Thursday, September 27, 2007


Industrial Relations Commission of NSW annual conference
September 27, 2007

I want today to give you a crash course on the strengths and weaknesses of economics, with special reference to the labour market. It occurs to me that, because of the specialised nature of your work, most of you probably already know a fair about the topic. If so, I hope you’ll find what I say reinforcing rather than boring. Let me start by saying that I don’t see myself as an economist, but rather as a journalist who writes about economics. This allows me to act as a kind of interpreter and go-between, standing between the economists and the public. I see my role as providing my readers with a critique of economics and economists, much as our theatre critics provide our readers with a critique of the latest plays. My goal is to explain and demystify economics, advising my readers on when they ought to accept the advice of economists and when they shouldn’t.

The subject matter of economics

Economics is the study of how market economies organise the production and consumption of goods and services. In other words, it deals with a very important aspect of life - all of us are consumers and most of us are producers - but only one aspect. It’s preoccupied with the practical, material aspect of life, so that if you get too preoccupied by economics - as many business people, politicians, economists and economic rationalists do - you risk neglecting or devaluing the non-material aspects of life, such as the social, the artistic and the spiritual.

Macro-economics is concerned with seeking to manage or guide the overall, national economy as it moves through the ups and downs of the business cycle. The managers of the economy use various instruments to stabilise demand, holding it back when the economy is growing strongly and threatening to worsen inflation, but boosting demand when the economy’s growth is weak and unemployment is high or rising. The object of demand management is simply to reduce the amplitude of the cycle, pulling down the peaks and filling in the troughs, thereby keeping both inflation and unemployment low. Historically, the main instrument used to manage demand was the budget (known as fiscal policy). But for the past 20 years or so the dominant instrument has been the manipulation of interest rates by the now-independent Reserve Bank (known as monetary policy). The Reserve raises interest rates when it wants to discourage borrowing and spending and thus inhibit inflation pressure; it lowers rates when it wants to encourage borrowing and spending and thus hasten growth and job creation.

A primer on microeconomics

But that’s as much as I want to say about macro. Micro-economics is trickier, more interesting, more germane to our purpose and more controversial. Micro is the study of individual consumers, workers and firms using markets to produce and consume goods and services. At the heart of microeconomics is what’s called the ‘neo-classical model’ in which price is set by the interaction - and intersection - of demand on the one side and supply on the other. So conventional microeconomics is preoccupied with price; it strips away other commercial considerations so it can get to what economists regard as the heart of the matter, price. If economists wore tee-shirts, what they’d say is: Prices Make The World Go Round.

It’s the ‘price mechanism’ that economists see as bringing supply and demand - and hence markets - into equilibrium, or balance. Movements in relative prices - that is, the price of one good relative to other goods - are seen as conveying ‘signals’ to both buyers and sellers, consumers and producers. A rise in price says to producers, produce more - it’s now more profitable to be selling these things, so get cracking and make more of them. A rise in price says to consumers, buy less - look for cheaper substitutes or be more economical in your use of this stuff. Now, if a rise in price calls forth an increase in supply on the one hand, but a decrease in demand on the other, what happens? The price falls back and supply and demand settle at a new equilibrium point. Similarly, a fall in relative prices will send the opposite signals to buyers and sellers, calling forth a reduction in supply and an increase in demand which raises the price and establishes a new equilibrium. Here you see the rationale for the cry of laissez faire - the market is assumed to be a self-righting system, provided you leave it alone to do its own thing.

Another definition of economics is that it’s the study of ‘the economic problem’, which is the problem of scarcity. Scarcity arises because our resources - of land, labour and capital - are finite, whereas our wants are infinite. Scarcity in this context doesn’t mean as scarce as hen’s teeth, merely that things aren’t free - they can be acquired only at a price. Economists believe the right price for something is the price that reflects the degree of scarcity (ie the cost) of the resources embodied in it. Prices are too high when they exceed the item’s scarcity value; prices are too low when they understate the item’s scarcity value.

So microeconomics is about economists seeking to help the community grapple with its abiding material problem, the problem of scarcity, which causes many of our wants go unsatisfied. Economists’ contribution is to help the community use its finite resources in ways that allow it to satisfy the optimum quantity of wants - that is, not the maximum number of wants but the combination of wants the community most highly values. In other words, microeconomics is about helping the community get a quart out of a pint pot, get more bang for its buck. This explains the microeconomists’ preoccupation with efficiency - getting the most bang for your buck - and its close relative, improved productivity. But ‘efficiency’ is a word to which economists attach their own meanings. At one level, what economists call ‘technical efficiency’ (or sometimes productive efficiency) is about being economical in the use of resources, eliminating waste, finding better ways to do things. That’s pretty much the common meaning of efficiency. But economists are more interested in what they call ‘allocative efficiency’ - which is about making sure the community’s resources are allocated to producing that combination of goods and services that it most highly values. The market could throw up lots of different combinations, but economists want to help us strive for the combination we most highly value. While we’re at it, let me just define productivity - it’s not production, its production relative to the resources used to produce it, or output per unit of input. The most common measure of productivity is the productivity of labour - output per worker, or per hour worked.

But economists aren’t engineers or management consultants or even business people. So how do they think they can contribute to making factories more efficient or improving the overall allocation of resources? They don’t profess to know much about the detail of any of these things. But they don’t think they need to because what they understand is the power of market forces, and it’s market forces that - if you stand out of the way - will bring about improvements in technical efficiency and allocative efficiency. Firms seek continually to improve their technical efficiency because of their assumed desire to maximise their profits. Consumers, in their efforts to maximise their utility (satisfaction), unconsciously seek to maximise allocative efficiency. And firms co-operate in this, giving consumers exactly what the consumers want because that’s the way firms maximise their profits.

How do consumers and firms decide what to do? By reacting to prices and changes in prices. Prices (and remember that interest rates and wages are prices) act as incentives, and yet another definition of economics is that it’s the study of incentives. If a market isn’t as efficient as it could be, the reason is likely to be that the incentives it faces have been distorted in some way, probably by misguided government intervention. So you should reform intervention in the market (deregulate), which will increase the competitive pressure on firms in the market. Increased competition will increase the pressure on firms to improve their technical efficiency - raise their productivity - but will also oblige those firms to pass the benefits of their higher productivity on to their customers in the form of improved service or lower prices. The lower and less distorted prices - prices that more accurately reflect scarcity value - will lead to greater allocative efficiency. As I’m sure you’ve realised, what I’ve been outlining is the rationale for micro-economic reform, the goal of which is simply to use improved technical and allocative efficiency and higher productivity to increase our material living standards.

Economic rationalism

Mention of microeconomic reform brings me to explaining the difference between economists and economic rationalists. Not all economists are economic rationalists and not all economic rationalists are economists. Economic rationalists are people who take a fundamentalist attitude towards the neo-classical model that’s at the heart of conventional microeconomics. They have a simple, almost religious faith in the efficacy and applicability of the model. Most government, business and media economists and many academic economists would be happy to wear the economic rationalist label, but many academic economists wouldn’t. The latter are far too conscious of instances of ‘market failure’ and other limitations of the simple neo-classical model, whereas economic rationalists tend to think problems of market failure aren’t a big deal. The non-economists who are economic rationalists - such as the former Liberal backbencher John Hyde and the chairman of the ACCC, Graeme Samuel - tend to be libertarians and great believers in individualism, who are attracted to the certainty, logicality and simplicity of the model. It offers a simple, obvious (though not necessarily easy) answer to every problem - which is the attraction of all forms of fundamentalism.

In my experience, those mainly academic economists who specialise in the study of particular markets - such as health economists and labour economists - tend to be much more conscious of the relevance of instances of market failure to that market, whereas general economists are happy to run any particular market through their pocket neo-classical model without worrying too much about the peculiarities of that market.

This may be the place for me to observe that, in my experience, labour economists (and the related discipline of industrial relations specialists) tend to be highly factionalised. Most tend to be openly sympathetic to the union cause, though you can always find a few who defend the employer interests. I regret that it’s so hard to find knowledgeable labour economists who try to call it down the middle.

The strengths of economics

Having given you a very basic explanation of what economics and economists are on about, let me move to the critique. The first thing to say is that there’s a lot of truth and power to demand-and-supply analysis. Market forces are powerful. People do change their behaviour in response to price signals. You do see people driving the long way to avoid paying a toll, driving round to find the cheapest service station, queuing and pushing and shoving to get the best bargains at the Boxing Day sales. You do see black markets emerging where governments attempt to hold prices below the market-clearing level. You do see rent control leading to an inadequate supply of rental accommodation.

One of the useful roles economists play is to remind us of the importance of opportunity cost. Because resources are finite and can be used only once, if you use them to acquire item A, you can’t use them to acquire items B to Z. The opportunity cost of an action is the cost of the next most desirable action you must give up. It’s a pathetically simple concept, but it’s surprising how often we forget it, so economists do well when they continuously remind us to be sure we really want the things we say we want because, in choosing them, we’re giving up other things.

A related benefit of the economic way of thinking is that it encourages us to continually ask the follow-up question: but then what happens? People are always coming to wrong conclusions on economic questions because they look only at direct, first-round effects, failing to trace through the second, subsequent or indirect effects. For instance, non-economists often conclude that computerisation destroys jobs in the industry in which it’s applied. They don’t go on to ask the question: but then what happens? What happens is that the productivity of the firm’s labour improves - it can now produce more output per worker, which constitutes an increase in real income. Some of that increase may be passed on to the firm’s remaining workers in higher wages, some may be passed on to customers in lower prices (or prices that are ‘lower than they otherwise would be’) and some may be retained by the firm’s owners. The point is that, wherever the income ends up, it will be spent, and when it’s spent it will create jobs. This why economist say that new technology doesn’t destroy jobs it ‘displaces’ them, moving them from the original industry to industries elsewhere in the economy.

