The real reasons GST won’t be changed

After the months we've spent debating changes to the goods and services tax, a lot of people were surprised to learn last week that the idea's been abandoned.

But not me. I've been expecting it since November 24. Why? Because everything has unfolded just as my colleague Peter Martin revealed in the column he wrote 12 weeks ago.

"The big GST decision, on whether to lift it to 15 per cent, is already as good as made. The Treasurer and Prime Minister won't do it. Nor will they extend the goods and services tax to food, to health or to education, although they might yet extend it to financial services," Martin wrote.

What was arguably the biggest political scoop of the year was ignored. Maybe the denizens of the House with the Flag on Top didn't believe it. What's an economics editor doing getting scoops? Why would you bury a scoop in a column? Why was he told when we weren't?

Or maybe it suited no one in the building to kill off the GST story so soon. Politics is like a drama, where each player sticks to his part. Labor didn't want to know there'd​ be no change to the GST because it wanted to keep running its scare campaign.

Similarly, the press gallery wanted to keep milking the story for scary headlines. As for the government, it would have wanted to manage expectations, gradually conditioning its backbenchers and business urgers to the idea that tax reform wouldn't be as radical as first thought.

When the time was ripe, ministers' offices would start leaking bits of the story to key journos – the proper way to get a scoop – preparing the way for the boss to drop a big hint on some TV program, before formally acknowledging the decision.

The trouble with Martin's scoop was it was out of sequence; it didn't fit the standard choreography; it was the media playing something other than their allotted role. When the play was only half-way through, a rogue journo stood up and read out the last page.

Better to pretend it hadn't happened.

But this means we've been given the sanitised, media-managed version of how the decision was reached. For a start, careful leaking has removed the demand for the government to explain why it rejected the options for broadening the GST base.

Fortunately, Martin gave us the unsanitised explanation. Extending the tax to fresh food "was never going to happen". It would hit low earners hardest, and these days it's almost impossible to compensate them, we were told.

Extending it to health and education was considered to be unfair. People who use public schools and hospitals would pay no extra, while those already paying for access to private schools and hospitals would pay extra, Martin told us.

Last week's official version of the government's reason for deciding not to increase the rate of GST was its Damascus-road experience on January 25 when Treasury surprised it with modelling showing that using an increase in the GST to cut rates of personal income tax would do nothing to foster "growth and jobs".

Two small problems. First, this should have come as no surprise to anyone who'd read the tax reform discussion paper issued last March, which advised that personal income tax and the GST were little different in terms of economic efficiency.

Second, it portrays the decision not to change the GST as a simple economic calculation, untouched by base political considerations. Yeah, sure.

For a start, Treasury's modelling also shows that big efficiency gains could be had by using an increase in the GST to cut the rate of company tax. The government's unwillingness to contemplate such a switch was obviously political.

But the really significant consideration glossed over by the media's sanitised version of events is Martin's revelation that, since the GST was introduced, it's become much harder and more expensive to compensate low and middle income-earners for the regressive effect of indirect tax increases.

These days, many low income-earners neither pay income tax nor receive government benefits. Labor excluded many part-time workers from income tax by trebling the tax-free threshold to $18,000 a year, while the Liberals made superannuation payouts tax-free.

When people neither pay income tax nor receive a benefit, how do you compensate them? How do you even know how much to give them?

This explains why Treasury now estimates that at least half the gross proceeds from a GST increase would be needed for compensation, leaving much less room for tax cuts – personal or company – and making the politics of tax reform much more daunting.

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One way to foster growth and jobs

Things may be gloomy in other countries, and even in parts of our own economy, but there's one aspect of Australian life where everything's on the up: we're enjoying a sustained prison boom.

Consider this. Over the 66 years to 1984, Australia's rate of imprisonment per head of population rose by a paltry 13 per cent. Over just the past 30 years, however, it's more than doubled.

How's that for progress? We now have more than 36,000 people behind bars, meaning our imprisonment rate exceeds that of Canada, Britain and most of Europe.

And I'm happy to acknowledge that the Aboriginal community has made a quite disproportionate contribution to this achievement. The Indigenous imprisonment rate is now more than 45 per cent higher than it was at the time of the Royal Commission into Aboriginal Deaths in Custody.

This exciting news is brought to us by Dr Don Weatherburn, director of the NSW Bureau of Crime Statistics and Research, in a conference paper to be delivered on Thursday.

Weatherburn calculates that if we can only maintain the rate of growth we've achieved in the past five years for another three, we'll be up to more than 43,000 prisoners nationwide.

Think of the contribution to "growth and jobs". A screws-led recovery. And think of the improvement in productivity as we stuff more prisoners into our existing jails.

But that's not the best of it. We've been able to keep prison numbers growing even as rates of crime have been falling. How's that for an achievement?

How's it been done? Easy. Over the past 30 years we've pursued policies that result in more people being refused bail, more people getting a prison sentence and more people staying in prison for longer.

Truly, the prison industry and its backers could teach the commercial world a thing or two about drumming up business.

To be fair, there was a long period when rates of crime got worse and worse. According to Weatherburn, it started in the 1960s when servicemen returning from Vietnam brought heroin with them. The rate of heroin use began to climb, and with it a lot of heroin-related crime.

Between 1973 and 2001, rates of theft and robbery soared. Property crime spread from working-class suburbs such as Redfern, Footscray and Fortitude Valley to middle-class suburbs as well. By 1983, nearly one in 10 Australian households had been victims of some form of household property crime in just the past 12 months.

The public got fed up. Led by the shock jocks, the media jumped on the bandwagon and state politicians competed with each other to prove they were tougher on crime than thou.

Australians became prison-happy. Got a problem? Whack some people in jail. Problem doesn't seem to be easing? Lengthen their sentences. Still not happy? Keep getting tougher, without ever checking to see if it's working.

But now crime rates have been falling since 2000, the time when the heroin problem suddenly went away. The national robbery rate is down by two-thirds, as is the burglary rate. Motor vehicle theft is down by more than 70 per cent and all other forms of theft by more than 40 per cent.

Even the rate of assault seems at last to be coming down in NSW and Victoria.

You could, if you were of a mind to, argue that crime is down precisely because more baddies are locked up. But this ignores all the other factors that may have changed.

Careful analysis by criminologists finds that a higher rate of incarceration does reduce crime, but only to a small extent, too small to explain much of the extent of the fall.

Of course, the nigglers – economists and suchlike – would point out that all this imprisonment is costing taxpayers a lot. In the 12 years to 1994-95, national spending on corrective services almost doubled to $880 million a year.

By now it's almost trebled to $2.6 billion a year. And if it continues its present rate of growth it will be up to $3.5 billion in three years' time.

We're spending a fortune to keep people locked up for ages even though it's not a very effective – and thus a very expensive – way to reduce crime.

But what about what about all the "growth and jobs" we're generating? You won't hear this from politicians, but those niggling economists will tell you we don't need growth for growth's sake, nor even jobs for jobs sake.

The fact is that all spending – by households, businesses or governments – creates jobs, so it's not enough to say this project or that will create jobs. That's why, if we've got any sense, we'll ensure that what we spend on brings us the most of those things we most want.

To give you an idea, the $2.6 billion a year we're spending keeping so many people banged up is the same as the cost of employing about 2800 probation and parole officers for 10 years, or putting more than 100,000 students through university.

At a time when governments – federal and state – profess to have no money to spare for worthy causes, perhaps we should be looking for ways to punish offenders that are more effective in reducing crime and aren't so expensive.

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Why the very rich have got richer

Everyone knows the gap between rich and poor has been widening in most developed countries, but why is it happening? Have the rich been smarter and harder working, or have they just been craftier than the rest of us?

Between the end of World War II and sometime in the 1970s or '80s, the gap got progressively narrower, reducing inequality. Since then, however, the trend has reversed and the rich have got richer faster than the poor have got less poor.

That's particularly true for the English-speaking rich countries, though it hasn't happened as much in Oz as it has in Britain and, especially, the United States.

Here, real incomes have increased at the bottom, the middle and the top, though they've risen a lot faster at the top. And the respective shares haven't changed much in very recent years.

It remains true, however, that Australia's been part of the international trend to exceptionally strong growth in incomes right at the top of the distribution, say, the top 1 per cent.

In Australia's case, Professor Paul Frijters, of the University of Queensland, and Dr Gigi Foster, of the University of NSW, sought to explain this growth in top incomes in a paper published in the Australian Economic Review.

