce efficiency. And if we look for them there are many ways we can reduce inequality and increase efficiency at the same time. Let’s do it.

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Mixed progress on reform of power prices

Do you think you're paying too much for electricity? Would you like to see an end to hefty annual price rises, maybe even a fall in prices that goes beyond the abolition of the carbon tax? Well, be patient. The econocrats are working on it.

It may surprise you that they've been in the process of reforming electricity prices for the best part of 20 years, and they're far from finished. They got part of the power system working well, had a bad slip with another bit, and the jury's still out on a third. But they're working away and are confident of success - eventually.

The national electricity market - covering all of Australia bar Western Australia and the Northern Territory - is actually a creation of our econocrats, their grand experiment in market competition.

Before this, we had separate, state-owned monopolies that charged us pretty much what they wanted to charge, particularly because our demand for power kept growing every year. The reformers' bright idea was to link up all the eastern and southern states and turn them into a market by making all the individual power stations compete to feed electricity into the national grid at the lowest prices possible.

Buying the power at the other end of the grid would be various electricity retailers, which would deal directly with households and business users. These, too, would be required to compete with each other to win our business, since we'd be free to buy our power from whichever retailer we chose.

Linking the power stations in the wholesale market with the retailers supplying power to you and me would be the high-voltage transmission and lower-voltage distribution network (the "poles and wires", as pollies keep calling it).

Since it would never be economic to build rival networks, this would have to stay as a monopoly. And being a monopoly, whether it was sold off or remained government-owned, the prices it charged the retailers - and they passed on to us - would need to be closely regulated to prevent rip-offs.

The reform of the first part of the system has worked really well. Competition between the electricity generators has been cut-throat, prices haven't changed much over the years and no power stations are making excessive profits.

But the cost of generating the electricity makes up only about 30 per cent of the retail prices we pay. The big problem has been that faulty rules have prompted the regulators of the network operators' charges to grant them excessive increases, to the point where "network charges" now explain about half of retail power prices.

It's five years of these big increases, much more than the carbon tax or the renewable energy target, that have caused retail prices to grow so fast. A big part of the problem is that, about four years ago, the demand for electricity, which had been growing every year for a century, stopped growing and started falling.
It fell mainly because of new laws requiring appliances to be more efficient in their use of power and because all the fuss Tony Abbott was making about the price of electricity prompted us to be more price-conscious and look for ways to reduce our usage.

The network operators began investing heavily to improve the capacity of the network to meet the ever-higher peak demand for power on hot summer afternoons when a growing number of us had airconditioners going full blast.

One small problem: the fall in annual demand for electricity meant the brief seasonal peak had stopped rising. For several years the industry refused to believe the downturn in demand from the network was more than a blip.

So we've expanded the capacity of the network beyond what we're likely to need for some time. But you and I are paying extra for this expansion and will continue paying until it's paid off.

The good news is the econocrats have finally woken up to the problem. Actually, they were woken up in 2012 by the fuss Julia Gillard made when she realised Abbott was framing her for price rises she didn't cause.

In 2012 the rules were changed to give the regulators greater power to limit increases in the network charges passed on to retailers. Such changes take far longer than you'd imagine to flow through, but from now on it seems likely the network component of retail electricity bills will stay fairly steady in dollar terms.

The econocrats have proposed a further reform which, when it takes effect, will require the networks to bill retailers according to the time of day and time of year when you and I use electricity. With the spread of "smart meters" - which show the precise times when each household uses its electricity - we'll be charged according to our time of use, with those of us who show restraint during peak periods paying less, and those who don't paying more. This should produce a lasting solution to the (expensive) problem of ever-rising peak demand on hot afternoons.

That leaves the question of the effectiveness of competition between the growing number of electricity retailers, big and small. Here the jury is still out. Much depends on how smart we are in finding the retailer offering the best deal - on which quest I offer some tips in my little online video spiel.

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How the econocrats can lift their game

When we judge the performance of chief executives, most of us know the boss who's good at cutting costs isn't worth as much as the boss who's also able to improve the outfit's products and processes. Well, the same goes for treasurers and finance ministers - and their econocrats.

It seems the fiscal managers are running low on good ideas. But not to worry - the former Treasury and prime ministerial adviser Dr Ric Simes, now of Deloitte Access Economics, had some useful advice to offer in a speech to the Australian Business Economists last week.

Simes argues governments themselves have an important role to play in achieving the improved productivity performance the econocrats keep saying we need. Especially when "productivity" is better thought of as "technological progress" and the figures for measured productivity aren't as important as actual improvements in welfare.

"For those parts of the economy where market forces are paramount, government's main role is to make sure that regulation or its own actions allow competition to unfold without unwarranted intervention," Simes says.

To me, this means econocrats should urge their masters to tread carefully when powerful business interests, fighting to shore up a technologically superseded business model, demand that governments make breaches of government-granted copyright a hanging offence.

