MICROECONOMIC REFORM

September 18, 2007

The rationale for microeconomic reform

The fundamental objective of microeconomic reform is to improve the economy’s technical, allocative and dynamic efficiency and thereby raise our material standard of living. In distinction to conventional macro management – which focuses on stabilising demand over the short term – microeconomic policy focuses on improving the supply (production) side of the economy over the medium to longer term.

The mechanism for micro reform

The basic mechanism of microeconomic reform is to reduce government intervention in product and factor markets (the capital or financial market and the labour market) in ways designed to increase the degree of competition in those markets. Increased competition in markets should increase the pressure on firms both to raise their technical efficiency and to pass the fruits of that higher productivity on to their customers in the form of better service or lower prices. Combined with prices that better reflect the true ‘resource costs’ of producing goods and services, this should improve the efficiency of the allocation of resources within the economy, thereby causing a higher trend rate of economic growth and thus higher material living standards.

Dynamic efficiency

Dynamic efficiency refers to the economy’s ability to adjust over time in response to changing circumstances. A dynamic economy is adaptable, responsive and flexible. It is able to cope with external or domestic economic shocks to supply or demand without generating either too much inflation or too much unemployment. Our economy’s ability to sail through the Asian crisis of 1997-98 – assisted greatly by the dollar’s depreciation when demand for our exports fell off – convinced many economists that micro reform had made our economy a lot more flexible than it had been.

And, as part of this, our lasting return to low inflation has shown the economy to be much less ‘inflation-prone’ than it had been. Intensified competition in so many markets has greatly reduced the scope for firms to exercise pricing power, for importers to pass on imported inflation and for unions to negotiate excessive, ‘sweetheart’ wage deals. In short, we now have much less problem with ‘cost-push’ inflation. Another part of this is that the move to enterprise bargaining and away from centralised wage fixing has greatly reduced the scope for big pay rises in one area to ‘flow on’ to workers in other areas. This would have helped to lower our NAIRU – the ‘non-accelerating-inflation’ rate of unemployment - thereby permitting the unemployment rate to go lower without igniting wage-inflation problems.

The economy’s greater dynamism and ability ‘roll with the punches’, this has made it less unstable and thus made the macro managers’ job of stabilising the economy as it moves through the business cycle a lot easier – a major, but largely unexpected benefit from micro reform.

Key microeconomic reforms

We can list eight key areas of micro reform over the past two decades:

1. Capital markets. The Australian dollar was floated in December 1983 and controls over foreign exchange removed. Bank interest rates were deregulated and foreign banks licensed to operate in Australia.

2. Trade reforms. Import quotas – mainly for motor vehicles and textiles, clothing at footwear – were removed in the late 1980s and tariff protection for manufacturing and agriculture phased down. The effective rate of assistance to manufacturing fell from around 35 per cent in the early 1970s to 5 per cent by 2000.

3. Infrastructure services. Airlines, coastal shipping, telecommunications and the waterfront were partially deregulated. Government utilities – including railways, ports, electricity and water – were made more efficient and less overstaffed. Many were commercialised and corporatised; some were privatised. Government-owned banks, insurance companies, airlines and a telephone company were privatised.

4. Industry deregulation. Many industries – including stock broking, petrol distribution, eggs, bread and dairy – have been deregulated, as have shopping hours.

5. Government services. Many reforms have been introduced, including competitive tendering and contracting out, performance-based funding, the formal definition and costing of ‘community service obligations’ and user-pays pricing.

6. Labour market. The prices and incomes Accord, operating from 1983 to 1996, restructured and simplified awards and shifted from centralised wage fixing to enterprise bargaining. The Howard Government’s Workplace Relations Act of 1996 further reduced the scope of awards and introduced a formal system of individual employment contracts known as Australian Workplace Agreements. Work Choices seeks to discourage collective bargaining and unionism.

