Global warming is too 'wicked' to just muddle our way through

It’s probably always true that democracies take too long to accept the need to act decisively to avert foreseeable problems. We never do it well, but always manage to muddle through. We wait until the problem’s reached crisis point. Everyone’s panicking, and thus willing to accept the tough remedies needed. But I fear climate change is too “wicked” a problem to be solved this usual way.

An extra problem for Australia is that we have a government rendered impotent by its internal divisions. The good news – of sorts – is that when the captain of the ship goes AWOL, the crew take over. The premiers – Liberal and Labor – are stepping in to fill the gap. And business can see the writing on the wall and is taking evasive action.

It’s obvious the world is moving to renewable energy and, before long, oil, gas and coal will become “stranded assets” selling a product for which demand can only decline. Here and overseas, banks are worrying about the security of their loans to fossil-fuel businesses, pension funds and investment managers are worrying about their members’ distaste for investing in polluting businesses, and energy businesses such as AGL and now BHP are dividing themselves into good bank and bad bank, so to speak.

Much of the wake-up call to finance and business is coming from financial regulators. Our Australian Prudential Regulatory Authority (APRA) has initiated a climate vulnerability assessment for banks, encompassing scenarios up to 3 degrees of average global warming, and has issued draft guidance for companies to stress test their own finances against scenarios of up to 4 degrees warming.

But in the report, Degrees of Risk, released this week by the Breakthrough – National Centre for Climate Restoration, and written by David Spratt and Ian Dunlop, the authors warn that if by these actions the climate-risk regulators imply warming of 3 to 4 degrees is manageable, or could be adapted to, APRA risks doing more harm than good.

Why? Because with warming of that extent, it’s doubtful we’d still have any banks. The authors say scientists consider 4 degrees of warming to be an existential threat, incompatible with the maintenance of human civilisation. And 3 degrees would be catastrophic, perhaps leading to outright chaos in the relations between nations.

If warming was anything like that bad, applying “stress tests” and doing “scenario planning” would be largely irrelevant.

The authors quote one professor saying that a 4-degree future is “incompatible with an organised global community, is likely to be beyond ‘adaptation’, is devastating to the majority of ecosystems and has a high probability of not being stable”.

Another prof says “it’s difficult to see how we could accommodate 8 billion people or maybe even half that . . . it will be a turbulent, conflict-ridden world”.

Among other impacts, the authors say, 4 degrees would in the long run melt both polar ice caps, with a sea-level rise of about 70 metres. Even 3 degrees would be catastrophic and make some nations, and regions, unliveable.

The authors say most people don’t understand what “global mean [average] warming” implies. As a general rule, global average warming of 4 degrees – covering land and ocean – is consistent with 6 degrees over land (that is, warming over the ocean would be a lot lower, bringing the average down) and with average warming of 8 degrees over land in the mid-latitudes.

That, in turn, risks an average warming of 10 degrees in summer. Or perhaps 12 degrees during heatwaves. All this is packed inside a tolerable-sounding global annual average warming of 4 degrees.

The authors say that Western Sydney has already reached heatwaves of 48 degrees. Add 12 degrees to that and you get summer heatwaves of 60 degrees. Phew.

Now, remember that psychologists and communications experts have been warning climate change campaigners that, if they make their message too frightening, the reaction of many people won’t be to rush out and join Extinction Rebellion, but to close their ears and do nothing.

Remember, too, that the modelling and projections of the climate scientists are far from certain sure and, as with the virus modelling of the epidemiologists, are based on assumptions that keep changing as our understanding of the phenomenon improves.

For these reasons, the UN’s Intergovernmental Panel on Climate Change has long erred on the side of understatement. But the risk with all this is that sensible people with the best intentions – such as regulators of the financial system – don’t realise how bad things could get.

The authors of Degrees of Risk say the science of climate change is inherently complex because it describes the dynamics of a multi-dimensional, “non-linear” system, involving many sub-systems and networks of adverse “cascade effects”.

“Some responses to increasing levels of greenhouse gases are relatively linear and able to be projected well by climate models” but other responses are “non-linear, characterised by sudden changes, rather than smooth progress, which take the system from one discrete state to another, possibly with system cascades” where one change touches off a chain of changes.

“Factors contributing to this non-linearity include the existence of tipping points – polar ice sheets [melting], for example – where a threshold exists beyond which large, system-level change will be initiated, and positive feedbacks [that is, self-reinforcing loops] drive further change.

“In a period of rapid warming, most major tipping points, once crossed, are irreversible on human time frames”.

The authors’ message to regulators of the financial system is that the risk to banks and businesses at degrees of warming of anything like 3 or 4 degrees are huge, but so uncertain as to be unmeasurable. We need to act on the precautionary principle of significantly reducing emissions now, so we never get to find out how bad it could be.

The more prosaic message I draw is that we mustn’t kid ourselves that climate change is just another problem with unpopular solutions that we’ll muddle through as we always do.

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Morrison hasn't noticed that economic times have changed

Apparently, if you think Scott Morrison's refusal to use the budget to boost the economy is motivated by an obsession with showing up Labor by delivering a huge budget surplus, you’re quite wrong.

No, he’s sticking to the highest principles of macro-economic management (which principles Reserve Bank governor Dr Philip Lowe doesn’t seem to understand).

We now know this thanks to the first speech of the new secretary to the Treasury, Dr Steven Kennedy, made last week. He explained to Senate Estimates the long-established orthodoxy among macro-economists in the advanced economies that "short-term economic weakness or unsustainably strong growth is best responded to by monetary policy" (interest rates) not fiscal policy (government spending and taxation).

Although the budget’s "automatic stabilisers" shouldn’t be prevented from assisting monetary policy in keeping growth stable, fiscal policy’s medium-term objective was to "deliver sustainable patterns of taxation and government spending".

Temporary fiscal actions should be taken only in "periods of crisis", which would be uncommon.

Now, I have to tell you Kennedy isn’t making these rules up. They did become orthodoxy in advanced-economy treasuries in the 1980s. They’re the reason John Kerin’s budget of 1991, delivered in the depths of "the recession we [didn’t] have to have" contained zero stimulus, meaning the stimulus, when it came in February 1992, came too late.

And it was the lesson he learnt from this stuff-up that prompted former Treasury secretary Dr Ken Henry to urge Kevin Rudd to "go early" after the global financial crisis in 2008.

These rules will have a familiar ring to those of us who each year study the fine print in budget statement 3 on the fiscal strategy. Particularly in the reference to the role of the budget’s automatic stabilisers, you see the fingerprints of Treasury’s leading macro-economist in recent decades, Dr Martin Parkinson.

Which is all very lovely. Just one small problem: the circumstances of the advanced economies – including ours – have changed radically since those rules were establish in the 1980s. They made sense then; they make no sense now.

For a start, how can you say, leave it all to monetary policy, when the official interest rate is almost as low as it can go? Has no one in the Canberra bubble noticed? Or do they imagine a switch from conventional to unconventional monetary policy tools would be seamless and involve no loss of efficacy or adverse consequences?

And since when did the orthodox assignment of roles between fiscal and monetary policies involve monetary policy resorting to unconventional measures?

The diminished effectiveness of monetary policy is a big part of the reason the world’s leading macro-economists have for some time been moving away from the old view that monetary policy was superior to fiscal policy as the main instrument for stabilising demand.

All those reasons are spelt out by Harvard’s Professor Jason Furman – a former chairman of President Obama’s Council of Economic Advisers – in a much-noted paper (summarised by me here). It was written as long ago as 2016, but doesn’t seem yet to have reached the banks of the Molonglo.

If there’s one thing macro economists know it’s that, these days, the economies of the developed world – including ours – don’t work the way they used to in the 1980s, or even before the financial crisis.

Interest rates are at record lows around the developed world not only because inflation is negligible but also because the world neutral real interest rate has been falling for decades and is now lower than it’s ever been.

This is linked to the fact – often referred to by Lowe, but not mentioned by Kennedy - that the supply of loanable funds provided by the world’s savers greatly exceeds the demand to borrow those funds for real investment.

Around the developed world – and in Australia – consumption is weak, business investment is weak, productivity improvement is low and real wage growth is low, while employment growth is stronger than you’d expect in the circumstances. Countries keep revising down their estimates of the "non-accelerating-inflation rate of unemployment" (that is, full employment), but no one really knows just how low it now is.

