How our penchant for magic numbers gets us into trouble

A lot of the problems we cause ourselves – whether as individuals or as a community – arise from the way we've evolved to economise on thinking time by taking mental shortcuts.

We are a thinking animal, but there are two problems. First, we have to make so many thousands of decisions in the course of a day – most of them trivial, such as whether to take another sip of coffee – that there simply isn't enough time to think about more than a few of them.

Second, using our brains to think requires energy, in the form of glucose. But glucose is not in infinite supply. So we've evolved to save energy by minimising the thinking we do.

As Daniel Kahneman​ – an Israeli-American psychologist who won the Nobel prize in economics for his work with the late Amos Tversky​ on decision-making – explains in his bestselling Thinking, Fast and Slow, our brains solve these two problems by making all but the biggest, non-urgent decisions unconsciously.

This is Thinking Fast. We don't think about taking another sip of coffee, we just notice ourselves reaching for the cup.

But even when we are Thinking Slow, carefully considering a big decision – such as which house to buy, or whether to marry the person we've been seeing – we still have a tendency to save glucose by relying on what Kahneman and Tversky dubbed "heuristics" – mental shortcuts.

They stressed that our use of such shortcuts is, in general, a good thing. We fall into the habit of jumping to certain conclusions because, most of the time, they give us the right answer while saving brain fuel.

But they don't give us the right answer in every circumstance, and it's the classes of cases where they lead us astray that are most interesting and worth knowing about.

Kahneman and Tversky kicked off a small industry of psychologists thinking up different potentially misleading mental shortcuts and giving them fancy names.

I have a couple of my own I'd like to add to the list.

I call the first one "box labelling" – saving thinking time by consigning things or people to boxes with particular labels.

For example: "I regularly vote Labor/Liberal, therefore I don't have to think about the rights and wrongs of all the policy issues the pollies argue over, but can get my opinion just by checking which side my party's on."

You can see how common this is if you look those media opinion polls that show you how many people support or oppose a particular policy – say, curbing negative gearing – then show you who those people would vote for in an election.

Much more often than not, people take their lead on an issue from the position their favoured party takes.

You also see it by watching what happens to the index of consumer confidence when there's a change of government. Almost all those who voted for the losing party switch from optimism to pessimism, while those who voted for the winner switch from pessimist to optimist.

My second mental shortcut is "magic numbers". Experts develop and carefully calculate some economic or financial indicator, based on various assumptions.

The indicator measures changes in something we know is important, so we get used to watching it closely for an indication of how things are going.

Trouble is, we end up putting too much reliance on the indicator, using it as a mental shortcut – a substitute for thinking hard about what's going on.

We turn it into a magic number – a single figure that tells us all we need to know. We use it to inform us about things it wasn't designed to measure.

But, above all, we forget about all the assumptions on which it's built, assumptions that can become inappropriate or misleading without us noticing. That's when our magic numbers hit us on the head.

The American economic historian Barry Eichengreen attributes part of the blame for the global financial crisis to Wall Street's excessive reliance on a financial indicator called "value at risk" or VaR.

As Wikipedia tells us, VaR "estimates how much a set of investments might lose, given normal market conditions, in a set time period such as a day. VaR is typically used by firms and regulators in the financial industry to gauge the amount of assets needed to cover possible losses."

Eichengreen tells of the banking boss who, late each afternoon, would call for the figure giving the investment bank's VaR. If it fell within a certain range, the banker would go home content. If it was outside the range, he'd stay until he'd done whatever was needed to get it back into range.

The problem was his neglect of the assumptions on which the calculation was based, in particular, "given normal market conditions". Conditions stopped being normal without him realising and – like all its competitors – his bank got into deep trouble.

But the most notorious magic number is gross domestic product, GDP. It was developed by economists after World War II to help them manage the macro economy, but has since been widely adopted as the single indicator of economic progress.

Economists know that GDP is good at what it measures, but was never designed to be a broader measure of wellbeing. This, however, doesn't stop them treating the ups and downs of GDP as the be-all and end-all of economics, as a substitute for thought.

Another word for this is "bottomlinism" – don't bother me with the details, just give me the bottom line.

