BEHAVIOURAL ECONOMICS AND PUBLIC POLICY

Dinner address, Reserve Bank Roundtable, August 8, 2007

‘Economics has not only become boring but also threatens to become irrelevant.
Therefore I do not feel embarrassed about being unorthodox. In fact, I rather enjoy it!’
Frey (2001)

One of my favourite economist jokes is the one that says an economist is someone
who can’t see something working in practice without wondering whether it also
works in theory. There are two professions that possess an intuitive understanding
of the propositions economists have come to call ‘behavioural economics’. They are
the marketers, and the politicians. So what is behavioural economics? It’s
economists satisfying themselves intellectually that there is a logic — as opposed to
a rationality — to the intuitive behaviour of economic agents. It’s economists
laboriously disabusing themselves of the mistaken beliefs they have acquired about
the way agents behave, as a result of their internalising the assumptions on which
neoclassical economics is built.

Behavioural economics is the scientific study of intuition. It involves accepting the
power of intuition — that people are much more intuitive than rational — and
understanding the reason why this is so, which gets back to the way humans have
evolved and, specifically, the way their brains have evolved. Neuroscience tells us
that the primitive, more instinctive and emotional part of our brain often
overrides — or beats to the punch — the more recent, more logical part of our
brain. This leads to a strange dualism in our minds: we’re often motivated to do
things by considerations the more intellectual part of our brain knows to be unwise.
This dualism explains why we have ‘present selves’ and ‘future selves’ which, in
turn, helps explain the self-control problem humans have — a major topic of study
for behavioural economists — and the misprediction of utility, time-inconsistent
preferences, myopia and procrastination that this involves (Stutzer and Frey 2006). I
guess what I’m saying is that, for a full appreciation of the intellectual power and
fascination of behavioural economics, it helps to take in some neuroeconomics
(Camerer et al. 2005).

Let me also say that I use the term behavioural economics to encompass the closely
related field of research into happiness — or subjective wellbeing, if you prefer a
more scientific-sounding label. Lest you feel that happiness is taking your
newly-acquired tolerance of behavioural economics a bridge too far, let me just
point out that happiness is the subject that brought Professor Frey’s name to
international prominence (Frey and Stutzer 2002), and that when Daniel Kahneman,
the psychologist who won the Nobel prize in economics for his role in founding
behavioural economics, had finished with prospect theory and heuristics, he moved
on to the study of utility and wellbeing (Kahneman et al. 1999).

Conventional, neoclassical economics is widely held to be positive, not normative.
But one of the things you soon realise when you study behavioural economics is
that this is the wrong way round. Behavioural economics is the study of the way the
world actually is, whereas conventional economics is the study of the way the world
should be. That is, we’re not rational, but in many circumstances we’d be better off
if we were. The study of self-control problems involves reaching an understanding
that the seemingly irrational things people do in their search for commitment
devices — such as failing to claim tax rebates in fortnightly 'pay as you earn' tax
instalments so as to maximise the size of their annual tax refund cheque, which the
person is more likely to save — have their own logic; that they represent fallible
agents trying to make themselves more rational. The study of self-control problems
also leads you to the view that there may be a new role for economics in helping to
make the world more rational, by imposing prohibitions on certain disadvantageous
behaviour. In fact, governments already do this extensively — and with widespread
public acceptance. It’s just that no one sees it as having anything to do with
economics, and often economists would be quietly disapproving of such
interventions.

As an economic journalist, I’m supposed to keep my remarks practical, but I do
want to say something theoretical and controversial. I believe that the assumptions
on which the neoclassical model is based pervade the beliefs and policy preferences
of economists far more than most of them realise. Economists generally have a
strong commitment to individualism, freedom of the individual, the benefits of
choice and the value of personal responsibility and, hence, a bias against
government intervention and a desire to keep governments small and taxes low.
This characteristic of neoclassical economics gives it a great affinity with the
libertarian political philosophy, which to me explains why the right wing of
economic rationalism is a lot more heavily populated than the left wing. (Who’s on
the left wing of economic rationalism? Mike Keating, Fred Argy, Bob Gregory and
a few others.)

But my point is this: I believe conventional economics’ commitment to
individualism and suspicion of government intervention rests heavily — more
heavily than most economists realise — on the assumption that economic agents act
rationally. We doubt that governments could ever know better than the individual
how that individual’s income could best be spent. Why? Because we assume the
individual is rational in all things — that she can accurately predict utility, never
does things she comes to regret and never displays time-inconsistent preferences.
When you accept that individuals are far from rational you open up the possibility
that governments may well be better judges of what’s best for the individual. We
assume agents are rugged individualists and are happiest when treated as such,
whereas psychology tells us humans are group animals, whose preferences are
heavily influenced by those around them, who care deeply about what others think
of them, who are anxious to fit in but also conscious of their status within the group
and desirous of raising that status. In other words, I believe that conventional
economics’ exaltation of individual freedom is simply scientifically outdated — a
hangover from the 18th and 19th centuries, when we knew far less about human
behaviour than we do today.

There are two broad approaches economists can adopt towards the lessons of
behavioural economics. One is to use insights from behavioural economics to
reframe essentially unchanged policy prescriptions from conventional economics,
so as to make them more politically palatable. We know, for instance, that people
react differently to essentially the same propositions, depending on how they are
framed. We know that more people would decline consent for a medical operation
with a 10 per cent failure rate than they would an operation with a 90 per cent
success rate. We know from Kahneman’s asymmetric value function, for instance,
that people weight losses more heavily than gains of the same amount. From this,
Richard Thaler (1985) developed four rules for reframing gains and losses:
segregate gains (don’t wrap all the Christmas presents in a single box), combine
losses (because this reduces aggregate pain), offset a small loss with a larger gain
and segregate small gains from large losses.

The second approach we can adopt is to use the lessons of behavioural economics to
change the policies we pursue. I have no objection to the first approach — indeed, I
think it would repay the close attention of econocrats. But I’m more excited by the
second, more radical approach. So let me suggest some very general policy
implications I draw from behavioural economics.

First, I believe that the profession needs to return to its original goal of maximising
aggregate utility rather than maximising consumption possibilities. We now know it
is possible to measure utility — to some extent at least. We also know that revealed
preference is far from foolproof. People are not good at predicting their utility and
they often come to regret their decisions — even to wish someone had stopped them
doing what they did. We know people get locked into behaviours they wish they
could control. Neuroscience makes it easy to see how people’s consumption
decisions can be influenced at a semi-conscious level by advertising that appeals to
their emotions. Among other implications, a switch of emphasis from consumption
back to utility would require economists to abandon their see-no-evil approach to
advertising. Many of the points that follow flow from a recommitment to
maximising utility.

