Slowly, economists are revealing the weaknesses in their theories

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Cut in penalty rates another win for 'bizonomics'

When we look at all the crazy behaviour in the United States, we comfort ourselves that it couldn't happen here. Well, last week we took another step in that direction.

Why do blue-collar workers get so alienated and fed up they vote for someone as mad as Donald Trump? It couldn't be because, while America has waxed fat over the past 30 years, their pay has been stagnant in real terms.

How have the top few per cent of US households captured most of the economic growth for three decades?

Three main reasons, which apply in varying degrees to us.

First, because globalisation and "skill-biased" technological change have produced a small number of winners and a large number of losers.

Second, because far from using the tax-and-transfers system to require the winners to compensate the losers, we've gone the other way, making the income-tax scale less progressive and tightening up on payment of benefits to people of working age.

Third, because although the economy has changed in ways that weaken organised labour, we've doubled down, weakening legislative arrangements designed to reduce the imbalance in bargaining power between bosses and workers.

The unions have been weakened by the greater ease with which employers can move their operations overseas and by the technology-driven shift from goods to services.

The legislative attack has focused on removing union privileges, weakening workers' rights and weakening workers' bargaining power by discouraging collective bargaining and favouring individual contracts.

In the US there's been a failure to raise minimum wage rates. Here, there's been a decades-long campaign to eliminate penalty rates for people working "unsociable" hours which, supposedly, are anachronistic.

The mentality that produced these developments is "bizonomics" – something that sounds like economics because it repeats buzzwords such as "growth" and "jobs", but isn't.

In Australia, micro-economic reform has degenerated into a form of rent-seeking that's saying the way to a prosperous economy is to keep business – the people who create the jobs – as happy as possible.

This bizonomics isn't new, of course, as attested by its slogan: What's good for General Motors is good for America.

As it relates to the labour market, the proposition is that the way to make things better for everyone is to make life tougher for the workers.

Pay them less, give them less job security in the name of greater "flexibility", acquiesce to business's ambition of making working life a 24-hour, seven-days-a-week affair, and we'll all be better off.

The flaws in that argument – and the price to be paid for playing this game for decades – are now more apparent.

For a start, the number of workers and their dependents far outnumbers the bosses and owners and their dependents. So if all you end up doing is transferring income from the workers to the bosses, far more people lose than gain.

Of course, that's never what we're promised. The promise is always that the loss to existing workers is justified by the gain to all the would-be workers who'll now get a job.

Trouble is, too often you end up with a lot of workers making a sacrifice with only a handful of would-be workers finding jobs.

The Fair Work Commission's decision to cut Sunday and public holiday penalty rates for workers in hospitality and retail is an experiment in trickle-down economics, based on faith rather than evidence.

That makes it like everything else on big business's "reform" agenda: the immediate benefits come directly to business – in the form of cheaper labour – but, not to worry, those benefits will trickle down to the rest of us, so in the end it will all be much better for everyone.

Do you wonder why the punters don't believe it and conclude simply that "the government" has cut wage rates to benefit its big business mates, thus adding to their disillusionment and willingness to vote for populist fringe parties?

As I've explained before, the claim that lower penalty rates in retailing will lead to growth and jobs is – like the argument for protection – based on a fallacy of composition and the absence of "economy-wide" thinking.

The most likely effect is that total consumer spending remains little changed, but more of it's done on Sundays and goes on recreation and retail.

Plus an apartheid weekend, where the high-paid still get it, but the poor have to work.

A fearless prediction: now business has got some of the "reform" it's seeking, no one will ever bother to come back in a few years' time and do a proper study to check whether all the promises we were given came to pass.

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Don’t be sure lower penalties mean more jobs

The argument that reducing or eliminating weekend penalty wage rates would have great economic benefits is obvious to all business people and economists – but not to me. I think it's fallacious.

The received wisdom was well expressed by Anna McPhee, of the Retail Council: "The rebalancing of penalty rates to reflect the needs of the modern economy will mean retailers can create jobs to meet increased consumer demand, which in turn will benefit the economy more broadly."

She was responding, of course, to the proposal in the Productivity Commission's draft report on Australia's Workplace Relations Framework that Sunday penalty rates in the hospitality, entertainment, retailing, restaurant and cafe industries be cut to the same level as Saturday penalty rates.

Even the commission goes along with the received wisdom: "Excessive penalty rates for Sundays reduce hours worked, mean unemployment is higher than it needs to be, and reduce options for businesses and consumers. Trading hours are likely to be lower and capital under-utilised."

But I believe such thinking rests on a fallacy of composition, that what's true for the individual must be true for the whole.

It's not hard to see why particular business people, thinking only of the circumstances of their own business, see lower penalty rates leading to more sales, higher profits and, as a pleasant side-effect, more not-so-well-paid casual employees.

There would be some, of course, who looked no further than benefit of the lower wage rates they'd be paying even if they didn't bother opening their business for more days or longer hours than they are at present.

And, indeed, since they'd now be earning more than they were, that might be enough for some.

But let's assume the owners of the affected businesses really did want to open longer, sell more and profit more. Their fixed costs would now be spread over more sales, while their main variable cost – wages – would be lower per hour.

Question is: where would all these extra sales come from? From rivals that didn't bother opening on Sundays? That advantage isn't likely to last.

From businesses in other industries that now sold less during the week because their customers were seizing the opportunity to spend more on the weekend?

Of course, even if that were true it need be of no concern to any business person confident of being able to sell more. Their motive is to make more money and that's all a market economy expects of them.

But here's my point: just because some businesses can make more and employ more, this doesn't do much for the economy overall if their success comes at the expense of other businesses that make less and employ fewer.

When the advocates of lower penalty rates tell us that many extra jobs will be created, they're surely expecting us to take that as meaning more jobs overall, not just more jobs in some industries but fewer in others.

So let's switch to a macro or, as the commission likes to say, "economy-wide" perspective. We're told it will be great because, with more businesses open on the weekend, consumers will spend more and it's this extra spending that will create more jobs.

But how much the nation's consumers spend is ultimately constrained by their income. Are we expecting that consumers will spend more by saving less? Why would this be a good thing?

Why are we compelling employees to save 9.5 per cent of their wages if we really don't care about people saving much? (And don't mind being more reliant on foreign investment as a consequence.)

Maybe so as to spend more on weekend entertainment the nation's consumers might borrow more – on their credit cards or however. Would this be good for the economy? In any case, borrowing to boost your consumption is not something the nation's consumers can go on doing for long.

I don't believe there is much scope for us to be consuming a lot more than we are already – certainly not over the medium term. If so, then a lot of the businesses that sell more will be taking sales from other businesses.

And there's another possibility, one I suspect is quite likely: those businesses that open for longer on the weekend will sell more at the weekend, but less during the week.

To the extent that businesses achieve nothing more than spreading essentially the same amount of sales over longer opening hours – which I think is quite likely – they're likely to be worse off rather than better. The economy-wide benefits will be small, as will the net gain in employment.

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