Why a little inflation isn't such a bad thing

I was in a taxi on Wednesday when we heard on the radio that the consumer price index had risen by just 2.5 per cent over the year to March - smack in the middle of the Reserve Bank's target, leaving it room to cut interest rates further if need be. So, no probs there.

"But why do we have any inflation?" the cab driver asked me. "When I came to Australia I could buy a rock cake for 8? - the other day they wanted $3.50."

It was a simple, sensible question. Unfortunately, the answer isn't at all simple. The short answer, however, is that it's a policy choice. That is, the monetary authorities - the central bank and the government - believe a moderate rate of inflation (moderate meaning between 2 per cent and 3 per cent, on average) is, on balance, a good thing.

Inflation refers to a persistent rise in the general level of prices. It may surprise you that in Britain over many centuries there was no net rise in the level of prices. Prices would rise during wars, but then fall back after the war was over. Governments controlled the price level by tying the amount of money in circulation to the amount of gold, and then controlling the amount of gold.

But this "gold standard" broke down during the Great Depression, and after World War II it was replaced by the Bretton Woods system where each country's currency was fixed to the US dollar, with the US dollar fixed to a gold price of $US35 an ounce.

This system meant all other countries effectively imported their inflation rate from the US economy. The Americans kept inflation pretty low until they began financing the Vietnam War by printing money rather than borrowing from the public.

This caused the fixed exchange-rate system to break down in the early 1970s, with most developed countries allowing their currencies to float. This gave them the ability to control inflation for themselves.

The trick, however, is that they - and we - do so not by controlling the quantity of money in circulation (as the monetarists tried and failed to do in the old days), but by using their ability to control the price of money - interest rates - to keep the demand for goods and services pretty much in line with the supply of goods and services. But if the authorities have the ability - in principle, at least - to use their control of interest rates to control the price level, why don't they keep it completely stable, thus allowing a zero increase in the CPI? Why do they permit inflation averaging a couple of per cent a year, and call this "practical price stability" (as they do).

Short answer: because they care about unemployment as well as inflation. The first reason is their belief that, due to practical limitations, the CPI tends to overstate the rise in the price level. Huh? This is because of the delay in including new products in the CPI basket of goods and services, and also because it treats as inflation price rises actually caused by an improvement in the quality of goods in the basket. For instance, part of the reason for the price of the new model Holden being higher than the price of the previous model is that it's a better car - better under the bonnet or better accessories.

If you accept that the CPI tends to overstate inflation then achieving zero inflation as measured by the CPI would involve keeping money so tight you were actually forcing prices down, which would be quite damaging to the economy and employment.

The second reason the econocrats like a bit of inflation is that there can be times when wages grow too quickly and make employing people too expensive. Wages need to fall back a bit, but workers are hugely resistant to cuts in their wages (and sensible employers don't fancy the idea, either).

The thing is that, if there's a positive rate of inflation it's much easier to cut wages in real terms by raising them less than the inflation rate. This is what happens in every recession.

The third reason the econocrats regard a bit of inflation as helpful is that, in a deep recession, they may judge it necessary to stimulate the economy not just by cutting interest rates but by cutting them so far they're negative in real terms - that is, cutting them until they're actually lower than the inflation rate (as they are right now in the US and Britain).

Think it through: when real rates are negative, lenders are actually paying people to borrow from them (after you allow for the effect of inflation), so this should be highly stimulatory. But, clearly, you can't bring about negative interest rates - something you'd only ever do in an emergency - unless you've got a positive inflation rate to go below.

So those are the three reasons the Reserve Bank is satisfied with an inflation rate averaging 2 to 3 per cent and defines this as practical price stability.

But back to my taxi driver. It's all very well to remember how much less you had to pay for things in the old days and feel cheated, but you shouldn't forget your income is also a lot higher than it was in the old days. In fact, just about everyone's income - whether wages or the pension - grows a bit faster than prices are rising, so there's no cause to feel cheated by the system. That is, almost everyone's income has risen in real terms over the years.

This real income growth is the reason economists are so unimpressed by punters and pollies carrying on about the trouble they're having keeping up with "the cost of living". You can achieve that delusion only by focusing on what's happened to the prices you pay and ignoring what's happened to your income.

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Budget surplus suddenly out of political fashion

Something highly significant has happened in just the past week: it's become clear the tide has turned in our politicians' demonisation of budget deficits and debt. What used to be anathema is so no longer.

Predictably, it's happened not because the pollies have seen the light, but because they've been mugged by reality. In consequence, the Grattan Institute's John Daley may well be right in saying we face a "decade of deficits".

That's not to say we'll hear no more of unpopular cuts in government spending, however. We'll get more of those in Wayne Swan's budget next month, and a lot more should Tony Abbott win the election in September. But these will be about stopping the parties' expensive election promises making the budget deficit even bigger, not about getting back to surplus. In Abbott's case it will involve cutting away Labor's favourite programs and replacing them with his own.

I won't be sorry to see an end to the economically illiterate nonsense the pollies have been spouting for so long about the evils of deficits and debt. That's because there are times when deficits are exactly what governments should be running and when modest levels of debt are nothing to worry about.

But, equally, there are times when surpluses are just what governments should be running. And we'd have to be terribly unlucky for such times not to return well before another 10 years have passed.

Governments have been agonising over the need to restrain budget deficits for almost all of the four decades I've been observing them - usually without much success. But the fashion for outright demonising of deficits began when Peter Costello became treasurer in 1996, claimed to have inherited a "budget black hole" from his Labor predecessors but, after one super-tough, promise-breaking budget, soon found the budget had swung back into surplus, only to stay there for the rest of the Howard government's 11-year term.

The steady stream of surpluses, combined with the proceeds from privatising Telstra, allowed him to eliminate the manageable debt he had also inherited. Costello used this experience to argue incessantly that deficits are always bad and surpluses always good, with the Liberals the party of surpluses and Labor the party of deficits.

When the global financial crisis hit in late 2008 and pushed the budget back into deficit, with Kevin Rudd's stimulus spending adding to that deficit, the immediate effect of the crisis on our economy proved surprisingly modest and it suited both sides to claim we had escaped recession.

Labor claimed this proved what a good economic manager it was, whereas the Libs used it to prove Labor's stimulus spending was unnecessary and wasteful, leaving our children and grandchildren weighed down by horrendous government debt.

The more years have passed with unemployment, inflation and interest rates all staying low during Labor's term, the more the Libs have focused on attacking its economic management by repeating the Costello line that deficits are always bad and by exaggerating the size of its debt.

Rather than patiently explaining the economic ignorance of this deficit demonising, however, Labor capitulated to it, with Julia Gillard promising faithfully in the 2010 election campaign to have the budget back to surplus by this financial year.

Problem is, the budget has not played ball. Much to the amazement of economists (and the consternation of Treasury's forecasters), the recovery in the economy has not been accompanied by a commensurate recovery in tax collections. Among the many reasons for this, the main one seems to be that our dollar has stayed high even though the prices for our mineral exports have fallen back.

This dawning reality is what forced Wayne Swan to concede just before Christmas that the budget would remain in deficit this financial year. Knowing the weakness on the budget's revenue side is likely to continue indefinitely, he's made no new commitment on when it will be returned to surplus.

But he and Penny Wong keep saying they won't be cutting government spending just to get the budget back to surplus, for fear of this costing jobs. Clearly, they've allowed their membership of the Deficits Are Evil Club to lapse.

For years the Libs have condemned Labor's timid explanations as mere excuses and have been promising to return the budget to surplus as soon as they got back to office. But the reality of the budget's revenue weakness has finally dawned on them, too.

