Game theory can be practical

Children play games. Teenagers play video games. Footballers play games. Economists don't admit to playing games. They prefer to say they study game theory.

This week two academic gamesters, the economist Alvin Roth, of Harvard Business School, and the mathematician Lloyd Shapley, of the University of California, Los Angeles, were awarded the Nobel Prize in Economics for their efforts.

This brought to 10 the number of academics who've won the prize in recent years for helping to develop game theory.

You read a lot about economics in newspapers, but you rarely read about game theory. This may be because, as yet, it's still pretty theoretical without much practical application - though, as we'll see, Roth's endeavours are a notable exception.
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But, as all those prizes attest, it's a relatively new area of economic inquiry, one the academics are greatly excited by and believe holds much promise. It's also an approach that's spread to other social sciences.

I'll try to explain it simply, using information cribbed from various sources, but it's actually highly mathematical - another reason it's so attractive to academics, who seem to be turning economics into applied maths.

Economists study how societies allocate resources between competing uses. Conventionally, they study how this is achieved by the movement of prices paid in markets bringing supply and demand into equilibrium.

The standard model assumes the buyers and sellers in those markets are each so small they have no effect on the prices being paid. In reality, many markets are dominated by a few big companies which do have the ability to influence the price.

So game theory began as an alternative way of studying the behaviour of the many ''oligopolies'' that characterise modern economies.

Game theory is the study of how people or firms behave in ''strategic'' situations - those where each player in a market, when deciding what to do, has first to consider how others might respond to that action. So, like a game of chess, the ''games'' economists study have a set of players, a set of moves or strategies available to those players and a range of ''payoffs'' (consequences) of each combination of strategies.

Economists use game theory to describe, predict and explain people's behaviour. They've used it to study auctions, bargaining, merger pricing, oligopolies and much else.

Unlike conventional analysis, game theory allows the possibility of ''multiple equilibria'' - more than one possible outcome the participants regard as satisfactory. And it studies ''decision-making under uncertainty'' - having to make decisions without knowing what the future holds.

Game theory is also able to study co-operative games (where players may form coalitions in competing with other players) as well as non-co-operative games (where all players compete as individuals).

For the most part, however, game theory retains the conventional (unrealistic) assumption of ''rationality'' - people know what's in their best interests and that's what they do.

Game theory began with simple two-player, ''zero-sum games'' - if I win, you must lose. It's moved on to multiple-player, positive-sum games - games where all players may gain because of the ''gains from trade'' (exchange) between people.

The classic game is ''the prisoner's dilemma'', where two prisoners must separately decide whether to co-operate with the other (by admitting nothing) or to ''defect'' (dob in the other in the hope of a lighter sentence). It shows why, in the absence of trust between them, the prisoners may choose not to co-operate (the ''rational'' choice for each), even though it's in their best interests to do so. This game is so famous because it studies the great problem of civilised societies: how to deal with ''free-riders'' - people who take advantage of others' willingness to co-operate.

The work of Shapley and Roth is a long way from that. Shapley, a theoretician who did most of his work in the 1960s, studied ''matching markets''. In most markets you choose what you want and hand over your money. In matching markets you make your choice, but you also need to be chosen by the other side.

If a market has an application or selection procedure, it's a matching market. Such markets determine some of the most important changes in our lives. Marriage, for instance. You don't like thinking of marriage as a market? That's why, in many matching markets, the transaction occurs without the use of money. Using money to determine who gets what would be ''repugnant''.

Shapley was concerned with reaching outcomes in non-monetary matching markets that were ''stable'' - where nobody wanted to change their pair in the belief they could do better.

(This equilibrium is the co-operative games' equivalent to a ''Nash equilibrium'' in non co-operative games. In a Nash equilibrium, each player is making the best choice they can, given the choices of the other players. John Nash, an earlier Nobel laureate, was the mentally disturbed mathematician played by Russell Crowe in the movie, A Beautiful Mind.)

Shapley's contribution, with David Gale, was to discover an algorithm (a mathematical set of rules for solving a problem) that would lead to stable pairs. Say thousands of students have applied to enter 20 universities, setting out their preferences.

The algorithm turns on ''deferred acceptance'' - the unis make their offers, the students select the best offer they've received, but delay accepting it, rejecting any other offers. The unis make further rounds of offers until the process is complete and students then accept the best offer they've had.

Gale and Shapley proved their algorithm always leads to stable pairs. They also showed the side that starts the process gets the better deal. Their approach discourages players from attempting to game the system by not stating their true preferences.

The contribution of Roth, who spent time at Sydney University this year, is more practical. He's taken the Gale-Shapley algorithm, studied it using laboratory experiments and applied it to real-world matching exercises.

He's expert in ''market design'' - changing the rules in markets so they work more efficiently in producing the best outcomes for people. He says a ''free market'' is one that moves freely in achieving efficient outcomes, not necessarily a market with no intervention by the government. In the United States, Roth has helped make changes that improve the pairing of medical interns with hospitals, the pairing of students with high schools and the matching of kidney donors with recipients. He's also done the last one in Australia, actually improving some people's lives.

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Psst. Don't tell anyone about poverty

It's remarkable that, despite all the effort and expense the government goes to in measuring gross domestic product, it doesn't run to the modest extra expense of measuring poverty. But this being so, it's hardly remarkable the media and the public pay far more attention to the gyrations of GDP than to the extent of poverty.

Why the lack of official interest in such a basic measure of how we're doing as a nation? Because, in an egalitarian country such as ours, poverty isn't much of a problem?

Err, no. In the mid-2000s, Australia's rate of poverty was the fourth highest among 18 developed economies. Surely the reason couldn't be that our record is so bad that the government would prefer us not to think about it? Hmmm.

The more I think about it, the more I want to know what there is to know about poverty in Australia.
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And, when some of our big charities - Anglicare, St Vincent de Paul and the Salvos - feel it worth expending some of their precious funds to commission a report on the subject, as they did this week, I'm inclined to take notice. Who knows when next the problem will be drawn to our attention?

As you've seen from the headlines, the report finds that more than 2 million Australians - one person in eight - is living in poverty. This poverty rate of almost 13 per cent has changed a bit but not a lot over the past decade. It's not shooting up, but neither is it falling.

What exactly is meant by ''living in poverty''? How is it measured?

There is more to being poor than just an absence of money. Another dimension is how isolated you are from the support of other people. But this measure - calculated from official surveys by the social policy research centre at the University of NSW - is a purely monetary one.

The next point is that poverty is measured differently in rich countries from poor countries.

In the developing world they measure ''absolute poverty'' - whether you're so poor you're at risk of death from malnutrition.

In rich countries few people, no matter how poor, are starving. So we measure ''relative poverty'' - how many people or households have incomes well below what's typical in our community. And how low is ''well below''? Usually, that's a case of drawing an arbitrary line, and drawing it so low there isn't much room for argument.

This study sets the poverty line at a level commonly used in comparisons between the rich countries. It ranks the disposable (after-tax) incomes of all households from highest to lowest, then draws the line at 50 per cent of the median (dead-middle) income.

The study finds almost 13 per cent of households fall below the line. Hold that thought.

The main way people avoid poverty is by having a job and earning income from it. So you'd expect that, unless people were on particularly low wages, or could find only part-time work, or had a lot of others depending on them, working households would avoid poverty.

The main way governments seek to avoid poverty in the community is by paying a range of social security benefits to those people who, for one reason or another, are unable to work.

Those too old to work get the age pension; those too sick get the sickness benefit; those physically or mentally unable to work get the disability support pension; those too busy minding children get the single parenting payment; those too busy caring for a relative get the carer payment. And those who just can't find a job get the dole.

The federal minimum wage - increased each year by Fair Work Australia - is comfortably above the poverty line which, in 2010, was $358 a week for single adults.

And, most people with children to support get the relatively generous family tax benefit.

So why do 13 per cent of people fall below the poverty line? The biggest single reason is that the levels of the various social benefits fall below the line. Way below in the case of the dole; a little below in the case of the single parenting payment and the age pension.

It follows that, unless they can supplement their payment with income from savings or a little part-time work, people living on social security payments are at great risk of poverty. Overall, 37 per cent of people on social payments live below the line. But the proportions vary widely according to the type of payment: 14 per cent of those on the age pension, 42 per cent of those on the disability pension, 45 per cent of those on the parenting payment and, get this, 52 per cent of those on the dole. Not surprising then, that people on social payments account for almost two-thirds of those in poverty.

The next most important factor explaining why people fall below the line is the high cost of housing.

In particular, the gap between the costs of owning and renting. It's a safe bet the majority of people in poverty are renters.

It may surprise you that the retired account for only about 15 per cent of those below the line. That's because so many own their homes outright.

When you're measuring relative poverty, it follows as a matter of arithmetic that the only way to reduce the proportion of people falling below the line is for their incomes to increase at a faster rate than incomes generally.

