Hate rising prices? Please blame supply and demand, not me

Have you noticed how, to many economists, everything gets back to the interaction of supply and demand? Understand this simple truth and you know all you need to know. Except that you don’t. It leaves much to be explained.

Why has the cost of living suddenly got much worse? Because the demand for goods and services has been growing faster than the economy’s ability to supply those goods and services, causing businesses to put their prices up.

Since there is little governments can do to increase supply in the short term, the answer is to use higher interest rates to discourage spending. Weaker demand will make businesses much less keen to keep raising their prices. If you hit demand really hard, you may even oblige businesses to lower their prices a little.

But, as someone observed to me recently, saying that everything in the economy is explained by supply and demand is a bit like saying every plane crash is explained by gravity. It’s perfectly true, but it doesn’t actually tell you much.

Consider this. After rising only modestly for about a decade, rents are now shooting up. Why? Well, some people will tell you it’s because almost half of all rental accommodation has been bought by mum and dad investors using borrowed money (“negative gearing” and all that).

The sharp rise in interest rates over the past year or so has left many property investors badly out of pocket, so they’ve whacked up the rent they’re charging.

Ah no, say many economists (including a departing central bank governor), that’s not the reason. With vacancy rates unusually low, it means that the demand for places to rent is very close to the supply available, and landlords are taking advantage of this to put up their prices.

So, what’s it to be? I think it’s some combination of the two. Had the vacancy rate been high, mortgaged landlords would have felt the pain of higher interest rates but been much less game to whack up the rent for fear of losing their tenants.

But, by the same token, it’s likely that the coincidence of a tight housing market with a rise in interest rates has made the rise in rents faster and bigger than it would have been. It would be interesting to know whether landlords with no debt have increased their prices as fast and as far as indebted landlords have.

The point is that knowing how the demand and supply mechanism works doesn’t tell you much. It doesn’t allow you to predict what will happen to either supply or demand, nor tell you why they’ve moved as they have.

It’s mainly useful for what economists call “ex-post rationalisation” – aka the wisdom of hindsight.

Economic theory assumes that all businesses – including landlords – are “profit-maximising”. But in their landmark book, Radical Uncertainty, leading British economists John Kay and Mervyn King make the heretical point that, in practice rather than in textbooks, firms don’t maximise their profits.

Why not? Well, not because they wouldn’t like to, but because they don’t know how to. There is a “price point” that would maximise their profits, but they don’t know what it is.

To economists, when you’re just selling widgets, it’s a matter of finding the right combination of “p” (the price charged) and “q” (the quantity demanded). Raising p should increase your profit – but only if what you gain from the higher p is greater than what you lose from the reduction in q as some customers refuse to pay the higher price.

What you need to know to get the best combination of p and q is “the price elasticity of demand” – the customers’ sensitivity to changes in price. In textbooks or mathematical models, the elasticity is either assumed or estimated via some empirical study conducted in America 30 years ago.

In real life, you just don’t know, so you feel your way gently, always standing ready to start discounting the price if you realise you’ve gone too far. And the judgments you make end up being influenced by the way you feel, the way your fellow traders feel, what you think the customers are feeling and how they’d react to a price rise.

How flesh-and-blood people behave in real markets is affected by mood, emotion, sentiment, norms of socially acceptable behaviour and other herding behaviour – all the factors that economists knowingly exclude from their models and know little about.

Keynes called all this “animal spirits”. Youngsters would call it “the vibe of the thing”. It’s psychology, not economics. And it’s because conventional economics attempts to predict what will happen in the economy without taking account of airy-fairy psychology that economists’ forecasts are so often wrong.

They may know more about how the economy works than the rest of us, but there’s still a lot they don’t know. Worse, many of them don’t think they need to know it.

It’s clear to me that psychology has played a big part in the great post-pandemic price surge. It didn’t cause it, but it certainly caused it to be bigger than it might have been.

The pandemic’s temporary disruptions to supply and the Ukraine war’s disruption to fossil fuels and food supply provided a cast-iron justification for big price rises, and it was a simple matter for businesses to add a bit extra for the shareholders.

It was clear to the media that big price rises were on the way, so they went overboard holding a microphone in front of every industry lobbyist willing to make blood-curdling predictions about price rises on the way. (I’m still waiting to see the ABC’s prediction of the price of coffee rising to $8 a cup.)

Thus did recognition that the time for margin-fattening had arrived spread from the big oligopolists to every corner store. One factor that constrains the prices of small retailers is push-back from customers – both verbal and by foot.

All the media’s fuss about imminent price rises softened up customers and told the nation’s shopkeepers there would be little push-back to worry about.

In the home rental market, dominated as it is by amateur small investors, who rightly worry about losing a tenant and having their property unoccupied for more than a week or two, it’s the commission-motivated estate agents who know when’s the right time to urge landlords to raise the rent, and how big an increase they can be confident of getting away with. 

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Why economists keep getting it wrong, but never stop doing sums

Why are economists’ forecasts so often wrong, and why do they so often fail to see the freight train heading our way? Short answer: because economists don’t know as much about how the economy works as they like to think they do – and as they like us to think they do.

What happens next in the economy is hard to predict because the economy is a beehive of humans running around doing different things for different reasons, and it’s hard to predict which way they’ll run.

It’s true we’re subject to herd behaviour, but it’s devilishly hard to predict when the herd will turn. Humans are also prone to fads and fashions and joining bandwagons – a truth straightlaced economists prefer to assume away.

I think it embarrasses economists that their discipline’s a social science, not a hard science. Their basic model of how the economy works became entrenched long before other social sciences – notably, psychology – had got very far.

They dealt with the human problem by assuming it away. Let’s assume everyone always acts in a rational, calculating way to advance their self-interest. Problem solved. And then you wonder why your predictions of what “economic agents” will do next are so often astray.

Actually, the economists don’t wonder why they’re so often wrong – we do. They prefer not to think about it. Anyway, there’s this month’s round of forecasts we need to get on with.

The economists’ great mission over the past 80 years has been to make economics more “rigorous” – more like physics – by expressing economic relationships in equations rather than diagrams or words.

These days, you don’t get far in economics unless you’re good at maths. And the better you are at it, the further up the tree you get. The academic profession is dominated by those best at maths.

Trouble is, although using maths can ensure that every conclusion you draw from your assumptions is rigorously logical, you’ll still get wrong answers if your assumptions are unrealistic.

In the latest issue of the International Monetary Fund’s magazine, the ripping read named Finance and Development, a former governor of the Bank of Japan reminds his peers about the embarrassing time in 2008, after the global financial crisis had turned into the great recession, when Queen Elizabeth II, visiting the London School of Economics, asked the wise ones why none of them had seen it coming.

With frankness uncharacteristic of the Japanese, the former governor observed that King Charles could go back and ask the same question: why did no one foresee that the economic managers’ response to the pandemic would lead to our worst inflation outbreak in decades?

One answer would be: because all our efforts to use computerised mathematical modelling to make our discipline more rigorous have done little to make us wiser. The paradox of econometric modelling is that, though only the very smart can do it, the economy they model is childishly primitive, like a stick-figure drawing.

The best response some of the world’s economists came up with, long after the Queen had gone back to her palace, was that academic economists had largely stopped teaching economic history.

These days, economists can’t do anything much without sets of “data” to run through their models. And before computerisation, there were precious few data sets. But those who forget history are condemned to . . .

The great temptation economists face is the one faced by every occupation: to believe your own bulldust. To be so impressed by the wonderful model you’ve built, and so familiar with the conclusions it leads you to, you forget all its limitations – all the debatable assumptions it’s built on, and all the excluded variables it isn’t.

As part of the academic economists’ campaign for an inquiry into the Reserve Bank, some genius estimated that the Reserve’s reluctance to cut its already exceptionally low official interest rate even lower in the years before the pandemic had caused employment to be 250,000 less than it could have been.

Only someone mesmerised by their model could believe something so implausible. Someone who, now they’ve got a model, can happily turn off their overtaxed brain. There’s no simple linear, immutable relationship between the level of interest rates and the strength of economic growth and the demand for labour.

At the time, it was obvious to anyone turning their head away from the screen to look out the window that, with households already loaded with debt, cutting rates a little lower wouldn’t induce them to rush out and load up with more – the exception being first-home buyers with access to the Bank of Mum and Dad, who as yet only aspired to be loaded up.

To be fair to the Reserve in this open season for criticism, it’s far more prone to admitting the fallibility of its modelling exercises than most modellers are – especially those “independent consultants” selling their services to vested interests trying to pressure the government.

In its latest statement on monetary policy, the Reserve explains how its modelling finds that supply-side factors explain about half the rise in the consumer price index over the year to September 2022.

But then it used a more sophisticated “dynamic stochastic general equilibrium model” which found that supply factors accounted for about three-quarters of the pick-up in inflation.

The Reserve’s assistant governor (economic), Dr Luci Ellis, told a parliamentary committee last month that this “triangulation” left her very confident that the demand side accounted for at least a quarter and probably up to a third of the inflation we’ve seen.

(Remembering the debate about the extent to which the present inflation surge reflects businesses sneaking up their profit margins – their “mark-ups,” in econospeak – note that this second model includes “mark-up” as part of the supply side’s three-quarters. Always pays to read the footnotes.)

One of the tricks to economics is that many of the economic concepts central to the way economists think are “unobserved” – the official statisticians can’t measure them directly. So you need to produce a model to estimate their size.