As Simes says, digital technologies have lower entry barriers and are forcing businesses to be both more productive and more responsive to consumers. So don't help incumbents resist change.

But, he says, the potential for technology to make some of the largest improvements in Australian lives lies in government-heavy sectors including health, education and transport. In these areas, progress has been too gradual.

"The exemplar is probably electronic health records, which have been the focus of considerable effort for perhaps 15 years now, but where we still seem to be a long way off the goal of having them routinely used throughout the health system.

"Or, take even an example where we have done well, the SCATS - Sydney Co-ordinated Adaptive Traffic System - for control of traffic lights. SCATS was originally developed 40 years ago, it has been constantly refined since then and is now in use in 27 countries.

"So, a success story - yet, as a Sydney driver, I know my welfare would be improved with a more refined SCATS system. It's coming - NICTA [the National Information Communications Technology Research Centre of Excellence] and others are working on optical-based monitoring and improved optimisation algorithms - but more support for both the research and especially its deployment would lift my welfare!"

Simes notes that in both cases, electronic health records and SCATS, the strict efficiency improvements from the technology - the bit that would help government budgets - represent a relatively small part of the overall benefits to the community.

"Especially in health and education, many of the benefits will involve improvements in the quality and range of services rather than efficiency gains," he says.

"Making the most effective use of digital technologies in health and education - as well as other areas where government has a direct role, such as smart technologies in transport and utilities - will deliver much larger economic and social benefits than where we seem to like to focus much of our policy attention, such as whether we should get the budget back into balance by 2017 or 2019."

Another potentially major area of micro-economic reform, Simes says, is how we organise our cities. Up to 80 per cent of Australia's output and employment occurs within its major cities. This has happened in the pursuit of economies of agglomeration.

"Yet we know that the problems are mounting. Congestion, compromised open spaces, the loss of amenity all risk detracting more and more from those benefits."

As with digital, many of the benefits from fixing these problems would not show up in our standard measures of welfare derived from the national accounts.

"Ten minutes less travelling time to work, or to school, doesn't have direct effects on gross domestic product. A more vibrant space around the harbour, or convenient shopping centre in the 'burbs, doesn't get picked up. But social welfare is clearly affected," he says.

Taking Sydney as an example, if commuter travel times on its roads were reduced by five minutes per trip, the benefits would amount to $3.6 billion a year, if an individual's time is valued at average weekly earnings.

To this you could add savings for freight or commercial vehicles. And savings for going to the shops, or school, or to the beach.

Echoing the patron saint of treasurers, Simes wants to lift our gaze to "the big picture".

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Digital revolution transforms productivity debate

A second former econocrat has joined former secretary of the Prime Minister's department Dr Mike Keating in seeking to lift the tone of the economic debate.

"We are spending too much effort debating how and how quickly we should bring the Commonwealth budget back into balance," Dr Ric Simes said in a speech to the Australian Business Economists this week.

"We need to elevate the economic debate from the level of catchcries about debt and deficits, or about productivity or even about the use of cost-benefit analyses. We need some deeper analyses being brought to the surface."

Simes, now a director of Deloitte Access Economics, formerly of Treasury and economic adviser to Paul Keating as prime minister, wants to see a more sensible discussion about productivity.
Productivity is obviously important and policy should indeed be focused on lifting it.

"But we do need to be careful about what this may mean in a particular circumstance," he said. One problem is that productivity is being used as a catchcry for myriad causes, often unjustifiably.

Simes agreed with Mike Keating's trenchant observation that "business associations, some leading employers and their camp followers in the media are insisting that future reforms must focus on alleged labour market rigidities and reductions in taxation, as if these were the most important influences on productivity".

And while "there is scope for improved labour relations to make a modest contribution to improved productivity ... the main responsibility for improvements in that regard lie with employers themselves," Keating has written.

"The best thing that employers and their trade associations could do is to stop passing the buck to everyone else for their own failings, and get on with making their workplaces more productive using the existing freedoms that they undoubtedly have," Keating concludes.

Simes adds that this is exactly what most businesses try to do. For his evidence, keep reading.

Simes' second problem with how "productivity" is being used in the debate concerns its measurement. "Productivity is simply a less than perfect measure of economic wellbeing, and having the public debate focus so much on what the Bureau of Statistics reports as productivity can be unhelpful."

Indeed, Professor John Quiggin, of the University of Queensland, had called productivity an "unhelpful concept", mainly because of problems with the way the contributions of labour and capital were measured in its calculation.

Simes agreed with Quiggin that we'd be better off using a term that was closely related to productivity, "technological progress" - that is, the introduction of technological innovations such as new products and improved production technologies.

Rhetoric - the choice of terms - did matter, Simes said, and had we been using the term technological progress instead of productivity, the debate wouldn't have been so open to distortion by vested interests.

"Tax, or industrial relations, or fiscal policy, can and should be refined, but they are not at the heart of why measured productivity weakened after 2000," he said.