Julia Gillard could reduce poverty at a single (expensive) stroke: a decent, one-off increase in the indefensibly low rate of the dole.

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Reserve Bank moves to Plan B on interest rates

IT'S not at all clear that falling commodity prices - or the Reserve Bank's latest cut in the official interest rate - will lead to a lower Aussie dollar. But if it doesn't fall, and the economy doesn't look like it will stay growing at its trend rate, the Reserve will just keep cutting rates.

The best way to think of the Reserve's problem in using monetary policy (interest rates) to maintain non-inflationary growth is that for some years it's been trying to keep the economy on an even keel while we're being hit by two powerful, but opposing economic shocks: the expansionary shock from the resources boom and the contractionary shock from its accompanying very high exchange rate.

This involves predicting, then continuously monitoring the relative strengths of the opposing forces, with the objective of keeping inflation in the 2 to 3 per cent range and the economy growing at about its medium-term trend rate of 3.25 per cent a year - neither much less than that nor much more (because the economy's already close to full employment).

For most of last year the Reserve's greatest worry was that the stimulus from the resources boom, applied to an economy already near full employment, would push up inflation. By November it realised any inflation threat had passed - it was actually falling - whereas growth was on the weak side of trend. It therefore cut the cash rate by 125 basis points (1.25 percentage points) between November and June.
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The latest reassessment of the balance between the two conflicting forces bearing on the economy is that the fall in coal and iron ore prices and the shelving of expansion plans by some second-tier miners will cause mining investment spending to peak in the middle of next year, a little earlier and a little lower than expected.

This pushed the growth forecast for the overall economy a bit below trend. Hence this month's rate cut.

It's reasonable to attribute the Aussie's remarkable strength since the start of the resources boom predominantly to our high commodity export prices and vastly improved terms of trade.

That makes it reasonable to expect the fall in export prices would lead to a commensurate fall in the Aussie, thus reducing its contractionary effect on our export and import-competing industries.

But the historical correlation between our terms of trade and our exchange rate, while strong, can also be quite loose for fairly long periods. So it's not surprising the Aussie has held up so well.

The plain truth is that, because financial markets simply aren't as ''efficient'' as it suits some economists to believe, no theory they can come up with adequately and always explains the Aussie's ups and downs.

The best you can say is the terms-of-trade theory works well a lot of the time and over the medium to long term, while its main rival - that the Aussie's driven by the size of the ''differential'' between our interest rates and those on offer in the big economies - sometimes works at other times.

So it's equally unsurprising the 150-basis-point fall in our official interest rate since November has done little or nothing to get the Aussie down.

My guess is the Aussie could stay much where it is for years to come. Why? Because of a third, omnibus theory: those countries with the best growth prospects tend to have strong exchange rates whereas those with poor prospects tend to have weak exchange rates.

It's a safe bet that, even if we were to fail in our attempt to get growth back up to trend, our prospects will stay a mighty lot better than those for the United States and Europe. Then there's our AAA sovereign credit rating and exposure to the fastest-growing region, Asia, to entice capital inflows.

Remember, exchange rates are relative prices, so if some countries are down, others must be up. We're not alone in the strong-currency boat: there's also Switzerland, Canada, New Zealand and Sweden.

So, what if the Aussie stays up and its contractionary effect on the economy remains undiminished? The Reserve would just keep cutting the official rate until it foresaw growth getting back up to trend.

In principle, the only thing that could deter it from this response is rising inflation pressure, but with growth below trend that's hardly likely.

Its goal wouldn't be to get the dollar down (though that would be welcome) so much as to stimulate the presently ailing, interest-sensitive parts of the domestic economy: home building and commercial (as opposed to mining-related) construction.

This would quite possibly get house prices growing reasonably strongly which, in turn, could perk up consumer confidence, particularly for people in or near retirement.

But that's actually the vulnerability in such an approach by the Reserve. Returning to a period of exceptionally low mortgage interest rates risks igniting another credit-fuelled boom in property prices, at a time when many households remain heavily indebted and most foreign economists can't understand why we haven't had a property bust.

The rich world spent most of the 1970s, '80s and '90s worrying about how to get inflation down to acceptable levels. We now know that, particularly since the advent of independent central banks and inflation targeting, the central bankers have got (goods-and-services price) inflation licked.

One small problem: as the global financial crisis so powerfully reminded us, in the process they've aggravated the problem of asset-price inflation, with its huge bubbles and terrible busts.

To date, the world's monetary economists are at a loss on how they can control goods-price inflation and asset-price inflation at the same time.

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Labour market can be flexibile as well as fair

If you listen to business, we still have big problems with the labour market. John Howard deregulated it, but then Julia Gillard re-regulated it and now we can't do a thing with it.

The business people are right to this extent: particularly at a time when the economy is under so many pressures for change in its structure - the rise of the emerging market economies and the resources boom it has produced, the digital revolution, the return of the prudent consumer, and more - we do need a labour market that's "flexible".

But what exactly does flexibility mean? Well, not what some bad employers think: unilateral freedom to change their staff's working arrangements without recompense or consultation. That's one-sided flexibility.

No, what flexibility should mean is the ability of the labour market to adjust to the shocks that hit the economy without generating excessive inflation or unemployment. You get some, but it doesn't linger for years.

Another word for it is "resilience" - the ability to take the punch, then bounce back.

So how are we doing on that score? A lot better than business's complaints may lead you to believe. In a speech this week, Philip Lowe, the deputy governor of the Reserve Bank, reeled off a host of respects in which the labour market is more flexible.

He started by noting that, despite all the gloominess - and notwithstanding its apparent rise to 5.4 per cent last month - the official unemployment rate is still very low by the standards of the past 30 years.

In that time there have been only four years in which the unemployment rate has averaged less than 5.25 per cent. (Note for sceptics: contrary to urban myth, the method of calculating the rate hasn't changed in that time.)

Lowe reminds us Australia has one of the lowest unemployment rates among the advanced economies - "an outcome that seemed improbable for much of my professional career".

Although the unemployment rate has been virtually unchanged for more than two years, this conceals a great deal of coming and going from jobs. The figures show that in February this year, about 2.3 million people - almost a fifth of the workforce - were newly employed, having been in their job for less than a year.

Whereas a little less than half of these people were starting work for the first time (or for the first time in a long time), 1.2 million people moved from one job to another. And this in a year when the net growth in employment was a mere 23,000.

In other words, a fraction more people gained jobs than lost them, even though the media trumpeted the job losses and said next to nothing about the job gains.

About three-quarters of the job changes were voluntary, including for personal reasons or to take advantage of new opportunities. The remaining quarter was involuntary, including because employers went out backwards or changed the nature of their business.

It's always true that far more people move around than we imagine when we see the small net changes from month to month. In the jargon, "gross flows" far exceed net change. But Lowe finds some evidence all the structural pressures affecting the economy at present have led to a higher rate of job turnover.

If you take all the people who left their job over the year to February and compare it with the all people employed at some time during the year, this was the highest in two decades.

That's true for both voluntary and involuntary "separations" - meaning it's a sign of greater flexibility in the labour market. It suggests that, while a lot of jobs ceased to exist, at the same time a lot of new job opportunities opened up in other parts of the economy and many displaced workers were able to find new jobs without much drama.

Another indication some parts of the labour market are expanding while others are contracting is that the official measure of the number of job vacancies has remained relatively high, even though the growth in employment overall has been so small.

Consider this: since 2007, about 300,000 net additional jobs have been created in the health care sector, 200,000 in professional and scientific services, and about 130,000 each in mining and education.

So where's the downside? Employment in manufacturing has fallen by about 70, 000 and the number of jobs in retailing has stopped growing.

Despite this significant variation in employment growth by industry, there hasn't been any widening of the rates of unemployment among the nation's 68 local regions. Compared with 10 years ago, the average unemployment rate is lower and the variation between regions is lower, not higher.

About half the regions have unemployment rates below 5 per cent and almost three-quarters have rates below 6 per cent. In only three regions is the rate above 8 per cent, compared with 13 regions a decade ago. That's lovely, but what about wages? Here there has been increased dispersion. Since 2004, average wages in mining have risen by about 10 per cent relative to the economy-wide average. Workers in professional services have also experienced faster-than-average increases, Lowe says.

Conversely, relative wages have declined in the manufacturing, retail and the accommodation industries, each of which has experienced difficult trading conditions in recent times.

Sounds pretty flexible to me. This adjustment of relative wages has help move workers around the changing economy so shortages of skilled workers in some areas have been fairly limited.

Lowe observes the adjustment of relative wages has occurred "without igniting the type of economy-wide wages blowout that contributed to the derailment of previous mining booms".

He declares the industrial relations system is more flexible than it was two decades ago and says it's essential the labour market retains its flexibility. But though industrial relations laws and practices are important in this, "they are by no means the full story".