Second, economists need to study consumption. It never ceases to amaze me that
economists can exalt consumption in the way they do and then take so little interest
in it. The happiness literature makes it clear that people find some forms of
consumption more satisfying than others (Seligman 2002; Van Boven and
Gilovich 2003).

Third, economists need to acknowledge the importance people attach to social
status and social comparison. Conventional economics is good at helping the
community maximise its income, but it can do nothing to maximise people’s
relative income. And yet, we know that people are more interested in increasing
their income in relative terms than absolute terms. From a community-wide
perspective, a status race is pointless and wasteful. It’s likely that, as real income
rises over time, a higher proportion of income is devoted to the purchase of
positional goods. Is this why we pursue efficiency? It’s also likely that efforts to
minimise the role of government and limit the growth of taxation have the effect of
allowing people to maximise their spending on positional goods at the expense of
the provision of public goods that would yield them greater utility (Frank 1999).

Fourth, the simple model of labour supply is misleading and needs rethinking. In
practice, economists tend to underplay the one thing the model gets right: that
leisure yields utility. In the unfavourable comparisons of rates of economic growth
and levels of GDP per capita made between America and Europe, there is little
acknowledgement that much of the difference is explained by the Europeans’
preference for leisure over work. On the other hand, the model is quite wrong in
assuming that work yields disutility. The happiness literature makes that clear —
even if it wasn’t obvious. Like you and me, most people derive great utility from
their work most of the time. It follows that much could be done to increase utility by
policies encouraging job enrichment. That is, when your goal is to maximise utility
rather than consumption, you see for the first time that the issue of job
satisfaction — which may be enhanced by such practices as team work or giving
workers greater autonomy — is part of the economist’s brief.

We know, too, that unemployment is a major source of unhappiness in peoples’
lives — or, if you prefer, of disutility (Clark and Oswald 1994; Layard 2003). This
fact creates a conflict between measures to increase efficiency and maximise utility
DINNER ADDRESS 151
that reformers rarely acknowledge. This may be partly because their modelling
assumes full employment, but I believe it’s also thanks to a hidden assumption that
the unemployed are to be envied for all their leisure time.

Fifth, policy makers undervalue the utility people derive from security and
predictability. We give too little weight to the utility workers derive from job
security, for instance. We need to learn that efficiency isn’t everything.
Sixth, self-control problems are ubiquitous, but susceptible to policy remedies.
Some self-control problems may be regarded as minor (television watching, for
instance), but many constitute significant social and economic problems: obesity,
smoking, drinking, drug-taking, gambling, speeding, the overuse of credit and the
inability to save. Economists aren’t as conscious as they should be that government
intervention — and often, outright controls — to assist people conquer their
self-control problems and to protect the community from negative externalities are
widespread, of long standing and uncontroversial. Consider all the regulation
governing the consumption, sale and advertising of alcohol and tobacco. Consider
all the controls — speed limits, seatbelts, random breath-testing — that have
succeeded in reducing the road toll. Consider the way employees are compelled to
save 9 per cent of their wages, and how little opposition that relatively recent
measure encountered. It’s clear to me that the public often wants governments to
impose these external commitment devices on it — and that this attitude makes
considerable sense. The insights of behavioural economics should help economists
to be much more receptive to proposals to use intervention to alleviate self-control
problems, including the newly recognised problem of obesity.

Economics doesn’t have to be boring, stuck in a rut and open to the charge of being
based on out-of-date science. But to make economics more interesting and relevant
to the solution of a wider range of the community’s problems, economists have to
be willing to learn new tricks.


Behavioural Economics and Public Policy

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TALK TO TREASURY MACROECONOMIC GROUP’S PLANNING DAY

Old Parliament House, Canberra
July 18, 2007

David Gruen has asked me to talk about the policy issues I believe Treasury should be thinking about in briefing an incoming government, new or returning. I’m not convinced I could give you much useful advice on that score, but I’m going to address the topic quite broadly in the hope of saying something that gives you something to think about, even if - as I suspect is often the case - all I do is help you realise why you don’t agree with me. I’ll also focus fairly heavily on my special subject: the politics of economics.

In thinking about the next government I’m going to err on the side of envisaging a change of government, not because I think it’s a sure thing - I don’t - but because it gives us more interesting things to think about and because preparing a briefing for a new government is a more challenging exercise. It’s possible I may have had more experience than some of you of observing change-overs. In my career I’ve seen three at the federal level: from Whitlam to Fraser in 1975, from Fraser to Hawke in 1983 and from Keating to Howard in 1996.

Thinking about a change of government

At one level you might think that a change-over from Howard to Rudd would be a relatively simple affair given that the remarkable success of existing policies means there’s broad agreement between the two parties on the question of macro management - on the medium term frameworks for monetary policy and for fiscal policy, including balancing the budget on average over the cycle and limiting the growth in revenue as a proportion of GDP. In case any of you have any doubts, I’d remind you that politicians’ behaviour in opposition usually offers a poor guide to their behaviour in government, so that the behaviour of Labor when last in government offers the best guide to its behaviour when next in government. We can expect a Rudd government to be quite conservative and responsible, anxious to lay to rest the popular stereotype that Labor is no good at economic management, anxious to avoid getting offside with the financial markets, anxious to be seen as ‘pro-business’ - more anxious about it than the Libs ever need to bother being - and anxious to avoid being seen as the lackeys of the (in any case, hugely politically weakened) union movement. The more the Libs push that line against Labor in the run up to the election, the more determined a Labor government would be to disprove it in practice. This time there’d be no Accord to give the unions a seat at the Cabinet table.

But it would be a mistake to see the lack of significant difference between the two sides on macro policy as making the briefing of an incoming Labor government a ho-hum affair. That’s because a change of government represents a rare and vitally important point of challenge and opportunity for Treasury. It’s a quickly passing opportunity for Treasury to establish a relationship of two-way trust and loyalty with the new administration. Treasury does so by demonstrating its commitment to apolitical service to the government of the day, by demonstrating that it’s already been giving much thought to the new government’s problems from the new government’s perspective and by demonstrating its competence (including its detailed knowledge of the new government’s stated policies). The more politicised the public service becomes, the more important this welcoming-committee role becomes.

But there’s a second reason the first few days of the new government’s term are of such strategic significance: they represent an unparalleled opportunity to get action on all those issues the outgoing government had consigned to the too-hard basket, including those that most offended the interests of its core constituency.