But never inquiring beyond the bottom line will often end up misleading yourself or getting you into trouble. That's particularly true of people who hear the words "deficit" and "debt" and immediately assume the worst.

In business, however, the most dangerous magic numbers – the most egregious substitute for the effort of thought – are known as KPIs – key performance indicators.

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The local school is in decline, reducing social cohesion

I love living in my suburb. I shop locally, just so I can run across friends and neighbours on a Saturday morning, and be greeted with a smile – even a name – by shopkeepers who know me.

I figure the best ways to get to know people in your suburb is to own a dog – you get to talk to other dog-owners as you stand around in the local park – and send your kids to the local school. You can't help getting to know the other parents in your kids' classes.

But all that was some years ago, and times change. The local school isn't the institution it used to be.

Perhaps it won't surprise you to be told that, over the years, our capital cities have become more stratified, with a greater tendency for better-off people to live in better-off suburbs – the ones with water and views and, these days, those closest to the centre – and for the less well-off to live in less well-off suburbs far from the centre.

This is most true of Sydney, then Melbourne – which is catching up with Sydney in size – but less true of the other capitals.

But maybe this will surprise: something similar is happening to our schools, particularly secondary schools.

We have a widening divide between the schools attended by the offspring of better-educated, better-off parents, and those attended by, well, the not so well educated and paid.

This is happening partly in consequence of the increasing stratification of suburbs, but also because of the education policies pursued by federal and state governments.

Unlike almost all other rich economies, Australia runs three school systems rather than one.

This array has tempted us to treat school as though it was a market, where government, Catholic and independent schools compete for youthful customers, thus providing parents with greater choice and obliging government schools to lift their game.

John Howard was big on choice. Julia Gillard left Howard's pro-choice funding arrangements running until Labor's last year, while emphasising competition between schools.

She introduced the NAPLAN testing of literacy and numeracy and, to ensure parents were well-informed before making their choice, she introduced the My School website, loaded with detailed information about every school.

We got a lot of choice, but no improvement in measured performance. Moral: schools aren't a market.

One benefit, however, is that researchers can collate the My School data to give us a much clearer picture of what's happening to our schools. Leaders in this research are two retired high school principals, Chris Bonnor and Bernie Shepherd.

Everyone knows there's been a decades-long drift of students from government to non-government schools.

What our not-so-retired principals have discovered, however, is that this has masked a big shift from schools with low socio-educational advantage to those with high socio-educational advantage. (A school's socio-educational advantage is rated largely according to the socio-economic status of its students.)

My School shows that, over the five years to 2015, average enrolments at all schools grew by more than five students a year. But enrolments at schools with high socio-educational advantage grew by an average of 11 students a year, whereas enrolments at disadvantaged schools grew by just more than one student a year.

When choosing schools, many of us think of a hierarchy of excellence – in teaching and results – running from government to Catholic to independent. But that's just what you see on the packet. (Echoed by the prices of the packets.)

Studies estimate that 78 per cent of the variance in the performance of schools is explained by differences in their socio-educational advantage – that is, by the socio-economic status of their students.

Independent schools tend to get good exam results because most of their students come from well-educated families. Catholic schools get better results than you might expect because the days when their classrooms were full of working class kids are long gone.

You'd expect this to mean public schools increasingly full of disadvantaged kids getting poor results. True, but they retain a higher proportion of advantaged students than you'd expect.

Why? Partly because public schools in posh suburbs still have lots of smart kids, but mainly because – particularly in Sydney and, to a lesser extent, Melbourne – state authorities have responded to the demand for greater "choice" by creating more selective schools.

But this means greater stratification on the basis of socio-economic status even within the government system, coming at the expense of disadvantaged government schools.

Choice, however, isn't available to all parents. To have a choice you need either brains or money (which usually comes with brains attached).

The vogue for choice has also allowed greater stratification of students on the basis of religion. These days, Jewish kids go to Jewish schools, Muslim kids go to Muslim schools and Baptist and Pentecostal kids go to "Christian" schools.

Trouble is, high socio-educational advantage schools aren't always located in high-status suburbs. So these days, a lot more traffic congestion is caused by a lot more students and parents travelling longer distances to and from school.

