Why economic modelling is so tricky

When I was studying economics at university in the mid-1960s, I wasn't quite sure what a "model" was. These days, politicians and business people are always using the word, and most of us think we know what they mean.

In case you're not sure, here's an explanation I would love to have seen at uni, provided by Dr Richard Denniss, executive director of the Australia Institute, in his new paper, The Use and Abuse of Economic Modelling.

"A model, be it a model car or an economic model, is a simplified representation of a more complex mechanism. A model is typically smaller, simpler and easier to build than a full-scale replica. A model sheds light on the main features of the reality it seeks to represent," Denniss writes.

"An economic 'model' is not a physical thing, like a model car. Rather, it is a mathematical representation of the linkages between selected elements of the economy."

Thus an economic model is, unavoidably, a simplified version of the economy, or an aspect of the economy. It includes those aspects of reality the model-builder regards as most important in explaining what happens, and leaves out all those aspects that don't seem to make a big difference.

So the results you get from a model are only as good as the modeller's choice of what to include and what to leave out. In practice, the model's predictions will often prove astray because some factor the modeller assumed wouldn't be important turned out to be.

Different types of economic models are used for different purposes. Earlier this week I used Denniss's paper to discuss the input-output model that industry lobbies use to make their industry sound bigger than it is.

Today let's discuss the most sophisticated models economists have developed; "computable general equilibrium" models. These are often used to shed light on the effect of a major policy change on the economy over the next 10 or 20 years.

Economists often analyse only a part of the economy, called a "partial equilibrium analysis", while assuming ceteris paribus (all other things remain equal) in the rest of the economy. This is unrealistic because, in the economy, everything is connected to everything else. Changes in one bit lead to changes in other bits, which then feed back on the first bit. So general equilibrium models attempt to capture all these interactions between different industries and markets. (In practice they can't capture all of them, so they still rely on the ceteris paribus assumption to cover those they leave out.)

If you remember nothing else about models, remember this: their weakness is they are built on a host of assumptions, and therefore are only as good as the assumptions on which they are built. Some assumptions are obviously unrealistic and couldn't possibly hold; some happen to be overtaken by events.

Models are sets of equations with dependent and independent variables. The modeller decides the values of the independent (or "exogenous") variables and the model calculates the values of the dependent ("endogenous") variables. So, if the modeller puts in the wrong independent variables (usually assumptions or guesses about the future), the dependent variables will be wrong, too.

The model-builder also specifies the "elasticity" (sensitivity) of the relationships between the variables. For instance, when the exchange rate rises will the reduction in exports be big or small? Elasticities are partly based on empirical evidence, but they also reflect the model-builder's beliefs about how the economy works. Should that belief be wrong, the model's results will be wrong.

It's common for general equilibrium models to be Keynesian in the short run (up to 10 years) but neoclassical in the long run (20 years or more). That is, key variables such as inflation, unemployment and economic growth are determined by the strength of aggregate (total) demand in the short run, but by the strength of aggregate supply in the long run.

This means the economy is assumed to be at full employment in the long run, and economic growth over the period is assumed to be determined solely by the growth in the labour force (the population of working age and its rate of participation in the labour force) plus the rate of improvement in the productivity of labour.

How do you know what the average rates of growth in population and productivity will be over the next 20 years? You take an educated guess, then plug them in. But here's the trick: once you've done that, you've predetermined where the model's results will end up, regardless of whatever policy changes you simulate happening to the economy in the meantime.

No matter how much some change knocks the economy off its assumed long-run course, the model's specifications assume it will not only get back on course but also catch up to where it would have been.

The economy can take up to 10 years to return to its "steady state".

So, the bigger the initial departure from the long-run trend, the bigger the ultimate bounce back - by design. And, by design, nothing can ever happen that changes our destiny.

Thus the model assumes away "path dependency" - the idea that where we end up is determined by what happens to us on the way; that some developments leave us permanently better off, while some leave us permanently worse off. This is clearly unrealistic.

But see what it means? It means the policy change you're purporting to be testing doesn't stand a chance of making much lasting difference, for good or ill. And that means your test is a sham. You give the appearance of testing some proposition, but the outcome is essentially predetermined.

I think such models should be used only in private by consenting economists. They have a good understanding of the assumptions on which the model's results are built and they know whether they share the modeller's faith that the economy works the way her model assumes it does.

When the results of these models are paraded before the public - by governments and treasuries, as well as interest groups - they can't help but mislead. They appear to be proving some policy change would be good or bad but, in truth, they're coming to predetermined conclusions.

The sign that the sponsors and modellers are out to mislead is shown by their failure to highlight their model's key assumptions in some sort of comprehensible product disclosure statement.

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Talk to Fairfax employment group, Sydney, 6.2.12

I want to say a few words about the outlook for the economy in general and employment in particular, but before I do I have to issue a standard consumer warning: economists have a very bad record in forecasting what will happen in the economy, so you’d be wise not to take a blind bit of notice of anything I say.

But let me give you my prediction: the economy’s performance this year is likely to be just a fraction below average, but it will feel a lot worse than average - particularly when it comes to employment. Why? Because the media will be making it sound worse than it is.

Let’s start by talking briefly about the overseas situation. We’ve heard a lot about the troubles of the euro area - and those troubles are very real - but the forecast I’m about to give and all the forecasts we’ve been hearing lately are based on the assumption the Europeans muddle thru: they go through a period of significant weakness, where they’re a drag on the rest of the world economy, but they don’t implode and become a major restraint on world growth. In recent days the situation in Europe has been looking a bit better - a bit less like it’s about to implode - which is nice, and may it continue. Even so, the risk of things in Europe turning really bad is still uncomfortably high.

Around the middle of last year there was a lot of concern about the weakness of the US economy, but it’s been looking a bit better in recent times - not brilliant, but growing fast enough to slowly reduce unemployment. So that’s good.

In such a world - but, of course, with China and the rest of developing Asia still growing quite strongly - the outlook for us, which the Reserve Bank is likely to announce later this week, is for the economy - real gross domestic product - to grow by 3.25 per cent this year. This is the economy’s long-run rate of growth. Where will the growth come from? Particularly from the huge surge in business investment spending on the construction of new mines and, especially, natural gas facilities. But also - and contrary to anything you might have heard - from reasonably strong consumer spending. It used to be true that households were increasing their rate of saving, but it hasn’t been true for some time. The rate of household saving has been steady at 10 pc of disposable income for about a year, meaning consumer spending must being growing at the same rate as disposable income is growing. If you find that surprising, it may be because you’re confusing consumer spending with retail sales. Retail sales have been very weak, but they account for only about a third of consumer spending.

The labour force grows by a percent or so every year thanks to natural increase and immigration, so employment has to grow by that much just to hold unemployment steady. Normally growth at the average rate of 3.25 per cent a year would be sufficient to hold unemployment steady, but employment grew unusually strongly in 2010, and since then a lot of employers seem to have been holding off hiring more workers, allowing their existing workers to work more hours, but waiting to see what happens to the economy. If they keep thinking this way it seems likely the unemployment rate will slowly creep up, from its present 5.2 pc to about 5.5 pc in June and maybe 6 pc by December. That wouldn’t be good, but remember that an unemployment rate of between 5 and 6 pc is still a lot better than we experienced for most of the past 20 years. And 5 pc is getting towards the lowest point the Reserve Bank will allow unemployment to fall to because of its concern to keep inflation under control. As the unemployment rate falls close to 5 pc or lower, the Reserve starts to raise interest rates; if it starts rising towards 6 pc the Reserve starts cutting interest rates. It did that twice towards the end of last year, and if it doesn’t cut them again tomorrow, most economists are confident we’ll get more cuts this year.

Just because unemployment is likely to rise a bit doesn’t mean no new jobs will be created. For a start, and as we’ve just seen, total employment can still grow modestly even though unemployment is drifting up. Only if unemployment is shooting up is it likely that total employment is unchanged or falling. But, in any case, there’s a further point to understand - one that’s very important to the job you guys are doing. The figures the media quote each month for employment and unemployment are figures for the net change between this month and last month. If total employment around Australia is up by, say, 35,000, it’s easy to jump to the conclusion that only 35,000 positions were filled during the month; every existing worker stayed in their job, and they were joined by 35,000 more workers, presumably coming from being unemployed. Fortunately, it’s not like that. The truth is that, on average, every month about 370,000 people leave their employers and about the same number take up jobs with a new employer. So when the figures tell you employment rose by 35,000 last month, what this actually means is that the number of people taking up new jobs exceeded the number leaving jobs by 35,000. In other words, there’s huge turnover in the job market every month - even in the depths of a recession - even if the net change in total employment isn’t very big - in either direction. If you think that figure of 370,000 is so huge it’s hard to believe, you’re forgetting how big the workforce is. It’s almost 11.5 million, meaning about 3 per cent of workers leave their jobs every month - to get a better one, to have a baby, to retire, to go on an extended overseas trip, or whatever. My point is, don’t think just because employment is likely to be growing only slowly and unemployment to be creeping up, there won’t be many potential customers for you. There should be.