"Flexibility also comes from having an adaptable [my emphasis] workforce - one that has the right general skills, the right training and the right mindset," he concludes.

"Whether or not Australia fully capitalises on the opportunities that the growth of Asia presents depends critically upon the ability of both workers and business to adapt, and to build and use our human capital."

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The Asia boom is just getting going

Have you noticed how joyfully the media trumpet the bad news they seek out so assiduously? The latest is that the resources boom is finally busting. O frabjous day! Callooh! Callay!

It's true the prices we're getting for our exports of coal and iron ore, having lifted the terms on which we trade with the rest of the world to their most advantageous level in 200 years in the September quarter of last year, have been falling ever since and have further to go.

It's true China's economy has slowed markedly in recent times and this, combined with the fall in export prices, has prompted some of our smaller mining companies to shelve their plans for new mines.

And last week the Reserve Bank warned the peak in mining investment spending was likely to occur next year and reach a lower level than earlier expected. Fearing a slowdown in the economy, it cut the official interest rate another notch.

So, is this the dumper many people have feared? Is the much ballyhooed resources boom about to disappear into the history books?

Don't be misled. As the secretary to the Treasury, Dr Martin Parkinson, argued last week, it was always misleading to think the resources boom, being just another boom, would soon bust, leaving us in the lurch with nothing to show but holes in the ground.

For a start, it's a bit previous to be kissing the boom goodbye. Spending on the building of new mines and liquefied gas plants is expected to keep growing strongly for another year before it starts to fall back. Even then it will stay way above what we normally see for several more years.

Coal and iron ore prices may be falling, but don't imagine they'll return to anything like what they were. At their best, our terms of trade - the prices we get for our exports relative to the prices we pay for our imports - were almost 80 per cent better than their average throughout the 20th century.

The econocrats now expect that, by 2019, they will have collapsed to a mere 50 per cent above that 100-year average. Nothing to show for it? This means we'll remain wealthier than we were (our exports will continue buying far more on world markets than they used to).

Taken by itself, this lasting improvement in our terms of trade suggests another thing we'll have to show is a dollar that stays well above the US70? or so it averaged in the decades following its float. That means a dollar that remains uncomfortably high for our manufacturers and tourism operators.

All this ignores a further benefit from the resources boom which, though it's already started, is largely still to come: vastly increased quantities of coal, iron ore and natural gas for export. This, too, adds to our wealth.

Before the start of this supposed here-today-gone-tomorrow "boom" - which began almost a decade ago - mining accounted for less than 5 per cent of the nation's total production of goods and services. Its share is now well on the way to 10 or 12 per cent.

At the same time, manufacturing's share will continue its decline from about 15 per cent in 1990 to 12 per cent at the start of the boom and 8 per cent today to maybe 6 per cent by the end of this decade. (Much of this decline, however, is explained by the faster growth of the services sector as we, like the rest of the rich world, move to a knowledge-based economy.)

So yet another lasting effect of this fly-by-night boom is a marked and lasting change in the structure of our economy. To the consternation of some, the non-services part of our economy is becoming less secondary and more primary.

The underlying reason for this shift is the same reason it was always mistaken to imagine this is a transitory commodity price boom like all those we've seen before: the economic emergence of the developing world, led by Asia.

With the industrialisation of China and India, the globe's centre of economic gravity is shifting from the North Atlantic to the Indian and Pacific oceans. It's happening so fast it's visible to the naked eye. All the economic troubles of the Europeans and Americans are speeding it up, not slowing it down.

Remember how the world's richest 20 per cent owned 80 per cent of the wealth? Forget it. The poor countries already account for half the world's annual production of goods and services. Over the next five years, they'll account for three-quarters of the growth in world production.

So we're witnessing a tremendous change in the structure of the world economy, something so big economic historians will still be talking about it in 200 years' time. Is it surprising the effects on our economy are so big and so lasting?

We're greatly affected because of our proximity but also because our economy is so complementary to the emerging Asian ones. We have in abundance what they need in abundance: primary commodities. Their need for our raw materials will roll on for decades, including as Indonesia transforms itself from the world's fourth most populous country to its fourth richest.

This raises the final reason the mining boom shouldn't be lightly dismissed. As Parkinson reminded us, it's just the first wave of change arising from the Asian century. Next comes the rural boom as global demand for agricultural produce surges.

The third wave is the global growth in the middle class - from half a billion to more than 3 billion souls - with its growing demand for better services, goods and experiences. Just another passing boom?

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We need to talk about the budget

I have a terrible fear that just as the rest of the developed world is demonstrating how much better off our three decades of budgetary discipline have left us, we're in the early stages of letting it slip.

Australians have drawn many (usually disheartening) conclusions from the tribulations of the Europeans and Americans since the global financial crisis, but they don't seem to be getting the most obvious message: thank god we've kept our nose clean on the budget.

You can look at the Europeans' problems and say the key to them is the unsound basis on which they built their common currency, but the euro wouldn't be in trouble were it not for the decades of fiscal (budgetary) indiscipline of so many of its member countries.

They've gone for 30 years or more not bothering to balance their budgets and, as a consequence, building up huge levels of government debt. Add the crisis and its need to bail out banks and stimulate economies, and debt levels jump to the point where a banking crisis morphs into a sovereign debt crisis.

This story of laxity is matched in the United States (not to mention Britain). Although America's long-term bond rates are extraordinarily low - evidencing little sign of concern by the bond market - it's clear the Americans face considerable difficulty getting their growing deficit and debt levels under control.

In marked contrast, Australian governments - federal and state - have been obsessed by the need to restrain deficits and debt since the early 1980s, notwithstanding the ups and downs of the business cycle in that time.

The development of a suitably responsible but cyclically flexible "framework" for the conduct of fiscal policy began with the Hawke government's budget "trilogy" and culminated in Peter Costello's charter of budget honesty and medium-term fiscal strategy, requiring the budget to be balanced "on average over the medium term".

What makes our performance so remarkable isn't our early start in the design of budgetary commitments, but that successive governments have stuck to them.

That's true even of our budgetary response to the financial crisis. Kevin Rudd was able to unleash huge budgetary stimulus because net federal debt had been eliminated. But the medium-term strategy effectively required the increased spending to be temporary, and so it was.

Many Australians probably don't realise the Europeans' and Americans' budgets face enormously increased pressure over the next decade and more as the baby boomers retire. Why? Because governments long ago set up highly generous public pension schemes that haven't been adequately funded by employee contributions.

Yet again, we're in the clear. The cost of our low, flat-rate, means-tested age pension will not blow out much as the baby boomers retire. (Admittedly, the tax concessions attached to superannuation are far too expensive, though that's not a baby-boomer problem. And the Rudd-Gillard government is taking steps to wind them back.)

The depth of Australians' aversion to deficits and debt is well demonstrated by the opposition's success in frightening the punters over the modest rise in public debt following the financial crisis, and the government's manic determination to get back to surplus in 2012-13 come hell or high water.

So why my fear that, in terms of our commitment to fiscal rectitude, this is as good as it gets? That, just when we're witnessing the huge trouble we've avoided by being so disciplined, we're preparing to lurch into indiscipline?

Because both sides of politics are gearing up for next year's federal election with wildly expensive commitments they'll have enormous trouble fitting into a balanced budget. And because, though neither side wants to admit it, the revenue side of the budget is in so much trouble.

Each side is leading us down a different garden path. Labor is trying to buy the election with promises of vastly increased spending on a disability insurance scheme, grants for schools and much else. It's given us absolutely no indication of how it will pay for this spending "going forward".

For his part, Tony Abbott is trying to buy the election with promises to abolish the two new taxes that raise about $10 billion a year, the proceeds from which are already fully committed. For good measure, he's promising to lower the tax burden generally.

It's hard to believe either side would have sufficient discipline - sufficient willingness to impose deeply unpopular spending cuts - to pay for their promises and leave the budget bottom line heading ever further into surplus as we steadily eliminate the net public debt both sides profess to be so concerned about.

And that's before you take account of the two complications the Treasury secretary, Dr Martin Parkinson, reminded us of in a major speech on Friday. First is that economic growth - and hence, tax collections - in coming decades will be slower for demographic reasons (more on that another day).

Second, the serious structural problems on the budget's revenue side: income tax's loss of bracket-creeping power thanks to eight years of tax cuts; company tax's problems with the miners' huge depreciation deductions and the evaporation of capital gains, and the goods and services tax's problems with the return to normal growth in consumption and the changing pattern of consumer spending.

All these weaknesses say it will be a long time before tax revenue returns to its earlier proportion of gross domestic product, if it ever does.

"Combined," Parkinson says, "the slowing economic growth, rising expectations of government, and a constrained revenue base, are likely to force an explicit debate about the size and scope of government."

Bring it on.

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How the financial system works

It’s amazing to think the mighty, mysterious, overawing edifice of high finance - run by people much smarter and infinitely better-paid than us - is built on a pathetically simple, often fickle emotion: trust.

