Competition does have its drawbacks

Competition is billed by economists as a wonderful thing, the invisible restrainer of a capitalist economy and essential to ensuring consumers get a good deal.

But many economists aren't as conscious as they should be that competition has costs as well as benefits.

It's true, of course, that monopoly is usually a terrible thing, allowing arrogant, inflexible behaviour on the part of producers, with little pressure on them to keep prices down or to provide much choice. Dealing with government departments shows you what monopolies are like.

Economists tend to assume the more competition the better and that customers can never get too much choice. But this shows how – despite their loud protestations to the contrary – their thinking is excessively influenced by their most basic, least realistic model of "perfect competition".

Psychological experiments show that when shoppers face too much choice, they tend to avoid making a decision. That's because the information they need to make informed choices isn't freely available and because the human mind hasn't evolved to be good at choosing between more than two items with differing characteristics.

Many real-world markets are characterised by oligopoly: a few large firms accounting for most of the sales. Oligopolies make economic sense because they're needed to fully exploit economies of scale (which are assumed away under perfect competition). So, in reality, competition and scale economies are in conflict.

In oligopolies and even in markets with a relatively large number of producers, competition is blunted by product differentiation, much of which is cosmetic. As with most advertising, product differentiation is intended to induce consumers to make decisions on an emotional rather than rational basis.

Phoney differentiation is also intended to frustrate rational comparison. It's not by chance that it's almost impossible to compare mobile phone contracts.

When economists speak of competition, they're usually thinking of competition on price. But though oligopolists watch their competitors like hawks, they much prefer to avoid price competition, competing rather via advertising, marketing, packaging and other differentiation.

Mackay's Law of competition states that the key to competition is to focus on the customer, not your competitor. But this is what oligopolists don't do.

In the real world – including the media – competitor-oriented competition is rife. This robs customers of genuine choice. It's a form of risk aversion: if I do the same as my competitor, I minimise the risk of him beating me.

It's what, in Harold Hotelling's classic example, prompts two ice-cream sellers to be back-to-back in the middle of the beach, regardless of whether some other positioning would serve customers better. It explains why business economists' forecasts tend to cluster, usually around the official forecast.

In his book The Darwin Economy, Robert Frank, of Cornell University, argues that lefties tend to see inadequate competition as the most prevalent form of market failure, whereas it's actually "collective action problems".

A collective action problem arises when the players in a market realise they're doing something mutually destructive, but no one's game to stop doing it for fear of being creamed by their competitors.

Usually in commercial markets the only answer is for the government to intervene and impose a solution on all players; for which they're grateful.

However, that's no help to our political parties, which have got themselves locked in a game of ever-declining standards of behaviour they don't know how to escape from. It's collective action problems that make it so easy for the politicians to manipulate the media.

The advocates of federalism believe it's good to have the states free to be different and competing against each other. In reality, the competition is mainly negative. The states compete to attract foreign investors with special tax concessions and the foreigners play them off against each other.

In the early 1970s, the McMahon government transferred its payroll tax to the states to give them the "growth tax" they needed to cover their growing spending. In the decades since then, they've done little but compete with the others by raising their tax-free thresholds and cutting their rates.

The huge increase in federal grants to private schools over recent decades was justified as increasing parents' choice and imposing competitive pressure on public schools. There's little evidence it's worked, nor much even that it's held down private school fees.

Similarly, Julia Gillard's My School website, with all its information about the academic performance of particular schools, intended to increase competition between them, has failed to produce any increase in the proportion of students achieving national minimum standards in reading, writing and numeracy over the five years to 2014.

Depending on circumstances, competition can make things better or worse – or little different.

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Why the Trans-Pacific Partnership is no game-changer

Think you know a bit about economics? Try this quick quiz: what's your impression of the Trans-Pacific Partnership Agreement reached between the United States and 11 other Pacific Rim countries, including Australia, this week?

Would you say it is: a) a gigantic foundation stone for our future prosperity that will boost growth, create jobs, raise living standards and increase productivity; b) a terrible deal that advantages big American multinationals at our expense, or c) not a big deal either way?

Malcolm Turnbull and his ministers' exaggerated claims about the benefits likely to flow from the agreement rest on the expectation that it will allow our farmers to sell more sugar, beef, cheese, wool and rice to the other economies, at higher prices.

Since these gains have been achieved at little cost in terms of increased access to our market for the other countries' exports, we're surely well ahead on the deal.

Does that make sense? Only if you don't know much economics.

As for the claim that it's a terrible deal, it has some truth to it, but is itself exaggerated. It's true that part of the deal involves our acceptance of "investor-state dispute settlement" arrangements, which allow foreign companies – but not local businesses – to take actions for damages against governments that make decisions which adversely affect their profits.

This is an unwarranted imposition on democratic governments' sovereignty which, at best, will involve them in significant legal costs in fending off vexatious claims.

It's true, too, that trade deals with the US have involved attempts to advantage American companies holding intellectual property – patents, copyright and trademarks – at the expense of local consumers.

And the intense secrecy in which the TPPA has been negotiated – we still don't know the details of the agreement and won't for some months – raises justified suspicion in many people's minds. What is it that big companies and lobby groups may know, but the public may not?

Even so, it does seem that Trade Minister Andrew Robb has fended off American attempts to further advantage foreign pharmaceutical companies at the expense of Australian patients and taxpayers.

In the old days trade agreements were about increasing trade between countries. These days, they're at least as much about imposing restrictions on governments' freedom to legislate as they see fit.

But to assess the likely effects on the economy – on growth, incomes, jobs and productivity – we need to set this legislative aspect to one side and focus more directly on trade and investment.