But the measurement problem went further. "I think we have a fundamental problem in that our measures of gross domestic product or productivity are becoming less reliable proxies for economic welfare."

If instead of looking at productivity statistics we stand back and look at the way societies and businesses are changing, we find some profound changes under way, particularly the digital revolution.

We see consumers forcing retailers and media companies to transform. His own research had found that, without telework, only 14 per cent of new mums said they would return to work with their old employer, but 61 per cent said they would if telework was available.

His research had found how companies' information technology policies on staff use of social media at work and BYOD - bring your own device - were of growing importance in attracting young and talented employees.

He'd found that businesses able to create a "collaborative" working culture - including through use of digital technologies - succeeded in growing faster than otherwise.

What has this to do with productivity? First, most of the change we were seeing was being driven by individuals, whether they be consumers, workers, students or patients. To a trained economist, this should suggest that economic welfare had probably risen - and risen a lot.

It was hard not to conclude that individuals making deliberate decisions to do something new were adding to their own welfare, and to society's.

But, second, if this isn't showing up in our measures of welfare - such as GDP or productivity - then maybe there was something wrong with those measures. It seemed to Simes that "productivity, as measured, misses many, if not most, of the gains to consumer and social welfare that digital technology is delivering".

It didn't capture the benefits from improved convenience when we no longer had to queue for ages to renew a licence or at our bank branch. Nor the convenience of being able to search for a needed service in a fraction of the time it took before the internet.

It didn't capture the benefits of much greater choice. The Amazon books site, for instance, took costs out of the supply chain (thus reducing prices to consumers) but also provided much greater choice of books in a convenient manner.

Studies by Erik Brynjolfsson and others at the Massachusetts Institute of Technology had estimated that the easy access to a greater choice of books generated seven to 10 times the consumer welfare that the more efficient supply chain generated (the only bit that would make it into measured productivity).

He wasn't saying we should include the benefits of convenience and choice in our measurement of GDP - that wouldn't work.

No. "What I am arguing is that we need to be careful to base policy decisions on a deeper understanding of our objectives and not be driven by simplistic rhetoric," he said.

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Why almost all of us are 'out of touch'

When politicians say things such as that the poor don't buy petrol, it's easy to accuse them of being "out of touch". Actually, all politicians face that accusation before they're through. It's one of our favourite things to say about pollies we disapprove of.

But let's turn it around: exactly how in touch are you and I? Much less than we imagine.

We know a lot about our own circumstances and those of our friends and neighbours, but are surprisingly deficient in our understanding of people outside our circle.

And one of our greatest deficiencies is our inability to see ourselves as others see us, to place ourselves on the spectrum. Take the question of income.

In 1999, researchers at the University of NSW conducted a survey asking people to nominate their family's gross income and then to say where they believed that income placed them in the distribution of all families' income.

The results showed that more than 93 per cent of respondents believed their income to be in the middle 60 per cent of the distribution.

Most of us like to imagine we're middle-income earners. Ask us where we fit and almost no one admits to being either rich or poor (unless they're accused of not using much petrol).

A survey conducted this year for the Australia Institute, found a similar result but put it a different way: nearly all Australians think the average income is the same as their own income.

Of those respondents reporting their own annual household income to be between $20,000 and $40,000, 58 per cent believed the average income of all households lay within that range.

For those on $40,000 to $60,000, 71 per cent thought this was average. For $60,000 to $80,000 it was 61 per cent, for $80,000 to $100,000 it was 55 per cent, and for $100,000 to $150,000 it was 51 per cent.

Even for those on more than $150,000 a year, a third of them thought that was average. According to the Australian Bureau of Statistics, the average household income in Australia is $80,700.

But how could so many of us be so out of touch? How could we be so unaware of how the other half lives and which half we fit into?

I'm sure there are various reasons, but one of the big ones is something that's been going on for years without most of us noticing. Our cities are becoming more socially stratified, with the better-off congregating down one end and the less well-off down the other.

These days, you're less and less likely to find suburbs with a cross-section of high and low income-earners, or highly and lowly educated people.

So we don't know how the other half lives because they are in the other half - the half we live far away from and rarely visit or even drive past. Pretty much all our family, friends and workmates are in the same half we're in.

A study conducted last year by Jane-Frances Kelly and Peter Mares, of the Grattan Institute, Productive Cities, looked at maps of who lives where in Australia's largest cities and tracked how this had changed in the 20 years between 1991 and 2011.

The authors found that the residents of our four biggest cities have enjoyed rising incomes and have become much better qualified. At the same time, however, our cities had become more polarised.

"Increasingly, high-income residents with university-level qualifications cluster in suburbs close to city centres, while residents on lower incomes, and residents with vocational [trade certificate and diploma] qualifications, are more likely to live around the city fringes," they say.

"In each city, it is also possible to identify particular areas of disadvantage, where a high proportion of residents have no formal qualifications beyond secondary school, where labour market participation is low and where a high proportion of young people are 'disconnected' - that is, neither working nor engaged in education or training."