Leading to the decline of the local school. Less than a third of schools now have an enrolment that resembles the people in their local area.

Sounds a great way to reduce the nation's social cohesion.

What did the rich kid say to the poor kid? Nothing. They never met.

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Too many stuff-ups about to put economic reform into reverse

I have bad news and worse for advocates of micro-economic reform. First, the jig is up. There'll be few if any further major reforms. Second, the backlash against mounting wreckage from failed reforms is about to begin.

Since the reform push has degenerated into little more than business rent-seeking – let's cut tax on business and increase it on consumers; let's push the legislated balance of power in industrial relations further in favour of employers – it's neither surprising nor regrettable that voters have called a halt.

Micro reform has lost all credibility with voters. Most oppose company tax cuts for big business, cuts in penalty rates and a freeze on the minimum wage. Neither side of politics will pursue these "reforms" with any enthusiasm.

Economic rationalists will blame all this on irrational populism, but if they were more honest with themselves they'd admit the economic case for bizonomic​ reforms – what's good for business must be good for the economy – is debatable and often unconvincing.

And who could blame the public for holding economists accountable for all the stuff-ups committed in the name of reform over the years: the implosion of the deregulated wool price scheme, the wasteful public-private partnerships, the dubious effectiveness of the Job Network, the disastrous admission of for-profit providers of childcare.

The dodgy education businesses selling access to permanent residence to foreign students, the "contestable" pink batts scheme, the failure of encouraging competition between government and private schools, the huge rip-offs of students and taxpayers arising from federal and state efforts to make vocational education and training "contestable", the privatisation of airports and ports with their monopolies intact.

Economic rationalists are so heavily into confirmation bias they've managed not to notice this record of disasters, but they'll be hard pressed not to see the next one, when for-profit providers rip off the disabled in the name of making the National Disability Insurance Scheme "contestable".

Last week the former high priest of micro reform (and Productivity Commission boss) Gary Banks attacked a politician for daring to blame the failures of energy policy on the private sector's lack of enterprise.

Leaving aside his one-eyed criticism of government subsidies for renewable energy (while just happening not to notice the implicit subsidy of fossil-fuel generators arising from the absence of a price on carbon), Banks was right.

The blame must go to the econocrats who designed the national electricity market and the politicians who took their advice.

That we've gone from about the cheapest to about the dearest electricity – and that without a price on carbon – can be blamed on the malfunctioning of micro reform.

The "market" is the utterly artificial creation of government, run by several government agencies with a 6000-page rule book, responsible to a committee of nine governments.

The reformers' wholesale electricity market seemed to be working well, but now lacks the flexibility to cope with energy emergencies. The price regulation of largely privatised natural monopoly network operators was gamed for years before the regulators woke up, and price competition between electricity retailers is weak and margins high.

Historically, economic rationalists under-rate market failure, but are highly conscious of "government failure" – where government intervention intended to correct market failures ends up making things worse.

This is the rationale for micro reform. Governments have mixed objectives, with little motivation to keep things efficient. Much better to leave it to the private sector, driven by the profit motive to put efficiency above all else.

Really? Economic rationalists and econocrats are naive, partly because many of them have never actually worked for the private sector, and are shocked to discover how powerful is the profit motive in motivating business people to game the system, look for loopholes and, far too often, simply break the law.

Private businesses are always overbidding for privatised businesses and underbidding for contracts to provide government services. Governments think this is terrific, until the businesses wake up to their error and try to extract some profit by overcharging or cutting quality, exploiting the incomplete contracts they signed.

Much of this is bureaucratic incompetence, but it's also conservative governments seeing privatisation and out-sourcing in partisan rather than efficiency terms: it's about moving economic assets and activities from the "them" column to the "us" column, so more businesses are beholden to your party and happy to donate.

Turns out the push to reduce "government failure" has produced reverse government failure. We start out trying to stop government intervention to correct market failure that's making things worse, but end up making them worse than they already were.

Then we wonder why the punters want no more "reform".

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Why we needn't worry about our massive foreign debt

When you consider how many people worry about the federal government's debt, it's surprising how rarely we hear about the nation's much bigger foreign debt. When it reached $1 trillion more than a year ago, no one noticed.