At the level of theorising, they say there are two rival potential explanations: that incomes have become more unequal as a byproduct of market forces, or as a result of political decisions.

The first explanation focuses on a shift in the "marginal productivity" of skills. Changes in technology – the obvious candidate being the information and communication revolution, aka computerisation and digitisation – have increased the value of certain highly skilled jobs relative to other, less skilled, more routine jobs.

This economists refer to as "skill-biased technological change". Some jobs are replaced by machines, others are in greater demand because of the need for people to control and maintain the new machines and to manage a more complex organisation.

In such a world, you'd expect the wealthiest people in the community to be highly technically trained and great organisers – people like Bill Gates and Warren Buffett.

A related phenomenon is what the authors call "increasing returns to superstars", but is otherwise known as the rise of "winner-takes-all" markets.

Legal and sporting contests, for example, reward people not so much because they're highly skilled but because they're more highly skilled than others.

Such rewards increase with the size of the market in which the contest occurs.

"Moving from a world where every town runs its own competition to one where a single high-stakes competition is held for a whole country, or the whole world, involves the replacement of local winners with uber-winners who enjoy far higher returns but of whom there are far fewer per type of contest, resulting in a more unequal overall income distribution," Frijters and Foster say.

"This kind of effect explains the enormous salaries earned by today's soccer stars, top artists, top financial advisers, inventors who obtain patents, and so on."

It's advances in communication technology that do most to explain the increased scale of many markets. Bigger scale means a bigger gap between people at the top of the world market and winners in the local market.

The returns to innovation are also much greater in a global market than in a local one, because you're pushing out for the whole world what economists call the "production possibility frontier" – increasing the menu of different goods and services we're able to produce.

The alternative explanation for growing inequality – especially at the very top – is the effect of political favours.

"Our democratic political process both sets the rules of economic interaction amongst market agents [participants] and allocates political favours, including taxes and subsidies. In this view, each institution within a country's bureaucracy has some discretionary power of its own," the authors say.

The political balance of power may change and lead to changed taxes and transfer (welfare) payments in ways that favour the rich and hurt the poor. This may happen by accident or by political design.
It may happen because interest groups become more effective at lobbying governments or because the rich become better at exploiting loopholes in regulations or taxes.

So much for theoretical possibilities. What hard evidence can we find to help us choose between those possibilities?

A study by Sir Anthony Atkinson, a British world expert on inequality, and Andrew Leigh, former economics professor and now federal Labor politician, found that reductions in tax rates explain between a third and half of the rise in the income share of the richest 1 per cent in five English-speaking countries.

But Frijters and Foster took the unusual approach of seeing what clues they could deduce from studying the BRW magazine's list of the richest 200 Australians in 2009. They found that the industry category producing the largest number of super-rich Aussies – 61 – was buying and selling property.

Natural resources was second with 23, then "organising financial investments" with 19. "These 103 cases account for the vast bulk of the $119 billion owned by the top 200 in 2009."

Only eight families in the top 200 held large amounts of inherited wealth and all eight were in those three industry categories. So most of the money of our super-rich was made relatively recently.

As best the authors could determine, only five people on the list invented things. Another five were top entertainers. So only 5 per cent of our super-rich could be classed as superstars or top innovators.

About half spent their efforts on activities where local political decisions determine the winners: about who gets to build which property where, who gets access to favourable mining concessions, and so on.

On the basis of this evidence – which is hardly definitive – the authors conclude that "the political favours story seems more likely than the marginal productivity story".

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Why big business has so much influence

According to the Labor Party's rising star, Senator Sam Dastyari, 10 big companies control our political process. They are the four big banks, three big mining companies, the two big grocery chains and the one big telco, Telstra.

The only surprise in that list was his third miner, not the foreign-owned Glencore Xstrata – to go with the foreign-owned BHP Billiton and Rio Tinto – but the largely Australian-owned Fortescue Metals.

I doubt it's quite that simple but, on the other hand, I doubt many people would believe me if I claimed that big business had no great influence on our politicians.

You don't need to look far to find evidence of the power wielded by "the big end of town".

Consider the fate of the mining tax. First Julia Gillard allowed the original big three miners to redesign the tax to their own satisfaction, hugely reducing its revenue-raising potential, then Tony Abbott abolished it.

Or consider the banks. Whenever they fail to pass on in full to home buyers a cut in the official interest rate, the pollies on both sides are loud in their condemnation. But they never actually do anything.

Since the global financial crisis they haven't been game to make the one big change we need, obliging the banks to choose between their government guarantees and their right to continue engaging in speculative market trading.

When the former Labor government responded to the various cases of bank-owned outfits giving appalling advice to small investors by tightening up the rules and limiting the use of commissions, first Labor toned down its investor protections in response to bank objections, then the incoming Coalition government attempted to tone them down a lot more.

And any number of farmers and small suppliers will tell you Woollies and Coles are allowed to get away with murder.

It's tempting to think the economy is controlled for the benefit of big business, not mere consumers.

But there are plenty of counter examples. Take Malcolm Turnbull's decision not to make changes to the goods and services tax.

Who do you think was pushing hardest for the GST to be raised? They hoped the proceeds would be used to cut the rate of company tax.

The point is that politicians survive only by getting enough votes, and each of us gets a vote but companies get none.

Turnbull turned away from the increased GST because he feared the economic benefits from a change wouldn't be sufficient to justify the risk of losing many votes.

But if politicians care ultimately only about votes, why are they so prone to accommodating the interests of big business? Because the two sides compete hard to attract votes during election campaigns using advertising, direct marketing and other expensive tools.

The parties need money to finance their campaigns, and big business and big unions are willing to supply it. Election campaigning has become a kind of arms race, where each side can never get enough. Give the parties public money to help with expenses and it doesn't satisfy them, it just moves the race to a higher level.

But does this mean businesses are attempting to buy influence with people in power? Does it mean the parties are effectively selling favours?

What an utterly offensive thing to say. Joe Hockey would be shocked. Businesses just want to support the democratic process. The parties are happy to take the money, but donors gain nothing in return.

Don't believe it? Neither does the Organisation for Economic Co-operation and Development. It says so in a new report, Financing Democracy: Funding of political parties and election campaigns and the risk of policy capture.

"Although money is necessary for political parties and candidates to operate and reach out to their voters, experience has shown that there is a real and present risk that some parties and candidates, once in office, will be more responsive to the interests of a particular group of donors rather than to the wider public interest," the report says.

"Donors may also expect a sort of 'reimbursement' for donations made during an election campaign and to benefit in future dealings with the respective public administration, for instance through public procurement or policies and regulations."

The report proposes a framework of items to avert the capture of government policy by interest groups. It advocates tight regulation of party donations, but warns that rules can be avoided by the use of "third-party" funding (interest groups in sympathy with, but not part of, particular parties) and other legislative loopholes.

It calls for a highly independent, well-resourced electoral authority with monitoring powers and the ability to impose sanctions ranging from fines and criminal charges to the power to confiscate illegal donations. Sounds a long way from our electoral commission.

It reported on political donations only last week. The donations it informed us of had been made up to 19 months earlier. Even so, the figures may not be complete. There is little penalty for late disclosure.
Parties are not required to disclose donations under $12,800, and buying a seat at a dinner table with a minister is not classed as a donation.

The OECD report says public reporting of donations should be timely, reliable, accessible and digitally searchable. Why? To make it easier for civil society groups and the media to be effective watchdogs.

Perhaps that's why we don't do it.

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Too many 'no-brainer' cures for health, education

If the tax system and industrial relations aren't high priorities on my reform agenda, what does deserve to be at the top of the list? It's obvious: health and education are crying out for attention.

There are many reasons why economic reformers should be paying more attention than they are to education and health. One is that they're bedrock responsibilities of government.

The second is that each of them constitutes a major industry, big enough for a poor performance to be significant at the macro-economic level. Together they account for 11 per cent of gross domestic product, but for technical reasons this understates their significance.

A better indication of their contribution to economic activity is given by their shares of total employment. Education and training accounts for 8 per cent all jobs, making it a bigger employer than manufacturing.

Health care and social assistance is actually our biggest industry by far, accounting for almost 13 per cent of all jobs. All told, these two public sector-dominated industries account for more than one worker in five, 2.5 million souls.