In Sydney and Melbourne, individuals on higher incomes are clustered in inner suburbs and suburbs with desirable natural attributes such as beaches, trees and hills.

In Sydney, the highest median incomes are found in inner, northern and harbourside and beachside suburbs, while the lowest median incomes are concentrated in western and south-western suburbs more distant from the CBD.

In Melbourne, the highest median incomes are found in inner, eastern and bayside suburbs, while the lowest median incomes are concentrated in more distant western, northern and south-eastern suburbs.

A map also shows a clear pattern in house prices. "The premium placed on proximity to the city centre is evident in steep house-price gradients in Sydney, Melbourne, Brisbane and Perth," they say.

Research by the Reserve Bank shows that, if you rank house prices for any of those cities according to their distance from the central business district, you get an almost perfect curve that (using figures from 2010) starts well above $1 million in Melbourne and Sydney and then declines steadily to about $300,000 when you're more than 60 kilometres from the centre.

This relationship between proximity and house prices has strengthened in recent decades, with average annual growth in house prices about 2 per cent higher in inner suburbs within five kilometres of the centre than on city fringes.

Those people out in the boondocks have no idea how much we struggle with our mortgages - and we have no idea that they have problems too. Price of petrol, for starters.

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Mining boom makes little sense

Conventional economic analysis assumes the behaviour of businesses is always rational but, in reality, the booms and busts that cause the ups and downs of the business cycle are driven by emotion more than rational calculation: unwarranted optimism, greed, impatience, short-sightedness and herd behaviour. Consider our resources boom.

The ideology of economic rationalism says private enterprise can do no wrong; ill-advised behaviour by business arises only through its rational response to distorted incentives created by the misguided interventions of governments.

This confers on the demands made by business a sanctity the captains of industry are quick to exploit. But their demands often aren't in the community's wider interest.

Now we're emerging from the decade-long resources boom it's easier to view the process with greater insight and make a more sober assessment of its costs and benefits.

What happened was a huge jump in the world prices of coal and iron ore as China's period of rapid economic development of heavy industry and infrastructure caused global demand to outstrip global supply.

The surge in China's demand caught the world's mining industry unprepared.

Like miners in other countries, our largely foreign-owned miners lapped up the huge increase in prices and profits.

But it didn't take long for greed ("the profit motive", if you prefer) and the irrational optimism that drives the world's entrepreneurs to take over, with companies seeking to exploit the high prices to the full by expanding their production capacity as much as possible as fast as possible.

What then kicked off was a multibillion-dollar race - between rival companies in a country, but also with the many companies in other countries, all expanding their capacity as fast as they could.

It takes a long time to build new mines and bring them into production. So the chances of your mine being completed in time to enjoy the super-high prices aren't great - the more so because it's essentially a self-defeating process: the more companies join the race and the harder they try to be among the first to complete, the sooner supply catches up with demand and prices start falling.

If mining companies were more rational, fewer would join the race. But companies are just as subject to herd behaviour as investors in a booming sharemarket. A mining chief who didn't join the comp would be subject to heavy criticism.

This is where the irrational optimism comes in. Each individual entrepreneur is in no doubt he'll be among the race's winners. We're gonna make a motza.

But while the miners are busy gearing up, their foreign customers are just as likely to be coming towards the end of their own boom in investment and construction. The inevitable result is that the global mining industry moves from a starting point of undercapacity to an end point of overcapacity.

This is the eternal story of mining. Only in passing is it ever in equilibrium; it's almost always in either under or oversupply - probably spending a lot more time over than under, the less profitable of the two conditions.

Now, this cycle isn't news to conventional economics, with its familiar "cobweb theorem" and "hog cycle" seeking to explain the phenomenon. But these models put too much of the blame on the unavoidable delays in increasing production, and too little on animal spirits.

And they don't prepare us for all the waste and inefficiency involved in a resources boom. In the miners' race to be first in and best dressed they compete furiously for resources, bidding up hugely the prices of labour, equipment and materials, and ending up with mines that cost them far too much to build.

They also develop lower-grade mineral deposits, the exploitation of which becomes uneconomic as soon as the world price drops back from its record heights.

In the aftermath of the boom, many acquisitions are written off, the chief executives who presided over these excesses get the chop and are replaced by bosses whose main skill is cost-cutting. They make speeches about how excessive Australian wages are.

Anyone who has followed the fortunes of our big three - BHP Billiton, Rio Tinto and Glencore Xstrata - will know just what I'm talking about.

In their race-driven frenzy to start new projects, the miners always portray themselves as impatient for God's will to prevail, with any politicians or community members who have doubts about allowing them to rip up the environment denounced as agents of the anti-progress devil.

In the aftermath of such booms we realise we should have refused to be rushed. Why does no economist ever warn us to be less short-sighted? Their faulty model.