The first duty of Treasury is to immediately present the incoming government with evidence of a budgetary crisis that demands an immediate and radical response. That’s what John Stone did for the incoming Hawke government even before it had been sworn in and what Ted Evans did for the incoming Howard government in 1996. I’ve seen it done at the state level many times and incoming CEOs of major companies almost invariably do something similar. I call it ‘doing a Mother Hubbard’: we came to government, looked in the fiscal cupboard and were shocked and appalled to discover it was bare. It’s actually a time-honoured trick that will be much harder to pull off in the era of the PEFO. The first point of it is to get all your predecessor’s dirty fiscal linen out in the open while the recognition of those presently hidden, unacknowledged costs can be blamed on your predecessor. It has to be done in an atmosphere of high-drama crisis, so your alibi will stick in the mind of the electorate and so any early economic setback or lack of progress can be excused.

But the second purpose of the crisis is to provide a cover for a process by which the incoming government slashes away at those budget measures aimed at its predecessor’s political heartland so as to make room for those measures it has promised to grant its own political heartland. The process also allows the new government to defer or abandon some of its non-core promises. This is a vitally important exercise from Treasury’s perspective because of the need to prevent the new government from merely adding its pet projects on top of its predecessor’s pet projects.

A common practice is for the new government to establish a committee of audit to reinforce the message that it inherited a fiscal mare’s nest, but the Howard government’s experience shows that the auditors need to be selected with care. Give the job to a bunch of academics and they’ll give you a report whose recommendations are too radical to your taste.

On a related theme, I have to tell you that the older I get the more I doubt the pertinence of the old cry in response to election promises, ‘where’s the money coming from?’. The honest answer - which no politician would dare give - is, ‘if and when we win the election, Treasury will tell us’. Why? Because that’s what Treasury’s paid to do: tell the government of the day how it can cover the cost of the policies it wishes to pursue. Hidden in that is a more subtle task: to take the incoming government’s election promises and explain to it how, by adding qualifications and limitations that were not mentioned or explicitly ruled out before the election, it can significantly curtail the budgetary cost of the promise. It may also be able to gain some budgetary leeway by fiddling with the timing of commencement of the program.

Thinking about the next recession

I have a feeling this election won’t be a good one to win. Why not? Because of the high chance that the record expansion phase finally comes to an end sometime in the next few years, leaving us in recession. Think about it: we have a history of governments being thrown out of office after they’ve presided over a recession. That’s true of the Whitlam, Fraser and Hawke-Keating governments, although in Paul Keating’s case there was a one-term lag thanks to John Hewson’s GST/Fightback package. Parties that are in government generally have good reputations for economic management, then lose it during their recession and leave office being regarded as pretty hopeless. The incoming government then does its best to rub in their predecessor’s bad reputation and live off it for as long as possible. The Hawke-Keating government suffered this fate notwithstanding its unprecedented record of economic reform. I might add that, though the Labor government’s poll ratings on economic management weren’t too bad during most of its term, the voters’ views on which party is good at which policy area are terribly stereotyped, meaning that the Liberals’ identification with business gives them a big inbuilt advantage.

But now consider what would happen if the Libs lost office this year and a recession occurred during the new government’s term. The Libs would have managed to enjoy a completed period of more than 11 years in power without a recession, whereas Labor would have plunged the economy into recession within a year or two of regaining power. Nothing could be more calculated to reinforce for the long term the perception Peter Costello has been so successful in inculcating with all his talk about Labor’s Beazley Budget Blackhole, deficits and debt, that the Libs are God’s gift to economic management, whereas Labor simply can’t be left in charge of the till.

So that’s why I say I’m not sure this would be a good election to win. I’m sure that wouldn’t discourage Labor from wanting to win, but I’m equally sure the scenario I’ve just outlined would have occurred to Labor and that, should it win, it will quickly turn its mind to this potential problem. It will do all in its power to blacken the economic reputation of its predecessor in the hope that, should a recession occur reasonably soon after the change of government, it will be able to shift the blame back on the Libs. If I’m right, it will be expecting Treasury to play its part in this exercise.

But now let’s turn out minds to the possible nature of the next recession (and remember that this discussion applies equally to Liberal or Labor governments). Dr Don Stammer, formerly of Deutsche Bank, says no economist or economic journalist is worth feeding unless they’ve lived through at least four recessions and, if they have, they’re entitled to charge a premium for their advice. In my working life I’ve experienced the recession of the mid-70s, the recession of the early 80s and the recession of the early 90s - and they’ve left a lasting impression on me.

The first thing to say is that I don’t see any signs that a recession in imminent. But I don’t believe for a moment that the business cycle has been abolished and nor do I believe our luck can hold forever. Equally, however, I don’t think you ever get much warning that a recession is on the way. They tend to be brought on by what Don Stammer famously calls the X Factor - the factor no one had been expecting. But I do think there are a few things we can say. One is that I don’t think we’ve ever had a recession of exclusively domestic causes. Equally, I don’t think we’ve had a recession of exclusively external causes - though in 2001 we did have a mild world recession that didn’t lead to a downturn here.

I deduce from this that our economy goes into recession when some external disturbance combines with some domestic imbalance or vulnerability. I don’t think we have to look far to find the most likely source of domestic vulnerability: our extraordinarily heavily indebted household sector. It’s highly vulnerable to a sudden fall in employment - from whatever cause - which would make it impossible for affected households to maintain their mortgages. This threatening atmosphere could put the wind up many employed but heavily indebted households which, in their efforts to reduce their exposure, could significantly slow their consumer spending. The contraction would come not so much from the direct effect of newly unemployed households as from the indirect, contagion effect on other indebted households.

I believe that, when it comes to dealing with recessions, it’s important not to get caught fighting the last war. I say this because of my painful experience with the recession of the early 90s. Early in that process, despite widespread gloom and doom in the business community, Treasury was confidently predicting just a ‘soft landing’. Treasury argued that the prime domestic cause of the two previous recessions - in the mid-70s and early 80s - had been wage explosions and, since this time wages were well under control thanks to the Accord, this downturn was not likely to be severe. I bought that argument and loudly and confidently predicted a soft landing, knowing to ignore all the contrary anecdotal evidence I was hearing. As it transpired, the landing was anything but soft. So that proved a terribly wrong call on my part and caused me a lot of grief in the office, where all the anecdote merchants tried hard to convince the editor of my incompetence.