Last Thursday, Abbott declared that "all bets are off" on the question of when a Coalition government would achieve a surplus. He's repeated the warning since. And also on Thursday, shadow treasurer Joe Hockey advised that "we are not going to go down the path of austerity simply to bring the budget back to surplus because it would end up being a temporary surplus".

So though we can expect to hear a lot more about Labor's alleged bad budgeting, we'll be hearing nothing more about achieving surplus ASAP. For both sides it's now a mere "aspirational objective".

I fear, however, we're swinging from one extreme to the other, from falsely claiming budget deficits are always evil to complacently accepting them long after it's become prudent to eliminate them and start repaying debt.

To say deficits aren't always evil is not to say they're always OK. So be warned: when budget surpluses fall out of fashion with the politicians, it won't be long before they're back in favour with economists - and commentators such as me.

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GITTINS’ GOSPEL: THE ECONOMICS OF JUST ABOUT EVERYTHING

I read that the Anglican Archbishop of Sydney, Dr Peter Jensen, very much disapproves of playing I Did It My Way at people’s funerals, describing it as ‘vulgar egotism’. This is a pity because, in my own vulgar and egotistical way, I like to think that, in the more than 30 years I’ve been the Herald’s economics editor, I’ve tried to do it my way, not the way other journalists would do it. The besetting sin of journalists is to write to impress other journalists. Failing that, they write to impress their contacts. But I’ve always believed in writing for the benefit of the Herald’s readers, for the intelligent layperson.

Perhaps because I didn’t take enough notice of the economics they tried to teach me at Newcastle Uni, I’ve had to work to understand economics, to understand what’s happening in the economy and understand the rationale behind the economic policy of the government of the day. But once I’ve figured it out, I’ve been keen to pass on that understanding to my readers. I write for the person who, though they lack formal training in economics, knows the topic is important and is keen to learn about it.

In my latest book, Gittins’ Gospel, a selection of my columns, I confess that my father was a preacher and I’ve inherited his sermon-delivering habit. Like his sermons, mine have been less fire-and-brimstone and more about teaching, although since journalists aren’t supposed to teach I prefer to say I’m an exponent of ‘explanatory journalism’. In the first part of my career I acted as a kind of missionary, trying to convert people to the economists’ way of thinking (and, indeed, there is a section of the book devoted to helping people understand how economists think). But as my career has progressed - as I’ve read more about economics and got older and, I hope, wiser - I’ve become more aware of, and critical of, the limitations of economists and conventional economics. So these days I see my role as more like that of the Herald’s theatre critic - I explain economics and the economy, but I also offer my readers a critique of economics and economists, pointing out their weaknesses and helping readers make up their own minds on how much to believe and not believe.

The full title of the book is: Gittins’ Gospel: the economics of just about everything. ‘The economics of just about everything’ is the title for our meeting tonight, and Ross Kerridge has given me a list of just about everything he wants me to talk about. I’ll get on to that in a minute, but first I should say something about why I was so vulgar and egotistical as to call a book, Gittins’ Gospel.

Well, it was partly an allusion to the sermonising habit I inherited from my father - who, by the way, delivered his sermons to tiny congregations in New Lambton (where I was born) and Cessnock, went away for some years but came back to Lambton, Merewether, East Maitland and Shortland. But it was also a reference to the main conclusions I’ve come to in almost 40 years of studying the topic, and the main messages I’ve been trying to get over.

Economics need not be stratospheric or incomprehensible: it’s about the ordinary business of life, about going to work, earning and income, then spending that income on all the things we need. But it’s about the material side of life and, important though that is, it’s not the only dimension of our lives, and we oughtn’t to focus on it to the exclusion of the other important dimensions: the relational, the social and even the spiritual. Similarly, the community and our political leaders need to take their advice from a much wider range of experts than just economists. Nor should we allow economists to advise us on matters outside their field of competence - as they often try to do. In other words, a big part of my gospel is that economics needs to be kept in context.

Another theme of my gospel is that the modern practice of lobby groups, and even governments, commissioning supposedly ‘independent modelling’ to bolster their case for or against some policy change is almost always an attempt to blind the public with science. I see part of my role as to demystify econometric modelling. Economic modelling is at once hugely complicated and surprisingly primitive. It rarely proves what the people who paid for it say it proves. It’s always built on assumptions - which are rarely spelt out by the people waving around its conclusions - and it’s always possible to vary the assumptions to ensure you get the results the outfit paying for the research was hoping for. The media should be a lot more sceptical in its reporting of the results of supposedly independent modelling, and in the book I look at three well-publicised cases and show how the modellers managed to produce the misleading results they did.

I love being a journalist, but the longer I stay in the business the more critical I become of the way the media do their job. A lot of what they do can be misleading, and in the book I devote a section to explaining how not to be misled. Literally, the word ‘gospel’ means ‘good news’ - but the media seem increasingly, almost exclusively, full of bad news - which some readers are finding increasingly off-putting. Well, I’m an optimist and, though I’m not afraid to face up to the problems we encounter - as of course we do - nor am I reluctant to point to the respects in which we’re doing quite well. This book is a book for optimists.

Economics is meant to be about people and for people; take the people out of an economy and you don’t have an economy. But much of the economics you read seems remarkably impersonal. So another theme of my gospel is that we need to get the people back into economics. We need an economics fit for humans. You often see me writing that conventional economics incorporates a misleading model of human behaviour. Its two big weaknesses are its assumptions that we’re all coldly rational calculators of what’s in our interests, and then that we’re all rugged individualists - that our attitudes and behaviour are never influence by the attitudes and behaviour of those around us, and that we never act in groups. In truth, the findings of modern psychology show we’re highly instinctive and emotional animals, and also that we’re highly social, ‘groupish’ animals. So in recent years I’ve been reading a lot more widely than conventional economics so as to get a better picture of how humans actually behave. And when that reading leads me to something interesting and important, I pass it on to my readers. The book contains a section - We’re only human - that brings together 10 of the columns I’ve written about these findings.

For instance, rationality tells us we need to be completely realistic about the state of the world and our place in it. But psychological research tells us that’s bunkum. It turns out to be healthier and more useful to hold a few unrealistic views about ourselves and the world.

People with high self-esteem---which is most of us---believe themselves to be healthier, more intelligent, more ethical, less prejudiced and better able to get along with other people than average. Obviously, a lot of those judgments are unrealistic. But that’s beside the point. The point is that self-esteem makes us both happier and better equipped to deal with the world. The lack of self-esteem is highly debilitating.

People with the freedom to control their own lives, make their own choices and decisions---at work and at home---are happier and even healthier. But it’s a question of perception---how much control you think you have. People with a positive attitude to their boss, for instance, may see themselves as having more freedom of action than those who see their boss as censorious and untrustworthy. (What’s more, in my experience such attitudes tend to be self-fulfilling.)

But nowhere is self-deception more prominent than in the personal characteristic of optimism. Indeed, it’s virtually built into the definition of optimism. Optimists are people who take the credit for their successes but blame their failures on others or on circumstances. They regard setbacks as temporary rather than permanent, and specific (I happened to strike a bad teacher) rather than universal (all teachers are bad).

So optimists tend to overestimate their abilities and their chances of success in dealing with the world, whereas pessimists tend to underestimate their abilities and their chances of success. Fortunately, most of us are optimists, which does much to explain why most of us are reasonably happy most of the time.