That's equivalent to 60 per cent of the nation's annual income (gross domestic product), whereas the federal net public debt is headed for less than a third of that – about $320 billion – by June.

Similarly, when you consider how much people worry about the future of the Chinese economy, American interest rates and all the rest, it's surprising how little interest we take in our "balance of payments" – a quarterly summary of all our economic transactions with the rest of the world.

Note, I'm not saying we should be worried about our foreign debt. We already do more worrying about the federal government's debt than we need to.

No, I'm just saying it's funny. Why do we worry about some things and not others?

Short answer: the politicians don't want to talk our "external sector" because it sounds bad. The economists don't want to talk about it because they know it isn't bad.

But since we're on the subject – and since Reserve Bank deputy governor Dr Guy Debelle gave a speech about it this week – let's see what's been happening while our attention's been elsewhere.

If you're unsure of the difference between the two debts, it's simple. The federal net public debt is all the money owed by the federal government to people, less all the money people owe it (hence that little word "net").

According to Debelle, about 60 per cent of all bonds issued by the feds is owed to foreigners and 40 per cent to Australian banks and investors. About a quarter of all bonds issued by the state governments is held by foreigners.

In contrast, the nation's net foreign debt is all the money Australian businesses and governments (and any other Aussies) owe to foreigners, less what they owe us. (For every $1 we owe them, they owe us 52¢.)

But how did we rack up so much debt?

Long story. Let's start with the balance of payments, which is divided into two accounts. The "current" account shows the money we earn from all our exports of goods and services, less the money we pay for all our imports, giving our "balance on trade".

Our imports usually exceed our exports, giving us a trade deficit. This deficit has to be funded (paid for) either by borrowing from foreigners or by having them make "equity" (ownership) investments in Australian businesses or properties.

Of course, when we borrow from foreigners, we have to pay interest on our debts. And when foreigners own Australian businesses, they're entitled to receive dividends.

The interest and dividends we pay to foreigners, less the interest and dividends they pay us (actually, our superannuation funds and Australian multinationals), is the "net income deficit".

We've been running trade deficits for so long, and racking up so much net debt to foreigners, that the net income deficit each quarter is much bigger than our trade deficit.

But add the trade deficit and the net income deficit (plus some odds and ends) and you get the deficit on the current account of the balance of payments.

The money that comes in from various foreign lenders and investors to cover the current account deficit is shown in its opposite number, the "capital and financial account".

Because the price of our dollar (our exchange rate) is allowed to float up and down until the number of Aussie dollars being bought and sold is equal, the deficit on the current account is at all times exactly matched by a surplus on the capital account, representing our "net [financial] capital inflow" for the quarter.

It turns out that, in the years since the global financial crisis of 2008-09, the current account deficit has narrowed.

In the 14 years to then, it averaged 4.8 per cent of GDP. In the years since then it's averaged 3.5 per cent. And in calendar 2016 it was just 2.6 per cent.

Why has it narrowed? Well, Debelle explains it's mainly a reduction in the net income deficit component of the overall deficit, which is at its lowest as a percentage of GDP since the dollar was floated in 1983.

The rates of interest we're paying on our foreign debt are lower because Australian – and world – interest rates are a lot lower since the crisis. And our dividend payments to foreign owners of Australian companies fell as the fall in coal and iron ore prices hit mining company profits.

That's nice. But while ever we have any deficit on the current account, our foreign debt will grow, and it already exceeds $1 trillion. Isn't that a worry?

Not really. It's not growing faster than our economy (GDP) is growing, and thus our ability to afford the interest payments.

More to the point, the current account deficit is just the counterpart to all the foreign capital flowing into Australia and helping us develop our economy faster than we could without foreign help.

The proof that such a massive debt doesn't mean we're "living beyond our means" is, first, that the nation – households, businesses and governments combined – saves a high proportion of its income rather than spending it on consumption.

Everything the nation saves each year is used to fund new investment in houses, business structures and equipment, and infrastructure. This investment is further proof we're not living beyond our means.

In fact, the nation invests more each year than we save. Huh? Well, the extra funding is borrowed from foreigners.

You can call it the surplus on the capital account of the balance of payments, or the "net foreign capital inflow" or – get this – the current account deficit.