The problem with that analysis was that, as is the bias of most macro economists, it sought evidence and explanations for recession only in the real economy, ignoring the financial economy. But, as Ian Macfarlane was the first to explain publicly, financial factors were the key cause of that recession and its severity. The deregulation of the financial system and the admission of foreign banks had led to an orgy of business borrowing associated with successive asset price booms in the stock market followed by the commercial property market. When high interest rates eventually caused the music to stop, the corporate sector found itself heavily leveraged and highly exposed, many with assets that were no longer worth what had been paid for them. The response was that the corporate sector, including the banks themselves, entered a protracted period of ‘balance sheet repair,’ which involved running down debts by cutting investment spending, cutting staff and otherwise cutting expenses. The problem with this, of course, is that it spreads the problem to other firms, which deepens and prolongs the adjustment period.

Now, the point I want to make is that, in thinking about the next recession, we shouldn’t focus exclusively on what could go wrong in the real economy, but remember that we could again be clobbered by the financial side. For a long time I believed that we’ve got so proficient at controlling inflation - we’ve become so vigilant - that the next recession couldn’t possibly involve the usual train wreck of inflation getting away and interest rates being held so high for so long that a deep recession becomes inevitable. If so, the next recession would be a mild one. I no longer think that because, as Ian Macfarlane made pretty clear in his Boyer Lectures last year, the smart money is expecting the repair of household balance sheets to be the major domestic cause of the next recession. That means it’s likely to be severe and protracted - especially when measured the way politicians and the electorate measure the severity of recessions: by the effect on unemployment, not the effect on output.

At present, thanks to the long-lasting salutary effect of the last recession our corporate sector is not highly geared. But should the next recession be delayed and the private equity craze continue (which it may not), by the time the next recession does arrive we could find ourselves with a highly geared corporate sector as well as a highly indebted household sector. If so, expect the next recession to be doubly severe.

Here it’s important to remember what I think of as a cross between Goodhart’s Law and Murphy’s Law. When monetary policy manages to get a handle on goods and services price inflation control, it tends to encourage the emergence of a problem it finds much harder to handle, credit-fuelled asset price booms. To put it another way, when the economy has been growing strongly and steadily for some time, businesses in search of ever-growing profits tend to become emboldened to take on more risk by gearing up. We see the perfect demonstration of this in the private equity fashion. Trouble is, we all know it will end in tears. Note that here we see one reason for the perpetuation of the business cycle, where the very success of the expansion phase sows the seeds of its eventual destruction.

Now let me introduce a complication I’ve been thinking about lately, but haven’t yet resolved in my mind. In the past 10 or 15 years it’s become terribly fashionable to analyse the challenges of business life in terms of ‘risk management’. I’ve even seen business types getting climate change and emission trading legitimised in their minds by branding it as risk management. Risk management can be about risk spreading, but easily degenerates into nothing more than risk shedding. Businesses can shift risk to their customers, but for the most part they shift it to their employees. I suspect that the protracted period of companies seeking to maintain double-digit profit growth by eternal cost cutting involves a lot of risk-shifting to employees. It’s not greatly relevant to Australian circumstances, but the classic example of risk-shifting to employees has been the move from defined-benefit to defined-contribution pension schemes - which has made older employees far more vulnerable to vagaries of the sharemarket. Another example is the advent of just-in-time inventory management, where firms’ economising on inventory costs has shifted the risk and cost of supply-chain disruption to their employees - who are now far more likely to find themselves temporarily laid off because of, say, a strike at a supplier’s factory. I don’t think there’s much doubt that Work Choices - including the neutering of the unfair-dismissal provisions and reduction in the availability of redundancy payments - has greatly increased firms’ ability to shift risks to their employees. Added to that you have the growth in casual employment, the conversion of employees into contractors and the widespread use of labour-hire firms.

My point is that this risk-shifting trend may have altered the internal dynamics of recessions in ways that are hard to predict. If in a downturn firms are better able to limit the fall in their profits by more easily cutting their wage bills - and thus their employees’ and erstwhile employees’ incomes - does this make the recession less severe or more? If Work Choices gives employers the upper hand in industrial relations, does this mean a recession is likely to see more lay offs or more workers on four-day weeks - that is, is the pain more concentrated on a few or more evenly spread across the many? Does it make much difference? One possibility is that the greater freedom to dispense with the services of casuals, contractors, labour-hire workers and even permanent employees means unemployment will shoot up much earlier than it did. The corollary, however, should be that the absence of labour hoarding means unemployment recovers earlier. We shall see.

Now for a more positive note. If I’m right in predicting that the next recession is more likely to arise from some disruption giving rise to adverse balance sheet effects than from a loss of control over inflation, that does have one big advantage. It means the macro managers ought to feel free to respond to the downturn by the quick and wholehearted application of stimulus. The Reserve Bank can afford to slash interest rates in the way the Fed did in 2001. That’s one of the rewards from our return to good control. Similarly, with general government net debt eliminated, there’s no impediment to the government adding significant discretionary fiscal stimulus on top of the reversal in the automatic stabilisers. There maybe some political embarrassment arising from the way the medium-term fiscal strategy has degenerated into the promise of eternal surpluses, but in the pressures of the moment that will be quickly cast aside.

Here it may be useful to recall the experience of the last recession, where it was originally argued that all the discretionary stimulus should come exclusively from monetary policy, with fiscal policy holding to its medium-term goal apart from the automatic response of the automatic stabilisers. This is what produced the most amazing budget of my career, the only one delivered by John Kerin who, with Paul Keating skulking on the backbench, proceeded to be more Keating than Keating, and stood up in the middle of the recession (August 1991) and declined to kick-start the economy. (That budget was also remarkable for being delivered in the early afternoon without a lockup, thereby uniquely demonstrating that the lockup serves no economic purpose, but survives purely as an instrument of media management.) The joke of all that, of course, was that once Keating became prime minister a few months later, he lost little time in organising the hugely stimulatory mini-budget of February 1992. And the lesson of all that is that the politician who can resist the temptation to use the budget to stimulate the economy during a recession has yet to be born. That being the case, it makes more sense for Treasury to switch to recommending a stimulatory stance of fiscal policy as soon as possible.

One last point since I suspect that some of you have never experienced a recession during your working lives. The burden of recessions is felt very unevenly. Some people lose their jobs, others lose their businesses, while the great majority of people are little affected. Overtime will dry up and their real wage may slide a little, but you’ll even find the odd person doubting that the recession is real because the restaurants are still full. Even so, recessions are highly unpleasant times for economists (and economic commentators) to be alive. The public turns on economists, history is rewritten to blame them for everything, the public is not prepared to entertain discussion of any economic issue bar getting unemployment down, and the period of gloom and doom - the regular encounters with punters who can’t see how the economy will ever get back on its feet again - lasts interminably. Two or three years. So if you’ve never lived through a recession, be warned: they’re no fun.