This is something economists and bankers understand in theory but, in their world of high-falutin’ mathematical models, keep forgetting in practice - to everyone’s cost. In this they exhibit the very human fallibility they so often assume away in their fancy calculations.

It’s also so elemental - and so humbling - they rarely talk about it. So when someone in authority spells it out for the benefit of mere mortals, it’s work taking note. An assistant governor of the Reserve Bank, Dr Guy Debelle, did so in a speech last week.

He started by explaining what banks and the financial sector do. They act as ‘intermediaries’ between savers and borrowers, taking the funds they raise from savers - through deposits, for instance - and lending them to those who wish to borrow, whether they’re businesses, governments or householders.

The financial sector is an intermediate sector, Debelle says. It’s not at the end of a production chain producing something that directly generates satisfaction. Rather, it’s a critical link along the way; the oil that keeps the economy ticking over. ‘When the oil dries up,’ he says, ‘the economic engine starts to malfunction and can ultimately grind to a halt.’

So the financial sector is different from other parts of the economy and its central role in keeping the rest of the economy functioning explains why it’s subject to considerably more government regulation and oversight than other industries (something many governments forgot in the years before the global financial crisis).

But why do we need financial intermediaries? Why don’t savers lend to borrowers directly? Mainly because of ‘asymmetric information’. This just means I know more about my affairs than you do. It’s hard for a saver to know whether the person or business to which they’re going to lend money will use the money wisely and be in a position to repay the loan when it falls due.

In contrast, a bank is practiced at making such an assessment of credit-worthiness and so can reduce (but never eliminate) the degree of asymmetry. The size of the interest rate charged by the bank should reflect its assessment of the degree risk of not being repaid.

The other main advantage of lending via intermediaries is their scope for ‘diversification’ - making a range of different loans to people or firms in different circumstances means the bank should not be overly exposed to a particular loan going bad.

So banks are able to ‘mutualise’ risk in a way individual savers can’t. ‘If there is a problem with one loan, the lender should be earning sufficient interest on the rest of its loan portfolio to cover the loss,’ Debelle says.

Now we see where trust comes into it. Largely because of the problem of asymmetric information, there has to be trust between depositors and the bank that their funds are safe. And there is trust between the bank and its borrower that the borrower has provided accurate information and will act in good faith.

Trust is needed to cover the asymmetry that remains despite the ‘due diligence’ of the depositor in assessing the riskiness of the bank and of the bank in assessing the riskiness of the borrower.

Trust is particularly important because banks engage in ‘maturity transformation’ - in the jargon, they ‘borrow short and lend long’. Banks will let you deposit your money ‘at call’ (you can withdraw it at any time) but, on the other hand, will lend this money for periods up to 30 years.

Were too many depositors to lose trust in their bank at the same time, it would not be able to call in all its loans and so would not be able to return the depositors’ money. To prevent such a thing occurring, central banks stand ready to lend to banks if they need it. The trust in these arrangements is almost always enough for them not to be needed, Debelle says.

Banks don’t always hold on their own books all the risk (debt) they’ve taken on, but use devices such as ‘securitisation’ (bundling many consumer loans into a bond, which is then sold to investors) to distribute the risk around the financial system.

This means the process of financial intermediation often has a number of links in the chain. This, in turn, means trust needs to be present at every stage in the chain. ‘One breakdown in this chain of trust between ‘counterparties’ can throw a spanner in the works of the whole process,’ he says.

Guess what? The global financial crisis can be explained as a consequence of the breakdown of trust.

The years leading up to the crisis were a period of what Debelle calls ‘lazy trust’. Things were going along fine, so too many people relaxed their due diligence. Too many borrowers were taken at their word, without checking.

‘Moreover, with long chains of intermediation involved, there was often too much distance between the ultimate holder of the risk and the source of the risk. Too many links means that details get lost or misheard. If the due diligence is necessarily incomplete by the very nature of financial transactions, then that incompleteness is likely to get magnified, the more chains there are in the transaction.

‘The due diligence gets dissipated along the chain. There is a presumption that someone further up the chain did the due diligence.’

Such behaviour was anything but rational. As Debelle concedes, ‘good times beget complacency’. ‘It does seem to be a trait of human behaviour that has been evidenced many times in financial history.’

Lazy trust evaporated. The financial system switched rapidly from complacency to deep mistrust. In particular, trust broke down between financial institutions. Knowing they had a lot of bad loans on their own books, institutions assumed the same was true of their competitors, though to an unknown extent.

Institutions stopped lending to each other, so intermediation broke down. Central banks had to step in and provide banks with the funds they needed. This is still true in Europe, and a lack of trust in the longevity of the euro has made people unwilling to lend even to some governments.

The trouble now is that trust can be quickly and easily shattered, but takes a long time to rebuild.

Read more >>

GLOBALISATION - the importance of an economically literate Australia

Business Educators Australasia Conference, Sydney, Thursday, October 4, 2012

Just as the media have lost interest in talking about globalisation it’s starting to have big effects on Australia and on the daily lives of Australians. Often, the consequences of globalisation are buried too deep to be visible to the untrained eye, but that doesn’t change the reality. Why are overseas holidays a lot cheaper these days? Why are a lot of factories laying off workers? Why have the banks started putting up interest rates off their own bat, or not passing on all of the cuts in rates? Why isn’t my super doing as well as it used to? Why are the retailers always complaining? Why do the mining companies keep running all those ads telling us what great guys they are?

The short answer to all those questions is ‘globalisation’. Whenever something changes in Australia we have a tendency to look around us for an explanation. Increasingly, however, the explanation comes from elsewhere in the world. If we want to understand what’s happening to our lives - the forces shaping our lives - we need to understand globalisation: what it is, what’s driving it, how it affects us and where it’s taking us. To be economically literate - to have an understanding of what’s going on - Australians need to understand the process of globalisation. For many of our students, high school is the main chance they’ll have to learn about a largely invisible force that’s influencing their present and their future.

What is globalisation?

Globalisation is a process - a process by which the natural and human-made barriers between countries are being reduced. The natural barriers of time and space are being reduced by advances in technology, particularly the information and communications technology revolution. The human-made barriers between countries are being reduced by deregulation - governments pulling down or greatly liberalising the rules and regulations they have made to keep their economy separate from other economies. Sometimes governments pull down their barriers because advances in technology have made it easy to get around them. The point is that, as the barriers between countries and national economies are reduced, more of the forces changing our lives are coming from abroad.

The back story

I suppose you could say the process of globalisation began with the first trade between countries, by ship or on the Silk Road. But it’s generally held that the first wave of globalisation began in the late 19th century, with the spread of steel-hulled steamships, mass migration to the New World and the invention of the telegraph and laying of undersea cables. This first wave was brought to a halt by World War I and reversed by the protectionist reaction to the Great Depression.

The second wave began slowly after World War II, with the successive rounds of reductions in import duties and restrictions on trade under the General Agreement on Tariffs and Trade, developments in transport (including invention of the jumbo jet), information processing and telecommunications, the development of offshore financial markets and the advent of the multinational company.

At first the great increase in trade was between the developed countries themselves. But then the developing countries - particularly in Asia - began switching their development strategies from ‘import replacement’ (attempting to develop manufacturing sectors behind high barriers to imports) to export-led growth. Developing countries began lowering their protection, and the last round of multilateral reductions in import restrictions under the GATT - the Uruguay round of 1994 - saw many developing countries (including China) joining the newly formed World Trade Organisation.

The emerging economies

The greatly increased trade and flows of foreign direct investment between the developed and developing countries led to strong growth in many developing countries - particularly in Asia. Multinational companies set up manufacturing operations in these countries and transferred the latest technology, effectively spreading the industrial revolution and fostering rapid industrialisation and urbanisation. The most rapidly advancing economies - which are moving from poor to middle-income - are now referred to as ‘emerging economies’. Some countries - including South Korea and Singapore - are now classed among the high-income countries, as developed rather than developing.

Before the industrial revolution began in Europe in the late 18th century, the two biggest economies were China and India. That was on the strength of their big populations. Because China and India remain the two most populous countries, and because their economic emergence began earlier than many other developing countries, their development is shifting the world’s centre of economic gravity from the North Atlantic (America and Europe) towards Asia.

The standard pattern of economic development established in Asia in the decades since World War II has been the production for export of simple, labour-intensive manufactures such as textiles, clothing and footwear, taking advantage of the main thing the poor countries have to offer the world: an abundance of poorly educated but cheap labour. As this early trade starts to lift national income, the level of education and skill rises and the country progresses to producing more elaborately transformed manufactures. Although some people in rich countries imagine it’s not happening, education, skills and national income rise and so do real wage levels. Eventually, labour becomes too expensive for the country to continue producing simple, labour-intensive manufactures, so this production moves to other poor countries that are just starting out on the road to development. Countries that export also have to import; they tend to import those raw materials they don’t produce domestically and capital equipment for further economic development. Initially, economic development probably adds to income inequality in the emerging economies, even while lifting many people out of absolute poverty. Eventually, however, rising real wage rates should work to reduce inequality.