Be clear on this: there's no doubt that reducing barriers to trade between countries increases the material prosperity of the countries involved. Reduced protection and increased trade have played a significant part in the greater prosperity enjoyed first by the developed economies and then the "emerging" economies since World War II.

Most of those gains were achieved by successive rounds of multilateral reductions in import tariffs and quotas. That is, the reductions applied to all of a country's trading partners, not just some.

But the World Trade Organisation has been trying unsuccessfully since 2000 to organise another multilateral agreement. In the meantime, countries have taken to making bilateral trade deals, where the concessions made to the other country aren't available to any other economy.

This makes them preferential trade agreements, not the free trade agreements they are known as.

They're greatly inferior to multilateral agreements because they tend to divert trade from more efficient to less efficient supplier countries, simply because the less efficient suppliers happen to be subject to lower import duties.

And the picking and choosing between which countries get preferential treatment and which don't creates a need for complex "country of origin" rules that add much red tape to international trade.

This week's regional preferential trade agreement between 12 countries representing 40 per cent of world gross domestic product will still be trade-diverting to some degree, particularly since it excludes such significant trading partners as China, India and Indonesia.

But it could lessen the burden of red tape if, as mooted, it involves uniform country-of-origin rules.

The other weakness of trade deals is their encouragement of mercantilist thinking – the notion that countries get rich by exporting as much as they can and importing as little as they can – a fallacy economists have been fighting since the days of Adam Smith.

The nature of bargaining is to gain as many concessions as you can while making as few of your own as you can. But this is the exact opposite of the way you maximise the economic gains from trade.

You gain most not by inducing trading partners to reduce their barriers to your exports, but by reducing your own barriers to their exports. You gain when you shift productive resources from things you aren't very good at doing to things you are.

That's the first reason for believing a modest increase in sales for our farmers and little change for our import-competing industries won't do much to increase growth, jobs and productivity.

The second reason – and another reason mercantilism is fallacious – is that if we did get a lot higher prices for our agricultural exports without much change in import prices, this improvement in our terms of trade could be expected to lead to a rise in the value of our dollar.

If so, our farmers might be better off but this would be at the expense of our manufacturers, tourist industry and other exporters of services.

As yet we've done no modelling of the likely economic benefits of the TPPA. But various American modelling exercises – and our officially commissioned modelling of our recent bilateral deals with South Korea, Japan and China – all suggest the gains will be small – say, a level of GDP that's just 0.5 per cent higher than otherwise after 10 years. No big deal.

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MUST WE DESTROY JOURNALISM IN ORDER TO SAVE IT?

Talk to the New News conference, Wheeler Centre, Melbourne Friday, October 9, 2015

In the last phase of my career as a journalist - I’ve just published my memoirs, A Life among Budgets, Bulldust and Bastardry - I, like many journos, have become greatly exercised by the challenge that the digital revolution presents to the continued existence of “quality” or “serious” journalism - journalism that has a serious intent, even though it’s perfectly capable of seeing the funny side of things. The ABC’s journalism is serious enough, but since it’s already electronic I don’t see it as being under the degree of threat that faces the newspapers. I’m not sure how the traditional tabloid papers will survive, but I’m concerned mainly about the two papers I work for - the SMH and The Age - and also the Financial Review and The Australian which, according to Eric Beecher, between them “provide most of Australia’s coverage of politics, justice, economics, business, science, health, welfare, public policy, international affairs, arts, culture and ideas”.

There are two issues of concern: first, finding a future for the occupation of journalist in the digital world, but second, ensuring the news media continue to fulfil their “higher purpose” of reporting important information about our society that otherwise wouldn’t be brought to many people’s attention, and helping to hold governments accountable to the public. It’s the news media’s higher purpose - rare, maybe even unique, among profit-making industries - that makes its survival a matter of great importance for the community, not just to those who make their living from it.

Of course, this isn’t the first time the practice of journalism has been disrupted by changes in technology, though I doubt any previous change has been as disruptive as this one. It’s possible that in a decade or two we’ll look back and wonder what all the fuss was about, but at present we can’t know whether things will turn out well or ill and, in any case, it may well be that all the agonising and debating we do will play its own part in ensuring the ultimate outcome is satisfactory.

One thing I don’t fear is that the public could ever lose its interest in news. Humans are curious, pattern-seeking, threat-searching and intensely social animals, so an insatiable desire to know the latest news - and to know it as soon after it happens as possible - is hardwired in all of us. Humans have been seeking out news since we sat around the camp fire yarning after a hard day’s hunting and gathering.

So I don’t doubt that news will survive in the digital age. But that’s not the same as saying the present “legacy” providers of news are bound to survive - particularly those formerly oriented to providing it on dead trees. A knowledge of previous waves of technological change in any industry makes it easier to believe the place of the old, huge, lumbering incumbent suppliers will be taken by new smaller, more flexible and more innovative suppliers in the changed market for news. That would be bad news for all those journalists presently employed by the legacy news outlets, but not necessarily for the consumers of news, or for journalism’s fulfilment of its higher purpose.

In all this I don’t want to be seen as imply that the digital disruption of the news media is a bad thing. I have no doubt that, like most widely adopted technological advances, it is bringing considerable benefits to users. To take one simple example, the move of classified advertising from broadsheet newspapers to the internet has hugely improved the quality and flexibility of classified advertising, while also hugely reducing its cost to people taking out ads. The problem is that this difference in the price of classifieds is what used to be used to pay the wages of journalists on broadsheet newspapers.