To give him his due, Kennedy’s speech reveals him to be just as puzzled as the rest of us about why the economy is behaving so differently.

But one thing seems clear: the private sector isn’t generating sufficient demand to get us out of "secular stagnation," so it’s up to the public sector to fill the void. And, sorry, but with monetary policy down for the count, that means using fiscal policy. They're the new, 21st century rules.

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Economic chaos of Whitlam years not all his fault

Gough Whitlam was a giant among men who changed Australia forever - and did it in just three years. No argument. The question is whether the benefits of his many reforms exceeded their considerable economic costs.

The answers we've had this week have veered from one extreme to the other. To Whitlam's legion of adoring fans - many of whom, like many members of his ministry, have never managed to generate much understanding or interest in economics - any economic issues at the time aren't worth remembering.

To his bitter, unforgiving critics - led by former Treasury secretary John Stone - his changes were of dubious benefit, in no way making up for the economic chaos he brought down upon us.

The truth is somewhere in the middle.

To his many social reforms must be added a few of lasting economic benefit: diplomatic and trading relations with China, the Trade Practices Act with its first serious attack on anti-competitive business practices and - the one so many forget - the Industries Assistance Commission, whose efforts over many years led eventually to the end of protection against imports, removed by the next Labor government.

Not all of his many social reforms have survived. The Hawke-Keating government removed remaining vestiges of his non-means-tested age pension and ended the failed experiment with free university education, which did little to raise the proportion of poor kids going to university, but cost a fortune and delivered a windfall to the middle class at the expense of many workers.

The best modern assessment of the Big Man's economic performance comes in the chapter by John O'Mahony, of Deloitte Access Economics, in The Whitlam Legacy, edited by Troy Bramston.

O'Mahony's review of the economic statistics tells part of the story: "The years of the Whitlam government saw the economic growth rate halve, unemployment double and inflation triple".

But that conceals a wild ride. By mid-1975, inflation hit 17.6 per cent and wage rises hit 32.9 per cent. The economy boomed in 1973 and the first half of '74, but then suffered a severe recession.

From an economic perspective, Whitlam did two main things. He hugely increased government spending - and, hence, the size of government - by an amazing 6 percentage points of gross domestic product in just three years.

Some have assumed this led to huge budget deficits. It didn't. Most of the increased spending was covered by massive bracket creep as prices and wages exploded.

Many of Whitlam's new spending programs should have come under his predecessors and would have happened eventually. Some can be defended as adding to the economy's human capital and productive infrastructure, others were no more than a recognition that our private affluence needn't be accompanied by public squalor.

From this distance it's hard to believe that in 1972 large parts of our capital cities were unsewered. That's the kind of backwardness Whitlam inherited.

The Whitlam government's second key economic action was to pile on top of high inflation huge additional costs to employers through equal pay, a fourth week of annual leave, a 17.5 per cent annual leave loading and much else.

Clyde Cameron, Whitlam's minister for labour, simply refused to accept that the cost of labour could possibly influence employers' decisions about how much labour they used.

From today's perspective, there's nothing radical about equal pay or four weeks' leave. But to do it all so quickly and in such an inflationary environment was disastrous.

When the inevitable happened and Treasury and the Reserve Bank jammed on the brakes and precipitated a recession, Labor's rabble of a 27-person cabinet concluded the econocrats had stabbed them in the back, panicked and began reflating like mad.

What Labor's True Believers don't want to accept is that the inexperience, impatience and indiscipline with which the Whitlam government changed Australia forever, and for the better, cost a lot of ordinary workers their jobs. Many would have spent months, even a year or more without employment.

But what the Whitlam haters forget is that Labor had the misfortune to inherit government just as all the developed economies were about to cross a fault-line dividing the postwar Golden Age of automatic growth and full employment from today's world of always high unemployment and obsession with economic stabilisation.

Thirty years of simple Keynesian policies and unceasing intervention in markets were about to bring to the developed world the previously impossible problem of "stagflation" - simultaneous high inflation and high unemployment - that no economist knew how to fix, not even the omniscient and infallible John Stone.

It was 30 years in the making, but it was precipitated by the Americans' use of inflation to pay for the Vietnam war, the consequent breakdown of the postwar Bretton Woods system of fixed exchange rates, the worldwide rural commodities boom and the first OPEC oil shock, which worsened both inflation and unemployment.

The developed world was plunged into dysfunction. The economics profession took years to figure out what had gone wrong and what policies would restore stability. Money supply targeting was tried and abandoned.

The innocents in the Whitlam government had no idea what had hit them; that all the rules of the economic game had changed. The point is that any government would have emerged from the 1970s with a bad economic record.

Malcolm Fraser had no idea the rules had changed, either. His economic record over the following seven years was equally unimpressive.

It took the rest of the developed world about a decade to get back to low inflation and lower unemployment. It took us about two decades. I blame the Whitlam government's inexperience, impatience and indiscipline for a fair bit of that extra decade.

My strongest feeling is that when the electorate leaves one side of politics in the wilderness for 23 years it's asking for trouble. It's Time to give the others a turn after no more than a decade.

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Why the success of the G20 matters

It's easy to be cynical about the G20. Will the meeting of finance ministers and central bank governors in Sydney this weekend, and the leaders' summit in Brisbane in November, amount to anything more than talkfests?

People say the Brisbane summit will be the largest and most important economic meeting ever held in Australia. That's true, but it just means it will be bigger than the Sydney APEC leaders' summit in 2007 - which is remembered mainly for The Chaser boys' Bin Laden stunt.

But though it's easy to be cynical, it's a mistake. It's possible the two meetings this year will prove no more than talkshops, but that would be a great pity. And, since Australia is this year's chair of the group, it's up to Joe Hockey and Tony Abbott to make sure they're worth more than that.

The G20 began in 1999 as a group for finance ministers and central bankers, in the aftermath of the Asian financial crisis, which revealed the need for greater co-operation and co-ordination between governments in responding to crises in the global financial system and, better, making changes to the global financial "architecture" (rules and institutions) that reduced the frequency and severity of financial crises.

The formation of the G20 was a recognition that the G7 (compromising only Europe, North America and Japan) wasn't truly global, particularly because it excluded the emerging BRICS economies - Brazil, Russia, India, China and South Africa.

For a decade or two most of the growth in the global economy has come from the BRICS, and the developing economies now account for more than half gross world product. For a better global spread, the G20 also adds Argentina, Indonesia, Mexico, Saudi Arabia, South Korea, Turkey, the European Union and, of course, Oz. With just these 20, it accounts for 85 per cent of gross world product.

In 2009, in the aftermath of the global financial crisis, the G20 was upgraded from just finance ministers to include summits of presidents and prime ministers, an acknowledgment of the way economic power had spread beyond the North Atlantic. But why do we need these get-togethers?

Because, as Christine Lagarde, boss of the International Monetary Fund, said recently: "The breakneck pattern of integration and interconnectedness defines our times."

It has become unfashionable for the media to talk about globalisation, but it's continuing apace. As Mike Callaghan of the Lowy Institute said last week: "If there is one lesson from the [global financial] crisis, it is the interconnectedness between financial markets. Events in US financial markets had worldwide consequences. We need co-operation to deal with globally operating financial institutions."

These days, global integration is being driven less by deregulation and more by advances in technology, particularly the information and communications revolution. One part of this is the way the internet has globalised the media.

News of an economic calamity in one country is now conveyed to the rest of the world almost instantly. Financial traders in New York or other centres can start moving money out of the affected country in no time. They can then take a set against neighbouring countries they merely fear may have a similar problem, giving rise to a big problem called "contagion", where trouble spreads like a communicable disease.

And TV news that a few banks are tottering in Europe can scare the pants off consumers and business people in countries around the world, prompting them to stop spending until their confidence returns.

But it's not just crises. As Callaghan reminds us, more and more businesses now operate globally. Goods are more likely to be "made in the world", with inputs from many countries rather than just one. So the trade policies agreed by the international community have to adapt to the new reality that such "value chains" are increasingly driving world trade.

Then there's tax. The more businesses that operate globally, the more businesses that are able to exploit loopholes between different countries' tax laws, shifting their profits to countries with low tax rates. This is eroding the tax base of many countries - including ours - so their taxes aren't raising as much revenue as they should be.

