WELLBEING, MONEY, PSYCHOLOGY AND ECONOMICS

Conference on Quality of Life, Deakin University
November 30, 2006

I want to talk to you about the increased interaction between the disciplines of psychology and economics, and focus particularly on the relationship been income and subjective wellbeing, as befits a conference on quality of life. But first I need to explain that I’m not an economist myself. Rather, I’m a journalist who writes about economics.

Psychology and economics

You won’t be surprised to know that the academic discipline of economics is pretty inward-looking and hidebound. It’s still dominated by the neoclassical model of markets developed first by economists such as Adam Smith in the 18th century and Alfred Marshall in the 19th. It’s evolved a bit since then, but not as much as you might expect and not as much as I suspect psychology has. The conventional neoclassical model is built on many debatable assumptions, but most of the academic effort has gone not on trying to improve those assumptions but on mathematising the model, which permits many rigorously logical conclusions to be drawn - given the assumptions. All this maths allows the economists - like psychologists - to believe their discipline is more rigorously scientific than the other social sciences.

There have been various new developments in economics over the years - most of which have come to dead ends - but the relatively recent developments I find most interesting and most promising are based on borrowings from the work of psychologists. It may surprise you to know that the Nobel Prize in economics has twice been won by psychologists. Herb Simon of Carnegie-Mellon won it in 1978 for his ‘pioneering research into the decision-making process within economic organisations’. Conventional economics assumes economic man - homo economicus - to be a lightning-quick calculator of costs and benefits. Simon argued that people often use rules of thumb that economise on the cost of collecting information and on the cost of thinking. Their rationality was thus ‘bounded’ and rather than maximising their utility they ‘satisfice’ - they do as well as they think possible.

The second Nobel to a psychologist went to Daniel Kahneman of Princeton in 2002. He took Simon’s work a lot further, winning the prize ‘for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty’. It’s not directly relevant to quality of life, but I’ll say a little about it because it is interesting and it does, at present anyway, represent psychology’s most successful incursion into the thinking of economists. With the help of some economists, Kahneman founded a new school of thought within economics, known as behavioural economics, which has attracted a big following among younger academics.

Decision-making

As we’ve seen, behavioural economics challenges one of the central elements of conventional microeconomic theory: the assumption of Homo economicus. Economic man is assumed to be rational and self-interested. She always carefully evaluates all the options before making any decision, and always with the object of maximising 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 aren’t 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’ 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 is supposed to and often cannot 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.

Wellbeing and utility

That’s enough about psychology’s first challenge to economic orthodoxy. After Kahneman had made his mark on the theory of decision-making he moved on to join many other psychologists - and a few pioneering economists - in studying subjective wellbeing, quality of life, life satisfaction, happiness, call it what you will. This study ought to be of intense interest to economists because it’s hard to see much difference between psychologists’ subjective wellbeing and economists’ utility or satisfaction. In original intention, neoclassical economics is about studying the way individuals maximise their utility. As you know, conventional economics was heavily influenced by Bentham’s utilitarianism. So if economics has a goal, it’s to help the community maximise its utility.

The problem is that economics has rather lost its way on the question of utility. Sometime in the 1930s it was decided that the trouble with utility is that it’s unobservable - you can’t measure it. You can’t know how much utility A derives from the consumption of a glass of beer relative to B. The most we can hope to know is how they order or rank their choices. A prefers beer to wine, but wine to lemonade. But no mater. Since A and B are rational, and are always seeking to maximise their utility, it’s clear their preferences will be revealed simply by looking at what they choose to buy with their income. Their ‘revealed preference’ will tell us all we need to know about their utility.

Note how this seemingly neat shortcut relies heavily on the assumption of rational choice, that people always know and do exactly what’s best for them. They never do anything they subsequently regret and if occasionally they make a mistake, they quickly realise their error and never repeat it. Note, too, how circular the logic has become. How do we know what people want? From what they do. How do we know they do what they want? Because they do it. And here we see an old prejudice among economists that affect their attitudes towards psychology and its experiments, as well as surveys of wellbeing: ignore what people say they want, just focus on what they do. The other short-circuitry at work is that, though in theory economics is about maximising utility, in practice it ends up being about maximising consumption. Which particular forms of consumption? Doesn’t matter - just consumption. Which consumption is the private business of each consumer and not a fit subject for economists or governments to meddle with. How do you maximise consumption? By maximising the income from which people finance their consumption. How do you do that? By getting the economy to grow as fast as you reasonably can.

Now perhaps you see why the psychologists’ huge body of work on wellbeing is highly relevant to the work of economists - and highly challenging to their conventional views. And the particular pressure-point is obvious: the relationship between income and wellbeing. That’s what the economists who study wellbeing are most interested in. So what have we discovered about income’s role in wellbeing? We’ll get to that in a moment, but first I want to say something about terminology.

Speaking the same language

I think there’s much to be gained from an inter-disciplinary approach to many issues, but I’m constantly disappointed by the lack of contact between academics of different disciplines. They often criticise each other from afar - from the comfort of their own camps - but rarely get together to argue through issues of common interest. As a result, they’re often quite ignorant of the others’ way of looking at things, thus allowing much misunderstanding and incomprehension.