Finally, I said the economy wouldn’t be too bad this year, but the media will be making it sound worse than it is. Why do I say that? Because the media, knowing we regard bad news as a lot more interesting than good news, will be doing what it always does: emphasising the bad news about the economy and not saying much about things that are going OK. But I suspect there’ll be a special reason this year. The very high dollar is making life particularly tough for manufacturers, the tourist industry and overseas-student education. Some employers have been laying off workers, and it’s a safe there’ll be more. It’s an equally safe bet those lay-offs will be highly publicised by the media. This is likely to create the impression in people’s minds that the jobs market is a lot weaker than it actually is - for three reasons. First, people don’t realise how big our economy is, so they’re more impressed by relatively small numbers than they should be. Last week Toyota announced its intention to reduce its numbers by 350. That seems a lot, but beside the third of a million workers who leave their jobs every month it’s a fleabite. Second, you wouldn’t know it from the way the media talk, but the high dollar isn’t destroying Australian jobs so much as reducing them in some industries and increasing them in others. People may be losing jobs in manufacturing, but employment will be rising in other industries. Such as? Mining and construction, as the obvious ones, but also many parts of the services sector: health care, finance and insurance, public administration, various professions and arts and recreation. Finally, people tend to lose their jobs in bulk, whereas employment tends to increase in dribs and drabs. We get to hear about the big layoffs, but not the individuals being taken on.

All up, it should be too bad this year.

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Damned lies and economic modelling

One of my resolutions this year is to spend more time trying to prevent lobby groups from using dodgy economic "modelling" to mislead my readers. Canberra has developed a bad case of modelling mania, but most of it is dubious. The less you know about modelling, the more it impresses you.

Any day of the week you can hear politicians demanding to see the modelling behind some figure the government has produced (even if Treasury did a quick calculation on the back of an envelope).

But the worst offenders are business interests, which pay big money to Canberra economic consultants to produce supposedly independent reports aimed at persuading governments to give them something, or at persuading the public to stop the government taking something from them.

One trick they often pull is trying to make their industry sound bigger and better for the economy than it is. Just last week the Minister for Manufacturing, Kim Carr, was defending the government's grants to the car industry by claiming it provides employment to 46,000 workers and "more than 200,000 in associated jobs".

But the industry that's been trying hardest to bolster its economic importance lately is mining. According to a press release issued by the Australian Mines and Metals Association, "213,200 people are directly employed in mining, oil and gas operations in Australia, with an additional 639,600 indirect jobs created by the resource industry".

Did you notice how the second of those suspiciously precise figures was precisely three times the first? "Spurious accuracy" is one of the signs a con job is in progress.

I'm sure you've seen the ads sponsored by the Minerals Council of Australia and others telling "Our Story" about what a wonderful, caring industry it is. The related website says that "across the nation, mining employs 187,400 people directly, and a further 599,680 in support industries". So for every mining job, another 3.2 are created elsewhere.

According to a report funded by Peabody Energy, "the Australian coal industry employs over 32,000 people and indirectly creates an additional 126,000 jobs in Queensland and New South Wales". So that's an employment "multiplier" of 3.9.

Where do these figures come from? Knowing how many people are employed in a particular industry isn't hard. Every month the Bureau of Statistics conducts a giant sample survey of households, asking them about their experience in the labour market. That's where our monthly figures for employment and unemployment come from. Every third month the bureau asks people what industry they work for.

It's obvious that all industries buy materials and other "inputs" from other industries, to which they then apply a lot of labour and equipment to produce whatever goods or services are their "output". So every industry can justly claim its purchases from other industries create jobs in those industries. Many could claim to create more jobs indirectly than directly.

But how do they know how many? They pay an economic consultant to do a report that tells them. How do the consultants know? They look up the industry's multiplier in a model-based document produced by the bureau called the input-output tables.

Trouble is, the tables are subject to significant limitations, which make it easy for them to be misused. All is explained in a paper by Dr Richard Denniss, of the Australia Institute, to be released today, The Use and Abuse of Economic Modelling in Australia: Users' Guide to Tricks of the Trade.

Like all models, the bureau's input-output model is built on a host of assumptions, as the bureau acknowledges in its accompanying documents. This reliance on assumptions shouldn't surprise you. Were you to work out a household budget for the year, you'd have to make many assumptions, including about what will happen to prices in the future.

Denniss reminds us of the key assumptions: that the relationships between inputs and outputs are fixed and so unaffected by changes in technology or changes in the relative prices of inputs; that all the output of an industry is identical, with no differences in quality or features; and that increasing the quantity of the industry's output would yield no economies of scale.

These unrealistic - but unavoidable - assumptions greatly limit the use you can make of employment multipliers without misleading yourself or others. You can't assume that doubling the size of an industry (such as mining) would also double the number of jobs it created directly and indirectly. Nor can you assume that a significant reduction in the size of an industry (such as car making) would mean the same reduction in total employment.

Another problem is that the employment multipliers involve double counting - more than one industry taking the credit for "creating" a job in some other industry. Denniss finds that if you used the multipliers to calculate the jobs directly and indirectly created by each Australian industry, then added them up, the total would be 187 per cent of all the jobs in the nation.

Yet another problem is the implication that the significant expansion of an industry would do nothing but add to employment in the industry and elsewhere. This assumes such an expansion would have no effect on wage rates, skill shortages, the exchange rate and much else.

Denniss quotes the results of some quite different modelling commissioned by the proponents of what would be one of the world's largest mines, the China First mine in Queensland. It found that, though the mine would lead to 6000 new jobs, it would also lead to the loss of about 3000 jobs, most of them in manufacturing.

We should be highly sceptical about claims made by interest groups on the basis of reports

from "independent" consultants with no acknowledgment of all the hidden assumptions.

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Europe has serious troubles, but we don’t

The economic news from Europe in recent days hasn’t been good. And it could get worse as the year progresses. Those guys have big problems. But let’s not spook ourselves by imagining it to be any worse than it is.

Unfortunately, there’s been a tendency in parts of the media to convey an exaggerated impression of how bad things are and of the extent to which Europe’s problems translate into problems for us.

Take last week’s downwardly revised forecast for the world economy in 2012 from the International Monetary Fund. We heard a lot about the fund’s dire warnings of what could happen if the Europeans didn’t get their act together, but what wasn’t made clear was that the fund’s actual forecast was for global recession to be avoided.

Though the forecast for growth in the world economy this year WAS cut significantly from the forecast in September, at 3.3 per cent it’s below the long-run average rate of about 4 per cent, but still comfortably above the 2 per cent level generally regarded as representing a world recession.

No one thought it necessary to tell us - even though Wayne Swan reminded journalists of it at his press conference - that, from our perspective, the fund’s revisions were old news. They were surprisingly similar to the revised forecasts the government adopted in its mid-year budget review last November.

The fund has the United States growing by 1.8 per cent this year; Treasury had it at 2 per cent. The fund has the euro area contracting by 0.5 per cent; Treasury had it contracting by 0.25 per cent. For China, the fund has growth of 8.2 per cent, whereas Treasury had 8.25 per cent. For India it’s the fund’s 7 per cent versus Treasury’s 6.5 per cent.

Bottom line? The fund has the world growing by 3.3 per cent, whereas Treasury had it at 3.5 per cent.

Journalists are always criticising politicians for repeatedly re-announcing new spending programs, thus leaving the public with an inflated impression of how much is being spent. But journos aren’t above doing much the same thing.

We get a fuss when the government revises down its forecasts in November, then another fuss when the fund announces essentially the same revisions. And in between we get a fuss when the World Bank announces its revisions. Three for the price of one.

Actually, you can understand why the uninitiated got excited about the bank’s revisions. Whereas Treasury had forecast world growth of 3.5 per cent, the bank revised its forecast down to just 2.5 per cent. But no one remarked on that, just as they didn’t seem to notice when, only a week later, the fund put its prediction at a seemingly healthier 3.3 per cent.