To the legacy newspapers, the challenge of the digital revolution comes at two, interrelated levels. One is the shift of readers from newspapers to the various online platforms: the website, the tablet apps and, increasingly, the mobile phone apps. The other is the shift of classified and display advertising from newspapers to online platforms. The newspapers’ online platforms have captured only a small part of the shifted advertising, with much of it going to search engines and social media sites. In any case, the prices received for digital advertising are very much lower - exceptionally so for ads on mobile phone.

I’d be delighted if time proved me wrong, but I don’t doubt that newspapers’ days are numbered. That’s likely both because of the continuing shift of advertising to online and because most of the younger generation favours screen-based information and simply doesn’t read newspapers. I don’t know of any survey evidence, but my guess is that few people younger than baby boomers still read newspapers - and not even all the oldies do. To me, the only uncertainly is how long newspaper revenue will continue to exceed newspaper costs and thus how long before they are closed. Two years? Five? Ten? Probably sooner than 10.

At present, however, newspaper revenue from advertising and cover price accounts for about two-thirds of total news-related revenue at Fairfax Media. The challenge facing the company as a purveyor of news is clear: to build up digital revenue - from advertising and subscriptions - to the point where it more than covers the editorial and other costs of a digital-only news provider. The challenge is less daunting than it seems when you remember that the newspaper revenue comes with considerable costs in addition to the wages of journalists, in the form of printing and physical distribution costs. Obviously, we won’t have to raise sufficient digital revenue to cover the cost of printing and distributing the papers when we no longer produce them. By the same token, however, the considerable costs of printing and distributing make the challenge of getting the digital-only business up to critical mass more urgent. That’s because the two-thirds of total revenue coming from newspapers won’t need to fall all that much further before it ceases to cover the printing and distribution costs and thus makes it no longer profitable to continue printing papers and earning newspaper advertising and cover-price revenue.

So the key question is, what do we have to do to greatly increase our digital revenues? What changes do we have to make not just to our digital platforms but to our journalism - our news offering, if you like - to get our revenues up to where we’ll soon need them to be? Well, one approach would be to focus most of our effort on increasing our advertising revenue while collecting whatever subscription revenue comes our way. An alternative approach would be to focus most effort on increasing our subscription revenue, while being more targeted in our efforts to attract ad revenue. I call the first approach Plan A - because it’s closer to the approach Fairfax is actually pursuing at present - and the alternative approach, Plan B, because it’s the one I believe we’ll have to turn to if Plan A can’t be made to work. Let me describe the features of these rival “business models”.

Plan A

Plan A is the approach most likely to instinctively appeal to journalists because, on the surface at least, it seems to involve no fundamental change in news gathering as we’ve always done it. Indeed, it actually involves a return to journalism as it used to be practiced. The main change seems to be in the way we package the news for a digital age, rather than in the nature of the news we report.

From a commercial perspective, the plan involves maximising what critics call “clicks”, but digital editors prefer to call “page impressions” or, with a slight refinement, “unique browsers”. It’s believed that what digital advertisers want is “reach” - the biggest audience possible - and their preferred measure of this is the monthly total of unique browsers.

How do you get lots of clicks? Well, not so much by resorting to click bait or “churn” - appropriating the successful stories of other news outlets - but by reverting to the breaking news business. You focus on reporting the big stories of the day, getting them onto the site and apps as soon as possible, then improve your offering with side-bar stories, pictures, graphics, videos and commentary as soon as they can be organised.

For the most part your competitors are offering essentially the same stories you are, but you hope that your timeliness, the quality of your reporting, photos and videos, combined with the reputation of your masthead, will win you more clicks than the others. It’s clear some headlines attract more clicks than other headlines, so much attention is given to writing the best ones.

The digital delivery of news is so new that outlets are still experimenting with different ways of presenting it and users are changing their behaviour in response to developments in technology, meaning the news environment is ever-changing and digital editors aiming to keep increasing their clicks are continually responding to these changes.

A declining proportion of clicks is from people coming direct to our website, with more coming via referral from social media such Facebook and search engines such as Google. Fewer people are using the site and an ever-growing proportion are using their mobile phone app to check the latest. As digital readers’ habits over the course of the day change, so does the need to update our platforms. We haven’t quite got to the point where they’re updated 24/7, but we’re getting closer, with journos now working early and late shifts and more effort being made to respond to the recent surge in Sunday browsing.

By their nature, digital platforms provide numerical feedback in real time about the popularity of particular stories and general topic areas. Responding to this feedback is a big part of the way we try to get more clicks.

All this says there’s more change in the way we package our news than in the stories and topic areas we cover. We still chase every story we believe our readers will find newsworthy. So I think most journalists and editors remain reasonably comfortable with this response to the digital challenge. Journalists like to compete with each other, and they’re attracted to the simple, objective, numerical and frequent measure of their success provided by the click count. It’s the closest the digital world provides to the old newspaper world’s ultimate measure of journalistic success: circulation. It seems to replicate the old bargain between journalists and management: our contribution to the company’s commercial success is to maximise circulation; how you convert that circulation into revenue is up to you and none of our business.

This is Plan A, but I have worries about it on two levels. First, I’m not sure it’s sufficient to secure our future financially. It’s not clear to me that simply maximising clicks will gain all the revenue we need to more than cover the cost of our news gathering effort. Too much of the advertising revenue in the digital world is captured by the two social media and browser giants that presently dominate the provision of breaking news. And advertising rates seem sure to shrink rather than fatten as users move to getting most of their news via mobile phone.

Further, I find it hard to believe that “reach” - maximum eyeballs - is the most advertisers want from us, much less the most valuable thing the quality news media are capable of offering them. My guess is that advertisers and ad agencies are just as much at sea in the digitally disrupted world as the former newspaper companies are. If advertisers aren’t sharp enough to see that we’re capable of offering them something more valuable than mere “reach” we should be doing more to educate them. We should be developing and promoting “metrics” that better demonstrate what we’ve got to offer advertisers.