Now, you may say, but what if the jobs lost are for middle-aged blue-collar males in manufacturing, whereas the jobs created are more suited to white-collar women working in the service industries? Good question. I think this happened a lot as computerisation worked its way through manufacturing in the 1970s and 80s. Sometimes the problems of the individual tend to be overlooked as economists focus on generalised answers. Some would say we should have done more to help these men retrain to make them suitable for other jobs, but a hard-line economic rationalist would claim that these men would have found jobs had it been possible for the price of their labour to fall to a level low enough to reflect its now reduced value, thereby making that labour attractive to some employer.

One way to test an economic argument you’re being given is to ask whether it’s approaching the issue from the demand side or the supply side. An argument isn’t fully persuasive unless it takes account of both sides. For instance, it’s not enough to say that part-time jobs have become more prevalent over the past 30 years because it’s more efficient for a firm to employ two or three workers for a few hours on Thursday nights and Saturday mornings, rather than one worker for 40 hours a week. This is undoubtedly true and it’s a good example of the kind of things employers do to keep the productivity of labour steadily increasing from year to year. But, in the context of the labour market, it’s a demand-side explanation; it focuses on what suits the buyers of labour, employers. It’s not fully convincing until you can find a story that explains the growth in part-time work from the viewpoint of the suppliers of labour, the workers. But you can find such a story, of course: it’s not hard to believe there’s been a growth in the number of married women and full-time students who’ve been happy to take up part-time rather than full-time jobs.

The role of models

Even so, the neo-classical model often oversimplifies things and leads to mistaken analysis and wrong predictions. Just like model trains or model planes, economic models consciously simplify complex reality. They’d be of no use if they didn’t. The idea is to include and highlight the key factors and get rid of the unimportant issues that merely cloud the workings, thereby capturing the essence of what causes what. The question to ask of a model is not whether it’s left things out, but whether what it’s left out is important. And the test of that is how good it is at predicting how people (‘economic agents’) will behave in given circumstances. I believe that, in many circumstances, the standard model’s prediction record is poor.

The weaknesses of the model can be seen by looking at the assumptions on which it’s built. It’s important to understand that formal economic reasoning, which is often done mathematically, is rigorously logical - given the assumptions on which it’s based. So if you don’t like the conclusions of economics, the thing to examine is the assumptions on which the reasoning is based.

The weaknesses of economics

To me, conventional economics’ greatest weakness is its assumption that agents are ‘rational’ - that is, that we always act with carefully calculated self-interest. We know from much psychological research - not to mention common observation - that people are instinctive rather than rational. They frequently make decisions contrary to the model’s predictions, they have trouble predicting their own utility, make logically inconsistent decisions, have trouble making themselves do what they know is in their longer-term best interests, are moved by altruism and perceptions of fairness and much, much more. One of the most effective criticisms of economic analysis is: I don’t believe real people behave that way. How do you, the economist, know they do? Honest answer: we don’t know it, we just assume it.

One major weakness of the model that economists readily acknowledge (but don’t necessarily take sufficiently seriously) is its inability to take account of factors than aren’t reflected in prices. Any costs or benefits that aren’t reflected in market prices are known as ‘externalities’. When I run a factory that emits pollution into the atmosphere or the river this imposes a cost (a ‘negative externality’) on the rest of the community that isn’t reflected in the actual costs I incur and pass on to customers in my prices. When, in the good old days, statutory authorities trained far more apprentices than they needed, knowing they’d be poached by the surrounding private employers, they were generating a benefit (a ‘positive externality’) those firms didn’t have to pay for and for which the statutory authorities received no recompense. The existence of externalities - positive or negative - constitutes an instance of ‘market failure’. That is, the market and its price mechanism can’t be relied on to deliver the favourable outcomes the standard model promises. The solution is to find ways to ‘internalise’ the externalities to the costs and benefits faced by firms and consumers - to get them reflected in prices - so the price mechanism can deal with them. This is done by devices such as pollution taxes, tradable permit schemes and government subsidies.

There are various other classes of market failure apart from externalities, but I tend to think of them in terms of ‘model blindness’. Economists suffer the same problem as every other profession: what I call model-blindness - a tendency to view the world and to analyse problems exclusively through the prism of their model. To focus on those variables their model focuses on and a tendency to ignore all those factors from which their model abstracts. This is a simple error, but it’s amazing how often it’s made.

The community is preoccupied with perceptions of fairness, whereas standard microeconomic analysis ignores equity considerations. When you press them, economists will tell you they have nothing to say on the fairness and redistributive effects of their policy prescriptions because this involves value judgments that are beyond their area of competence. Yet it’s remarkable how often economic rationalists in particular will press policies on the community without bothering to warn people that, in reaching those policy prescriptions, they have taken no account of equity issues. This is unprofessional behaviour.

The neoclassical model focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of problems and market failure. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Problems with the simple model of the labour market

These are general problems with economists’ use and abuse of their model, but let’s cut to the chase and focus on problems with the use of the conventional model to analyse issues in one particular market, the market for labour, in which workers are the suppliers and firms the demanders. General economists have a tendency to analyse the labour market as though it’s just another market, but there’s an obvious and most important respect in which the labour market differs from other markets. In every other market you’re dealing with the buying and selling of inanimate objects, whereas in the labour market the thing being bought and sold can’t be separated from the seller - that is, whether you like it or not, the unit of labour you buy comes with a live human being attached. That human may be agreeable or disagreeable, cooperative or uncooperative, hard working or lazy, capable or incapable. The fact that labour comes with humans attached cannot fail to affect the behaviour of both the buyer and the seller, something the model makes no allowance for. The role of humans is a strong argument against analysing the labour market in a way that totally ignores considerations of fairness. Another consequence is that the cost of labour to the employer is the income of the employee (ignoring the role of labour ‘on-costs’ such as payroll tax, workers compensation premiums etc). The attachment of humans to labour also invalidates the usual assumption that the items being bought and sold are homogenous. Two carpenters with identical qualifications and experience may be quite different as employees.

The standard model of the labour market assumes that, ceteris paribus, the higher the price of something, the less of it people will buy. This is the rationale for economists’ opposition to minimum wage rates. Set the minimum wage at a level higher than the rate the market would determine - that is, set the rate at a level that’s ‘binding’ - and the result is the market doesn’t ‘clear’. Some people remain unemployed. There is truth to this simple argument, but it ignores a complication: by how much would wages have to fall to achieve the elimination of unemployment? In other words, to what extent would people already employed under a binding minimum wage have to suffer a loss of income to achieve jobs for those at present unemployed? Would a small fall in the rate bring about a large increase in demand or would it take a large fall to bring about a small increase in the quantity demanded? In the jargon, is the demand for labour relative to its price elastic (sensitive to changes) or inelastic? This is the question on which economists need to be pressed. They will come armed with empirical estimates of the price elasticity, but how much faith you should have in those estimates is another matter. They’re pretty safe to have picked estimates that suit their case and to have ignored estimates that didn’t.

The basic model of the labour market assumes that the suppliers of labour face a simple choice: supply an hour of work and earn income or choose an hour of ‘leisure’ (which just means non-work) and enjoy yourself. The bit the model gets right is that leisure yields utility (satisfaction) - though this is something business people and economists often fail to acknowledge in their rhetoric. However, what the model gets wrong is its assumption that work yields disutility - that the only reason people work is for the money, the spending of which yields utility. In real life, most of us derive considerable utility from our work; much of our very identity comes from our work. This flaw in the model prompts economists to underestimate the importance of job satisfaction, job enrichment and job security. They underestimate the personal pain of unemployment - pain greater than can be explained by the loss of income involved - partly because of the hidden assumption of their model that the unemployed are to be envied for all their leisure time. (Another reason is the neo-classical model’s assumption that the macro economy is in a permanent state of full employment, so no one stays jobless for long.)

A related problem - which should really come under the heading of model-blindness - arises from the fact that the model takes account of only those factors that can be readily expressed in monetary terms. This leads to the sloppy assumption that the only incentives that matter are monetary. In truth, the working world abounds in non-monetary incentives: the satisfaction of a job well done, loyalty to employers and a desire for the boss’s approval, not to mention the pursuit of power and status.

An implicit assumption of the model that’s highly relevant to Work Choices, but which many economists conveniently forget, is that the parties to a transaction have roughly equal bargaining power. Where the parties’ bargaining power is highly unequal you won’t necessarily get the mutually beneficial outcomes the model promises. Certainly, the gains aren’t likely to be evenly distributed. This is the economic rationale for economists’ long-standing acceptance of the legitimacy of collective bargaining. The fact that so many economic rationalists are supportive of the push for individual contracts makes me suspect their analysis has been clouded by partisanship.

Work Choices has made me increasingly conscious of another of the model’s weaknesses: its neglect of what you might call ‘social externalities’. I’m disturbed by the attack on - the demonisation of - penalty rates for work at unsociable hours and the scope for partially cashing out holiday pay. My worry is not so much that the compensation for the loss of these benefits may be inadequate, but that these penalties performed an important social function. Combined with the deregulation of shopping hours, the attack on penalty rates is bringing about the steady demise of the weekend. Why is this a good idea? Although all of us like being free to shop or visit places of entertainment on the weekend, the trend to working at unsociable hours must be harmful to family life - something of great utility to all of us.