A third reason for giving health and education more attention than economists have done is that their unavoidable – and, indeed, desirable – high degree of government regulation and participation means normal market disciplines are missing, making them more susceptible to waste and ineffectiveness.

Every doctor or health worker will tell you of waste in the health system, while the anti-government brigade is right in saying there's little evidence of improvement to show for all the extra money we've pumped into education in recent years.

A fourth reason is the intrinsic importance of both industries. Not many industries have more significant effects on our lives, wellbeing and quest for longevity than healthcare. Education hugely influences the quality of our lives and, to get mercenary, our earning capacity as individuals and as a nation.

It's amazing how business people and economists wring their hands over our supposedly weak productivity performance without ever concluding it means we should leave no stone unturned to get education right at every level, from early childhood development to post-grad research.

In the era of the information economy, any country that's stuffing up education at almost every level the way we are is asking to be relegated to the ranks of the poor and needy.

The final reason is that, precisely because government involvement in health and education is unavoidable, they constitute a major part of government spending – federal and state – and thus a major part of the other dimension of our economic challenge: budget repair.

Study the successive Treasury intergenerational reports – federal and state – and a single fact leaps out: the one, overwhelming threat to future budgets is the projected ever-growing cost of health care, only part of which is explained by an ageing population.

Which brings me to the point: econocrats are frequently involved in governments' unceasing decisions about health and education, but that involvement is much more focused on achieving budget savings than on ensuring all the government regulation and subsidisation of health and education leaves us with health and education systems that deliver Australians value for money both socially and economically.

Like so many of the interest groups, econocrats are obsessed with funding education and health rather than ensuring both systems are working in ways that have found a good trade-off between fairness and efficiency and effectiveness.

Quite frankly, when Treasury and Finance put on their expenditure review committee hats their contribution to the decision-making process is more likely to be welfare-diminishing than welfare-enhancing.

Their first besetting sin is short-sightedness. Forgetting (as we usually do) that knowledge is valuable for its own sake, education is all about long-term investment in human capital. But who can worry about that when we're pulling out all the stops to ensure this year's budget deficit doesn't look bad?

In health, it's obvious that well-chosen preventive health measures will yield big payoffs to taxpayers down the track. But when the heat was on in the first Abbott/Hockey budget, preventive health measures were among the first items thrown on the bonfire.

The econocrats' other besetting sin is what I call "no-brainer" economics. Don't bother learning about the specifics of the field you're dealing with, don't consult the health economists – if there are education economists out there I wish they'd get in touch – just wade in with your pocket-rocket model of all markets and propose "getting the [exclusively monetary] incentives right" and "introducing competition" from for-profit providers (such as shonky vocational "colleges").

Is this the best economists can do? If so, they're part of the problem and need reforming.

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We're a long way from getting bank regulation right

The movie version of The Big Short is so good you probably don't need to read the best-selling book by my far-and-away favourite finance writer, Michael Lewis.

If you want to go deeper than the events culminating in the global financial crisis of 2008 to a more systemic analysis of why we've had so much trouble with the financial system and will continue to unless we change the rules more radically than we have, I recommend you read Other People's Money, by a leading British economist, Professor John Kay.

It's required reading for the nation's economists but, although it's very thorough, it's eminently readable by ordinary mortals. Similarly, although it doesn't deal specifically with Australia's financial system, its analysis is more readily applied to Oz than a book more focused on Wall Street.

Kay was in Australia this week, and when I spoke to him he left me in little doubt that he wasn't wildly impressed by our financial system inquiry, conducted by a panel dominated by people from the industry and led by former Commonwealth Bank boss, David Murray.

Not much there to ruffle the industry's feathers.

The Murray report does little to contradict the conventional wisdom that the huge expansion of the "financial services" industry over the past 30 years has been a great boon to the wider economy.

We've benefited from much financial innovation, deeper financial markets and a revolution in the management of financial risks.

But have we? We've certainly enjoyed much greater access to credit and much more convenient banking thanks to automatic tellers, direct debits and credits, and bill-paying on the internet.

But much of this is owed to advances in information processing and telecommunications rather than banking expertise.

Much of the "innovation" in the development of new financial products has been motivated by a desire to get around government taxes and regulations.

We're often told that all the trading of financial claims the banks and other market participants do between each other has made financial markets deeper and more liquid, thus making it possible for bank customers – individuals or businesses – to buy or sell a large block of shares or currencies without their transaction having a big, adverse effect on the market price.

Kay counters that all the trading of claims between financial institutions has, in fact, made financial markets far deeper than is required by users from the "real economy". Their need to buy and sell securities without moving the price could be met by opening the markets for a quarter of an hour a week.

But surely all that trading – in conventional securities, but also in ever-more exotic "derivatives" that get ever-more removed from the physical assets they are supposedly derived from – is aimed at helping customers manage the financial risks they face.

Well, that's what bank bosses and economists told us for years. Kay recalled the now-infamous incident in 2005, where a young Indian upstart from the International Monetary Fund attending the US Federal Reserve's annual conference at Jackson Hole, Wyoming, queried the value of recent innovation in financial markets and warned of troubles ahead.

The young fool was quickly put back in his box. One heavy defended the innovations, claiming that "by allowing institutions to diversify risk, to choose their risk profiles more precisely, and to improve the management of the risks they take on, they have made institutions more robust".

"These developments have also made the financial system more resilient and flexible – better able to absorb shocks without increasing the effects of such shocks on the real economy," he went on.

Later, another heavy agreed: "Financial institutions are able to measure and manage risk much more effectively. Risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries."

You've guessed how this story ends. Within two or three years, the global financial crisis revealed all that as the opposite of the truth – to the great cost of taxpayers who had to bail out banks in the US and Europe and all the people in the real economy who lost their jobs or businesses.

It turns out the financial markets weren't managing risk by spreading it thinly across many people – as happens with an insurance policy, for instance – but were multiplying it (by gearing up and by creating derivatives of derivatives) and concentrating it in the hands of a relatively small number of big banks. Nobody knew how much risk particular banks had taken on.

The other way to "manage" risk is to find someone whose particular circumstances give them the opposite "risk profile" to yours. Do a deal and the problem is solved at each end.

In practice, however, such perfect matches are very hard to find. The best you can do is find a partner who's "risk seeking" – they want to take on the risk because there's a chance they'll clean up if you've jumped the wrong way.

In other words, they're willing to speculate. Turns out that's the main thing our bigger financial system is doing: not managing risk in any genuine sense, just making bets with each other.

These days, no central banker makes speeches extolling our bigger financial sector and much better ability to handle risk.

Trouble is, Kay says, all the tightening of regulation – including the requirement for banks to hold higher levels of capital, which the Murray report so strongly supported – hasn't done enough to ensure we don't have another crisis.

We have loads of regulation, all of it acceptable to the banks, whatever their grumbles. We could have less regulation if we regulated the right things the right way.

We could leave speculative trading between financial institutions largely unregulated provided it was separated from the normal banking activity than must always be effectively government-guaranteed. But the banks mightn't like that.

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Good reason to be angry about the banks

Are you angry about the banks? A lot of Australians are. And a lot of people in the United States and Europe are a lot angrier than we are, with good cause.

In Oz, we're annoyed mainly by the banks' very big profits and the way they never seem to miss a trick in keeping those profits high.

In other countries, people are angry about the way the banks and other financial institutions, having stuffed up their affairs to the point where they almost brought the global economy to its knees, were promptly bailed out at taxpayers' expense, so that few went bust, with almost no executives going to jail and many not even being fired.

By now, however, you're probably used to bankers and economists saying you don't understand and are quite unreasonable in your criticisms.

That's why you need to know about the book, Other People's Money, by John Kay. Kay, who's visiting Australia and this week spoke to a meeting organised by the Grattan Institute, says he wrote the book to help ordinary people understand "what it is they're angry about".

You want the dirt on the banks? No one's better qualified to spill the beans than Kay, an economics professor from Oxford and columnist for the Financial Times, who was commissioned to write a report on the sharemarket for the British government.

He starts by noting that over the past 30 or 40 years, each of the developed economies has experienced "financialisation" – huge growth in the size of what these days is called their "financial services sector" to the point where it's among their biggest industries.

For years, we've been told this is a wonderful thing, a sign of our economy's growing sophistication and ability to manage risk. Kay doesn't believe it.

We've always had a financial sector composed of banks, insurance companies and other institutions, and we've always needed one.