In other words, technology-driven globalisation - the ever-reducing barriers separating particular economies - is throwing up problems that can't be solved by individual countries acting individually.

So we need greater communication, co-operation and co-ordination between countries, first, to discourage countries from pursuing "beggar-thy-neighbour" policies - I attempt to fix my problems at your expense, which usually provokes retaliation, so we all suffer - and, second, to find group solutions to the various problems.

The first couple of G20 leaders' summits in 2009 were quite effective in ensuring the Great Recession wasn't as bad as it could have been. But the truth is the G20 has been running out of momentum, resorting to high-sounding rhetoric while getting bogged down in excessive detail.

Considering how crisis-prone the global economy has become, it's important merely for world leaders, treasurers and central bankers to know each other, have face-to-face meetings and phone each other.

But we also need more joint action, and if the G20 doesn't lift its game the big boys will stop coming to meetings and eventually shift their interest to a smaller, more cohesive group which includes China and a few others, but excludes Australia.

Clearly, it wouldn't be in our interests to lose our seat at the top table. That's why it's so important we use our position as this year's chair to get the G20 back on the rails. Many pre-meeting phone calls need to be made by Hockey and Abbott to their counterparts, to gather support on the directions to be taken.

Then they need to chair the meetings effectively, discouraging set-piece speeches and encouraging interchange that improves mutual understanding and makes progress on a limited range of key issues.

We have a lot to gain or lose.

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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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OK gloomsters, let's run some worst-case scenarios

In the long boom before the global financial crisis, when economists convinced themselves they'd achieved the Great Moderation and everyone was confident the good times would roll on forever, anyone who thought they saw a problem looming was either ignored or dismissed as a fool.

In the North Atlantic economies' continuing agonies since the crisis, it's been roughly the reverse. Excessive optimism has swung to excessive pessimism and anyone who thinks they see a problem looming gets a microphone and loud speaker stuck in front of their face.

Now it's the people who don't think the end is nigh who tend to be ignored. Our cyclical switch to pessimism is being compounded by the media's natural bias in favour of bad news and the tendency of people who dislike the Gillard government to believe everything in the economy has gone to hell.

One person who thinks things aren't as bad as they're being painted is Glenn Stevens, governor of the Reserve Bank. He gave a speech this week in which he begged to differ with the doomsayers. The cogent arguments he advanced deserve more attention than they've been given.

When it comes to dark forebodings, first prize goes to fears of a break-up of the euro. But worries about a hard landing in China are now coming second. Stevens examines the figures and concludes they show "Chinese growth in industrial output of something like 10 per cent, and gross domestic product growth in the 7 to 8 per cent range. To be sure, that is a significant moderation from the growth in GDP of 10 per cent or more that we have often seen in China in the past five to seven years."

But not even China can grow that fast indefinitely and there were clearly problems building up. It's far better the moderation occurs, he argues, if this increases the sustainability of future expansion.

What's more, the Chinese authorities have been taking well-calibrated steps in the direction of easing macro-economic policies, as their objectives for lower inflation look like being achieved and as the likelihood of slower global growth affecting China has increased.

Next he responds to the pessimists' greatest fear of disaster in the domestic economy: a collapse in house prices. He's not convinced they're overvalued by our historical standards. And while, expressed as multiples of annual household disposable income, they seem very high compared with American prices, they are within the pack of other developed countries. It's the US that seems out of line.

But Stevens emphasises he's not saying there's no possibility house prices will fall. "It is a very dangerous idea to think that dwelling prices cannot fall," he says. "They can, and they have." But the ingredients you'd look for as signalling an imminent crash seem even less in evidence now than five years ago.

"Even though we don't face immediate problems, we should ask: what if something went wrong?"

OK, so let's look at some worst-case scenarios. If the thing that goes wrong is a "major financial event" emanating from Europe, he says, the most damaging potential transmission channel would be if there were a complete retreat from risk, capital market closure and funding shortfalls for financial institutions.

This would be a problem for many countries, of course, not just us. But in that event the Aussie dollar might decline, perhaps significantly.

"We might find that, in an extreme case, the Reserve Bank - along with other central banks - would need to step in with domestic currency liquidity, in lieu of market funding. The vulnerability to this possibility is less than it was four years ago; our capacity to respond is undiminished and, if not actually unlimited, is not subject to any limit that seems likely to bind."

An alternative version of this scenario, if it involved the sort of euro break-up about which some people speculate, could be a flow of funds into Australian assets. In that case our problem might be not being able to absorb that capital. But that means the banks would be unlikely to have serious funding problems.

If the thing that went wrong was a serious slump in China's economy, the Aussie would probably fall, Stevens says, which would provide expansionary impetus to the Australian economy. But more importantly, we could expect the Chinese authorities to respond with stimulatory measures.

"Even if one is concerned about the extent of problems that may lurk beneath the surface in China - say in the financial sector - it is not clear why we should assume that the capacity of the Chinese authorities to respond to them is seriously impaired.

"And in the final analysis, a serious deterioration in international economic conditions would still see Australia with scope to use macroeconomic policy, if needed, as long as inflation did not become a concern, which would be unlikely in the scenario in question."

Next, what if house prices did slump after all? In such a scenario people typically worry about two consequences. The first is a long period of very weak construction activity, usually because an excess of housing stock resulting from previous over-construction needs to be worked off. But we've already had a long period of weak residential construction and it's hard to believe it could get much weaker at the national level.

The second common worry is about what a slump in house prices would do to the balance sheets of the banks and other lenders. But this scenario is regularly covered by the Australian Prudential Regulation Authority in its "stress-testing" of the banks.

"The results of such exercises always show that even with substantial falls in dwelling prices, much higher unemployment and associated higher levels of defaults, key financial institutions remain well and truly solvent."

Stevens points out that a lot of the adjustments we're complaining about at present - including households' higher and more normal rates of saving, a more sober attitude towards debt, the reorientation of the banks' funding away from short-term foreign borrowing, and weak house prices - are strengthening our resilience to possible future shocks.

"The years ahead will no doubt challenge us in various ways, including in ways we cannot predict. But what's new about that? Even if the pessimists turn out to be right on one or more counts, it doesn't follow that we would be unable to cope.

"Acting sensibly, with a long-term focus, has as good a chance as ever of seeing us through," Stevens concludes.

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Herd behaviour, fashion and status seeking

Think for more than a moment about the causes of the global financial crisis - the fallout from which is still hurting the US and Europe - and you realise herd behaviour had a lot to do with it.

People paid extraordinarily high prices for houses because they felt they were trailing the Joneses. Brokers sold unsound mortgages because they had to keep up with rival brokers. Funds managers - remunerated according to their relative performance against other managers - traded shares with the same motive.

So, the study of herd behaviour must be a pretty important part of economics, right? Wrong. Between 1970 and the onset of the crisis only nine out of 11,500 articles in three esteemed economic journals discussed herd behaviour. And when they did discuss it they usually viewed it as "informational learning" - learning what I should do from your behaviour. If you hear a fire bell and see people running for the exit, you don't inquire further, you just join them.

Yeah, sure. That explains it. Fortunately, one economist who's taken a great interest in herding is Professor Andrew Oswald, of the University of Warwick, in Britain, and the IZA research institute, in Bonn. Oswald spoke about herd behaviour and keeping up with the Joneses at a conference this week to celebrate the contribution of Professor Ian McDonald, of Melbourne University.

Unlike his peers, Oswald has spent his career crossing the boundaries between economics and the other social sciences. Now he's forging links with the physical sciences and is on the board of editors of the journal Science.

On herding, Oswald took his lead from a seminal zoological paper written in 1971. "Before that article, the standard theory in biology was that herds had some inexplicable communitarian instinct," Oswald says. But the article argued that an animal clusters with others because its relative position is what matters. When you're being threatened by a predator, clustering with others reduces the chance it will pick you as its prey.

What has this to do with humans? Just our preoccupation with our position relative to others. Our desire to be in fashion - to wear what our peers are wearing - is motivated subconsciously by our strong desire to keep up.

And falling back worries us because it involves dropping down the status ladder. So, our often demonstrated desire to do what other people are doing seems to show a deep, though unconscious, concern to defend or advance our status (or rank) relative to others.

