Economist proposes a socio-economic model

What can economists tell us about love and power, why people are loyal, how groups form and how they get their members to abide by the group's norms of acceptable behaviour? Not much.
Everyone knows conventional economics is built on a stick-figure conception of humans and the way they work.
 
Until now. An economics professor at the University of Queensland, Paul Frijters, has attempted the remarkably ambitious project of developing a unified theory of human behaviour, turning the mainstream model of the economic system into a model of the socio-economic system.

With help from Dr Gigi Foster, of the University of NSW, he's set it all out in the book An Economic Theory of Greed, Love, Groups and Networks. We'll find out soon enough what the rest of the economics profession makes of it.

He starts with the principles of mainstream economics, then adds and integrates selected ideas his research has determined have considerable power in explaining human behaviour.

The bit he starts with, which comes straight from the mainstream, is the assumption that humans are carefully calculating maximisers of their personal benefit. Or, as Frijters prefers to put it, ''humans are mainly motivated by greed''.

This conception of ''homo economicus'' - economic man - emerged in the Enlightenment period. In the early Middle Ages, by contrast, materialism was seen in society as strongly immoral, Frijters explains.
Even so, it's a quite one-dimensional conception of human behaviour. We're a lot more complicated than that. This assumption accounts for much of the criticism of conventional economics (including from yours truly).

So the ''core concepts'' Frijters adds to the conventional assumption of ''greed'' aim to broaden the model's explanation of human motivations and behaviour.

The first concept he adds is ''love'', by which he means love for other humans, but also love for one's beliefs. ''Love is defined as a form of unconditional loyalty, and will be said to be present whenever a person would be willing to help advance the interests of the object of his love, even if the object of his love would not notice the help and even if the loving person would receive no observable reward,'' Frijters says. So love includes the ideas of altruism and loyalty.

''Selfish materialism is extremely powerful in explaining many of our laws, our customs, our politics, and our choices as consumers. Yet selfish materialism alone cannot lead to the kind of human organisations we see in reality.

''I expect to see love as a major player involved in almost every facet of an individual's decision making ? Love within companies should be an integral part of how teams of people actually get things done within organisations.''

Another major criticism of the simple model of conventional economics is its assumption that each of us acts only as an individual, unaffected by the behaviour of those around us. This means no ''economic actor'' has more power than another.

In truth, humans are a group animal whose self-image is inextricably linked to the groups of which they are part. And the reality is that the dominant power relations in modern societies aren't between one individual and another, but rather between individuals and groups.

So the second feature Frijters adds to the mainstream view is groups and the power they generate. Each of us is a member of any number of groups, affecting our family life, social life and working life. Beyond that, our religion, ethnicity and nationality make us members of more, often powerful, groups.

It's because groups generate and exercise power that they need to be added to the model. Power is the ability to influence the behaviour of others. Part of this power comes from the development of norms of acceptable behaviour within the group. Many of us feel considerable loyalty to the groups we're in, which partly explains why we confirm to group norms.

Frijters argues there are five basic types of social groups: small hierarchies, with a clear leader, a few of high rank and a group of underlings totalling no more than a few dozen individuals in all; small circles of reciprocity, with people who are equals and share a common goal; large hierarchies, where members don't know each other; large circles of reciprocity; and networks.

Networks are his third addition to the mainstream view. They are facilitators of exchange - of goods and services, or just information. They exists because of the need to overcome ''frictions'' in markets arising from the information and transactions costs the simple mainstream model assumes away.
Individuals search for goods, buyers and suppliers within networks of small size or large anonymous networks such as the internet.

So how does Frijters' model improve on the answers to questions from the mainstream model? What questions does it answer that the mainstream can't?

On the common questions of whether international trade should be encouraged or protected against, what governments should do about monopolies and how to discourage firms from polluting, his model doesn't much change the conventional answers.

But it can answer some questions the conventional approach can't. With its assumption of calculating, self-interested behaviour, the old approach can't explain why people go to the bother of voting when the chance one vote will change the outcome is minuscule.

Frijter's model says people vote because they're idealistic and identify with the group that is Australian voters.

Nor can the old approach explain why people don't avoid or evade paying tax a lot more than they do. Rates of ''voluntary compliance'' are, in fact, surprisingly high (though not as high as in the old days).
Frijter's model says people feel loyalty to the group of fellow Australians and conform to the social norm that paying taxes is a form of reciprocity that's reasonable to expect of members of the group.

And this is no idle question. He says getting people to pay taxes is probably the single most important ingredient supporting our system of governance.

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The four business gangs that run America

IF YOU'VE ever suspected politics is increasingly being run in the interests of big business, I have news: Jeffrey Sachs, a highly respected economist from Columbia University, agrees with you - at least in respect of the United States.

In his book, The Price of Civilisation, he says the US economy is caught in a feedback loop. "Corporate wealth translates into political power through campaign financing, corporate lobbying and the revolving door of jobs between government and industry; and political power translates into further wealth through tax cuts, deregulation and sweetheart contracts between government and industry. Wealth begets power, and power begets wealth," he says.

Sachs says four key sectors of US business exemplify this feedback loop and the takeover of political power in America by the "corporatocracy".

First is the well-known military-industrial complex. "As [President] Eisenhower famously warned in his farewell address in January 1961, the linkage of the military and private industry created a political power so pervasive that America has been condemned to militarisation, useless wars and fiscal waste on a scale of many tens of trillions of dollars since then," he says.

Second is the Wall Street-Washington complex, which has steered the financial system towards control by a few politically powerful Wall Street firms, notably Goldman Sachs, JPMorgan Chase, Citigroup, Morgan Stanley and a handful of other financial firms.