A case in point is the economists’ supposed measure of full employment, the NAIRU – non-accelerating-inflation rate of unemployment – the lowest the rate of unemployment can fall to before this causes wage and price inflation to take off.

Some of those business economists who believe the Reserve hasn’t raised interest rates nearly enough to get inflation down justify this judgment by saying our present unemployment rate of 3.7 per cent is way, way below what conventional modelling tells us the NAIRU is: about 5 per cent.

But Ellis told the parliamentary committee that the Reserve had rejected this estimate. The “staff view” was that the NAIRU had moved from “the high threes to the low fours”, and this was what its forecasts were based on.

So why dismiss the conventional model? Because, Ellis explained, it’s driven solely by demand-side factors. It’s “not designed to handle the supply shocks that we have seen over COVID”.

Oh. Really. Didn’t think of that. Mustn’t have had my brain turned on.

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Creative destruction: Even pandemics have their upside

There’s nothing new about pandemics. Over the centuries, they’ve killed millions upon millions. But economic historians are discovering they can also have benefits for those who live to tell the tale. Take the Black Death of the 14th century.

In October 1347, ships arrived in Messina, Sicily, carrying Genoese merchants coming from Kaffa in Crimea. They also carried a deadly new disease. Over the next five years, the Black Death spread across Europe and the Middle East, killing between 30 and 50 per cent of the population.

What happened after that is traced in a recent study, The Economic Impact of the Black Death, by three American academics, Remi Jedwab, Noel Johnson and Mark Koyama, and summarised by Timothy Taylor in his popular blog, the Conversable Economist.

The immediate consequences of all the deaths were severe disruptions of agriculture and trade between cities. There were shortages of goods and shortages of workers, so those who did survive had to be paid well. This will ring a bell: with shortages of supply but strong demand, inflation took off.

In England, the Statute of Labourers, passed in 1349, imposed caps on wages. It was highly effective during the 1350s, but less so after that. Similar restrictions were imposed elsewhere in Europe.

Over the next few decades, after economies had adjusted to the worst of the disruptions, the continuing shortage of workers resulted in many rural labourers moving to the cities, which had vacant houses as well as jobs. Farmers had to pay a lot to keep their workers, so real wages had grown substantially by the end of the century.

Since many noblemen had died, the distribution of income became less unequal. Ordinary people could afford better clothing. So, many countries passed “sumptuary” laws under which only the nobility were allowed to wear silk, gold buttons or certain colours. Nor could the punters serve two meat courses at dinner.

Sumptuary laws were an attempt by elites to repress status competition from below.

The authors say the economic effects of the Black Death interacted with changes in social and cultural institutions – accepted beliefs about how people should behave. Serfdom went into decline in Western Europe because of the fewer labourers available.

People became even more inclined to marry later and so have fewer children. Stronger, more cohesive states emerged and the political power of the church was weakened.

It’s widely believed that all these developments played a role in the economic rise of Europe, particularly north-western Europe.

Taylor notes that one of the great puzzles of world economic history is the Great Divergence - the way the economies of Europe began to grow significantly faster than the economies of Asia and the Middle East, which had previously been the world leaders.

This divergence began soon after the Black Death.

“Of course, many factors were at work. But ironically, one contributor seems to have been the disruptions in economic, social and political patterns caused by the Black Death,” he concludes.

Fortunately, advances in medical science mean our pandemic has cost the lives of a much smaller proportion of the population. And believe it or not, advances in economic understanding mean governments have known what to do to limit the economic fallout – even if we didn’t see the inflation coming.

Governments knew to spare no taxpayer expense in funding drug companies to develop effective vaccines and medicines in record time.

One consequence of our greater understanding of what to do may be that this pandemic won’t alter the course of world economic history the way the Black Death did.

Even so, it’s still far too soon to be sure what the wider economic consequences will be. Changing China’s economic future is one possibility. Come back in 50 years and whoever’s doing my job will tell you.

Even at this early stage, however, it’s clear the pandemic has led to changes in our behaviour. Necessity’s been the mother of invention. Or rather, it’s obliged us to get on with exploiting benefits from the digital revolution we’d been hesitating over.

Who knew it was so easy and so attractive for people to work from home – with a fair bit of the saving in commuting time going into working longer. And these days many more of us know the convenience of shopping online – and the downside of sending back clothes that don’t fit.

Doctors were holding back on exploiting the benefits of telehealth, but no more. Prescriptions are now just another thing on your phone. And I doubt if the number of business flights between Sydney and Melbourne will ever recover.

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How human psychology helps explain the resurgence of inflation

The beginning of wisdom in economics is to realise that models are models – an oversimplified version of a complicated reality. A picture of reality from a particular perspective.

I keep criticising economists for their excessive reliance on their basic, “neoclassical” model – in which everything turns on price, and prices are set by the rather mechanical interaction of supply and demand.

It’s not that the model doesn’t convey valuable insights – it does – but they’re often too simplified to explain the full story.

Sometimes I think Reserve Bank governor Dr Philip Lowe is like someone whose brain has been locked up in a neoclassical prison. But in his major speech on inflation two weeks ago, he showed he’d been thinking well outside the bars, looking at various models for a comprehensive explanation of how inflation could shoot up so quickly and unexpectedly.

He observed that another “element in the workhorse models of inflation is inflation expectations.” This relatively recent, more psychological addition to mainstream economics says that what businesses and unionised workers expect to happen to inflation tends to be self-fulfilling because they act on their expectations.

We’ve heard much about the risk of worsening inflation expectations, including from Lowe. It’s been the main justification offered for jacking up interest rates so high, so fast. But Lowe admitted it’s a weak argument.

“Inflation expectations have picked up a little, but...there is a high degree of confidence that inflation will return to target. This suggests that a pick-up in inflation expectations is not a primary driver of the sharp rise in inflation,” he said.

As Professor Ross Garnaut has observed - and recent Reserve research has confirmed – “the spectre of a virulent wage-price spiral comes from our memories and not current conditions”.

But, Lowe said, there’s something here that’s not easily captured in our standard models. That’s “the general inflation psychology in the community. By this, I mean the general willingness of businesses to see price increases and the willingness of the community to accept price increases.

“Prior to the pandemic, it was very difficult for a business person to stand in the public square and say they were putting their prices up. And a common theme from our liaison [regular interviews with business people] was that because most businesses had trouble putting their prices up, wage increases had to be kept modest. That was the mindset.”

Mindset? Mindset? That’s not a word you’ll find in any economics textbook. There’s no equation or diagram for mindsets.

Today, however, “business people are able to stand in the public square and say they are putting their prices up, and they can point to a number of reasons why.

"The community doesn’t like it, but there is a begrudging acceptance. And with prices rising, it is harder to resist bigger wage increases, especially in a tight labour market,” Lowe said.

“So, the psychology shifts. Or as the Bank for International Settlements put it in its recent annual report: when inflation is high, it becomes a coordinating mechanism for pricing decisions.

"In other words, people really start to pay attention to changes in costs and prices. The result can be faster and fuller pass-through of cost shocks and more frequent price and wage adjustments.

“There is some evidence that is already occurring, which is contributing to the strength of the pick-up in inflation,” Lowe added in his speech earlier this month.

To be fair, this is just the latest version of a thesis – a “model” – Lowe has been developing for years. And I think he’s on to a phenomenon which, when added to all the mechanistic, mathematised rules of the standard model, takes us a lot further in understanding what the hell’s been happening to the economy.

It’s taking the standard model but, contrary to its assumptions, accepting that, as the social animals that humans are, economic “agents” – whether consumers, bosses, workers or union secretaries – have a tendency to herding behaviour.

You can observe that in financial markets any day of the week. We feel comfortable when we’re doing what everyone else’s is doing; we feel uncomfortable when we’re running against the herd.

Anyone knows who has worked in business for a while – as many econocrats and academic economists haven’t – business behaviour is heavily influenced by fads and fashions. One role of sharemarket analysts is to punish companies that don’t conform to the fad of the moment.

The world’s economists spent much time between the global financial crisis and the pandemic trying to explain why all the rich economies had spent more than a decade caught in “secular stagnation” – a low-growth trap.

I think Lowe’s found a big piece of that puzzle. Business went through this weird period of years, when because no one else was putting up their prices, no one wanted to put up their prices.

The inflation rate fell below the Reserve’s target range, and stayed there for years. Businesses had no reason to invest much, so productivity improvement fell away, and economic growth was weak.

But then, along came the pandemic, lockdowns, huge budgetary and monetary stimulus, borders closed to immigrants, and finally a massive supply shock from the pandemic and the Ukraine war.

Suddenly, some big price rises are announced, the dam bursts and everyone – from big business to corner milk bars – starts putting up their prices. The spell has broken, and I doubt we’ll go back to the weird world we were in.

But the other side of the no-price-rises world was an obsession with using all means possible – legal or illegal – to cut labour costs. This greatly reinforced the low-growth trap we were caught in. But it was made possible also by the various developments that have robbed workers of their bargaining power.

It’s not yet clear whether the end of the self-imposed ban on price rises will be matched by an end to the ban on decent pay rises. If it isn’t, we’ll still be lost in the woods.

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Inflation psychology: firms charge what they can get away with

Economists think inflation is all about economics. What they don’t know is that it’s also about psychology. But Reserve Bank governor Dr Philip Lowe shows a glimmer of understanding when he refers not to “inflation expectations” but to “inflation psychology”.