7. Taxation reform. Capital gains tax, fringe benefits tax and the dividend imputation system were introduced in 1985 and 1987, along with large cuts in income tax rates. The goods and services tax was introduced in 2000, replacing the narrow wholesale sales tax and a range of state stamp duties. The company tax rate was cut to 30 per cent.

8. National competition policy. An agreement between Paul Keating and the state premiers in 1995 had four main elements: extension of the Trade Practices Act to government businesses and the professions; reforms to public monopolies; introduction of a regime to provide other firms with access on reasonable terms to privately owned monopoly infrastructure services; and introduction of a program to review all federal and state legislation restricting competition. National competition policy has now been replaced by the National Reform Agenda.

Evidence of the benefits of micro reform

During the five years to 1998-99, labour productivity grew at the highest rate for at least 30 years. The improvement in the average productivity growth rate over this five-year period (of about 1 percentage point) provided the equivalent of an additional $7000 to the average Australian household.

This remarkably strong performance is widely attributed to the delayed effects of micro reform. In the years since then, however, our productivity performance has fallen back to normal levels. This may be because of the fall-off in further reform under the Howard Government. The poorer performance in very recent years is thought to be due partly to the surge in mining investment associated with the resources boom which, while the new production capacity is still coming on line, means the mines are employing more workers without any increase in output. This should be just a temporary factor, of course.

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WHAT’S WRONG WITH STANDARD ECONOMICS

Talk to Sydney University Economics Society
September 13, 2007

I want to start by saying that, in a minor way, The Sydney Morning Herald is an employer of economics graduates from Sydney University. We hire about one every two years. Over the years we’ve hired Steve Burrell, Stephen Ellis (now a columnist from America in the Business Australian), Tom Allard, Jessica Irvine and Jake Saulwick. We’ll have another one coming on board next year. (I wish I’d hired another name you may recognise, Stephen Long of the ABC.)

The thing to note is that everyone on that list is a product of Political Economy, not the mainstream economics course. So I have pretty well-formed views about Sydney University graduates as potential employees. Why do I hire out of PE? I like PE students because PE is an essay-based course (and economic journalists have to be able to explain economics in words, not diagrams or equations), because PE students have a demonstrated interest in politics (and I regard economic journalism as a branch of political journalism) and because PE seems to attract a disproportionate share of very bright students (and I try to hire only people who are exceptionally bright).

In passing I should tell you that I don’t select trainees on the basis of the marks they got. I’m more interested in their extra-curricular activities - whether they were on the SRC, got involved in running clubs and societies, whether they wrote for Honi or the Union Record - because what I’m really looking for is people with a burning desire to be a journalist, people who’ll throw themselves into it, people who are ‘hungry’ to succeed.

I should tell you that I’m very happy with the people I recruit from PE, which is why I keep going back. In recent years, however, I’ve encountered one problem: most PE graduates haven’t actually done any courses in standard, neoclassical economics. It’s amazing, but true. This is a significant weakness and I usually have to insist that the people I hire go back and do some standard economics by distance education. I don’t think the people running PE are doing their students any favours churning out supposed economists who know less about conventional economics than someone who’d done economics at high school.

What I say to my PE graduates is that I don’t require them to believe the neoclassical model - as we’ll see, I have a lot of doubts about it myself - but I do require them to know it inside out. Why? Because the neoclassical model is the language of the public debate about economics in this country and every other country. If you don’t speak the language, you don’t participate or even understand the argument. You’re certainly in no position to convince the participants in the debate they’re barking up the wrong tree.

Of course, some of the conventional economics graduates who are whizzes at the maths aren’t good at speaking the language, either. But while I’m offering a critique of PE, let me be equally frank about the conventional course. I think its great weakness is the opposite of PE’s - it’s so busy teaching the intricacies of the neoclassical model that it doesn’t find time to give students an adequate understanding of the significant limitations of the model and the alternatives to it. To teach the model without adequately explaining its limitations is, to me, professional negligence. So there’s nothing wrong with economics at Sydney Uni that couldn’t be fixed by rolling the rival courses together - by making sure each side gets a fair dose of what the other side is teaching.