These days, almost every US Treasury secretary - Republican or Democrat - comes from Wall Street and goes back there when his term ends. The close ties between Wall Street and Washington "paved the way for the 2008 financial crisis and the mega-bailouts that followed, through reckless deregulation followed by an almost complete lack of oversight by government".

Third is the Big Oil-transport-military complex, which has put the US on the trajectory of heavy oil-imports dependence and a deepening military trap in the Middle East, he says.

"Since the days of John D. Rockefeller and the Standard Oil Trust a century ago, Big Oil has loomed large in American politics and foreign policy. Big Oil teamed up with the automobile industry to steer America away from mass transit and towards gas-guzzling vehicles driving on a nationally financed highway system."

Big Oil has consistently and successfully fought the intrusion of competition from non-oil energy sources, including nuclear, wind and solar power.

It has been at the side of the Pentagon in making sure that America defends the sea-lanes to the Persian Gulf, in effect ensuring a $US100 billion-plus annual subsidy for a fuel that is otherwise dangerous for national security, Sachs says.

"And Big Oil has played a notorious role in the fight to keep climate change off the US agenda. Exxon-Mobil, Koch Industries and others in the sector have underwritten a generation of anti-scientific propaganda to confuse the American people."

Fourth is the healthcare industry, America's largest industry, absorbing no less than 17 per cent of US gross domestic product.

"The key to understanding this sector is to note that the government partners with industry to reimburse costs with little systematic oversight and control," Sachs says. "Pharmaceutical firms set sky-high prices protected by patent rights; Medicare [for the aged] and Medicaid [for the poor] and private insurers reimburse doctors and hospitals on a cost-plus basis; and the American Medical Association restricts the supply of new doctors through the control of placements at medical schools.

"The result of this pseudo-market system is sky-high costs, large profits for the private healthcare sector, and no political will to reform."

Now do you see why the industry put so much effort into persuading America's punters that Obamacare was rank socialism? They didn't succeed in blocking it, but the compromised program doesn't do enough to stop the US being the last rich country in the world without universal healthcare.

It's worth noting that, despite its front-running cost, America's healthcare system doesn't leave Americans with particularly good health - not as good as ours, for instance. This conundrum is easily explained: America has the highest-paid doctors.

Sachs says the main thing to remember about the corporatocracy is that it looks after its own. "There is absolutely no economic crisis in corporate America.

"Consider the pulse of the corporate sector as opposed to the pulse of the employees working in it: corporate profits in 2010 were at an all-time high, chief executive salaries in 2010 rebounded strongly from the financial crisis, Wall Street compensation in 2010 was at an all-time high, several Wall Street firms paid civil penalties for financial abuses, but no senior banker faced any criminal charges, and there were no adverse regulatory measures that would lead to a loss of profits in finance, health care, military supplies and energy," he says.

The 30-year achievement of the corporatocracy has been the creation of America's rich and super-rich classes, he says. And we can now see their tools of trade.

"It began with globalisation, which pushed up capital income while pushing down wages. These changes were magnified by the tax cuts at the top, which left more take-home pay and the ability to accumulate greater wealth through higher net-of-tax returns to saving."

Chief executives then helped themselves to their own slice of the corporate sector ownership through outlandish awards of stock options by friendly and often handpicked compensation committees, while the Securities and Exchange Commission looked the other way. It's not all that hard to do when both political parties are standing in line to do your bidding, Sachs concludes.

Fortunately, things aren't nearly so bad in Australia. But it will require vigilance to stop them sliding further in that direction.

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Top economist says what we hardly dare to think

Just as it s taking the world a lot longer to recover from the global financial crisis than we initially expected, so it s taking a lot longer than we might have expected for voters and their governments to learn the lessons and make the changes needed to ensure such devastation doesn t recur. But the penny has dropped for some.

Jeffrey Sachs, of Columbia University, is one of the biggest-name economists in the world. Yet in his book, The Price of Civilisation: Economics and Ethics after the Fall, he admits America s greatest problem is moral, not economic. Actually, he says that at the root of America s economic crisis lies a moral crisis. He puts into words thoughts most of us have hardly dared to think.

Sachs says America s weaknesses are warning signs for the rest of the world. The society that led the world in financial liberalisation, round-the-clock media saturation, television-based election campaigns and mass consumerism is now revealing the downside of a society that has let market institutions run wild over politics and public values, he says.

His book tracks the many ills that now weigh on the American psyche and the American financial system: an economy of hype, debt and waste that has achieved economic growth and high incomes at the cost of extreme income inequality, declining trust among members of the society and the public s devastating loss of confidence in the national government as an instrument of public well-being .

Even if the American economy is on the skids, he says, the hyper-commercialism invented in America is on the international rise. So, too, are the attendant ills: inequality, corruption, corporate power, environmental threats and psychological destabilisation.

A society of markets, laws and elections is not enough if the rich and powerful fail to behave with respect, honesty and compassion toward the rest of society and towards the world. America has developed the world s most competitive market society but has squandered its civic virtue along the way.

Without restoring an ethos of social responsibility, there can be no meaningful and sustained economic recovery.

America s crisis developed gradually over several decades, he argues. It s the culmination of an era the baby-boomer era rather than of particular policies or presidents. It is a bipartisan affair: both Democrats and Republicans have played their part.

On many days it seems that the only difference between the Republicans and Democrats is that Big Oil owns the Republicans while Wall Street owns the Democrats.

Too many of America s elites the super rich, the chief executives and many academics have abandoned a commitment to social responsibility. They chase wealth and power, the rest of society be damned, he says.

We need to reconceive the idea of a good society. Most important, we need to be ready to pay the price of civilisation through multiple acts of good citizenship: bearing our fair share of taxes, educating ourselves deeply about society s needs, acting as vigilant stewards for future generations and remembering that compassion is the glue that holds society together.