Notorious for their “physics envy” – where the world works according to known and unchanging laws, so everything can be reduced to mathematical calculation – economists think changes in prices are determined by the interaction of the “laws” of supply and demand.

This is true, but far from the whole truth. Especially for the prices set in the jobs market – aka wages – where this simple “neoclassical” analysis almost always gives wrong answers.

Economists’ first attempt at a less mechanical approach to the relatively modern problem of inflation – a continuing rise in the general level of prices – came from Milton Friedman and another Nobel laureate’s realisation of the important role played by people’s expectations about what will happen to the inflation rate.

If it worsens significantly and this leads enough people to expect it to stay high or go higher, their expectations may lead to the higher rate becoming entrenched via a “wage-price spiral”.

That is, expectations of higher inflation tend to be self-fulfilling because people act on their expectations. If businesses expect higher price rises generally, they adjust their own prices accordingly. And workers and their unions adjust their own wage demands accordingly.

When last the rich world had a big inflation problem, in the second half of the 1970s and much of the ’80s, this theory seemed to work well, though it took years for expectations to worsen. Then it took years of keeping interest rates high and demand weak, and getting actual inflation down below 3 per cent, before expected inflation came back down.

The inflation target, of 2 to 3 per cent on average, was set in the mid-90s to help “anchor” expectations at an acceptable level.

All this is why the latest leap in inflation has led some economists to worry that, if expectations become “unanchored”, inflation may become entrenched at a much higher level.

This fear explains why many are anxious to use higher interest rates to get actual inflation back down ASAP. If falling real wages help to speed the process, so much the better.

Two small problems with this. For a start, there’s little evidence – either here or in the other rich economies – that expectations have moved up. Sensibly, everyone expects that, before too long, the inflation rate will go back to being a lot lower.

In the real world of price-setting by firms and workers, it takes a lot longer for expectations to shift prices than it does for prices in share and other financial markets to bounce around.

But the deeper reason worries about worsening expectations are misplaced is that, since this theory became so influential in the ’70s, the mechanism by which the expected inflation rate becomes the actual rate has broken down.

Businesses retain the ability to raise their prices when they decide to – and to discount those prices should they discover they’ve pushed it too far and are losing sales - but organised workers have largely lost their ability to force employers to grant higher pay rises.

If you doubt that, ask yourself why the number of days lost to strikes is now the tiniest fraction of what it was in the ’70s. We’ve seen a little strike action lately, but it’s coming almost wholly from workers in the public sector – the main part of the workforce that’s still heavily unionised.

But the breakdown of the inflation-expectations theory and the “wage-price spiral” as explanations of the relatively modern phenomenon of inflation – a continuing rise in the general level of prices – leaves us looking elsewhere for explanations.

A big part of it is the message those economists who specialise in studying competition have to give financial economists such as Lowe: you don’t seem to realise that our modern oligopolised economy gives many big businesses a lot of power over the prices they’re able to charge.

Oligopoly is about the few huge firms dominating a particular market reaching a tacit agreement to keep prices high and stable, and limit their competition for market-share to non-price areas such as product differentiation and marketing.

As former competition czar Rod Sims has pointed out, this greatly reduces the ability of higher interest rates to influence prices in many big slabs of the economy.

But if many big businesses can improve their profitability by deciding to raise their prices, why did they wait until only a year ago to decide to start whacking up them up? Because it ain’t that simple.

All firms would like to raise their prices all the time. What stops them is the knowledge that they can’t charge more than “what the market will bear”. They worry about two things: what will my competitors do? And what will my customers do?

When there’s a big rise in input costs, the knowledge that all my competitors are facing the same cost increase gives me confidence we’ll all be passing it through to the customer at the same time.

That’s why it was the sudden, large and widespread increase in the cost of imported inputs caused by the pandemic and the Ukraine war that started the latest bout of prices rises at the retail level.

But, as Lowe keeps saying, the supply chain cost increases don’t explain all the rise in retail prices. He makes the obvious point that firms find it easier to raise their prices at a time when demand is strong and people are spending. His interest-rate rises are intended to stop demand being so strong and conducive to price rises.

But the less obvious point – especially to people mesmerised by the neoclassical way of thinking – is the role of psychology. I’ve got a great justification for increasing my prices, but no one’s counting. If my costs have risen by 5 per cent, but I increase my prices by 6 per cent, who’s to know?

Sims reminds us that this is just the way firms with pricing power behave. They raise their prices and profits in ways that aren’t easy for their customers to notice.

That covers big business. In the main, small businesses don’t have much pricing power. But “what the market will bear” is greater when the media has spent months softening up their customers with incessant talk about inflation and how high prices will go.

Lowe can’t say it, but it’s not uncooperative workers that are his problem, it’s businesses using the chance to slip in a little extra for themselves.

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Everyone else has an inflation problem, why can't we have one too?

I suspect we’re engaged in a strange exercise of trying to convince ourselves that we, like the Americans, Brits and Europeans, have a big problem with inflation. I fear that, if we try hard enough, we’ll succeed.

As the December quarter consumer price index shows, it’s true some prices have risen noticeably. The price of petrol has jumped and so have home building costs.

But, as our top econocrats have been reminding us, that’s not a big deal. The world price of oil has always gone up and down, for many reasons – none of which we have any ability to influence. Most other rises we’ve seen are temporary problems caused by the pandemic and governments’ response to it, as the supply of certain goods (but not services) falls short of demand. Computer chips, for instance.

And, as Reserve Bank governor Dr Philip Lowe demonstrated in his recent testimony to a parliamentary committee, our price rises are nothing like as big a deal as those in America, Britain and Europe, where there’s a lot more going on than just the passing effects of the pandemic.

Lowe noted that, over the past year, electricity and gas prices have risen by 25 per cent in the US and Europe, and even more in Britain, but by 2 per cent in Australia. Used car prices are up 40 per cent in the US, but nothing like that here.

People complain about rising rents but, as with mortgage interest rates, there’s a gap between advertised rates and what people actually pay. Actual rents have fallen in Sydney and Melbourne. And though everyone’s highly conscious of the jump in petrol prices, petrol accounts for only about 3 per cent of the cost of all the goods and services households buy.

The funny thing is, there are various groups in Australia that want to believe our problem’s as big as the other rich countries’. The key group is the financial markets. As Lowe said, “some in financial markets look at what’s going on in the United States and Europe and say, ‘They’ve got higher inflation, it’s coming to Australia’. They may be right” - he said before going on to explain why that was unlikely.

But so convinced are our financial markets that we’re just a carbon copy of the US economy that they’re laying bets the Reserve will be forced to start whacking up interest rates within a few months and will go hell for leather for the rest of the year.

The media have been happy to report this speculation as though it’s pretty much set in stone. “Inflation on the rise” is a good story and “rates to rise” even better.

As for the public, it’s kinda pleased to be told inflation’s a big problem, not because it likes rising prices, but because it confirms what people have always believed: that keeping up with “the cost of living” is always a struggle.

If you run a bit short before pay day, this is incontrovertible proof that prices are rising rapidly. The notion that the problem may be inadequate pay rises never seems to occur.

The CPI people carry in their heads always gets much bigger increases that the one calculated by the Bureau of Statistics because ordinary mortals’ memory of price rises is always stronger than their memory of price falls. And it never occurs to them to include in their sums all the many prices that didn’t change.

Which means, I fear, there’s a big risk that all the talk of inflation and rising prices – and all the media stories of a rise in this or that price; stories that multiply when “inflation” becomes the flavour of the month - could become a self-fulfilling prophecy.

To see this, you need to remember where we’ve come from: eight years of surprisingly weak growth in wages and six years of the (officially-calculated) inflation rate being below 2 per cent.

For much of that time, Lowe – whose scrutiny of statistics is supplemented by having his “liaison” people speak to more than 100 key businesses a month – has explained the weakness in wage and price inflation as arising from a strong “cost-control mentality” among Australian businesses.

Lowe explains that many businesses – retailing in particular – have been through a period of intense competition. There’s the threat from “category killers” such as Bunnings and Officeworks, the decline of department stores, Aldi taking on Coles and Woolies, and the move to online shopping, which has opened access to overseas competitors and made price more “salient” in decisions to buy things.

This increased competition came at a time when retail demand hasn’t been particularly strong (thanks mainly to weak wage growth). Special sales and other forms of discounting have been widespread.

In these circumstances, firms have been most reluctant to raise prices. Rises in purchase costs that may not last have been absorbed rather than passed on. Instead, firms have become obsessed with controlling their costs – including, and in particular, their labour costs.

In their book Radical Uncertainty, British economists John Kay and Mervyn King argue there’s no such thing as a profit-maximising firm. It’s not that firms wouldn’t like to earn maximum profits, it’s that they don’t know where that point is.

In real life, there’s no diagram or equation you can look up to tell you. You know there is a “price point” beyond which you’ll lose more in sales than you gain from the price increase, but you don’t know where it is. In real life, you have to feel your way, reading the signs and making sure you don’t push it too hard.

See where I’m going? We’re coming from a period where price rises have been heavily constrained for a long time. Not big, not many. “I haven’t been game to raise my prices because none of my competitors have been been either.”

Suddenly, however, everyone’s talking about inflation and every day the media are reporting that this price is rising and that price is going up. It’s obvious prices everywhere are taking off.

“One of my competitors has moved, so I can too. There’s always some cost increase I can point to. In this environment, I won’t get much push-back from customers. The media’s been softening them up.”