We've needed it to help us make payments to each other, to bring people wanting to save together with homeowners and businesses wanting to borrow, to help us save for retirement and to help individuals and businesses manage the risks associated with daily life and economic activity (insurance policies being the obvious example).

We need a financial sector to service the needs of the "real economy" of households and businesses producing and consuming goods and services. But none of this justifies the huge growth in the financial sector we've seen.

Most of that growth has come in the form of massively increased trading between the banks themselves in "financial claims", such as shares and bonds and foreign currencies and "derivatives" (claims on claims, and even – if you've seen The Big Short – claims on claims on claims).

If you add together all the financial assets ("claims") owned by all the banks and other financial outfits, they exceed by many times the value of the physical assets – such as houses and business buildings and equipment – which are the ultimate basis for all those claims.

The value of foreign currencies changing hands each day vastly exceeds the value of currencies needed by businesses and tourists paying for exports and imports. Similarly, the value of shares changing hands each day vastly exceeds companies' needs to raise new share capital and end-investors' needs to buy into the market or sell out.

Kay says that, in Britain, bank lending to firms and individuals in the real economy amounts to only about 3 per cent of their total lending.

All the rest is lending to other banks and institutions busy buying and selling bits of paper to each other – making bets with each other that the prices of those bits of paper will rise or fall in coming days.

Kay makes what, for an economist, is the very strong condemnation that almost all this speculative activity is "socially unproductive". It might or might not benefit the people doing the trading, but it's of no benefit to the rest of the economy.

He observes something I've noticed, too: economists have put little effort into explaining why all this trading in claims is so hugely profitable, allowing people near the top of the banks (but not their many foot soldiers) to be paid such amazing salaries.

If all they're doing is making bets with each other, why aren't the gains of the winners exactly cancelled out by the losses of the losers?

His answer is that the claims-trading parts of banks have found ways to exaggerate the profits they make by counting expected future profits they haven't actually captured – "paper profits" – but delaying recognition of expected "paper losses" until they're realised.

This game can continue for as long as everything's on the up and the bubble's getting bigger. Once it bursts, of course, former supposed profits become present, unavoidable losses. Many banks teeter on bankruptcy, but the government bails them out and they live to gamble another day.

Kay says the answer is to rigidly separate the old-fashioned parts of banking – the facilitation of payments, and lending to households and businesses; the bits that must be kept going through recessions – from all the speculative trading in claims.

It's a free country and "investment" banks should remain free to bet against each other, but there should be no taxpayer bailouts or other government protection for those that do their dough.

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Big business-biased 'reform' won't fly

I'm confident this year will see the economy performing better than many people expect – those who underrate the importance of domestic influences – but I'm far from confident it will be a year of great progress on economic reform.

There are plenty of things that need reforming, but anyone who thinks the top two are the tax system and industrial relations is confusing rent-seeking with reform.

Rent-seeking involves interest groups pressuring governments to change laws and regulations in ways that advantage them at the expense of others. Look at our tax "debate" and that's just what you see.

Big business and high income-earners want to pay less tax – a cut in the rate of company tax and in the top personal tax rate – and if that means other people paying higher tax, say through a higher goods and services tax, so be it.

Naturally, their self-interest is cloaked in claims about how good this would be for the economy. Benefits going directly to the well-off, we're assured, will trickle down to the punters.

But rarely do the advocates of such reforms spell out the mechanisms by which lower rates of tax are supposedly transformed into greater effort to "work, save and invest", much less produce empirical evidence.

It's remarkable how many highly trained economists go along with this self-serving pseudo-science.

There are two giveaway signs that the present push on taxes isn't genuine reform. First, the one area where there's solid evidence that high (effective) marginal tax rates are discouraging work effort is in returning mothers' transition from part-time to full-time work, but no one's proposing to do anything about this.

Second, if people are so anxious to respond to globalisation's threat to our tax base by shifting it away from taxing mobile resources, how come they're so set on increasing the GST rather than taxing the ultimate immobile resource, land?

Of course, we've yet to see how far Malcolm Turnbull will go in seeking to give his party's business backers the "reform" they seek. If he doesn't go far, they'll brand him as lacking courage. It will be more accurate to say he lacks foolhardiness. Rejigging the tax system to favour the better-off will always be hard to sell to the rest of the electorate.

As for industrial relations reform, there's never been a time when it's less needed. Certainly not the reform that gives employers more power to limit the wage rises of their workers. This stuff is straight wishful thinking by bosses.

One thing we'll notice this year is the potential for conflict between tax reform and budget repair. It was good last week to see the secretary to the Treasury, John Fraser, discharging Treasury's sacred duty to put fiscal rectitude above all else, by reminding us of the importance of returning the budget to surplus.

Predictably, the political journalists' conclusion that Fraser was warning of the imminent loss of our AAA credit rating missed the point. Rather, he was openly correcting his masters' repeated contention that a return to "growth and jobs" (mysteriously brought about by business-biased tax reform) would fix the budget problem.

Not when the deficit you're running is more structural (caused by explicit spending and taxing decisions) than cyclical (caused by temporary weakness in the economy), he told them. So there's no substitute for hard decisions to cut spending and raise taxes.

Can the Turnbull government reform taxes and repair the budget in the same year? We'll see, but I doubt it.

In any case, it won't get far as long as it sticks to its political ideology that higher taxes are the greatest economic evil, so the only acceptable way to return the budget to surplus is to slash government spending.

Trouble with this mentality is that while it rests easily in the minds of conservative governments – and Treasury secretaries – in practice it's almost impossible to implement.

That's because it shifts the burden of repair towards welfare recipients and ordinary wage-earners, and away from high income-earners using concessions and loopholes to pay less tax than they should.

Problem: the votes of the chosen victims far outweigh the votes of the high-income beneficiaries. Surely Turnbull, Scott Morrison and Fraser learnt that from the utter disaster of the government's first budget.

He didn't say it, but Fraser's speech implied that recent increases in spending on the disabled, on disadvantaged school kids and on higher wages for welfare and childcare workers were a waste of money and needed to be chopped back.

If we never get back to budget surplus, such ideological bias and pig-headedness will be a big part of the reason.

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Economy will look better when mining investment stops falling

Here's a little tip for the start of another working year: if you want to make much sense of the economy, you need a good feel for arithmetic.

Thanks to our obsession with economic growth, we're almost always focusing on the change in economic indicators like gross domestic product and its components, such as consumer spending, business investment, imports and exports. (And the figures we look at are usually "in real terms" – they've had the effect of inflation removed from them.)

So the big focus is on whether indicators have grown or shrunk since last quarter or last year and, if so, by how much. This means I often find myself writing a sentence such as "the growth in X – exports, say – accounted for more than all the growth in GDP".

Almost every time I do I get someone saying "what? how can that be true? How can the growth in a component of the total account for more than all the growth in the total?"

If that objection makes sense to you, you're showing your lack of arithmetic imagination. It's perfectly possible for one component to grow by more than the growth in the total provided some other component shrinks. Oh, of course.

Now consider this: we've been very unhappy with our "below trend" (below average) rate of economic growth in recent years, such as our growth of just 2.5 per cent over the year to September.

But everyone knows our problem is that we're having to make a transition from growth led by mining – in particular, by the massive surge in investment in the construction of new mines and natural gas facilities – to growth led by the rest of the economy.

And rough calculations suggest that the "non-mining economy" grew by about 3 per cent over the year to September.

Since we know the economy overall grew by 2.5 per cent, this means the "mining and mining-related economy" must have contracted over the year. This is hardly surprising: mining investment spending is dropping like a stone.

It's also good news. For a start, it says we've made a lot of progress in getting the rest of the economy growing strongly.

But there's another, arithmetic point. The collapse in mining investment can't go on forever. Eventually you hit bottom and can't fall any further. When that happens, the mining sector stops "subtracting from growth".

And when mining is neither subtracting from growth nor adding to it, the quite-strong growth in the non-mining economy will be all the growth we've got – and it, we can hope, will still be growing by 3 per cent a year.

In other words, the economy should speed up as soon as it loses the drag coming from the big contraction in mining investment. And that should happen by about the end of this year.

Next, have you noticed how popular it's become to measure the budget's performance by looking at the change in the level of government spending as a proportion of "nominal" (that is, before adjusting to remove the effect of inflation) GDP?

In principle, it makes sense to compare nominal government spending with the nominal size of the economy. It's saying that the size of the economy grows for various reasons – inflation, real growth, growth in the population – and it shouldn't worry us that government spending is growing for the same reasons.