The American people are generally broadminded, moderate and generous, he says. But these are not the images of Americans we see on television or the adjectives that come to mind when we think of America s rich and powerful elite.

America s political institutions have broken down, so that the broad public no longer holds these elites to account. And the breakdown of politics also implicates the public. American society is too deeply distracted by our media-drenched consumerism to maintain habits of effective citizenship.

Sachs says a healthy economy is a mixed economy, in which government and the marketplace play their roles. Yet the federal government has neglected its role for three decades, turning the levers of power over to the corporate lobbies.

The resulting corporatocracy involves a feedback loop. Corporate wealth translates into political power through campaign financing, corporate lobbying and the revolving door of jobs between government and industry; and political power translates into further wealth through tax cuts, deregulation and sweetheart contracts between government and industry. Wealth begets power, and power begets wealth.

How have American voters allowed their democracy to be hijacked? Most voters are poorly informed and many are easily swayed by the intense corporate propaganda thrown their way in the few months leading to the elections.

We have therefore been stuck in a low-level political trap: cynicism breeds public disengagement from politics; the public disengagement from politics opens the floodgates of corporate abuse; and corporate abuse deepens the cynicism.

Sachs says globalisation and the rise of Asia risks the depletion of vital commodities such as fresh water and fossil fuels, and long-term damage to the earth s ecosystems.

For a long time, economists ignored the problems of finite natural resources and fragile ecosystems, he writes. This is no longer possible. The world economy is pressing hard against various environmental limits, and there is still much more economic growth and therefore environmental destruction and depletion in the development pipeline.

Two main obstacles to getting the global economy on an ecologically sustainable trajectory exist, he says. The first is that our ability to deploy more sustainable technologies, such as solar power, needs large-scale research and development.

The second is the need to overcome the power of corporate lobbies in opposing regulations and incentives that will steer markets towards sustainable solutions. So far, the corporate lobbies of the polluting industries have blocked such measures.

In Australia, of course, the public interest has so far triumphed over corporate resistance. But the survival of both the carbon tax and the mining tax remains under threat.

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A new economic history of Australia

It drew little comment, but the centrepiece of Julia Gillard's white paper on the Asian century was her target of raising Australia's standard of living - income per person - from the 13th highest in the world into the top 10 by 2025. Considering the three richest economies on the list are the tiddlers of Qatar, Luxembourg and Singapore, it's clear we're already very rich.

Perhaps the reason this grand objective excited so little interest is that, for us Australians, there's nothing new about being in the materialist winners' circle. As Ian McLean, an economic historian at the University of Adelaide, reminds us in a new book, Why Australia Prospered, we joined that company from about 1820, and between 1860 and 1890 we were the richest country of all.

Few countries have been so successful for so long, he says. Some have achieved comparable levels of income only since World War II (think Japan or Italy). Many Asian countries are making good progress in catching up to these levels, though they still have some distance to travel (even South Korea).

McLean reminds us one country has experienced long-term relative decline after having achieved membership of the rich nations' club in the early 20th century: Argentina. And even New Zealand, which tagged along near us for most of the journey, has been falling further behind since the 1970s.

So, in the first major economic history of Australia for 40 years, McLean sets out to explain why we became rich so soon and how we've managed to stay that way for the most part of 200 years.

The story we have in the back of our minds explains it in a phrase: we're the Lucky Country. The Europeans who settled in this vast land had the good fortune to arrive at a place well suited to farming and teaming with valuable minerals. For more than 200 years we've been living off that great luck.

There's no doubt Australia's longstanding prosperity owes a lot to the exploitation of its bountiful "natural endowment". We became a major world producer and exporter of wool as early as the 1820s, and it stayed our principal export earner until the 1950s, save for the 1850s and 1860s when it was supplanted by gold.

McLean says the gold rush was "no flash in the pan". Gold continued to be important to our prosperity for several decades. And we remain a significant world producer to this day.

At the start of the wool boom in 1820, Australia's European population was just 30,000. By the time gold was discovered in 1851, it was up to 430,000. Thanks to the gold rush, in just 10 years it had reached 1.2 million. Most of those people stayed, and by the start of the serious depression of the 1890s it was 3.2 million.

The story of our lucky natural endowment continued with the discovery of many mineral deposits in the 1960s, right up to the Asia-driven resources boom of the past decade. Still today, primary products account for two-thirds of our export income.

But McLean disputes the notion our unending prosperity can be explained simply in terms of our lucky strikes. For one thing, their study of many countries has led modern economists to the conclusion that possession of some valuable resource deposit is almost always a curse rather than a blessing.

It tends to lead to squabbling over who gets the proceeds, corruption, complacency, underdevelopment and stagnation. By contrast, resource-bereft countries such as Singapore or Taiwan seem to have succeeded precisely because they knew they had nothing going for them beside their own efforts.

Clearly, Australia is an exception to the "resource curse" rule. But then we have our erstwhile southern hemisphere twin, Argentina, as a reminder you do have to play your cards right.

Our long prosperity defies another conventional wisdom: colonies get exploited by their colonising power. McLean finds no evidence of significant exploitation by the British. On the contrary.

Unlike some Asian colonies, our economy had to be built from scratch. Who built the foundations and paid for them? The British taxpayer. We benefited from our convict origins. The Brits were expecting it to cost them, and the 160,000 convicts they sent us were selected for their suitability for hard work.

A big part of the reason we got rich so quickly was that such a high proportion of the population was in the workforce. Then there was the advantage of being part of the British Empire trading bloc and the privileged access it gave us to Britain's market.