I also suspect the conventional course would be better if it devoted less time to exploring the model’s limiting cases and more to giving students practice at applying the model to specific problems. That is, after all, what economic practitioners do: apply the theory they learnt at uni to the real-world policy problems they are grappling with. But don’t get the idea from this I’m critical of the emphasis on theory in university economics courses. I’m not - not a bit. Universities should be all about theory. Theory is their comparative advantage. It’s the only thing they’re good at and they should stick to it. They shouldn’t worry about teaching vocational skills because it’s hard to learn vocational skills at uni and surprisingly easy to learn them on the job - when you get a job. It’s because economic practitioners spend their professional lives applying the theory they learnt at uni - because pretty much all the theory they know is the theory they learnt at uni - that unis should concentrate on giving their students the best understanding of theory possible. And students should concentrate on tanking up with theory while they’ve got the chance and not worry that it’s all too theoretical. The practice will come later. And when you’ve had a bit of practice you’ll realise that the theory was more useful than you thought when you were learning it.

That’s probably the most useful thing I could say to many of you: don’t sit around telling yourself how useless and unrealistic all the theory is they’re trying to make you learn. You haven’t actually had enough experience to have an informed view of what theory’s useful and what isn’t. So take your lecturers on trust: accept that if they think it’s worth teaching it must be worth learning. If my experience is any guide, when you are experienced enough to judge you’ll realise most of what they taught you was worth learning.

Of course, decent teaching of theory gives plenty of attention to teaching the limitations of the theory. So now that I turn to my topic of what’s wrong with standard theory please don’t think I’m saying economics is rubbish and you’re wasting your time with it. I’m not saying that and I don’t believe that. I could give you a speech on what’s right and useful about the neoclassical model - and if I had time I would - but instead I want to talk about the limitations of the model because that’s where I suspect the conventional course is weakest. Everything in life has strengths and weaknesses and neoclassical economics is no exception.

Perhaps before I launch in I should explain that my view of my role as an economic commentator has changed over the years. For a long time I saw myself as a sort of missionary for economics, explaining the economic way of thinking and trying to persuade people to accept the economic rationalists’ policy prescription. But that was before I’d thought more and read more about the limitations of standard economics. So now I see my role as someone paid to provide the Herald’s readers with a critique of economics and economists, just as theatre critics provide our readers with a critique of the latest plays. Economists are so influential in the debate about public policy - and they act so certain that they’re the bearers of God’s Infallible Truth - that our readers often need reminding of their blind spots and the narrowness of their advice. Of course, putting economists back in their box when I consider they’ve overstepped their area of competence doesn’t stop me still devoting a lot of time to explaining economic concepts and the motivation behind government policy positions.

I suspect the biggest problem with economics is that it split off from the rest of science - the natural sciences and the social sciences - over 100 years ago, so that while there have been many major advances in those sciences since then, economics has been in its own, self-contained world and has carried on down its own path oblivious to those advances.

In Eric Beinhocker’s recent book, The Origin of Wealth, he argues that, thanks to the work of Leon Walras and others in the 19th century, the primary inspiration for neoclassical economics was physics, particularly the physics of motion and energy. Walras introduced differential calculus to economics and the organising paradigm that the economy is an equilibrating system. But Beinhocker says economics took its inspiration from physics at a time when physicists had discovered the first law of thermodynamics, but not yet discovered the second law. As a result, economics is based on terribly out-of-date physics. It’s now clear to physicists - but not economists - that the economy isn’t a closed, equilibrating system at all, but rather an open, disequilibrium, complex adaptive system.