Can we talk ourselves into having a real inflation problem like the other rich countries? We’ll find out whether prices can be raised by imagination alone.

I fear, however, that getting those higher prices passed through to bigger wage rises will be a taller order. And, if that doesn’t happen, we’ll get no ongoing increase in the inflation rate, just a worsening in the cost of living.

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It's the holidays, so let's have some fun with economic puzzles

So it’s holiday season, when (almost) everyone takes a break, chills out and tries not to think about workaday worries. So let’s have some fun. Let’s do a few economic puzzles.

There’s an old joke in economics that says, “it may work in practice, but does it work in theory?” If you take that to mean economists care more about getting their theory right than about its usefulness then, yes, too many of them do.

But an empirical revolution is happening in economics, where economists test their standard theory to see how well it explains the real world. A big part of this is the rise of “behavioural economics” which, rather than simply making the conventional assumption that everyone acts “rationally” – with carefully considered self-interest – in the economic decisions they make, studies the many reasons people often make decisions that aren’t rational.

So, first puzzle. When, in 2012, prime minister Julia Gillard introduced what she called a “price on carbon” and opposition leader Tony Abbott correctly labelled a “carbon tax”, which increased the price of electricity, she took care to cut income tax and increase pensions in a way designed to leave households on average incomes no worse off.

Among Abbott’s many criticisms, he claimed the move would fail to reduce electricity consumption because people would simply use their tax cut to allow them to keep buying the same amount of power. Puzzle: conventional economics says Abbott was wrong, but behavioural economics suggests he may have had a point.

In compensating most people for the cost of her carbon tax, Gillard was doing just as economists advised. They were confident people would still reduce their electricity use because theory says a change in the price of some item has two, conflicting effects: the income effect and the substitution effect.

The income effect reduces the consumer’s real (after-inflation) income, whereas the higher price relative to the prices of similar items encourages the consumer to substitute other items for the now-dearer item, at least to some extent.

So even though Gillard’s compensating tax cut eliminated the income effect, economists were confident the remaining substitution effect would still encourage people to use less electricity and use what was left of their tax cut on something else they wanted more of.

But behavioural economics says maybe it’s not that simple. One of its early and major findings is that many people are “loss averse” – they hate losing money from the increase in the price of electricity more than they like getting the money back as a tax cut.

So, contrary to theory, many people wouldn’t have felt the tax cut left them no worse off. If so, they may well have chosen to use all their tax cut to keep buying the same amount of electricity.

For the record – and for whatever reason or reasons (remember, this wasn’t an experiment where all else was held equal) – electricity sales and emissions of carbon dioxide fell sharply during the two years before the Abbott government abolished the “carbon pricing mechanism”.

Then they rose again. History will not be kind to that man.

Second puzzle. An ABC series called How to Live Younger presented scientific evidence showing that regular exercise throughout life can rewind the clock on cognitive (mental) decline, fight cancer, prevent disease, beat depression and even enhance our lives by making us smarter and more creative.

So people who’ve exercised throughout their lives generally do much better in old age. It’s also true that people who aren’t used to exercising find it harder to start working out and so don’t get as much “utility” - enjoyment and benefit – from exercising.

The economists’ convention model of “rational decision-making” predicts that knowledge of all this will lead parents to encourage their children to exercise and lead kids to keep it up as young adults and in middle age, thus setting themselves up for a healthy, happy old age.

Doesn’t always happen that way, you say? True. By why not?

Because, as behavioural economists recognise, many people, even those who fully understand how keeping fit will benefit them in old age, still have trouble making themselves exercise regularly. If they get out of the habit, it’s hard to get back into it.

A finding of behavioural economics is that this is partly explained by the “projection bias” that affects the thinking of many people. They mistakenly believe that the benefit they enjoy from exercise at this stage of their life will be the same in later stages. Actually, they’ll benefit more in later stages if they keep exercising now; if they give up exercise now they’ll find it harder to take it up again later.

So, whereas conventional economics can’t see there’s a problem – also with adverse consequences for the health system and the taxpayer – behavioural economics can see it. It can see the case for a government education campaign to help people overcome their projection bias, for instance.

And there are techniques individuals use to overcome their projection bias, short-sightedness and lack of willpower. Psychologists call such techniques "commitment devices". I did little exercise until, in my late 40s, a diabetes doctor ordered me to start.

I’ve been able to keep going to the gym two or three times a week since then, and I enjoy it. The tricks I’ve used to keep it up are to have a highly qualified trainer and go at set times with a bunch of gym buddies who’ve become good friends.

A couple of times last year I criticised academic economists for not doing enough to make their theories more realistic – and more useful to the students they teach.

The two “puzzles” we’ve just looked at are derived from a university exam paper in behavioural economics, sent to me in response to my criticisms by Professor Simon Grant, of the Australian National University.

It seems that, at least at our better universities, economists don’t just bang on with conventional theory oblivious to its limitations.

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Nobel winners make economics more useful, not a parlour game

It turns out that, in economics, maths – like technology and much else – can be used for good or ill. The three academic economists (and one ghost) who won this year’s Nobel Prize in “economic science” used mathematics to make economics more realistic and thus more useful to society.

The reason economics has become dominant among the social sciences – has had so much influence over the thinking and actions of governments - is the belief that understanding how and why people behave the way they do in the economic dimension of their lives – their producing and consuming – will help our leaders solve problems with the economy and make us happier and more prosperous.

But sometimes I suspect that the bulk of academic economists – whose beaverings won’t go anywhere near winning any prize – have lost sight of the goal of improving economists’ understanding of how the economy works and being more useful to the community and its leaders in improving our lives.

I worry that academic economists have become more inward-looking and more concerned with impressing each other than in serving the mugs who ultimately pay their wages. (I make the same criticism of journalists, by the way.)

In the years since World War II, the greatest project in academic economics has been to make it more scientifically “rigorous” by making it more mathematical. To express economic reasoning not in words or diagrams, but in equations.

These days, you shouldn’t do economics at university if you’re no good at maths (which may help explain why student numbers are down). No one gets to be an academic economist unless they’re good at maths. No one gets to be an economics professor unless they’re really good at maths.

Impressing the other academics with your great maths is the way you get on in academic economics. Maths is just so logical, so beautiful, so “elegant”. But sometimes I think these people love maths for its own sake and are turning economics into a branch of applied mathematics.

In an infamous study economists prefer to forget, economists attending the American Economics Association’s annual meeting were asked to answer a question about opportunity cost. Eighty per cent of them got it wrong. Opp cost is the foundation on which most economics rests. Makes you think all these PhDs know more maths than basic economics.

It’s true that expressing an argument in mathematical equations exposes any flaws in your logic – given the assumptions the argument is built on. That’s why the results of modelling – including the epidemiological variety – should be viewed with caution until you know and accept as plausible the key assumptions on which the modelling’s based.

The other day I wrote that economics’ greatest weakness is its primitive model of human behaviour, based on the mere assumption that people always behave “rationally” – which I defined as acting with carefully considered self-interest.

A couple of economics professors took me to task on Twitter. Oh no, not that old canard. “Rational” is just one of the many words in economics that are used to mean something other than their meaning in common speech.

No, what we mean by “rational” is not that people always think logically, but that we look at people’s “revealed preference” – what they actually do, not just what they say. This, I was assured, had long been part of mainstream economics.

Sorry, not convinced. It’s a circular definition: what people actually do (as measured by the statistical data available) is rational behaviour. Why? Because people are always rational. It’s getting around an implausible assumption by making it even more implausible. By defining non-rational behaviour out of existence.

Why would you do that? To make the assumptions of the neo-classical model mathematically “tractable”. That contrived meaning of “rational” may be longstanding mainstream econometrics, but it ain’t mainstream economics. That’s unconsciously assuming economics is now just maths.

When people were going crazy buying toilet paper last year, Australia’s brightest young economist export, Professor Justin Wolfers, argued it was “rational fear” to join the queue because, if you didn’t, toilet paper might all be gone when yours ran out. That was using “rational” to mean what everyone thinks it means.

You can say the same about former Federal Reserve chairman Alan Greenspan’s famous admission in 2008, after the global financial crisis, that he was mistaken to assume the banks’ “self-interest” would protect them from doing risky things that ended up damaging their shareholders.

The commentator Ian McAuley has observed that both engineers and economists use equations and mathematical models, but engineers check their maths against reality and modify their equations accordingly. Economists? Not so much.

To be fair, predicting the behaviour of bridges and suchlike is a lot easier than predicting the behaviour of human beans. This has led many academic economists not to worry about the plausibility of the assumptions on which their model rest.

Just make whatever nips and tucks are need to mathematise the mainstream model and think of all the fun games you’ll be able to play running different “data sets” through it. Other academic economists will be impressed.

Fortunately, not all academic economists are content with their work having such a tenuous link to real-world problems. Nor are the people who decide who gets the Nobel Prize in economics. The various founders of behavioural economics – which my critics contend isn’t real economics - have received awards, including a psychologist.

And the three academic economists sharing last week’s awards were about trying to make economics more realistic and therefore useful to economic policymakers.

Professor David Card, of the University of California, Berkeley, sought to test the straight-from-theory belief - then almost universally accepted by mainstream economists – that raising the minimum wage would increase unemployment, by searching for empirical evidence to support or refute neo-classical theory.