So much for the virtues of a little self-deception.  Now let me ask you a personal question: how honest are you? According to the people who study these things, not as much as you think you are. In an experiment in which people were asked to solve puzzles and were paid a set amount for each puzzle they solved, some participants were told to check their answers against an answer sheet, count the number of questions answered correctly, put their answer form through a shredder, report the number of questions they got right to the experimenter and receive the money they had earnt. A second group wasn’t allowed to shred their answers before reporting how many they got right. Those whose claims about how many they got right couldn’t be checked claimed to have got significantly more correct than the second group.

Those who cheated probably counted a problem they would have answered correctly if only they hadn’t made a careless mistake. Or they counted a problem they would have got right if only they’d had another 10 seconds. In other words, they didn’t tell blatant lies, they just gave themselves the benefit of any doubt, bent the rules a little bit in their own favour. And get this: they wouldn’t have thought they were cheating. When subjects are asked to rate how ethical they are compared to other people on a scale of zero to 100, where 50 is average, the average rating is usually about 75. That is, almost all of us consider ourselves to be more ethical than other people. Clearly, that’s not possible.

We’re often unaware of how inconsistent we are. We may think of ourselves as scrupulously honest because we’d never steal and would always return a wallet we found, forgetting that we take home office stationery because this is ‘not the same thing’. That’s why it’s always hypocritical to accuse others of hypocrisy---all of us are hypocrites.

The psychologists who study ‘behavioural ethics’ say our ethical behaviour is often inconsistent and, at times, even hypocritical. ‘People have the innate ability to maintain a belief while acting contrary to it,’ they say. ‘Moral hypocrisy occurs when individuals’ evaluations of their own moral transgressions differ substantially from their evaluations of the same transgressions committed by others.’ Hypocrisy is part of the human condition; we’re all guilty of it. So you could say accusing someone else of being hypocritical is itself a hypocritical act.

One lesson from a new field of study known as ‘neuro-economics’ is that our brains seem to have different systems for ‘wanting’ and ‘liking’. Wanting is about motivation, whereas liking is about pleasure. Think of the kid who begs and begs his parents to buy a pet---or a guitar---then loses interest in it within a few days. There was a yawning gap between wanting and liking. All of us have times when we lack the motivation to do something we know we’d enjoy. That’s almost the definition of being depressed. It’s given rise to a psychological therapy called PAT---pleasant activity training: make a list of the things you enjoy doing and then do them more often. Don’t scoff.

That’s just a sample of the topics I cover in the book, so I hope you enjoy it.

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THE ECONOMIC LANDSCAPE AND FUTURE CHALLENGES

Talk to The Salvation Army Moneycare Financial Counselling Conference, Collaroy

Asking an economics specialist to talk about the economic landscape and future challenges, as Tony Devlin did, is an open invitation for the specialist to whip out all his slides and bang on about his forecasts for economic growth, unemployment, inflation, interest rates and all the rest. Fortunately, I’m an economic commentator rather than a forecaster, so I don’t have a set of forecasts to dazzle you with - or bore you with - and, in any case, I’m sceptical about the value of forecasts.  Economists don’t have a good record on accurately forecasting what will happen.

All I’d say is that, although you’d never know it from all the complaints we hear, it’s now been about 22 years since the last time Australia had a severe recession, and in that time the economy has grown at a reasonably steady rate with the official unemployment falling from about 11 per cent in 1991 to something around 5 per cent - which most economists regard as about as low as it can go without causing inflation problems. You’d have to say this record period without a severe recession obviously can’t go on forever, and when we do have another severe recession, that’s when a lot of businesses fail and unemployment shoots up, causing a lot of us to realise for the first time just how good we’ve had it for so long. It will also be when the demand for your services as financial counsellors grows far beyond your ability to cope.

But I have no particular reason to expect the next severe recession will occur any time soon, so my best guess is that the economy will continue growing much as it has been, with various industries continuing to feel the pain of a high dollar, but with enough growth to limit any great rise in the official unemployment rate. However, I do expect people - particularly business people - to cheer up a lot if, as everyone expects, Tony Abbott wins the election in September. This is partly because all newly elected governments enjoy a honeymoon period in which everyone’s pleased to see the back of the last lot and hopeful the new lot will be much better, but also because I’m convinced a lot of the gloom we’re hearing from business - big and small - has more to do with politics than the actual state of the economy. People forget the day-to-day management of the economy is done by the central bankers, not politicians.

The other thing my crystal ball tells me is that an Abbott government will have a lot of trouble keeping all the promises it has made on the budget, which means budgeting is likely to remain tight and probably get tighter in the coming years. This suggests continuing pressure on grants to outfits like the Army, particularly so when you see the Coalition promising not to make budget savings at the expense of high income-earners.

Before I move on, you may have noticed that all my references were to ‘severe’ recessions. This is because, contrary to the conventional wisdom propagated by both sides of politics, I believe we did have recession in Australia - though a mild one - at the time of the global financial crisis in late 2008 and early 2009. The claim that we escaped recession rests on the slender fact that the contraction in the economy was concentrated in one quarter (0.7pc in Dec q 08) rather than spread over two consecutive quarters, even though the rate of unemployment jumped by 1.6 percentage points in just nine months (trend figures: 4.2% in Aug 08 to 5.8% in May 2009; part rate fell by 0.3pcps; using SA figures, increased by 1.8pcps in 10 months between Aug 08 and June 09 to 5.9%). But while this deterioration was too small and too brief to be noticed by most Australians, my guess is it was noticed by the Army in the form of less generous donations and by an increase in the number of people needing financial counselling - no doubt after a delay. Because downturns always hit the bottom harder than the middle and the top, I suspect the Army’s ‘recession meter’ is a lot more sensitive than other people’s.

 I've been thinking a fair bit lately about differences in people’s perspectives and perceptions of the economy. Whereas economists form their views about the state of the economy using economy-wide statistics - meaning they view the economy from a helicopter, so to speak - most business people and ordinary citizens base their views on their own experience and the experience of those around them. What’s happening to me is what’s happening to the economy. If I’m a shopkeeper and my sales are down, it’s obvious the economy’s very weak. If I’m a worker but I haven’t been able to find a job for months, it’s obvious the economy’s stuffed.

The second, more ephemeral factor that influences the views of non-economists is what they see and hear from the media about the state of the economy. But apart from when it’s quoting the official statistics, most of what the media tell us is quite unrepresentative of what's happening to most people. Why? Because the media tell stories about the experiences of individuals, and the stories the media choose to tell are those they believe their audience will find interesting. But the stories we find most interesting are those that are unusual rather than usual, thus making them unrepresentative of the economy rather than representative. This explains the media’s overwhelming preference for bad news rather than good news: people find bad news far more interesting. So, for example, any factory that decides to lay off 350 people will hit the headlines, whereas a factory that took on 350 workers would hardly rate a mention.

Another thing to bear in mind is that, in general, the people to whom the Army provides financial counselling come from the opposite side of the tracks to the relatively well-off and well-educated readers I write for. I often take a fairly unsympathetic line to the complaints of the comfortably off precisely because I'm aware of the genuine, often extreme financial hardship suffered by people struggling to manage on very much lower incomes. But just as I try to remind my readers how comparatively well off they are, so you need to remember that the people you see are also unrepresentative of the wider economy. If one in five adult Australians experience financial stress each year, then four in five don’t experience stress to any great extent.

When the people you counsel complain about the high cost of living, I’m inclined to believe them and be sympathetic. But in recent years it’s become fashionable for people in the comfortable world also to complain about the high cost of living, and there is little objective evidence to support these complaints. Nothing special.