To quote Beinhocker, ‘when Walras imported the concept of equilibrium from physics into economics, he gained mathematical precision and scientific predictability. But he paid a high price for that gain - realism. The mathematics of equilibrium required Walras and later economists to make a set of highly restrictive assumptions that have increasingly detached theoretical economics from the real world. Traditional economics has what computer programmers call a “garbage in, garbage out” problem. If you feed a computer bad inputs, it will with absolute precision and flawless logic grind out bad outputs. Likewise, most traditional economic models begin with unrealistic assumptions and then, with mathematical inevitability, work their way to equally unrealistic conclusions. … This is why there is little empirical support for many core ideas of traditional economics, and in some cases empirical evidence directly contradicts the theory’s predictions.’

The point here is not that conventional economics is too mathematical, but that it’s not using the right maths. The right maths would, no doubt, be a lot trickier and permit a lot less precise conclusions. But I don’t want to be drawn any further on this point because, though I’ve been happy to quote Beinhocker, I don’t profess to know anything much about physics and maths.

I’m a lot more confident in pointing to another area of science where, more than 100 years ago, economics split off on its own track, so that it’s now largely oblivious to subsequent advances. That science is psychology. It was quite primitive 100 years ago, but since then has made considerable gains in understanding the drivers of human behaviour. It’s quite understandable that, with psychology being then as primitive as it was, economics built itself on the assumption that economic agents behaved rationally in all things. It was very much a product of the thinking of the Enlightenment.

But psychology’s challenge to microeconomic theory strikes at that central assumption of Homo economicus. Economic man is assumed to be rational and self-interested. He or she always carefully evaluates all the options before making any decision, and always with the object of maximising his or 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 are not 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’ (packaged) 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’s supposed to and often can’t 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.

I believe this has powerful implications for the aspect of the neoclassical model that economic rationalists (particularly right-wing rationalists) find so attractive: its elevation and celebration of individualism. The individual should be free to choose, and governments should be most circumspect in how they constrain individuals’ freedom, including by taxing them to pay for the public provision of services and to redistribute income. This elevation of the individual and, by implication, denigration of a more communitarian approach, turns out to rest heavily on the assumption that individuals are rational. If individuals are rational decision-makers then it follows, as the rationalists keep asserting, that governments can never know what is good for you better than you know yourself. Governments should therefore tax individuals as little as possible, and maximise the private provision of such things as education and health care. If individuals are not particularly rational in their decision-making, however, then there may well be a case for government paternalism in certain circumstances.

Another aspect of the non-rationality of economic agents is the way, contrary to the assumptions of the model, they aren’t rugged individualists but are heavily influenced by the behaviour of people around them. My tastes and preferences aren’t fixed, but are highly variable, influenced by what others are doing and what happens to be fashionable. I care deeply about winning the approval of others and have a great desire to fit in. At the same time I’m preoccupied with my social status. I want by my conspicuous consumption to not just keep up with the Jones but to overtake them, demonstrating my superior social standing. As my real income rises over time, more and more of it will be devoted to the purchase of positional goods. This is a particular challenge to conventional economics because, while it’s very skilled at raising the material living standards of the community generally, it’s simply powerless to do what most people would wish it to: raise their relative income. Obviously, anything it does to raise the relative income of some people will lower the relative income of just as many. Another aspect of the fact that humans are group animals is the herd behaviour investors so frequently exhibit in markets for financial assets, contrary to the contentions of the efficient market hypothesis.

Thanks to relatively recent advances in neuroscience, we now know a lot more about how our lack of rationality is a function of the way our brains have evolved. It turns out that the primitive, more instinctive, 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 silly.

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 or studied harder for exams - are prospective and uncertain. 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, gambling or even speeding, 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. Problems of self-control are ubiquitous to modern life, but standard economics is oblivious to their existence.

Before we pass on I should acknowledge that the relatively recent school of economic thought known as behavioural economics is fully aware of the way the assumptions of standard economics fly in the face of advances in psychology and is seeking ways for more realistic assumptions about human behaviour to be incorporated into the equations of the standard model. I suspect, however, it won’t be easy.