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Many reasons for the impossible: power demand falling

We know the two great certainties in life are death and taxes, but many thought there was a third: the inexorable rise in consumption of electricity. As the population grew and each of us got a little more prosperous each year, we'd use more power. The mighty electricity industry was built on that certainty.

Except that electricity consumption has been falling for the past four years. To say this has taken the industry by surprise is an understatement. For well over a century – even during the Great Depression – the quantity of electricity used in Australia each year was greater than the year before.

It took the industry and its regulators two or three years to accept the trend was more than just a hiccup on the ever-upward path, which delay probably added to the decline.

There are few aspects of the economy – global or national – where change is more significant, more diverse or more interesting than energy supply and demand – where energy covers coal, gas (conventional and unconventional), petroleum, wind, solar and other renewables. Expect to hear more from me on the topic.

But there are few questions more interesting than exactly why the unthinkable, a fall in electricity consumption, has come about. Short answer: a surprisingly large combination of reasons, although Tony Abbott's crusading against the carbon tax must get some of the credit.

The best attempt to quantify the various factors involved comes from a report prepared by Dr Hugh Saddler, an energy expert with the Pitt and Sherry consultancy, for the Australia Institute. Saddler's modelling covers the years to 2012-13, but we know from reporting this week by Origin Energy and AGL that the fall continued in 2013-14.

Saddler focuses on energy produced and consumed from the National Energy Market, which covers the five eastern states and the ACT, but the decline is occurring also in Western Australia. After peaking in 2008-09, consumption from the national market in 2012-13 was down by almost 8 terawatt hours, or 4.3 per cent.

But that's only half the story. Just as important as why demand has fallen is why it hasn't continued growing, as continued growth in the population and the economy would lead us to expect. Saddler estimates that had demand continued growing from 2004 at its average rate of growth over the previous 20 years (2.5 per cent a year) it would have been 37 terawatt hours more than it actually was in 2012-13.

This shortfall is equal to the output of almost 5000 megawatts of coal-fired generation capacity, the combined capacity of the Bayswater and Eraring power stations in NSW, or Loy Yang A and B and Hazelwood in Victoria.

"All of the decline in consumption has been at the expense of coal-fired generators, with the result that many are now barely profitable," Saddler says.

Greenhouse gas emissions fell by 9.2 megatonnes of carbon dioxide equivalent, about 2 per cent of Australians total annual emissions.

So what has caused our power consumption to fall rather than rise? The biggest single reason is the introduction from the late 1990s of regulations to increase the energy efficiency of refrigerators, freezers and many other residential and commercial appliances, and to increase the energy efficiency of new buildings.

Saddler estimates this explains 37 per cent of the 37 terawatt-hour shortfall from what might have been.

The next biggest part of the explanation is structural change in the economy away from electricity-intensive industries. Over the year to September 2012, three major NSW industrial power users – Port Kembla steelworks, Kurri Kurri aluminium smelter and the Clyde oil refinery – were partly or completely shut down. This explains 10 per cent of the 37 terawatt-hour shortfall.

The evidence also suggests that power consumption by other major industrial users has been little changed over the three years to 2012-13. Saddler estimates that this failure to grow explains a further 14 per cent of the shortfall, taking the total contribution from structural change to almost a quarter.

The next most important part of the explanation is the response of electricity users, particularly residential users, to the higher prices they were being charged. Saddler finds that after 2010 there was "an abrupt change in consumer responsiveness to higher prices".

This was the time when the possible effect of a carbon tax on electricity became a major political issue thanks to the efforts of Abbott and his "sceptic" mates. At the time, retail electricity prices were rising spectacularly, mainly because of a huge increase in spending on upgrading the transmission and distribution networks (poles and wires) to cope with an expected ever-rising peak demand on hot summer afternoons.

Saddler finds evidence to support his argument that all this carbon-tax-related fuss about the high cost of electricity caused many households to be a lot more conscious of what was happening to their power bills and to respond by finding ways to cut their usage – to the extent that they "have managed to completely offset the effect of higher prices on their household budgets by reducing consumption".

This highly unusual jump in the short-run "price elasticity" of electricity explains 19 per cent of the shortfall, he estimates.

He further calculates that the growth in output from rooftop photovoltaic solar and other small, distributed generators accounts for about 13 per cent of the shortfall. This, of course, is a fall in the demand for electricity supplied by the major, mainly coal-fired generators, not a fall in the use of electricity as such.

Saddler notes that for the past three years the annual peak demand has been falling, not increasing, despite the huge investment to cope with ever-rising peaks. When will this additional capacity, which is now built and for which all electricity consumers are paying – and will continue to pay for some years to come – be required, if ever, he asks.

Good question.

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CARING ABOUT FAIRNESS

Talk to Legal Aid Conference, Sydney, Friday, August 22, 2014

I’m trying to give fewer speeches these days, and I knock back far more invitations than I accept, but I agreed to talk to you today mainly because I felt I ought to thank you. Thank you for the work you’re doing, for the contribution you make in ensuring that people are informed about their rights and responsibilities under the law and are adequately represented before the courts.