Economists have long been suspicious of survey evidence, of asking people what they think about things or why they do things. It's too subjective; how can you be sure they're telling you the truth? This is one of the profession's reservations about the study of happiness (of which Oswald has been a leader among economists).

So, Oswald has been interested in finding more objective ways to measure feelings such as happiness. When I compare your rating of your satisfaction with life with your spouse's or your friend's rating of your satisfaction, do they line up? (Yes, they do.)

He's done a lot of work using the British medical profession's system for rating people's mental health, rather than just asking people how they feel about their lives.

Another approach is to use magnetic resonance imaging (MRI scanning) to see what happens inside people's brains when they have certain feelings or encounter certain ideas.

Yet another approach Oswald is pursuing is the use of "biomarkers": can changes in a person's physiology - their heart rate or blood pressure, say - tell us about what they're thinking and feeling?

Oswald quotes the results of a study by German economists who put pairs of people in adjacent brain scanners and asked them puzzle questions, with money rewards for correct answers. They found that outperforming the other guy had a positive effect on the reward-related parts of the brain. People compare themselves with others and enjoy feeling they're winning.

You reckon that's pretty obvious? Not to an economist. Their standard model assumes away all interpersonal comparison. My likes and dislikes ("preferences") are unaffected by other people's preferences and never change over time.

Raise my income by $10 and my satisfaction ("utility") increases. Raise my income by

$20 and there's a commensurately greater increase in my utility. Raise my income by

$10 while you increase my mate's income by $20 and I won't mind a bit.

Actually, we know from happiness research that relative income (how my income compares with yours) has a big effect on how satisfied people feel with their lives.

Oswald asks whether our satisfaction from social status accelerates or decelerates as we increase in status. That is, does our pursuit of status bring increasing marginal utility or decreasing marginal utility?

This question is still being researched empirically. Oswald quotes the case of top tennis players. The gain in utility from going from being third in the world to second is likely to be much bigger than the gain from going from eighth to seventh.

But increasing marginal utility is probably limited to the very top of the status ladder, with diminishing utility applying to most of us.

We know, for instance, that though people with high incomes are happier than those with low incomes successive increases in income buy progressively smaller and smaller increases in satisfaction with life.

Another thing we know is that the rising average real incomes the developed economies have achieved over the decades haven't led to any increase in average levels of satisfaction.

This raises what Oswald calls a "disturbing possibility". "Maybe modern society is stuck," he says. "Individually, we chase higher income and 'rank', but for society as a whole this cannot be achieved."

Here's another worry: "Herd behaviour is often very natural and individually rational. But it has the potential to be disastrous for the group," he says.

"When rewards depend on your relative position it will routinely be dangerous to question whether the whole group's activity is flawed, and be rational simply to compete hard within the rules that govern success."

In the dotcom bubble a decade ago - where the shares of internet companies that had never made a dollar of profit traded for ever more ridiculous prices - those analysts who said it made no sense got fired.

"In financial markets, people are now routinely rewarded in a way that depends on their relative performance" - whether they're in the top quartile, second quartile or whatever. "That's dangerous," he concludes.

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Doomsday rate cut scenarios off mark

If the Reserve Bank ends up cutting the official interest rate by 0.25 percentage points on Melbourne Cup Day, it won't be because the economy has weakened so much as because it's not looking as strong - and thus, inflationary - as the Reserve had earlier expected.

The air is full of uncertainty and fear about the fate of the European and American economies, with one excitable pundit even predicting a ''world recession''. But, short of a major meltdown, the North Atlantic countries' troubles won't be a big part of the Reserve's reasons for fine-tuning the stance of its monetary (interest rate) policy.

No one knows what the future holds, and there's a ''non-trivial probability'', as the economists say, that the US economy will start contracting again and, more significantly, the problems in Greece will be so badly handled that the European economies implode.

Were that to happen, be in no doubt: the Reserve wouldn't just be lowering rates by one or two clicks, it would be slashing rates in much the way it did in the global financial crisis of 2008-09. But that's far from the authorities' ''central forecast''. They expect the US to grow by a bit under 2 per cent next year, while the euro area achieves no growth.

What would plunge Europe and the world back into crisis - with Europe entering a period of severe contraction - would be for Greece to leave the euro. That's because of the panic this would cause to euro depositors in many other member-countries.

It's likely the Europeans well understand what they need to do to avoid a conflagration: first, restructure the Greek government's debt (which means bond holders accepting big write-downs); second, recapitalise those European banks hard-hit by the write-down; third, have the European Central Bank purchase large quantities of European governments' bonds so as to lower bond yields and, hence, commercial interest rates.

So the Europeans' problem isn't knowing what to do, it's achieving the agreement of 17 squabbling member-countries to do it. The likeliest outcome is that they do enough to avert catastrophe, but not enough to prevent recurring episodes of financial-market jitters.

Our authorities' forecasts for 2012 aren't far from those the International Monetary Fund published last month. These have the US growing by 1.8 per cent and the euro area by 1.1 per cent. If so, that leaves the world economy growing by, what - 1.5 per cent? No, by 4 per cent - which is about the trend rate of growth. Huh?

What's missing from the sum is China's growth, expected to slow to a mere 9 per cent, and India's, to a paltry 7.5 per cent. Even Latin America is expected to grow by 4 per cent and sub-Saharan Africa by 5.8 per cent.

So much for a world recession.

Weakness in the North Atlantic doesn't equal weakness in Australia by a process of magic. You have to trace linkages between them and us. An important one is psychological: the effect of a sliding sharemarket, worrying news from the North Atlantic and over-excited talk of world recessions on the confidence of Australian consumers and business people.

As for ''real'' (tangible) linkages, these days the US and Europe aren't big export customers of ours. So the key question is the extent to which weakness in the North Atlantic leads to weakness in China, India and the rest of developing Asia.

These days, China is a lot less dependent on exports to the North Atlantic than it used to be. And the Chinese authorities have both the political imperative and the economic instruments needed to keep domestic demand growing fast enough to prevent much of a slowdown in production and employment growth.

So, barring a European implosion, the North Atlantic troubles' effect on us is likely to be limited mainly to their effect on confidence. If so, what are the domestic factors that could lead the Reserve to lower interest rates a little?

In May the Reserve was forecasting growth in 2011 of 4.25 per cent. In August it cut that to 3.25 per cent. Today it would probably say 3 per cent.

But get this: the overwhelming reason for these revisions is the temporary effect of the Queensland floods, in particular the loss of output from coalmines that are taking far longer than expected to resume production.

There have been various highly publicised areas of weakness in the domestic economy - the troubles our manufacturers are having coping with a high exchange rate, very weak department store sales and weak housing starts - but overall (and excluding extreme weather events), there's little sign of weakness.

Despite the much-publicised fall in

consumer confidence, consumer spending grew by 3.2 per cent over the year to June, bang on trend. Business investment has been strong and is sure to get stronger. And earlier figures showed worsening inflation and worryingly strong growth in labour costs per unit of production.

Indicators released this week show strong growth in exports and strengthening retail sales, home building approvals and non-residential building approvals.

The strongest evidence of weakening is in the labour market, with employment growth clearly slowing from its earlier fast past, and the unemployment rate jumping 0.4 percentage points to 5.3 per cent in just two months.

But this is a puzzle because, though growth in employment is weak, growth in hours worked isn't. And though surveyed unemployment is supposed to have jumped, the number of people on the dole is steady.

So how does the Reserve come to be contemplating lowering the official interest rate a little? Because its job is to keep interest rates at a level sufficient to keep inflation travelling within its 2 to 3 per cent target range, and the outlook for inflation has become less threatening.

For a start, the Bureau of Statistics has revised the underlying inflation rate over the year to June from 2.75 per cent to 2.5 per cent. Second, the outlook for economic growth isn't quite as strong as it had been. And third, the atmospherics of the labour market have improved, with more consumers worried about losing their jobs and employers less worried about the emergence of excessive wage demands.

The present stance of monetary policy is ''mildly restrictive''. But if the risk of inflation rising above the target range is now much reduced, the stance of policy should be returned to neutral. That would require a fall in the official rate of just one click - two at most.

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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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West heads to a Greek tragedy, too

To boil it down, the reason Greece is in so much trouble is that every Greek wanted a government that did all the expensive things governments do, but none wanted to pay tax.