Joan Robinson, perhaps the most famous female economist and a contemporary of Keynes at Cambridge, once said that the purpose of studying economics is to learn how to avoid being deceived by economists. My take on the subject isn’t so defamatory: I think we study economics to learn when to use the many synonyms for the word ‘money’. Money is a vague term, can’t you be more specific? I’ve noticed that many social scientists use the words ‘income’ and ‘wealth’ interchangeably, whereas to economists they have quite specific, and different, meanings. Economists, like a lot of academics, are quite arrogant. So when you use those two words interchangeably, they’re either confused or they conclude you’re ignorant and not worth taking seriously.

Income is what you earn during a period from wages, business profits or investments, plus cash benefits received from governments. Most income is spent on living expenses - consumption - while some is saved. Wealth, on the other hand, is the value of the assets you own, less any money you owe. You add to it by saving some of your income, by gifts and bequests from others and by capital gain. Income is measured over a period of time - a week or a year - whereas wealth is measured at a point in time, such as the first day or the last day of a week or a year. So income is a flow of value over time, whereas wealth is a stock of value at a point in time. Consumer spending is primarily done from income, but the two aren’t the same thing because people spend less than their income when they save, or more than their income when they borrow to finance additional consumption.

It’s clear that what we’re talking about in the wellbeing context is almost always income, not wealth or consumption. Another thing psychologists seem weak on is the distinction between absolute levels of income and relative income. Relative income is how much I earn during a period relative to what other people are earning. A person or household’s absolute level of income is viewed in isolation from other people’s, though it can be compared over time - with how much I earned a year ago or how much I expect to earn in a year’s time. This distinction may seem pedantic but, as we shall see, it’s pivotal to the interpretation of the effect of income on wellbeing.

Income and wellbeing

Let me summarise the research results as I understand them. The first point to make is that, contrary to popular wisdom, money does make us happy - up to a point. Studies of developing countries show that the higher the average level of income per person in a country, the happier the people in that country say they are. So, up to a certain point, rising GDP per person does make people happier. That point, however, is about $US10, 000 or $US15,000 a year per person - a point that Australia and all the other developed countries passed a very long time ago. Studies show that even though the people in rich countries' income per person has doubled or trebled in real terms since the 1950s, average levels self-reported happiness haven't changed - they haven't fallen, but nor have they risen. In other words, and to use an economists' term, when it comes to happiness, money is subject to significant DMU - diminishing marginal utility. An increase in our income adds little if anything to our utility.

Why do increases in absolute income do little to make us happier? Because of a pervasive human trait psychologists call adaptation. It doesn't take long before we get used to our newly improved circumstances and come to take them for granted. They get absorbed into the status quo and we go back to being about as happy as we always were. To put the point another way, soon after we achieve a higher level of material success, our aspirations move up another notch and we go back to being dissatisfied with our achievements.

The second point to make is that if, instead of comparing different countries over time, we look at particular countries at a point in time, we do find that people with higher incomes are happier than people with lower incomes. Particularly in the case of Australia, however, the difference is surprisingly small - that is, on average, rich people are only a bit happier than poorer people. How are these two seemingly contradictory findings reconciled? It's simple: people seem to be a lot more concerned about the level of their income relative to others than about what's happened to the level of their income over time. When all of us enjoy rising incomes at pretty much the same rate - which is what's been happening over the decades - none of us feels any better off. What little satisfaction we get from high incomes comes from having an income that's higher than other people's. We use our income as an indicator of success in life and of our social status. And some research suggests that it's really social status that affects our happiness much more than income as such.

Now, here’s where I beg to differ with my mate Bob Cummins (professor of psychology at Deakin University, Melbourne). When Bob looks at the results from the Australian Unity Wellbeing Index, and in his article in the Journal of Happiness Studies in 2000, he concludes that income has a significant effect on wellbeing. On average, people in the top income bracket report greater subjective wellbeing than those in the middle bracket and those in the middle report greater wellbeing than those in the bottom bracket. Well, I could quibble about whether those differences are big enough to be judged significant - to me they seem quite small. Very large increases in income are needed to produce quite modest increases in wellbeing - my point about income being subject to greatly diminishing marginal utility as income rises beyond the poor-country threshold.

Bob uses this evidence of greater levels of wellbeing for higher income-earners to argue that it supports the homeostatic theory of wellbeing - the theory that subjective wellbeing is held within a narrow range determined by personality. Bob argues that people with higher incomes enjoy higher wellbeing because they suffer less from homeostatic defeat. This is because they can buy the resources necessary to optimise the operation of their homeostatic system. Now, I want to make it clear that I’m not attacking the homeostatic theory as such. Indeed, I think we can drop the homeostatic bit out of the argument completely and we’re left with the standard materialist argument in favour of being rich: the rich are happier because they can afford to buy more than other people - more comfort, more assistance, more everything.