Moving to a more mundane level, economists suffer the same problem as every other profession: what I call model-blindness - a tendency to view the world and to analyse problems exclusively through the prism of their model. To focus on those variables their model focuses on and a tendency to ignore all those factors from which their model abstracts. This is a simple error, but it’s amazing how often it’s made. It occurs partly because there is so little engagement between economists and people from other disciplines - so that economists rarely get a chance to see themselves as others see them - and partly because the teachers of economics devote so little attention to ensuring their students fully appreciate the limitations of the model.

As we’ve seen, the community is preoccupied with perceptions of fairness, whereas standard microeconomic analysis ignores equity considerations. When you press them, economists will tell you they have nothing to say on the fairness of their policy prescriptions because this involves value judgments that are beyond their area of competence. Yet it’s remarkable how often economic rationalists in particular will press policies on the community without bothering to warn people that, in reaching those policy prescriptions, they have taken no account of equity issues. This is unprofessional behaviour.

The neoclassical model focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have roughly equal bargaining power – which is often not the case. We’re hearing more about this lately as farmers and other small businesses complain about being squeezed by big business, such as the two supermarket chains. It’s been remarkable to see the Howard Government running advertisements to remind small businesses of the changes to the Trade Practices Act that now permit them to bargain collectively with big business, while at the same time using Work Choices to discourage collective bargaining between individual workers and their employers.

Another assumption of the conventional model is that both buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of the problems and ‘market failure’ in markets. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Yet another major weakness of the model is its failure to take account of social externalities. The deregulation of shopping hours, combined with the attack on weekend penalty rates, is fast bringing about the demise of the weekend without the community ever consciously deciding this would be a good thing. Similarly, I believe Work Choices’ attack on overtime, weekend and public holiday penalty rates and provisions for the partial cashing out of holiday pay could be damaging to family life.

Then there’s the sloppy thinking that goes from the fact that economics is capable of dealing only with monetary incentives to the implicit assumption that only monetary incentives matter. This is classic model-blindness. Clearly, the real world abounds in important non-monetary incentives, including the intrinsic enjoyment of work and pursuit of job satisfaction, and the pursuit of power and status. Ignore these factors and you get wrong answers.

But perhaps the thing that worries me most about standard economics is the way its adoption of the assumption of ‘revealed preference’ - that what people do is a reliable guide to what they want - in the 1930s allowed the goal of economic efficiency to be changed from maximising utility to maximising consumption. Clearly, much utility exists outside consumption - including utility derived from job satisfaction, job security and family life. I fear this derailing of the goals of economics has turned economics into the ideology of materialism and economists into the high priests in the temple of mammon.

This at last brings me to my ostensible reason for being here, to publicise my new book, Gittinomics. What is Gittinomics - what’s my special twist on the subject? Well, most of what I’ve said today isn’t in the book. The book is a kind of exposition of how the micro economy works, but from the perspective of the ordinary person. I call it home economics. My emphasis is on understanding the system to make sure you’re a master of the market system, not a victim. Making it work for you, not you for it. To that end, the first thing to understand is the need to keep economics in perspective and economists in their place.

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MAKING SENSE OF ECONOMICS: BEYOND THE OTHODOXY

Talk to The New Institute, Hamilton
August 28, 2007

I’ve now been a journalist for 33 years, spending all that time working for the Sydney Herald and virtually all of it as an economic journalist. So I thought what I’d do tonight was tell you a little about my intellectual pilgrimage over that time – how my views about economics have evolved. I should start by telling you that, though I have a lot of economics in my degree, I make no claim to be an economist. What I was when I came to the Herald 33 years ago was a chartered accountant. I used to tell people I was an accountant pretending to be an economist, but these days I prefer to say I’m a journalist who writes about economics. That gives me a little bit of distance from the economists, a bit of independence, making me a kind of interpreter and go-between between the profession and my readers. Not so much a theatre critic as an economists critic.

I have to tell you that, after 33 years, my enthusiasm for the subject matter of economics – figuring out how economies work, determining what motivates people in the economic aspects of their lives – is greater than it’s ever been. The subject fascinates me – I love making new discoveries about economics and then passing them on to my readers. My ideal holiday is to take a box of new books on economics – most of them bought on Amazon – up to the weekender we rent on the central coast and just sit on a banana chair in the backyard devouring them.