Plan A doesn’t sufficiently “leverage” the serious news providers’ brand, reputation and following. Presumably, we’re hoping our reputation for trustworthiness will bring us more clicks than go to the former tabloid papers or to the digital upstarts. But is this the best we can do? In the old world the readership of the serious press came predominantly from the best-educated and most highly paid part of the market, known to advertisers as the ABs. Our circulations were always smaller than those of the tabloids, but our charges for ads were always higher because of our clientele’s greater buying power. We got the ads from David Jones and Myer, they got ads for the weekly specials at Coles and Woolies supermarkets. Can it be true that up-market advertisers are no longer willing to pay a premium to advertise on up-market digital news platforms? Alternatively, is it true that, by our efforts simply to maximise clicks from all comers, our clicks have become worth little more to advertisers than the tabloid sites’ clicks?

Another advantage of attracting a predominantly AB audience is that these are people well able to afford a digital subscription should they judge the service we offer to be of sufficient value to them. But if we’re simply trying to maximise clicks by offering breaking news that’s just faster and better than all our many competitors, why would this be something many people would be willing to pay for?

But this question of quality - of seriousness - brings me to my second and more important worry about Plan A: will it allow us to adequately discharge our higher purpose - a purpose that not only contributes to the quality of the nation’s governance but also provides serious journalists with much of their job satisfaction?

Editors committed to the Plan A business model may deny it, but it’s hard to see how aiming to maximise clicks by beating our competitors on all the big breaking stories of the day leaves much room or resources for self-initiated, proactive reporting. For investigative reporting and the search for scoops that tell Australians things they wouldn’t otherwise find out about how they are being governed. Room even for the vast amount of news that usually falls into the important but not terribly exciting category, including a lot of the topics on Eric Beecher’s list: science, health, welfare, public policy, international affairs, arts, culture and ideas.

Putting the great bulk of our resources into fabulous coverage of the great excitements of the day puts too much of what we do into the lap of chance occurrence and the efforts of governments and other vested interests to use the media for their own ends. It doesn’t leave much room for anything but the most immediate, top-of-the-head comment and analysis. It favours the emotional assertion of strong opinions, not the careful weighing of pros and cons. It leaves little room for mature reflection, for the how and why as well as the who, what, when and where. It feeds the ever-shorter attention span, leaving too many news stories only partially digested. Nor does it leave much room for newspapers to exploit their former strength of having well-known columnists - “personal brands” - who help distinguish your outlet from its rivals and attract their own crowd of loyal followers. Such columnists contribute not quantity of clicks but quality of “engagement” - users who stay on the page not 30 seconds but however long it takes them to read most of an article.

Plan B

So what’s the alternative approach that offers legacy serious newspapers a better chance commercial survival and continued discharge of their higher purpose? As I outline in greater detail in the last chapter of my book, Plan B starts by accepting that the digital revolution is leading to the “commodification” of news, which leads inevitably to the bifurcation of the news task. A basic news service is now available from any number sites. It’s all much the same and it’s almost always free. It’s so freely available that you can’t charge for it, nor can you expect that, by being a little better than all the others, you’ll attract a disproportionate share of the eyeballs and advertising revenue.

Plan B accepts that, once the present period of multiplying news sites gives way to a period of consolidation - as some platforms survive but most run out of money - the journalistic task will divide into two: a smaller number of journalists producing the basic, breaking news, working mainly for the wire services and the ABC, plus a smaller number of journos working for outlets that specialise in adding value to the commodified news produced by others.

This other category of news outlet adds value by using more experienced and more specialised journalists to add background and analysis. Value-adding makes news less incremental. Rather than adding to the confusion, it seeks to dispel it. It limits its value-adding to a narrower range of topics, giving great emphasis to reporting “local” news - city and state politics, transport, health and education - where the competition from other sites is least. It pursues exclusive stories and investigative reporting. It highlights the contribution of its big-name columnists, using them to attract loyal readers.

Commercially, it focuses most on revenue from subscriptions, while adding high-end ad revenue attracted by its AB audience. The gated access to value-adding, exclusives, investigations and name-brand columnists gives people sufficient reason to buy a subscription. And the value-adding is what does most to continue the news media’s discharge of its higher purpose.

If I’m right in believing Plan A is unsustainable, leading to continued rounds of redundancies, it will be only a matter of time before the legacy providers of serious news gravitate to Plan B - provided, of course, they don’t run out of money or damage their brands too badly before they complete the transition. Should they fail, however, I don’t doubt that various new, unencumbered and enterprising digital platforms will arise to fill the need they left unmet.

We won’t have to destroy journalism in order to save it, but I fear we will have to change the way it is practiced more radically than we have so far.

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How digital disruption allows higher prices

Do you think much about the process involved when you decide to buy something some seller is offering you? If you're like most consumers, probably not. But the businesses doing the selling do, which ought to be a warning.

And the study of exchange – the buying and selling of goods and services – is the central element of economics. Economists long ago concluded they had it all figured.

Trouble is, the digital revolution is changing the way sellers behave when we buy things online or use the internet to check out the choice before deciding what to buy.

These hidden changes are revealed in the eye-opening book, All You Can Pay, by former Fairfax Media journalist Anna Bernasek and her husband, D. T. Mongan.

None of us wants to pay more than we have to to buy the things we decide we need. But the great insight of economists is that we'd often be prepared to pay more for something we want than we're required to.

The difference between what we're willing to pay and what we actually have to is known to economists as the "consumer surplus". It's a measure of how much better off the purchase has left us.
The more successful competition is in holding down the market price, the greater is our consumer surplus and thus the more we've gained from living in a market economy.