It's only noteworthy when government spending is growing faster or slower than the economy.

But here's where it helps to have a feel for arithmetic. When you keep comparing an economic variable to a particular "denominator" (the number that goes on the bottom of the sum) over many years, you're implicitly assuming that the denominator (nominal GDP, in this case) moves in a reasonably steady, reliable way.

If so, any change in the ratio (the percentage) can be attributed to changes in the "numerator" (the number that goes on the top; in this case, government spending). If the denominator isn't moving in a stable fashion, then this instability could be contributing to the change in the percentage, making it hard to be sure what's going on with the numerator.

Trouble is, the resources boom has played havoc with the stability of nominal GDP. Why? Because GDP, being a measure of the nation's production of goods and services, naturally includes our production of exports.

But we know that the prices we were getting for our main mineral exports – coal and iron ore – shot up to unheard of levels in the early part of the boom, then from mid-2011 began falling back to earth.

To see how this has affected the stability of nominal GDP, consider these comparisons (for which I'm indebted to Michael Blythe, chief economist of the Commonwealth Bank). Over the nine years to 2001-02, it grew at an annual average rate of 6.1 per cent. (This would be inflation of 2.5 per cent plus real growth of about 3.5 per cent.)

We can think of that as nominal GDP's "normal" rate of growth. But then the prices boom starts and continues for the nine years to 2010-11, during which it grew at a rapid annual average rate of 7.2 per cent.

In the four years to 2014-15, however, the fallback in export prices caused nominal GDP to grow at a pathetic annual rate of 3.4 per cent – just a bit more than half what's "normal".

Get the point? The ups and downs of our mineral export prices shouldn't have any direct effect on the growth in government spending (though the boost to tax collections may have encouraged governments to be more generous on the spending side).

So the resources boom has had the effect of causing the government spending-to-GDP ratio to understate the extent of the growth in spending during the boom years, but now is overstating it.

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Why it shouldn't be a bad year for our economy

Thanks for asking. Yes, I enjoyed my holiday – read some good books I'll tell you about later – but, unfortunately, didn't get far enough away from the media to avoid hearing all the gloomy news about the economy.

The Americans raised interest rates, the Chinese sharemarket fell, oil prices fell, share prices fell around the world, our dollar fell, the Chinese announced their economy was growing quite strongly, which everyone refused to believe.

Anything I've missed? Rarely has a year got off to such bad start, we were told. Might be worse than the global financial crisis, according to some guru whose name I forget. Recession will be knocking on our door, we're told.

Sorry, I'm not convinced. My guess is this won't be such a bad year for us, and next year will be quite good. Why? Because we've got a lot going for us domestically and because the bad things happening overseas won't have as much effect on our fortunes as many people have come to imagine.

It's become fashionable, particularly among our big business people, to take all the foreign economic news terribly seriously, on the assumption it has big implications for us Down Under.

I'm old enough to remember a time when most people believed that what happened to our economy was always of our own making. The Whitlam government tried to blame the recession of the mid-1970s on overseas factors, but everyone knew it was lying.

Since those far off-days, the world economy has globalised, of course, with the Hawke-Keating government doing much to open our economy to the rest of the world, particularly by floating our dollar and dismantling our protection against imports.

Another thing that's globalised is the media. When something bad happens anywhere in the world, we're told about it within an hour or two. Good news takes longer to pass on, if it gets through at all.

In the just-ended summer silly season, all the bad economic news from abroad has been a godsend to the parched local media, and we've played it for all it's worth.

But I think that, in adjusting to the globalised, joined-up world economy, we've gone too far the other way, assuming everything that happens overseas will determine our fate, that our economy is just a cork tossed on a global sea.

It's true that China's economy now has more influence on our future than the American or European economies we know more about, but even this can be overdone.

As can the media's extraordinary preoccupation with the ups and down of local and foreign sharemarkets, about which they – and we – know little. Hardly a news bulletin passes without us being told of the latest movement in the Dow, Footsie​ and Hang Seng.

The advent of compulsory superannuation saving has made our retirements more dependent on the fortunes of the sharemarket and, more to the point, made us more conscious of that dependency.

But sharemarkets have always gone up for a period and then down for a period, gone down for a while and then gone back up. Even during the market's long periods of seemingly steady rise, it's down on at least as many days as it's up.

So people who think they can learn anything useful about their affairs by listening to the nightly news to hear what happened to the market today – and then cursing when it's down – are fools. They've allowed the media to find a new way of making them feel bad.

Almost every economic event has advantages and disadvantages, producing winners and losers. When we allow a panicked global sharemarket and disaster-loving media to interpret those events for us, they soon convince us a fall in oil prices is bad news, not good, and the lower Aussie dollar is more bad news, even though it's what our economists have been praying for.

Perhaps our excessive attention to foreign news is fed by the widespread belief that countries make their living by selling things to other countries. So if other countries' economies are weak, our economy will be too, because they won't be buying much from us.

Fortunately, it ain't true. Or, to be accurate, it's 20 per cent right and 80 per cent wrong. It's true that Australians, like everyone else, make their living by producing goods and services and selling them to other people.

What's not true is that the other people have to be foreigners. Aussies will do just as well. About 20 per cent of what we produce is sold to foreigners, leaving a mere 80 per cent sold to locals.

That's why it's easy to exaggerate the effect that weak foreign demand for our goods and services will have on our economy. And the fact is that although prospects for the biggest export-oriented part of our economy – mining – are poor, the prospects for domestically oriented industries are good.

Unofficial estimates show the mining-related part of the economy is going backwards, whereas the "non-mining economy" has been growing at the healthy annual rate of about 3 per cent.

You see this in our figures for employment. Over the year to December, employment grew by more than 300,000 workers, a strong 2.7 per cent increase. The official rate of unemployment fell from 6.2 per cent to 5.8 per cent.

I'll be surprised if this steady improvement doesn't continue this year.

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MY JOURNEY TO SCEPTICISM ON TAX REFORM

Talk to Australasian Tax Teachers Association, Sydney, Thursday January 21, 2016

My interest in taxation goes back to the mid-1960s when my first job on leaving school was to work for a small chartered accounting practice in Newcastle, where, in between auditing assignments, I would prepare accounts and simple tax returns for individuals and small businesses, while studying part-time for a commerce degree at Newcastle University.

I ended up working for one of the then Big Eight accounting firms, Touche Ross, in Sydney. I was on secondment to their San Francisco office at Christmas 1971 when, to my amazement, I discovered in a phone call from home that I’d passed my last exam to achieve my long-held ambition of becoming qualified as a chartered accountant. It proved to be the most disillusioning event in my life. I realised I was a lot better at passing accounting exams than I was at being an accountant, certainly an auditor. I decided tax was the most interesting aspect of public accounting, but also decided I didn’t want to devote the rest of my working life to helping the well-off avoid their obligations to the community.

I decided to take a one year break from my accounting career and go back to uni. Initially I thought of doing an MBA at the University of NSW and, on the strength of that, got offered a job at UNSW as part-time tutor in first year accounting. In the end I decided to do the first year of what’s now the BA Communications degree at UTS. I kept the tutoring job, however, and kept it the following year, after I became an overgrown graduate cadet journalist at the Sydney Morning Herald.

It wasn’t long before the Herald encouraged me to specialise in writing about economics, on the grounds that economics and accounting were “pretty much the same thing, aren’t they?”. I’d done three years of economics in my commerce degree, but it never made much sense to me and I’d forgotten most of what I was supposed to know.

The one clear area of overlap between accounting and economics was, of course, taxation. So in my early days as an economic commentator I wrote a lot about taxation, making the adjustment from the approach of a tax practitioner to that of an economist concerned with tax design. The very first feature I wrote was one explaining a new-fangled idea called tax indexation. I also remember writing one explaining the new Labor Treasurer Frank Crean’s plan to introduce a capital gains tax.

I guess it would have been in the late 1970s that I noticed the challenging things being said by some newly arrived tax expert, quoted extensively by The Australian, Dr Neil Warren. I was much impressed, but it was a few years before I met the great man and was amazed to have him tell me I’d been his tutor in first year accounting. Ever since, I’ve referred to him as “my most distinguished student”.

So now you know why I’m here tonight. When Neil asked me, I couldn’t say no. He further induced me by saying that, since the conference theme was looking backward and looking forward, and I’d been taking an interest in tax reform for more than 40 years, it wouldn’t be an arduous assignment.