So which one is right? They all are. That’s to say, they’re all saying the same thing. I find it hard to understand how anyone who knew their business could bang on about how low the bank’s forecast was without pointing out that it does its forecasts on a different and inferior basis to everyone else.

Whereas our Reserve Bank and Treasury, and the fund, add each country’s gross domestic product together using exchange rates that take account of the US dollar’s widely differing purchasing power in each country, the World Bank doesn’t bother. It uses market exchange rates.

So it perpetually understates the rate of growth in the emerging economies of Asia, thereby understating world growth, since most of it has for quite some years come from Asia. But not to worry. If you took the fund’s country-by-country forecasts and added them together the same misleading way the bank does, what would you get? Growth of 2.5 per cent. Same forecast on either basis.

The trouble with all these forecasts and pronouncements from international agencies is it’s hard for the public to assess what they amount to by the time they reach our shores. These pronouncements rarely mention Australia. And shock waves from Europe have to come to us via China, India and the rest of Asia.

I think the media could try harder to bridge this gap rather than leaving us with the vague impression disaster for Europe means disaster for Australia. Actually, what matters for us is not world growth so much as the growth in our major trading partners, with each partner’s contribution weighted according to its share of our exports.

When Treasury did this sum in the mid-year review, growth in the world economy of 3.5 per cent translated to growth in our major trading partners of 4.25 per cent. All this despite Europe’s recession.

Fran Kelly of Radio Nation Breakfast did go to the trouble of asking the lead author of the fund’s World Economic Outlook, Jorg Decressin, what the revised forecasts meant for us. His reply deflated most of the hype we’ve been subjected to.

‘Australia will be affected by these downgrades only to a limited extent,’ he said. Oh. ‘At this stage, growth in output for Australia is still reasonably strong.

‘Growth in Australia is importantly driven by major investment projects that are in the pipeline and these are funded by strong multinationals that don’t have problems assessing funding.’ Oh.

‘There is no advanced economy - or maybe there are one or two - that is as well placed as Australia in order to combat a deeper slow down, were such a slowdown to materialise and that’s because, well, you still have room to cut interest rates if that was necessary and you also have a very strong fiscal [budgetary] position,’ he said.

Do you get the feeling you’ve heard all this before? Maybe it’s true.

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All hail mighty Aussie dollar, as it's here to stay

This year we'll see more painful evidence of Australian businesses accepting the new reality: our dollar is likely to stay uncomfortably high for years, even decades.

It has suited a lot of people to believe that just as the resources boom would be a relatively brief affair, so the high dollar it has brought about wouldn't last.

If there were no more to the resources boom than the skyrocketing of world prices for coal and iron ore, that might have been a reasonable expectation. But the extraordinary boom in the construction of new mining facilities makes it a very different story.

The construction boom is likely to run until at least the end of this decade, maybe a lot longer. The pipeline of projects isn't likely to be greatly reduced by any major setback in the world economy. That's particularly because so much of the pipeline is accounted for by the expansion of our capacity to export natural gas. The world's demand for gas is unlikely to diminish.

Last time I looked, the dollar was worth US105?, compared with its post-float average of about US75?. But that's not the full extent of its strength. At about 81 euro cents and 67 British pence it's the highest it's been against those currencies for at least the past 20 years.

In the context of the resources boom, the high exchange rate performs three economic functions. First, it helps to make the boom less inflationary, both directly by reducing the prices of imported goods and services and indirectly by lowering the international price competitiveness of our export- and import-competing industries.

Second, by lowering the prices of imports, it spreads some of the benefit from the miners' higher export prices throughout the economy. In effect, it transfers income from the miners to all those consumers and businesses that buy imports, which is all of them. So don't say you haven't had your cut.

Third, by reducing the price competitiveness of our export- and import-competing industries, it creates pressure for resources - capital and labour - to shift from manufacturing and service export industries to the expanding mining sector.

That is, it helps change the industry structure of the economy in response to Australia's changed "comparative advantage" - the things we do best among ourselves compared with the things other countries do best.

As businesses recognise the rise in the dollar is more structural than temporary and start adjusting to it, painful changes occur, including laying off workers. Paradoxically, this adjustment is likely to raise flagging productivity performance.

Economists have long understood that the exchange rate tends to move up or down according to movement in the terms of trade (the prices we receive for exports relative to the prices we pay for imports). This explains why the $A has been so strong, for most of the time, since the boom began in 2003.

But here's an interesting thing. In the December quarter of last year, our terms of trade deteriorated by about 5 per cent as the problems in Europe caused iron ore and other commodity prices to fall. They probably fell further this month.

This being so, you might have expected the $A to fall back a bit, but it's stayed strong and even strengthened a little. Why? Because when the terms of trade weakened, other factors strengthened. The main factor that's changed is the rest of the world's desire to acquire Australian dollars and use them to buy Australian government bonds.

Indeed, the desire to hold Australian bonds was so strong it more than fully financed the deficit on the current account of the balance of payments in the September quarter. It may have done the same in the December quarter. Among the foreigners more desirous of holding our bonds are various central banks.

Remember that, at the most basic level, what causes the value of the $A to rise on any day is that people want to buy more of them than other people want to sell. The price rises until supply increases and demand falls sufficiently to make the two forces equal.

So economists' theories about what drives the value of the $A are just after-the-fact attempts to explain why the currency moved the way it did. We know from long observation that there's a close correlation between our terms of trade and the $A.

But we also know this correlation is far from perfect. There have been times when the two parted company for a while. It's apparent the dollar is driven by different factors at different times.

And it now seems apparent that our relatively superior economic performance and prospects are taking over as the main factor driving the dollar higher (even though our terms of trade would have to deteriorate a mighty lot further before they were back to their long-term average).

There are various reasons why foreign investors (including central banks with currency reserves that have to be parked somewhere) would like to increase their holdings of Australian government bonds.

For a start, we're now one of the few "sovereigns" (national governments) still with a AAA credit rating. For another, the yield (effective interest rate) on Australian 10-year government bonds is almost 4 per cent, compared with about 2 per cent on US Treasury bonds or German bunds.

And the present and prospective state of our economy is a lot healthier than that of the North Atlantic and Japanese economies. Why are our prospects so much brighter and our interest rates higher? In short: the mining construction boom, of course.

It seems clear the world's financial investors are shifting their portfolios in favour of $A-denominated financial assets. And remember, because they're so much bigger than we are, what's only a small shift for them is a big deal for us.

All this suggests the Aussie will stay strong, even as our terms of trade fall back. Remember, too, the huge spending on mining construction over the years will require a lot of foreign financial capital to flow into Australia, helping keep upward pressure on the exchange rate.

This doesn't say the $A has become a safe-haven currency. Were some sudden disaster to occur in Europe it would probably take a dive as frightened investors rushed to the safe haven of US Treasury bonds.

But it probably wouldn't take long for the Aussie to recover - just as it didn't take long after the sudden disaster of the collapse of Lehman Brothers in 2008.

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Economic fixes must offer a fair go for all

When you listen to street interviews with people in the troubled countries of the euro zone, a common complaint emerges: whereas some people waxed fat in the boom that preceded the crisis, it's ordinary workers who suffer most in the bust, and they and even poorer people who bear the brunt of government austerity campaigns intended to fix the problem.

In other words, achieving a well-functioning economy is one thing; achieving an economy that also treats people fairly is another. Economists and business people tend to focus mainly on economic efficiency; the public tends to focus on the fairness of it all.

Fail to fix the economy and almost everyone suffers. But offend people's perceptions of fairness and you're left with a dissatisfied, confused electorate that could react unpredictably.

The trick for governments is to try to achieve a reasonable combination of both economic efficiency and fairness. Fortunately, but a bit surprisingly, the need for this dual approach has penetrated the consciousness of the Organisation for Economic Co-operation and Development - the rich nations' club which is expanding its membership to include the soon-to-be-rich countries.

New research from the organisation deals with ways governments can get their budgets back under control without simply penalising the vulnerable and ways they can improve the economy's functioning and increase fairness at the same time.

Much of the concern about fairness in the hard-hit countries of the North Atlantic has focused on bankers. In the boom these people made themselves obscenely rich by their reckless, greedy behaviour, eventually bringing the economy down and causing many people to lose their businesses and millions to lose their jobs.

But their banks were bailed out at taxpayers' expense - adding to the huge levels of government debt the financial markets now find so unacceptable - and few bankers seem to have been punished. Some have even gone back to paying themselves huge bonuses.

It's a mistake, however, to focus discontent on the treatment of a relative handful of bankers. The fairness problem goes much wider. In most developed countries, the long boom of the preceding two decades saw an ever-widening gap between rich and poor.