By the same token, sellers are often able to sell their wares for a higher price than the minimum at which they'd be willing to sell. This difference is the "producer surplus". The smaller the producer surplus, the more competition in the market is advancing the interests of consumers.

It's obvious that producers would like their surplus to be as great as possible. The history of the modern market economy is the story of how businesses have discovered ways of increasing that surplus even while competition between them has been working to keep it small.

For most of the past century we lived in the era of mass-produced consumer goods, as epitomised by Henry Ford. He invented the production line as a way of more fully exploiting economies of scale and keeping the price of his cars as low as possible.

The lower the price, he reasoned, the more people who could afford a car. And the more cars he sold, the higher his profits. To keep costs and prices low he produced just one kind of car, in one colour, black.

But, as Bernasek and Mongan record, Ford was eventually overtaken by General Motors, pursuing a different strategy of selling a range of models at differing prices, aimed at different segments of the market. GM even started changing each model slightly every year.

This "product differentiation" involved selling more than just a car: style, fashionability, social status, even self-expression. From an economist's perspective, however, it was about gaining the freedom to charge a higher price, making the "market price" harder to discern, reducing consumer surplus and increasing producer surplus.

If each consumer has their own price they're willing to pay, the ideal from a profit-maximising producer's perspective is to charge each individual a price that matches their willingness to pay. That some people would pay a price much lower than others are paying won't matter provided you're getting as much as you can out of each of them.

Trouble is, how do you know how much a person is willing to pay? You don't. But for years many businesses have practiced various forms of "price discrimination" involving charging broad categories of customers higher prices than others.

Cinemas, for instance, charge adults more than children. Airlines charge business travellers more than holidaying families. They do this not out of the goodness of their hearts, but to maximise their producer surplus.

But this is where the online revolution is making it a lot easier for sellers to assess the willingness to pay of particular customers. The more information they have on file about you – your age, sex, address, occupation and record of previous purchases – the more accurately they can estimate how much they can get away with charging you.

The authors explain that the trend to "customisation" is actually a way of asking you to disclose more about what you're looking for, giving the seller greater control over what you're offered and at what price.

Chain stores' loyalty cards are primarily a way of gathering information about your buying habits and preferences. If I know you invariably buy brand X, I know I don't need to offer you a lower price.

These days, prices are often framed as discount off what's purported to be the usual price. But how do you know the price wasn't bumped up before it was discounted? And how do you know the discount you're being offered isn't lower than others are getting?

Most of us still do only some of our shopping online rather than in stores, so it's early days for the trends Bernasek and Mongan see emerging.

But it's not hard to believe it's getting ever easier for businesses to convert consumer surplus to producer surplus by charging us more than they used to.

The more prices become personalised, the harder it becomes to know the actual market price – even the average price – customers are paying. If that day dawns, the benefits of living in a market economy will be greatly reduced.

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OBSERVATIONS ON MACRO MANAGEMENT

Talk to Economic Society, Victorian branch, Wednesday, September 9, 2015

I want to draw on a few themes from my new book, Gittins: A life among budgets, bulldust and bastardry, particularly some observations about macro management, recessions and, what I consider to be my special subject, the politics of economics.

Don Stammer, the veteran business economist, says you need to have seen four recessions before you’re fully qualified. I thought the global financial crisis of 2008-09 would bring my fourth, but if you don’t count that---l count it as a potentially severe recession turned into a mild one by remarkably skilful management---I’ve seen three big ones. The recession of 1974-75 would by itself have caused the Whitlam government’s defeat had there not been more than enough other reasons. The severe recession of the early 1980s brought the Fraser government’s reign to an end after just seven years and the severe recession we didn’t have to have in the early 1990s---in the sense that all recessions happen by accident rather than design---finally did for the perpetrator of that bravado in 1996, although his execution was delayed three years by the political inexperience of a former economics professor, John Hewson.

I soon formed the view that recessions occurred roughly every seven years. I know from the three recessions that have occurred so far ‘on my watch’---each of them accurately branded ‘the worst recession since the Great Depression’---how terrible recessions are: the fear and pain they cause to small business people, workers who lose their jobs and young people who have the misfortune to be leaving school or university at the time. Whitlam’s recession saw the rate of unemployment shoot up from 2 per cent to 6 per cent, Fraser’s recession saw it peak at 10 per cent and Keating’s at 11 per cent. I know how thoroughly depressed people get for years on end, convinced things will never pick up again. I also know how bitter are the public’s recriminations against economists. Recessions may be a ‘good story’---in the sense they give people like me plenty to write about---but I hate them.

My notion that recessions occur about every seven years remains pretty true for all the developed economies bar Australia. Even if you count the mild recession of the GFC---which I do---it remains true we haven’t had a recession bad enough for ordinary people to notice for 24 years. There are two things to say about this.

First, in one sense only it’s a pity you have to be so old to know how terrible a severe recession is and hence to be hugely relieved, even grateful, we managed to avoid one in the aftermath of the GFC. About seven years later the North Atlantic economies are still embroiled in the Great Recession we escaped.

Second, that we’ve avoided severe recession for an unprecedented period is thanks more to good management than good luck. Even if you’re so ill-informed as to imagine our escape from the Great Recession is due purely to China and the resources boom, you still have to explain 17 years of uninterrupted growth since the recession of the early 90s, including our exemption from the world recession of the early noughties. We should have been brought low by the Asian crisis of 1997-98, but weren’t.