I suspect people complain about the cost of living when they don’t have anything more serious to worry about - such as having to find a job or even the risk they may lose their job. I also suspect the complaints of the comfortably off mostly boil down not to the high cost of living but the difficulty some people encounter achieving the higher standard of living to which they aspire. No matter how high your income, it's always possible feel financially stressed if you over-commit yourself. You can often have difficulty making ends meet if your income is always fully committed and you leave yourself no buffer to cope with unexpected expenses, such as a big increase in utility bills.

As financial counsellors well know, many people have a low level of financial literacy. Many people also have low factual knowledge of the hip-pocket effects of government tax and benefit changes. A recent survey by the progressive think tank Per Capita found that more than half of respondents believed the carbon tax had increased the price of petrol, when it doesn’t apply to petrol. Most respondents estimated the tax had increased their cost of living by $20 a week or more, whereas the Treasury estimate was just under $10 a week. And almost half of respondents claimed to have received no compensation from the government in tax cuts or benefit increases, whereas Treasury’s estimate was that 90 per cent of households would get some compensation and about two-thirds would be fully compensated.

And then, of course, there are the many better-off people who imagine themselves to be middle income-earners when they are, in fact, in the top 10, 5 or even 2 per cent.

Everyone has their own perspective on the economy. There’s the reality and the perception - and the two are often very far apart.

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Easter message to business is think relationships

At this time of year it's worth pondering: many business people and economists think of themselves as Christians, but what implications does this carry for the way they view the world and conduct their affairs?

According to Michael Schluter, founder of Relationships Global and, these days, a business consultant, Christianity is a "relational" religion. If so, it doesn't sit easily with market capitalism as it is conceptualised by economists and practised by business people.

The primary emphasis of economics and business is on satisfying the wants of the individual. In this they give little priority to individuals' human relationships.

Is Christianity much different? Certainly, in the Evangelical version I grew up with, it too focuses on the individual. And you could be forgiven for wondering whether it pays much attention to relationships.

But here Schluter begs to differ. He says all of Christianity is a relational story. It starts with humankind created in God's image, but then the relationship is ruptured in the Garden of Eden. Finally, God comes to earth as a baby and ends up dying on a cross with the expressed purpose of restoring the broken relationship with humankind.

What does God require of us? Jesus summarised it: all the law and the prophets depend on two commandments - love God with all your heart, and love your neighbour as you love yourself. What could be more relational than that?

Schluter says life can be viewed from many perspectives: financial, environmental, individual, material. But "as Christians, we need to see all of reality through a relational lens if we are to look at the world as God sees it".

All of life is ultimately about relationships. For example, he says, "every financial transaction is an expression of an underlying relationship between nations, organisations or individuals".

The development of a society can be measured not in terms of economic growth but by the quality of relationships between individuals and between ethnic and other social groupings.

Education's goal can be defined as acquisition of wisdom for children to be able to serve their family and community, rather than acquisition of technical skills merely for personal career advantage.

"At a personal level, our happiness and wellbeing are determined primarily by the quality of our relationships. Arguably, financial issues - for example, debt and savings - matter to us primarily due to their relational implications," he says.

Above a certain income, wellbeing indices point to the central importance of relationships. Even for those below this income threshold it's not clear if the priority of income is for personal benefit or for group benefit, such as the care of children.

Debt is closely associated with depression and also with divorce, child abuse and social isolation, he says. Survival rates after serious illness are more closely associated with levels of relational support than with levels of income.

"It is easier to find someone financially rich and miserable than someone relationally rich and miserable," he says. "It is hard to find someone on their death bed who says, 'I wish I had spent more time in the office'."

The individualism of our culture leads us to miscalculate the significance of events because it takes little or no account of "externalities" - that is, the effects on third parties.

For example, companies and public service agencies move staff to new locations to maximise economic productivity, and economic analysis applauds their decision to do so. But no attempt is made to measure the social or relational costs of such dislocation, especially to spouses or partners, children, friends and parents and grandparents whose relationships have been disrupted.

Schluter says business, finance and public sector organisations are increasingly coming to recognise that financial evaluation of performance is insufficient.

"The purpose of companies is increasingly defined inclusively to recognise the significance of company decisions for many stakeholders, rather than instrumentally, where customers, suppliers and so on are regarded simply as means to increase shareholder profits."

Low levels of national debt - a measure of inter-generational loyalty - decrease economic instability and aid economic growth. Political stability is a foundation for economic prosperity, but depends on peaceful relations between ethnic and religious groups and between rich and poor.

"To see the world in relational terms requires a re-education process as the media, corporate advertising and our own inclinations constantly point us towards seeing things from an individualistic or materialistic point of view," Schluter concludes.

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Being smart and being logical aren't the same

Years ago, a leading American teaching hospital admitted a 21-month-old boy we'll call Kevin. He was pale and withdrawn, drastically underweight, had constant ear infections and was refusing to eat. He'd been neglected by his parents.

A young doctor took charge of his case. He hated having to draw blood from Kevin's emaciated body and noticed the boy refused to eat after being poked with needles. Intuitively, he kept invasive testing to the minimum and instead tried to provide the boy with a caring environment. Kevin began to eat and his condition improved.

But the young doctor's superiors didn't approve of his unconventional efforts. So a host of specialists, each interested in applying a particular diagnostic technology, set out to find the cause of the boy's illness. If he dies without a diagnosis, we've failed, they reasoned. Over the next nine weeks Kevin was subjected to batteries of tests, which revealed nothing decisive. He stopped eating again, so the specialists sought to counter the combined effects of infection, starvation and testing with intravenous nutrition lines and blood transfusions.

But Kevin died before his next scheduled test. The doctors continued testing at the autopsy, hoping to find the hidden cause. One doctor commented: "Why, at one time he had three IV drips going at once! He was spared no test to find out what was really going on. He died in spite of everything we did!"

That story is told by a distinguished German psychologist, Gerd Gigerenzer, of the Max Planck Institute, in what many academics would call his hugely "counter-intuitive" book, Gut Feelings.

But here's the trick: what university-trained people are encouraged to regard as "intuitive" isn't intuitive at all. It's what all their learning has led them to believe is the right way to think or act. In this, academic sense of the word, it was the specialists who were acting intuitively: their training told them they couldn't begin to help the boy until they'd first correctly diagnosed his problem.

Thanks to this way of thinking, they tested him until their actions helped to kill him. But the way Gigerenzer uses the word, it was the young doctor who acted on his intuition, casting his professional training aside and trusting his gut feelings.

Gigerenzer's point? In this particular case, the young doctor was right to trust his instinct and his better-trained and more experienced superiors were led astray by all their learning.

What's more, he claims, cases where relying on your gut feelings rather than on careful analysis leads to better decisions are surprisingly common.

But such a conclusion - itself based on Gigerenzer's scientific (if controversial) research - is, in the academic sense of the term, hugely counter-intuitive. It's the opposite of what educated people would expect.

It's a mistake to imagine only economic rationalists are on about rationality. Ever since the Enlightenment of the 17th and 18th centuries, virtually all university teaching has stressed the need for reasoned, logical analysis. You make decisions by gathering all the relevant information you can, then weighing it up carefully and logically.

Economic rationalists assume that's the way we really do make decisions. But the American psychologist Daniel Kahneman - whose life's work is beautifully summarised in his book Thinking, Fast and Slow - won the Nobel prize in economics for demonstrating that the vast majority of the decisions we make are made unconsciously, instantaneously and instinctively.