It’s certainly true that my memory of tax reform goes back a long way. A lot of my early learning on tax design came from the dozen-or-so little blue booklets that Treasury prepared for the benefit of the Asprey committee. I was working in the Herald’s bureau in Parliament House on the day in 1975 when the Whitlam government released both the Asprey committee’s final report and Russell Matthews’ report on tax indexation, making clear its unwillingness to implement any of their many recommendations.

Much of my education on tax design came from Treasurer Keating’s successive tax advisers, first Greg Smith, then Ken Henry. In more recent years I get much of my inspiration on tax matters from that great, under-sung tax expert, Peter Davidson. I attended the Tax Summit in 1985 and was amazed to have Ken tell me years late that my unwavering support had done most to keep Option C alive until the arrival of the summit, despite the rest of the Cabinet’s - and the ACTU’s universal opposition to Keating’s “broad-based consumption tax”. As you know Option C - which combined the retail sales tax with a capital gains tax and fringe-benefits tax - was reject. The coup de grace came, predictably, from the Business Council which, though it was very keen to see the consumption tax, didn’t fancy the income-tax base broadening, and thought it could pick and choose. It ended up with the worst of both worlds. If there’s a way to play your cards wrong, depend on the Business Council to find it. It took Keating less than a month to transmogrify from the leading advocate of a VAT-like tax to its leading opponent. Which, as we all remember, did much to help him win the unwinnable election against Professor John Hewson in 1993.

All this means I’ve be a witness to every part of Australia’s 25-year tremble on the brink before introducing at VAT, from its advocacy by Treasury in one of those blue booklets, its proposal by Asprey, John Howard’s quickly suppressed attempts to introduce a tax on services while he was Malcolm Fraser’s treasurer, Keating’s failure at the Tax Summit, Hewson’s failure to introduce a 15 per cent GST as part of Fightback! and, finally, Howard’s introduction of a 10 per cent GST following the 1998 election, which he went within a whisker of losing.

The introduction of the GST in July 2000 represented the last hurrah for the Asprey report - the final implementation of all its major recommendations. And it took only 25 years. On the day of its release in 1975, almost every political pundit would have been prepared to bet that none of its untouchable recommendations would ever be accepted.

You probably know that the role played by the Asprey report in providing a guiding light for Treasury to follow though all those wilderness years was the inspiration for Ken Henry’s major report on tax reform in 2010. He wanted to leave his successors in Treasury with another long-term guide as to the directions in which further changes to the tax system should head and not head. The fact that so few of his proposals were accepted wouldn’t have disappointed him as much as some commentators have imagined.

But I imagine he must be pretty rueful about the failure of his minerals resource rent tax. This must surely be the greatest tax reform stuff-up of our era. Everything that could go wrong, did, at every stage of the process, leave the blame to be widely shared between Ken (for recommending such a complex, unfamiliar and impractical tax), the prime minister (two of them), the treasurer, Treasury, the economics profession (which couldn’t understand how the tax worked) and the opposition leader, for his award-winning opportunism. At the level of political economy there is much to be learned from this monumental stuff-up, though it’s probably more a job for an investigative economic journalist than for a thesis-writer.

In recent times I’ve been among those reminding people that most of the extensive economic reforms of Hawke-Keating years were achieve with the assistance of tacit bipartisanship, particular from Howard and Hewson. It’s important to remember, however, that tax reform was the notable exception to the rule. Rarely can either side resist the temptation to exploit the self-interest and resistance to change of those groups who see themselves as losers.

But while we’re talking about the quarter-century saga of the introduction of a GST, I have to confess that it was the beginning - but by no means the end - of my growing scepticism about the importance of tax reform. At the start of the great GST exercise I was much exercised by the efficiency benefits arising from the general rule of broadening the base to cut the rate and the specific application of using a single-rate tax on almost all classes of consumption to avoid distorting consumers’ choices. But eventually I decided, in the absence of any empirical evidence, that the efficiency gains were probably not all that great and, by themselves, didn’t justify all the angst involved.

I maintained my support for a GST up to and including Howard’s successful introduction, but by the end my strongest motivation was just the need to protect the government’s revenue-raising capacity by replacing the defective and declining wholesale sales tax - not to mention the state franchise taxes struck down by the High Court - with a robust and broad-based consumption tax likely (as we then assumed) to grow pretty much in line with the growth of the economy.

I justified the regressive nature of the tax by arguing that this could be offset by progressively shaped income-tax cuts and, failing that, by compensation via transfer payments. In reality, however, the tax cuts that emerge are never progressive. And the compensation to lower income-earners can end up as a three-card trick.

In its general form the three-card trick says that if you want to help low income-earners you should always doing it via the tax and transfer system rather than by intervening directly in the allocation of resources. But then when you get to making your changes to the tax and transfer system, people argue that equity and efficiency are in conflict - in which case, sorry, but efficiency must win.

As it relates to things like increasing the GST, the three-card says yes, the change is regressive, but don’t worry, lower income-earners are fully compensated by higher pensions and benefits. Then it waits a beat and says, sorry, in recently years the growth in welfare spending has been “unsustainable” and drastic cuts are needed to avoid ever-growing budget deficits.

All this is the reason why, when Howard had to agree to exclude fresh food from his GST to get it past the Democrats in the Senate, I wasn’t greatly troubled. His total package was regressive and excluding fresh food was a quick and dirty way of making it much less so. I know the arguments about where you draw the dividing line between what’s taxable and what isn’t, but I think they’re overdone. I also believe that, in these days of computerisation, the costs of administering differing tax rates wouldn’t be great. Did anyone bother to gather empirical evidence of the efficiency cost of excluding fresh food? I doubt if they did. Perhaps it's not easily done. But I suspect those costs wouldn’t have been great. And in the choices Malcolm Turnbull faces this year, I doubt if he’ll revisit the question of taxing food. The compensation bill would be huge and the efficiency gain minor.

Aussie Holmes used to say that every economist needs a good sense of the relative magnitudes, so they don’t waste their energy worrying about problems that don’t matter much. It’s a version of opportunity cost. Such a sense is relevant not just to macro managers but also to tax economists. A related sentiment that gets too little notice from tax reformers is James Tobin’s remark that “it takes a heap of Harberger triangles to fill an Okun’s gap”. Unemployment is a far more obvious and bigger instance of inefficiency than a lot of the inefficiencies tax economists tend to obsess over. Perhaps the explanation here comes from Mark Twain: to a man with a hammer, everything looks like a nail.

My scepticism of efficiency arguments in tax reform goes much further than that. I’m sceptical of efficiency arguments based on simple neoclassical theory which lack empirical support. Economists ought to have learnt by now that just because an argument fits the theory doesn’t mean it works in practice. Then there’s the “model blindness” that affects most professions, but particularly afflicts economists. To argue that changes in marginal tax rates will have significant effects on people’s willingness to “work, save and invest” while taking no account of the myriad of non-monetary motivations is not what I call rigorous, no matter how impenetrable the equations.

Too often, arguments in favour of lower marginal rates are made in defiance of what empirical evidence is available. They are almost invariably made with reference to the rates faced by primary, full-time workers, whereas we’ve long known that the elasticities are significant only in the case of secondary workers. Patricia Apps has long argued that the interaction of the individual-centred tax system with the family-centred benefits system generates hugely higher effective marginal tax rates which do much to discourage mothers from progressing from part-time to full-time jobs. If we’re genuine in believing that tax reform is central to our efforts to encourage work effort, how come this issue is so rarely mentioned?

Sometimes, even the appeal to economic theory is partial - in both senses of the word. How come the claim that high tax rates discourage work, saving and investment is made without anyone ever bothering to note that theory says there’s two effects, income and substitution, that they’re in conflict and that the question of which effect dominates can only be answered empirically.

We keep being told that globalisation                                     

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Profit motive drives business to bend rules

Sometimes I think economists are people who believe fervently in private enterprise and the profit motive, but have never actually met a business person.

That doesn't apply to economists working for business, obviously, but it applies very much to the econocrats who give advice on economic policy and even, I suspect, academic economists.

Living in Canberra doesn't help.

One of the advantages of spending your entire career in the private sector, as I have, is that it disabuses you of the notion of business people as model economic agents rather than hugely fallible human beings.