In the United States, almost all the growth in real income over the period has been captured by the richest 10 per cent of households (much of it going to the top 1 per cent), so that most Americans' real income hasn't increased in decades.

It hasn't been nearly as bad in Australia. Low and middle household incomes have almost always risen in real terms, even though high incomes have grown a lot faster.

Looking globally, a lot of the widening in incomes has come from the effects of globalisation and, more particularly, technological change, which has increased the wages of the highly skilled relative to the less skilled. But a lot of the widening is explained by government policy changes, such as more generous tax cuts for the well-off.

The euro zone countries need not only to get on top of their budgets and government debt, but also to get their economies growing more vigorously. So the organisation has proposed structural reforms - we'd say microeconomic reforms - which can foster economic growth and fairness at the same time.

One area offering a "double dividend" is education. Policies that increase graduation rates from secondary and tertiary education hasten economic growth by adding to the workforce's accumulation of human capital while also increasing the lifetime income of young people who would otherwise do much less well.

Promoting equal access to education helps reduce inequality, as do policies that foster the integration of immigrants and fight all forms of discrimination. Making female participation in the workforce easier should also bring a double dividend.

Surprisingly - and of relevance to our debate about Julia Gillard's Fair Work Act - the organisation acknowledges the role of minimum wage rates, laws that strengthen trade unions, and unfair dismissal provisions in ensuring a more equal distribution of wage income.

It warns, however, that if minimum wages are set too high they may reduce employment, which counters their effect in reducing inequality. And reforms to job protection that reduce the gap between permanent and temporary workers can reduce wage dispersion and possibly also lead to higher employment.

Systems of taxation and payments of government benefits play a key role in lowering the inequality of household incomes. Across the membership of the organisation, three-quarters of the average reduction in inequality achieved by the tax and payments system come from payments. Means-tested benefits are more redistributive than universal benefits.

Reductions in the rates of income tax to encourage work, saving and investment need not diminish the inequality-reducing effect of income tax, provided their cost is covered by the elimination of tax concessions that benefit mainly high income earners - such as those for investment in housing or the reduction in the tax on capital gains. Getting rid of these would also reduce tax avoidance opportunities for top income earners.

So it's not inevitable that the best-off benefit most during booms and the worst-off suffer most in the clean-up operations after the boom busts. It's a matter of the policies governments choose to implement in either phase of the cycle.

You, however, may think it's inevitable that governments choose policies that benefit the rich and powerful in both phases.

But we're talking about the government of democracies, where the votes of the rich are vastly outnumbered by the votes of the non-rich. So if governments pursue policies that persistently disadvantage the rest of us, it must be because we aren't paying enough attention - aren't doing enough homework - and are too easily gulled by the vested interests' slick TV advertising campaigns.

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WHAT MAKES A GOOD LIFE?

January, 2012

Mainstream economics is about enabling people to lead a prosperous life; it’s about telling the community how to be more efficient in its use of scarce resources, with the objective of raising our material standard of living. But is a prosperous life a good life? Not necessarily. So what’s the relationship between prosperity and a good life? Or, to put the question in its classic form, does money buy happiness? The answer from the rapidly growing body of research into happiness, by a lot of psychologists and a few economists, is: yes it does - but only up to a point. I guess it must be possible to be poor but happy, but surveys suggest most people living below some minimum level of income aren’t particularly happy. Poverty doesn’t have a lot to recommend it.

But once people in affluent countries such as Australia reach an adequate but reasonably frugal standard of living, the surveys show that the ability of an extra $1000 of annual income to make people happier falls away surprisingly rapidly. For those of us who aren’t poor, acquiring extra money yields progressively less and less value for money.

Why does more money do so little to make us happier? Psychologists offer two main explanations. First, because humans adapt so readily to their changed circumstances. A new car, a new house, a new dress or a promotion does make us happier - as we expected it would - but usually within a few weeks the new thing becomes part of the status quo, leaving us little happier than we were. Second, it seems clear that what makes us happier is not having more money so much as having more money than other people, particularly those people you usually compare yourself with. It’s not absolute increases in our income that matter to us but relative increases. And relative increases are harder to come by, as well as leaving those whose incomes we overtake feeling less happy.

But if acquiring more money is such an ineffective way to improve our happiness, why do so many of us keep pursuing money? Partly because research shows we’re quite bad a predicting the extent to which events we hope for - or events we dread - will make us feel good or bad. We’re like a donkey chasing a carrot - we don’t have much in the way of a learning curve. Some scientists suggest our evolution as a species has programmed us to believe a little more money will finally make us happy because there must have been some point in our evolution where working hard contributed to our survival as a species. Whether or not that’s true, many of us do seem to have an inbuilt tendency to pursue money at the expense of things that actually contribute a lot more to our happiness - our relationships being the prime example - so there is a need for many of us to put more conscious effort into controlling our materialist urges.

We’re supposed to be talking about the good life, but I’ve switched to talking about happiness. Is pursuing happiness - or even achieving happiness - the same as living a good life? That depends on what you take happiness to mean. I usually talk about happiness because, as a journalist, I know it’s an attention-getting word, but it’s quite an ambiguous word. I suspect that much of the debate about whether the modern preoccupation with happiness is a good or bad thing arises from people attaching different meanings to the word.

If by happiness you mean hedonism - the pursuit of pleasure and the avoidance of pain - then, no, happiness is not synonymous with a good life. What I mean by happiness is not the pursuit of pleasure, nor even contentment (except in the sense that we’re content with our present level of material affluence). A word that comes closer to it is fulfilment - living a life we can look back on with a degree of satisfaction, and without too many regrets. To some people’s minds happiness is associated with smugness - I’m alright, Jack. But, to me the highest level of happiness - which I’m happy to label the good life - is a life with a lot of concern for others, starting with our nearest and dearest but going further to the less fortunate. Happiness isn’t a euphemism for selfishness, and preoccupation ourselves and our own needs is a bad way to achieve happiness.

Unless you’re old or bedridden, the good life is active rather than passive. There is plenty of room for ambition and striving in the good life - depending on your motive for all the ambition and striving. A good life will have its share of setbacks and sadness and even anger - not to mention its share of hard work.

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Moneyball shows competition isn’t always a winner

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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A little regulation brings out the best for all of us

Ask economists who is the father of economics and almost all of them will say Adam Smith. But a new book makes the amazing claim the true father is Charles Darwin. And if you ask economists the question in 100 years' time, that's what they'll say.

The book is The Darwin Economy, by Robert Frank, professor of economics at Cornell University.

Smith was the Scottish moral philosopher, who published his most famous work, The Wealth of Nations, on the eve of the industrial revolution in 1776 (just a few years after Captain Cook visited Botany Bay).

Among all his insights about how the economy works, the one for which he gets most credit is the "invisible hand". This is the notion that impersonal market forces channel the behaviour of greedy individuals to produce the greatest good for all.

Why does a business owner go to the trouble of designing a new product that consumers are likely to find appealing? Why does he invest such effort to revamp his production process to reduce costs? Simply to make more money - as many people realised before Smith.

What they didn't see was the response those actions would provoke from rival business owners, and how the ensuing dynamic - the invisible hand - would produce outcomes very different from those intended, Frank says.

If one producer comes up with a cheaper way of manufacturing a product, he can cut his price slightly and steal market share from his rivals. In the short run, his profits soar, just as he'd hoped. But the loss of market share by rival firms gives their owners a powerful incentive to mimic the original innovation.

And once the innovation spreads industry-wide, the resulting competition drives the product's price down to a level just sufficient to cover the new, lower production costs. The ultimate beneficiaries of all this are consumers, who enjoy steadily improved products at ever-lower prices.

There's much truth to this and it does much to explain why the market system has raised our material standard of living so far over the past 200 years.

So why does Frank then think economists will come to see Darwin as the true father of economics rather than Smith? Because Darwin's study of the natural world led him to a deeper insight about the often flawed nature of competition.

Although Smith was careful not to claim it, many economists (and many libertarians) have taken his invisible hand to mean that regulation of markets is unnecessary and undesirable because unbridled market forces can take care of things quite nicely on their own.

In fact, Smith was well aware that unregulated markets didn't always produce the best outcomes. For the most part, however, he imagined market failure to be the result of inadequate competition. Firms would find some way to nobble their competitors and overcharge their customers.

Critics on the left have long focused on anti-competitive behaviour as the key to understanding why markets fail. But they (and Smith) are missing an important point.

"Darwin's view of the competitive process was fundamentally different," Frank says. "His observations persuaded him that the interests of individual animals were often profoundly in conflict with the broader interests of their own species."