Self-government came early and bloodlessly in the 1850s.

But McLean gives much of the credit to the quality of our economic and political "institutions" - legal system, property rights, control of corruption, political arrangements and social norms - most of them inherited from the Brits.

The test of our institutions is their flexibility, their ability to adapt in response to changing circumstances and needs. As evidence of flexibility McLean cites the ending of transportation of convicts, a solution to the monopolisation of grazing land by squatters and the pull-back from using indentured islander labour on sugar plantations.

Much more recently you can point to all the economic reforms we undertook in the 1980s and '90s to open our economy to a globalising world. And to our skilful response to the global financial crisis - just the latest of many economic shocks the world has thrown at us.

Australians don't have tickets on themselves as great managers of our economic fortunes, but a look at the record - and at the performance of comparable countries - says we've had a lot more going for us than just luck.

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Moneyball shows competition isn’t always a winner

One of my favourite films for this year was Moneyball. Ostensibly, it's the story of how the real-life Billy Beane (Brad Pitt), general manager of the Oakland As baseball team, took the second-poorest team in the comp almost to the top.

At a deeper level, it's about how the super-cool guys of professional baseball got beat by the nerds.

It's about how the science of statistics can tell us things we didn't know about our world.

It's about the ultimate make-or-buy decision facing businesses: do you select and train up your own people, or go out and poach someone whenever you need a new heavy-hitter.

But, above all, it's about how competition in markets can fail to live up to its advertising. (If you didn't catch all those levels, read the book by Michael Lewis - much better than the movie.)

Professional baseball in America is a market. All the teams are privately owned businesses, the owners of which are out to maximise profits.

(That's in theory. In practice, many of the owners probably treat their team as an indulgence - a way to enjoy their fortune - as much as a way to increase their fortune; an end as much as a means.)

Beane was so short of money he turned to a bunch of highly educated baseball tragics, who thought studying a potential player's statistical record through high school and college baseball was a better way of predicting his success in the big league than relying on the judgment of talent scouts.

Much to the amazement and disapproval of the traditionalists - and despite their opposition - Beane and the nerds were proved right. Eventually, other teams started copying their methods.

This says to me that, contrary to the assumption of the economists' conventional model, all the guys running all the teams weren't playing for keeps until Beane and his nerds came along.

They wanted to win the comp, but they wanted to win while playing by the unwritten rules - the game's long-established social norms - of how you should go about winning.

To them, picking players by resort to a laptop full of statistics was almost as unsporting as using performance-enhancing drugs.

Here's the point: they didn't want to win for the money - as the model assumes - they wanted to win to impress the other guys in the comp. They were playing a game, not profit-maximising.

Economists portray competition as the foolproof path to efficiency and affluence. And the idea of living in an economy without competition - where everything was supplied by monopolies, whether privately or publicly owned - has zero appeal. Competition does help keep people on their toes.

But competition isn't the unmitigated blessing economists often assume it to be. As I discussed on Saturday, Robert Frank, in his latest book, The Darwin Economy, elucidates the case where competition leads to socially wasteful arms races, where what's good for the individual isn't good for the group.

The conventional model assumes we seek to maximise absolute values: businesses maximise profits, consumers maximise utility.

In real life, however, we're often more concerned about relative values: with how our salary compares with other people's, with whether our firm has the biggest market share. We care most about how we rank.

A related competitive failure occurs when firms (and the individuals who make them up) break (Hugh) Mackay's Law of competition: focus on the customer, not your competitor.

Thanks to their defective model of human behaviour, economists assume we compete only in response to monetary incentives. They forget the urge to compete is hardwired in the brain of the human animal.

We compete because we enjoy competing. We compete because we want to see how we rank in the comp - and we're confident we'll rank well. This, much more than greed, is what motivates the world's billionaire entrepreneurs.

We compete to impress the other players in the game. But when we do, we break Mackay's Law and our efforts don't benefit the community the way the model predicts.

Speaking of misguided competition, consider this from The Economist's Schumpeter column: "The vast majority of American universities are obsessed by rising up the academic hierarchy, becoming a bit less like Yokel-U and a bit more like Yale.

"Ivy League envy leads to an obsession with research. This can be a problem even in the best universities: students feel short-changed by professors fixated on crawling along the frontiers of knowledge with a magnifying glass.

"At lower-level universities it causes dysfunction. American professors of literature crank out 70,000 scholarly publications a year, compared with 13,757 in 1959.

"Most of these simply moulder: Mark Bauerlein of Emory University points out that, of the 16 research papers produced in 2004 by the University of Vermont's literature department, a fairly representative institution, 11 have since received between zero and two citations.

"The time wasted writing articles that will never be read cannot be spent teaching.

"In Academically Adrift, Richard Arum and Josipa Roksa argue that over a third of America's students show no improvement in critical thinking or analytical reasoning after four years in college."

Clearly, and despite all its virtues, competition can sometimes do more harm than good. But don't be so sure the American unis' misguided motivations could easily be corrected by applying some KPIs - key performance indicators.

It's a safe bet those universities have already been using KPIs to reinforce their academics' obsession with publishing or perishing.

In Australia, our governments have long allowed academic-dominated research councils to hand out research grants in ways that discourage our academics - certainly the economists - from researching Australian issues.

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Brave economist blows whistle on bosses' pay

You could be forgiven for not knowing it, but economists are meant to be tough on business. Their ideology holds that capitalism is good not because it's good for capitalists, but because it's good for consumers - and consumption is "the sole end and purpose of all production".

So said Adam Smith, who added that "the welfare of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer".

The economists' ideology holds that, when markets are working properly, most of the benefit flows to consumers in the form of lower prices and better service, with businesses making no more that "normal" profits (the lowest rate of profit needed to keep the firm's resources employed in its present industry).