There’s no denying that, if increasing productivity and our material standard of living were our sole objective, keeping our shops, offices and factories operating for as close to 24/7 as possible would help us achieve it. But who in their right mind would have such an unbalanced approach to life? Workaholic businessmen and economists blinded by their model to the importance of social externalities.

Labour market reform

I have no doubt that our move from the centralised wage-fixing system to bargaining at the enterprise level - the end of flow-ons and one-size-fits-all national wage increases and the downplaying of comparative wage justice - has played a major part in the economy’s improved performance: the return to low inflation, the record-length 16-year expansion phase that has allowed so much progress to be made in reducing unemployment and the fact that our biggest commodities boom in 50 years has so far led to no wage breakout.

But I think this has more to do with the decentralisation of wage-fixing than the deregulation of it. It’s far too soon for Work Choices to have played a significant part in these outcomes - with the possible exception of the remarkably low wage increases being recorded in retail and hospitality. The productivity of labour grew extraordinarily strongly in the second half of the 90s and this helps explain the quite strong growth in real wages during the Howard Government’s term, notwithstanding the maintenance of low inflation.

When it suits them, the economic rationalists like to attribute all the credit for our improved productivity performance to the reform of the labour market. They can’t prove this, of course, and at other times they’re inclined to give the credit to all the other reform we’ve seen in the financial system and the markets for particular products: the floating of the dollar, the deregulation of the banks and countless other industries, privatisation, the virtual ending of protection, the reform of monopoly public utilities, tax reform and so forth.

My guess is that more of the credit should go to product market reform. The intensity of competitive pressure - both domestically and from imports - in so many markets has reduced the market power of firms, ended the sweetheart deal and put a lot of pressure on managers to improve the performance of their firms. They, in turn, have passed the pressure on to their workers, exhibiting a toughness, even callousness that wasn’t there to nearly the same extent in the good old days. Having said that, the move to enterprise bargaining has undoubtedly made it easier for managers to drive a harder bargain with their employees.


Economists specialise in studying the material aspect of our lives and how we can improve it. They are knowledgeable and their advice is effective. As we have proved for ourselves over the past 20 years, following that advice will make the community more prosperous. But while the material aspect of our lives is important, it’s not all important. Sensible people seek to balance affluence against other considerations - fairness and the social, artistic and spiritual dimensions of our lives. The trouble with economists is that their advice is narrow - sometimes narrower than they’re aware of and often more narrow than their hearers realise. Sensible communities don’t allow economists to advise on areas outside their field of competence and balance the advice of economists against the advice of experts in the other important aspects of life.


Tuesday, September 18, 2007


September 18, 2007

The rationale for microeconomic reform

The fundamental objective of microeconomic reform is to improve the economy’s technical, allocative and dynamic efficiency and thereby raise our material standard of living. In distinction to conventional macro management – which focuses on stabilising demand over the short term – microeconomic policy focuses on improving the supply (production) side of the economy over the medium to longer term.

The mechanism for micro reform

The basic mechanism of microeconomic reform is to reduce government intervention in product and factor markets (the capital or financial market and the labour market) in ways designed to increase the degree of competition in those markets. Increased competition in markets should increase the pressure on firms both to raise their technical efficiency and to pass the fruits of that higher productivity on to their customers in the form of better service or lower prices. Combined with prices that better reflect the true ‘resource costs’ of producing goods and services, this should improve the efficiency of the allocation of resources within the economy, thereby causing a higher trend rate of economic growth and thus higher material living standards.

Dynamic efficiency

Dynamic efficiency refers to the economy’s ability to adjust over time in response to changing circumstances. A dynamic economy is adaptable, responsive and flexible. It is able to cope with external or domestic economic shocks to supply or demand without generating either too much inflation or too much unemployment. Our economy’s ability to sail through the Asian crisis of 1997-98 – assisted greatly by the dollar’s depreciation when demand for our exports fell off – convinced many economists that micro reform had made our economy a lot more flexible than it had been.

And, as part of this, our lasting return to low inflation has shown the economy to be much less ‘inflation-prone’ than it had been. Intensified competition in so many markets has greatly reduced the scope for firms to exercise pricing power, for importers to pass on imported inflation and for unions to negotiate excessive, ‘sweetheart’ wage deals. In short, we now have much less problem with ‘cost-push’ inflation. Another part of this is that the move to enterprise bargaining and away from centralised wage fixing has greatly reduced the scope for big pay rises in one area to ‘flow on’ to workers in other areas. This would have helped to lower our NAIRU – the ‘non-accelerating-inflation’ rate of unemployment - thereby permitting the unemployment rate to go lower without igniting wage-inflation problems.

The economy’s greater dynamism and ability ‘roll with the punches’, this has made it less unstable and thus made the macro managers’ job of stabilising the economy as it moves through the business cycle a lot easier – a major, but largely unexpected benefit from micro reform.

Key microeconomic reforms

We can list eight key areas of micro reform over the past two decades:

1. Capital markets. The Australian dollar was floated in December 1983 and controls over foreign exchange removed. Bank interest rates were deregulated and foreign banks licensed to operate in Australia.

2. Trade reforms. Import quotas – mainly for motor vehicles and textiles, clothing at footwear – were removed in the late 1980s and tariff protection for manufacturing and agriculture phased down. The effective rate of assistance to manufacturing fell from around 35 per cent in the early 1970s to 5 per cent by 2000.

3. Infrastructure services. Airlines, coastal shipping, telecommunications and the waterfront were partially deregulated. Government utilities – including railways, ports, electricity and water – were made more efficient and less overstaffed. Many were commercialised and corporatised; some were privatised. Government-owned banks, insurance companies, airlines and a telephone company were privatised.

4. Industry deregulation. Many industries – including stock broking, petrol distribution, eggs, bread and dairy – have been deregulated, as have shopping hours.

5. Government services. Many reforms have been introduced, including competitive tendering and contracting out, performance-based funding, the formal definition and costing of ‘community service obligations’ and user-pays pricing.

6. Labour market. The prices and incomes Accord, operating from 1983 to 1996, restructured and simplified awards and shifted from centralised wage fixing to enterprise bargaining. The Howard Government’s Workplace Relations Act of 1996 further reduced the scope of awards and introduced a formal system of individual employment contracts known as Australian Workplace Agreements. Work Choices seeks to discourage collective bargaining and unionism.

7. Taxation reform. Capital gains tax, fringe benefits tax and the dividend imputation system were introduced in 1985 and 1987, along with large cuts in income tax rates. The goods and services tax was introduced in 2000, replacing the narrow wholesale sales tax and a range of state stamp duties. The company tax rate was cut to 30 per cent.

8. National competition policy. An agreement between Paul Keating and the state premiers in 1995 had four main elements: extension of the Trade Practices Act to government businesses and the professions; reforms to public monopolies; introduction of a regime to provide other firms with access on reasonable terms to privately owned monopoly infrastructure services; and introduction of a program to review all federal and state legislation restricting competition. National competition policy has now been replaced by the National Reform Agenda.

Evidence of the benefits of micro reform

During the five years to 1998-99, labour productivity grew at the highest rate for at least 30 years. The improvement in the average productivity growth rate over this five-year period (of about 1 percentage point) provided the equivalent of an additional $7000 to the average Australian household.

This remarkably strong performance is widely attributed to the delayed effects of micro reform. In the years since then, however, our productivity performance has fallen back to normal levels. This may be because of the fall-off in further reform under the Howard Government. The poorer performance in very recent years is thought to be due partly to the surge in mining investment associated with the resources boom which, while the new production capacity is still coming on line, means the mines are employing more workers without any increase in output. This should be just a temporary factor, of course.


Thursday, September 13, 2007


Talk to Sydney University Economics Society
September 13, 2007

I want to start by saying that, in a minor way, The Sydney Morning Herald is an employer of economics graduates from Sydney University. We hire about one every two years. Over the years we’ve hired Steve Burrell, Stephen Ellis (now a columnist from America in the Business Australian), Tom Allard, Jessica Irvine and Jake Saulwick. We’ll have another one coming on board next year. (I wish I’d hired another name you may recognise, Stephen Long of the ABC.)

The thing to note is that everyone on that list is a product of Political Economy, not the mainstream economics course. So I have pretty well-formed views about Sydney University graduates as potential employees. Why do I hire out of PE? I like PE students because PE is an essay-based course (and economic journalists have to be able to explain economics in words, not diagrams or equations), because PE students have a demonstrated interest in politics (and I regard economic journalism as a branch of political journalism) and because PE seems to attract a disproportionate share of very bright students (and I try to hire only people who are exceptionally bright).

In passing I should tell you that I don’t select trainees on the basis of the marks they got. I’m more interested in their extra-curricular activities - whether they were on the SRC, got involved in running clubs and societies, whether they wrote for Honi or the Union Record - because what I’m really looking for is people with a burning desire to be a journalist, people who’ll throw themselves into it, people who are ‘hungry’ to succeed.

I should tell you that I’m very happy with the people I recruit from PE, which is why I keep going back. In recent years, however, I’ve encountered one problem: most PE graduates haven’t actually done any courses in standard, neoclassical economics. It’s amazing, but true. This is a significant weakness and I usually have to insist that the people I hire go back and do some standard economics by distance education. I don’t think the people running PE are doing their students any favours churning out supposed economists who know less about conventional economics than someone who’d done economics at high school.