Consider the outsized antlers of bull elk. These antlers function as weapons not against predators but in the competition among bulls for females. Since the bull with the biggest antlers gets to mate with the females, while the others don't, the process of natural selections has given male elk ever-bigger antlers.

But big antlers are a big disadvantage when elk are being preyed on, making them more likely to be killed and eaten by wolves. So what's in the interests of the individual bull is actually contrary to the interests of the group.

While no individual bull would want to be disadvantaged by having smaller antlers than the others, all the bulls would be better off if all of them had the width of their antlers narrowed by, say, half a metre (which would leave the relative size of their antlers unchanged).

You can tell the same story about peacocks' tails, huge elephant seals and many other animals that compete to be the sexual top dog. They all suffer a "collective action problem" - they're locked in a kind of arms race from which no individual can escape, even though all individuals realise how costly the race is. The only solution to the individuals' problem is for the animals - human animals - to act collectively. For them all to agree on a truce - a strategic arms limitation treaty, so to speak - or for some external authority, such as a government, to impose a solution on all of them. All would benefit from such an imposition so, contrary to the assumption of the libertarians, all are likely to welcome it.

The Nobel-prize-winning American economist, Thomas Schelling, quotes the case of ice-hockey players. When helmet-wearing is voluntary, no one is prepared to suffer the small competitive disadvantage of wearing one. But, since helmets do increase safety, all players would vote to make them compulsory.

Frank argues that for competition to give rise to collective action problems - wasteful arms races, if you like - is more the rule than the exception. Why? Because in many important areas of life, performance is "graded on the curve". It's not your absolute score that matters, it's your relative score - that is, where you rank in the comp.

"The dependence of reward on rank eliminates any presumption of harmony between individual and collective interests," Franks says, "and with it, the foundation of the libertarian's case for a completely unfettered market system."

Frank says since individual humans' reproductive success has always depended first and foremost on "relative resource holdings" - which males look the best physical specimens and the best providers; which females look the best child-bearers and homemakers - it would be astonishing if the evolved brain didn't care deeply about relative position.

Hence the tendency as we become ever-more affluent for a growing share of our income to be spent on "positional goods" - that is goods or services which, as well as doing whatever it is they are supposed to do, also signal to the world by their expensiveness our superior position in the pecking order.

Frank concludes that the real reason we regulate markets is to protect ourselves from the consequences of excessive competition.

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How to get more bang from your bucks

The retailers may be worried we aren't spending enough this Christmas, but that doesn't mean most of us aren't spending a fair bit. We always do. And, of course, for those of us off on summer holidays, the spending doesn't stop on Christmas Eve.

Economists are great apostles of efficiency, which they advocate so we have more money to spend on consumption. Strangely, however, they have little interest in how efficiently we spend our money. Are we spending it in ways that maximise the satisfaction (or "utility") we derive? They hardly know or care.

For advice on consumption efficiency we must turn to the psychologists - particularly those who study happiness (another word for utility). Earlier this year three famous psychologists, Elizabeth Dunn, of the University of British Columbia, Daniel Gilbert, of Harvard, and Timothy Wilson, of the University of Virginia, published an article called, If money doesn't make you happy, then you probably aren't spending it right.

The truth is, once you've satisfied your basic needs, getting and spending more money is a progressively less effective way to make yourself happier. The more you spend, the less effective each extra dollar becomes.

But that's partly because some forms of spending are more satisfying than others, and Gilbert's research shows humans aren't very good at predicting what will make them happy.

So the authors propose some principles that psychological research suggests will help us get more bang from our bucks. One that's particularly apposite at this time when we celebrate the birth of Santa is: help others instead of yourself.

Somebody who had nothing to do with Santa once said it was more blessed to give than to receive. Turns out he was right. Dunn has done various experiments that show giving gifts to people or making donations to charity makes people happier than spending money on themselves.

Studies of people's brains using magnetic resonance imaging showed that when people chose to give money to a local food bank this caused activity in the part of their brain typically associated with receiving rewards.

Why should this be? Because humans are the most social animal on the planet, the quality of our social relationships is a strong determinant of our happiness. So almost anything we do to improve our connections with others tends to improve our happiness as well.

Particularly at this time of year, retailers try to entice us with offers to "buy now, pay later". I don't doubt this helps increase sales, but it's pretty much the opposite of how you gain greater satisfaction. Another principle the authors propose is: pay now and consume later.

Consume now, pay later is a bad idea because it eliminates anticipation, and anticipation is a source of "free" happiness, the authors say. Delayed gratification means you get the pleasure of thinking about how good it will be and then you get the pleasure of actually experiencing it. We also get pleasure from looking back on experiences, but we get more from anticipating them.

A third principle is: beware of comparison shopping. The trouble with comparison shopping is it focuses your attention on those attributes of the items that are easily compared, not necessarily the attributes most important to how much satisfaction you'll get from the item once you've got it home and are using it.

This may be particularly true of internet shopping, which is likely to increase the emphasis on the attribute that's most easily compared: price. That's fine - especially when you're comparing identical items. But price is only one consideration. More important ones are whether you really want the thing in the first place, and how much use you're likely to make of it.

The next principle seems odd: follow the herd instead of your head. Research suggests the best way to predict how much we'll enjoy an experience is to see how much someone else enjoyed it. That's because we're so bad at predicting our utility. It's probably also because, being such intensely social animals, we usually feel comfortable doing what everyone else is doing (even if we don't like admitting it).

Next: buy many small pleasures instead of a few big ones. Present-buying parents, please note. The reason the pleasure from acquiring new things wears off so soon is that we so quickly get used to them. Psychologists say we "adapt" to them. So a key tactic in seeking to increase the pleasure we get from things is to find ways of slowing our rate of adaptation. One way to do it is to buy a lot of little things and get satisfaction out of each of them rather than buy a few big hits.

And they say economists use jargon. See if you can translate this: "Across many different domains, happiness is more strongly associated with the frequency than the intensity of people's positive affective experiences." (Positive affect means good feelings.)

In a study of Belgians, those who had a strong capacity to savour the mundane joys of daily life were happier than those who didn't.

I've left for last a principle I've written about before: buy experiences instead of things. We adapt to the ownership of things more quickly than to experiences. We anticipate and remember experiences more than things.

Our experiences are more centrally connected to our identities. And experiences are more likely to bring us into connection with other people.

Turns out this is the retailers' problem. We're not spending less overall, we're just spending less of our income on the goods retailers sell and more on the services they don't. Overseas holidays, for instance. But not for me, this time. Come Boxing Day I'm off up the coast for a few weeks.

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Secret of successful economy is 'frameworks'

The proof we suffer from an economic cringe as well as a cultural one is our tendency to attribute our better position relative to the other advanced economies purely to good luck. In truth, it's owed as much to our markedly superior economic management over the past 20 years.

What? Poor little Oz runs its economy far better than the mighty Yanks and the haughty Europeans? You betcha.

Last week both Ric Battellino, deputy governor of the Reserve Bank, and Dr Martin Parkinson, secretary to the Treasury, warned we would not be immune from the public debt troubles of Europe and the United States.

However, Parkinson said, we can take some comfort from our starting position. ''We are located in the fastest growing region in the global economy with a number of opportunities likely to present themselves over the next decade,'' he said.

''Equally, the flexibility of our economy and our medium-term oriented policy frameworks have assisted Australia manage the impacts from external volatility.''

According to Battellino, we need to monitor the unfolding European situation carefully and remain alert to the risks. ''Having said that, I remain confident that Australia, with its strong government finances, resilient banking system, relatively low exposures to the troubled countries and strong links to the dynamic Asian region, is well placed to deal with events that may unfold,'' he said.

So it's true we're enjoying the good luck of being close to Asia and loaded with the very natural resources it's willing to pay so dearly to get its hands on. But it's also true our leaders have understood the need for us to ''enmesh'' our economy with Asia's since Malcolm Fraser's day, and have worked towards that end.

Our econocrats can take a lot of the credit for the sound state of our banks. They didn't fall for - and didn't let their political masters fall for - all the happy talk about deregulation and free markets.

But wait, there's more - much more. And Battellino offered a big clue to it. He noted that government debt in the euro area had been rising as a proportion of gross domestic product for much of the period since the 1970s.

''This occurred because governments loosened fiscal [budgetary] policy during recessions, but did not fully reverse those policies during the subsequent cyclical recoveries,'' he said. ''In aggregate, budgets in the countries that now form the euro area have been continuously in deficit for the past 40 years.''