Economists should also distinguish between the capitalists (the suppliers of capital - the shareholders) and the managers, who are supposed to be merely the agents of the shareholders who must at all times represent the true interests of the shareholders, never their own interests. Likewise, company directors are supposed to represent the shareholders' interests, not management's interests.

So economists are supposed to be pro-market, not pro-business and certainly not pro-management.

That's how it's supposed to be, but often not the way it is. In practice, economists who work for business aren't free to criticise it in public. The same goes for those who work for conservative governments (or Labor governments anxious to keep on side with business). And few academic economists take an interest in such mundane issues.

But another factor that helps explain the gap between principle and practice is that the economists' basic model recognises no role for collective action, including action by governments. So when things go wrong in markets, economists' first inclination is to defend the market and blame governments.

All this explains why economists have such a poor record in speaking out about excessive executive remuneration - as witness, the Productivity Commission's report on the subject of a few years back. That this is a case of market failure is as plain as a pikestaff, but the commission's economists searched under every rock without finding it.

One honourable exception to this glaring dereliction, however, is Diane Coyle, who tells it as it is in her latest book, The Economics of Enough. As her previous bestsellers attest, Dr Coyle - whose PhD is from Harvard - is a most orthodox economist.

Seeking to explain the origins of the explosion in executive pay, she attributes it to the deregulation of the financial markets in the US, Britain and elsewhere.

"Organised crime aside," she says, "the most ostentatious flaunting of wealth has emanated from the banking sector. As it turns out, these vast earnings and bonuses were undeserved. The bankers [in the US and Britain] ran up large losses, ruined their shareholders, and left taxpayers with the bill. It will be extraordinary if they turn out to have fooled, scared or bullied politicians around the world into stepping back from fundamental reform of the banking sector."

But the key point is the impact such high incomes in banking have had on the rest of society.

"The bonuses far in excess of salaries, and the spending on big houses, fast cars and designer clothes they funded, did create a climate of greed," she says.

"People in other professions who are in reality in the top 1 per cent or even 0.1 per cent of the income distribution were made to feel poor by the bankers.

"Banking bonus culture validated making a lot of money as a life and career goal. It made executives working in other jobs, including not only big corporations but the public sector too, believe that they deserved bonuses.

"Remuneration consultants, a small parasitic group providing a fig leaf justification for high salaries, helped ratchet up the pay and bonus levels throughout the economy.

"The whole merry-go-round of bonuses and performance-related pay is a sham. In almost every occupation and organisation it is almost impossible to identify the contribution made by any individual to profits and performance - complicated modern organisations all depend on teamwork and collective contributions."

So what can be done about it? In late 2009, the British government introduced a penal tax on bonuses above #25,000 in banking. The tax was criticised, not only by bankers but also by others who thought the measure impractical.

"But it was one of the few measures any government has so far taken that was absolutely right. The symbolism is vital even if by itself the measure doesn't bring to an end the corrosive culture of greed. Whatever the practical limitations on their actions, governments can still achieve a lot in symbolic terms, which should never be underestimated when it comes to impact."

And governments could do a lot more to change the social norms that helped destroy the Western financial system. For example, they could halt bonus payments in the public sector altogether, or introduce a general additional tax on non-fixed parts of people's pay packages.

"I am not opposed to people making more money if they studied hard or worked hard for it, or took the risk of setting up a successful new business - on the contrary, effort and entrepreneurship must be rewarded amply," Coyle says.

"Nevertheless, governments have to give a lead in restoring the sense of moral propriety and social connection between those people who are part of the extraordinarily wealthy global elite and the great majority of those with whom they share their own nation.

"Senior bankers should also contribute to this task of making greed and excess socially unacceptable once again." Amen to that.

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Sydney too must go up to go green

As a denizen of the inner city, I love getting away to the countryside. Away from the tar and cement and exhaust fumes to the trees and grass and clean air. In the country or on the coast you feel closer to nature, leading a simpler, cleaner life, doing less damage to the environment. I always feel that, being more natural, trees and grass are good for the spirit.

So it comes as a bit of a shock to read in Triumph of the City, the latest book by America's leading urban economist, Professor Edward Glaeser, of Harvard, that cities are a lot greener than the suburbs and countryside.

''Cities are much better for the environment than leafy living,'' Glaeser says. ''Residing in a forest might seem to be a good way of showing one's love of nature, but living in a concrete jungle is actually far more ecologically friendly.

''We humans are a destructive species, even when ? we're not trying to be. We burn forests and oil and inevitably hurt the landscape that surrounds us. If you love nature, stay away from it.''

We could minimise our damage to the environment by clustering together in high-rises and walking to work, he says. We maximise our damage when we insist on living surrounded by greensward. Lower densities inevitably mean more travel, and that requires energy. While larger living spaces certainly have their advantages, large suburban homes also consume much more energy.

Anyone who believes global warming is a real danger should see dense urban living as part of the solution. Over the next 50 years, China and India will cease to be poor rural nations, and that's a good thing. They, like the West before them, will move from farms to urban living.

''If billions of Chinese and Indians insist on leafy suburbs and the large homes and cars those suburbs entail, then the world's carbon emissions will soar ? The critical question is whether, as Asia develops, it will become a continent of suburban drivers or urban-transit users.''

Historically, the wealthy managed to combine city and country living by having two homes. Winter months were spent in the city, while hot summers were spent on the country estate.

Less expensive solutions were to surround towns and cities with a green belt. Failing that, big city parks were established. But the emergence of faster, cheaper transportation made it possible to live with trees and work in the city.