Greece's politicians did not have the courage to tell their people that, in the end, you cannot have one without the other.

The Greek government ran budget deficits for year after year, racking up more and more government debt, eventually doing dodgy deals to disguise the amount of that debt until - surprise, surprise - the day of reckoning arrived.

Greece is now in the hands of its bank manager and - another surprise - he is not inclined to be gentle or reasonable.

The ostensible reason the rest of Europe is more worried than sympathetic is Greece's membership of the euro currency group and the knowledge that a lot of their own banks have lent to its government. That, plus the fact that Ireland and Portugal are in similar dire straits.

Were Greece to default on its sovereign (government) debt, it could touch off a financial tsunami - driven as much by fear as logic - that swept up the whole of Europe and even reached across the Atlantic to America.

But, really, why should the major advanced economies of the world be so worried about the fate of a piddling country like Greece? Because their own noses are not clean. They are not as far down the track as Greece and the others, but they, too, have been running big budget deficits year after year, building ever-increasing government debt.

They, too, have not had the courage to tell their voters that government benefits have to be paid for with higher taxes.

Australia used the long boom before the global financial crisis to run successive budget surpluses and so pay off all our net federal government debt, but the United States, Japan, Britain, Italy and various other European countries continued building up big government debts.

Then, when the financial crisis struck, they borrowed huge sums to bail out their teetering banks and, to a lesser extent, to stimulate their deeply recessed economies. Put that on top of their existing high levels of debt and even the mightiest economies of the world are in too deep.

In most of the leading economies, the ratio of government debt to gross domestic product will have risen by 2014 to the region of 100 per cent of GDP, compared with 60 to 70 per cent before the crisis. Japan, which started with a high government debt ratio because of its 1990s economic crisis, will end up with a figure of about 240 per cent by 2014.

This explains the stern warning the Bank for International Settlements, the central banks' central bank, issued at the weekend. The major advanced economies should not just be worried about Greece, it said, they should be worried about themselves. If the huge debt levels of the major economies prompt the world financial markets to wonder if those debts will be honoured, so that the markets take a set against sovereign debt in general, the majors, too, will be in big trouble.

But as the British economist Dr Diane Coyle reminds us in her new book, The Economics of Enough, it is worse than that.

We have known for years that the major advanced economies are facing immense pressure on their budgets from the ageing of their populations. They are committed to generous pension payments and healthcare spending for their retiring baby boomers at a time when, for many countries, their populations will be falling.

The Organisation for Economic Co-operation and Development has estimated that, within a decade, the government of the average member country will need to borrow 5 per cent of gross domestic product a year more than it does at present.

The ideal way to get on top of your debts is to trade your way out. Keep the income coming in, hold down your expenses and use the difference to pay down the principal. What makes it hard is the continuing big interest payments you have to meet before you can reduce the principal. Once your bankers lose faith in you, they may well increase the interest rate you are paying to cover their heightened risk.

For governments it is even harder. If they start from a position of annual deficit, they have to slash spending and raise taxes just to return the budget to balance and so stop adding to the principal. To get the budget into surplus - and so have money to reduce the principal - they have to cut spending and raise taxes even further.

But the more governments cut their spending and raise taxes, the more they slow the growth of their economies. And the more slowly their economies grow, the more slowly their tax revenue grows and the higher is their spending on dole payments, making it that much harder to get back to surplus.

The trouble with bank managers is that when finally they lose patience with you, they become quite unreasonable, imposing requirements and restrictions that actually make it harder for you to repay your debt. And when the "bank manager" takes the form of a herd of anonymous traders in global financial markets, their actions can be destructive and even self-defeating.

No matter how deep the problems of the developed world, it will survive. But these seemingly prosperous countries - which have gone for many years falsely inflating their prosperity by borrowing from the future - are reaching their day of reckoning.

Even if they avoid another financial crisis, they are set for a protracted period of austerity and relative penury, with their economies growing only slowly for many years. They have not woken up to this yet, but they will.

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Pop bubbles before they can cause havoc

Don't drop your bundle yet. It would be a brave person - braver than me - who denied any possibility of another global financial crisis.

Sure it's possible, but it's far from certain. And another financial crisis might be like we eventually realised the last one was: more North Atlantic than global.

The Bank for International Settlements is the central bankers' club. And central bankers don't warn of catastrophe if they really fear one's on the way. When things really are near crisis point, they are calm and reassuring.

So this is the world's bank manager issuing wayward clients with a stern lecture on the need to mend their ways. The bank is saying, don't assume the problems are limited to Greece, Ireland and Portugal. The big North Atlantic economies - the United States, Britain and much of Europe - have huge, unsustainable levels of government debt, and should the financial markets lose confidence in those countries' efforts to get on top of their debts, another crisis is possible.

It's preaching against the optimistic attitude in those countries that the crisis has passed and it's back to business as usual. No, no, back to the grindstone.

To that extent it's dead right: those economies face at least another decade of low growth as they grind away at reducing their public and private debts.

This is not a message aimed at us. We could be affected by another financial crisis but we're just as well placed to cope as we were with the first.

Our banks remain well supervised, with few loans to the worst-affected governments. Our government debt is laughably small compared with the US and Europe. Our interest rates are not too low.

If there's one lesson from the first crisis, it's that our fortunes depend much more on Asia than on Europe and America.

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Economists part of Inside Job (Movie previews!)

It always takes the movie world a while to catch up with real life, but it's finally caught up with the global financial crisis. There's the Oscar-winning documentary Inside Job and a classic Hollywood job, The Company Men. I recommend both.

Inside Job deals with the origins of the crisis on Wall Street; The Company Men deals with consequences on Main Street from the resulting Great Recession. Let's start with the "real economy".

America's unemployment rate started rising in October 2008, reaching 10 per cent a year later. It's still about 9 per cent. Say it quickly and it doesn't sound too bad. People lose their jobs when the economy turns down - what else is new?

The great strength of The Company Men is the way it shows us what happens to the lives of three men who lose their jobs when their company decides to "rightsize". These aren't ordinary workers, they're executives close to the top of the tree, which gives them further to fall.

They are well-paid guys who seem to have committed themselves for almost all they earn. First is the humiliation of their lowly status at the outplacement agency and then the disillusionment as their repeated efforts to find another job get nowhere.

At first they attempt to conceal the shame of their unemployment from their children, neighbours and relations. Then comes the steady divestment of the big toys they can no longer afford. Marriages are strained by money worries. Their self-identity came from their job; their job is no more.

They were let go because their company's share price had fallen in the crash and something big must be done to restore it. But every company's share price fell, so what's the problem? The problem turns out to be the chief executive's need to raise the value of his share options. Whether on Main Street or Wall Street we see the new morality of corporate capitalism: look after No. 1 and don't feel any responsibility for the consequences of your actions for customers or colleagues.

In the words of one reviewer, Inside Job is the story of a crime without punishment. Wall Street's reckless behaviour caused the crisis and the huge damage it did to businesses, workers and retirement savings in America and Europe.

The banks were bailed out at great expense to the taxpayer, but so far almost no one has been punished for misconduct or negligence. Many of the perpetrators walked away with millions. The payment of outrageous bonuses hardly skipped a beat.

The film's graphics do a good job of explaining the central role - and the madness - of toxic derivatives such as collateralised debt obligations and credit default swaps.

Many of the docos you see on political and economic themes are acts of left-wing self-indulgence. Not this one. The sense of outrage it builds up in the audience is eminently justified. Indeed, it leaves you wondering how the American public has been so easily diverted from demanding Wall Street be brought to heel.

The outrage arises as you realise Wall Street is virtually a law unto itself. It was progressively deregulated at its own urging by congresses of both colours. Now its immense wealth and lobbying ability prevent it from being effectively reregulated.

For the most part, administrations' key economic regulators - Federal Reserve governors (Paul Volcker, Alan Greenspan) and Treasury secretaries (Robert Rubin, Hank Paulson, Tim Geithner) - come from the upper reaches of Wall Street.

When the big business-dominated Bush administration was replaced by the reformist Barack Obama, Republican-affiliated Wall Streeters were replaced by Democrat-affiliated Wall Streeters.