All of us are entitled to equal treatment under the law regardless of our means, but you don’t need me to tell you that, in a market economy such as ours, legal expertise is expensive, thus producing a big disparity between theory and practice in the dispensation of justice. Legal aid seeks to reduce that contradiction, but the inadequacy of its financing leaves many practitioners feeling they need to make a personal contribution.

I hope and expect the work you do brings you a lot of satisfaction - a lot of psychic income, as economists sometimes say - but, even so, I know that whether you’re working pro bono, whether you’re paid some quite inadequate government fee or whether you’re a full time government employee, all of you are making an actual-money sacrifice. The opportunity cost of your contribution is high.

The role of legal aid lawyers came into my mind when I was thinking about the wider implications of the Abbott government’s proposed changes to university funding. If the deregulation of fees led to very much higher fees for law students - as it almost certainly would - new graduates would be highly conscious of the huge debt they owed. And, assuming the plan to charge a ‘real’ interest rate on the debt goes ahead, highly conscious of the way the debt was being added to for as long it took to pay it off. The risk is this could make them a lot more mercenary in their choice of a career, more inclined to seek a high-paying job rather than a possibly more satisfying but less well paid job at a community law centre or in legal aid. It would be a similar story in medicine, with more young graduates anxious to get into high-paying specialties and fewer interested in the slog of general practice. Would this be a good thing? It would certainly be an ‘unintended consequence’.

Since we’re on the subject, and I’m sure it’s a topic of interest to most of you, let me use the rest of my time to examine it. Many people oppose the government’s proposed changes as ‘unfair’, but I think in this case the question of what’s fair and what’s not is much harder to determine that than.

When the Hawke-Keating government reintroduced uni fees - HECS, the higher education contribution scheme - the rationale was that, even though there is a public benefit from having a better educated, more highly skilled workforce, graduates gain a considerable private benefit from the acquisition of a degree - one worth, on average, a total of maybe three-quarters to a million dollars in higher salary over their working life. That being so, it was fair to other, non-graduate taxpayers to ask graduates to make a significant contribution towards the cost of their education. They’d still be way ahead on the deal.

The one big worry was that making graduates contribute to the cost of their education, and acquire a debt to the government, might deter bright young people from poor families from seeking to advance themselves. Professor Bruce Chapman, of the ANU, sought to overcome this problem by inventing the ‘income-contingent loan’, where the government effectively lends students their tuition fees, but students don’t have to begin repaying their loan until their income reaches a certain threshold. From that point, the tax office imposes a repayment of a certain small proportion of their income, with the proportion rising as their salary rises. Once a year the balance outstanding is indexed by the inflation rate. To an economist, this means the loan is subject to a real interest of zero. Because this interest rate is so concessional, and because repayments are geared to the debtor’s ability to pay and the level of repayments is never onerous, the fact that a student came from poor family shouldn’t deter them from going to uni. In Chapman’s mind, HECS is an equity (fairness) measure, intended to give students from poor families equal opportunity to go to uni.

The Howard government increased these fees some years later and also introduced three categories of fees, high, medium and low. This new fee structure was a hybrid one, based partly on recovering the cost of providing the degree and party on the amount of income a holder of that particular degree was likely to earn. The medicos went into the top category because medical education is expensive to provide. Law degrees are reasonably cheap to provide - no laboratories - but they also went into the most expensive fee category on the basis that lawyers earnt a lot of money. You probably know that; I mention it because, if the deregulation of uni fees leads to much higher fees for law degrees, it wouldn’t be hard for law students to be charged fees well in excess of their degree’s actual cost of provision. Would this be fair?

To analyse the fairness of the Abbott government’s proposed changes, we need to distinguish between the changes to the HECS loan-repayment scheme and the deregulation of fees. The main change on the HECS side is the plan to impose a real interest rate, based on the long-term government bond rate. Here Chapman has done some modelling which leads him to conclude the change would make HECS quite unfair, in that graduates who go into lower-paying occupations would end up paying much more interest than those who go into higher-paying occupations, simply because it took the less-well-paid much longer to pay off their debt. This would also apply to graduates whose full-time career was interrupted by childcare responsibilities or overseas travel. And it would apply particularly to students who spent a few years at uni before giving up and taking a non-graduate job. Of course, those graduates who went on to a high starting salary with quick progression to higher salaries - such as lawyers, doctors and others - wouldn’t be greatly burdened by the real interest rate because they’d pay back their loan so much quicker.

Even so, there seems little doubt the plan to impose a real interest rate on HECS would be significantly unfair. But judging whether fee deregulation would be unfair is trickier. Indeed, you could argue that requiring those who aspire to be among the highest income-earners - the great majority of whom come already from reasonably privileged homes - to pay a higher proportion of the cost of the education that makes this possible would make the system fairer rather than less fair.