What I say to my PE graduates is that I don’t require them to believe the neoclassical model - as we’ll see, I have a lot of doubts about it myself - but I do require them to know it inside out. Why? Because the neoclassical model is the language of the public debate about economics in this country and every other country. If you don’t speak the language, you don’t participate or even understand the argument. You’re certainly in no position to convince the participants in the debate they’re barking up the wrong tree.

Of course, some of the conventional economics graduates who are whizzes at the maths aren’t good at speaking the language, either. But while I’m offering a critique of PE, let me be equally frank about the conventional course. I think its great weakness is the opposite of PE’s - it’s so busy teaching the intricacies of the neoclassical model that it doesn’t find time to give students an adequate understanding of the significant limitations of the model and the alternatives to it. To teach the model without adequately explaining its limitations is, to me, professional negligence. So there’s nothing wrong with economics at Sydney Uni that couldn’t be fixed by rolling the rival courses together - by making sure each side gets a fair dose of what the other side is teaching.

I also suspect the conventional course would be better if it devoted less time to exploring the model’s limiting cases and more to giving students practice at applying the model to specific problems. That is, after all, what economic practitioners do: apply the theory they learnt at uni to the real-world policy problems they are grappling with. But don’t get the idea from this I’m critical of the emphasis on theory in university economics courses. I’m not - not a bit. Universities should be all about theory. Theory is their comparative advantage. It’s the only thing they’re good at and they should stick to it. They shouldn’t worry about teaching vocational skills because it’s hard to learn vocational skills at uni and surprisingly easy to learn them on the job - when you get a job. It’s because economic practitioners spend their professional lives applying the theory they learnt at uni - because pretty much all the theory they know is the theory they learnt at uni - that unis should concentrate on giving their students the best understanding of theory possible. And students should concentrate on tanking up with theory while they’ve got the chance and not worry that it’s all too theoretical. The practice will come later. And when you’ve had a bit of practice you’ll realise that the theory was more useful than you thought when you were learning it.

That’s probably the most useful thing I could say to many of you: don’t sit around telling yourself how useless and unrealistic all the theory is they’re trying to make you learn. You haven’t actually had enough experience to have an informed view of what theory’s useful and what isn’t. So take your lecturers on trust: accept that if they think it’s worth teaching it must be worth learning. If my experience is any guide, when you are experienced enough to judge you’ll realise most of what they taught you was worth learning.

Of course, decent teaching of theory gives plenty of attention to teaching the limitations of the theory. So now that I turn to my topic of what’s wrong with standard theory please don’t think I’m saying economics is rubbish and you’re wasting your time with it. I’m not saying that and I don’t believe that. I could give you a speech on what’s right and useful about the neoclassical model - and if I had time I would - but instead I want to talk about the limitations of the model because that’s where I suspect the conventional course is weakest. Everything in life has strengths and weaknesses and neoclassical economics is no exception.

Perhaps before I launch in I should explain that my view of my role as an economic commentator has changed over the years. For a long time I saw myself as a sort of missionary for economics, explaining the economic way of thinking and trying to persuade people to accept the economic rationalists’ policy prescription. But that was before I’d thought more and read more about the limitations of standard economics. So now I see my role as someone paid to provide the Herald’s readers with a critique of economics and economists, just as theatre critics provide our readers with a critique of the latest plays. Economists are so influential in the debate about public policy - and they act so certain that they’re the bearers of God’s Infallible Truth - that our readers often need reminding of their blind spots and the narrowness of their advice. Of course, putting economists back in their box when I consider they’ve overstepped their area of competence doesn’t stop me still devoting a lot of time to explaining economic concepts and the motivation behind government policy positions.

I suspect the biggest problem with economics is that it split off from the rest of science - the natural sciences and the social sciences - over 100 years ago, so that while there have been many major advances in those sciences since then, economics has been in its own, self-contained world and has carried on down its own path oblivious to those advances.

In Eric Beinhocker’s recent book, The Origin of Wealth, he argues that, thanks to the work of Leon Walras and others in the 19th century, the primary inspiration for neoclassical economics was physics, particularly the physics of motion and energy. Walras introduced differential calculus to economics and the organising paradigm that the economy is an equilibrating system. But Beinhocker says economics took its inspiration from physics at a time when physicists had discovered the first law of thermodynamics, but not yet discovered the second law. As a result, economics is based on terribly out-of-date physics. It’s now clear to physicists - but not economists - that the economy isn’t a closed, equilibrating system at all, but rather an open, disequilibrium, complex adaptive system.

To quote Beinhocker, ‘when Walras imported the concept of equilibrium from physics into economics, he gained mathematical precision and scientific predictability. But he paid a high price for that gain - realism. The mathematics of equilibrium required Walras and later economists to make a set of highly restrictive assumptions that have increasingly detached theoretical economics from the real world. Traditional economics has what computer programmers call a “garbage in, garbage out” problem. If you feed a computer bad inputs, it will with absolute precision and flawless logic grind out bad outputs. Likewise, most traditional economic models begin with unrealistic assumptions and then, with mathematical inevitability, work their way to equally unrealistic conclusions. … This is why there is little empirical support for many core ideas of traditional economics, and in some cases empirical evidence directly contradicts the theory’s predictions.’

The point here is not that conventional economics is too mathematical, but that it’s not using the right maths. The right maths would, no doubt, be a lot trickier and permit a lot less precise conclusions. But I don’t want to be drawn any further on this point because, though I’ve been happy to quote Beinhocker, I don’t profess to know anything much about physics and maths.

I’m a lot more confident in pointing to another area of science where, more than 100 years ago, economics split off on its own track, so that it’s now largely oblivious to subsequent advances. That science is psychology. It was quite primitive 100 years ago, but since then has made considerable gains in understanding the drivers of human behaviour. It’s quite understandable that, with psychology being then as primitive as it was, economics built itself on the assumption that economic agents behaved rationally in all things. It was very much a product of the thinking of the Enlightenment.

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

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

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

I believe this has powerful implications for the aspect of the neoclassical model that economic rationalists (particularly right-wing rationalists) find so attractive: its elevation and celebration of individualism. The individual should be free to choose, and governments should be most circumspect in how they constrain individuals’ freedom, including by taxing them to pay for the public provision of services and to redistribute income. This elevation of the individual and, by implication, denigration of a more communitarian approach, turns out to rest heavily on the assumption that individuals are rational. If individuals are rational decision-makers then it follows, as the rationalists keep asserting, that governments can never know what is good for you better than you know yourself. Governments should therefore tax individuals as little as possible, and maximise the private provision of such things as education and health care. If individuals are not particularly rational in their decision-making, however, then there may well be a case for government paternalism in certain circumstances.

Another aspect of the non-rationality of economic agents is the way, contrary to the assumptions of the model, they aren’t rugged individualists but are heavily influenced by the behaviour of people around them. My tastes and preferences aren’t fixed, but are highly variable, influenced by what others are doing and what happens to be fashionable. I care deeply about winning the approval of others and have a great desire to fit in. At the same time I’m preoccupied with my social status. I want by my conspicuous consumption to not just keep up with the Jones but to overtake them, demonstrating my superior social standing. As my real income rises over time, more and more of it will be devoted to the purchase of positional goods. This is a particular challenge to conventional economics because, while it’s very skilled at raising the material living standards of the community generally, it’s simply powerless to do what most people would wish it to: raise their relative income. Obviously, anything it does to raise the relative income of some people will lower the relative income of just as many. Another aspect of the fact that humans are group animals is the herd behaviour investors so frequently exhibit in markets for financial assets, contrary to the contentions of the efficient market hypothesis.

Thanks to relatively recent advances in neuroscience, we now know a lot more about how our lack of rationality is a function of the way our brains have evolved. It turns out that the primitive, more instinctive, emotional part of our brain often overrides - or beats to the punch - the more recent, more logical part of our brain. This leads to a strange dualism in our minds: we’re often motivated to do things by considerations the more intellectual part of our brain knows to be silly.

It’s as though we have two selves, an unconscious self that’s emotional and short-sighted and a conscious self that’s reasoning and far sighted. We have trouble controlling ourselves in circumstances where the benefits are immediate and certain, whereas the costs are longer-term and uncertain. When you come home tired from work, for instance, the benefits of slumping in front of the telly are immediate, whereas the costs - feeling tired the next day; looking back on your life and realising you could have done a lot better if you’d got off your backside and played a bit of sport or studied harder for exams - are prospective and uncertain. Similarly, the reward from eating food is instant, whereas the costs of overeating are uncertain and far off in the future - being regarded as physically unattractive, becoming obese, becoming a diabetic, dying younger etc. As everyone knows who’s tried to diet, give up smoking, control their drinking, gambling or even speeding, save or get on top of their credit card debt, it’s very hard achieve the self-control our conscious, future selves want us to achieve. Problems of self-control are ubiquitous to modern life, but standard economics is oblivious to their existence.

Before we pass on I should acknowledge that the relatively recent school of economic thought known as behavioural economics is fully aware of the way the assumptions of standard economics fly in the face of advances in psychology and is seeking ways for more realistic assumptions about human behaviour to be incorporated into the equations of the standard model. I suspect, however, it won’t be easy.