But it's not just the politicians who are compromised. The film's director, Charles Ferguson, shows how many of America's big-name academic economists are also on the Wall Street payroll. He outlined the case against economists in an article in The Chronicle of Higher Education. Ferguson's leading academic villain is Larry Summers of Harvard. He has long been a champion of privatisation and deregulation and as deputy secretary then secretary of the Treasury in the Clinton administration he oversaw the repeal of the Glass-Steagall Act, which had kept commercial banks separate from investment banks since the Depression.

Between 2001 and his entry into the Obama administration as director of the National Economic Council, Summers made more than $20 million through consulting and speaking engagements with financial firms.

Martin Feldstein, also of Harvard, a major architect of deregulation in the Reagan administration and president for 30 years of the non-government National Bureau of Economic Research, was on the board of the failed insurance giant, AIG, which paid him more than $6 million, and also on the board of the subsidiary whose dealings in credit default swaps brought the company down.

Feldstein's arrogant performance in the film was exceeded only by that of Glenn Hubbard, chairman of the Council of Economic Advisers in the Bush administration and dean of Columbia Business School. He's an adviser to many financial firms, resigning from the board of Capmark, a major commercial mortgage lender, shortly before its bankruptcy in 2009.

Frederic Mishkin, a professor at the Columbia Business School and a member of the Federal Reserve Board from 2006 to 2008, was paid $124,000 by the Icelandic Chamber of Commerce to write a paper praising its regulatory and banking systems, two years before Iceland blew up.

Laura Tyson, a professor at Berkeley and director of the National Economic Council in the Clinton administration, is on the board of Morgan Stanley, which pays her $350,000 a year.

Some of America's leading academic economists, from the most prestigious universities, make frequent pronouncements on public policy in the media, expecting to be venerated as disinterested experts. They rarely see a need to disclose their conflicts of interest.

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A FISCAL POLICY UPDATE

VCTA Student Revision Lectures
September 12, 2010

The economy has been on a roller-coaster ride from resource boom to global financial crisis to recovery from the mildest of recessions to the likelihood of an early return to the resources boom and an economy at near full employment. Monetary policy played its accustomed role in all this and Keynesian fiscal policy returned to the fore. But did we have a recession? And just what was the role played by fiscal/budgetary policy?

Yes, we did have a recession

The widespread belief - encouraged by the Rudd government - that Australia avoided recession is based solely on the notion that a ‘technical’ recession occurs when real GDP contracts for two quarters in succession. But though this rule is widely used by the media, it’s merely rule of thumb with no status among economists. It’s quite arbitrary, and doesn’t always give the right answer. A better definition of recession was given by Dr David Gruen of Treasury: ‘a sustained period of either weak growth or falling real GDP, accompanied by a significant rise in the unemployment rate’.

The evidence that we did have a (very mild) recession is clear: we saw the collapse of various local fringe financial institutions, a 0.7 per cent fall in real GDP in the December quarter of 2008 and weak growth in later quarters, a rise of 230,000 (1.8 percentage points) in unemployment and a bigger rise in under-employment, much tougher borrowing conditions for small business, and weakness in retail sales and home building as the effects of budgetary stimulus wore off.

The reasons why the recession was so mild and short-lived were many: our banks didn’t get into difficulties, the continued strength of our exports to China, the strong growth in the population, the reluctance of employers to retrench their skilled staff and the dramatic cuts the official interest rate. But much of the credit must go to the fiscal stimulus, which was particularly effective in turning around the collapse in business and consumer confidence following the US and European banking crisis.

Fiscal policy

Definition: the manipulation of government spending and taxation to influence the strength of demand.

Instruments: variation of the size and composition of government spending and taxation.

Objective: to serve as a backup to monetary policy in achieving internal balance - low inflation, low unemployment and a relatively stable rate of economic growth. It is conducted in accordance with the government’s ‘medium-term fiscal strategy’: to ‘achieve budget surpluses, on average over the medium term’.

This strategy, which the Rudd government essentially took over intact from the Howard government, was carefully worded so as to fully accommodate a Keynesian approach to fiscal policy. It implies that fiscal policy will support economic growth and jobs by allowing the budget to move into temporary deficit during an economic downturn. So it was deliberately framed in a way that permits the automatic stabilisers to respond to a downturn by turning the budget balance from surplus to deficit. But it also permits the Government to apply discretionary fiscal stimulus, provided the budget balance is brought back into surplus once the economy recovers. In this way, the deficits in the bad years will eventually be offset by surpluses in the good years, thus causing the budget to be balanced (or even in surplus) on average over the full cycle. In other words, the strategy is constructed to permit what I call ‘symmetrical Keynesianism’.

The fiscal stimulus

During the boom, fiscal policy was given a limited role to play in the policy mix, with the heavy lifting left to monetary policy. Once the economy turned down, however, fiscal policy came to fore. The Government announced its first fiscal stimulus package (worth $10 billion) in October 2008, then a second package (worth $42 billion) in February 2009. And it announced a $22 billion national infrastructure program in the 2009 budget.

The measures included in the various packages were intended to comply with three principles enunciated by Treasury and known as the ‘three Ts’: measures needed to be timely, targeted and temporary. Timely meant they should take effect as soon as possible; targeted meant the spending should go to those people or activities most likely to involve spending rather than saving; temporary meant they should involve only a one-off cost to the budget (eg cash bonuses, specific capital works) rather than a continuing cost (eg tax cuts, pension increases).

Some people have the impression that most of the stimulus spending went on cash bonuses. In fact, they cost about $22 billion, less than a third of the Government’s total stimulus spending of $74 billion over the four financial years to2011-12. The remaining two-thirds went on ‘shovel-ready’ minor capital works (road black spots, level crossings, public housing, roof insulation and primary schools) and major infrastructure projects (roads, rail, ports and broadband).

Whereas in May 2008 the government was projecting a long run of budget surpluses, it is now projecting large budget deficits, leading to an increase in the Australian Government’s net debt. It is important to understand, however, that most of this deterioration has been caused by the operation of the budget’s automatic stabilisers, rather than by the Government’s explicit spending decisions. Lower prospective tax collections required the Government to write down its projected revenue by $110 billion over the five years from 2008-09 to 2012-13. Higher prospective dole payments would also have contributed to the deterioration in the budget balance.

The latest estimates suggest the government is expecting the budget deficits over the four years to 2011-12 to total $135 billion. Thus discretionary fiscal stimulus accounts for only a bit over half of the accumulated deficits, with the automatic stabilisers accounting for the rest.

Stimulus spending by governments is intended to have ‘multiplier effects’. Empirical research shows, however, that, particularly because of leakages to saving and imports, the multiplier effects are much smaller in real life than in textbooks. In the Treasury’s calculations for the budget it used highly conservative (pessimistic) multipliers of 0.6 for the Government’s cash bonuses and 0.85 for capital works spending. It now seems clear that the fiscal stimulus has been far more successful than even its promoters expected. That is, the multipliers seem to have been greater than expected.

The changing policy mix

The Opposition’s calls for the stimulus spending to be curtailed now the economy has begun to recover fail to take account of the originally planned phase-down as the T-for-temporary spending programs expire. According to Treasury’s calculations, after the December quarter of 2009 the stimulus spending’s contribution to GDP growth swung from positive to negative. This occurred because, though more stimulus money was spent in the March quarter, it was less than the stimulus money spent in the December quarter. And this meant it subtracted from the rate of growth in GDP (even though it still added to the level of GDP). In other words, from the end of December the stance of fiscal policy switched from expansionary to (mildly) contractionary as the stimulus was withdrawn. To hasten this planned withdrawal would make fiscal policy more contractionary.

By contrast, the various increases in the cash rate we’ve seen, taking it to 4.5 per cent, merely represent moves to take the stance of monetary policy from stimulatory to neutral.

What we have to show for the fiscal stimulus

The Opposition runs hard with the line that, thanks to all the fiscal stimulus, we’re left with nothing to show but a lot of deficits and debt. This isn’t true. Clearly, we’ll be left with all the shovel-ready capital works - rail crossings, fixed black spots, social housing, school buildings and ceiling insulation - and major infrastructure.

But that’s not all - though you have to be an economist to see it. Even the money spent on the cash splashes and unneeded assembly halls has left us with something to show. All the spending - discretionary and automatic - reduces the time it will take for the level of real GDP to return to its previous peak. And that leaves us better off than we would have been in two respects. First, the smaller the rise in unemployment and thus the fewer people unemployed - and the shorter the time they spend unemployed - the less the atrophy (wasting away) of individuals’ skills. Reducing this problem, which economists call ‘hysteresis’, is a benefit not just to the individuals involved, but also to the community.