But I also have to tell you that, partly as a result of that reading, I’ve had increasing doubts about conventional economics – doubts at the theoretical level and the practical level. Most economists are pretty smug about the success of their discipline. They ignore their appalling record as forecasters and think the profession has a pretty good handle on how the economy works. But I think economics is hugely primitive. In the 230 years since Adam Smith we’ve uncovered a few basic truths about economic behaviour, but what we don’t know far exceeds what we do. That’s why the forecasting is so bad – we’ve got only the roughest idea of how the economy works.

The core of conventional economics is still what’s called the neoclassical model – the idea that price is determined by the interaction of supply and demand. Economic rationalists are people who take this model and, rather than using it as an analytical tool that you pull out of your kitbag when you think it’s the right tool for the job, elevate it to the status of a religion – a fundamentalist religion. And, like all fundamentalist religions, it has features that some people find very attractive: a few simple rules that, provided you have faith, explain the whole world. It gives you the illusion of certainty and an answer to every question. You can apply the model to any economy, any industry, any market – and the fact that you don’t know much about the specific circumstances is no problem. The model’s answers are always simple and universal.

Now, I don’t want to knock the neoclassical model and its religious devotees completely. Market forces are very real and very powerful. You frequently see people changing their behaviour in response to changes in prices. Market forces are often like a balloon – you can try to repress them, only to see them pop up elsewhere in a distorted form. Black markets are the obvious example.

And the great virtue of economic rationalists, at their best, is their opposition to economic privilege: to producers using some form of monopoly power – whether natural, business-made or government-made – to reduce competition and give themselves an easy, profitable life at the expense of their customers. Many, perhaps most, industries and professions try this on to a greater or lesser degree. In the argy-bargy a few years ago over medical indemnity, I was most entertained to watch the fisticuffs between the two professions that just about invented economic privilege: the doctors and the lawyers. I’ve been thinking that, these days, the race is not so much to the swift as to the industry that best uses the media to win public sympathy for the preservation of its economic privilege – particularly as the political parties become more poll-driven and intent on staying in power by giving the public what it says it wants. The economic rationalists have an analysis, known as public choice, which says that just about all government intervention in industry, no matter how well-intentioned, ends up being captured by the industry being regulated and manipulated so as to advantage the producers over the consumers. I’m afraid there’s a large measure of truth to that analysis.

But that’s enough praise of economic rationalists and the neoclassical model. The model seriously oversimplifies real-world markets and economies. It focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have roughly equal bargaining power – which is often not the case. We’re hearing more about this lately as farmers and other small businesses complain about being squeezed by big business, such as the two supermarket chains (though the small businesses usually forget to mention that most of the cost savings get passed on to supermarket customers).

Another assumption of the conventional model is that both buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of the problems and ‘market failure’ in markets. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Another significant weakness in conventional economics is its assumption that economic agents (people) always act rationally – that is, with clear-headed self-interest. The relatively new school of behavioural economics, which draws heavily on psychology, has demonstrated that people’s behaviour is often far from rational. People are emotional and often exhibit herd behaviour, particularly in share and property markets. People don’t even act with an understanding of such basic economic concepts as opportunity cost. With such a flawed model of human motivations as its basis, is it any wonder the economists’ model is such a hopeless predictor of economic behaviour?

Now let me say a little about my new book, Gittinomics. In all the interviews I’ve done to publicise it, only one interviewer has come close to saying the obvious: you have to be pretty egotistical to name an -omics after yourself. So what’s so special about my version of economics? All capitalist economics seeks to explain how the capitalist system works. I guess what’s different about my take on the subject is its emphasis on making sure you’re a master of the system, not a victim. Making it work for you, not you for it.