Changing world trade patterns

Historically, the developed countries have been importers of raw materials - food, fibre, minerals and energy - and exporters of manufactures. Much of the growth in their trade with each other since the war has been based on high levels of specialisation - ‘intra-industry trade’ (eg trade between the car makers in different countries) rather than on comparative advantage. Most of their economic growth has come from growth in their services industries - health, education, business services, culture and recreation - most of which hasn’t involved overseas trade.

With the rise of the emerging economies and particularly China, however, much of the world’s manufacturing activity is moving to Asia, causing manufacturing to contract in developed economies and faster growth in their sophisticated services sectors. But the ICT revolution is also making it possible for some services to be traded between countries. Initially this has involved the ‘outsourcing’ of fairly menial jobs such as call centres and data processing, but it is growing to include such high-end services as software development and sub-editing.

Many people in the developed economies are alarmed by the shift of jobs in manufacturing and services to the cheap-labour countries. They see it as a loss with no corresponding gain. Some have even convinced themselves there’s no gain to the cheap-labour countries because multinationals appropriate all the profits. They imagine that because we would not want to work for such pay and conditions, workers in the poor countries are being exploited and gain little. In truth, the poor countries gain greatly from their export income and local workers are keen to get a job and earn an income, particularly the generally better-paying jobs offered by foreign multinationals.

The gains from trade are mutual, though not necessarily equal. Rich countries (and their workers) gain from their access to cheaper manufactures and services, and also from their access to bigger markets for their exports. This is not to deny that the outsourcing of jobs causes pain to workers displaced from their jobs and needing to find new ones, nor that the benefits from trade with poor countries may be shared unequally.

Emerging economies take the running

For many decades, the United States and the other developed countries made the running for the global economy; their growth largely determined the world’s growth. Now, however, China, India and the other emerging economies have expanded to the point where they account for more than half of gross world product (when countries’ GDPs are combined after adjusting to achieve purchasing power parity), and for at least a decade their growth has accounted for most of the annual growth in gross world product. With the North Atlantic economies still mired by the GFC, this is likely to become even truer for at least the rest of the decade, which will hasten the shift in the world’s economic centre towards Asia. Similarly, whereas the cycle in world commodity prices used to be driven by the North Atlantic economies’ economic cycle, now Asia’s cycle - and its more structural demand - will drive.

Australia and the rise of Asia

Whereas the usual pattern is for developed countries to import raw materials and export manufactures, Australia’s huge endowment of national resources means for us it has always been the other way round: we tend to mainly export rural and mineral commodities and mainly import manufactures. For most of the 20th century it looked like we were getting the losing end of the stick. World trade in commodities wasn’t growing much and prices were stagnant, whereas trade in manufactures was growing strongly with ever-rising prices. About the time of the Sydney Olympics, in 2000, it was fashionable for foreign businessmen to condemn us as an ‘old’ economy.

What changed all that was the emergence of the Asian economies, led by China. When countries start to develop they require huge amounts of steel - to make exports but also for building factories, railways, bridges, buildings and even roads. When their consumers become more prosperous they want to buy appliances and cars made of steel. It just so happens that Australia is one of the world’s chief producers and exporters of the two main components of steel: iron ore and coking coal. China’s booming demand for coal and iron ore caught the world’s producers off guard, causing global demand to outstrip global supply, forcing prices up to unknown heights. The main commodity exporters are now rushing to expand supply. As they do prices will fall back.

Since the early noughties we’ve been selling China and India ever-growing quantities of iron ore and coking coal, plus steaming coal for use in power stations, all at exceptionally high prices. This is the origin of our resources boom which, as prices start to fall back, is continuing in a boom of investment in the construction of new mines and natural gas facilities. As this additional production capacity comes on line, the volume (quantity) of our exports of coal and iron ore will be expanding, even as the prices we get for them ease back.

Studies of the stages in the economic development of other, now-developed Asian economies - such as Japan and South Korea - suggest the period during which a rapidly developing economy needs exceptional amounts of steel can last for 20 or 30 years. This explains why the resources boom is regarded as more structural (lasting) than cyclical (temporary). It also explains why the lasting increase in demand for our mineral and energy exports will bring about a change in the industrial structure of our economy. The mining industry will account for a significantly higher proportion of GDP, and its expansion will attract labour and capital from other Australian industries, whose share of GDP will decline.

The rise in the value of the dollar, which has accompanied the rise in the export prices we receive, has worsened the international price competitiveness of our export and import-competing industries, particularly manufacturing, but also tourism and the education of international students. This has the effect of reducing those industries’ sales and profits. Some manufacturers have been hit hard, with factories closing and workers being laid off. The manufacturers are demanding additional government assistance, and get much sympathy from the public. But economists point out that the high dollar and its contractionary effect on manufacturing is actually part of the market mechanism that is helping to shift resources from the contracting manufacturing to the expanding mining. This, of course, doesn’t stop the process being very painful for the manufacturers and their workers.

The high dollar is one of the main ways ordinary Australians are benefitting from the resources boom. It is redistributing income from the miners to all those firms and consumers who buy (the now-cheaper) imports. Everyone who has taken advantage of the strong dollar to go on an overseas holiday is sharing in the benefits from the resources boom, whether or not they realise it. Even so, because the miners are doing so well from the boom they have been seeking to reduce public resentment of their good fortune by running advertisements pointing to all the good things they are doing in the community.

As China and India develop economically they are acquiring a larger and prosperous middle class, which is expected to grow considerably over the next 20 years. The growth of Asia’s middle class will increase the opportunity for greater Australian exports to Asia of food (meat, wheat and dairy products), manufactures and tourism.

The digital revolution

No technological development has done more to break down the barriers between countries than the digital revolution, particularly the spread of the internet, which is now being accessed more easily via tablet devices and smart phones. This is greatly benefitting the users of the internet, but is forcing considerable structural change on many industries.

The internet has undermined the ‘business models’ - the traditional way of selling products - of the music industry, film and television and, with the advent of the e-book, publishing and bookselling. The newspaper industry is being turned on its head by the shift of classified and display advertising and news to the internet and other digital ‘platforms’. The internet is also making many formerly non-tradable services tradable.

The retail industry is being hit and forced to change by a host of different forces: the end of the period in which households were reducing their rate of saving, thus allowing consumer spending to grow faster than household incomes; and consumers’ preferences shifting from goods to services. But the biggest challenge is coming from the digital revolution. People are using their smart phones in stores to compare prices with those offered by other stores and then demand discounts. And people are using the internet to buy online, including from overseas sites. This is not yet having a big effect on retailers, but it will in coming years. Retailers complain that people buying on the internet usually avoid having to pay the GST, and that the high dollar is making overseas prices more attractive. But these are not their biggest problem. It’s that multinational companies are used to selling identical books, CDs, DVDs, software, shoes and many other things at different prices in different countries. That is, for many years many big companies have engaged in international price discrimination, generally charging much lower prices in America than in Britain, with highest prices in Australia. The internet is breaking down this discrimination and will eventually force down many Australian prices.

Financial integration

Since the 1980s, reductions in the cost of telecommunications and deregulation have been turning the many national financial markets increasingly into one big set of global financial markets. As part of this, most developed countries have floating exchange rates, with the level of those exchange rates now affected less by trade flows (the current account of the balance of payments) and more by short-term capital flows (the capital account). This has increased the frequency of financial crises, such as the Asian financial crisis of 1997-98 and the global financial crisis of 2008-09.

Greater financial integration added to the severity of the GFC and the speed with which it spread around the world. While the crisis was centred on America’s sub-prime home loan debacle, it turned out many of these toxic assets had been bought by European banks. The globalisation of the media meant news of bank failures in the US, Britain or Europe was beamed into living rooms in all the countries of the world, almost in real time. This frightening news caused an instantaneous slump in business and consumer confidence in virtually every country, including many not directly affected by the crisis, such as Australian and China and the other emerging economies.

World recessions are usually sequential - some countries are still going in while others are coming out - thus making them less severe. But the world recession precipitated by the financial crisis was highly synchronised because of the integration of global financial markets and the globalisation of the news media. This contributed to the severity of the recession.

The greater integration of financial markets has increased the likelihood of ‘contagion’ - when one country gets itself into difficulty, this may cause the financial markets to lose confidence in neighbouring countries, whether or not they have the same degree of problems as the original country. After the tiny Greek economy got into difficulties within the euro area, European officials worried the market’s loss of confidence could spread to Portugal, Spain and even Italy.