And here's the clue: ''Clearly, there was no fiscal rule that aimed to balance the budget over the economic cycle, as there is in Australia.''

He could have said much the same about the build up of public debt in the US, which saw its credit rating downgraded this year and looks likely to induce a fiscal crunch in 2013.

The truth is our economy was quite badly managed in the 1970s and much of the '80s. But whereas that's still true of Europe and the US, it hasn't been true of us for at least the past 20 years - during which time, you'll recall, we haven't had a serious recession, while the others have had two or three.

So what's the secret of our success? Our econocrats' commitment to making the conduct of fiscal policy and monetary (interest-rate) policy subject to clearly defined medium-term ''frameworks'' - systems of rules and targets - so as to reduce their susceptibility to short-term political expediency.

With monetary policy, that's been straightforward. In 1993, then Reserve Bank governor Bernie Fraser joined the international trend for monetary policy to be conducted by the central bank independent of the elected government, guided by an inflation target. Fraser's genius was in specifying such a sensible, flexible target: 2 per cent to 3 per cent on average over the cycle.

This regime was adopted formally by the incoming Howard government in 1996. The framework has achieved its goal of reducing and ''anchoring'' inflation expectations, so the target has been achieved without great restraint on economic growth. And successive governments - Liberal and Labor - have copped without anything more than a grumble all the Reserve's moves to raise interest rates at politically inconvenient times.

As the towering public debts of the North Atlantic economies attest, the pursuit of a framework for fiscal policy has been much more our own work, with little overseas precedent to guide us. It began with the ''trilogy of commitments'' unveiled in the Hawke government's first budget of 1983, and was reinforced with new targets for reducing the budget deficit in the Keating government's post-recession budget of 1993.

But the biggest stride towards a rigorous framework came with Peter Costello's enactment of the Charter of Budget Honesty upon election in 1996. At the charter's centre was Costello's ''medium-term fiscal strategy'' to ''maintain budget balance, on average, over the course of the economic cycle''. He lived by this strategy, achieving 10 budget surpluses during his term, before the onset of the global financial crisis (to which should be added Keating's three surpluses before the recession of the early '90s).

The present Labor government endorsed the Libs' medium-term strategy and its response to the crisis was consistent with it. In Labor's second stimulus package of February 2009 it conformed to the charter's requirement that it spell out a ''deficit exit strategy'', choosing to limit real growth in its spending to 2 per cent a year and forswearing any further tax cuts until a healthy budget surplus was restored.

''Frameworks'' are a boring subject, little mentioned by the media. But they've been our secret weapon in producing vastly superior outcomes to the Europeans and the Yanks.

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Economy follows wherever our moods take us

To anyone but the economists and financiers, getting to the bottom of what the problem is in Europe is hellishly complicated. The more you read the more confused you get. But you can boil it down to the combination of the availability of credit and what Keynes called ''animal spirits''.

To anyone but the economists and financiers, getting to the bottom of what the problem is in Europe is hellishly complicated. The more you read the more confused you get. But you can boil it down to the combination of the availability of credit and what Keynes called ''animal spirits''.

Animal spirits refer to the tendency of the human animal to go through alternating waves of excessive optimism and excessive pessimism. Because we're a highly social animal, we tend to all be optimistic or pessimistic together. Animal spirits are contagious.

In principle, the availability of credit is a wonderful thing, allowing families to buy a home long before they could pay cash for it and businesses to expand beyond their owners' savings.

Taken separately, the existence of credit and animal spirits isn't a big problem. Taken in combination, however, they can be lethal. Animal spirits - also known as ''confidence'' and ''expectations'' - are the main factor causing the economy to speed up and slow down, speed up and slow down again.

Add the availability of credit - which, once availed of, becomes debt - and the amplitude of the ups and downs is greatly increased to produce the business cycle of boom and bust.

The potentially toxic combination of credit and confidence can be a problem for households, businesses, banks or governments. The risk is they borrow too much while everyone's confident the present up-and-up will last forever, then get into trouble when the mood switches and everyone fears the end is nigh.

In Europe's case the main problem is with excessive borrowing by governments. As Ric Battellino, retiring deputy governor of the Reserve Bank, explained this week, government debt in the euro area has been growing faster than gross domestic product for the past 40 years.

The 17 countries' combined net public debt at the start of the global financial crisis equalled about 45 per cent of GDP. Since then it's jumped a third to 60 per cent. If those net figures don't impress you (most of those you see are gross, taking no account of the countries' financial assets), note that these euro-wide averages include Greece with a net debt of about 130 per cent of GDP and Italy with about 100 per cent.

The trouble with debt, of course, is it has to be ''serviced''. You have to pay the interest as it falls due and sometimes also repay part of the principle. Businesses and governments tend not to repay their borrowings but just roll them over (renew them)when they come to the end of their term.

You pay interest out of current income. This is rarely much of a problem while everyone's optimistic and your income keeps growing. But when the mood swings to pessimism and the economy turns down - or when the economy turns down and the mood swings to pessimism; it's often hard to be sure which causes which - it can get a lot harder to keep up your interest payments when your income isn't growing as fast or is falling.

The trouble with interest payments, of course, is they're not optional. Many households and firms have to cut back their other spending to make sure they can make their interest payments. When too many of them have to do that, the economy takes another lurch down, taking confidence with it.

Governments, on the other hand, tend merely to run bigger budget deficits. But when you're borrowing just to meet your interest payments, your debt and your interest payments grow rapidly.

And you find you've got another problem. The very people who lent to you so happily during the optimistic phase now turn on you. They say you're a hopeless money-manager, they worry about whether they'll get their money back, they'll only lend you more money at a much higher interest rate and may even press you to repay some principal.

Whereas during the optimistic phase they probably didn't charge you an interest rate high enough to adequately reflect their risk that you wouldn't be able to repay them, in the pessimistic phase - when you're at your most vulnerable - they probably charge you more than needed to cover that risk.

It's all terribly illogical, unfair and, worse, counterproductive. The people who shouldn't have lent you so much blame you, not themselves. They go from being too optimistic, to too pessimistic; too easy to too tough. And by doing so they threaten not only your survival, but their own.

Great system, eh? It's one of the great weaknesses of the generally highly beneficial capitalist system. It occurs because the humans who inhabit the system are emotional, herd animals, contrary to economists' happy assumptions that we're all rational and markets never get it wrong. It occurs when, as until recently, economists, regulators and politicians start believing their own bulldust.

All this helps explain why the governments of the euro area, having borrowed far more than they should have over many years, are now in so much trouble. Some, of course, have borrowed a lot more than others. These are the ones in the most trouble. But since they're all yoked together in the euro, they're all in trouble together.

Once the worst case - Greece - focused their attention, the financial markets began turning one by one on the other bad cases, as markets do. Trouble is contagious. Even the strong countries - Germany and France - are sus because their strength may not be sufficient to prop up all the others.

In the modern world, countries aren't allowed to go bankrupt. They always get bailed out, usually by the International Monetary Fund. In the case of the euro area, much of the bailing out will probably be done by the European Central Bank.

But salvation for sinners always comes with hefty punishment attached, to make sure they learn their lesson. Punishment comes in the form of ''austerity'' - big cuts in government spending and increases in taxes - which initially make things worse rather than better.

At present we're going through a drawn-out period of uncertainty while all the politicians involved argue about taking their medicine. I'm confident they'll eventually get their act together but, even if they do, Europe is in for an unpleasant decade.

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PM Gillard: hard worker, hard-nosed, hard to read

Having observed Julia Gillard's government for more than a year, I must say she's hard to pigeon-hole. Is the woman who changed the government's mantra from "working families" to "hard-working families" a typical Labor prime minister, as many business critics of Fair Work believe, or a pale imitation of a Liberal leader, as her willingness to sell uranium to India and her opposition to same-sex marriage lead many critics on the left to conclude? Does she stand up to powerful industries or kowtow to them?

You can make a surprisingly long list of social changes you'd expect the Labor heartland to be pretty happy about (even though it seems far from enamoured of its first female federal leader).

The introduction of paid parental leave (which, admittedly, occurred under Kevin Rudd) is an important step in reforming the institutions of the labour market to make them more suited to the needs of the better-educated sex.

Equal pay for women in the community sector - most of the cost of which will be borne by the federal budget - remedies an age-old injustice, which never made sense and couldn't have survived in a world of shortages of labour.

Plain-packaging for cigarettes is preventive-health reform that leads the world. The international tobacco industry has few friends, but very deep pockets to fight the Gillard government with advertising and legal action.