Until relatively recently, economists believed there was no way they could use experiments to test their theories. But a previous Nobel laureate showed some laboratory experiments were possible. And Card showed how theory could be tested by finding a “natural experiment” – a circumstance where the real world had created a test group and a control group, such as two nearby cities in different states, where one state had raised the minimum wage and one hadn’t.

Professors Joshua Angrist and Guido Imbens have done natural experiments too, and have also developed statistical methodologies for going beyond finding correlations between two variables to being able to demonstrate which caused which – showing other social scientists how it could be done.

The point is that the three honoured economists (plus the ghost of Professor Alan Krueger, who was a co-author with two of the three, but died in 2019) did reams of maths – or, more specifically, statistics – but put it to much more productive purposes. There’s hope for economics yet.

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Economists need updating on what makes humans tick

At the heart of the weaknesses of economics – its frequently wrong predictions and the bad advice its high priests often give governments – is its primitive understanding – its “model” - of how and why humans behave the way they do.

It’s taking economists far too long to realise that to understand how the economy works you’ve got to start by understanding how the people who make up the economy work. The model economists started with in the second half of the 19th century and haven’t really moved on from is the mere assumption that businesses, workers and consumers always behave “rationally” – with carefully considered self-interest.

In the 150 years since economists decided their stick-figure assumptions were a sufficient foundation on which to build their model of economic behaviour, the other social sciences – psychology, sociology, anthropology – have made much progress in understanding human behaviour and motivations.

So, just this once, let’s set aside “Homo economicus” and see what wisdom the more social social scientists have to impart.

In his book, Moral Tribes, the Harvard moral psychologist Joshua Greene lays out a view of human behaviour that accounts for most of the things missing from economics. He starts with the proposition that the way humans behave is heavily influenced by the way we have evolved.

As one of the founders of behavioural economics, the psychologist Daniel Kahneman, explained in Thinking, Fast and Slow, humans are good at thinking rationally, but it takes time and (literally) requires energy, so we’ve evolved to make most of our everyday decisions instantly and instinctively – without conscious thinking.

Our feelings and emotions can’t be dismissed because their role is to do most of our thinking for us. To motivate our instinctive reactions.

Humans have spent all but the past 10,000 years or so in roaming bands of hunters and gatherers. So it’s no surprise we still think like members of a tribe. We feel an affinity with those in our tribe, but not with people in other tribes.

As tribal animals, we care deeply about our relations with those around us, the other members of our tribe. It’s being in the tribe that protects us from harm and provides us with food, friends and someone to mate with. So we have to keep in with the tribe; make sure we’re not kicked out.

This is where moral attitudes come from. Morality is about how we treat others. Greene says “morality is a set of psychological adaptations that allow otherwise selfish individuals to reap the benefits of co-operation”.

You can get competition within tribes, but mainly they’re about co-operation for mutual benefit. We co-operate to organise enough food and shelter, but also for the group’s protection against its enemies, animal or human.

As tribe members, the moral issue we face is “me versus us”. We’ve evolved to remember to suppress unbridled self-interest and treat others well. Thus we’re good at co-operating in shared objectives, and our moral standards involve punishing others who fail to co-operate.

This co-operation does much to explain our success in becoming the dominant species and in radically transforming the world to make ourselves more comfortable. Greene says we’ve defeated most of our natural enemies. We’ve outsmarted most of our predators, from lions to bacteria.

But note this: our ability to co-operate as a tribe has evolved into a weapon to use in competing with other tribes. And, though our evolutionary instincts may not have changed a lot since we ceased being roaming hunters, our success has greatly changed the circumstances in which we live.

Though we live in countries with populations of many millions, we still have moral instincts that evolved to help us solve the problem of me versus us, not the problem of us versus them.

In one sense, we no longer live in small tribes that don’t have much contact with other tribes, but only sometimes do we see ourselves as living in, say, one big Australian tribe. We tend to see ourselves as members of many tribes, according to our differing characteristics: not just the party we vote for, but the part of the country we live in, our ethnic origin, our religion, our occupation, social class, education and much else.

Our tribal instincts keep most of us believing and behaving the way our tribe thinks we should. But the moral intuition of particular tribes has evolved in differing directions. What I see as the moral – or fair – thing to do, may be quite different to how you and your tribe see it.

Most countries used to be fairly homogeneous, with most people in the country adhering to the same religious views, particularly about issues such as abortion, same-sex marriage and assisted death.

These days, many people have abandoned traditional religious views, though many haven’t. And much moving between countries means most countries have many people from differing religious traditions.

This leaves us with moral tribes that can’t agree on what’s right or wrong. This applies not just to sexual morality, but to whether I think it’s “fair” for me to pay more tax to support you when (I tell myself) you wouldn’t need my support if you’d worked as hard as I have to get what I’ve got.

Because our two-speed brains are adept at finding fancy rationalisations for “values” that are really just instinctive desires, we argue about our sacred Right to this or that treatment – which the other tribe counters with its own sacred (but conflicting) Right.

And, Greene says, even when we think we’re being fair, we unconsciously favour the version of fairness most congenial to our tribe.

He offers no magic answers to these widespread problems caused by modern tribalism. But he does say that, with a better understanding of why these tribal disputes arise, we all ought to be a lot less self-righteous about the moral correctness of our position and more willing to find compromises all of us can live with.

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It's the rich wot get to complain and the poor wot get infected

If you’re anything like me, you’re getting mighty tired of lockdowns. I miss being able get out of the house whenever I choose, I miss going to restaurants and – my favourite vice – going to movies. That bad, huh? You’re right, I don’t have much to complain about. I don’t envy those having to school their kids while working at home – although I do miss seeing my grandkids in the flesh.

If you think I need reminding of how easy I’m doing it compared with a lot of others, you’re probably right. But I suspect that’s true of many of us, even those of us doing it just a tiny bit tougher than me.

Apart from those with kids to mind, the first hardship dividing line is between those of us easily able to work from home and those not. This probably means those still on their usual pay and those reliant on some kind of government support.

Even those unable to work from home but “fortunate” to work in an essential industry probably pay the price of running a much higher risk of getting the virus. And that without anyone doing enough to help them get jabbed.

Another divide would be between those in secure employment, with proper annual and sick leave entitlements, and the third of workers in “precarious” employment, most of whom are casuals rather than in the “gig economy”.

Having so many workers without entitlement to sick leave has been a burden for those involved and for the rest of us, namely an increased risk of being infected by someone who, needing the money, keeps working when they shouldn’t.

But though the dividing lines are different in a pandemic, the greatest divide of all is unchanged. As the old song says, it’s the same the whole world over, it’s the rich wot gets the pleasure, it’s the poor wot gets the blame.

Any amount of research confirms what the medicos call “the social gradient” – the well-off tend to be in much better health than those near the bottom. They’re less likely to be overweight (I must be an exception) and less likely to smoke.

The Mitchell Institute at Victoria University has just issued the second edition of its “health tracker by socio-economic status”. It finds that the 10 million Australians living in the 40 per cent of communities with lower and lowest socio-economic status have much higher rates of preventable cardio-vascular diseases, cancer, diabetes or chronic respiratory diseases than others in the population.

Why then should we be surprised to learn that, though Sydney’s outbreak of the Delta variant seems to have started in the better-off eastern suburbs, it soon migrated to the outer south west, where it finds a lot more business?

Last week the welfare peak body, the Australian Council of Social Service, issued a joint research report on Work, Income and Health Inequality, with academics at the University of NSW.

ACOSS boss Dr Cassandra Goldie says “the pandemic has exposed the stark inequalities that impact our health across the country. People on the lowest incomes, and with insecure work and housing, have been at greatest risk throughout the COVID crisis. Now, they are the same people who are at risk of missing out in the vaccine rollout”.

Then there’s the question of trust. Social trust works through social norms of behaviour, such as willingness to co-operate with strangers and willingness to follow government rules. As in other rich countries, our trust in governments has declined over the years. Last year it seemed to lift, as many of us believed we could trust our leaders – particularly the premiers – to save us from the pandemic.

Whether that confidence survives this year’s missteps we’ll have to see. But the economic historian Dr Tony Ward, of Melbourne University, reminds us of a significant finding in this year’s World Happiness Report: in general, the higher a country’s level of social trust, the lower its COVID-19 death rate.

Stay with me. An experiment by the American behavioural economist Alain Cohn and colleagues in Switzerland involved “losing” 17,000 wallets in 355 cities across 40 countries and seeing how many of them were returned to their supposed owners.

The rate of wallet return was about 80 per cent in the Scandinavian countries and New Zealand, just under 70 per cent in Australia, less than 60 per cent in the US and less than 30 per cent in Mexico.

Ward did his own study and found that two-thirds of the difference between countries could be explained by their degree of inequality of income. The greater the inequality, the less trust. When he added survey data on people’s perceptions of corruption, his apparent ability to explain the differences in trust rose from 68 per cent to 82 per cent.

Premier Gladys Berejiklian and her minions tell us the virus is raging in certain “LGAs of concern” because people aren’t doing as they’ve been asked. Maybe their lack of co-operation reflects a lack of trust in the benevolence of those higher up the income ladder. Inequality doesn’t come problem-free.

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Afterpay tells us we're suckers for the illusion of 'free'

There’s more to be learnt - sorry, there are more “learnings” – from the phenomenal success of Aussie “fintech” start-up Afterpay before it drifts off into corporate history. Learnings about human nature, public policy and what switched-on economists call “market design”.