Kahneman showed that these unconscious, snap decisions are based on deeply ingrained mental short-cuts, or rules of thumb, which psychologists call "heuristics". He further argued that a lot of these heuristics are illogical and so cause us to make many bad decisions. This is the basis for the title of the well-known book by the behavioural economist Dan Ariely, Predictably Irrational.

But this is where Gigerenzer begs to differ. He argues that in many but not all circumstances, the heuristics we use lead to good decisions - better decisions than we'd make if we took the time to gather more information and think the decision through.

And this is true even though many heuristics seem to the educated mind to be illogical. Why? Because we often must make decisions almost instantly, because deliberation can get in the way of our unconscious motor skills, because gathering information has costs (not all of which are monetary), because the future is uncertain no matter how much we know about the past, and because of our "cognitive limitations" - too much information confuses us and makes us indecisive. What's more, some information can mislead us, containing "more noise than signal".

Gigerenzer's research contradicts two core beliefs of economists and other rationalists: more information is always better and more choice is always better. Rather than building complex decision-making systems that take account of as many factors as possible, we should search for "fast and frugal" decision rules that are shown to work most of the time. Spending less time on some decisions can actually improve them.

Relying on intuition or gut feelings isn't acting on impulse or caprice. This is because our brain's use of its intelligence isn't necessarily conscious or deliberate.

"The intelligence of the unconscious is in knowing, without thinking, which rule is likely to work in which situation," he says.

"What seem to be 'limitations' of the mind can actually be its strengths."

The logic-based approach to decision-making "assumes that minds function like calculating machines and ignores our evolved capacities, including cognitive abilities and social instincts. Yet these capacities come for free and enable fast and simple solutions for complex problems ...

"Logic and related deliberate systems have monopolised the Western philosophy of the mind for too long. Yet logic is only one of many useful tools the mind can acquire. The mind, in my view, can be seen as an adaptive toolbox with genetically, culturally and individually created and transmitted rules of thumb," he concludes.

Don't get Gigerenzer wrong. His line of argument is in no way anti-intellectual. Rather, he's used his intellect and the scientific method to challenge conventional thinking about how our intellect works.

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How multinationals rort our tax system

You're familiar, I'm sure, with the Double Irish Dutch Sandwich. It sounds tasty - but only to the big multinational companies that use it to avoid tax. According to the Assistant Treasurer David Bradbury in a speech he gave late last year, it's the device Google uses to pay very little Australian company tax on the profit it makes on an estimated $1 billion a year in Australian advertising revenue.

As Bradbury explains it (using media reports, he says, not inside information), the fine print of contracts Australian firms sign with Google says they're buying their advertising from an Irish subsidiary of Google.

Our rate of tax on company profits is 30 per cent, whereas Ireland's is 12.5 per cent. But that's just the start of the sandwich. The Irish subsidiary then pays a royalty payment to a Dutch subsidiary, but it's then paid back to a second Irish holding company of Google's, which is controlled in Bermuda - which has no company tax.

The media usually attribute the invention of the double Irish to Apple, Bradbury says. But evidence given to the British public accounts committee suggests Amazon paid no tax in Britain despite about $4.9 billion in sales by routing transactions through Luxembourg, where it faced an effective tax rate of 2.5 per cent.

The committee also heard that Starbucks had paid no tax in Britain for three years, despite sales totalling about $1.8 billion - in part because of royalty payments for the use of the brand.

With their government busy raising taxes and slashing government spending to get its budget deficit down, the Brits are pretty steamed up about multinationals not bearing their fair share of the tax burden. Governments in many developed countries are deciding tougher measures need to be taken to curb the multinationals' rorting of the system, and ours is no exception.

It's a problem governments have been grappling with for decades, of course, since the early days of globalisation and the rise of companies with operations in several countries. Then, the game was simply for multinationals to shift their profits to countries where taxes were low. One way to do this was for the part of the company where taxes were lower to sell its products to subsidiaries in high-tax developed countries at inflated prices. The big countries developed rules to limit such ''transfer pricing''.

Another trick was for a subsidiary to borrow from head office most of the capital it needed, with head office then charging an interest payment that absorbed most of the subsidiary's profits. Our ''thin capitalisation'' rule limits interest deductions to $3 of debt for each $1 of share capital, and there's talk this may be tightened in the budget.

In a speech he gave this month, Bradbury says you don't need to be doing business on the internet to use something like a double Irish scheme. ''What you do need is the global presence of a multinational enterprise and the ability to attribute a large part of your profits to intangible assets,'' he says.

And we know intangible assets - such as software, databases, patents, copyright and ''goodwill'' or ''brand value'' - play an increasingly important role in the global economy. In the United States, investment in intangible assets has exceeded investment in tangible assets for more than a decade.

Existing international legal arrangements rest heavily on the notion that income should be taxed in the country of its ''source''. When economic activity was dominated by farms, factories and mines, it usually wasn't hard to see that the source of income was where the factors of production were physically located.

But now ''the increasing importance of intangible capital to production challenges the very idea that we can always objectively determine where economic activity occurs,'' Bradbury says.

All this helps explain the emergence of ''stateless income'' - income that's not taxed in the source country of the production factors that gave rise to the income, nor in the ultimate parent company's jurisdiction. It's income that doesn't belong anywhere for tax purposes.

This, in turn, explains how the profits of US-controlled corporations in Luxembourg are equivalent to 18 per cent of its gross domestic product. For the Cayman Islands and Bermuda the proportions are more than 500 per cent and 600 per cent of those countries' gross domestic product.

Stateless income is not simply a product of transfer pricing abuses, but also arises from decisions about where to place financial capital within a multinational group. It involves exploiting differences in countries' tax systems and hybrid instruments treated as borrowings in a country and shares in another.

Tricks like these can place single-country businesses at a competitive disadvantage. They - and individual taxpayers - are forced to bear an unfair share of the tax burden. But many big-business executives reject the notion that paying a fair share of tax is part of a broader social compact. Tax is just another business cost. If dodging it is legal, morality doesn't enter into it.

The Gillard government is working to ensure our transfer-pricing rules are up with world's best practice and the general anti-avoidance provision of our tax act is broadened to encompass the tricks multinationals try on.

It has asked Treasury to study what more can be done, and will work to improve the information multinationals have to make public about profits and tax payments.

The Organisation for Economic Co-operation and Development has had to lift its game in promoting multilateral action to limit tax rorting by global companies.

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CAN AUSTRALIA BECOME THE FOOD BOWL OF ASIA?

RAS Hot Topic Debate, Sydney Showground, Tuesday, March 26, 2013

Can Australia become the food bowl of Asia? Short answer: probably not. Longer answer: not without either a lot of taxpayer subsidy (which is unlikely to be forthcoming) or without a lot more economic reform than rural voters have shown any sign of being willing to accept.

I suspect I’ve been invited here today as the anti-hero, the economic rationalist bad guy for everyone to boo and hiss. That’s OK; I’m happy to help provide the entertainment. But before I get on with it you should know that my father grew up on a dairy farm in the Lockyer Valley of Queensland and my mother grew up on a cane farm in North Queensland.

There’s little doubt the continued rapid economic development of Asia will produce a huge middle class over coming decades who’ll want to eat a lot more Western foods. It’s highly unlikely the Asians will be able to meet their own increased demand, so Asia will become a major food importer. A big part of the reason the Asians won’t be able to supply their own food demand is that they’ve really stuffed up their agriculture, and climate change will make it much worse.