Globalisation has increased the number of ‘channels’ through which economic difficulties in one country are transmitted to other countries. Formerly, the main channel was international trade. Now there’s a financial channel, where problems with the finances of one country lead to a global rise risk premiums, increasing borrowing costs in many other countries. And there’s a psychological channel, where bad news from one part of the world can damage business and consumer confidence in other countries, even those not directly affected.

The GFC and its aftermath in the US and Europe have had a big effect on our banks, even though they had been tightly supervised by our authorities and held few of the assets that became toxic. The world’s central banks have tightened their rules for the world’s banks, requiring them to hold higher proportions of shareholders’ capital and higher proportions of their funds in liquid form. This has increased the costs facing our banks along with other countries’ banks. Before the GFC, our banks obtained a high proportion of the funds they needed to relend to Australian customers from short-term borrowing in overseas markets. At the time, these funds were very cheap. But their price increased greatly as a result of the crisis. After the crisis, our authorities realised our banks’ heavy reliance on short-term foreign borrowing made them vulnerable to further international crises. So they required the banks to borrow for longer periods overseas and to rely more on domestic deposits. The greater competition between our banks to attract local deposits has greatly increased the interest rates they have to pay on those deposits (to the benefit of Australian savers). They’ve also had to pay more for their longer-term foreign borrowings. This has increased our banks’ cost of borrowed funds quite independently of changes in the official cash rate. And it explains why the banks have been increasing their rates without reference to the cash rate and cutting rates by less than the full fall in the official rate. The Reserve Bank has retained its control over market interest rates by cutting its cash rate by more than it otherwise would have.

Our sharemarket is another of the financial markets that has become more globally integrated in recent decades. Being one of the first markets to open each morning, it takes its lead from what happened on Wall Street overnight. You would hope that, eventually, the value of an Australian company’s shares will reflect that company’s own prospects. In the short-term, however, our market tends to reflect the worries of investors in Wall Street and Europe. And the prospects for those economies are not bright at present.

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The psychological roots of morality (and politics)

Paul Keating still quotes his early mentor, Jack Lang: "In the race of life, always back self-interest - at least you know it's trying". This may be why, as treasurer, Keating so readily embraced economic rationalism. The economists' working model assumes the self-interest of the individual is the sole force that makes the world turn.

Fortunately, the latest research tells us it's not that simple.

I can't go on a sight-seeing holiday without taking a few good books for a little intellectual sustenance at the end of the day. One book I took this time was a ripper, The Righteous Mind: Why good people are divided by politics and religion, by Jonathan Haidt, a moral psychologist at the University of Virginia.

Haidt (pronounced Height) says decades of research by political scientists have concluded that self-interest is a weak predictor of voters' policy preferences.

Why? Because people care about the groups they belong to - whether they be racial, regional, religious or political. They seem to be asking themselves not "what's in it for me?" but "what's in it for my group?". Political opinions function as "badges of social membership".

Whereas the old view was that natural selection had caused us to evolve into self-seeking competitors, Haidt argues we're more accurately thought of as "homo duplex" - a creature who exists at two levels: as an individual and as part of the larger society.

Human nature is mostly selfish: our minds contain a variety of mental mechanisms that make us adept at promoting our own interests, in competition with our peers, he says. But human nature is also "groupish": our minds contain a variety of mental mechanisms that make us adept at promoting our group's interests, in competition with other groups.

"We evolved to live in groups. Our minds were designed not only to help us win the competition within our groups, but also to help us unite with those in our group to win competitions across groups," he says. "We are not saints, but we are sometimes good team players."

All this goes a long way towards explaining the psychological roots of morality. Haidt defines moral systems as interlocking sets of values, norms, practices and institutions that work together to suppress or regulate self-interest and make co-operative societies possible.

His research leads him to believe moral intuitions arise automatically and almost instantaneously in our minds, long before moral reasoning has a chance to get started. Moral reasoning is not something we do to figure out the truth. Rather, it's a skill we evolved to further our social agendas - to justify our own actions and defend the teams we belong to.

Human nature is intrinsically moral, but it's also intrinsically moralistic, critical and judgmental.

"Our righteous minds made it possible for human beings - but no other animals - to produce large co-operative groups, tribes and nations without the glue of kinship," he says. "But at the same time, our righteous minds guarantee that our co-operative groups will always be cursed by moralistic strife."

We're much more aware of other people's moral shortcomings than our own, often making us "selfish hypocrites so skilled at putting

on a show of virtue that we fool even ourselves".

Haidt says one of the hardest problems humans face is co-operation without kinship. We instinctively co-operate with people to whom we're directly related, but co-operation within wider groups carries the ever-present temptation to "free-ride" - to enjoy the benefits co-operation brings while avoiding pulling our weight.

The more people free-ride, and the more we see others failing to pull their weight, the more co-operation breaks down and we all forgo the benefits it could bring.

Haidt argues morality is, in large part, an evolved solution to the free-rider problem. We develop norms of acceptable, co-operative behaviour and find ways to sanction people who aren't co-operating.

His empirical research into the moral sentiments of people from around the world leads him to identify six dimensions to people's moral concerns. First is care/harm; we are sensitive to signs of suffering and need, and despise cruelty. Second is liberty/oppression; we resent attempts to dominate us. Third is fairness/cheating; people should be rewarded or punished in proportion to their deeds.

Then there's loyalty/betrayal; we trust and reward team players, but want to sanction those who betray the group. Next is authority/subversion; we recognise rank or status and disapprove of those not behaving properly, given their position. Finally there's sanctity/degradation; we care about what we do with our bodies and what we put into them.

Haidt believes these moral concerns are shared by people regardless of their culture, nationality or wealth. But, of course, people interpret them differently and put more weight on some than others.

Our differing moral emphases are reflected in our differing political sympathies. So the unending battle between small-L liberal and conservative policies is a manifestation of "deeply conflicting but equally heartfelt visions of the good society".

Haidt finds that small-L liberals' moral concerns are limited to just the first three dimensions: they care deeply about the harm suffered by minorities and the needs of the poor, about oppression and about fairness.

Conservatives, on the other hand, care about all six dimensions. Their most sacred value is to "preserve the institutions and traditions that sustain a moral community". So they worry also about maintaining loyalty, acceptance of authority and the sanctity of our bodies.

The conservatives' broader range of moral concerns means they understand the motivations of liberals better than liberals understand the motives of conservatives.

Haidt argues the community benefits from the ever-present tension between the two sides - each emphasises important aspects of maintaining a good society - if only we could restore a greater degree of civility between the contending parties.

Read more >>

THE ECONOMICS AND POLITICS OF GOVERNMENT INTERVENTION IN THE ECONOMY

Talk to Graduate School of Government, University of Sydney

I want to give you a primer on the pros and cons of government intervention in the economy. While, as public servants, you take government policy activity for granted - it’s what you’re employed to do - the appropriate role of government (whether, and under what circumstances, governments should intervene in markets) is perhaps the most contentious topic in politics and economics. Let’s take a quick look at an aspect of the politics of intervention before we take a much closer look at the economics.

The political philosophy of intervention

The political philosophy of libertarianism - which gives primacy to individual liberty and carries a presumption against the need for government intervention - is overrepresented in the political debate in Australia and particularly the US. While by no means all economists are libertarians, most have a big streak of it in them because the dominant model of conventional, ‘neo-classical’ economics is built on three key assumptions that almost inevitably bias it against intervention. Those who come to the neo-classical model from a political perspective (giving primacy to individual freedom) rather than an economic perspective (giving primacy to the best management of the economy) adopt a fundamentalist, no-questions-asked approach to the model.

The first key assumption is that people always act ‘rationally’ in the decisions they make. That is, they act with clear-headed, carefully calculated self-interest. One of the commonest catch-cries of the libertarians is: how could the government possibly know what’s in my best interests better than I know myself?’. Well, if we all were as rational as the model assumes we are, that would be a killer argument. In reality, however, most of us are often far from rational in much of our decision-making. We act on instinct, we’re swayed by our emotions, we don’t pay enough attention - don’t read the label, the instructions or the product statement - and we tend to do what everyone else is doing. In which case, it’s perfectly possible - in principle, at least - that governments could know what’s in our best interests better than we know ourselves.

The second assumption is that markets are self-correcting or self-righting - that, in the jargon of economists, they have an inbuilt tendency to return to equilibrium. You don’t need to study the behaviour of the financial markets to doubt the veracity of that proposition. Sometimes it happens; many times it doesn’t.

The third assumption is that society consists solely of individuals - individual consumers, and firms so small relative to the size of the market they have no ability to influence the market price. So the possibility of people acting collectively - whether voluntarily or by electing a government to make decisions on their behalf - is simply excluded from model. It admits no circumstance where, by co-operating rather than competing with each other, we could achieve a superior outcome.

Put the three assumptions together - we’re always rational, markets are self-righting and individual actions are the only ones available - and you see why the only thing government intervention could do is stuff things up. Hence the advice to governments: laissez faire - leave things alone.