Moving to a more mundane level, economists suffer the same problem as every other profession: what I call model-blindness - a tendency to view the world and to analyse problems exclusively through the prism of their model. To focus on those variables their model focuses on and a tendency to ignore all those factors from which their model abstracts. This is a simple error, but it’s amazing how often it’s made. It occurs partly because there is so little engagement between economists and people from other disciplines - so that economists rarely get a chance to see themselves as others see them - and partly because the teachers of economics devote so little attention to ensuring their students fully appreciate the limitations of the model.

As we’ve seen, the community is preoccupied with perceptions of fairness, whereas standard microeconomic analysis ignores equity considerations. When you press them, economists will tell you they have nothing to say on the fairness of their policy prescriptions because this involves value judgments that are beyond their area of competence. Yet it’s remarkable how often economic rationalists in particular will press policies on the community without bothering to warn people that, in reaching those policy prescriptions, they have taken no account of equity issues. This is unprofessional behaviour.

The neoclassical model focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have roughly equal bargaining power – which is often not the case. We’re hearing more about this lately as farmers and other small businesses complain about being squeezed by big business, such as the two supermarket chains. It’s been remarkable to see the Howard Government running advertisements to remind small businesses of the changes to the Trade Practices Act that now permit them to bargain collectively with big business, while at the same time using Work Choices to discourage collective bargaining between individual workers and their employers.

Another assumption of the conventional model is that both buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of the problems and ‘market failure’ in markets. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Yet another major weakness of the model is its failure to take account of social externalities. The deregulation of shopping hours, combined with the attack on weekend penalty rates, is fast bringing about the demise of the weekend without the community ever consciously deciding this would be a good thing. Similarly, I believe Work Choices’ attack on overtime, weekend and public holiday penalty rates and provisions for the partial cashing out of holiday pay could be damaging to family life.

Then there’s the sloppy thinking that goes from the fact that economics is capable of dealing only with monetary incentives to the implicit assumption that only monetary incentives matter. This is classic model-blindness. Clearly, the real world abounds in important non-monetary incentives, including the intrinsic enjoyment of work and pursuit of job satisfaction, and the pursuit of power and status. Ignore these factors and you get wrong answers.

But perhaps the thing that worries me most about standard economics is the way its adoption of the assumption of ‘revealed preference’ - that what people do is a reliable guide to what they want - in the 1930s allowed the goal of economic efficiency to be changed from maximising utility to maximising consumption. Clearly, much utility exists outside consumption - including utility derived from job satisfaction, job security and family life. I fear this derailing of the goals of economics has turned economics into the ideology of materialism and economists into the high priests in the temple of mammon.

This at last brings me to my ostensible reason for being here, to publicise my new book, Gittinomics. What is Gittinomics - what’s my special twist on the subject? Well, most of what I’ve said today isn’t in the book. The book is a kind of exposition of how the micro economy works, but from the perspective of the ordinary person. I call it home economics. My emphasis is on understanding the system to make sure you’re a master of the market system, not a victim. Making it work for you, not you for it. To that end, the first thing to understand is the need to keep economics in perspective and economists in their place.


Tuesday, August 28, 2007


Talk to The New Institute, Hamilton
August 28, 2007

I’ve now been a journalist for 33 years, spending all that time working for the Sydney Herald and virtually all of it as an economic journalist. So I thought what I’d do tonight was tell you a little about my intellectual pilgrimage over that time – how my views about economics have evolved. I should start by telling you that, though I have a lot of economics in my degree, I make no claim to be an economist. What I was when I came to the Herald 33 years ago was a chartered accountant. I used to tell people I was an accountant pretending to be an economist, but these days I prefer to say I’m a journalist who writes about economics. That gives me a little bit of distance from the economists, a bit of independence, making me a kind of interpreter and go-between between the profession and my readers. Not so much a theatre critic as an economists critic.

I have to tell you that, after 33 years, my enthusiasm for the subject matter of economics – figuring out how economies work, determining what motivates people in the economic aspects of their lives – is greater than it’s ever been. The subject fascinates me – I love making new discoveries about economics and then passing them on to my readers. My ideal holiday is to take a box of new books on economics – most of them bought on Amazon – up to the weekender we rent on the central coast and just sit on a banana chair in the backyard devouring them.

But I also have to tell you that, partly as a result of that reading, I’ve had increasing doubts about conventional economics – doubts at the theoretical level and the practical level. Most economists are pretty smug about the success of their discipline. They ignore their appalling record as forecasters and think the profession has a pretty good handle on how the economy works. But I think economics is hugely primitive. In the 230 years since Adam Smith we’ve uncovered a few basic truths about economic behaviour, but what we don’t know far exceeds what we do. That’s why the forecasting is so bad – we’ve got only the roughest idea of how the economy works.

The core of conventional economics is still what’s called the neoclassical model – the idea that price is determined by the interaction of supply and demand. Economic rationalists are people who take this model and, rather than using it as an analytical tool that you pull out of your kitbag when you think it’s the right tool for the job, elevate it to the status of a religion – a fundamentalist religion. And, like all fundamentalist religions, it has features that some people find very attractive: a few simple rules that, provided you have faith, explain the whole world. It gives you the illusion of certainty and an answer to every question. You can apply the model to any economy, any industry, any market – and the fact that you don’t know much about the specific circumstances is no problem. The model’s answers are always simple and universal.

Now, I don’t want to knock the neoclassical model and its religious devotees completely. Market forces are very real and very powerful. You frequently see people changing their behaviour in response to changes in prices. Market forces are often like a balloon – you can try to repress them, only to see them pop up elsewhere in a distorted form. Black markets are the obvious example.

And the great virtue of economic rationalists, at their best, is their opposition to economic privilege: to producers using some form of monopoly power – whether natural, business-made or government-made – to reduce competition and give themselves an easy, profitable life at the expense of their customers. Many, perhaps most, industries and professions try this on to a greater or lesser degree. In the argy-bargy a few years ago over medical indemnity, I was most entertained to watch the fisticuffs between the two professions that just about invented economic privilege: the doctors and the lawyers. I’ve been thinking that, these days, the race is not so much to the swift as to the industry that best uses the media to win public sympathy for the preservation of its economic privilege – particularly as the political parties become more poll-driven and intent on staying in power by giving the public what it says it wants. The economic rationalists have an analysis, known as public choice, which says that just about all government intervention in industry, no matter how well-intentioned, ends up being captured by the industry being regulated and manipulated so as to advantage the producers over the consumers. I’m afraid there’s a large measure of truth to that analysis.

But that’s enough praise of economic rationalists and the neoclassical model. The model seriously oversimplifies real-world markets and economies. It focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have roughly equal bargaining power – which is often not the case. We’re hearing more about this lately as farmers and other small businesses complain about being squeezed by big business, such as the two supermarket chains (though the small businesses usually forget to mention that most of the cost savings get passed on to supermarket customers).

Another assumption of the conventional model is that both buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of the problems and ‘market failure’ in markets. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Another significant weakness in conventional economics is its assumption that economic agents (people) always act rationally – that is, with clear-headed self-interest. The relatively new school of behavioural economics, which draws heavily on psychology, has demonstrated that people’s behaviour is often far from rational. People are emotional and often exhibit herd behaviour, particularly in share and property markets. People don’t even act with an understanding of such basic economic concepts as opportunity cost. With such a flawed model of human motivations as its basis, is it any wonder the economists’ model is such a hopeless predictor of economic behaviour?

Now let me say a little about my new book, Gittinomics. In all the interviews I’ve done to publicise it, only one interviewer has come close to saying the obvious: you have to be pretty egotistical to name an -omics after yourself. So what’s so special about my version of economics? All capitalist economics seeks to explain how the capitalist system works. I guess what’s different about my take on the subject is its emphasis on making sure you’re a master of the system, not a victim. Making it work for you, not you for it.

To that end, the first thing to understand is the need to keep economics in perspective and economists in their place. Economists are experts in one important but limited aspect of life: the material. No one knows better than they do how best to maximise our production and consumption of goods and services. When a community follows their advice - as we pretty much have been for the past 25 years - it gets rich.

Trouble is, sensible people don’t maximise the material aspect of life, they optimise it. That is, they balance it against other, non-material objectives. For instance, most economists know little about the question of fairness and, for the most part, they ignore it. Press them and they’ll tell you frankly that it’s outside their area of competence. Likewise, they’re largely oblivious to the social and spiritual aspects of life. Will the policies they advocate damage family life, for instance? Sorry, never given it any thought. Why don’t you consult a social worker or a priest? Why not indeed. Economists’ advice is one-dimensional. When we give that advice primacy and fail to meld it with the advice of experts in other areas, we risk becoming a richer but more socially dysfunctional society.

And what applies at the national political level also applies in our everyday lives. Most of the things capitalism has to offer us are good - provided we don’t overdo them. Trouble is, the system is usually pressing us to overdo them. Take the ready availability of credit. Thanks to financial deregulation and our return to low inflation, interest rates are lower and the banks are anxious to lend. When we use that credit to buy our own home, we’re generally better off. But when we use credit cards or home equity loans to buy consumer goods we can’t afford, we risk becoming victims.

Credit cards don’t remove the need to save for the things we buy. Since debts have to be repaid, they merely allow us to do the saving after we’ve acquired the item rather than before. The trick is that you also have to pay a lot of interest. So when we allow our impatience to get the better of us, we end up devoting much of our income not to buying things but merely to paying interest. And if carrying a lot of debt on top of our mortgage makes us feel continuously weighed down - I owe, I owe, it’s off to work I go - that’s another strike against our being masters not victims. It’s great to live in such a successful capitalist economy, where not all but most of us enjoy a fair degree of comfort. But when we take the advertising too seriously and start deluding ourselves that buying more stuff will make us happy, we risk becoming victims.