When Asian demand grows much faster than world supply, the effect is to raise world food prices. But as supply eventually catches up, world prices fall back, leaving only those countries and farms that have been able to increase their production with a lasting benefit. Asia’s increasing demand is already pushing world prices higher - or higher than they otherwise would be. And I don’t doubt they’ll go a lot higher. If so, that will be a free lunch for Australian farmers: without increasing their production much if at all, they will - for a time - get much higher prices for what they do produce.

But for us to become the food bowl of Asia requires us to greatly increase the volume of rural production. What I doubt is whether we’ll be able to much increase our production. Why not? Because there are too many obstacles to increased production and farmers and their political representatives show so little sign of being willing to pay the very real prices needed to overcome those obstacles.

The first obstacle is that, partly because we didn’t have the scientific knowledge and partly through wilful neglect, we, too, have stuffed up our fragile farming land, degrading our soil, water table and rivers, and using lots of chemicals that have adverse side-effects - chemicals that will, in any case, become hugely more expensive. We need a lot more water pricing and other economic reforms to get on top of these obstacles to higher production.

The next big obstacle is that climate change will make farming conditions much worse, shifting the rain north and increasing the frequency and severity of extreme weather events such as droughts, cyclones and floods. So far, however, farmers and the National Party have found it easier to deny the existence of climate change and hope it goes away.

The final obstacle to greatly increased farm production is the sector’s very weak productivity performance over several decades. Increasing productivity involves a lot of changes many farmers won’t like: greater investment in on-farm innovation and automation, involving the application of much more equity capital by big companies and Chinese investors. This, in turn, involves more farm consolidation and more agribusiness, but fewer family farms and farm employment. The continued provision of drought relief serves to perpetuate the existence of small, inefficient, badly managed farms. Governments should be promoting productivity by investing in agricultural research and development, but instead they’re wasting taxpayers’ money on the eternal pipe dream of Northern Development, from the Ord River scheme to the Alice Springs to Darwin railway. All of us dream of the free lunch. But a better motto for agricultural dreamers is: no gain without pain.

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Labor and Liberals must end budget dishonesty

An immediate federal election is the last thing we need unless we're happy for it to be a fiscal lucky dip. Both sides have much work to do yet to provide voters with adequate information on the cost of their policies and election promises and how they'll be paid for.

Labor must deliver this mainly in the budget; the Coalition must release its facts and figuring no later than early in the election campaign proper. And don't be in any doubt: it's a tall order for each of them.

There are three reasons why this is so.

First, both sides say they're committed to returning the budget to surplus during the next term of Parliament, with the Libs claiming to be able to do it earlier and better than Labor.

Second, the relatively recently discovered structural weakness on the revenue side of the budget is a problem for either side.

It will be a particular problem for the side that wins the election, of course. But, to the extent Treasury takes account of this weakness in its revenue forecasts and projections in the budget and the pre-election update, it will be a problem for both sides during the campaign.

Third, in their very different ways, both sides have made some very expensive promises. So, at a time when revenue growth is likely to be unusually weak, both sides are promising to be particularly generous in increasing spending or cutting taxes, while also losing little time in returning the budget to surplus.

To remind you, company tax, the mining tax and other taxes on profits are being hit by the fall in export prices, plus the dollar's failure to drop down as expected. Income tax collections are being hit by the way eight tax cuts in a row have reduced the extent of bracket creep.

And collections from the GST are being hit by the end of the era where consumer spending grew much faster than household incomes and by the shift in spending towards those items excluded from the tax, particularly private health and education spending.

In theory, this is a problem for the states, not the feds. In reality, all major revenue problems common to the states end up on the feds' plate.

Because Labor's in government, and because most of its big promises are already enshrined in legislation, its moment of truth will come in the budget. In particular, it will have to demonstrate convincingly how it will cover the cost of the twin centrepieces of Julia Gillard's re-election pitch: the National Disability Insurance Scheme (costing about $8 billion a year by 2018) and the Gonski education-funding reforms (costing about $6.5 billion a year by the end of the decade).

Gillard and Wayne Swan have promised to spell out in the budget the "structural savings" they will make to fully fund this additional spending. "Savings" may include reductions in tax concessions ("tax expenditures") as well as cuts in conventional expenditure, but "structural" means the savings must continue - and grow - over many years.

Rest assured, the opposition and the commentariat will hold Labor to account on this score. And one thing this means is that it won't be nearly sufficient for Swan to show how these two ever-more-expensive policies will be funded merely for the coming four years. If it takes up to six years for them to reach their full yearly cost, that's how far into the future Swan's figures must go to show he has that cost covered.

Further, credibility will be attained only if, unlike the past two or three budgets, this one involves no resort to creative accounting: no shifting of spending from the budget year back to the previous, almost-ended year, no use of Swan's "fiscal bulldozer" to push spending commitments off beyond the forward estimates where they can't be seen, and no exploitation of loopholes in the definition of the underlying cash balance, including funding spending on the national broadband network off-budget.

As for the Coalition, if it is to come clean with voters there must be no repetition of its utterly dishonest performance in the 2010 election campaign, where it refused to have any of its promises properly costed by the econocrats, claimed its costings had been "audited" by an accounting firm when it had done little more than check the arithmetic, and only after the election was revealed to have published costings that were wrong by up to $11 billion.

This time, there will be no excuse if the Coalition fails to use the services of the Parliamentary Budget Office. And with all the provisions of its own charter of budget honesty in operation, should it try the old stunt about being shocked to discover a big black hole when it saw the books, we'll know it is fudging. It won't be Ju-liar, it will be Tony-liar.

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How what's hurting most is also what saved us

While many business people see the economy as badly performing and badly managed, our econocrats see it as having performed quite well and better than could have been expected. Why such radically different perspectives on the same economy?

Partly because business people - particularly those from small businesses - view the economy from their own circumstances out: If I'm doing it tough, the economy must be stuffed. By contrast, macro-economists are trained to ignore anecdotes and view the economy from a helicopter, so to speak, using economy-wide statistical indicators.

A bigger difference, however, is that business people are comparing what we've got with what we had, whereas the economic managers are comparing what we've got with what we might have got, which was a lot worse.

Business people know everything was going swimmingly in the years leading up to the global financial crisis of 2008-09, but in the years since many industries - manufacturing, tourism, overseas education, retailing, wholesaling - have been travelling through very rough waters.

The econocrats, however, have a quite different perspective: whereas the rest of us love a good boom, those responsible for managing the economy view them with trepidation. Why? Because they know they almost always end in tears and recriminations.

Particularly commodity booms. As a major exporter of rural and mineral commodities, we've had plenty of these in the past. They've invariably led to worsening inflation, a blowout in the trade deficit and ever-rising interest rates, followed by a recession and climbing unemployment. The latest resources boom was the biggest yet, involving the best terms of trade in 200 years, leading to a once-a-century mining investment boom. It could have - even should have - led to a disaster, but it didn't.

The macro managers' primary responsibility is to maintain "internal balance" - low inflation and low unemployment - which involves achieving a reasonably stable rate of economic growth. No wonder commodity booms make them nervous.

So how have they gone? As Dr Philip Lowe, deputy governor of the Reserve Bank, said in a speech this week, over the three years to March, economic output (real gross domestic product) has increased by 9 per cent, the number of people with jobs has risen by more than half a million and the unemployment rate today is 5.4 per cent, the same as it was three years ago.

Underlying inflation has averaged 2.5 per cent over the period, the midpoint of the medium-term inflation target. "So over these three years we have seen growth close to trend, a stable and relatively low unemployment rate and inflation at target," he says.