But global tobacco has a fraction of the power the licensed clubs have in opposing compulsory pre-commitment for people using poker machines. Although this issue was forced on Gillard by her lack of a majority, she has yet to waver in her determination to get it passed by Parliament. And though it, too, is a reform without international precedent, it could do much to reduce the gambling industry's indefensible exploitation of people addicted to poker machines.

Rudd should get most credit for several other social improvements: the national homeless strategy, the national rental affordability scheme (tax breaks for investors in affordable housing) and the first injection of funds into social housing in many a long day.

Rudd started, but Gillard has continued, Labor's many measures to pare back John Howard's middle-class welfare by declaring a family on $150,000 a year to be not rich, but comfortable. These measures don't just save money, they make the budget more redistributive in favour of the genuinely deserving.

And Gillard has defied the powerful private health insurance industry by continuing Rudd's efforts to get means-testing of the health insurance tax rebate approved by Parliament.

Gillard has committed herself to making introduction of a national disability insurance scheme her top social reform in the rest of her term. By providing help to people who inherit their disability or acquire it from an accident around the home, this would fill a longstanding gap in our social safety net. It would be a historic advance (and is one of the few reforms Tony Abbott hasn't opposed).

But against all that there are a couple of areas where Gillard's performance has been anything but what you would expect from Labor. The first is her education "reforms" copied from the American Republican Party.

Trying to "incentivate" school teachers as though they were as money-hungry as chief executives merely insults their professionalism. Providing parents with greater information about the performance of schools is fine, but doing so before summoning the courage to correct the bias in federal school funding in favour of well-off schools risks hanging under-resourced public schools out to dry.

Gillard has spent four years postponing change to Howard's middle-class-welfare school-funding formula. Her response next year to the belated review will show whether her courage has recovered.

The tax concessions attached to superannuation have long been heavily biased in favour of high income earners such as yours truly. To call them middle-class welfare would be an understatement.

Rather than using the opportunity provided by the decision to phase-up compulsory employee contributions from 9 per cent to 12 per cent of salary (a multi-billion-dollar gift to the financial services industry) to shift the tax benefit from high to middle and low income earners, the government will merely use some of the revenue from the mining tax to correct the position where workers on the 15 per cent income tax rate gain no concession on their contributions.

But the most puzzling and indefensible aspect of Rudd policy continued by Gillard is the mistreatment of sole parents and, more so, people on unemployment benefits. Both groups were explicitly excluded from the over-generous pension increase in 2009.

For many years, age and invalid pensions have been indexed to average earnings, meaning they rise faster than inflation, whereas the dole has been indexed only to inflation. In consequence, the dole paid to single adults is now less than two-thirds of the single pension, a shortfall of $131 a week.

The dole is now so low it's just 36 per cent of median household income, putting it well below the commonly drawn poverty line of half median income. It's also just 45 per cent of the after-tax minimum wage - meaning there is little risk its generosity is deterring people from taking a job.

One defence of low unemployment benefits is that most people aren't on them for long. But more than half the people on the dole have been on it for a year or more. And the government is also limiting the assistance it gives the long-term unemployed to help them find a job.

This discrimination against the unemployed is now so extreme the Henry tax reform recommended it be corrected. And even the Business Council agrees.

Perhaps Gillard's lack of sympathy for the unemployed arises because, being unable to find a job, they're not hard-working.

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Reserve has re-assessed outlook for world growth

Just as a stopped clock is right twice a day, so the financial markets' belief that Europe's sovereign debt problems are the primary factor influencing the Reserve Bank's decisions about interest rates, having been wrong for most of the year, has finally proved on the money.

A psychologist would say the financial markets have been suffering a "salience" problem. Their judgments about how the Reserve will adjust the official rate have been overly influenced by the factor sticking out in their minds and also on their minds most recently: Europe.

If Europe is on their front burner, it must also be on the Reserve's. Since the outlook for Europe is so worrying and so conducive to slower economic growth, the markets have for months been predicting that big falls in our official rate are imminent.

Month after month the markets have stuck to this view, ignoring the Reserve's twice-monthly explanations of its thinking, which, while acknowledging the worries and uncertainties over Europe, have repeatedly emphasised the state of the domestic economy and, in particular, the outlook for domestic inflation, as key considerations.

So when, on Melbourne Cup day, the Reserve acted for the first time in a year and chose to lower interest rates by a notch, the markets weren't surprised. But they were right for the wrong reason. As the Reserve made clear, it was able to ease a notch because the economy wasn't accelerating to the extent it had been expecting, thus making the Reserve more confident inflation would stay on track over the next year or two.

But all that changed last week, when the Reserve eased the rate another notch, this time making it clear its decision had been influenced by the changed prospects for the global economy.

So what exactly were its motivations? Was it taking out a little insurance, fearing the worst might come to the worst in Europe? No, nothing so dramatic.

It doesn't take many brain cells to get the wind up over Europe and assume the worst. It takes more brain power to quietly assess the probability of a complete disaster. And more again to assess the strength of any troubles in Europe by the time the ripples reach the Antipodes via China.

By now, the shape of the solution to Europe's problem is reasonably clear. The 17 member countries of the euro area (or, if they insist, almost all the members of the European Union) need to sign up to a new fiscal compact, which imposes limits on the size of their budget deficits and levels of public debt relative to gross domestic product, with automatic penalties for countries that breach these limits.

The pact would also impose timetables for countries presently well in excess of those limits to comply with them, again with penalties for breaches.

Once these strictures had been ratified - thus plugging the obvious hole in the euro currency union, as well as guaranteeing the errant borrowers would mend their ways - the European Central Bank would be willing to start buying up the bonds of member countries, thus forcing down their yields.

It would cut its official interest rate to next to nothing and engage in "quantitative easing" (buying government bonds to cover deficit spending and so, in effect, printing money). Thus all the budgetary contraction would be offset to some extent by monetary stimulus.

While it's painfully apparent the European leaders are having trouble getting their act together - thus increasing the risk of disaster occurring by accident - it's also apparent they're neither fools nor suicidal.

So to assume Europe is headed inevitably for an implosion - as many punters seem to - strikes me as nothing more than unthinking pessimism. Our more experienced observers put the probability of a complete disaster no higher than about one chance in three.

This says the chances are twice as high that Europe will muddle through. But it's clear that even if the full calamity of a collapse in the euro is averted, even if everyone dons their fiscal straitjacket, the financial markets calm down and ordinary life resumes, the outlook for the European economy is particularly weak.

All those economies committed to the fiscal austerity of tax increases and swingeing spending cuts - and it will be quite a few of them - face the dismal prospect of fiscal contraction leading to reduced revenue, reduced revenue leading to a need for more fiscal contraction, and so on and on.

If you wonder how any politician could agree to such an appalling exercise, you're starting to understand why Europe's politicians have had so much trouble getting themselves up to the barrier. They've had to reach the realisation the financial markets - which went for years happily lending them more money than was good for them - are now not going to tolerate any easier or more sensible work-out of their debt problems.

For our purposes, it's now clear the greatest likelihood is negative to flat growth in Europe for at least the next year or two (the forecast period) and probably far longer. It's also clear that, while the US economy has gained momentum recently, it too faces unavoidable fiscal contraction, if not next year then in 2013.

With evidence China's exports to Europe are already being hit, the Reserve decided last week to revise down its forecasts for world growth. This will change its forecasts for domestic growth and inflation only a little, but it was enough to raise the Reserve's confidence it could cut rates another notch without jeopardising achievement of its inflation target.

Meanwhile, the financial markets are betting the official rate will have fallen by another 1.5 percentage points by the middle of next year. I call that courageous.

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Nice set of figures should shut up the gloomsters

Something strange is happening to the Australian psyche at present. A lot of people are feeling down about the economy. They're convinced it's pretty weak, and any bit of bad news gets a lot of attention.

But most of the objective evidence we get about the state of the economy says it is, under the circumstances, surprisingly strong. Consider the national accounts we got this week.

They show the economy - real gross domestic product - grew by 1 per cent in the September quarter, more than most economists were expecting. And not only that, the Bureau of Statistics went back over recent history, revising up the figures.

Originally we were told the economy grew by a rapid 1.2 per cent in the June quarter, but now we're told it grew by an even faster 1.4 per cent. Originally we were told the economy contracted by 1.2 per cent in the March quarter because of the Queensland floods and cyclone, but now we're told the contraction was only 0.7 per cent.

Those figures hardly fit with all the gloominess. So how fast is the economy travelling, on the latest numbers? We're told it grew by 2.5 per cent over the year to September, but that figure includes the once-off contraction in the March quarter, which is now ancient history.