Homes and cars account for about 40 per cent of the average American household's emissions of carbon dioxide, half of which is attributable to cars. People could buy more fuel-efficient cars, but the big difference is whether you drive 500 kilometres a year or 50,000, which depends on whether you live in a city or a suburb. Cities are also greener than suburbs because city households use less electricity.

''Smart environmentalism requires thinking through the inadvertent side-effects of different environmental policies and recognising those that actually do more harm than good,'' Glaeser says. The conservationists who keep the San Francisco Bay area free from new construction are preventing development in the greenest part of America. They are consequently increasing development in America's browner areas, such as baking-hot, air-conditioned Texas.

''In older cities like New York, NIMBYism hides under the cover of preservationism, perverting the worthy cause of preserving the most beautiful reminders of our past into an attempt to freeze vast neighbourhoods filled with undistinguished architecture.

''In highly attractive cities, the worst aspects of this opposition to change are that it ensures that building heights will be low, new homes will be few, prices will be high, and the city will be off-limits to all but rich people.''

People seem surprisingly ignorant of how supply and demand work. When the demand for a city rises, prices will rise unless more homes are built. When cities restrict new construction, they become more expensive.

Cities grow by building up or out. When a city doesn't build, people are prevented from experiencing the magic of urban proximity. Preserving a city can, in fact, require destroying part of it, Glaeser says.

The modern desire to preserve Baron Haussman's Paris has helped turn the affordable Paris of the past - with its history of impecunious but ultimately celebrated artists - into a boutique city that today can be enjoyed only by the wealthy.

There is great value in protecting the most beautiful parts of our urban past, but cities shouldn't be embalmed in amber. Too much preservation stops cities from providing newer, taller, better buildings for their inhabitants.

Height restrictions - in Paris, New York and Mumbai - should be of interest and concern to far more of us than just the planning professionals. ''These rules are shaping the future of our cities and our world,'' Glaeser says. ''If the cities' history becomes a straitjacket, then they lose one of their greatest assets: the ability to build up.''

Height, he says, is the best way to keep prices affordable and living standards high.

Glaeser's observations seem of obvious relevance to Sydney and the decisions facing the O'Farrell government. Our sky-high house and unit prices are partly the product of strong demand being met by a woefully inadequate supply of additional houses and units. Now those high prices are contributing significantly to Sydney and NSW's weak rate of economic growth.

The lack of additional supply comes partly from our topography, but mainly from excessive government restrictions on development. But there are limits to how far Sydney can be allowed to sprawl - including the inadequacy of public transport.

Sydney needs to go up, and part of that up is more medium-density housing in north shore Liberal electorates, including the Premier's own.

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Is this time different?

When the Queen asked economists why so few of them had foreseen the global financial crisis, our professor Geoff Harcourt and some other academics petitioned her to say, among other things, that one reason was their profession's loss of interest in economic history.

That sad truth was demonstrated convincingly by two American professors, Carmen Reinhart and Kenneth Rogoff, in a book which has since become a modern classic, This Time Is Different: Eight Centuries of Financial Folly. It's just out in paperback, published by Princeton University Press.

In their landmark study of hundreds of financial crises in 66 countries over 800 years, Reinhart and Rogoff find oft-repeated patterns that ought to alert economists when trouble is on the way. One thing stops them waking up in time: their perpetual belief that ''this time is different''.

But, as we're witnessing at present, even when economists and financial market players have been hit over the head by reality, their ignorance of history stops them understanding what happens next. Wall Street and Europe fondly imagined the Great Recession was behind them, only to discover it's still rolling on.

Reinhart and Rogoff could have told them - did tell them - financial crises of this nature aren't so easily escaped. The Great Recession was so called to signify that another depression had been averted.

The authors say a more accurate name would be the Second Great Contraction. ''The aftermath of systemic banking crises involves a protracted and pronounced contraction in economic activity and puts significant strains on government resources,'' they say.

They show that, in the run-up to America's subprime crisis, standard indicators such as asset price inflation, rising leverage (debt relative to the value of assets), large sustained current account deficits on the balance of payments and a slowing trajectory of economic growth exhibited virtually all the signs of a country on the verge of a severe financial crisis.

So why did so few economists recognise the signs? Everyone thought this time was different.

''Our basic message is simple,'' the authors say, ''we have been here before. No matter how different the latest financial frenzy or crisis always appears, there are usually remarkable similarities with past experience from other countries and from history.

''Recognising these analogies and precedents is an essential step towards improving our global financial system, both to reduce the risk of future crisis and to better handle catastrophes when they happen.''

When looking for the root cause of the global financial crisis, a lot of people put it down to human greed. That's true enough, but it doesn't give us much to work on.

The authors' studies lead them to a different culprit: debt. Credit is crucial to all economies, ancient and modern. Progress would be a lot slower without it. So the point is not that credit is bad, but that it's dangerous stuff.

''Balancing the risks and opportunities of debt is always a challenge, a challenge policymakers, investors and ordinary citizens must never forget,'' the authors say.

But ''if there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by government, banks, corporations or consumers, often poses greater systemic risks than it seems during a boom.

''Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are.''

Such large-scale debt build-ups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short-term and needs to be constantly

refinanced.

Again and again, countries, banks, individuals and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits. Many players in the financial system often dig a debt hole far larger than they can reasonably expect to escape from, most obviously in the US in the late 2000s.

''Government and government-guaranteed debt ? is certainly the most problematic, for it can accumulate massively and for long periods without being put in check by markets ? Although private debt certainly plays a key role in many crises, government debt is far more often the unifying problem across the wide range of financial crises we examined.''

Financial crises are nothing new. They've been around since the development of money and financial markets. And they follow a rhythm of boom and bust through the ages. ''Countries, institutions and financial instruments may change across time, but human nature does not,'' they say.