And that's not all. The investment boom hasn't led to a large increase in the current account deficit. There hasn't been an explosion in credit. Increases in asset prices have generally been contained. And the average level of interest rates has been below the long-term average, despite the huge additional demand generated by the record levels of investment and high commodity prices.

So "we have managed to maintain a fair degree of internal balance during a period in which there has been considerable structural change, a very large shift in world relative prices, a major boom in investment and a financial crisis in many of the North Atlantic economies", Lowe says.

So how was this surprisingly OK performance achieved? Well, that's the funny thing. The two factors that have done so much to make life a misery for so many businesses - the high dollar and increased household saving - are the very same factors that have been critical to our good macro-economic performance.

The high dollar brought about by the resources boom has reduced the ability of our export industries to compete in the international market and reduced the competitiveness of our import-competing industries in our domestic market, making life very tough for many of them.

For a while, many hoped the dollar's rise would be temporary, but now "there is a greater recognition that the high exchange rate is likely to be quite persistent and firms, including in the manufacturing sector, are adjusting to this", Lowe says.

"Many are looking to improve their internal processes and address inefficiencies. They are focusing on products where value-added is highest and where the quality of the workforce is a strategic advantage. We hear from businesses right across the country that they are looking for improvements and that many are finding them."

But here's the other side of the story. Had we not experienced the sizeable appreciation, he says, it's highly likely the economy would have overheated and we would have had substantially higher inflation and substantially higher interest rates.

"This would not have been in the interests of the community at large or ... in the interests of the sector currently being adversely affected by the high exchange rate." And it's unlikely we would have avoided a substantial real exchange-rate appreciation, with it coming through the more costly route of higher inflation. (The real exchange rate is the nominal exchange rate adjusted for our inflation rate relative to those of our trading partners.)

Next, the rise in the net household saving rate from about zero to 10 per cent of household disposable income since the mid-noughties represents about an extra $90 billion a year being saved rather than consumed by households.

This reversal of the long-running trend for consumption to grow faster than household income explains much of the pain retailers and wholesalers have been suffering. We've had more retail selling capacity than we've needed, forcing shops to fight for their share of business.

But had households spent that extra $90 billion a year on consumption, it's likely there would have been significant overheating. The exchange rate would have been pushed up, the trade balance would be worse and there would have been more borrowing from the rest of the world.

"And both inflation and interest rates would have been higher. I suggest that these are not developments that would have been warmly welcomed by most in the community," Lowe concludes.

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Economists show racism alive and well in Oz

Australians aren't racist - and even if some people are, you and I certainly aren't. It's true, of course, that many of us are terribly stirred up about the arrival of so many uninvited boat people. And both sides of politics vie to be seen as harsher in their treatment of these interlopers. Then there's Julia Gillard's new-found concern about foreigners getting to the head of the jobs queue.

But this has nothing to do with racism. Gillard reassured us in the 2010 election campaign that we should say what we feel in the asylum-seeker debate without being constrained by self-censorship or political correctness.

"For people to say they're anxious about border security doesn't make them intolerant. It certainly doesn't make them a racist," she said.

It may surprise you that racial discrimination has long been a subject of study by economists - particularly American economists and particularly as people's "taste for discrimination" relates to the labour market.

Two economists from the University of Queensland, Redzo Mujcic and Professor Paul Frijters, will publish the results of a natural field experiment on Thursday in which trained "testers" of different ethnic appearance got on buses in Brisbane, discovered their travel card wouldn't work, but then asked the driver to let them to make the trip anyway.

Various testers did this more than 1500 times. Overall, the driver agreed in almost two-thirds of cases.

But whereas the success rate for testers of white appearance was 72 per cent, for testers of black appearance it was just 36 per cent.

Testers of Indian appearance were let on 51 per cent of the time, whereas those of Chinese, Japanese or Malaysian appearance were allowed to travel about as much as Caucasians were.

On average, bus drivers were 6 percentage points more likely to favour someone of the same race. Black drivers tended to be the most generous, accepting in 72 per cent of cases, compared with 54 per cent by Indian drivers and 64 per cent by Asian and white bus drivers.

If you think that's interesting, try this: to test the importance of how people were clothed, the testers were then dressed in business suits with briefcases. The success rate of whites rose by 21 percentage points and the combined rate for blacks and Indians rose to 75 per cent.

Next, the testers were dressed in military clothes. The success rate of whites rose by 25 percentage points while the combined rate for blacks and Indians rose to 85 per cent.

As a follow-up, the researchers then conducted a random survey of bus drivers at selected resting stations in Brisbane, presenting them with pictures of the same test subjects and asking the bus drivers whether they would let them on or not with an empty travel card.

Some 80 per cent of the bus drivers at resting stations indicated they would give free rides to Indian and black test subjects, even though in reality less than 50 per cent were let on.

Indeed, bus drivers said they would let on white subjects 5 percentage points less often than black subjects, whilst in reality white test subjects were favoured at least 40 percentage points more than black testers.

The main reason given for not letting someone on was it was against the rules, while the main reason to let someone on was it was no burden to do so.

It's all a bit disturbing - if not so surprising - but how do we make sense of it? And what's it got to do with economics?

Frijters, perhaps Australia's leading exponent of "behavioural" economics, is developing an economic theory of groups: the different types of groups and how and why they form. All of us feel an affinity with a range of groups. Businesses and government agencies are groups, but there can be groups within those groups; working teams as well as sporting teams. Mixed in with all this are in-groups and out-groups - people we want to associate with and people we don't.

Often we form groups so as to co-operate in achieving some goal. And groups often involve reciprocation - I do you a favour in the expectation that, when my need arises, you'll do me one.

So Frijters explains the results of his experiment in terms of group behaviour. "People with Indian or black complexions are more likely to be treated as an out-group and less worthy of help compared to Caucasians and Asians," he says.

"The reason bus drivers were more reluctant to give black and Indian help-seekers a free ride was that they did not personally relate to them."

When testers were sent to bus stops in military clothes this made them appear to be patriots, defending the same community as the bus driver. So the drivers' original out-group reaction could be overcome by in-group clothing.

The more favourable treatment of testers in business dress suggests the "aspirational groups" of the bus drivers include people richer than themselves, people with more desirable visual characteristics. That is, people the drivers regard as part of their in-group.

If all this sounds more sociological or to do with social psychology than with economics, it is. But that's the point of behavioural economics: to incorporate insights from other social sciences into economics.

And what have groups got to do with economics? That's simple: the objective of many groups is to give their members greater control over economic resources.

Frijter's new book, An Economic Theory of Greed, Love, Groups and Networks, written with Gigi Foster, will be published this month.

Can't wait.

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Tax facts contradict voters’ perceptions

Is Labor a big taxing, big spending government, as Tony Abbott and his Liberal colleagues claim, or has it been taxing us a lot less than the Howard government did, as Wayne Swan claims? As with many conflicting claims by pollies, it depends on how you interpret the figures.

In truth, the Libs always make such a claim against Labor because it plays into the electorate's deeply ingrained stereotypes about the strengths and weaknesses of the two parties.

Most people believe Labor is better when you want it to spend money helping you, whereas the Libs are better when you want them to keep taxes down.

But we need to come to a more evidence-based conclusion than that. On the face of it, it's easy to believe Gillard Labor is a big taxer when you remember it's introduced two major new imposts, the carbon tax and the mining tax.

But it ain't that simple because both taxes were part of packages where much of the proceeds of the new tax was used to cut other taxes. Money from the carbon tax was used to exempt certain export industries from paying it and to finance a small income tax cut for all individuals earning up to $80,000 a year.