I decided very early in that 17-year period that the ultimate test of good economic management was to keep the recessions as far apart as possible, mainly because recessions put a lot of people out of work for long periods, and the longer you’re jobless the harder it gets for you to regain a berth. I could have decided the ultimate test was to keep the inevitable recessions as mild as possible. Either way, our economic managers pass with flying colours. I know Australians find it hard to believe Aussies could be world-class at anything but sport, but it happens to be true of our econocrats.

I know because I watched at close quarters as it happened and I know how they did it. It’s certainly true that our economic management was pretty bad for at least the first decade of my time as an observer. But between the late 80s and the early 90s the econocrats started getting their act together. Although most of the seeds were sown under the Hawke-Keating government, the Howard government was the first to enjoy the fruits. The Rudd-Gillard government also enjoyed them---as witness, its avoidance of the Great Recession---though it lacked the whit and internal cohesion to reap the harvest.

The econocrats did it by persuading their successive political masters to subject the conduct of day-to-day economic management to ‘frameworks’ of rules and targets intended to limit the scope for politically motivated short-termism. The obvious example is the decision---formalised by Peter Costello---to use an inflation target to guide decisions about changes in the official interest rate and to hand control over interest rates to an independent central bank.

The many acts of ‘micro-economic reform’---including floating the dollar, deregulating the banks and various other industries, phasing out protection against imports and shifting the locus of wage-fixing to the level of the individual enterprise---also helped. Micro reform failed in its stated objective of permanently lifting the rate at which the economy could grow, but it had an unexpected benefit: by intensifying the competition within industries it made the economy far less inflation-prone and unemployment-prone, thus greatly simplifying the macro-managers’ task in keeping the economy on an even keel.

What they do in Canberra

The theory of public choice 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 long suspected that the way our bureaucracy is 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?

Of course, the two government agencies whose motivations and behaviour I’ve watched most closely are Treasury and the Reserve Bank. Being---like Prime Minister & Cabinet and the Finance department---‘co-ordinating departments’---Treasury and the Reserve have no particular industries they regard as ‘clients’. For instance, though the Reserve has daily dealings with the banks and the financial markets, I’ve never suspected its decisions about the level of interest rates were influenced by anything other than what it believed to be in the best interests of the wider economy over the medium term.

In other words, Treasury and the Reserve are on about macro management or ‘stabilisation policy’. But since they each wield different macro instruments, there is some specialisation between them. The question I ask is: what would they die in a ditch over? They care about lots of things, but what do they care about most?

In the Reserve’s case, the answer is inflation. Its attitude is, if we don’t accept ultimate responsibility for keeping inflation under control, who will? It also regards its instrument---monetary policy, or the manipulation of interest rates---as the best one to use to keep inflation in check. All this is implicit in its single target of keeping the rate of inflation between 2 and 3 per cent on average over the medium term. When it first adopted that solitary target 20 years ago, some took this to mean achieving low unemployment was not something it cared much about. Fortunately, our experience since then has dispelled such fears. The best way to think of its objective is ‘non-inflationary growth’. Even so, it does mean that, when forced to choose, fighting inflation will always come first.

So what does Treasury care most deeply about? What does it see as its ultimate responsibility, the responsibility others are less likely to care so much about? This took me longer to realise, but treasuries---state as much as federal---care most about the budget and getting it back to surplus just as soon as the state of the business cycle permits. As the recent troubles of governments in America and Europe attest, left to their own devices politicians are capable of running budget deficits year after year, in bad times and good, for decades until finally their lack of self control gets them into serious difficulties, invariably at the most inopportune times.

That our governments’ records have been so much more disciplined is testimony to our treasuries’ obsession with keeping budgets in balance ‘over the cycle’ and thereby avoiding the build-up of excessive levels of public debt. It’s testimony also to our treasuries’ greater success in persuading their political masters to curb their natural instinct to spend more than they raise in taxes.

Bearing in mind the wide discrepancy between the politicians’ willingness to increase taxes to cover their increased spending, much of Treasury’s effort goes into urging politicians to restrain their spending and into developing devices to help the co-ordinating, ‘purse-string’ ministers keep the other, ‘spending ministers’ in line. In this, Fraser’s attempt in the mid-1970s to punish Treasury by splitting a Finance department off from it---with Treasury responsible for revenue and Finance responsible for spending---had the unexpected effect of doubling Treasury’s influence at the cabinet table. It could have meant Treasury lost interest in the spending side of the budget, but it certainly hasn’t.

When Costello introduced the reforming Charter of Budget Honesty early in the Howard government’s term, he included---no doubt at Treasury’s suggestion---a requirement for Treasury to produce an ‘intergenerational report’ every five years to assess the fiscal sustainability of present government policies over the next 40 years. The first of these reports in 2002 found that (given a quite restrictive assumption about the growth in tax revenue) the present comfortable budget surpluses would soon give way to ever-growing budget deficits thanks to the ageing of the population and, more particularly, the public’s ever-growing demand for access to medical science’s ever-more-expensive advances in health care.

The following three reports have used the same assumptions to tell essentially the same story. From the first report it became clear to this (not unsympathetic) Treasury watcher that the report was being used by the treasurer as a kind of waddy to wave over the heads of the spending ministers. See the problems we face down the track? See how much worse it would be if I were to stop beating off your grandiose schemes? It was such a handy implement the state treasuries lost little time in producing their own intergenerational reports, each telling a story remarkably similar to federal Treasury’s.

But the state treasuries’ favourite disciplinary device is the state governments’ triple-A credit rating, ratings that emerged early in the Hawke-Keating government’s budgetary reforms when it ceased the practice of borrowing on the states’ behalf. No innovation could have been more effective in disciplining the states’ propensity to borrow, probably to the extent that it helps explain those governments’ inadequate spending on infrastructure.