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After dinner speech to Social Policy Conference dinner

Australian Social Policy Conference dinner
Sydney, Thursday, July 12, 2007

Peter Saunders - the Peter Saunders I call the original and best Peter Saunders - tried to inveigle me into giving this talk by promising me a free feed, but something in the back of my mind warned me that meals are never free. So then he tried the line that I could use the occasion to plug my latest book - and he had me. Actually, I’m going to plug my last two books.

What do you get when you cross an economist with someone from the mafia? An offer you can’t understand. Both books seek to defy that prediction. If you happen to be interested in finding an easy-read introduction to conventional economics - the economics of inflation and unemployment and interest rates that you find in newspapers - I recommend the book I published last year, the one with the blue cover, Gittins’ Guide to Economics.

But the book I want to talk about is my latest, one that’s not like any conventional economics book in that its focus is on you, not the economy. It’s about how you live your life within the economy and make sure the economy is working for you, not you for it. This is the book with the red cover, modestly titled Gittinomics.

One of the ways I’ve tried to keep the economics practical and interesting is to mix in with it a fair bit of psychology and neuroscience. Conventional economics assumes we’re all coldly calculating and rational in the decisions we make, but over the past 20 years or more psychologists and neuroscientists have demonstrated how far this is from the truth. It turns out that the primitive, more emotional part of our brain often overrides - or beats to the punch - the more recent, more logical part of our brain. This leads to a strange dualism in our minds: we’re often motivated to do things by considerations the more intellectual part of our brain knows to be nonsensical.

The classic example, of course, is advertising. The central proposition of most ads is that mothers who buy a certain brand of margarine - or a certain brand of sliced bread - will have good-looking, healthy, happy families. Intellectually we know such propositions to be absurd. We imagine there must be some simple souls somewhere who fall for such rubbish, but we certainly don’t. Sorry. Advertisers wouldn’t spend millions each year on such ads if they didn’t work on people in general and enough individuals in particular. Clever appeals to our emotions can induce an emotion-driven response from us even though the more reflective part of our brain knows them to be laughably silly.

Once you accept that we’re capable of responding in a quite unthinking way to the opportunities and temptations thrown at us in this consumer economy, various things become clear. For instance, who’d be silly enough to believe you don’t have to pay for stuff you buy with a credit card? Only a few silly teenagers? No, many of us. Consider an experiment undertaken by some marketing professors at MIT. They organised an auction using written bids for some very attractive basketball tickets. They did the experiment twice. The first time they said you’d have to pay for the tickets with cash; the second time they said you could pay by credit card. The people in the credit card auction offered to pay twice as much as the people who had to pay by cash. The trick is that, when you pay by credit card, you can postpone the need to worry about whether you can really afford the thing you’re buying.

Another instance of the difficulty we have keeping control of our money concerns choice. Politicians, economists and business people assume choice is an unmitigated blessing and the more choice we get the better. In truth, the psychologists have demonstrated that when we’re faced with too much choice we find it confusing and debilitating. Consider an experiment in which researchers set up a display of exotic jams in a gourmet food store, offering a saving if you bought a jar. In on case they offered people tastes of 24 different jams; in another case they offered just six varieties. Comparing the two cases, the larger array attracted more people to the table, even though people tasted about the same number of jams in both cases. But get this: when only a small number of jams were offered, 30 per cent of people bought some; when the larger number of jams was offered, only 3 per cent of people bought. In other words, people found the larger array confusing and so avoided making a decision to buy.

This inability to cope with tricky choices makes it fairly easy for retailers to manipulate us. Consider the way theatres sell popcorn.

Or, consider the way we pick wine from a wine list in a restaurant.

Though almost all of us have spent almost all of our lives living in a market economy, many of us don’t know much about how markets work. We have it in our heads that businesses just add a set mark-up to their costs and that’s what they charge us. But often it doesn’t work that way. For instance, the higher prices charged for organic fruit and vegetables or free-range eggs or ‘fair-trade’ coffee commonly far exceed the extra cost involved in producing the item. Why? Because people with tender consciences about the treatment of chickens or third-world coffee growers - or people worried about the chemicals used to produce non-organic food - are willing to pay higher prices to assuage their consciences. When you’re selling free-range eggs you’re selling something extra beside the eggs: conscience balm. And if that’s what you want, the retailers are happy to charge you more and take your money.

While we’re on the subject of what’s called ‘behavioural economics’ I want to talk about something that’s not in the book. I’ve been thinking a lot lately that there’s a contradiction at the heart of the capitalist system. The system includes many people who make their living by tempting you to buy things and do things which are fine if you do them only in moderation, but which can bring you down if you do too much of them. So the key to being a winner - a master - in the capitalist system is to possess the self-control to resist the temptations it continually throws at you. If you oblige the capitalists and always buy what they’re pushing, you’ll help to make them rich but, paradoxically, you’ll become a loser - a victim - of the system.

What are these temptations? They’re manifold. The one we’re most conscious of these days is the temptation to eat too much. But there are many more: to get too little exercise, to smoke, to drink too much, to watch too much television, to gamble too much, to shop too much, to save too little and put too much on your credit card, to work too much at the expense of your family and other relationships.

All of those things are being pushed on us by the system. They’re what the capitalists are trying to sell us. A lot of highly paid advertising people, marketers and merchandisers make their living finding ever-more effective ways to persuade us to indulge. In the case of exercise, no one’s selling the lack of exercise, but lots of people are selling ways to avoid exercise - whether it’s going everywhere by car, using the remote or watching sport on telly rather than playing it. Admittedly, people are also selling ways to get fit - from exercise bikes to gym subscriptions and all the right gear to wear - but then you’ve got to make sure you don’t get hooked on being underweight or using steroids to bulk up.

OK, so we need to demonstrate a bit of self-control in our lives. What’s so new and surprising about that? Two things.

First, research by psychologists, neuroscientists and behavioural economists has shown that humans have a great problem exercising self-control. We think it’s up to us to decide how much to eat or how much TV to watch but, in fact, many of us find it very hard to restrain ourselves in the way we know we should. Experiments with people who’ve had the two sides of their brains severed in some accident show that the reasoning part of our brain often doesn’t know why the faster, more instinctive part of our brain decided to do what it did, but is adept at thinking of plausible explanations for its behaviour. In other words, humans are prone to ex-post rationalisation.