The expected proceeds from the mining tax were used to fund a big instant tax write-off for small business, a refund of the tax on super contributions for employees earning up to $37,000 a year and to cover the loss to the taxman when compulsory super contributions are raised from 9 per cent to 12 per cent of wages.

So that argument doesn't wash. Going the other way, however, the Libs are right when they remind us that much of the cumulative $150 billion worth of "savings" Swan likes to boast about constitutes reductions in tax concessions rather than cuts in government spending.

Whenever Swan claims to be a lower taxer than the Howard government, the Libs reply indignantly that tax collections have risen hugely under Labor. As with so many of the claims politicians on both sides make, this is literally true, but calculated to mislead.

It's true that, from the total tax collections of $278 billion in 2007-08 (John Howard's last budget), collections first fell to $261billion in 2009-10 (thanks to the global financial crisis) but, on the latest best guess, are to rise to about $335 billion this financial year. That's a net increase of $57 billion, or 20 per cent, over the five years since Howard's last budget.

Convinced? You shouldn't be. Such a comparison looks worse than it is because it ignores the effect of inflation. If we subjected the Howard government to the same trick, we'd say tax collections increased by $163 billion, or 140 per cent, over 12 years.

No, we should, at the very least, allow for inflation and look at the real increase in tax collections. By my rough figuring, using the implicit price deflator for gross domestic product, the real increase in tax collections is about 10 per cent.

That's not too terrible over five years. But the usual way to evaluate the growth in taxes is to compare them with the size of the economy (measured by nominal GDP) at the time.

This is the way the Organisation for Economic Co-operation and Development and many other official bodies do it and was the way the Howard government was happy to have itself measured.

It represents a way of assessing the burden of taxation relative to the overall economy's capacity to bear that burden.

Doing it this way shows tax collections have averaged about 21per cent of GDP over Labor's five years.

By contrast, they averaged 23.4per cent of GDP over the Libs' 12 years, and a remarkable 24 per cent over their last six years.

This is the basis for Swan's claim to be taxing us more lightly than Peter Costello did, and the numbers are on Swan's side.

The truth is that Costello was our highest-taxing treasurer ever, although for much of his time he tried to hide the fact by pretending the goods and services tax had nothing to do with the feds.

In 2004-05 and 2005-06 tax collection reached a record 24.2per cent.

Of course, although politicians often like to pretend everything that happens in the economy happens because they made it happen, the truth is that much of what happens is caused by factors beyond their control.

A big part of the reason the Libs' raised so much tax is that they presided over the first half of the resources boom, before the GFC. And much of the reason Swan has taxed us more lightly is that some taxes haven't fully recovered from the GFC, the second half of the resources boom hasn't been as lucrative as the first, export prices have now fallen back a long way and, to make things worse for the taxman, the fall in export prices hasn't led to a fall in the dollar.

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Why tax revenue is falling short of budget

Try this quick quiz: which matters more, the growth in ''nominal'' gross domestic product or the growth in ''real'' GDP? Sorry, it was a trick question. The right answer is a favourite reply of economists: it depends.

If your interest is in how fast the economy's growing (or not growing), the answer is real GDP - GDP after allowing for the effect of inflation. But if your interest is in how fast the federal government's tax receipts are growing the answer is nominal GDP - GDP before allowing for inflation.

Why is nominal the right answer for tax receipts? Because, as Treasurer Wayne Swan keeps saying, ''we live in the nominal economy through the prices we pay and the incomes we earn''. As part of this, the income tax we pay is based on our nominal income and the indirect taxes we pay are based on our nominal spending.

Fine. If you didn't know the growth in nominal GDP is the best guide to the growth in tax revenue before, you do now. But why has Swan been making so much of this in recent days? Because it's the main reason why, despite all his savings measures (and creative accounting), the government won't be able to keep the promise it made in the 2010 election campaign to get the budget back to surplus this financial year.

That promise was based on a Treasury projection for 2012-13 included in the 2010-11 budget. But tax collections simply haven't grown as strongly as Treasury projected they would, and the main reason they haven't is that nominal GDP has been behaving strangely.

We're used to assuming that, if the economy's growing in real terms (which it has been), the government's tax revenue will be growing at least as fast and probably faster. (Why faster? Because almost half the feds' tax collections come from personal income tax, which grows extra strongly because, in the absence of the indexation of tax brackets, it's subject to ''bracket creep''.)

When economic events are proceeding normally, the distinction between nominal and real GDP doesn't matter much. Obviously, the difference between nominal and real GDP is the inflation rate, and if inflation is running within the Reserve Bank's 2 per cent to 3 per cent target range, the two totals should be moving pretty much in parallel.

To put it another way, nominal GDP should be growing at a reasonably steady 2.5 percentage points or so faster than real GDP. But we learnt from last week's national accounts for the December quarter that, for the first time on record, the past three consecutive quarters have seen nominal grow by less than real, not more. Since real GDP grew by 1.9 per cent, nominal GDP should have grown by about 4 per cent. Instead it grew by a pathetic 1.6 per cent.

Swan noted in a recent speech to business economists that nominal has grown by less than real for only four short periods in the 53 years since the Bureau of Statistics began producing quarterly national accounts.

The last time nominal was really weak was in the global financial crisis. Before that it was the Asian financial crisis of 1997-98 and, before that, the Menzies government's credit squeeze in 1961. In all but the credit squeeze episode, the explanation was the same: a sharp fall in global commodity prices led to a sharp deterioration in our ''terms of trade'' - the prices we receive for our exports relative to the prices we pay for our imports.

Ah. Whenever we talk of inflation, people think automatically of the main measure of inflation we use, the consumer price index. But in fact there are many measures of inflation, most of the others being derived from the national accounts.

The difference between nominal and real GDP is measured not by the CPI but by the ''implicit price deflator'' for GDP. When the economy's travelling normally, there shouldn't be much difference between the GDP deflator and the CPI and other measures of the change in the price of domestic spending.

But ''normal'' means when our terms of trade aren't changing much. When they're improving or deteriorating sharply, the GDP deflator and measures of domestic-spending inflation really part company.

Why? Because domestic spending includes the prices of imports but excludes the prices of exports, whereas GDP and its deflator exclude the prices of imports but include the prices of exports.

It works out that nominal GDP will grow very much faster than real GDP when our terms of trade are improving sharply, but nominal may even grow more slowly than real when our terms of trade are deteriorating sharply - as they were last year. But why wasn't Treasury expecting

the terms of trade to deteriorate and allowing for this in its projections of tax revenue? It was, and it has been - for most of the past decade, in fact. But it wasn't budgeting for the deterioration to be as fast as it's been, particularly in the September quarter.

That was the first problem with its revenue forecasts. The second, less obvious, one was this: on the basis of past behaviour, Treasury (and everyone else) was expecting any deterioration in the terms of trade to be accompanied by a similar fall in the exchange rate.

To everyone's surprise, the dollar has stayed up. This means the prices of imports haven't risen in the way you'd have expected, causing domestic inflation to be lower than expected. This, in turn, has meant nominal incomes haven't risen as fast as could have been expected.

So this factor, too, helps explain why tax collections haven't risen as fast as forecast. The latest estimate is that tax collections will fall about $10 billion short of what was forecast in the budget last May.

The last thing to say is that by no means all federal taxes are closely aligned with nominal GDP. The strongest relationship is with taxes on profits - company tax, income tax on unincorporated businesses and the two resource rent taxes. These account for about a third of total tax revenue.

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