My point is that Bob hasn’t demonstrated, as he claims, that income has a significant effect on wellbeing. Rather he’s demonstrated a much smaller claim, that relative income has an effect on wellbeing. The point is that, if more income makes us happier because we can afford to buy more stuff (or, in Bob’s terms, because we can buy resources to overcome homeostatic failure) then, as everyone’s income rises over time in line with economic growth, all of us can afford to buy more stuff so our reported wellbeing should rise over time. But we know from many studies that though the real incomes of people in the developed economies have risen by a factor of three or four since World War II, their reported wellbeing hasn’t budged. So we’re left with the much more qualified statement that higher relative income increases the wellbeing of those towards the top. And we’re left with the likelihood that the reason a high-income earner feels a little happier has to do not with her ability to buy more stuff but with her knowledge that’s she’s been more socially successful than many others.

Why am I labouring this distinction between increasing absolute income over time and possessing a higher relative income at a point in time? Because it has profound implications for the goals of economic management. From the point of view of economists and politicians, this finding is bad news. Why? Because though the pursuit of economic growth can raise everyone's income in absolute terms, there's nothing it can do to raise everyone's relative income. Obviously, there'll always be some people who come towards the top of the class and some people who come towards the bottom. We might change the order around, but that will produce as many losers as winners, leaving the population no better off overall.

To repeat, this is a devastating conclusion for economists – and particularly economic rationalists – whose whole practical motivation has been based on the assumption that helping the community raise its productivity and increase its production and consumption of goods and services will leave it unequivocally better off. There is no doubt that, materially, we are better off than we were even 10 years ago: our homes are bigger and better, our cars are better, our food and clothing are fancier and we have any number of wonderful new gadgets to save us labour or entertain us. But though we are better off, we don’t feel better off.

Implications for economic policy

This brings us to the implications of wellbeing research for economic policy should economists and politicians someday incorporate them into their thinking. Richard Layard, a leading British economist who has embraced the psychological push says that, beside adequate income, the research shows six main factors affect happiness: mental health, satisfying and secure work, a secure and loving private life, a secure community, freedom, and moral values.

So my first policy implication is that reducing unemployment should be given a much higher priority by the economic policy-makers. Research shows that being unemployed makes people particularly unhappy, a lot more unhappy than can be explained by the loss of income they suffer by not having a job. What people miss is the sense of identity and self-worth that comes from a job, and also, no doubt, the social contact. Economists may protest that they are already giving high priority to reducing unemployment but, in truth, their pursuit of this goal is conditional. Their concern with the efficient allocation of resources means they frown on any solutions (job sharing, job-creation schemes, public sector employment, for instance) that involve modest inefficiencies. The truth is that the overwhelming goal of economists is to hasten the growth in the economy’s production of goods and services, and the jobs generated in this process are just a fortunate by-product.

My second policy implication is that governments and employers could do a lot to raise subjective well-being if they put more emphasis on the enrichment of jobs – increasing job satisfaction by giving workers more personal control, opportunity to use their skills, variety in tasks, respect and status, and contact with others. Taken literally, the economists’ model assumes that all work is unpleasant – a disutility – and is undertaken purely to gain the money to buy the things that bring utility. Like the rest of us, economists know that, in reality, work carries much intrinsic satisfaction. But they don’t follow this realisation through to their policy prescriptions. They are perpetually advocating labour market reform aimed at ensuring labour is used more efficiently, treating labour as though it were just another inanimate economic resource, and ignoring the feelings of the human beings attached to the labour. Various of the ways labour can be used more efficiently make life unpleasant and even unhealthy for the workers involved: ever-changing casual hours, rolling shift work, split shifts and firms continually moving their staff to different cities. When we pursue efficiency at the expense of people, economists have got things round the wrong way, trashing ends so as to advance means.

A third implication is that economic policy-makers should recognise the benefit of stability. People like stability – it makes them feel secure and happy. What’s more, it breeds a highly valuable commodity: trust. People don’t like continuous change. Macroeconomic management is aimed a stabilising the rate of growth in demand, and that’s good. But microeconomists perpetually advocate change (‘reform’) aimed at increasing efficiency, raising productivity and quickening the production of goods and services – the very objective we now know doesn’t make people any happier. Often, micro reform involves ‘displacing’ workers from the reformed industries where their labour wasn’t being used efficiently. This is a process that causes no heart searching among economists because their model: first, assumes alternative employment will be readily forthcoming; second, ignores the intrinsic satisfaction from work and, third, assumes unemployed workers will have a whale of a time enjoying all their new-found leisure.

A fourth policy implication is that the thing economists celebrate as ‘competition’ and are always trying to encourage because it acts as a spur to efficiency and growth, is actually ‘rivalry’ that creates losers as well as winners and thus generates roughly as much unhappiness as happiness. Rivalry is hardwired into our brains, but a case can be made that social comparison is not something we should be encouraging. Seen in this light, we should think twice about the unceasing calls for us to do this or do that to preserve or improve the economy’s international competitiveness. But why? It is just rivalry on a global scale. It is saying, we must make sure foreigners do not get richer at a faster rate than we are, or even, God forbid, overtake us on the league table.

Fifth, instead of merely unquestioningly promoting consumption, economists should be doing something they rarely do: studying it. They need to see whether there are some forms of consumption that that yield more satisfaction than others. It may be that, in our striving for social status, we are devoting too much of our time and income to the purchase of ‘positional goods’ - conspicuous consumption – and too little to activities empirical research now tells us would yield greater satisfaction. Robert Frank of Cornell says the ‘gains that endure’ are more likely to include social life, time with our children, less travel time to work, more job security and better health care. Layard says we should be spending a lot more on fighting glaring evils – and sources of profound unhappiness - such as depression.