It’s as though we have two selves, an unconscious self that’s emotional and short-sighted and a conscious self that’s reasoning and far sighted. We have trouble controlling ourselves in circumstances where the benefits are immediate and certain, whereas the costs are longer-term and uncertain. When you come home tired from work, for instance, the benefits of slumping in front of the telly are immediate, whereas the costs - feeling tired the next day; looking back on your life and realising you could have done a lot better if you’d got off your backside and played a bit of sport, sought a further qualification at tech, studied harder for exams, spent more time talking to your kids etc. Similarly, the reward from eating food is instant, whereas the costs of overeating are uncertain and far off in the future - being regarded as physically unattractive, becoming obese, becoming a diabetic, dying younger etc. As everyone knows who’s tried to diet, give up smoking, control their drinking, save or get on top of their credit card debt, it’s very hard achieve the self-control our conscious, future selves want us to achieve. Many of us may have no trouble controlling ourselves in most of the behaviours I’ve listed, but I doubt there’s anyone much who can claim to have themselves perfectly under control in every area.

The second reason for getting so excited about the problem of self control is the likelihood that the very success of the capitalist system in making us more affluent is serving to heighten our self-control problem. Economics is all about coping with the problem of scarcity. But human ingenuity - including the development of the capitalist system - has increasingly overcome scarcity. These days, most of us in the developed economies have a greater problem coping with abundance than scarcity. For instance, we’ve evolved to eat everything that comes our way, because nutrition was scarce on the African savanna, but now food is abundant and, hence, cheap. So we’ve lost the natural control that, until relatively recently, stopped our instinct to overeat from making us overweight. Similarly, the huge growth in our real incomes over the past century has made it easier for us to afford to overindulge in many of the other vices I listed. Credit is another thing that’s become readily available and relatively cheap.

So I’m beginning to think that overindulgence and difficulties in self control are the big problem of our age. There are solutions to this problem - at the government policy level and at the level of individuals controlling their own behaviour (the latter involving subtle ways of tricking our unconscious selves) - which I suspect will become an increasing focus as the 21st century progresses.

Read more >>

ENVIRONMENTAL ECONOMICS

July 24, 2007

The environment and economic activity

Mankind's economic activity - the production and consumption of goods and services - adversely affects the natural environment in many ways. It causes pollution, the using up of natural resources and the endangering of species. Linked with mankind's economic activity as a cause of environmental damage is the growth in the human population. More people mean more disturbance to the natural environment.

Economic activity will have a damaging effect on the environment no matter what system is used to organise that economic activity, whether it be a market system, command system or traditional system. However, since our economy is organised using the market system, we will focus on the way a market system affects the environment.

Economic arguments for preservation of the environment

There are four main economic arguments in favour of the preservation of the natural environment:
1) environmental assets. Environmental assets (such as clean air, clean water, attractive views, native species and fish in the sea) are just as much economic resources as the resources on which economics traditionally focuses: land, labour, capital and enterprise. Environmental assets are used in the process of production and consumption and are scarce (in limited supply). They are not 'free goods' because they can be used up. (Note: air can't be used up, but clean air can be.) If environmental resources can be used up, they should not be used wastefully, but used with economy ie allocated to their most efficient use. The main difference between traditional economic resources and environmental assets is that traditional economic resources have clearly defined private property rights, whereas environmental assets are common property. The price mechanism (and economic analysis) has difficulty coping with resources that are common property (ie market failure), but this isn't a reason to ignore environmental assets.

2) satisfaction of wants. The goal of economics is to maximise the satisfaction of the community's wants. It's clear that, as well as its material wants (more goods and services), the community has environmental wants (eg clean air and water, attractive views and the preservation of species). If economics ignores environmental wants because the market mechanism finds it hard to cope with them, it will not help maximise the community's satisfaction. It seems that, as the community's material standard of living rises, the value it places on environmental wants ('quality of life') increases.

3) environmental feedback. Much economic activity depends on the preservation of the environment eg effect of environmental damage on tourism; effect of land degradation on farming; effect of water quality on commercial fishing; over-harvesting of fish. As well, some environmental damage generates private costs eg double-glazing of windows to reduce noise pollution.

4) inter-generational equity. Much environmental damage is irreversible (eg clearing of land, building dams, destruction of native forests and extinction of species) and some resources are non-renewable. Current economic activity has implications for the environmental inheritance of future generations.

Economic arguments against preservation of the environment

There are three main economic arguments against preservation of the environment:
1) opportunity cost. Just as some material wants may only be satisfied at the expense of others, so some environmental wants may only be satisfied at the expense of some material wants. This is the correct way to express alleged economic arguments against environmental protection eg banning the logging of native forests will 'destroy jobs'; banning mining in national parks will 'harm the balance of payments'. A higher 'quality of life' may well involve a lower material standard of living. This is not a problem as long as the community understands the consequences of the choices it makes.

2) distributional implications. The costs and benefits of environmental protection may not be shared equally across the community. eg the people who gain most satisfaction from protecting native forests may not be the same people who lose their jobs.

3) the value of labour. Economists seek to make the most economical use of all resources, including man-made capital and labour. But environmentalists are concerned to make the most economical use (or even minimum use) of only natural resources, including energy. Implicitly, they attach little value to capital and labour. Because of the high cost of capital and labour, the market (and market-based intervention) will not produce as much recycling and avoidance of waste of raw materials as environmentalists desire.

Conflict between economic growth and environmental protection

The mainstream economists' view is that there is a conflict between man's desire to increase his material standard of living (ie produce more goods and services) and his desire to preserve the environment. The conflict arises because resources are scarce but wants are infinite. The opportunity cost of faster economic growth is more damage to the environment; the opportunity cost of less damage to the environment is slower economic growth.

There is, however, an exception to this general proposition: instances of government failure. Underpricing of publicly owned resources (eg forests, minerals) and underpricing of publicly provided services (eg electricity and water) can cause misallocation of resources and faster depletion of natural resources or unwarranted environmental damage (eg land degradation through irrigation; need to build more dams).

This is not to say that we face a mutually exclusive choice between either economic growth or environmental protection. It means the community must decide what trade-off it wants to make, what balance it wishes to strike, between these two valid, but conflicting, objectives. Economists are very familiar with trade-offs between conflicting objectives - which is why they developed the concept of opportunity cost.

Normally, the community determines the trade-off it desires between conflicting objectives in the market place via the price mechanism. It votes with its dollars. However, in the case of the conflict between economic growth and environmental protection, the market mechanism is not very effective in providing the community with the trade-off it desires. This is because environmental assets are common property rather than private property. Economic activity generates environmental externalities for third parties which those third parties lack the property rights to do anything about. This market failure means governments have to intervene in the market to ensure that the community's desired trade-off between economic growth and environmental protection is achieved. However, the political process by which governments seek to implement the community's preferences is an imperfect one where the true opportunity costs of choices may not be understood by the community.