Economists need to do more thinking about the way markets are – and should be – designed. The sub-discipline of market design recognises that, increasingly in the real world – especially the digital world – markets don’t work in the simple, transparent, what-you-pay-is-what-you-get way assumed by economics textbooks.

This means there’s more scope for “market failure” – market forces not delivering the benefits that economic theory promises they will.

Afterpay’s first “learning” is that, far from being “rational” – carefully calculating – consumers (and taxpayers) are hugely attracted by the illusion that something is free. Afterpay’s success seems explained by Millennials being greatly attracted by its promise to let them BNPL - buy now, pay later - without charging any interest.

It seems young people are turning away from credit cards and their very high interest rates in favour of BNPL. When you think about it, however, you see there isn’t much difference between a credit card and an Afterpay BNPL interest-free loan.

A standard credit card is also an interest-free BNPL loan provided you pay it off at the end of the month, in full and on the dot. Fail to manage that, however, and you soon see how high credit card interest rates are.

(Warning to all lawyers and judges: apparently, your legal learning robs you of the ability to understand the argument that follows. To a lawyer, any payment to a lender can’t be a payment of interest unless it’s wearing a label that says “interest” and is expressed as a percentage of the amount lent. You’d all make good Millennials.)

With an Afterpay BNPL loan, it’s only interest-free if you make four equal fortnightly repayments on time. If you’re late with a repayment, you’re charged a $10 late fee. And if you’re more than a week late you’re charged another $7.

The usurious nature of these charges is disguised by their small absolute size (but the amount borrowed is also pretty small) and by our practice of expressing interest rates on an annual basis (this loan is only for eight weeks, not 52).

But that’s not all. As Milton Friedman didn’t win his Nobel prize for discovering, there’s no such thing as a free lunch. Even if the borrower using either a credit card or BNPL manages to repay their loan without incurring any penalty, the lender still has to receive the equivalent of an interest payment to make the transaction worth funding.

In the case of both credit cards and Afterpay loans, this is achieved by a “merchant fee” paid by the retailer that made the sale. The fee is a percentage of the amount lent although, in the case of Afterpay, it’s a huge 4 to 6 per cent plus a flat 30c. (My guess is the 30c is there to fool lawyers into thinking the fee couldn’t possibly be payment of interest).

Whatever the reason, Afterpay has managed to convince the lawyers that, since BNPL obviously has nothing to do with borrowing and lending, it cannot be subject to the Credit Act, meaning Afterpay is not subject to the “responsible lending obligation” and so escapes the expensive obligation to do credit checks and verify the borrower’s ability to repay the debt. (We’re assured, however, that Afterpay and its many imitators are subjecting themselves to a voluntary code of conduct.)

This raises another “learning” right there. Almost invariably, the many market disrupters produced by the digital revolution – including Uber and Airbnb – amount to the combination of a genuine, productivity-enhancing innovation (something every economist wants to encourage) and a trumped-up claim that, because we’re so new and different, none of the regulation that shackles the existing industry applies to us.

“Their workers are employees, ours aren’t. The firms we’re disrupting have to provide employee super contributions, annual and sick leave, and workers compensation insurance, as well as comply with health and safety requirements, but we don’t.”

This, of course, is why we’re developing a two-class workforce, where those unfortunate enough to be able to find work only in the “gig economy” have badly paid, precarious employment with bad conditions and few rights.

The thought that this regression to feudal conditions for some should be allowed to persist in an economy as rich as ours is utterly repugnant. And to respond to it by introducing a universal basic income is an admission of defeat.

But before we leave Afterpay, there’s another learning. Using merchant fees to hide the interest cost of BNPL schemes, whether credit cards or Afterpay-style, involves an arrangement that’s both inefficient and unfair. It encourages retailers to recover the effective interest cost by raising their prices to all their customers, thus obliging those who pay cash or with a debit card to subsidise those who choose to BNPL.

Afterpay prohibits retailers from recouping the cost by asking those who choose BNPL to pay a surcharge. Just as Visa and Mastercard used to prohibit retailers from imposing a surcharge on those who choose to pay by credit card.

For obvious reasons, the promoters of supposedly interest-free loans want the true cost of this free lunch to remain hidden. The Reserve Bank – which has oversight of payment system regulation – laboured for years to get the prohibition on credit-card surcharges outlawed, and finally succeeded.

These days, credit-card surcharges have become common. My guess is that these surcharges, not just the advent of Afterpay and its imitators, help explain the big shift from credit to debit cards. This is just what the Reserve wanted to see.

But it’s utterly inconsistent for the authorities to stop the banks from banning surcharges while allowing Afterpay to ban them. Maybe they’re applying some kind of infant-industry argument. Let them get established, then rope them into the regulatory fold.

Final learning: look around and you find our human susceptibility to the illusion of “free” in lots of places. Starting close to home, free-to-air television and – until Google and Facebook stole our business model – almost-free newspapers and websites were so much a part of the furniture that it was easy to forget that the cost of all the advertising they carried was buried in the cost of most of the things we buy.

The internet still carries a host of free sites with interesting and useful information, even if the legacy newspaper companies have finally moved to making most of their money via subscriptions.

Then there are Google and Facebook, for whom the market-design people have invented a new bit of jargon. They are “multi-sided platforms” whose ostensibly free services are paid for by selling to advertisers the myriad information the platforms have gathered about the preferences, actions and locality of their users.

But our love of the supposedly free – our preference for having the true cost of things hidden from our sight – applies just as much to us as taxpayers. It took the Liberals a long time to realise how much voters loved Medicare, and didn’t want it fiddled with. Why the great love? Bulk billing. The way it makes visits to GPs and hospitals appear free.

Despite all their speeches on the evils of higher taxes, the Libs (like Labor) have never needed to be told of the one tax increase we don’t mind because we don’t see it: bracket creep. When it comes to kidding ourselves, we’re past masters.

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Slowly, economists are revealing the weaknesses in their theories

Economics is changing. It’s relying less on theorising about how the economy works, and more on testing to see whether there’s hard empirical (observable) evidence to support those theories.

Advances in digitisation and the information revolution have made much more statistical information about aspects of economic activity available, and made it easier to analyse these new “data sets” using improved statistical tests of, for instance, whether the correlation between A and B is causal – whether A is causing B, or B is causing A, or whether they’re both being caused by C.

But another development in recent decades is economists losing their reluctance to test the validity of their theories by performing experiments. Let me tell you about two new examples of empirical research by Australian academic economists, one involving data analysis and the other a laboratory experiment.

We see a lot of calls for reform that take the form: change taxes or labour laws in a way that just happens to benefit me directly, and this will make “jobs and growth” so much better for everyone.

These reformers always convey the impression that the changes they want are backed by long established, self-evident economic principles. And they can usually find professional economists willing to say “yes, that’s right”.

But what gets me is that, when the self-declared reformers get their “reform”, it’s rare for anyone to bother going back to check whether it really did do wonders for jobs and growth. Wouldn’t there be something to learn if it was a great success, or if it wasn’t?

Do you remember back in 2017, when employers were campaigning for a reduction in weekend penalty rates? The retailers and the hospitality industry told the Fair Work Commission that making them pay much higher wage rates on Saturday and Sunday was discouraging some businesses from opening on weekends, to the detriment of the public’s convenience.

If only penalty rates were lower, more businesses would open on weekends, or stay open for longer, meaning consumers would spend more, and more workers would be employed for more hours, leaving everyone better off.

The employers got strong support from the Productivity Commission and some economist expert witnesses. So the commission decided to reduce the Sunday and public holiday penalty rates in the relevant awards by 25 to 50 percentage points, phased in over three years.

Associate Professor Martin O’Brien, of the University of Wollongong’s Sydney Business School, commissioned a longitudinal survey (looking at the same people over time) of about 1830 employees and about 240 owner-managers or employers, dividing the workers between those on awards and a control group of those on enterprise agreements (and so not directly affected).

The economists’ standard, “neo-classical” model of the way demand and supply interact to determine the market price, with movements in the price feeding back to influence the quantity that buyers demand and the quantity sellers want to supply, does predict that a fall in the price of Sunday labour will lead employers to demand more of it.

So what did the survey find? It could find no effect on employment in the retail and hospitality sectors. This is consistent with a growing body of mainly American empirical evidence that, contrary to neo-classical theory, increases in minimum wages have little effect on employment.

But here’s an interesting twist: a majority of employers reported not making the reduction in penalty rates and a majority of employees reported not receiving any reduction.

One explanation for this is that employers didn’t pass on the cuts because they valued staff loyalty and commitment. If so, this fits with the judgment of many labour economists that the relationship between a firm and its workers is far more nuanced than can be captured by the neo-classical assumption that price is the only motivator.

An alternative explanation, however, is that those employers didn’t cut the Sunday penalty rate because they weren’t paying it in the first place.

Turning to the laboratory experiment, it tests the much more theoretical assumption that the behaviour of people engaged in economic activities is guided by their “rational expectations” about what will happen in the future.

Economists have come to care about what people expect to happen because this affects the way people behave, and so affects the future we get. In recent decades, many mathematical models of the macro economy have used the assumption that people form their beliefs about the future in a “rational” way to make the maths more rigorous.

By “rational” they mean that people respond to new information by immediately and fully adjusting their expectations – beliefs – about what will happen to prices, the economy’s growth or whatever. Which is a lovely idea, but how realistic is it?