Sixth, the evidence that income is subject to diminishing marginal utility strengthens the case for redistributing income from rich to poor, since such transfers should increase total happiness. As yet, however, there is mixed evidence on the question of whether people who live in countries with a narrower gap between rich and poor are happier. Alesina et al. (2001) find that income inequality has a large negative effect on happiness in Europe, but not in the United States.

Finally, we should look sceptically at the incessant calls for lower tax rates to encourage people to work harder. By its very nature, the economists’ model assumes away all non-monetary motives for work. We do it only for the money. But the reminder of the intrinsic satisfaction we derive from work also reminds that higher income-earners in particular have powerful non-monetary motives for working long and hard: job satisfaction and the pursuit of power and status. Reducing tax rates would merely allow us to run faster on the hedonic treadmill, whereas I think we should slowdown. The drive for reduced government spending and lower taxes would leave people with more disposable income they could use to purchase education and health care privately, in the hope that these positional goods would enhance their social standing. Layard warns we should worry lest leisure, public goods and inconspicuous consumption (consumption that is not compared with the consumption of others) are under-produced because people focus so much on conspicuous consumption.

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THERE’S NO BUDGETARY ISSUE BIGGER THAN HEALTH CARE

Talk to Federal Health Department’s Biennial Health Conference
Sydney, Tuesday, November 14, 2006

So far we’ve heard from speakers giving expert and finely tuned comments on technical aspects of acute care funding, but I think the most useful contribution I can make given my own expertise is to help you see acute care funding in a broader budgetary and political context. I’ll also range wider than just hospital funding, partly because outsiders (including politicians) tend to see hospitals as part of the total health care package, but also because it can be a mistake to focus on particular elements of health care spending in isolation. The various elements are interrelated and these linkages can be overlooked if we’re not careful - particularly when different levels of government are responsible for different elements.

Consider the case of hospitals on the one hand and the pharmaceutical benefits scheme on the other. One of the trends of advance in medical technology is for the use of better medicines to keep people out of hospital. The result is we spend more on pharmaceuticals but make savings on the number and length of hospital stays - which, as we all know, are very expensive. When you divide health care funding into silos, however, it’s too tempting for the feds to get overexcited about the rapid growth in the cost of the PBS, and wonder what draconian measures could be taken to slow the growth, while ignoring the savings being generated elsewhere in the system.

I’m sure you’re aware of the many reports econocrats have produced in recent years examining the budgetary pressures likely to arise over the next 40 years as the baby boomers retire and the population ages. Federal Treasury began the fashion in 2002 with its Intergenerational Report, which it will update in next year’s budget. Then the Productivity Commission had a go - trying to add the implications for state as well as federal budgets - and most state treasuries have now completely similar exercises, culminating in the NSW Treasury’s report on long-term fiscal pressures, issued with this year’s state budget.

Although there’s been some attempt to obfuscate matters, all these studies come to the same, surprising conclusion: though population ageing will generate considerable budgetary pressures in most developed countries, the likely pressures in Australia are modest and manageable. This is mainly because our age pension is flat-rate and heavily means-tested. The budgetary cost of ageing will show up more in health care spending than in pensions, but won’t be great. Even so, all the reports have projected considerable upward pressure on government budgets over the coming 40 years. Most of that pressure will be coming in one spending category: health care. The studies show that, whether you look at federal or state, health accounts for about three-quarters of the projected growth in total government spending. At present in the NSW budget, health (mainly hospitals) is the second biggest spending category after education, accounting for 26 per cent of total expenses. In 40 years time it’s projected to be the biggest category, accounting for 37 per cent.

As we’ve seen, this growth will be partly due to the higher proportion of older people in the population. For the most part, however, it will be due to a combination of supply and demand factors unrelated to demography. On the supply side, continuing advances in medical technology will add to costs for various reasons: because improved procedures tend to be more expensive than those they replace, because more conditions become treatable and because safer, less intrusive treatments can be prescribed for a wider range of patients. On the demand side, the public will continue to press for the fullest and earliest possible access to medical advances.

The first point to make is: don’t let anyone tell you this inexorable pressure for increased spending on health care is a bad thing. It’s a good thing. The projections assume real income per person will double over the coming 40 years. And health care is what economists call a ‘superior’ (or merit) good. Superior goods are things to which we devote an increasing share of our income as it rises over time. In the case of health care, that’s eminently sensible and hardly surprising: as we get richer why wouldn’t we spend more on staving off death and disability? What more pressing priority could we have?

If health care was sold in the marketplace like most goods and services, the news that we were likely to significantly increase our spending on it over coming years would attract not the slightest controversy. The contention arises because health care is delivered primarily by the public sector, with its cost funded mainly by general taxation. So the first problem is: will the public be prepared to pay the higher taxation needed to cover the cost of the greater care it will be demanding? Short answer: it will almost certainly be reluctant to but, since the politicians’ desire to please voters will ensure health care spending continues growing strongly, the pollies will have no choice but to keep raising taxes.