Government policies to preserve the environment

Government policies to preserve the environment can be divided into two broad classes: command and control measures and economic instruments.

Command and control. In practice, most environmental intervention takes the form of legislation to prohibit or limit undesirable emissions and other activities. Local government zoning regulations limit polluting activities to certain areas, generally away from residential areas. State environment protection agencies set emission standards and rules for the disposal of waste and prosecute firms which fail to comply.

To the public, politicians and many environmentalists, regulation is the obvious way to respond to environmental problems. Regulation deals with the problem directly.
However, while economists accept that regulation and prohibition may be the only practical responses in some circumstances, they believe that, generally, regulation will not produce the best trade-off between SoL and environmental protection. This is because regulations impose costs without always creating incentives to find cheaper ways of reducing environmental damage.

Economic instruments. In our efforts to preserve the environment, economists favour the use of instruments which harness market forces to the service of the environment, believing that this will achieve the government's environmental objectives with minimum loss of economic growth. Economic instruments aim to 'internalise' externalities and, in the process, create incentives to meet environmental standards in ways that allocate resources efficiently.

Tradable permits. Governments may set an environmental standard which determines an acceptable level of emission, then award (or auction) permits to emit pollution up to the standard. Producers with low costs of controlling pollution have an incentive to do so, so they can sell part of their pollution rights to producers who face high costs of controlling pollution. The effect is to reduce the industry's overall cost of compliance with the standard. Tradable permits have an advantage over pollution taxes because the rate of emission is certain and the price of the permits uncertain, whereas with pollution taxes the rate of tax is certain and its effect on the level of emission is uncertain. Tradable permits can be used for other environmental protection, such as minimising the economic costs of limits on irrigation or fishing catches.

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TALK TO HOPE STREET BUSINESS LUNCHEON

Sydney, Friday, May 26, 2007

Brendan has asked me to say a few words sharing my background and experiences and what I’m really passionate about these days, and I’m happy to do so.

To understand me you have to know that I come from an extended family of Salvationists and that both my father and my mother were Salvation Army officers - ministers - making me a member of a strange group known to the Sallies as OKs - officers’ kids. My father was the minister of a long succession of very small congregations in NSW and Queensland. The Army moved him every two years - sometimes after only one year - and when he moved, we did too. In consequence, I went to five primary schools and three high schools around NSW and one in Brisbane. These days I’m what the Sallies call a ‘backslider’, but I think you can see pretty clear evidence of my upbringing in the things I write and the attitudes I take in my columns.

Both my parents came from big families in Queensland and I’m the only one in the family who’s not a Queenslander. Since I was born in Newcastle and ended my education in Newcastle I’m happy to tell people I’m from Newcastle and proud to say I was educated at the now-defunct Newcastle Boys High. Only when I’m trying to impress people do I say I went to Fort Street - and omit to mention it was only for a year. I did a commerce degree at Newcastle University, majoring in accounting but also doing a lot of economics - which I couldn’t see the point of and struggled to pass. In 1969 I left Newcastle, got a job working for the national auditing firm of Touche Ross (now merged with KPMG) and eventually qualified as a chartered accountant.

Not long after I qualified I took a year off to go back to uni and ended up stumbling into journalism. In 1974 I started at the bottom as a cadet journalist, at what was then considered to be the very mature age of 26. The editor who hired me said he couldn’t believe a qualified accountant would take to being a cadet reporter, but it was worth a try. A Kiwi mate was amazed and appalled that I’d consider giving up the status of being a chartered accountant to become a lowly reporter.

That was 33 years ago and I’ve been at the Herald ever since. I did a bit of reporting from the press galleries in Macquarie Street and Canberra, and wrote a fair few of those unsigned editorials on the same page as the readers’ letters. But I’ve been the Herald’s Economics Editor for 29 years, I’ve been a Herald columnist for 30 years and I’ve been doing exactly the same job I’m doing now for 24 years. I know I should have left the Herald and gone to another paper years ago, but my problem is that my ambition was to become the Herald’s Economics Editor, I achieved that ambition at the age of just 30, and in all the time since then I haven’t been able to think of a job I’d more like to do or a paper I’d more like to work for. I have the best job in the world: I’m paid a fat salary to sit in an armchair and pontificate three times a week. Bernard Levin, when a columnist on The Times, said he could never understand why they paid him for the privilege of publishing his opinions rather than making him pay them - and that’s how I feel (but don’t tell David Kirk I said so).

You should know that a great part of my success in journalism - certainly, my rapid rise to prominence - comes from being in the right place at the right time. The year I joined the Herald, 1974, has since been identified by economists as the great turning-point in the post-war economic history of Australia and the developed world. It was the year we felt the destabilisation of the first OPEC oil shock, the year the post-war Golden Age ended with the advent of stagflation, the year our economy entered a period of high inflation, high unemployment and general economic dysfunction that we didn’t start to emerge from until the mid-1990s, the year the Whitlam Government didn’t have any idea what had hit it, and the year it first dawned on the editors of Australian newspapers that the dominant, unending political story of their times was actually the economy. In such an environment there was a sudden, strong demand for the services of journalists who were capable of writing about the mysteries of economics. There weren’t many takers, so someone with my background was quickly pressed into service and promoted up the line. But I confess I’ve had to learn or relearn most of my economics on the job.

People often refer to me as an economist, but I’m not, and no true economist thinks I’m one. I used to say I was an accountant pretending to be an economist, but I can’t say that any more because, these days, I’d only be pretending to be an accountant as well. So now what I prefer to say is that I’m a journalist who writes about economics. This fits well with my changing views about my role. I’ve always been on about explaining economics and for a long time I saw my role as convincing my readers of the truth of economics. I was an early salesman for economic rationalism. But experience and wider reading has helped me see the limitations of conventional economics, so now I see myself as someone paid to provide my readers with a critique of economics, just as a theatre critic provides his readers with a critique of the latest plays. Economics has strengths and weaknesses and it’s my job to point them out.

As for something I’m feeling passionate about, I been thinking a lot lately that there’s a contradiction at the heart of the capitalist system. The system includes many people who make their living by tempting you to buy things and do things which are fine if you do them only in moderation, but which can bring you down if you do too much of them. So the key to being a winner - a master - in the capitalist system is to possess the self-control to resist the temptations it continually throws at you. If you oblige the capitalists and always buy what they’re pushing, you’ll help to make them rich but, paradoxically, you’ll become a loser - a victim - of the system.