To that end, the first thing to understand is the need to keep economics in perspective and economists in their place. Economists are experts in one important but limited aspect of life: the material. No one knows better than they do how best to maximise our production and consumption of goods and services. When a community follows their advice - as we pretty much have been for the past 25 years - it gets rich.

Trouble is, sensible people don’t maximise the material aspect of life, they optimise it. That is, they balance it against other, non-material objectives. For instance, most economists know little about the question of fairness and, for the most part, they ignore it. Press them and they’ll tell you frankly that it’s outside their area of competence. Likewise, they’re largely oblivious to the social and spiritual aspects of life. Will the policies they advocate damage family life, for instance? Sorry, never given it any thought. Why don’t you consult a social worker or a priest? Why not indeed. Economists’ advice is one-dimensional. When we give that advice primacy and fail to meld it with the advice of experts in other areas, we risk becoming a richer but more socially dysfunctional society.

And what applies at the national political level also applies in our everyday lives. Most of the things capitalism has to offer us are good - provided we don’t overdo them. Trouble is, the system is usually pressing us to overdo them. Take the ready availability of credit. Thanks to financial deregulation and our return to low inflation, interest rates are lower and the banks are anxious to lend. When we use that credit to buy our own home, we’re generally better off. But when we use credit cards or home equity loans to buy consumer goods we can’t afford, we risk becoming victims.

Credit cards don’t remove the need to save for the things we buy. Since debts have to be repaid, they merely allow us to do the saving after we’ve acquired the item rather than before. The trick is that you also have to pay a lot of interest. So when we allow our impatience to get the better of us, we end up devoting much of our income not to buying things but merely to paying interest. And if carrying a lot of debt on top of our mortgage makes us feel continuously weighed down - I owe, I owe, it’s off to work I go - that’s another strike against our being masters not victims. It’s great to live in such a successful capitalist economy, where not all but most of us enjoy a fair degree of comfort. But when we take the advertising too seriously and start deluding ourselves that buying more stuff will make us happy, we risk becoming victims.

Our politicians venerate the ‘aspirational voter’, but when our aspirations run exclusively to the material we’re setting ourselves up for a state of recurring dissatisfaction. To be masters of the system we need to control our aspirations, learning to be more content with what we’ve got and aspiring to be better gardeners, better golfers, better at our jobs, better partners, better parents, better human beings.

The capitalist system has ways of taking money from the poor, but also of doing down the comfortably off. Really? How? By selling the illusion of social status - and it doesn’t come cheap. The middle class spends an enormous amount of money keeping up with the Joneses and trying to demonstrate how well we’re doing by the clothes we wear, the cars we drive, the homes and suburbs we live it, the schools we send our kids to and much else. Almost by definition, the possessions that most impress people are the ones that cost most. There are too many cases where, provided they get their image and market positioning right, firms can defy the laws of demand and supply and sell more of their product by putting up their price.

What makes this game an illusion is that it’s like an arms race. People are always catching up and passing you, requiring you to earn more and spend more to regain your place. But if you’ve got the money, what’s wrong with spending it on big boys’ toys? Nothing - provided keeping your place in the status race doesn’t lead you to money stress, overwork, a feeling of being trapped or neglect of relationships that matter most.

If it does, you’re a victim. And here’s a good test of whether you are: how much do you enjoy your job? If you’re just doing it for the money, and feel constrained by your financial commitments from moving to a lesser paid but more satisfying job . . . well, you don’t need me to tell you you’re not master of your destiny. But your cage is of your own making. How can you escape to a better job or cut back the long hours you’re working? By reducing your financial commitments. How? By controlling your material aspirations and stopping trying to buy status. Is that too tall an order? Then don’t complain about being trapped by the system.

But wouldn’t the capitalist system collapse if we all cut our spending and did less work so we could spend more time enjoying our relationships? No, of course it wouldn’t. The economy would just grow at a slower rate. And that would be a cheap price to pay for lives that were less harried and where our relationships were more rewarding. I guess that’s what Gittinomics is driving at.

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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.

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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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