It’s not that simple, however. The fact that so much health care is delivered by - or, at least, funded by - the public sector rather than the private marketplace does mean there’s less discipline on spending and greater scope for over-servicing and other forms of waste and inefficiency. Even so, health care is funded primarily by general taxation for good reason: because we’re not prepared to let people who can’t afford health care they need go without. Health care is judged too important to be left to the market. And even though we can expect to see economic rationalists in the bureaucracy and elsewhere urging governments to shift more of the cost of health care off the budget and into private hands, I wouldn’t expect to see that process go very far.

Put all these factors together - inexorable pressure for greater spending, reluctance to pay the higher taxes needed to fund this spending, and well-founded suspicion that our delivery and funding arrangements aren’t as cost-efficient as they could be - and they add up to continuing and increasing pressure on the health system to do more with less.

In other words, I foresee health as the greatest public sector battle ground in coming years. There’ll be unrelenting pressure for improvement - or at least change - in funding arrangements. The likely growth in health care spending makes this inevitable. It’s possible a future federal Labor government could simply replace the now ailing Medicare with a completely new funding system that was just as radical as Medicare - or really, Medibank - was in its day. There’s nothing sacrosanct about Medicare. As Dick Scotton, one of its original designers has remarked, it was state of the health economists’ art when first conceived in the late 1960s, but there’d be something wrong if the health economists couldn’t come up with a vastly improved model 40 years later. There’s nothing sacrosanct about Medicare - save for one not-negotiable design feature: universality; the guarantee that all are covered and no one misses out. Preserve that and all the details are up for grabs. It’s universality that gives national health insurance its fairness or equity. What you’d be hoping for in replacing Medicare is greater efficiency in the allocation of health resources without much loss of fairness - or, in the parlance of economists, a better trade-off between the equally desirable but conflicting objectives of equity and efficiency.

I have to say, however, that if Labor has such a big bang replacement for Medicare up its sleeve, I’ve see no sign of it. The more likely prospect is for governments of either colour to be engaged in a process of continuous tinkering in response to the budgetary pressures I’ve described. We’ve heard from other speakers indications of the directions that reform could take. I’d just make two points. I believe the essential first step on the road to reform is to resolve the division of responsibility for health between levels of government, and the obvious answer is for the feds to take over public hospitals. That wouldn’t solve all problems, but it would make progress in solving them very much easier to achieve. Second, I don’t have much doubt that any progress we do achieve will involve moving the system in the direction of managed care. That’s the only way to achieve the unmentionable objective in every health bureaucrat’s mind: ensuring that too much of the increased spending on health care doesn’t end up lining the pockets of medical specialists.

Finally, it’s worth remembering that, though much of the talk about the need to increase efficiency and eliminate waste will be couched in terms of saving money and reducing spending on health, the reality is that, no matter how successful the economies are, there’ll be no reduction in health care spending nor even much slowing in the rate at which spending grows. Why not? Because of those inexorable pressures I’ve described. Rather, any success in raising efficiency will simply mean better value for the taxpayers’ ever-growing dollars.

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AN OUTSIDER’S CRITIQUE OF THE PERFORMANCE OF TREASURIES

Talk to Australasian Treasury Officers’ Conference, Hobart
November 3, 2006

I’m pleased to be here to talk to you and offer an outsider’s view of the performance of Treasuries - when I say Treasury, please take that to include finance departments where they’re separate from treasury and to refer to the ‘purse-string departments’ at both federal and state level. It’s not my practice in speaking to any group to tell them how wonderful I think that are, so my critique will be fairly critical. Of course, as an outsider it’s quite possible I’m misinformed - but, if so, I’m sure you’ll set me straight. Before I launch into any criticism, however, I should make it clear that I have a great deal of sympathy for treasuries and the vital role they perform in controlling public spending. It’s not a popular job, but someone has to do it and it may be that my original training as a chartered accountant gives me sympathy with those whose lot in life is to be that someone. Any fool can make themselves popular by spending money; it takes character to be the one who often says no. Or it may be my knowledge of economics gives me an acceptance that, despite the unwillingness of so many to accept it, there is a budget constraint, which will make its presence felt one way or another, and it’s much smarter to learn to live within it.

My basic claim, however, is that treasuries could be doing that job a lot better than they are. That, too often, they’re going through the motions using old fashioned budget restrictions to limit the growth in spending, using instruments that either aren’t very effective or that do a lot of collateral damage, whereas they need to be using newer techniques that are a lot more effective, imaginative or, as I like to say, scientific. And in that respect I think we need more than just the latest accounting fad.

But before we get on to all that, first we need to be clear about why we want to control spending and about the challenge that lies ahead. I’m not a believer that everything private is good and everything public is bad, so government needs to be kept as small as possible. Rather, government needs to be efficient and effective whatever its size. Why? Because of nothing more profound than opportunity cost. Because money doesn’t grow on trees and there’s a limit to how much tax people are prepared to pay. And because, to make the high levels of tax we must pay more politically palatable, we need to do more to counter the widespread perception that a much government spending is wasteful.