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How politicians use claims about 'jobs' to mislead us

What's the four-letter word politicians of both stripes most use to bamboozle voters? Jobs. Or, as Neville Wran, former NSW premier and never given to understatement, used to say Jobs, Jobs, Jobs.

Economists and business people worship at the shrine of Growth because it raises their material standard of living. Materialism is the god of our age.

But growth is rarely what the pollies try to sell the public on. No, what presses the right button with ordinary folk is jobs.

Just as most of us don't know much about art, but know what we like, so most of us don't know much about economics, but do know there's an eternal shortage of jobs. We can just never hope to have enough of them.

So the sleaziest, most obviously self-aggrandising business person knows to say about whatever money-making project they want permission to undertake that it will create loads and loads of new jobs.

No matter what damage your scheme would do to the surrounding environment – and thus to the prospects of other industries – nor how great the risk you'll skip town if it's not working out, promise jobs and you're already half way in the door.

You can always find a friendly economic consultant who, for a small consideration, will do some modelling of your proposition and produce a generous – even exaggerated – estimate of the many thousands of jobs your plan will generate. Directly and, not forgetting, indirectly. Thousands.

Then there's a high chance government politicians will take up your cause, accepting without question or qualification you inflated job estimates, and castigating all those who lack the vision to see how much your scheme will contribute to the community's wellbeing (not to mention their re-election).

This, among many other instances, is the story of the resources boom, which our leaders applauded all the way and made little effort to control.

Think of all the jobs created. The main price we paid was that the dollar, caused by the boom to stay way too high for too long, prompted a slab of our manufacturing sector to give up the struggle.

Perversely, the highly-publicised loss of jobs that followed has served only to reinforce the public's conviction that we can never have enough jobs and that anyone claiming to want to create a few should be welcomed without further question.

It's true, of course, that a healthy rate of growth in employment is the most important thing we should expect of our economy, given our growing population.

Trouble is, our uncritical obsession with jobs – any jobs – leaves us open to manipulation by business people and politicians with their own barrows to push.

Promoters of projects exaggerate the number of jobs they will create secure in the knowledge that politicians and the media will repeat their claims without bothering to check them.

And no one but no one will return a few years later to check the gap between what was promised and what was delivered.

With mining projects, too little is done to remind people that almost all the promised jobs are for the construction, not running the thing. As soon as the project's completed, the construction workers go back where they came from – often overseas – leaving the nearby towns as flat as a tack.

Many development projects require skilled workers. But workers with particular skills are usually in short supply, meaning the project doesn't create additional jobs for plumbers or whatever so much as create vacancies that have to be filled by attracting plumbers away from their existing jobs elsewhere.

Every dollar anyone spends has indirect, flow-on effects beyond what was originally spent on. But these indirect effects are hard to measure and easy to exaggerate.

My rule of thumb is that whenever you hear the promoters of projects talk about all the jobs to be created indirectly, they ain't to be trusted.

As you recall, the centrepiece of Malcolm Turnbull and Scott Morrison's "plan for jobs and growth" was their desire to cut the rate of company tax from 30 to 25 per cent over 10 years.

Last week the Senate agreed to cut the rate to 27.5 per cent for companies with turnover under $50 million a year.

Turnbull and Morrison have chosen to regard this a big win, and are already assuring us it will do wonders to encourage small and medium businesses to expand and create jobs.

ScoMo​'s demanding to know whether Labor would reverse the tax cut and spend the money on other things, such as education and health, accusing it of "playing cynical politics all along with no regard for the jobs and wages that are at stake".

Get it? Cutting company tax creates jobs; not cutting it doesn't. Nor does spending the money on education and health create jobs.

This is economic nonsense. ScoMo regards it as a self-evident truth that cutting taxes creates jobs whereas raising taxes destroys jobs. Unfortunately, no one's told the Scandinavians.

In fact, there's no empirical evidence of a relationship between countries' level of taxation and their success in creating jobs.

ScoMo's own Treasury modelling predicts that the full company tax cut would do almost nothing to increase employment.

Beware of politicians trying to sell propositions on the basis of all the jobs they'll create. They just know which of your buttons to press.

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