While the rhetoric of libertarians and some economists implies that markets have always existed and government intervention in markets is a much more recent and unwarranted intrusion, this is not historically accurate. Though it’s true humans have exchanged goods (traded with each other) for millennia, markets in the form we know - the market-based economy - are a much more recent development, dating from the dismantling and replacement of the feudal system. Markets are actually the creation of governments because they rest on government creation and enforcement of private property rights. And much of governments’ actions and interventions over the centuries have as their primary or secondary objective enhancing the functioning of the market-based economy. Think of the regulation of money as a medium of exchange and store of value, bankruptcy rules and commercial law. Even government spending on universal education and health has huge spin-off benefits for the market economy. Quite clearly, there never has been or ever will be such a thing as a ‘free market’. All there is are markets in which governments intervene to a greater or lesser extent.

Libertarians set the liberty of the individual as their supreme value, which must never be compromised. All of us set a high store on personal freedom. But most of us accept there are many other worthy objectives of government that are often in conflict with the untrammelled freedom of the individual. So the most sensible approach is to find the best trade-off between freedom and other important objectives - other dimensions of the public interest - being willing to diminish our freedom to the extent the conflicting objective is sufficiently important.

So much for libertarianism. Fortunately, economists take the question of intervention a little bit more seriously and go a lot deeper. Let’s start again, relying on an article that appeared in the 1995 edition of the Asian Development Bank's Asian Development Outlook.

The assumptions of the neo-classical model

Microeconomic theory starts with a simple model of markets in which there is 'perfect competition'. It says that, in the absence of government intervention, the interaction of self-interested consumers with profit-maximising firms will produce the most efficient allocation of the economy's resources. That is, those resources will be used to produce the particular combination of goods and services that offers the maximum satisfaction of consumers' material wants.

But to reach this desirable conclusion, the model relies on a host of assumptions. Most elementary textbooks list four key assumptions: the market must consist of large numbers of buyers and sellers; every firm must be selling an identical ('homogeneous') product; all buyers and sellers must have complete knowledge of all relevant prices, quantities, conditions and technologies; and there should be no barriers that prevent firms entering or leaving the market.

To these better-known assumptions, however, the Asian bank article adds four more: there should be no spillover or external effects, so that all parties bear the full costs and receive the full benefits of their production and consumption activities; there should be no unexploited economies of scale; all parties must know their own best interests; and there should be no uncertainties or ambiguities.

Do those assumptions strike you as realistic? Can you think of a market in which all of them hold true? Of course not. As the Asian bank says, 'these assumptions are extreme and unrealistic in their literal form'. And that's why this idealised model of perfect competition is merely the starting point of the economists’ theory of markets. 'Despite these glowing theoretical results’, the article continues, 'real-world markets may well be deficient in one or more of the necessary assumptions of the theoretical model and thus may fail to deliver the ideal efficiency that the perfect-competition model promises.'

Causes of ‘market failure’

The next step in the theory is to identify the circumstances in which markets will fail to deliver the goods. The bank lists at least seven kinds of 'market failure'.

First, market power. If there is only one (monopoly) or a few (oligopoly) dominant sellers in a market, and if entry by new firms isn't easy, the established sellers are likely to exercise market power. That is, prices will be higher and quantities produced will be lower than those promised by the competitive model. As well, quality may be lower, varieties limited and innovation diminished.

Second, ‘externality’ effects. If the actions of producers or consumers affect people outside the market, then the market's outcomes are unlikely to represent an efficient allocation of resources. In cases where these external effects are unfavourable - the generation of air or water pollution, for instance - the uncorrected market outcome yields too much of the particular activity, with prices that are too low and with too little effort made to reduce the unfavourable spillovers. In cases where the external effects are favourable - such as an innovation or new idea that others can use - the market outcome yields too little of the activity, with prices that are too high and with too little effort made to increase the externality.

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

Fourth, economies of scale. If firms aren't producing in high enough volume to exploit economies of scale fully, then their activities won't achieve allocative efficiency.

Fifth, incomplete information and uncertainty. If sellers and buyers don't have compete information about how products work, the alternative products, the range of prices and even about future events, their production and consumption decisions won't yield efficient outcomes.

Sixth, asymmetric information. If, as is often the case, the sellers know a lot more about the product and the market than the buyers do, then market outcomes will not be efficient.

Seventh, the 'second best' problem. If there are uncorrected market failures in one market, then perfect competition in related markets is unlikely to yield efficient outcomes even in those markets. That's because all markets are interrelated. It follows that, if a distortion in one market can't be corrected directly, a second-best solution may be to induce compensating distortions in related markets.

The economists’ ground rules for intervention

It's because economic theory identifies all these potential forms of market failure that intervention in markets is commonplace. But while the public is always urging governments to intervene to correct problems, real or perceived, and politicians are almost always keen to leap in, economists have a two-stage test before they accept such a need: First, a significant instance of market failure has to be demonstrated and, second, the ability of government intervention to correct the market failure - or at least do more good than harm - has to be demonstrated.

Causes of ‘government failure’

This brings us to a more recent development in economists’ theory of markets, which focuses on the possibility of 'government failure'. Government failure arises where government intervention to correct market failure worsens outcomes rather than improving them, or where the modest benefits don’t justify the considerable costs (eg the various subsidy schemes for household solar power). If we're going to talk about real-world markets, we also have to talk about real-world governments. The Asian bank’s article lists at least four sources of government failure.

First, ill-defined goals. Governments often have very broad, ill-defined and even conflicting goals for interventions. In practice, trying to achieve conflicting goals can lead to arbitrary and inefficient outcomes.

Second, weak incentives and poor management. With ill-defined goals and the absence of a profit motive, public employees are likely to face weak incentives for good performance. Good management is a scarce skill and is usually highly paid. Where top salaries aren't high enough, governments find it hard to attract and retain high-quality managers, thus worsening outcomes.

Third, information problems. Governments may encounter as much or almost as much difficulty in acquiring full information as market participants do.

Fourth, 'rent-seeking' behaviour. Specific interest groups will seek to use the forces of government to create special favours for themselves at the expense of others in the community. For instance, special subsidies, tax breaks or limits on competition. They invariably seek to justify this behaviour by claiming that it's in the national interest or even that it would correct market failure.

The theory of ‘public choice’

This brings us to the relatively recent political/economic theory known as ‘public choice’, developed by James Buchanan and Gordon Tullock. The theory holds, among other things, that politicians and bureaucrats always act in their own interest rather than the public’s interest, and that, whatever its original motivations, all government regulation of industry ends up being ‘captured’ by the industry and turned to the industry’s advantage in, say, reducing competition within the industry (to the incumbents’ advantage), increasing protection or in persuading the government to subsidise industry costs. The regulated have a huge incentive to get to the regulators so as to modify the regulation in ways the industry finds more congenial, or to advantage the existing players against new entrants or rival industries.

I don’t accept for a moment the accusation that all regulation of industry is subverted. But I do believe there’s more than a grain of truth to the accusation: there is considerable scope for regulatory capture. And I’ve often suspected that the way most bureaucracies are organised - where the department of agriculture looks after the farmers, the industry department looks after the manufacturers, the environment department looks after the greenies, the resources and energy department looks after the miners and the tourism department looks after the tourist industry - could have been purpose-built for regulatory capture. In the various industries’ battle for their share of industry assistance, in the inter-departmental battle for influence and resources, each industry has its own special champion, those whose true role is supposed to be to keep the industry acting within the bounds of the wider public interest. Is the bureaucracy divided up this way just to gain the benefits of specialisation, or is each department’s real role to keep their particular industry happy and not making trouble for the elected government?

Another dimension of potential government failure arises because governments - and government departments and agencies - have some of the characteristics of a monopoly. They deliver public services funded by the taxpayer and there are no alternative suppliers. Monopolies are almost always bad, becoming lazy, unresponsive, self-serving and high-handed in their treatment of the individual members of the public they are supposed to serve, who can be seen as ignorant inconveniences. It’s enormously tempting to deliver services according to rules than suit the department rather than the ‘client’.

I’m never greatly impressed by all the libertarian rhetoric about ‘the nanny state’. But they do have a good point. Governments simply can’t solve all the problems we face in our lives, so we do need to be wary of weakening the ordinary person’s acceptance that the first responsibility for solving their problems rests with themselves. We’ll be helping people who can’t help themselves, and in certain circumstances we’ll be providing universal assistance but, for the most part, it’s down to you. It’s too easy for talkback radio to expect a government solution to every problem that comes along, an expectation that’s fed by the way politicians on both sides seem to be promising just that in every election campaign.

Then there’s the related problem economists refer to as ‘moral hazard’: the more people know they’re covered against risks, the less hard they try to avoid those risks, thus leading to excessive claims for assistance. This is problem with all forms of insurance, which insurance companies try to counter by such devices as no-claim bonuses and high co-payments (‘front-end deductibles’).