I don’t think we’ll ever reach a time when most voters have a realistic acceptance that, at least in the long run, budgets must balance, thus producing a clear link between how much governments spend and how much they raise in taxation. Most people remain hopeful that governments will increase their spending - because there are so many worthwhile things the government could be doing - without that requiring them to pay higher taxes.

You’ve probably been labouring under that tension for as long as you’ve been in treasury, but I think it’s clear that tension is likely to intensify rather than abate. We’ve now been through a large number of exercises examining future fiscal pressures, starting with federal Treasury’s Intergenerational Report in 2002, then the Productivity Commission’s report and then studies by most if not all state treasuries, including the NZ dept of finance.

All those studies tell us much the same thing: if you look out over the next 40 years or so, yes, you do see considerable pressure for increased government spending. But only some of this pressure will be coming from the ageing of the population. If it were just population-related it would be quite manageable. According to all the studies, most of the pressure will be coming from spending on health - from the ever-more-expensive advances in medical technology and the public’s demand that it be given access to the benefits of that advance as fully and quickly as possible. It’s paying for health that will present the greatest single challenge to the treasury officers of the next 40 years.

Now, before I go on, I want to make it clear that I do see a bit of treasury propagandising at work here. When before have we had this amazing rash of studies of future fiscal pressures in every jurisdiction? I don’t think it’s been purely because of concerns about ageing. I think it’s also because of treasury concerns about living in an age of strongly growing revenue, budget surpluses and a record length expansion phase in the economy (with resources boom). With spending demands so easily accommodated, with no deficit problem to hold over politicians, where does the discipline come from? It doesn’t. So you have to manufacture it, fashion yourself a stick to wave around people’s heads. I suppose that’s fair enough.

In the process, however, we’ve managed to highlight an important point: many if not most forms of government spending are what I call ‘superior goods’, otherwise known as merit goods and bearing similar characteristics to luxury goods. That is, as our income increases, our spending on them increases at an ever faster rate. The classic example of a superior good is health care spending - and that makes all the sense in the world. As we get richer, why wouldn’t we want to devote a significant proportion of the increase to staving off death and staying hale and hearty for as long as possible? So be clear that the unrelenting pressure for increased health spending is fundamentally a good thing, not a bad thing. It’s a trend to be accommodated, not resisted. And, since we choose for good reasons (mainly to do with equity) to deliver health care mainly through the public sector, there’s no reason we should be unduly concerned about the likely increase in taxation needed to accommodate the community’s desire to live longer.

The wider point, however, is that health care is just one of the superior goods delivered by governments. Education is another obvious example - which is why it will be difficult to realise in practice the savings theoretically made possible by the lower birth rate. Take health and education and you’ve covered at least half of a state government’s recurrent spending. But the superior goods don’t stop there. Think about it and you realise that even something as mundane as law and order is a superior good: the richer I get, the more susceptible I become to worries about my personal safety and to fears that my wealth will be stolen from me.

The point is that, if so much of what governments do is deliver superior goods, then as incomes rise the pressure for increased government spending will be irresistible, and so will be the pressure for higher taxation. All governments have been reluctant to admit the obvious: that the primary solution to the future fiscal pressures their studies have identified will be higher taxation. (Treasuries haven’t wanted to admit it either because it counteracts their use of these studies as a weapon for enforcing discipline on the spending side.) It’s clear, however, that as our real incomes rise over the coming decades and our desire for spending on publicly-provided superior goods grows accordingly, the result will be a steady increase in the share of our incomes devoted to tax.

In principle, there’s no reason for that to be regarded as a bad thing. You’re the people who’ll be responsible for helping the politicians bring about that rise in taxation - or, perhaps, for persuading them that, since they’ve happily acceded to electoral pressure to bring the higher spending about, they must raise taxes to finance it responsibly.

I must concede, however, that while an increase in spending on superior goods is inevitable as incomes rise over time, there are extra risks of inefficient and wasteful spending where those superior goods are delivered through the public sector. Sometimes superior goods are delivered through the public sector because of their public-goods characteristics, but mainly I suspect it’s because of equity considerations. So a major responsibility for treasury officers over the next 40 years will be not simply trying to keep the lid on government spending, but continually searching for better trade-offs between equity and efficiency. If you try simply to impose increased efficiency at the expense of equity you’ll have limited success in getting your proposals adopted and persisted with (because equity considerations are so powerful politically). So, much better to be working on the much more intellectually demanding task of finding a better trade-off between the two.

Before I leave that outline of the likely outlook for both sides of the budget in coming decades, let me make one further point. I think it vitally important for treasury people to become more conscious of Fred Hirsch’s concept of ‘positional goods’. Positional goods or services are those which, along with doing whatever it is they’re supposed to do, are purchased also with the hope that they’ll demonstrate to the world our superior position in the social pecking order. In other words, it’s about conspicuous consumption and keeping up with the Jones. When you think about it you realise that, the more our incomes rise and the cost of necessities accounts for an ever-declining proportion of that income, the higher the proportion we’re likely to devote to the pursuit of social status via the purchase of positional goods - remembering that, when you choose to buy a BMW over a Toyota, the price of the Toyota is the cost of the transport vehicle you bought and the extra you shelled out to get the BMW is the cost of the positional good. Our private spending abounds in the payment of premiums intended to demonstrate our status. You can see it in the clothes we buy for ourselves and our children, the cars we buy, the homes and suburbs we choose to live in, the private schools we send our kids to, the private hospitals we insure for, the restaurants we eat at, the holidays we take and much, much more.