The economists' neo-classical model has an anti-government ideology hidden within it, which leads economists working in the public sector to idealise business people. They're rational operators and when they seem not to be that's only because governments have distorted the incentives they face.

Business people rational? Oh, you mean like the bosses at Fairfax Media? You mean the period when we had chief executives in and out the door in the space of a year or so? The stories I won't tell.

Business people don't have any better fix on what the future holds than anyone else, so often make decisions that turn out to be dumb. But they'll often realise that long before they pull the plug. And when they do they invariably blame the economy or government policy.

The economists' model and methodology lead them to ignore all motivations bar monetary incentives. Since most people have plenty of other motives – worthy and unworthy – for the things they do, this leads the economists to a host of wrong predictions.

But business bosses – from big outfits or small – would have to be the most money-motivated among us. Success is judged by the size of your package (even if it leaves you with no time to spend the stuff). Managers learn when they realise their staff isn't as money-hungry as they are.

Public sector economists say they believe in the profit motive, but they have no conception of what a powerful force it is and what unpleasant surprises it can give you when you unleash it.

It turns business bosses into short-term maximisers, willing to risk their company's future to make a quick buck. Alan Greenspan confessed that "those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief".

Years ago economists realised that public companies have an "agency problem" because the incentives facing the agents of its shareholder owners (otherwise known as chief executives) can conflict with the interests of those owners.

The economists decided the answer was to use incentives such as share options and performance bonuses to align the interests of agents and principals. It's been downhill ever since.

Why? Because money-hungry managers haven't been able to resist the temptation to game the system. It has probably done more harm than good.

Business people are so motivated by the profit motive they're always looking for loopholes and bending the rules.

This year's revelations about the behaviour of seemingly respectable firms in the way they pay casual employees suggests they may even go further than that – and that the designated regulators are mighty slow in doing their job of policing the regulations.

The econocrats don't seem to have realised that when you give people a chance to put their hand in the government's pocket, they go as crazy as people who take home all the shampoo and soap sachets from the motels they visit.

In the rush to get new homes built before the goods and services tax was imposed on them in July 2000, punters pushed up home prices by a lot more than the 10 per cent tax they were avoiding.

For an example of business people doing crazy, destructive things to get into the government's coffers, look at the operators willing to risk the lives of the kids installing pink batts.

This kind of money-madness seems to happen every time the other-worldly econocrats persuade the government to "contract out" the provision of some government service and invite private businesses in on the act.

The latest is for-profit providers of vocational education exploiting the government's HECS loan scheme by offering students a free laptop if they sign up for dubious courses.

By now, such an outcome was eminently predictable. Government incentives often induce people, whether punters or profit-seekers, to do greedy, dishonest and even self-destructive things.

Working for government seems to convince economists that, if they couldn't only get to meet a business person, he or she would be a wonderful, caring human being.

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Reprint from1995: Economics of the Dreamtime

Showing for one night only: Aboriginal Economics. Have you ever wondered what the Australian economy was like before all the whities arrived?

I've just been reading a book by our great economic historian, the late Professor Noel Butlin of the Australian National University - Economics and the Dreamtime: a Hypothetical History, published posthumously by Cambridge University Press in 1993.

Though for many years it was believed there were only about 300,000 Aborigines in the land before the First Fleet arrived in 1788, Professor Butlin calculates that it was much higher: between 1 million and 1.5 million.

They lived as bands of hunters and gatherers, ranging in size up to about 40 people. So did they have what you could call an economy? Of course they did - though, naturally, it was very different to ours. There was no money or markets and not much trade between the bands.

But decisions were made about production and consumption, there were rules of distribution, forms of property rights, a division of labour and efforts to raise productivity.

One researcher, Marshall Sahlins, has argued that Aborigines deliberately sought a low standard of living in terms of food, shelter and clothing. But, accepting this, they were "the original affluent society".

Reports from the early explorers suggest that Aboriginal bands hunted and gathered for only four to six hours a day, but frequently appeared to have plenty of food in their camps. They seemed to spend a great deal of their time gossiping, playing or sleeping.

Sahlins's purpose was to combat the modern assumption that material wants are infinite and the old view that hunter-gatherers were exposed to continuous risks of starvation and needed to work long hours each day.

That's fine, but Professor Butlin rejects the corollary that Aborigines failed to develop an advanced culture because of idleness. His argument is that what may seem to be leisure or idleness to Western eyes was actually economic activity to the Aborigines.

For one thing, in a culture without writing, talking is the main way of communicating information. A lot of talking has to take place to preserve and pass on the group's knowledge of how the world works.

He speculates that much of the "gossip" could have been meetings of the band's production planning committee: discussions about what game to hunt, what food to gather, where to look for it, when to move on and so forth.

What has been seen by Europeans as merely leisure-time activities, in which children participate in games of skill and agility, is important as education. "Reputed games of a form of 'football', organised throwing of small spears or boomerangs, climbing and wrestling could all transmit skills; and adult oversight of these activities could appear to be indolence," he says.

And time spent in ritual and ceremony was accorded far more value than mere leisure. Ceremonial activity served the purpose of preserving identity and order within the group, and so preserved economic efficiency and equity.

The general division of labour was that men hunted and women gathered. This fitted their "comparative advantage" since women were responsible for carrying or caring for children. Certain styles of hunting, by tracking and chasing larger animals or by tree climbing and chopping, required the hunter to be unencumbered. Gathering of plants, seafoods or eggs was more suitable for encumbered members of the group.

Some production, including fishing, occurred at night - which would explain why "shift-workers" slept during the day.

Production of capital goods was limited and they were often nondurable. Even so, there was a demand for clothing, bedding, stone tools and myriad wooden and fibre implements, as well as items needed for long-stay and short-stay dwellings, canoes or rafts.

On occasions when the bands joined in tribal meetings, large numbers of men (maybe several hundred), together with dogs, took part in great kangaroo hunting drives. "Efficiency derived from the ability to contain animal movements, more quickly capture wounded animals, share in transportation back to camp and so on," he says.

So this is an example of the pursuit of economies of scale in production. The most striking example of the use of capital equipment to increase production was the development in Western Victoria of massive networks of eel canals, directing and restricting the movement of eels in rivers.

The provision and maintenance of this asset, which entailed a great deal of communal effort, not only increased the yield per person but also enhanced the supply.

Another production technique was "fire-stick farming". The burning of limited areas (which required great skill and effort to limit the area) was used to capture game (in conjunction with net fences) or to expose other foods, including eggs, slow-moving creatures and yam fields.

It can be argued that burning raised the productivity of the land and this is part of Professor Butlin's claim that the Aborigines weren't just hunters and gatherers but "resource managers".

Their moving from place to place was partly dictated by seasonal crops and by drought. But "Aborigines appear to have been concerned with long-term viability and with a degree of resource management that would ensure their ability to return to any location, not merely to 'mine' one and leave it".

There is evidence also of technological advance. Stone tools became smaller, finer and possibly more precise. The exploitation of fine stone spear tips would have improved killing efficiency.

The advent of the hafted fine-stone chisel or adze greatly improved efficiency in the hollowing of logs, the shaping of spear-throwers, the construction of shields and the removal of bark for canoes, housing or artistic products, including all forms of carving.

One technological breakthrough, however, was imported. The dingo arrived with the trepang fishermen from Sulawesi. It appears to have spread rapidly throughout Australia and enabled a great increase in hunting efficiency.

What does all this prove? Well, just for once, it doesn't have to prove anything. But it does show that, to an economist, economics is everywhere.

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How many Aboriginals died after the colonialists arrived?

If we can't lift our minds from earnest discussion of the economy and its discontents between Christmas and New Year's Day, when can we? So let's take a summer squiz at the work of the rapidly diminishing band of economic historians.

One of the most interesting things they do is try to piece together economic statistics covering the years before much official effort was devoted to measuring the economy. The United States didn't start publishing figures for gross domestic product until 1947; we didn't start until 1960.

The global doyen of economic historians was the Netherlands-based Scot, Professor Angus Maddison, who devoted his career to "backcasting" GDP to 1820 for all the major economies and regions of the world.

Despite all the unavoidable and debatable assumptions involved, Maddison's estimates are still widely used. They're a reminder that, before Europe's Industrial Revolution, the two biggest economies were China and India.

Australia's most distinguished economic historians were Noel Butlin, of the Australian National University, and his older brother, Syd, of Sydney University (after whom its Butlin Avenue is named).