No, my reservations about fee deregulation don’t arise from a concern about ‘fairness’ in the conventional, distribution-of-income sense. For many years federal governments have been involved in a process of back-door privatisation of our universities. It’s clear the motive for this is primarily financial: to reduce tertiary education’s call on the federal budget. Before the process started, unis relied on the federal government for about 80 per cent of their funding. Today’s it’s down to about 40 per cent. The primary motive of fee deregulation is to create greater scope to continue this process, maybe eventually getting the unis off the books completely.

It’s significant that the decision to allow unis to set their own fees comes with a cut in federal per-student grants to the universities averaging 20 per cent. I have no doubt that, should fee deregulation go as planned, the government’s intention is to further cut its per-student grants. It probably also intends to push more of the burden of funding university research back on to the unis themselves and, through them, on to students via ever-higher fees. This seems clear from the government’s rhetoric linking fee deregulation with raising the international ranking of our top unis.

When I say successive governments have been quietly privatising our unis, I don’t mean they’d like eventually to see them as privately owned businesses. But it’s clear the goal is to make them non-government, non-profit organisations competing with each other in a tertiary education market. Unis are to be the next be step in the ‘marketisation’ of Australian life. Canberra’s primary motivation is to free its budget of the burden of the unis, but this motive is bolstered by its ideological conviction that the discipline of the market would drive out all the inefficiency in universities that every academic complains of, and leave us all much better off.

But this is where I hae me doots. Economists love markets, and most economic rationalists think the more aspects of our lives that are subject to the discipline of market forces, the better off we are. It is, of course, a more materialist approach to life, where we think more about money and self-interest and less about our contribution to the good of society and the wellbeing of others, where we’re more individualistic and less communitarian, where young lawyers are more likely to go for the big bucks and less likely to do a sappy thing like getting involved in legal aid. I don’t like the sound of it.

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Abbott's economic script is out of date

It doesn't seem yet to have dawned on Tony Abbott that he was elected because he wasn't Julia Gillard or Kevin Rudd, not because voters thought it was time we made a lurch to the Right.

The man who imagines he has a "mandate" to mistreat the children of boat people, ensure free speech for bigots, give top appointments to big business mates and reintroduce knights and dames, represented himself as a harmless populist before the election.

The other thing he doesn't seem to have realised is that just as he has us moving to reduce our commitment to action against climate change and to make the budget much less fair, the rest of the advanced economies are moving the opposite way.

President Obama is taking steps to overcome Congress's refusal to act on global warming, the Chinese get more concerned about it as each month passes and the International Monetary Fund is chastising us for our apostasy.

And while we use our budget to widen the gap between rich and poor, people in other countries are realising the need to narrow it.

Wayne Swan, former Labor treasurer, noted in a speech on Monday that "centre-right political leaders across the globe are acknowledging the obvious truth that capitalism is facing an existential challenge ... only last week ratings agency Standard and Poor's emphasised yet again that high inequality is a drag on growth".

In Australia, however, an increasing "vocal minority has decided to oppose any reform, no matter how necessary and no matter how obvious in its benefits to the whole nation, if they perceive it is in their short-term interests to do so".

"This is a recipe for unnecessary political division and widening social inequality, and unfortunately permanent reform failure," he says.

Australians had done much better than the Americans at matching strong economic growth with social equity but, according to Swan, "we're witnessing the Americanisation of the Right in this country. Obsessed with defending the advantages of the wealthiest in our society".

In his efforts to defend rather than correct his first budget's unfairness, Joe Hockey seems to be doing just that. Meanwhile, the messages from international authorities are very different.

In a recent paper on policy challenges for the next 50 years, the Organisation for Economic Co-operation and Development warned the growing importance of skill-biased technological progress and the rising demand for skills, will continue to widen the gap between high and low wages.

Unless this was corrected by greater redistribution of income, other OECD countries would end up facing almost the same level of inequality as seen in the US today. "Rising inequalities may backlash on growth, notably if they reduce economic opportunities available to low-income talented individuals," it warns.

Christine Lagarde, managing director of the International Monetary Fund, noted in a speech that the 85 richest people in the world control as much wealth as the poorest half of the global population - 3.5 billion people.

"With facts like these, it is no wonder that rising inequality has risen to the top of the agenda - not only among groups normally focused on social justice, but also increasingly among politicians, central bankers and business leaders," she said.

"Many would argue, however, that we should ultimately care about equality of opportunity, not equality of outcome." As it happens, Hockey has defended his budget's unfairness with just that argument.

"The problem is that opportunities are not equal. Money will always buy better-quality education and health care, for example. But due to current levels of inequality, too many people in too many countries have only the most basic access to these services, if at all. The evidence also shows that social mobility is more stunted in less equal societies."

Disparity also brings division. "The principles of solidarity and reciprocity that bind societies together are more likely to erode in excessively unequal societies. History also teaches us that democracy begins to fray at the edges once political battles separate the haves against the have-nots."