Why am I telling you this? Partly because I believe much of the pressure on governments to keep taxes down comes from the public’s desire to be left with as much disposable income as possible, to be spent on the pursuit of social status. But the pursuit of status, like an arms race, is a zero sum game. I can advance my place in the pecking order only at the expense of those I pass. So I wouldn’t have thought it an important public policy objective to leave people with as much positional spending money as possible. And yet, if you examine the descent into middle-class welfare by the Howard Government, for instance, I believe you can find examples of Howard providing public subsidies for positional goods: the 30 pc private health insurance rebate is one example, the increased grants to undeserving private schools is another.

To me, this is all the wrong way round. If you’ve got a situation where people are dead keen to spend money on private health and private schools - on things that are superior goods and publicly provided - you shouldn’t be subsidising them you should be exploiting them. In other words, the more we can make people pay privately for their pursuit of status-linked superior goods, the better off we are. Treasury officers forever searching for relatively politically painless ways of increasing taxation should never forget the device I call the ‘voluntary tax’. Private health insurance was a voluntary tax (you didn’t have to take it but, if you did, your public subsidy diminished), sending kids to private schools was a voluntary tax, gambling taxes are voluntary in a sense (though with risks of social costs if their pursuit is overdone) and tobacco tax is, too, in a sense. You should be looking for ways to increase voluntary taxation - which includes ‘taxing’ people pursuing social status - and perhaps it would help if this way of looking at things were explained to politicians tempted to go the other way.

OK, now let’s turn to my critique on the spending side. The conventional means used to try to limit spending - by imposing cuts or caps on agencies - has various disadvantages. It tends to favour existing programs over new programs, even though some older programs could be abandoned or turned over to private provision. It tends to favour cures over prevention - fixing problems after they’ve happened rather than stopping them happening. It often fails to motivate agencies to co-operate in identifying the fat and making sure it gets chopped rather than the bone. Indeed, it can leave governments vulnerable to passive resistance, where cuts are directed to those areas the government is likely to find most politically embarrassing, in the hope of forcing it to relent. I guess many of the new accounting approaches are aimed at overcoming these limitations, but I think we can do better.

One of the great temptations facing treasuries is to get so locked into the annual budget round that they end up focusing on cost containment in the short term rather than cost effectiveness in the longer term. When treasuries’ behaviour becomes too hand-to-mouth - too focused on getting this year’s budget balance looking OK - they can resist spending on the evaluation of programs that could be most informative in subsequent budget rounds, they can resist spending on health prevention and promotion simply because the costs are up front and the savings down the track. In other words, there’s a great temptation to be a short-term maximiser, with the result that you commit the greatest treasury sin: false economy. Public servants tell me of the crazy things agencies do in the name of efficiency - so much so that, to them, efficiency is synonymous with inefficiency. If something done in the name of efficiency is counterproductive or short-sighted, it’s not efficient by definition. I think the public sector abounds with false economy. Sometimes this won’t be the direct result of treasury decisions, it will be a damaging response by the agency to perverse incentives created by treasury.

When we lift our sights beyond this year’s magic budget-balance figure, we’re able to pay greater attention to the quality of government spending. Quality goes to the effectiveness of spending programs, but also to the thing the top-flight treasury officer should be perpetually in search of: the program which, though it’s classed as an expense, is actually an investment - an investment in future cost containment.

It’s important to remember that the spending agencies often have very little vested interest in measures that offer high value for taxpayers’ money. What departments are genuinely keen to have their programs rigorously evaluated? How many doctors would support spending on health promotion and prevention when that money could be spent on their own curative specialty? How many agencies want to do rigorous cost-benefit analysis of their capital works projects? In other words, if treasury isn’t pushing for these improvements, who will be? Now, you may say that if treasury were mad enough, it could support the spending of millions on dubious health promotion advertising campaigns. True - but all the more reason treasury should be pressing for - and paying for - rigorous assessment of what prevention programs work and what don’t.

I don’t know a lot about all the various accounting reforms - I won’t call them fads - I think the latest is performance budgeting. They may carry the answer to some of my criticisms. I have a feeling, however, that what we need is not so much better accounting as more economics. When I say we need a more scientific approach to spending control, the examples I have in mind come from economists, not accountants.

I’m thinking of such innovations as case-mix funding of hospitals. This is where, rather than giving a hospital funding based on an adjustment to what it got last year, it gets a flexible amount based on the known cost of efficiently dealing with particular types of cases, multiplied by the particular mix of cases the hospital encounters. Health economists put an enormous amount of research into developing the cost data needed for such a funding system. I’m not sure how much of the encouragement and funding of this research came from treasuries.