Noel backcast Australia's GDP to 1861, then began researching what the Australian economy must have been like before white settlement. He wrote up his findings in Economics and the Dreamtime: A Hypothetical History (which I wrote up in a column on April 5, 1995).

As part of this research Butlin devoted much effort to estimating the size of the Aboriginal population before 1788. The anthropologist Alfred Radcliffe-Brown wrote in the Commonwealth Yearbook of 1930 that it would have been more than 250,000, maybe even more than 300,000.

But Butlin's piecing together of the evidence told him this was way too low. He wrote in 1983 that it would have been 1 million or 1.5 million.

Then in 1988 some of Australia's leading archaeologists, led by John Mulvaney, argued that a more accurate estimate would be between 750,000 and 800,000. This has become accepted as "the Mulvaney consensus".

Now enter Dr Boyd Hunter, of the Centre for Aboriginal Economic Policy Research at ANU. With Professor John Carmody, a physiologist at Sydney University, he published this year in the Australian Economic History Review a long paper reviewing Butlin's population estimates.

The point, of course, is that the Aboriginal population declined dramatically in the early days of white settlement. We can be reasonably confident that, by 1850, the Indigenous population was only about 200,000.

Thus backcasting the figures to 1788 involves determining the main factors that led to the loss of Aboriginal lives and estimating how many lives they took, then adding them back. So the paper is a kind of whodunit.

One factor springing to the modern mind is that the unilateral appropriation of Aboriginal land led to much frontier violence, which started shortly after the arrival of the First Fleet and persisted well into the 20th century.

"Like any war, declared or otherwise, the conflict led to many deaths on both sides," the authors say. But even the controversial historian, Henry Reynolds, estimated the number of violent Aboriginal deaths at as many as 20,000, making this only a small part of the explanation.

Butlin allows for Aboriginal "resource loss", where tribes' loss of productive members and land used for sustenance led to people dying of "starvation or dietary-related diseases". Butlin's calculation implies this factor would have involved as many as 120,000 people.

That's still not the biggest part of the story. No, the big factor is the spread of introduced diseases. Such as? Tuberculosis, bronchitis and pneumonia, not to mention venereal disease.

But the big one is smallpox. Butlin and others have assumed that it spread rapidly around Australia along the extensive pre-existing Aboriginal trading routes after its first recorded outbreak in Port Jackson in April 1789.

In 2002, however, the former ANU historian Judy Campbell argued in her book, Invisible Invaders, that it was brought to Northern Australia by the Macassan coastal traders following its outbreak in Sumatra in 1780, then spread across the continent, reaching Port Jackson by early 1789.

This is where Hunter – no doubt relying heavily on the expertise of Carmody – brings to bear modern medical understanding of the infectiousness and mortality rates of various diseases. Although smallpox has a high rate of mortality – between 30 and 60 per cent of those who contract it – it's not highly infectious.

This means it happens most in densely populated areas and doesn't spread rapidly to distant areas. This casts doubt on Campbell's theory that smallpox spread rapidly from lightly populated Northern Australia to densely populated NSW.

But it also casts doubt on Butlin's theory that smallpox spread rapidly from Sydney to the rest of Australia via Aboriginal trading routes.

So what's Hunter and Carmody's theory? Are you sitting down? Gathering all the suspects in a room, detective Hunter deftly turns the finger of guilt from smallpox to the so-far unsuspected chickenpox.

The two are quite separate diseases, but this wasn't well-known in the 1780s. And since they both give rise to rashes or spots around parts of the body, many people may not have been able to tell the difference.

The point, however, is that chickenpox is about five times more infectious than smallpox, meaning it could spread a lot faster. It can recur in adults as shingles, which is also highly infectious. When adults contract chickenpox it can be fatal.

When the authors use chickenpox to do their backcast, assuming a low mortality rate of 30 per cent and also taking account of resource loss, they get a pre-contact Indigenous population (including up to 10,000 Torres Strait Islanders and up to 10,000 original Tasmanians) of about 800,000 – which by chance fits with the Mulvaney consensus.

If so, colonialists didn't outnumber the (much diminished) Aboriginal population until the mid-1840s. And by 1850 the total Australian population was still 25 per cent smaller than it was before colonisation.

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How to find happiness at Christmas

The beauty of Christmas is that it's a time when everyone's happy. Well, not quite. Better to say, it's a time when everyone tries to be happy, but we succeed in varying degrees.

When Dr Peter Clarke, of Griffith Business School in Brisbane, surveyed 450 people to ascertain the nature of "Christmas spirit", he found it had five components: bonhomie, gay abandon, ritual, shopping and a little bit of dejection.

Yes. We all have periods of less-than-perfect bliss and perhaps we don't have any more of them at Christmas than at other times; it just feels that way because we expect to be happy at Christmas and are surrounded by people trying so hard to be.

Perhaps. But my guess is more of us do experience periods of unhappiness at Christmas. There are those who, for various reasons, have no family or friends with whom to celebrate, or those who miss those now missing.

Then there's all the distress arising from overadministration of that substance supposed to magically generate good moods. Too many hangovers after too many Christmas parties, regretted behaviour at the office party (this year, Fairfax Media employees received a stern warning that no tolerance would be shown), things said around the dinner table that would have been better left unsaid. Old wounds opened.

Yes, Christmas has its share of unhappiness, even if just the wish we hadn't eaten (or spent) so much. There are, of course, a few traps that can be avoided.

If, as some clerics allege, materialism has become our dominant religion, Christmas must surely be our most sacred economic festival. But the evidence suggests that's not the way to wellbeing.

I've said it before, but it's one of my strongest conclusions after decades of economy-watching, so I'll say it again: the trick to succeeding in the capitalist system is to say no to most of the blandishments of the capitalists.

Professor Tim Kasser​, a psychologist at Knox College, Illinois, and Kennon Sheldon, a professor of psychology at the University of Missouri, wanted to determine what makes for a merry Christmas.

They asked 117 people of varying ages questions about their satisfaction, stress and emotional state during the Christmas season, as well as questions about their experiences, use of money and consumption behaviour.

They found that those who most remembered family and religious experiences were happier than those for whom spending money and receiving gifts were the main things they remained conscious of.

Of course, for many of us, religious experiences are no longer part of Christmas. Don't take this the wrong way – I'm not on a recruiting drive – but I suspect those who retain a religious commitment already have "man's search for meaning" sorted, while the rest of us can spend a lot of time looking for substitutes.

All those claims that the environment or economics or libertarianism or a dozen other things have become "the new religion" are unconsciously affirming that humans function better when they have something to believe in, something outside and above their own self-centred concerns.

There's psychological evidence to support that. It doesn't have to be the Christian religion, however. And other research has shown that a big part of the benefit people get from church-going, or its equivalent, is social contact and membership of a group.

One advantage of a religious upbringing that's of particular relevance at Christmas is an instinctive understanding that, to quote some chap supposed to have been born at this time, "it is more blessed to give than to receive".

Think of Christmas as about giving rather than receiving and you're well advanced towards a happier time. And, naturally, there's empirical support for the notion.

A study by Elizabeth Dunn and Lara Aknin​, of the University of British Columbia, and Michael Norton, of Harvard Business School, first asked a sample of 632 Americans to rate their general happiness, report their annual income and estimate how much they spent on bills and expenses, gifts for themselves, gifts for others and donations to charity.

They found that personal spending was uncorrelated with happiness, whereas higher "pro-social spending" correlated with significantly greater happiness.

Next, 16 employees were tested for their happiness well before and well after they received a profit-sharing bonus. They found that those who devoted more of their bonus to spending on other people or a charity experienced greater happiness after receiving the bonus. And how they spent their bonus was a better predictor of happiness than the size of the bonus itself.

This, of course, is just a narrower application of the much-noted principle that happiness can only be achieved indirectly. If you want to end up realising you're happy, focus on increasing the happiness of others, not your own.

In discovering all these studies, I must acknowledge the assistance of the British psychologist, Dr Jeremy Dean, author of the blogsite PsyBlog.

I'm indebted to him for drawing to my attention a study by Vohs, Wang, Gino and Norton, which finds that engaging in ritualised behaviour enhances the enjoyment of food, particularly if it makes you wait a little longer.

So, Christmas rituals are important. In my family, we repeat a short but almost incomprehensible Scottish grace by Rabbie Burns that our mother taught us, to the bemusement of in-laws.

Have a happy one.

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