We could do it the American way and say we grew at an ''annualised rate'' of 4 per cent in the September quarter (roughly, 1 per cent x 4), but that's too high because this quarter (and the previous one) includes a bit of ''payback'' (or, if you like, catch-up) as the Queensland economy got back to normal after its extreme weather.

(There's likely to be more catch-up in the present quarter as the Queensland coalmines finally pump out all the water and resume their normal level of exports, suggesting the Reserve Bank is reasonably safe to achieve its forecast of 2.75 per cent growth over the year to December.)

So the best assessment is that at present the economy is growing at about its ''trend'' (long-term average) rate of 3.25 per cent a year. If so, everything's about normal.

Ah yes, say the gloomsters, but all the growth's coming from the mining boom. Before we check that claim, let's just think about it. If we were viewing our economy in comparison with virtually every other developed economy, we'd be thanking our lucky stars for the mining boom.

But not us; not in our present mood. We're feeling sorry for ourselves because, for most of us, the benefits of the boom come to us only indirectly. (The other thing we ought to be thankful for apart from our luck is 20 years of clearly superior management of our economy. In stark contrast to Europe and the US, we have well-regulated banks and stuff-all public debt.)

It's true the greatest single contributor to growth in the September quarter was the boom in investment in new mines. New engineering construction surged 31 per cent in the quarter and total business investment spending rose by almost 13 per cent.

But though most of that remarkable boost is explained by mining, there was also a healthy increase in manufacturing investment.

And here's a point some people have missed: the second biggest contribution to growth in the September quarter (a contribution of 0.7 percentage points) came from the allegedly cautious consumer.

Consumer spending grew by 1.2 per cent in the quarter and by 3.8 per cent over the year to September. That's actually above its long-term trend. And consumer spending was strong in all the states, ranging from rises of 0.8 per cent in Victoria, 0.9 per cent in Western Australia (note) and 1.1 per cent in NSW, to 1.9 per cent in Queensland (more catch-up).

Although households are now saving about 10 per cent of their disposable incomes, this saving rate has been reasonably steady for the past nine months. So consumer spending is growing quite strongly because household income is growing quite strongly.

It's noteworthy that, according to Treasury, non-mining profits rose by 4.7 per cent in the quarter. And according to Kieran Davies, of the Royal Bank of Scotland, non-mining GDP grew by a solid 0.7 per cent in the quarter, just a fraction below trend.

So the notion that mining (and WA and Queensland) might be doing fine but everything else is as flat as a tack is mistaken. It's true, however, that some industries are doing it tough. Consumers are spending at a normal rate, but their spending has shifted from clothing and footwear and department stores to restaurants, overseas travel and other services.

Home-building activity declined during the quarter - a bad sign. The continuing withdrawal of the earlier budgetary stimulus meant that government spending fell by 2.5 per cent during the quarter. Public spending was a drag on growth in all states bar WA and Queensland (more catch-up).

Our terms of trade - export prices relative to import prices - improved by 2.7 per cent in the quarter (and by 13 per cent over the year to September) to be their best on record. But that's likely to be the peak, with key export prices falling somewhat in the present quarter.

The volume of exports rose by 2 per cent in the quarter, but the volume of imports rose by 4.3 per cent, mainly because of imports of capital equipment. So ''net exports'' (exports minus imports) subtracted 0.6 percentage points from overall growth in real GDP during the quarter.

Ah yes, say the gloomsters, but all this is old news - the September quarter ended more than two months ago. The economy must have slowed since then. After all, look at this week's news of a rise in the unemployment rate to 5.3 per cent in November.

It does seem true the labour market isn't as strong as the strength of economic activity would lead us to expect. This could indicate a degree of caution on the part of employers. But the rise in unemployment is slow and small, and if it's only up to 5.3 per cent we're still doing very well by the standard of the past 20 years.

As for the tempting line that everything's gone bad since the strong growth in the September quarter, just remember: that's what the gloomsters said when they saw the good growth figures for the previous quarter. Turned out to be dead wrong.

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Breakdown in relations is everyone's business

I get to meet a lot of famous and interesting people in my job, but few have had more influence on me than Dr Michael Schluter, the social thinker, social entrepreneur and founder of Britain's Relationships Foundation.

They say genius is being the first to say the obvious. If so, Schluter is one. I'm sure Socrates or Aristotle beat him to it but, in our time, Schluter is the first to forcefully remind us of something we all know: the importance of our human relationships.

We are, above all, social animals. After we've secured our physical survival, the most important thing in our lives is our relationships: with friends, neighbours, workmates and, above all, with our families - our parents, siblings, spouse and children.

Even if we've avoided speaking to them for years, even if they're dead and gone, we can't stop thinking about them. If we've cut ourselves off from our families, be sure we've sought to fill the vacuum with other relationships. Take away all our relationships and who'd have much reason to live?

So much for stating the obvious. But here's Schluter's simple, unarguably telling, point: if our relationships are so fundamental to our well-being, why do we keep forgetting to take account of them in our strivings? Wouldn't we be better off if we got into the habit of viewing all our endeavours through a lens that focused on their implications for our relationships?

How often do divorce lawyers advise people to avoid all attempts at reconciliation with their estranged spouse for fear of weakening their legal position? How often do doctors treat physical symptoms that aren't what's really troubling their patient?

How often do politicians who loudly proclaim their support for the family then consider 101 policy proposals without a thought as to their implications for people's relationships? As for economists, their model is so narrowly focused on the individual that they become oblivious to the potential effects of the policies they advocate on the relationships that sustain all individuals.

The truth is much of our ever-increasing material affluence over the past 200 years has been achieved at the expense of our relationships; by making the workings of the economy ever bigger, more complex and impersonal; by encouraging economic transactions between people who've never met, let alone had a relationship with each other.

Back to Schluter's insistent reminder: aren't we paying a price for ignoring the relational implications of all this? Wouldn't we be better off if we put the protection and promotion of our relationships back into the formula?

So far have we strayed from recognising the primacy of our relationships that the proposals of the mild-mannered, respectable, god-fearing Schluter sound positively radical.

About 150 years ago, the invention of the limited-liability company allowed people with money to invest to become owners of companies without taking any part in their management. The development of stock exchanges allowed people to buy and sell their shares in a company as easily and often as they liked. From these innovations came the huge corporations that dominate the economy today.

Economists see them as milestones on our path to prosperity. Schluter sees the downside. So, last month, in troubled Britain, he and a colleague, Jonathan Rushworth, launched a plan, Transforming Capitalism from Within: a Relational Approach to the Purpose, Performance and Assessment of Companies.

He proposes that enlightened firms submit themselves to the discipline of a 10-step ''relational business charter''. Step one is for the company to include in its articles of association a goal to become a profitable and sustainable business for the benefit of all its stakeholders - owners, directors, managers, employees, suppliers and customers - and the wider society.

Step two is to promote dialogue among company stakeholders, preferably through regular, face-to-face meetings.

Step three seeks to reduce ''relational distance'' between shareholders and the employees and other stakeholders by promoting share ownership by named individuals and family trusts rather than institutional investors such as pension funds.

The goal could be 25 per cent direct ownership pursued, partly, by encouraging employees to own shares. Ideally, a growing proportion of shareholders will live close to the company's main base.

Next, to achieve commitment, involvement and responsibility by shareholders, relational firms should encourage long-term ownership, perhaps by issuing additional shares to those who hold their shares for long periods.

Step five is for companies to help their employees achieve work-life balance by minimising long working hours and work at unsociable hours (including weekends) wherever possible. These things have a direct effect on the families of employees, particularly if the employee will not be present to share the bringing up of children.

Then firms will seek to respect the dignity of all employees by minimising remuneration differentials within the business. A ratio of 20:1 between top and bottom would be a good benchmark.

Relational companies will treat suppliers fairly and with respect, paying them promptly and giving them support to develop their businesses.

Relational companies will treat their customers and the local community fairly, respecting their concerns about reasonable payment terms and adequate service.

Step nine involves companies protecting their business and stakeholders by minimising the risk of financial instability, limiting their ''gearing'' - ratio of borrowing to shareholders' funds.

Finally, relational companies will fulfil their obligations to the wider society by paying a reasonable proportion of profits in tax in the country where those profits were earned. They will also spend a reasonable proportion of profits on corporate social responsibility.

The musings of a hopeless dreamer? I think our companies' present ruthless pursuit of profit at any cost is an excess that can't last. Schluter is a prophet pointing the way back to more sensible capitalism.

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