State governments of both colours live in fear of the political censure that might follow a downgrading of their credit rating, not the modest increase in their borrowing costs it would also bring. And state treasurers exploit this fear indefatigably. When occasionally state governments do suffer a downgrading, they work untiringly to get their top rating restored.

I half agree with the academic economists who think too much attention is paid to credit ratings and that state governments could borrow for infrastructure investment a lot more heavily than they do without this creating an economic (as opposed to political) problem. I also suspect the rating agencies draw their lines in the sand more conservatively for governments than they do for businesses.

When you remember the big American rating agencies’ disgraceful contribution to the sub-prime debt debacle---where they sold paying customers triple-A ratings for the mortgage-backed securities they were issuing, only to have those securities ultimately revealed as ‘toxic assets’---you wonder why they give governments such a hard time. I finally decided they do it because they viewed the state treasuries as their clients, and know full well the treasuries want them to take a hard line.

But having conceded all that, I don’t criticise treasuries and their treasurers for the way they use credit ratings to beat back spending ministers’ insatiable demands for more spending on this worthy cause and that. What the academic critics forget is that their theories provide no clear dividing line between what level of borrowing is safe and what isn’t. In the real world of government, treasurers have to draw an unavoidably arbitrary line and then enforce it. If they use the bogeyman of credit ratings to keep their governments out of trouble, I’ve been loath to criticise.

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Depressed economists lose faith in capitalism

The nation's practicing economists are working themselves into a state over the future of the economy, convincing themselves the prospects for growth are dismal and the only answer is more "reform".

They're being rallied by former Treasury secretary Dr Martin Parkinson.

He told the National Reform Summit that Australia risked sacrificing as much as 5 percentage points of economic growth over the next 10 years, the equivalent of the production and income lost during a recession.

"Unless we grab this challenge by the horns and really get concrete about what are the priority issues, we are actually going to find ourselves sleepwalking into a real mess," he said.

There's a host of dubious assumptions hidden behind this stirring call to economic arms. For a start, how do we know we've got a problem? How do we know we're heading for a decade of slow growth unless the government acts?

We don't. We look at the below-trend growth in six of the past seven years and, as any economic illiterate would, simply extrapolate it for 10 years. But why stop at 10? Why not make it 40?

One of the shafts of enlightenment at the summit, we're told, came when a modeller from Victoria University challenged the inter-generational report's modelling that the productivity of labour would improve at an average annual rate of 1.4 per cent over the next 40 years. The rival modeller's modelling put it at less than 1 per cent.

Really? Talk about the biter bit. Rather than using their models to bamboozle the punters, economists are bamboozling themselves, mistaking an "exogenous" variable for an "endogenous" one.

Putting that in English, both the 1.4 per cent and the 1 per cent are merely assumptions, not a finding of the models. No economist knows what will happen to productivity over the next two years, let alone the next 40. And no model can tell them.

All the economists are doing is what any mug punter would do: relying on gut feel rather than science. You may be optimistic about the future, but I'm pessimistic.

They're making the economic illiterate's assumption that our recent weak growth is structural rather than cyclical. Sure, falling commodity prices are reducing our real income, but one day they'll stop falling.

Sure, we're making heavy weather of the transition from the resources boom, but one day it will have been made. Simple statistical theory should be telling economists that a protracted period of below-average growth is most likely to be followed by a period of above-average growth.

The next weird thing about the economists' bout of depression is their assumption that the economy will go nowhere without government intervention. It's as though they've lost their faith in capitalism.

The economy isn't a living organism whose growth and striving is driven by consumers' self-interest and producers' profit-seeking; it's more like a marionette whose animation depends on the Public Puppeteer continually jerking its strings.

Economic growth, it seems, is exogenous not endogenous. Really? What textbook did you read that in?

When you convince yourself, as many economists have, that the only way we'll see faster growth and further productivity improvement is for governments to engage in extensive reform, you've convinced yourself our economy is deeply dysfunctional.

Hugely inflexible and uncompetitive, highly protected, rife with cartels and lazy government-owned monopolies.

You're saying all the (unrepeatable) reform of the 1980s and '90s – floating the dollar, deregulating the financial system and a dozen industries, removing import protection, decentralising wage-fixing and privatising or corporatising public utilities – delivered a once-only productivity improvement but no lasting gain in efficiency, flexibility or dynamism.

There's nothing about those reforms that will help the economy grow in the future, you imply. Somehow in the intervening decade or so all those reforms have disappeared under a jungle of inefficiency; the jungle that's preventing us from ever returning to our former average growth rate.

So now you're threatening to slash your wrists unless the government trawls through all the second-string reforms not yet made and gets on with them.

Naturally, your best advice on how we can get productivity improving faster relies on the things economists think matter most: prices (including tax rates and the wage-fixing system) and intensifying competition (much of which would appal the Business Council and other industry lobbies).

And what do we get if we follow your advice? Another fleeting productivity improvement or something of continuing benefit?

Sorry, guys, but the propositions you're advancing are more like a high-pressure sales job than a rational analysis of our future opportunities and threats. Why don't you take a break and cheer up?

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Contrary to reports, economy battles on

Joe Hockey is right. The economic news is hardly wonderful, but the media's attempt this week to convince us the economy was perilously close to recession was sensationalist nonsense.

What set them off was news from the Australian Bureau of Statistics' national accounts that real gross domestic product grew by just 0.2 per cent in the June quarter. What they forgot to mention was that in the previous quarter it had grown by 0.9 per cent.

As Hockey says, the figures "bounce from quarter to quarter". But why let that small fact get in the way of a good scare story?

The less excitable Dr Chris Caton, of BT Investment Management, put it another way: "The weak growth for the June quarter was in part payback for the strong growth in the March quarter."