Human nature brings us to the Achilles heel of debt: confidence. ''Perhaps more than anything else, failure to recognise the precariousness and fickleness of confidence - especially in cases in which large short-term debts need to be rolled over continuously - is the key factor that gives rise to the this-time-is-different syndrome.

''Highly indebted governments, banks or corporations can seem to be merrily rolling along for an extended period, when bang! - confidence collapses, lenders disappear and a crisis hits.''

We've come to believe sovereign debt defaults are unthinkable and extremely rare. This may be partly because ''a large fraction of the academic and policy literature on debt and default draws conclusions based on data collected since 1980''.

The book focuses on two particular forms of financial crises: sovereign debt crises and banking crises. The present global crisis began with failing banks and has now proceeded to the threat of sovereign debt default.

Which, having looked at more than a mere 30 years of data, we now discover is quite common. Had economists been researching the question with the diligence of Reinhart and Rogoff - who put most of their effort into assembling a massive database covering 66 countries for up to 800 years - they may have come up with a little statistic it would have been handy to know a bit earlier.

On average, government debt rises by 86 per cent during the three years following a banking crisis. And that's not the cost of the bank bailouts. It's mainly because banking crises ''almost invariably lead to sharp declines in tax revenues as well as significant increases in government spending''.

Had we known our history, it wouldn't have surprised us that, when you start with heavily indebted governments, a banking crisis soon leads to a sovereign debt crisis.

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Great cities inspire us to reach for the sky

As I'm sure you've heard, for the first time in human history more than half the world's population lives in cities. In the developing countries, particularly China, the urban population is growing by 5 million a month. In rich and poor countries alike, cities are a magnet. But why are people so keen to crowd into congested, expensive cities?

The explanation has to be primarily economic, but most economists studiously ignore the spacial dimension of economic activity. There is, however, a notable exception: Professor Edward Glaeser, of Harvard University, is one of the world's leading experts on urban economics.

In his new book, Triumph of the City, Glaeser proclaims cities to be humans' greatest invention. Why? Because they make us rich. ''Urban density provides the clearest path from poverty to prosperity,'' he says. People who live in big cities not only earn a lot more than those who don't, they're more productive.

Cities are ''the absence of physical space between people and companies''. This closeness generates ''economies of agglomeration''. Producing a product close to a large market cuts costs by allowing large-scale production and reducing distribution expenses. The bigger the city, the greater the scope for firms to specialise in particular fields. Firms know they'll have less trouble finding the labour they need in a big city; workers come to cities knowing there'll be plenty of good jobs.

Historically, big cities often arose because they were convenient hubs for national or international trade in particular products. Many developed their own manufacturing industries - garment-making in New York, cars in Detroit, for instance. But such areas of strength can be challenged by changes in technology. Big reductions in the cost of transport and communications have brought about ''the death of distance'' and shifted much manufacturing to developing countries where labour is cheaper.

Detroit has never recovered from greater competition with Japanese and other Asian carmakers. Its population is less than half what it was. New York lost most of its manufacturing industry, but began reinventing itself in the 1970s. Today, more than 40 per cent of Manhattan's payroll is the financial services industry.

This experience leads Glaeser to emphasise a different driver of the benefits of cities: knowledge.

''Humans are an intensely social species that excels, like ants or gibbons, in producing things together. Just as ant colonies do things that are far beyond the abilities of isolated insects, cities achieve much more than isolated humans,'' he says.

''Cities enable collaboration, especially the joint production of knowledge that is mankind's most important creation. Ideas flow readily from person to person in the dense corridors of Bangalore or London, and people are willing to put up with high urban prices just to be around talented people, some of whose knowledge will rub off.''

Cities magnify humanity's strengths. Because humans learn so much from other humans, we learn more when there are more people around us. Urban density creates a constant flow of new information that comes from observing others' successes and failures. Cities make it easier to watch, listen and learn.

Pundits have predicted that improvements in information technology will make urban advantages obsolete. Once you can learn from Wikipedia in Gilgandra, why pay Sydney prices?

''But a few decades of high technology can't trump millions of years of evolution,'' Glaeser says. ''Our species learns primarily from the aural, visual and olfactory clues given off by our fellow humans. The internet is a wonderful tool, but it works best when combined with knowledge gained face to face, as the concentrations of internet entrepreneurs in Bangalore and Silicon Valley would attest.''

An experiment challenged groups of six students to play a game in which everyone could earn money by co-operating. One set of groups met for 10 minutes' face-to-face to discuss strategy before playing. Another set had 30 minutes for electronic interaction. The groups that met in person co-operated well and earned more money. The groups that only connected electronically fell apart, as members put their personal gains ahead of the group's needs.

This fits with many other experiments, which have shown that face-to-face contact leads to more trust, generosity and co-operation than any other sort of interaction.

Cities, and the face-to-face interactions they engender, are tools for reducing the ''complex-communication curse''. Long hours spent one-on-one enable listeners to make sure they get it right. It's easy to mistakenly offend someone from a different culture, but a warm smile can smooth conflicts that could otherwise turn into flaming emails.

Glaeser says the ''central paradox of the modern metropolis'' is that proximity has become even more valuable as the cost of connecting across long distances has fallen. His explanation is that the declining cost of connection has only increased the monetary returns to clustering close together. Before, high transport costs limited the ability to make money quickly from selling a good idea worldwide. ''The death of distance may have been hell on the goods producers in Detroit, who lost out to Japanese competitors, but it has been heaven for the idea producers of New York, San Francisco and Los Angeles, who have made billions on innovations in technology, entertainment and finance.''