Our politicians venerate the ‘aspirational voter’, but when our aspirations run exclusively to the material we’re setting ourselves up for a state of recurring dissatisfaction. To be masters of the system we need to control our aspirations, learning to be more content with what we’ve got and aspiring to be better gardeners, better golfers, better at our jobs, better partners, better parents, better human beings.

The capitalist system has ways of taking money from the poor, but also of doing down the comfortably off. Really? How? By selling the illusion of social status - and it doesn’t come cheap. The middle class spends an enormous amount of money keeping up with the Joneses and trying to demonstrate how well we’re doing by the clothes we wear, the cars we drive, the homes and suburbs we live it, the schools we send our kids to and much else. Almost by definition, the possessions that most impress people are the ones that cost most. There are too many cases where, provided they get their image and market positioning right, firms can defy the laws of demand and supply and sell more of their product by putting up their price.

What makes this game an illusion is that it’s like an arms race. People are always catching up and passing you, requiring you to earn more and spend more to regain your place. But if you’ve got the money, what’s wrong with spending it on big boys’ toys? Nothing - provided keeping your place in the status race doesn’t lead you to money stress, overwork, a feeling of being trapped or neglect of relationships that matter most.

If it does, you’re a victim. And here’s a good test of whether you are: how much do you enjoy your job? If you’re just doing it for the money, and feel constrained by your financial commitments from moving to a lesser paid but more satisfying job . . . well, you don’t need me to tell you you’re not master of your destiny. But your cage is of your own making. How can you escape to a better job or cut back the long hours you’re working? By reducing your financial commitments. How? By controlling your material aspirations and stopping trying to buy status. Is that too tall an order? Then don’t complain about being trapped by the system.

But wouldn’t the capitalist system collapse if we all cut our spending and did less work so we could spend more time enjoying our relationships? No, of course it wouldn’t. The economy would just grow at a slower rate. And that would be a cheap price to pay for lives that were less harried and where our relationships were more rewarding. I guess that’s what Gittinomics is driving at.


Wednesday, August 8, 2007


Dinner address, Reserve Bank Roundtable, August 8, 2007

‘Economics has not only become boring but also threatens to become irrelevant.
Therefore I do not feel embarrassed about being unorthodox. In fact, I rather enjoy it!’

Frey (2001)

One of my favourite economist jokes is the one that says an economist is someone
who can’t see something working in practice without wondering whether it also
works in theory. There are two professions that possess an intuitive understanding
of the propositions economists have come to call ‘behavioural economics’. They are
the marketers, and the politicians. So what is behavioural economics? It’s
economists satisfying themselves intellectually that there is a logic — as opposed to
a rationality — to the intuitive behaviour of economic agents. It’s economists
laboriously disabusing themselves of the mistaken beliefs they have acquired about
the way agents behave, as a result of their internalising the assumptions on which
neoclassical economics is built.

Behavioural economics is the scientific study of intuition. It involves accepting the
power of intuition — that people are much more intuitive than rational — and
understanding the reason why this is so, which gets back to the way humans have
evolved and, specifically, the way their brains have evolved. Neuroscience tells us
that the primitive, more instinctive and emotional part of our brain often
overrides — or beats to the punch — the more recent, more logical part of our
brain. This leads to a strange dualism in our minds: we’re often motivated to do
things by considerations the more intellectual part of our brain knows to be unwise.
This dualism explains why we have ‘present selves’ and ‘future selves’ which, in
turn, helps explain the self-control problem humans have — a major topic of study
for behavioural economists — and the misprediction of utility, time-inconsistent
preferences, myopia and procrastination that this involves (Stutzer and Frey 2006). I
guess what I’m saying is that, for a full appreciation of the intellectual power and
fascination of behavioural economics, it helps to take in some neuroeconomics
(Camerer et al. 2005).

Let me also say that I use the term behavioural economics to encompass the closely
related field of research into happiness — or subjective wellbeing, if you prefer a
more scientific-sounding label. Lest you feel that happiness is taking your
newly-acquired tolerance of behavioural economics a bridge too far, let me just
point out that happiness is the subject that brought Professor Frey’s name to
international prominence (Frey and Stutzer 2002), and that when Daniel Kahneman,
the psychologist who won the Nobel prize in economics for his role in founding
behavioural economics, had finished with prospect theory and heuristics, he moved
on to the study of utility and wellbeing (Kahneman et al. 1999).

Conventional, neoclassical economics is widely held to be positive, not normative.
But one of the things you soon realise when you study behavioural economics is
that this is the wrong way round. Behavioural economics is the study of the way the
world actually is, whereas conventional economics is the study of the way the world
should be. That is, we’re not rational, but in many circumstances we’d be better off
if we were. The study of self-control problems involves reaching an understanding
that the seemingly irrational things people do in their search for commitment
devices — such as failing to claim tax rebates in fortnightly 'pay as you earn' tax
instalments so as to maximise the size of their annual tax refund cheque, which the
person is more likely to save — have their own logic; that they represent fallible
agents trying to make themselves more rational. The study of self-control problems
also leads you to the view that there may be a new role for economics in helping to
make the world more rational, by imposing prohibitions on certain disadvantageous
behaviour. In fact, governments already do this extensively — and with widespread
public acceptance. It’s just that no one sees it as having anything to do with
economics, and often economists would be quietly disapproving of such

As an economic journalist, I’m supposed to keep my remarks practical, but I do
want to say something theoretical and controversial. I believe that the assumptions
on which the neoclassical model is based pervade the beliefs and policy preferences
of economists far more than most of them realise. Economists generally have a
strong commitment to individualism, freedom of the individual, the benefits of
choice and the value of personal responsibility and, hence, a bias against
government intervention and a desire to keep governments small and taxes low.
This characteristic of neoclassical economics gives it a great affinity with the
libertarian political philosophy, which to me explains why the right wing of
economic rationalism is a lot more heavily populated than the left wing. (Who’s on
the left wing of economic rationalism? Mike Keating, Fred Argy, Bob Gregory and
a few others.)

But my point is this: I believe conventional economics’ commitment to
individualism and suspicion of government intervention rests heavily — more
heavily than most economists realise — on the assumption that economic agents act
rationally. We doubt that governments could ever know better than the individual
how that individual’s income could best be spent. Why? Because we assume the
individual is rational in all things — that she can accurately predict utility, never
does things she comes to regret and never displays time-inconsistent preferences.
When you accept that individuals are far from rational you open up the possibility
that governments may well be better judges of what’s best for the individual. We
assume agents are rugged individualists and are happiest when treated as such,
whereas psychology tells us humans are group animals, whose preferences are
heavily influenced by those around them, who care deeply about what others think
of them, who are anxious to fit in but also conscious of their status within the group
and desirous of raising that status. In other words, I believe that conventional
economics’ exaltation of individual freedom is simply scientifically outdated — a
hangover from the 18th and 19th centuries, when we knew far less about human
behaviour than we do today.

There are two broad approaches economists can adopt towards the lessons of
behavioural economics. One is to use insights from behavioural economics to
reframe essentially unchanged policy prescriptions from conventional economics,
so as to make them more politically palatable. We know, for instance, that people
react differently to essentially the same propositions, depending on how they are
framed. We know that more people would decline consent for a medical operation
with a 10 per cent failure rate than they would an operation with a 90 per cent
success rate. We know from Kahneman’s asymmetric value function, for instance,
that people weight losses more heavily than gains of the same amount. From this,
Richard Thaler (1985) developed four rules for reframing gains and losses:
segregate gains (don’t wrap all the Christmas presents in a single box), combine
losses (because this reduces aggregate pain), offset a small loss with a larger gain
and segregate small gains from large losses.

The second approach we can adopt is to use the lessons of behavioural economics to
change the policies we pursue. I have no objection to the first approach — indeed, I
think it would repay the close attention of econocrats. But I’m more excited by the
second, more radical approach. So let me suggest some very general policy
implications I draw from behavioural economics.

First, I believe that the profession needs to return to its original goal of maximising
aggregate utility rather than maximising consumption possibilities. We now know it
is possible to measure utility — to some extent at least. We also know that revealed
preference is far from foolproof. People are not good at predicting their utility and
they often come to regret their decisions — even to wish someone had stopped them
doing what they did. We know people get locked into behaviours they wish they
could control. Neuroscience makes it easy to see how people’s consumption
decisions can be influenced at a semi-conscious level by advertising that appeals to
their emotions. Among other implications, a switch of emphasis from consumption
back to utility would require economists to abandon their see-no-evil approach to
advertising. Many of the points that follow flow from a recommitment to
maximising utility.

Second, economists need to study consumption. It never ceases to amaze me that
economists can exalt consumption in the way they do and then take so little interest
in it. The happiness literature makes it clear that people find some forms of
consumption more satisfying than others (Seligman 2002; Van Boven and
Gilovich 2003).