Second, the milder the recession, the fewer viable businesses go bust, thus avoiding the destruction of various forms of tangible and intangible capital. Some capital equipment - and some understandings, networks and arrangements the firms have made - that could have been used to produce goods and services in the upswing is destroyed. So the milder the recession, the less the loss of productive potential because of the destruction of human, physical and intangible capital.

The opposition opposed all but the first stimulus package and has been continually finding fault. At first it argued the measures - particularly the cash splash - wouldn’t work. But it’s clear from the economic indicators - for retail sales, home loan approvals, new home building approvals and business investment in equipment - that the measures were highly successful in leading to increased private spending. It’s true some of the cash was saved rather than spent, but the marked improvement in business and consumer confidence at the time suggests this saving made many people less anxious about their debts and so less keen to cut back their spending as a precautionary measure.

Later the opposition switched to claiming much of the stimulus - particularly the spending on ceiling insulation and school buildings - had been wasted. It’s true the insulation program should have been much more carefully administered and that there was a degree of waste in the school building program. However, an official inquiry received complaints from only 2.7 per cent of schools, suggesting the extent of waste had been greatly exaggerated by the opposition and sections of the media. Stimulus spending always involves a difficult trade-off between conflicting objectives: the macroeconomic objective (getting the money spent as soon as possible so as to limit downturn in activity) and the value-for-money objective (making sure we have something of lasting value to show for the spending). The way to avoid waste is to take as long as necessary to ensure the money is spent well. So when speed is a high priority, some degree of waste is inevitable. Note, too, that even when spending is wasted on classrooms no one wants, it still creates jobs.

The tax reform package

The main measure announced in this year’s budget was a tax reform package, in partial response to the report of the Henry review of the tax system. After its amendment by Julia Gillard, the package consisted of a minerals resource rent tax, expected to raise about $10 billion in its first two years, the proceeds from which would be used to cover the cost of reducing the company tax rate from 30 per cent to 29 per cent, plus tax concessions for small business, superannuation and individuals. Note that the new tax won’t take effect until July 2012, so the measures it pays for will be phased in from that date. Note, too, that the package is roughly revenue neutral, meaning it’s wrong to imagine the resource tax will play a significant part in returning the budget to surplus.

Mr Swan is now expecting a budget deficit for the old financial year (2009-10) of $57 billion (or 4.4 per cent of GDP), falling to a deficit in the present financial year of $40 billion (2.8 per cent). With the cessation of most stimulus spending programs, this means the stance of policy adopted in the budget is mildly contractionary.

The budget is projected to reach a small surplus in 2012-13 for three reasons: First, the effect on the budget’s automatic stabilisers of the economy’s expected return to strong growth; second, the always-planned completion of the government’s temporary stimulus measures; and third, the government’s adherence to its ‘deficit exit strategy’ of allowing the level of tax receipts to recover naturally as the economy improves (ie avoid further tax cuts) and holding the real growth in spending to 2 pc a year until a surplus of 1 pc of GDP has been achieved. The fact that the government now expects the return to surplus to occur three years’ earlier than it expected in last year’s budget is explained by the much milder recession than it expected and the much stronger forecasts for the next four years.

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WHAT POLICY INSTRUMENTS ARE APPROPRIATE FOR THE GFC?

Talk to Graduate School of Government, University of Sydney
March 18, 2010

Before I get on to talking about the policy response to the GFC I want to go back to first principles and remind you that while, as public servants, you take government policy activity for granted - it’s what you’re employed to do - the appropriate role of government (whether, and under what circumstances, governments should intervene in markets) is perhaps the most contentious topic in politics and economics. The political philosophy of libertarianism - which gives primacy to individual liberty and carries a presumption against the need for government intervention - is overrepresented in the political debate in Australia and particularly the US. While by no means all economists are libertarians, most have a big streak of it in them because the dominant model of conventional, ‘neo-classical’ economics is built on the assumptions that people always act rationally and that markets are self-righting.

The ground rules for intervention

While the public is always urging governments to intervene to correct problems, real or perceived, and politicians are almost always keen to leap in, economists have a two-stage test before they accept such a need: 1) a significant instance of ‘market failure’ has to be demonstrated and 2) the ability of government intervention to correct the market failure - or at least do more good than harm - has to be demonstrated.

Market failure arises where:

a) there is insufficient competition within the market to produce the outcomes the model promises, or

b) there are ‘externalities’ (that is, where the actions of the participants in a market transaction have consequences for third parties [eg the wider community] whether those consequences are negative [eg generation of pollution] or positive [eg my education -or my invention of some improved technology - benefits other people]), or

c) where the goods or services being exchanged display the qualities of ‘public goods’. The two key qualities are that they a non-rivalrous (my consumption of the good doesn’t reduce the quantity of it available to others eg knowledge, use of the internet) and non-excludable (no one can be effectively excluded from using the good eg free-to-air television). The standard egs of public goods are lighthouses and defence spending, but there are other, less perfect examples. The free market will produce less of a public good than is in the best interests of the community because it’s so hard for private firms to make sufficient profit from producing it. This is why governments often end up producing those goods and services which have partial or complete public goods characteristics.

Other classes of market failure arise because of transaction costs, agency problems, or information asymmetry.
But there is also such a thing as government failure - where government intervention in the market makes things worse rather than better, or when the modest benefits don’t justify the considerable costs (eg the home insulation scheme?). There is a political/economic theory known as ‘public choice’ which holds, among other things, that politicians and bureaucrats always act in their own interest rather than the public’s interest, and that, whatever their original motivations, all government regulation of industry ends up being captured by the industry and turned to the industry’s advantage in, say, reducing competition within the industry (to the incumbents’ advantage), increasing protection or in persuading the government to subsidise industry costs.

Where I do stand in this debate? I believe market failure is common and that governments should usually act to correct it. But I also believe in govt failure and some degree of truth in the public choice critique. Governments and their bureaucrats do sometimes act in their own interests rather than the public’s and some regulation is captured and perverted by those being regulated. So I believe in intervention, but I also believe that getting intervention right, minimising unintended consequences and doing more good than harm is a tricky business, requiring a lot of careful thought, trial and error, experimentation, learning from experience and project evaluation. This is why I’m pleased to see you studying Policy in Practice and interested in discussing the choice of appropriate policy instruments.

Now let’s turn to the GFC. But before we do, let me just say this: one reason I was moved to remind you of the libertarian, free market, laissez faire view of the world is that it’s been very much in evidence in the debate about the causes and cures of the GFC, particularly in the US. It seems blatantly obvious to most people (including, I think, most economists) that the GFC is a case of massive market failure, but there have been plenty of libertarian-leaning economists in the US (and some here) willing to argue the crisis was really the product of government failure - government intervention gone wrong - and argue that the proposed regulatory response to correct the problem was unnecessary or even counterproductive. This, of course, is a line of argument that powerful interests in the financial markets are happy to hear and willing to sponsor.

I could talk about the GFC from a global perspective, but I’m going to concentrate on the Australian perspective - which, of course, is very different from that of the North Atlantic economies in the eye of the storm. (You can draw me out on the more global view in question time.)

The policy response to the crisis can be divided into two strands: 1) the macroeconomic response - the policy actions necessary to restore stability to the real economy, to lessen the recession and hasten the recovery and 2) the regulatory response - the policy actions necessary to correct the regulatory failures that permitted the crisis to occur and reduce the likelihood of a similar crisis recurring. I’m going to devote most time to discussing the choice of instruments in the macroeconomic response, but I will briefly discuss the prudential regulation response. (Again, you can draw me out in questions.)

The two main instruments available for macro management - the short-term stabilisation of demand as the economy moves through the business cycle - are fiscal policy (the manipulation of govt spending and taxation to influence the strength of demand) and monetary policy (the manipulation of interest rates to influence demand). Under the Keynesian influence, fiscal policy was the dominant instrument used in the post-war period, but from the mid-1970s the dominance switched to monetary policy. I want to start by explaining why fiscal policy fell out of favour with policy-makers - why they changed their view on which policy instrument was more appropriate for use in the day-to-day management of aggregate demand - and then explain why, contrary to that established view that fiscal policy was passé, it has been given a major role in the macro response to the GFC, both here and around the world.