So what do you have to do to be a successful city? Well, first, you have to overcome the three main costs of cities: disease, crime and congestion. After you've achieved clean water (solved the sewerage problem), the harder goals are safe streets, fast commutes and good schools.

Cities thrive when they have many small firms and skilled citizens. Industrial diversity, entrepreneurship and education lead to innovation. Innovation allows cities to overcome setbacks and stay prosperous.

''Human capital, far more than physical infrastructure, explains which cities succeed,'' Glaeser concludes. ''Infrastructure eventually becomes obsolete, but education perpetuates itself as one smart generation teaches the next.''

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How economists forgot much of what they knew

When I started as an economics writer in the mid-1970s, the Keynesian ideas that had guided macro-economic policy through the postwar Golden Age were judged a failure and economics was in crisis.

But now, as Professor John Quiggin of the University of Queensland reminds us in his new book, Zombie Economics, the global financial crisis and the Great Recession have revealed the ideas that replaced simple Keynesianism as failures that plunged economics back into crisis.

The end of the Golden Age and the loss of faith in Keynesianism were brought about by the advent of "stagflation" - high inflation despite a stagnant economy. Keynesian theory said you could have high unemployment or high inflation but not at the same time. It could fix one or the other but not both together.

There aren't many new ideas in economics, just old ideas tarted up. Keynes's ideas were new, however. The "neo-classical" orthodoxy of his day said recessions couldn't happen, so it couldn't explain the Great Depression of the 1930s and had no policies to end it.

Keynes identified various market "imperfections" that explained the economy's malfunctioning and advocated government spending to stimulate the economy and get it growing again. When economists lost faith in Keynesianism they turned back to the discredited neo-classical orthodoxy. Milton Friedman's "monetarism", for instance, was based on the old "quantity theory of money".

Government policymakers soon gave up on monetarism's targeting of growth in the supply of money - it didn't work - but a lasting consequence of that episode was to switch the primacy in macro-management from fiscal policy (the budget) to monetary policy (interest rates).

Keynesianism was criticised because its approach at the macro (top-down) level didn't fit with the bottom-up approach of micro-economics. Its conclusions about how the whole economy worked didn't fit with the standard conclusions about how individual markets worked.

Building models of the macro economy based on neo-classical micro-economic foundations had various attractions. Giving up Keynesianism's more realistic assumptions about how the world worked made the models more rigorously logical and amenable to mathematics.

Assuming everyone was rational and in possession of perfect information got economics back to its libertarian roots, creating a presumption against government intervention in markets and favouring small government and lower taxes.

One development on the old neo-classical foundation was the "efficient market hypothesis", which Quiggin says is the central theoretical doctrine of the "market liberalism" that replaced Keynesianism.

It says financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production. And coming after the collapse of the Keynesian Bretton Woods system of fixed exchange rates, it provided a rationale for the era of finance-driven capitalism that's ended so badly.

In its "weak form", the hypothesis says movements in the prices of assets such as shares can't be predicted from their past movements as claimed by "technical analysts". Like a drunk, share prices move in a "random walk" in reaction to whatever good or bad news next comes along.

In its "strong form", the hypothesis says the market price of an asset is the best possible estimate of its value, incorporating all the available information.

If this is true, bubbles can't develop in asset markets, causing them to crash when finally the bubble bursts.

You can see how this faith - an amazing triumph of hope over centuries of experience - encouraged the excessive deregulation of banks and the financial system, which had formerly been heavily regulated in response to the banks' key role in the Depression.

At the level of macro-economic theory, monetarism was soon superseded by "new classical" economics, incorporating mathematically (and ideologically) convenient propositions such as "rational expectations" and "Ricardian equivalence".

Rational expectations assumes people's expectations about future events will always be right; everyone has the same views about how the economy works as the economics professors who built the model.

Ricardian equivalence - named after David Ricardo, the classical economist who first thought of the idea, then dismissed it - assumes that when governments engage in deficit spending during recessions this has no stimulatory effect on the economy because everyone knows taxes will eventually have to rise to pay off the debt, so they start saving.

Between them, these ideas rendered ineffective government efforts to manage the macro economy. In practice, the academics were less damning of monetary policy. Predictably, new classical economics was never popular with politicians and treasuries, but it fed the general mood that the less governments intervened in the economy the better.

These "new classical" academics developed "real business cycle" theory to explain why economies move in cycles of boom and bust, even though simple neo-classical theory says they don't and many conservative economists had argued that all unemployment was voluntary. Under this theory all fluctuations in economic activity are caused by "exogenous shocks" (developments outside the economic system) such as changes in technology, the terms of trade or workers' preferences for leisure.

Eventually academics - including those in the "new Keynesian" school, which retained remnants of the old Keynesianism - coalesced around the "dynamic stochastic general equilibrium" model. This did allow for the possibility that wages and prices might be slow to adjust, and for imbalances between supply and demand, but moved the model only a short way towards the real world.

The fact that, following the malfunctioning of the 1970s, the main economies seemed to settle down after 1985 - with inflation back under control and unemployment lower - led many economists to conclude this Great Moderation proved economics was now on the right track and the business cycle had been tamed.

Famous last words. The US housing boom proved to be a giant bubble that eventually burst, we realised what crazy games the global financial markets had been playing, the sharemarket crashed, the banking system tottered on its foundations and the developed world entered by far the worst recession since the Depression, which looks likely to linger for the rest of the decade.

And the people whose unrealistic theories helped to bring the calamity about had no idea it was coming because they were playing "rigorous" mathematical games at the time.

I haven't done justice to Quiggin's book, so if you're interested in a readable exposition of the exploits of academic economists over the past 35 years I recommend it highly. It's the story of how economists forgot much of what they knew. Please, guys, don't do that again.

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