Dr Timo Henckel, of the Research School of Economics at the Australian National University, Dr Gordon Menzies, of the University of Technology Sydney, and Professor Daniel Zizzo, of the University of Queensland, analysed the results of an experiment conducted by Professor Peter Moffatt, of the University of East Anglia, involving 245 students answering questions.

On receiving each piece of new information, the subjects had first to decide whether to adjust their beliefs and then, if so, by how much. The experimenters found that the subjects reacted very differently.

They found that, in general, people don’t update their beliefs with each new piece of information. And when they do, they tend not to adjust their beliefs by as much as they probably should. In other words, people display a kind of belief conservatism, holding on to a belief for longer than they should.

They found that this conservatism is explained to some extent by people’s inattention – they were distracted by other issues – and to some extent by the complexity of the issue: it was “cognitively taxing”.

It turns out that very few people – just 3 per cent of the subjects – display the rational expectations economists assume in their model-building. Most people’s behaviour, the authors say, is better described as “inferential expectations”.

Now, you may not be wildly surprised by these findings. But, in the academic world, common sense doesn’t get you far. You must be able to demonstrate things the academic way.

Even so, Henckel says that the responses of the experiment’s subjects extend to many parts of life, from the behaviour of investors in the share and other financial markets – this is how bubbles develop – to people’s political convictions, where they hold on to beliefs for far too long, ignoring much contrary evidence.

Indeed, inferential expectations apply even to scientists, who form a view of the world which they will revise or overturn only if there is overwhelming evidence to the contrary. So don’t expect economic modellers to abandon their convenient assumption of rational expectations any time soon.

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Why people can be much nicer than economists assume

There’s a lot you can learn about the world of work – and human nature in general – from studying economics. Then again, there’s a lot you can’t learn from conventional economics – and, indeed, from the bum steers it can give you.

Consider this. The 18th century Scottish philosopher Adam Smith is said to be the father of economics. He wrote two monumental books, the second of which, The Wealth of Nations, contained the famous observation that “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest”.

The worthies who developed conventional economics – and its “neo-classical” model of how markets work, the main thing taught in economics courses – seized on this idea to describe an economy populated by profit-maximising firms and self-interested consumers, all of them competing with each other to get the best deal.

They developed Smith’s reference to the “invisible hand” of competition in markets to show how this self-interest on all sides miraculously ends up satisfying everyone’s wants. Hence modern economists’ eternal banging on about the benefits of competition.

But Smith’s first book, The Theory of Moral Sentiments, said something quite different: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, thought he derives nothing from it, except the pleasure of seeing it”.

So what’s it to be? Are we totally self-interested, or do we care about the wellbeing of others? Are we individuals competing against each other for the biggest bit, or are we caring souls who co-operate with others to ensure everyone gets looked after?

Short answer: we’re both. But study conventional economics and you’re told only about the selfish, individualistic, competitive side of our nature. The moral, collective, co-operative side is assumed away. Government is seen not as a force for good, but as an alien force whose intervention in the market risks stuffing things up.

If you wonder why so many of the predictions economists make prove astray, that’s part of the reason. But some years back, two American economists associated with the Santa Fe Institute in New Mexico, Samuel Bowles and Herbert Gintis, wrote A Cooperative Species, to try to balance the story.

In the process, they provide a more convincing explanation of why humans have become the dominant species on Earth – for good and ill.

They focus on the way humans co-operate with each other in many circumstances – including when hundreds of us work for a single business, which competes with other big businesses - and argue that we co-operate not only for self-interested reasons, but also because we are genuinely concerned about the wellbeing of others.

We try to uphold “social norms” of acceptable behaviour, and value behaving ethically for its own sake. For the same reasons, we punish those who exploit the co-operative behaviour of others.

“Contributing to the success of a joint project for the benefit of [your] group, even at a personal cost, evokes feelings of satisfaction, pride, even elation,” they say. “Failing to do so is often a source of shame or guilt.”

We came to have these “moral sentiments,” in Smith’s words, because our ancestors lived in environments, both natural and as constructed by humans, in which groups of individuals who were predisposed to co-operate and uphold ethical norms tended to survive and expand relative to other groups, thereby allowing these “pro-social” motivations to proliferate.

So they explain our motivations for caring about the wellbeing of others: we do it because it makes us feel good. But they also explain the distant evolutionary origins of our disposition to co-operate and its perpetuation to the present day.

Co-operation – engaging with others in a mutually beneficial activity - was part of the behaviour of homo sapiens when we were still living on the African savannah. We formed bands to make us more successful in hunting big animals.

But though co-operation is common in many species, human co-operation is exceptional in that it extends beyond our close relatives – whom we look after in obedience to our evolutionary urge to replicate our species – to include even total strangers. And we co-operate on a much larger scale than other species except the social insects, such as ants and bees.

We co-operate in political and military objectives as well as more prosaic everyday activities: collaboration among the employees in a firm, exchanges between buyers and sellers, and the maintenance of local amenities among neighbours.

So, though they don’t see it in these terms, economists focus on a form of co-operation that involves “reciprocal altruism”. Buyers benefit sellers; sellers benefit buyers.

But human co-operation goes much further, in that it takes place in much larger groups and in circumstances that are unlikely to be repeated. Why do people tip while passing through a country town? In my own town I have reason to care about my reputation. But if I’m in your town, why does it not occur to me to cheat you in some way?

Much experimental and other evidence shows that people gain pleasure from co-operating, or feel morally obliged to. On the other hand, people enjoy punishing those who exploit the co-operation of others, or feel morally obligated to do so.

“Free-riders,” as economists call them, frequently feel guilty and, if they are sanctioned by others, they may feel ashamed.

We may have started out co-operating to hunt wild animals and mind other people’s children, but today we co-operate to enjoy the benefits of “the division of labour” (we each specialise in something we’re good at), of market exchange and the pursuit of economies of scale (in irrigation, factories, information networks) and even warfare.

And we made all this work better by inventing governments capable of enforcing the rights to property and providing incentives for the self-interested to contribute to common projects.

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Humans beat computers at knowing when to leap into the unknown

Two leading British economists who’ve launched a scathing critique of the unrealistic assumptions their peers have added to conventional economics to make it more tractable mathematically have not spared one of my great favourites: “behavioural economics”. It has lost its way, too.

The economists are Professor John Kay of Oxford University and Professor Mervyn King, a former governor of Britain’s central bank, the Bank of England. Their criticism is in the book, Radical Uncertainty: Decision-making for an unknowable future.

As I wrote in this column last week, economists have been working for decades to make their discipline more academically “rigorous” by using mathematical techniques better suited to the “stationary” physical world – where everything that happens is governed by the unchanging laws of physics – or to games of chance, where the probability of something happening can be calculated easily and accurately.

Kay and King call this modelling “small worlds”, where the right and wrong answers are clearly identified, whereas the large worlds occupied by consumers, businesses and government policymakers are characterised by “radical uncertainty”. We must make decisions with so little of the information we need – about the present and the future – that we can never know whether we jumped the right way, even after the event.

Economists’ analysis and predictions are based on the assumption that everything individuals and businesses do is “rational” – a word to which they attach their own, highly technical meaning. They think it means the decision-maker was able to consider every possibility and think completely logically.

Behavioural economics – which has been a thing for at least 40 years – involves economists using the findings of psychology to help explain the way people actually behave when they make economic decisions. It takes the assumption that people always act “rationally” and subjects it to empirical testing. Where’s the hard evidence that people really behave that way?

It shouldn’t surprise you that behavioural economists have found much behaviour doesn’t fit the economists’ definition of rational. They’ve done many laboratory experiments asking people (usually their students) questions about whether they prefer A, B, C or D, and have put together a list of about 150 “biases” in the way people think.

These “biases” include that people suffer from optimism and overconfidence, overestimating the likelihood of favourable outcomes. We are guilty of “anchoring” – attaching too much weight to the limited information we hold when we start to think about a problem. We are victims of “loss aversion” – hating losses more that we love the equivalent gains. And much more.

But this is where Kay and King object. As has happened before in economics, some highly critical finding is taken by the profession and reinterpreted in a way that’s less threatening to the conventional wisdom.

Over the years, I’ve written about many of these findings, taking them to mean the economists’ theory is deficient and needs to be changed.

But Kay and King claim the profession has turned this on its head, seeing the findings as meaning that a lot of people behave irrationally and need to be shown how to be more sensible.

This is an old charge against conventional economists: they don’t want to change their model to fit the real world, they want to change the world so it fits their model.

Why? Because economists think they know what behaviour is right and what’s wrong. What’s rational and what’s irrational. There is, indeed, a popular book about behavioural economics called Predictably Irrational. (The economists love the “predictable” bit – it implies they can get their own predictions right with only minor modifications.)

Kay and King object that most (though not all) the listed “biases” are not the result of errors in beliefs or logic. Most are the product of a reality in which decisions must be made in the absence of a precise and complete description of the world in which people live.

“Real people do not optimise, calculate subjective probabilities and maximise expected utilities; not because they are lazy, or do not have the time, but because they know that they cannot conceivably have the information required to engage in such calculation,” they say.

They note that whereas the American behavioural economists led by the Nobel-prize-winning psychologist Daniel Kahneman have put a negative connotation on the “heuristics” – mental short-cuts – people take in making their decisions, a rival group led by the German psychologist Gerd Gigerenzer sees it as proof of how good humans are at coping with radical uncertainty. It’s amazing how often we get it right.