What are these temptations? They’re manifold. The one we’re most conscious of these days is the temptation to eat too much. But there are many more: to get too little exercise, to smoke, to drink too much, to watch too much television, to gamble too much, to shop too much, to save too little and put too much on your credit card, to work too much at the expense of your family and other relationships.

All of those things are being pushed on us by the system. They’re what the capitalists are trying to sell us. A lot of highly paid advertising people, marketers and merchandisers make their living finding ever-more effective ways to persuade us to indulge. In the case of exercise, no one’s selling the lack of exercise, but lots of people are selling ways to avoid exercise - whether it’s going everywhere by car, using the remote or watching sport on telly rather than playing it. Admittedly, people are also selling ways to get fit - from exercise bikes to gym subscriptions and all the right gear to wear - but then you’ve got to make sure you don’t get hooked on being underweight or using steroids to bulk up.

OK, so we need to demonstrate a bit of self-control in our lives. What’s so new and surprising about that? Two things.

First, research by psychologists, neuroscientists and behavioural economists has shown that humans have a great problem exercising self-control. We think it’s up to us to decide how much to eat or how much TV to watch but, in fact, many of us find it very hard to restrain ourselves in the way we know we should. This is because our brain is a complex mechanism, which evolved over millions of years. The older, more primitive part of our brain tends to make instant decisions on an instinctive, emotional basis. The newer, more rational part of our brain tends to make more reasoned judgements, but to be a lot slower off the mark. Experiments with people who’ve had the two sides of their brains severed in some accident show that the reasoning part of our brain often doesn’t know why the faster, more instinctive part of our brain decided to do what it did, but is adept at thinking of plausible explanations for its behaviour. Psychologists call this process ‘confabulation’ - others call it ex-post rationalisation.

It’s as though we have two selves, an unconscious self that’s emotional and short-sighted and a conscious self that’s reasoning and far sighted. We have trouble controlling ourselves in circumstances where the benefits are immediate and certain, whereas the costs are longer-term and uncertain. When you come home tired from work, for instance, the benefits of slumping in front of the telly are immediate, whereas the costs - feeling tired the next day; looking back on your life and realising you could have done a lot better if you’d got off your backside and played a bit of sport, sought a further qualification at tech, studied harder for exams, spent more time talking to your kids etc. Similarly, the reward from eating food is instant, whereas the costs of overeating are uncertain and far off in the future - being regarded as physically unattractive, becoming obese, becoming a diabetic, dying younger etc. As everyone knows who’s tried to diet, give up smoking, control their drinking, save or get on top of their credit card debt, it’s very hard achieve the self-control our conscious, future selves want us to achieve. Many of us may have no trouble controlling ourselves in most of the behaviours I’ve listed, but I doubt there’s anyone much who can claim to have themselves perfectly under control in every area.

The second reason for getting so excited about the problem of self control is the likelihood that the very success of the capitalist system in making us more affluent is serving to heighten our self-control problem. Our brains work the way they do as a result of our evolution. We are what we are because it contributed to our reproductive fitness. We evolved the way we did to protect us from the risk of death, for instance, and to cope with the problem of scarcity. As it happens, economics is all about coping with the problem of scarcity. But human ingenuity - including the development of the capitalist system - has increasingly overcome scarcity. These days, most of us in the developed economies have a greater problem coping with abundance than scarcity. For instance, we’ve evolved to eat everything that comes our way, because nutrition was scarce on the African savanna, but now food is abundant and, hence, cheap. So we’ve lost the natural control that, until relatively recently, stopped our instinct to overeat from making us overweight. Similarly, the huge growth in our real incomes over the past century has made it easier for us to afford to overindulge in many of the other vices I listed. Credit is another thing that’s become readily available and relatively cheap.

So I’m beginning to think that overindulgence and difficulties in self control are the big problem of our age. Even the worries we have about our despoiling of the environment and our excess emissions of greenhouse gases can be seen as problems of abundance. Too much unguided economic activity - which has also led to too much population growth - is upsetting the earth’s natural balance.

There are solutions to the problem of self control - at the government policy level and at the level of individuals controlling their own behaviour (the latter involving subtle ways of tricking our unconscious selves) - which I suspect will become an increasing focus as the 21st century progresses.

Read more >>

WELLBEING, MONEY, PSYCHOLOGY AND ECONOMICS

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

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

Psychology and economics

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

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

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

Decision-making

As we’ve seen, behavioural economics challenges one of the central elements of conventional microeconomic theory: the assumption of Homo economicus. Economic man is assumed to be rational and self-interested. She always carefully evaluates all the options before making any decision, and always with the object of maximising her personal ‘utility’ or satisfaction. But cognitive psychologists have demonstrated that humans simply lack the neural processing power to make the carefully calculated decisions economists assume. People aren’t rational, they are intuitive. And altruism is often an important consideration in their decision-making. People can’t chose correctly between three options where the best option is not immediately apparent. Rather than carefully thinking through the pros and cons of every decision, people tend to rely on mental shortcuts (‘heuristics’) which often serve them well enough, but also lead them into systematic biases. People are often slow to learn from their mistakes. They are frequently capable of reacting differently to choices that are essentially the same, just because the choices have been ‘framed’ differently. This means that, rather than being coldly rational, people’s decisions are often influenced by emotional considerations.

All this means that Homo sapiens differs from Homo economicus in many important respects. He doesn’t conform to economists’ assumption of fungibility (one dollar is indistinguishable from another), he is often not bothered by opportunity cost and thus has a strong bias in favour of the status quo. He doesn’t ignore ‘sunk costs’ as he is supposed to and often cannot order his preferences consistently. He is not averse to risks so much as averse to losses and he focuses more on changes in his wealth than on its absolute level.

Unlike Homo economicus, Homo sapiens cares deeply about fairness. Experiments show people will walk away from deals they consider treat them unfairly, even though those deals would leave them better off. People are prepared to pay a price to punish others they consider to have been behaving badly towards the group. Often people are concerned about ‘procedural fairness’ – how things are done, not just how they end up.

Wellbeing and utility

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

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

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

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

Speaking the same language

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

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

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

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

Income and wellbeing

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

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

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

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

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

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

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

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

Implications for economic policy

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

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

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

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

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

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

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

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

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THERE’S NO BUDGETARY ISSUE BIGGER THAN HEALTH CARE

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

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

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

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

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

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

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

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

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

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

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

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

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

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