Third, economists need to acknowledge the importance people attach to social
status and social comparison. Conventional economics is good at helping the
community maximise its income, but it can do nothing to maximise people’s
relative income. And yet, we know that people are more interested in increasing
their income in relative terms than absolute terms. From a community-wide
perspective, a status race is pointless and wasteful. It’s likely that, as real income
rises over time, a higher proportion of income is devoted to the purchase of
positional goods. Is this why we pursue efficiency? It’s also likely that efforts to
minimise the role of government and limit the growth of taxation have the effect of
allowing people to maximise their spending on positional goods at the expense of
the provision of public goods that would yield them greater utility (Frank 1999).

Fourth, the simple model of labour supply is misleading and needs rethinking. In
practice, economists tend to underplay the one thing the model gets right: that
leisure yields utility. In the unfavourable comparisons of rates of economic growth
and levels of GDP per capita made between America and Europe, there is little
acknowledgement that much of the difference is explained by the Europeans’
preference for leisure over work. On the other hand, the model is quite wrong in
assuming that work yields disutility. The happiness literature makes that clear —
even if it wasn’t obvious. Like you and me, most people derive great utility from
their work most of the time. It follows that much could be done to increase utility by
policies encouraging job enrichment. That is, when your goal is to maximise utility
rather than consumption, you see for the first time that the issue of job
satisfaction — which may be enhanced by such practices as team work or giving
workers greater autonomy — is part of the economist’s brief.

We know, too, that unemployment is a major source of unhappiness in peoples’
lives — or, if you prefer, of disutility (Clark and Oswald 1994; Layard 2003). This
fact creates a conflict between measures to increase efficiency and maximise utility
that reformers rarely acknowledge. This may be partly because their modelling
assumes full employment, but I believe it’s also thanks to a hidden assumption that
the unemployed are to be envied for all their leisure time.

Fifth, policy makers undervalue the utility people derive from security and
predictability. We give too little weight to the utility workers derive from job
security, for instance. We need to learn that efficiency isn’t everything.
Sixth, self-control problems are ubiquitous, but susceptible to policy remedies.
Some self-control problems may be regarded as minor (television watching, for
instance), but many constitute significant social and economic problems: obesity,
smoking, drinking, drug-taking, gambling, speeding, the overuse of credit and the
inability to save. Economists aren’t as conscious as they should be that government
intervention — and often, outright controls — to assist people conquer their
self-control problems and to protect the community from negative externalities are
widespread, of long standing and uncontroversial. Consider all the regulation
governing the consumption, sale and advertising of alcohol and tobacco. Consider
all the controls — speed limits, seatbelts, random breath-testing — that have
succeeded in reducing the road toll. Consider the way employees are compelled to
save 9 per cent of their wages, and how little opposition that relatively recent
measure encountered. It’s clear to me that the public often wants governments to
impose these external commitment devices on it — and that this attitude makes
considerable sense. The insights of behavioural economics should help economists
to be much more receptive to proposals to use intervention to alleviate self-control
problems, including the newly recognised problem of obesity.

Economics doesn’t have to be boring, stuck in a rut and open to the charge of being
based on out-of-date science. But to make economics more interesting and relevant
to the solution of a wider range of the community’s problems, economists have to
be willing to learn new tricks.

Behavioural Economics and Public Policy


Wednesday, July 18, 2007


Old Parliament House, Canberra
July 18, 2007

David Gruen has asked me to talk about the policy issues I believe Treasury should be thinking about in briefing an incoming government, new or returning. I’m not convinced I could give you much useful advice on that score, but I’m going to address the topic quite broadly in the hope of saying something that gives you something to think about, even if - as I suspect is often the case - all I do is help you realise why you don’t agree with me. I’ll also focus fairly heavily on my special subject: the politics of economics.

In thinking about the next government I’m going to err on the side of envisaging a change of government, not because I think it’s a sure thing - I don’t - but because it gives us more interesting things to think about and because preparing a briefing for a new government is a more challenging exercise. It’s possible I may have had more experience than some of you of observing change-overs. In my career I’ve seen three at the federal level: from Whitlam to Fraser in 1975, from Fraser to Hawke in 1983 and from Keating to Howard in 1996.

Thinking about a change of government

At one level you might think that a change-over from Howard to Rudd would be a relatively simple affair given that the remarkable success of existing policies means there’s broad agreement between the two parties on the question of macro management - on the medium term frameworks for monetary policy and for fiscal policy, including balancing the budget on average over the cycle and limiting the growth in revenue as a proportion of GDP. In case any of you have any doubts, I’d remind you that politicians’ behaviour in opposition usually offers a poor guide to their behaviour in government, so that the behaviour of Labor when last in government offers the best guide to its behaviour when next in government. We can expect a Rudd government to be quite conservative and responsible, anxious to lay to rest the popular stereotype that Labor is no good at economic management, anxious to avoid getting offside with the financial markets, anxious to be seen as ‘pro-business’ - more anxious about it than the Libs ever need to bother being - and anxious to avoid being seen as the lackeys of the (in any case, hugely politically weakened) union movement. The more the Libs push that line against Labor in the run up to the election, the more determined a Labor government would be to disprove it in practice. This time there’d be no Accord to give the unions a seat at the Cabinet table.

But it would be a mistake to see the lack of significant difference between the two sides on macro policy as making the briefing of an incoming Labor government a ho-hum affair. That’s because a change of government represents a rare and vitally important point of challenge and opportunity for Treasury. It’s a quickly passing opportunity for Treasury to establish a relationship of two-way trust and loyalty with the new administration. Treasury does so by demonstrating its commitment to apolitical service to the government of the day, by demonstrating that it’s already been giving much thought to the new government’s problems from the new government’s perspective and by demonstrating its competence (including its detailed knowledge of the new government’s stated policies). The more politicised the public service becomes, the more important this welcoming-committee role becomes.

But there’s a second reason the first few days of the new government’s term are of such strategic significance: they represent an unparalleled opportunity to get action on all those issues the outgoing government had consigned to the too-hard basket, including those that most offended the interests of its core constituency.

The first duty of Treasury is to immediately present the incoming government with evidence of a budgetary crisis that demands an immediate and radical response. That’s what John Stone did for the incoming Hawke government even before it had been sworn in and what Ted Evans did for the incoming Howard government in 1996. I’ve seen it done at the state level many times and incoming CEOs of major companies almost invariably do something similar. I call it ‘doing a Mother Hubbard’: we came to government, looked in the fiscal cupboard and were shocked and appalled to discover it was bare. It’s actually a time-honoured trick that will be much harder to pull off in the era of the PEFO. The first point of it is to get all your predecessor’s dirty fiscal linen out in the open while the recognition of those presently hidden, unacknowledged costs can be blamed on your predecessor. It has to be done in an atmosphere of high-drama crisis, so your alibi will stick in the mind of the electorate and so any early economic setback or lack of progress can be excused.

But the second purpose of the crisis is to provide a cover for a process by which the incoming government slashes away at those budget measures aimed at its predecessor’s political heartland so as to make room for those measures it has promised to grant its own political heartland. The process also allows the new government to defer or abandon some of its non-core promises. This is a vitally important exercise from Treasury’s perspective because of the need to prevent the new government from merely adding its pet projects on top of its predecessor’s pet projects.

A common practice is for the new government to establish a committee of audit to reinforce the message that it inherited a fiscal mare’s nest, but the Howard government’s experience shows that the auditors need to be selected with care. Give the job to a bunch of academics and they’ll give you a report whose recommendations are too radical to your taste.

On a related theme, I have to tell you that the older I get the more I doubt the pertinence of the old cry in response to election promises, ‘where’s the money coming from?’. The honest answer - which no politician would dare give - is, ‘if and when we win the election, Treasury will tell us’. Why? Because that’s what Treasury’s paid to do: tell the government of the day how it can cover the cost of the policies it wishes to pursue. Hidden in that is a more subtle task: to take the incoming government’s election promises and explain to it how, by adding qualifications and limitations that were not mentioned or explicitly ruled out before the election, it can significantly curtail the budgetary cost of the promise. It may also be able to gain some budgetary leeway by fiddling with the timing of commencement of the program.

Thinking about the next recession

I have a feeling this election won’t be a good one to win. Why not? Because of the high chance that the record expansion phase finally comes to an end sometime in the next few years, leaving us in recession. Think about it: we have a history of governments being thrown out of office after they’ve presided over a recession. That’s true of the Whitlam, Fraser and Hawke-Keating governments, although in Paul Keating’s case there was a one-term lag thanks to John Hewson’s GST/Fightback package. Parties that are in government generally have good reputations for economic management, then lose it during their recession and leave office being regarded as pretty hopeless. The incoming government then does its best to rub in their predecessor’s bad reputation and live off it for as long as possible. The Hawke-Keating government suffered this fate notwithstanding its unprecedented record of economic reform. I might add that, though the Labor government’s poll ratings on economic management weren’t too bad during most of its term, the voters’ views on which party is good at which policy area are terribly stereotyped, meaning that the Liberals’ identification with business gives them a big inbuilt advantage.

But now consider what would happen if the Libs lost office this year and a recession occurred during the new government’s term. The Libs would have managed to enjoy a completed period of more than 11 years in power without a recession, whereas Labor would have plunged the economy into recession within a year or two of regaining power. Nothing could be more calculated to reinforce for the long term the perception Peter Costello has been so successful in inculcating with all his talk about Labor’s Beazley Budget Blackhole, deficits and debt, that the Libs are God’s gift to economic management, whereas Labor simply can’t be left in charge of the till.