Kay and King agree, saying that if humans don’t make decisions in the computer-like way economists assume we do, “it is not because we are stupid but because we are smart. And it is because we are smart that humans have become the dominant species on Earth.

“Our intelligence is designed for large worlds, not small. Human intelligence is effective at understanding complex problems within an imperfectly defined context, and at finding courses of action which are good to get us through the remains of the day and the rest of our lives. [Which aren’t the best solutions, but are “good enough”.]

“The idea that our intelligence is defective because we are inferior to computers in solving certain kinds of routine mathematical puzzles fails to recognise that few real problems have the character of mathematical puzzles.

“The assertion that our cognition is defective by virtue of systematic ‘biases’ or ‘natural stupidity’ is implausible in the light of the evolutionary origins of that cognitive ability. If it were adaptive [in the survival-of-the-fittest sense] to be like computers we would have evolved to be more like computers than we are. . .

“Our knowledge of context and our ability to interpret it has been acquired over thousands of years. These capabilities are encoded in our genes, taught to us by our parents and teachers, enshrined in the social norms of our culture,” they conclude.

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Some major contagions have nothing to do with you-know-what

It’s a long weekend so, though we’re barred from enjoying it in the usual way, let’s at least forget the V-word. How about a quiz?

Let’s say the government is preparing for the outbreak of an unusual disease (no, not that kind of disease) that, should we take no action, is expected to kill 600 people. The government could act to combat the disease in either of two ways.

If program A is adopted, 200 people will be saved. If program B is adopted, there’s a one-third chance that 600 people will be saved, and a two-thirds chance that no one will be saved. Which one would you choose?

If you chose A, congradulations. You’re in good company. When this psychology experiment is run, about 72 per cent of subjects favour A and only 28 per cent favour B.

But then the government consults the epidemiologists. Their advice is: forget A and B, and consider program C or program D. If C is adopted, 400 people will die. If program D is adopted, there’s a one-third chance no one will die and a two-thirds chance that 600 will die. Which one would you choose?

If you chose D, more applause. In laboratory experiments, that’s what 78 per cent of subjects choose, leaving only 22 per cent choosing C.

But if you look at the four options again you find that program A and program C are the same. Under A, 200 out of 600 are saved; under C, 400 out of 600 die. It’s just that A highlights the positive, whereas C highlights the negative.

That 72 per cent of subjects favoured A, but only 22 per cent favoured C tells that most of us instinctively favour the safer, more certain outcome. Program B, remember, contained a two-thirds chance that no one would be saved. This instinctive preference confirms economists’ conventional assumption that most people are “risk-averse”.

But a closer look also reveals that program B and program D are the same. Program B offers a one-third chance that 600 people will be saved and a two-thirds chance that no one will be saved, whereas program D offers a one-third chance no one will die and a two-thirds chance that 600 will die.

(If you can’t see that, remember that, in probability theory, the expected outcome is the possible outcome multiplied by the probability of it happening. So B is ⅓(600) + ⅔(0) = 200. And D is ⅓(600) + ⅔(0) = 200.)

But if options B and D are the same thing expressed in different ways, how come the experiments show only 28 per cent of subjects choosing B, but 78 per cent choosing D? It’s because, relative to option C, which offered only the certainty that 400 people would die, option D offered a one-third chance that no one would die, and most subjects thought that was a risk worth taking.

This shows that, while it’s generally true that most people are risk-averse, as conventional economics assumes, a more powerful human characteristic – which conventional economics ignores – is that most of us are “loss-averse”.

A key insight of behavioural economics is that we hate losing something much more than we love gaining something of the same value. So much so that, surprisingly, we’re willing to run risks to avoid any loss.

If you hadn’t noticed, when you look closely you see that all four options offered the same “expected value”: 200 people saved, 400 lost. If everyone had realised this at the time, they should have been equally divided between the options.

Why were we so sure that A and C were much more attractive that B and D? Well, one possibility is that most of us aren’t much good at maths. But the more important explanation is that we are heavily influenced by the way a proposition is presented to us – by the way it’s “framed”, as psychologists say. The same proposition can be packaged in a way we find attractive or repellent.

This, too, is a truth that conventional economics knows nothing of, but behavioural economics – the school of economic thought that uses psychology to throw light on economic issues – has brought to economists’ attention.

Putting it differently, the choices we make are heavily influenced by the context in which we make them. This is one of the key arguments advanced by Robert Frank, an economics professor at Cornell University, is his new book, Under the Influence.

Frank notes that standard economic theory says the spending decisions we make depend only on our incomes and relative prices. People’s assessments of their needs and wants are assumed to be completely independent of the spending decisions of others around them.

But this too is where the assumptions of standard theory are unrealistic. In real life, the things we buy and do are often heavily influenced by the “context” of what our friends are buying and doing.

We wear the clothes we think are fashionable, and we judge what’s fashionable by what our friends are wearing. The best way to predict whether a young person will take up smoking is whether their friends smoke.

We have an impulse to conform – which is stronger than we often realise. That’s why we can’t resist buying toilet paper when others are grabbing it, or selling our shares when others are quitting the market.

Psychologists call this phenomenon “behavioural contagion” – our tendency to mimic the behaviour of others. When some things start to become popular, they often become very popular. Same if they start becoming unpopular.

Frank notes that our tendency to copy what others are doing can have positive consequences (as when people exercise more because their friends are doing it) or negative consequences (as when we drink heavily because the people we live with are).

He argues that economists ought to be more conscious of behavioural contagion because of the opportunities they present for governments to use taxation to encourage us to make better choices.

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Eat, drink and be merry, for tomorrow the virus won't get you

The coronavirus will harm the economy – ours and the world's – but how much damage it does will be determined not just by how far and how fast the virus spreads, but by what the government does to protect us from that spread and what people take it into their heads to do to protect themselves.

There's a good chance the reaction to the threat of the virus will do far more damage to the economy – and the livelihoods of the people who constitute it – than the damage it does to life and limb.

If the reports we hear of people stripping supermarket shelves and deserting cafes, bars and other places of recreation are a guide, the main consequence so far is an outbreak of national hypochondria. Crazed by an overexcited world media, Aussies have gone into panic mode well before the threat has materialised.

I suspect part of the problem is that word "pandemic" – the thing Scott Morrison last week acted on ahead of the World Health Organisation having declared. To many of us it's a highly emotive word, raising images of people dropping like flies as the disease spreads.

In the minds of epidemiologists, however, it just means the virus has popped up in quite a number of countries, without saying anything about how far and fast it's spreading in those countries.

According to Professor Ilan Noy, a specialist in the economics of disasters at New Zealand's Victoria University, "All signs point to a global overreaction to this crisis, and therefore to an amplified economic impact."

According to Professor Cass Sunstein, of Harvard Law School, "A lot of people are more scared than they have any reason to be. They have an exaggerated sense of their own personal risk."

That's because humans are notoriously bad at assessing the risks they face. Studies by psychologists and behavioural economists show individuals typically overestimate risks that are memorable, vivid or generate fear, while underestimating more common risks.

Noy says that, in a survey of 700 people in Hong Kong at the height of the SARS epidemic in 2002, 23 per cent of respondents feared they were likely to become infected. In the US, 16 per cent of respondents to a survey felt they or their family were likely to be infected. The actual US infection rate was 0.0026 per cent.

Sunstein says it's likely that, for residents of a particular city, "The risk of infection is really low and much lower than risks to which they are accustomed in ordinary life – say, the risk of getting the flu, pneumonia or strep throat."

One implication of this, he says, is that, "Unless the disease is contained in the near future, it will induce much more fear, and much more in the way of economic and social dislocation, than is warranted by the actual risk.

"Many people will take precautionary steps - cancelling holidays, refusing to fly, avoiding whole nations - even if there is no adequate reason to do that. Those steps can, in turn, increase economic dislocations, including plummeting stock prices."

But let's say you defy the odds and actually get infected. What are your chances then? Last week WHO said that, using the figures for China, for every 100 cases of coronavirus, about 80 people get better unassisted, 15 have serious but manageable problems, five are very serious and about three die. But that's for China. For the rest of the world it's more like 1 per cent who die.

So, like the flu, the coronavirus is usually something you get over fairly quickly. The people who don't recover quickly tend to be the elderly, and the few who die are usually those with another complication, such as asthma, cancer, cardiac disease or diabetes. (Oh no, that's me! I'm done for.)

But while you await your certain demise, remember something Scott Morrison said last week that didn't hit the headlines: "You can still go to the football, you can still go to the cricket, you can still go and play with your friends down the street, you can go off to the concert, and you can go out for a Chinese meal."

When it comes to the economy, remember that the share market is the drama queen of the financial world. It tends to overreact to bad news – but it does so knowing that later in the week it will be overreacting to good news. A cut in interest rates? God be praised.

Even so, the coronavirus and the efforts to contain it – official and amateur - have had adverse effects on the Chinese economy, with flow-on effects to our economy among others. The Chinese are already getting back to business, but it will be slow and economic activity – producing and consuming – has been seriously disrupted in the present quarter and probably the next. The world economy isn't strong and this will make it weaker.

Our border controls are hitting our tourist industry and universities. How much the overreaction of individuals adds to that we'll soon start seeing in economic indicators rather than anecdotes. In principle, we're experiencing a temporary adverse shock to the economy extending over a quarter or three, followed by a partial bounce back as consumers release pent-up demand and firms rush to fill back orders and re-stock.

Coming on top of all our other economic woes, however, it won't be fun.

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