Another example is the advent of income-contingent loans. Australia has been a world leader in this area, with Professor Bruce Chapman’s application of the concept to university fees being the finest example of applied economic rationalism. As is easily seen in the case of HECS, the beauty of income-contingent loans is the superior trade-off they offer between equity and efficiency. You can require students to make a higher contribution towards the private benefits they receive from a university education, without fear of making uni education too expensive for kids from poor families. If Treasury and Finance had been doing their job, the idea would have been developed by them. Now Professor Chapman and his colleagues are elaborating on the many other ways - such as drought assistance - in which savings could be made by replacing grants with income-contingent loans. But it’s not clear the purse-string departments are pursuing this opportunity with any enthusiasm.

To me, however, the cost-effectiveness potential of these ideas is dwarfed by the scope for long-term savings arising from the neuroscientists’ discovery of the crucial importance of an infant’s early years in determining both its IQ and its EQ - its intellectual ability and its emotional ability to fit in socially, apply itself to work or study and generally lead a successful life. I suspect that many of our politicians are better versed on this remarkable research than the econocrats are. But there’s no excuse for the purse-string controllers: the whole thing’s been checked out by the Nobel-winning economist James Heckman, who’s given it a rave review.

Heckman’s studies demonstrate that spending programs aimed at early childhood development (that is, long before school-age) have far higher cost-benefit scores than remediation programs for students, prisoners or the unemployed in later life. If you leave it that late, you’ll be lucky if the benefits exceed the costs. Heckman makes a killer point for economists: spending on early childhood development involves no conflict between equity and efficiency. That is, the things you might do to promote equality of opportunity are just as effective in promoting productivity and human capital formation, and vice versa. In other words, improving on early childhood development is as close as we come to a free lunch.

The implication of this body of research for spending on social programs is profound. It says that, in neglecting babies and spending money trying to help or punish young people and adults once their educational or behavioural problems come to the attention of the authorities, we’re getting it exactly the wrong way round. Whether you care about economic efficiency or about fairness, we ought to be massively re-orienting our social spending in favour of the very young. In fact, the only remaining justification for trying to help non-infants is simply the ethical point of not abandoning people who are victims of our earlier neurological ignorance.

At an intellectual level, many of our political leaders know this. The trouble with modern politicians, however, is that they’re more interested in being seen to be responding to problems than in actually solving them. So they spread their spending too widely and thinly. Explain to them about how babies’ brains develop and they ‘respond’ by initiating a few new early childhood programs, but they never spend anything like enough. Why not? Because they have other interest groups to keep happy and so they’re not prepared to divert funds from social programs where, though we now know the money is largely wasted, the profile is higher and the political pressure greater.

The people who should be throwing their weight behind the neuroscientists, social workers and early childhood educators in helping persuade the pollies to reform their spending priorities are the purse-string controllers. But are they? I doubt it. Why not? Because they’re not applying their brains and they’re not trying hard enough.

I want to finish by adding something different: I believe every up-and-coming treasury officer needs to be familiar with the relatively new school of economic thought known as behavioural economics. BE draws heavily on the findings of psychologists - including the psychologist Daniel Kahneman who won the Nobel Prize in economics in 2002 for founding the school - to study the way people actually make economic decisions in contrast to the conventional assumption of rational self-interest. It finds that most people don’t act on opportunity cost, don’t ignore sunk costs, dislike losses more than they like gains of equivalent size, are more loss averse than risk averse, practice mental accounting which breaks the assumption of fungibility, have big self-control problems and much more.

Why do ambitious treasury officers need to be familiar with this stuff? Various reasons. Because it helps them understand why the conventional model often mispredicts. Because it teaches them to respect and accommodate the electorate’s inescapable concerns about fairness, particularly procedural fairness - economists can abstract from fairness considerations, but the people to whom politicians answer never can. But also because the two professions with an instinctive understanding of BE are the marketers and the politicians. BE helps economists convince themselves of the truth and relevance of propositions politicians simply know to be true. So BE is a counter to the old treasury line that there are always only two policy choices: good economics (ie conventional economics) and political expediency. It turns out the pollies often have good reason to reject advice based on conventional economic assumptions that are normative (how people should behave) but not positive (how they do behave). The point is that when econocrats’ understanding of BE allows them to break out of the good-v-expedient mindset, they’re better equipped to find a better trade-off between what would be ideal in an ideal world and what politicians are likely to accept as doable.

There is much scope to elaborate on this point - to draw out the practical lessons for policy advisers from BE - but let me highlight just one: when you understand BE you realise that hypothecation should be embraced rather than opposed. Treasuries traditionally oppose hypothecation because it’s either a con on the public (it doesn’t actually lead to increased spending in the area in question) or it distorts spending choices (it does oblige more spending in the area than would otherwise occur). The trouble with this logic is that it’s too rational by half. In an era when people’s demands for increased spending are insatiable but their willingness to pay higher tax is limited, hypothecation is a useful tool. At the moment when public demand for new spending is at its height, the politician steps in and says sure I’d like to spend the money but I’d need to cover it by introducing this small levy or surcharge. The public invariably agrees. Why? Because it wants to see what normally is concealed from it: the link between what you pay and what you get. The Howard Government has made extensive use of the hypothecated surcharge. Why? Because it’s unconscious understanding of BE gives it better policy judgement than many econocrats, who’ve been blinded by the unrealistic assumptions of conventional economics.

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