My conclusions from the debate

Where I do stand in this debate? I believe market failure is common and that governments should usually act to correct it. But I also believe in government failure and some degree of truth in the public choice critique. Governments and their bureaucrats do sometimes act in their own interests rather than the public’s and some regulation is captured and perverted by those being regulated. So I believe in intervention, but I’ve been around long enough to know it’s a very tricky business, with enormous potential for creating perverse incentives and other unintended consequences. We need to work hard to get the intervention right, minimising unintended consequences and doing more good than harm. This requires a lot of careful thought, trial and error, experimentation, learning from experience and project evaluation. This is why I’m pleased to see you studying Policy in Practice and interested in discussing the choice of appropriate policy instruments.

Some general principles for improving intervention

First, avoid ideological extremes. Because the truth is a hard-to-find position somewhere in the middle, it’s tempting to seek the simple certainty of one extreme or the other. But the sensible position is to be neither opposed to almost all intervention nor indiscriminate in intervening. The hard part of bureaucratic endeavour is to find the sweet spot, where interventions do more good than harm. Avoid prejudiced assumptions that the private sector is always more efficient than the public sector, or that the public sector is always more committed to quality than the private sector. Take a pragmatic, evidence-based approach.

Second, rationalise policy objectives. A great advantage of the private sector is that everything it does has a single, simple objective: to make money. For governments, things are never that simple. They have, and should have, multiple objectives. But while it may be possible to kill two birds with the one stone, it’s never possible to kill five. Politicians always what to use the same dollar to satisfy a host of interest groups and almost always lack the discipline to set priorities among all the things it would be nice to do. But multiple objectives are usually conflicting and unless bureaucrats can reduce that conflict the chances of interventions being ineffective are high.

Third, respect the power of market forces. To deny the infallibility of market forces should not be to underestimate their power. Self-interest is a hugely powerful motivator, not just among the public but also within government and the bureaucracy. And people do change their behaviour in response to changes in prices - sometimes irrationally so. When you try to suppress market forces they usually pop up somewhere else, like squeezing a balloon. People will look for and exploit the inevitable loopholes in your regulations; if there’s a system they’ll game it.

Fourth, by the same token, remember the limitations of the conventional model. Those limitations are so pervasive it’s not surprising interventions lead to so many ‘unintended consequences’. People aren’t rational; they’re influenced by their emotions, by perceptions of fairness and by what everyone else is doing. The model ignores all incentives apart from monetary incentives and disincentives, whereas non-monetary incentives - motivations, would be a better word - are often pervasive. For instance, people can work hard because they’re ambitious for power and promotion independent of the extra salary, because they love what they’re doing, because of a work ethic or a sense of duty, because of the institution’s esprit de corps. Sometimes the creation of monetary incentives - paying people to do things - can be counterproductive if it crowds out pre-existing non-monetary motivations. SES performance bonuses may be a case in point.

Fifth, try to work with the grain. Market forces are so powerful it’s often better to harness them in the service of the regulatory objective than try simply to stomp on them. This is the rational for the ‘economic instruments’, such as trading schemes and pollution taxes, used in environmental regulation. Even so, environmental subsidy schemes can often be terribly wasteful, and in specific areas the best approach can be direct intervention - legislating to raise motor vehicle emission standards or to require the weatherproofing of new-built homes.

Sixth and finally, remember the gold standard of intervention: voluntary compliance. The best laws are laws that don’t need to be enforced because so many people comply with them voluntarily. Why would they? Because they’re actually conforming to the norms of socially acceptable behaviour. Humans are social animals, preoccupied by the desire to fit in, meet the approval of their peers, be like everyone else and be no more antisocial than others. Interventions that undermine existing social norms can be far more unsuccessful and damaging than expected.

Many interventions - whether direct rules about what people may or may not do, or numerical or monetary incentives, such as KPIs - can be so onerous in robbing people of autonomy and ability to exercise their professional judgment that they become counterproductive. People stop trying and caring, and switch to looking for loopholes and ways to cheat the performance measurements. Much better to find ways to get people to internalise the values of the institution or the society, so they do what’s wanted of them out of a sense of duty, loyalty and just the satisfaction of knowing they’ve made their contribution and performed their role well. Intrinsic motivation always trumps extrinsic motivation.

Remember, however, that well-judged interventions, which use the force of law to change people’s behaviour in socially desirable directions, can end up being reinforced by the development of new norms of acceptable behaviour. Why? Because, contrary to everything rationalists assume about how the world works, people seek to reduce their cognitive dissonance by changing their values and beliefs to fit their behaviour. Force me to change my behaviour and I’ll change my values to fit. Changed attitudes towards sexual harassment in the workplace, smoking indoors, and drinking and driving are among the many examples of this process in operation.

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We pay for miners' impatience

Is patience a virtue? Our mothers taught us that it was, but much economic thinking treats it as a vice. And business people treat their impatience as though it's a virtue. But I'm with mum.

What isn't in doubt is that impatience is a pretty much universal human characteristic; we're all impatient, to a greater or lesser extent. I hardly think that makes impatience "rational" but, even so, conventional economics is careful to take full account of it.

The most fundamental reflection of our impatience is found in interest rates. No one is likely to lend money to a non-family member without charging a fee. Lenders want to be rewarded for doing you a favour and also for running the risk they won't be repaid.

But why not charge borrowers a flat fee? Why charge them at an annual rate for however long it is they have your money? Because you're impatient to get it back. So interest rates are a reflection of our impatience.

It's because lenders are always paid, and borrowers always charged, an amount of interest that varies with the length of the loan, that interest rates reflect "the time value of money". Allow for that value and you see why a dollar today is worth more than a dollar tomorrow (or in a year's time).

If you had a dollar today, you could lend it to someone and charge interest; if you needed a dollar today you'd have to pay interest. This being universally true, it becomes "rational" for economic calculations to take account of our impatience, as reflected in our charging of interest on the basis of time.

This is why, if someone promises to pay you $1 million a year for 10 years, it's not sensible to value that promise at $10 million. It's worth less than that because you have to wait so long for the money. How much less? That depends on how long you have to wait and your degree of impatience.

This, of course, explains the common business practice of "discounting" future flows of cash (both incoming and outgoing) to determine the "net present value" of a project. (A "discount rate" is compound interest in reverse, working from the future to the present rather than the present to the future.)

But this practice of discounting at a constant rate over time is far from foolproof. For one thing, behavioural economists have shown that, in real life, we're a lot more impatient in the near term than the longer term ("hyperbolic discounting").

For another, conventional discounting implies we care little about the distant future, which flies in the face of our concerns about the wellbeing of our children and grandchildren ("intergenerational equity") and sustainability - ecological or otherwise.

Business people treat delay as a vice - they're always on their high horse about government delays in approving their projects - but impatience may be motivated by selfishness, shortsightedness and even greed. We want to be richer - and we want to be richer now.

So we demand quarterly performance reports and structure chief executives' remuneration packages to reward them for getting quick results. Then we discover they're neglecting to invest in the longer term, not worrying about what will happen to the business in future years, and complain about "short-termism".

John Maynard Keynes said many wise things, but his most foolish (or misapplied) was that "in the long run we are all dead". It's not true - I'm still alive after first hearing it almost 50 years ago - and it's a maxim most of us will live to regret following.

People have understood the shortsightedness of short-termism for decades, but little or nothing has been done to correct it. The truth is, the business world is shackled by its uncontrollable impatience, to our long-term detriment.

It doesn't seem to have occurred to those people complaining about being in the slow lane of the resources boom that their problems are being compounded by the miners' impatience to get in for their cut while the going is good.

That's because, in business circles, impatience is seen as something to be admired. Among economists, the speed at which market participants wish to proceed is seen as a matter for them in their response to market incentives, not something the government should interfere with.

The more the dollar stays high, despite the fall back in coal and iron ore prices, the more likely it's being held up by the huge mining investment boom, as miners rush to get extra production capacity on line before prices have fallen too far.

Miners are elbowing their competitors aside, trying the grab the labour and other resources they need to get their mine built before other people's mines.

In their mad scramble they're attracting resources away from other industries - including major public infrastructure projects - creating shortages of skilled labour and bidding up wages. This explains why miners are demanding that environmental and other approval processes be speeded up. Worry about the environmental consequences later; let's just do it!

But their mad dash to get their mines built as soon as possible is causing indigestion problems for the rest of the economy.

They're bidding up wages to attract the workers they need, and for a long time the Reserve Bank was afraid they would cause an inflation surge.

It kept interest rates higher in consequence - thus probably adding a little to the dollar's strength - and, either way, making life tougher for the manufacturers and tourism operators.

And all because no one was prepared to tell the miners our minerals would come to no harm staying in the ground, so they should stop making trouble for others by being so impatient.

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