Pope Francis put this in stark terms when he called increasing inequality "the root of social evil".

"It is therefore not surprising that IMF research - which looked at 173 countries over the past 50 years - found that more unequal countries tend to have lower and less durable economic growth," Legarde said.

Get that? Until now, the conventional wisdom among economists has been that efforts to reduce inequality come at the expense of economic growth. Now a pillar of economic orthodoxy, the IMF, has found it works the other way round: rising inequality seems to lead to slower growth.

Lagarde said other IMF research had found that, in general, budgetary policies had a good record of reducing social disparities. Social security benefits and income taxes "have been able to reduce inequality by about a third, on average, among the advanced economies".

What can we do? "Some potentially beneficial options can include making income tax systems more progressive without being excessive; making greater use of property taxes; expanding access to education and health; and relying more on active labour market programs and in-work social benefits."

Perhaps in his efforts to get a modified version of his budget passed by the Senate, Hockey could bring in the IMF as consultants.

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Stop wasting money on infrastructure

Don't laugh too hard at the ABC's new satire, Utopia, and the wasteful and appearances-driven antics Rob Sitch gets up to as head of the Nation Building Authority. It's too close to the truth to be funny.

One of the foremost areas where governments need to lift the efficiency of their spending - as opposed to cutting payments to the needy or short-sighted cost-shifting - is infrastructure. It has become an area where too much spending is never enough and anything labelled "infrastructure" is above critical scrutiny.

In recent days, however, we've been given cause to cast a more sceptical eye over spending on capital works. Consider first the views of a highly experienced former econocrat, Dr Mike Keating: "Australia has a long history of over-investment in infrastructure, with the costs exceeding the benefits, and under-charging the beneficiaries so that they demand more and more.

"It is therefore most reprehensible that this budget prides itself that new spending decisions will add $58 billion to total infrastructure investment, when none of the projects announced have been ticked off by Infrastructure Australia as having completed proper cost-benefit appraisals, probably because a great deal of this investment never could pass any proper evaluation.

"And this from a government that was properly critical of the former government and its approach to the national broadband network. Clearly this improper use of the nation's savings is not an acceptable reason for the other budget cuts, and the increase in petrol excise should not be tied to an increase in uneconomic road funding."

Yes, indeed. It's disillusioning behaviour from Tony Abbott, who promised "rigorous, published, cost-benefit analysis" of infrastructure projects.

Last week, Garry Bowditch, chief executive of the University of Wollongong's SMART infrastructure facility, offered a sobering assessment of capital works spending, noting that cost overruns have reached between $4 billion and $5 billion a year.

Value for money is thrown out the window, he said, when governments fail to time the construction of infrastructure to make sure they're not inflating the prices of labour, materials and equipment by competing with the private sector during booms.

Adjusted for inflation, Brisbane's Gateway Bridge, built in 1986, cost about $300 million. But when a second, identical bridge was built in 2010, during the mining construction boom, it cost $1.7 billion.

Bowditch, a former econocrat, called on governments to release cost-benefit analyses for Sydney's proposed $11.5 billion WestConnex motorway and Melbourne's $8 billion East West Link tunnel.

He argued that poor long-term planning by federal and state governments, which don't communicate well with each other, had led to unnecessary costly construction methods, such as tunnels, because land corridors had not been reserved for rail and road development.

Sir John Armitt, former chairman of Britain's Olympic Delivery Authority, said we should be using technology to improve the capacity of existing rail, road and energy networks, and to prepare for driverless cars.

Good point. Politicians love cutting ribbons and announcing grand, nation-building projects. But they'd waste less taxpayers' money if they got the pricing of existing infrastructure right first, and so had a more realistic estimate of the demand for additional infrastructure. It's called efficiency.

The credibility of economic modelling by allegedly independent consultants is surely shrinking before our eyes. Not long ago we were treated to the spectacle of two leading firms of economic consultants producing diametrically opposed modelling of the cost of the renewable energy target. Why? Surely not because they were commissioned by outfits with rival axes to grind?

Last week we learnt that AMP, whose funds lost a lot of dough after the failure of the outfit owning Sydney's Lane Cove Tunnel in 2007, is suing the consultants who provided excessive forecasts of the likely traffic flows, accusing them of producing figures that were "reverse engineered" by working backward from their client's commercial objective. Surely not.

One reason it would be good to see cost-benefit analyses of the aforementioned infrastructure projects adopted by the Coalition is to test the efficiency of Abbott's insistence that he'll finance roads but not public transport.

So far the NSW and Victorian governments have done a hopeless job of limiting congestion. Since building extra motorways adds to demand rather than reducing delays, my guess is neglect of public transport is the culprit.

But the Grattan Institute's report on cities as engines of prosperity reminds us that the longer it takes people to move between home and job, the harder it is to fully exploit the "knowledge spillovers" that drive the knowledge economy. Didn't you guys say you were worried about slow productivity improvement?

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