So that’s why I say I’m not sure this would be a good election to win. I’m sure that wouldn’t discourage Labor from wanting to win, but I’m equally sure the scenario I’ve just outlined would have occurred to Labor and that, should it win, it will quickly turn its mind to this potential problem. It will do all in its power to blacken the economic reputation of its predecessor in the hope that, should a recession occur reasonably soon after the change of government, it will be able to shift the blame back on the Libs. If I’m right, it will be expecting Treasury to play its part in this exercise.

But now let’s turn out minds to the possible nature of the next recession (and remember that this discussion applies equally to Liberal or Labor governments). Dr Don Stammer, formerly of Deutsche Bank, says no economist or economic journalist is worth feeding unless they’ve lived through at least four recessions and, if they have, they’re entitled to charge a premium for their advice. In my working life I’ve experienced the recession of the mid-70s, the recession of the early 80s and the recession of the early 90s - and they’ve left a lasting impression on me.

The first thing to say is that I don’t see any signs that a recession in imminent. But I don’t believe for a moment that the business cycle has been abolished and nor do I believe our luck can hold forever. Equally, however, I don’t think you ever get much warning that a recession is on the way. They tend to be brought on by what Don Stammer famously calls the X Factor - the factor no one had been expecting. But I do think there are a few things we can say. One is that I don’t think we’ve ever had a recession of exclusively domestic causes. Equally, I don’t think we’ve had a recession of exclusively external causes - though in 2001 we did have a mild world recession that didn’t lead to a downturn here.

I deduce from this that our economy goes into recession when some external disturbance combines with some domestic imbalance or vulnerability. I don’t think we have to look far to find the most likely source of domestic vulnerability: our extraordinarily heavily indebted household sector. It’s highly vulnerable to a sudden fall in employment - from whatever cause - which would make it impossible for affected households to maintain their mortgages. This threatening atmosphere could put the wind up many employed but heavily indebted households which, in their efforts to reduce their exposure, could significantly slow their consumer spending. The contraction would come not so much from the direct effect of newly unemployed households as from the indirect, contagion effect on other indebted households.

I believe that, when it comes to dealing with recessions, it’s important not to get caught fighting the last war. I say this because of my painful experience with the recession of the early 90s. Early in that process, despite widespread gloom and doom in the business community, Treasury was confidently predicting just a ‘soft landing’. Treasury argued that the prime domestic cause of the two previous recessions - in the mid-70s and early 80s - had been wage explosions and, since this time wages were well under control thanks to the Accord, this downturn was not likely to be severe. I bought that argument and loudly and confidently predicted a soft landing, knowing to ignore all the contrary anecdotal evidence I was hearing. As it transpired, the landing was anything but soft. So that proved a terribly wrong call on my part and caused me a lot of grief in the office, where all the anecdote merchants tried hard to convince the editor of my incompetence.

The problem with that analysis was that, as is the bias of most macro economists, it sought evidence and explanations for recession only in the real economy, ignoring the financial economy. But, as Ian Macfarlane was the first to explain publicly, financial factors were the key cause of that recession and its severity. The deregulation of the financial system and the admission of foreign banks had led to an orgy of business borrowing associated with successive asset price booms in the stock market followed by the commercial property market. When high interest rates eventually caused the music to stop, the corporate sector found itself heavily leveraged and highly exposed, many with assets that were no longer worth what had been paid for them. The response was that the corporate sector, including the banks themselves, entered a protracted period of ‘balance sheet repair,’ which involved running down debts by cutting investment spending, cutting staff and otherwise cutting expenses. The problem with this, of course, is that it spreads the problem to other firms, which deepens and prolongs the adjustment period.

Now, the point I want to make is that, in thinking about the next recession, we shouldn’t focus exclusively on what could go wrong in the real economy, but remember that we could again be clobbered by the financial side. For a long time I believed that we’ve got so proficient at controlling inflation - we’ve become so vigilant - that the next recession couldn’t possibly involve the usual train wreck of inflation getting away and interest rates being held so high for so long that a deep recession becomes inevitable. If so, the next recession would be a mild one. I no longer think that because, as Ian Macfarlane made pretty clear in his Boyer Lectures last year, the smart money is expecting the repair of household balance sheets to be the major domestic cause of the next recession. That means it’s likely to be severe and protracted - especially when measured the way politicians and the electorate measure the severity of recessions: by the effect on unemployment, not the effect on output.

At present, thanks to the long-lasting salutary effect of the last recession our corporate sector is not highly geared. But should the next recession be delayed and the private equity craze continue (which it may not), by the time the next recession does arrive we could find ourselves with a highly geared corporate sector as well as a highly indebted household sector. If so, expect the next recession to be doubly severe.

Here it’s important to remember what I think of as a cross between Goodhart’s Law and Murphy’s Law. When monetary policy manages to get a handle on goods and services price inflation control, it tends to encourage the emergence of a problem it finds much harder to handle, credit-fuelled asset price booms. To put it another way, when the economy has been growing strongly and steadily for some time, businesses in search of ever-growing profits tend to become emboldened to take on more risk by gearing up. We see the perfect demonstration of this in the private equity fashion. Trouble is, we all know it will end in tears. Note that here we see one reason for the perpetuation of the business cycle, where the very success of the expansion phase sows the seeds of its eventual destruction.

Now let me introduce a complication I’ve been thinking about lately, but haven’t yet resolved in my mind. In the past 10 or 15 years it’s become terribly fashionable to analyse the challenges of business life in terms of ‘risk management’. I’ve even seen business types getting climate change and emission trading legitimised in their minds by branding it as risk management. Risk management can be about risk spreading, but easily degenerates into nothing more than risk shedding. Businesses can shift risk to their customers, but for the most part they shift it to their employees. I suspect that the protracted period of companies seeking to maintain double-digit profit growth by eternal cost cutting involves a lot of risk-shifting to employees. It’s not greatly relevant to Australian circumstances, but the classic example of risk-shifting to employees has been the move from defined-benefit to defined-contribution pension schemes - which has made older employees far more vulnerable to vagaries of the sharemarket. Another example is the advent of just-in-time inventory management, where firms’ economising on inventory costs has shifted the risk and cost of supply-chain disruption to their employees - who are now far more likely to find themselves temporarily laid off because of, say, a strike at a supplier’s factory. I don’t think there’s much doubt that Work Choices - including the neutering of the unfair-dismissal provisions and reduction in the availability of redundancy payments - has greatly increased firms’ ability to shift risks to their employees. Added to that you have the growth in casual employment, the conversion of employees into contractors and the widespread use of labour-hire firms.

My point is that this risk-shifting trend may have altered the internal dynamics of recessions in ways that are hard to predict. If in a downturn firms are better able to limit the fall in their profits by more easily cutting their wage bills - and thus their employees’ and erstwhile employees’ incomes - does this make the recession less severe or more? If Work Choices gives employers the upper hand in industrial relations, does this mean a recession is likely to see more lay offs or more workers on four-day weeks - that is, is the pain more concentrated on a few or more evenly spread across the many? Does it make much difference? One possibility is that the greater freedom to dispense with the services of casuals, contractors, labour-hire workers and even permanent employees means unemployment will shoot up much earlier than it did. The corollary, however, should be that the absence of labour hoarding means unemployment recovers earlier. We shall see.

Now for a more positive note. If I’m right in predicting that the next recession is more likely to arise from some disruption giving rise to adverse balance sheet effects than from a loss of control over inflation, that does have one big advantage. It means the macro managers ought to feel free to respond to the downturn by the quick and wholehearted application of stimulus. The Reserve Bank can afford to slash interest rates in the way the Fed did in 2001. That’s one of the rewards from our return to good control. Similarly, with general government net debt eliminated, there’s no impediment to the government adding significant discretionary fiscal stimulus on top of the reversal in the automatic stabilisers. There maybe some political embarrassment arising from the way the medium-term fiscal strategy has degenerated into the promise of eternal surpluses, but in the pressures of the moment that will be quickly cast aside.

Here it may be useful to recall the experience of the last recession, where it was originally argued that all the discretionary stimulus should come exclusively from monetary policy, with fiscal policy holding to its medium-term goal apart from the automatic response of the automatic stabilisers. This is what produced the most amazing budget of my career, the only one delivered by John Kerin who, with Paul Keating skulking on the backbench, proceeded to be more Keating than Keating, and stood up in the middle of the recession (August 1991) and declined to kick-start the economy. (That budget was also remarkable for being delivered in the early afternoon without a lockup, thereby uniquely demonstrating that the lockup serves no economic purpose, but survives purely as an instrument of media management.) The joke of all that, of course, was that once Keating became prime minister a few months later, he lost little time in organising the hugely stimulatory mini-budget of February 1992. And the lesson of all that is that the politician who can resist the temptation to use the budget to stimulate the economy during a recession has yet to be born. That being the case, it makes more sense for Treasury to switch to recommending a stimulatory stance of fiscal policy as soon as possible.

One last point since I suspect that some of you have never experienced a recession during your working lives. The burden of recessions is felt very unevenly. Some people lose their jobs, others lose their businesses, while the great majority of people are little affected. Overtime will dry up and their real wage may slide a little, but you’ll even find the odd person doubting that the recession is real because the restaurants are still full. Even so, recessions are highly unpleasant times for economists (and economic commentators) to be alive. The public turns on economists, history is rewritten to blame them for everything, the public is not prepared to entertain discussion of any economic issue bar getting unemployment down, and the period of gloom and doom - the regular encounters with punters who can’t see how the economy will ever get back on its feet again - lasts interminably. Two or three years. So if you’ve never lived through a recession, be warned: they’re no fun.