Why fiscal policy fell out of favour with policy-makers

There has never been any denial that the budget’s automatic stabilisers should and do play an important counter-cyclical role. Rather, the query has been over discretionary policy. At least since the time of the Fraser government, monetary policy has been the primary instrument used for the short-term management of demand, with fiscal policy playing a back-up role at best. There was a great concern that policy adjustments needed to be more timely, to ensure their effects on economic activity were counter-cyclical rather than pro-cyclical. Policy-makers identified three causes of delay, and concluded that monetary policy was better than fiscal policy on two out of the three.

First, the recognition lag - the time it takes policy makers to realise that a policy adjustment is needed. This is caused mainly by delays in the publication of economic indicators and, on the face of it, you would expect it to apply equally to both policy arms. However, monetary policy has sought to reduce the lag by adopting a forward-looking or pre-emptive approach where policy adjustments are based on forecasts of inflation, with actual indicators used mainly to update the forecasts. Particularly because of the next point, this is easier to do with monetary policy than fiscal policy.

Second, the implementation lag - the time it takes to actually change the policy setting after it has been decided that it should be changed. Here, monetary policy wins hands down; it’s significantly more flexible. The stance of monetary policy is reviewed at every monthly meeting of the Reserve Bank board and could be changed even more frequently if necessary. Changes are easily implemented the following morning after the decision has been made. Policy can be changed in small or large, frequent or infrequent steps, without any implication that earlier decisions were wrong. By contrast, fiscal policy is usually adjusted only in May each year and though mini-budgets are possible, for them to come too soon after a budget, or for there to be too many of them, could attract criticism over short-sightedness. More significantly, there are delays while cabinet decides the particular tax or spending changes to make, while the legislative authority is passed through parliament, and while the administrative arrangements needed to put decisions into effect are put in place.

Third, the transmission lag - the time it takes for the implemented measure to affect economic activity. Here, fiscal policy wins. Government spending affects economic activity as soon as the money leaves the government’s coffers, while tax cuts or cash bonuses (transfer payments) affect activity as soon as the recipient chooses to spend the money. By contrast, Reserve Bank research shows that a sustained change in interest rates of 1 percentage point causes a change of 0.33 percentage points in real GDP in the first year, with a further 0.33 points in the second year and a further 0.17 points in the third, giving a total effect after three years of 0.83 percentage points.

But despite this advantage on the transmission lag, fiscal policy lost out because of its poor performance on the recognition and implementation lags.

Why fiscal policy is back in favour

It was always easy to predict that fiscal policy would come back into fashion just as soon as the economy dipped into recession. The politician who could resist the temptation to use the budget to stimulate the economy during recession has yet to be born.

But there were two other, more economic arguments favouring greater reliance on fiscal policy which arose from the particular nature of the global financial crisis. First, the synchronized nature of the global recession - because all developed economies were hit at the same time by the same developments in global capital markets - gave fiscal policy a comparative advantage. When a single country goes into recession, easing monetary policy can help stimulate the economy also by lowering its exchange rate, thus making its export and import-competing industries more price competitive. But that can’t happen when all the country’s trading partners go into recession and ease monetary policy at the same time, because there’s no one to depreciate against.

When a single country goes into recession, easing fiscal policy has the disadvantage that some proportion of the stimulus leaks overseas in the form of higher imports. But in a synchronized recession, when all countries ease fiscal policy at the same time their leakages cancel each other out. Each country suffers a leakage from imports, but also enjoys an injection from exports.

Second, the fact that this global recession had its origin in a crisis on the financial side of the economy was another factor counting in favour of fiscal policy. When you’ve got an impaired banking system, lower interest rates may not be passed through to households and businesses and, even if they are, the banks may be unwilling to lend. Further, if you’ve got an impaired banking system, the official interest rate will probably soon be close to zero, leaving no further room for conventional monetary easing, although ‘quantitative easing’ remains open. Countries in this situation are caught in the legendary Keynesian ‘liquidity trap’ - a classic justification for favouring fiscal policy over monetary policy.

That last argument doesn’t apply to Australia, of course, but all of these arguments explain why the circumstances of this global recession prompted even the ultra-orthodox International Monetary Fund to urge its members to respond to the downturn with fiscal policy.

A further, local factor is that, this time, worries about the recognition and implementation lags were countered by the peculiar nature of this crisis. We were able to see the shock coming, and start acting to counter it, well before it actually reached us across the Pacific (apart from the instantaneous effect on business and consumer confidence as Australians watched the crisis unfolding on TV every night).

Before we move on, I should warn you that fiscal policy has not replaced monetary policy as the dominant instrument of macro management. And Dr David Gruen of our Treasury has noted that the special circumstances that made fiscal policy such a necessary and major element in the response to the GFC aren’t likely to be present in future recessions.

The regulatory response to the GFC

As you know, in the heat of the crisis, in October 2008, the Rudd government responded by producing two new policy instruments: the government guarantee of all small deposits in banks and other deposit-taking institutions. This was in response to a lot of people moving their money to banks they perceived to be bigger and safer, thus causing significant problems for some of our smaller banks. An unwanted side effect of the guarantee was to prompt other people to move their savings out of unguaranteed non-bank trusts (such as mortgage trusts) requiring those trusts to freeze withdrawals for a time. Second, the government guaranteed the bank’s large deposits and wholesale funding, in return for a variable fee. This was necessary to ensure they could continue to obtain the considerable overseas funds they needed to continue operating, in the face of a world where most other developed countries’ government had guaranteed their banks. Because this latter guarantee was quite expensive for the banks, they stopped using it as soon as they could, and now it will be removed at the end of this month. It tended to advantage the bigger banks over the smaller ones. As yet, nothing has been done to regularise the guarantee of small deposits, which the government should really be charging for, thereby reducing the competitive advantage accorded to the guaranteed sector.

Looking at the regulatory response more broadly, I won’t discuss the regulatory failures that permitted the crisis to occur - particularly as there weren’t any great failures in the regulation of our banks - but go straight to discussing the improvements in regulatory instruments being worked up at the international level by two bodies associated with the Bank for International Settlements in Switzerland (the central bankers’ club): the Basel Committee on Banking Supervision and the Financial Stability Board. As part of the G20’s renovation of these bodies, Australia has a seat on both.

They are working on proposals to tighten up the international standards on the adequacy of the capital banks are required to hold - that is the limits on the extent to which banks may increase their gearing - including by closing loopholes in the capital adequacy standard and by introducing a supplementary leverage ratio. They are also working up proposals to require banks to improve their liquidity - their ability to pay their debts as they fall due - by holding greater highly liquid assets (such as government bonds, which can really be sold on the market) sufficient to tide them over for, say 20 days, if their short-term funding was suddenly cut off (as it was during the crisis).

This is all fine and much needed internationally, but the Australian banks - and the Australian authorities, especially APRA and the Reserve Bank - are concerned that the rules may be more onerous here than is justified by the good performance of our banks. These rules will increase the cost of ‘intermediation’ - which is what banks do, act as an intermediary between savers and investors, lenders and borrowers. Raising the cost of intermediation would mean widening the gap between the average interest rate the banks pay to borrow funds and the average interest rate the banks charge their borrowers. This increased cost would be passed on to the banks’ customers, particularly their borrowers. These higher interest rates to borrowers would act to dampen economic growth. That is, there is a price to be paid for making banking safer and less exposed to crises. A particular worry of the Australian banks and our authorities is that, as the liquidity requirement now stands, it would require our banks to hold more government bonds than are actually on issue.

Once the new capital and liquidity standards have been agreed on internationally, it will be up to the national authorities in each country (APRA in our case) to adapt them to local conditions and apply them locally. In theory, this means we don’t have to comply with any requirement that doesn’t suit us. In practice, however, we will be under considerable pressure from other countries to comply with the higher standards. Our banks need to borrow from overseas and want to operate in other countries, and their reputations would suffer if a perception arose that they were being inadequately regulated at home.

At present, our authorities are working on the two committees to ensure the final requirements are sufficiently flexible to accommodate the Australian case. To the extent that they fail, APRA will have to walk a fine line to modify the new standards in a way that doesn’t damage Australia’s reputation.

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