Just so. We were told, for example, that spending on home building fell by 1.1 per cent in the latest quarter, but not reminded that the previous quarter it had grown by a remarkable 5.6 per cent. There is no reason to believe the housing construction boom has ended.

We were told that the volume of exports fell by 3.3 per cent in the latest quarter, but not reminded that in the previous quarter it had grown by 3.7 per cent. Turns out the weather was unusually favourable around bulk-commodity ports in the first quarter, but unusually bad in the second.

We weren't told about these one-off negatives for growth in the June quarter, but much was made of a one-off positive: a sudden surge in defence spending, we were told, fully accounted for the quarter's 0.2 per cent growth.

(Actually, it was worse than that. Whereas total public sector spending made no contribution to overall growth in the March quarter, it contributed 0.6 percentage points in the June quarter.)

All this is why searchers after truth rather than headlines don't take quarterly changes in GDP too literally. Combine the two quarters and you get average quarterly growth of 0.55 per cent, or annualised growth of 2.2 per cent - which is probably closer to the truth.

It also fits better with a fact we were told only in passing, that the economy grew by 2 per cent over the year to June and by 2.4 per cent on average over the financial year, meaning Treasury's forecast of 2½ per cent was near enough to right - a point Hockey kept making and the media kept ignoring.

Examine the figures for the year to June and you don't find much evidence of an economy likely to collapse in a heap. Consumer spending grew by 2.5 per cent, home building by 10.4 per cent, public sector spending by 3.3 per cent.

Export volumes grew by 4.5 per cent, while import volumes fell by 0.7 per cent. In fact, apart from a small fall in the level of inventories, the only major negative contribution to growth came from business investment spending, which fell by 4.1 per cent.

That fall comes from the end of the mining construction boom, of course. It's a reminder of the truth of our position - that our transition from mining-led growth to more normal sources of growth has been far from smooth and isn't achieved yet - a truth too prosaic for the headline chasers. Growth in the low 2s is clearly well below average.

But if you dig a bit deeper you do find signs that the transition is proceeding, with help from record low interest rates and an ever-lower dollar.

For a start, there is evidence of recovery in non-mining investment. According to rough figuring by Kieran Davies, of Barclays bank, it's up by 4 per cent over the year to June, led by investment in the services sector.

Exports of services - including tourism and education - are also growing. Though little changed in the June quarter, their volume was up 7 per cent over the year, Davies says.

"With imports of services down 8 per cent over the past year as the falling exchange rate has made it more expensive to take an overseas holiday, trade in services [exports minus imports] added 0.1 percentage points to GDP in the June quarter and 0.6 percentage points over the past year."

Much has been made of the 1.2 per cent fall in "real net national disposable income per person", rightly described as the best measure of material living standards the national accounts provide. It's fallen for five quarters in a row.

Why? Because of the deterioration in our terms of trade - the prices we receive for our exports relative to the prices we pay for our imports - as coal and iron ore prices have fallen.

But it's important to see this in context. Why do so many people care so much about economic growth? I (and Joe and his boss) think it's mainly because they want to see more jobs created.

If so, real GDP - the quantity of goods and services workers are employed to produce - is a more relevant indicator than the various measures of "real income".

And the growth in GDP we've had has been sufficient to create 240,000 jobs over the year to July (including 68,000 during the supposedly knackered June quarter) and to stabilise the unemployment rate at just over 6 per cent.

It's true that the size of our real income has an effect on our spending on goods and services, and the demand for goods and services affects employers' demand for workers.

But much of the loss of income caused by lower coal and iron ore prices is borne by the mining companies (which are about 80 per cent foreign owned) and by state and federal governments (which collect lower mining royalties and company tax), rather than by the rest of us.

Times aren't easy, but we're not in bundle-dropping territory.

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The game pollies play rather than governing

It came to me while I was lying awake the other night: the business, union and community worthies at last week's National Reform Summit thought the way to make progress was to hammer out a compromise proposal most people could agree to. You hand it to the government, the opposition agrees, they whack it through parliament and problem solved.

But that's not the game Tony Abbott is playing.

He doesn't want agreement, he wants disagreement, but with the government on the majority side and its opponents on the minority side. That way, you get re-elected and maybe, as a bonus, there's some benefit to the country.

Pretty bad? Here's the worst part of my early-hours revelation: the other side's no better.

This is the way both sides have been playing the political game for years. It's just more obvious now because Abbott doesn't play it with as much finesse as his predecessors.

In Canberra, the game is known as "wedging", but is better described as "wedge and block". Whoever's in government thinks of issues acceptable to their side – and popular with voters – but inconsistent with the other side's values and thus likely to divide it. Ideally, the others oppose you and so get themselves offside with most voters.

Failing that, the pragmatists on the other side – who see perfectly what you're up to – reluctantly go along with you, but a more principled minority don't, so you've sown dissent among your opponents. Always a bad look to the electorate.

If the practitioners of expedience get their way without noticeable demur from the keepers of party principle, the wedge has been successfully blocked and you have to go away and think up another one.

How do you come up with a good wedge issue? You consult those polls that regularly ask voters which party is better at handling particular issues. Study these results and you find voters have highly stereotypical views about the parties' strengths and weaknesses.

The Liberals are better at what you'd expect a penny-pinching bosses' party to be better at: managing the economy, fighting inflation, keeping taxes and interest rates low and controlling the budget. And, of course, keeping the country safe from threats to our security.

Labor, on the other hand, is better at what you'd expect a big-spending workers' party to be better at: unemployment, social security, health, education, the environment and industrial relations.

In the months leading up to an election, each side manoeuvres to establish as key election issues problems the voters regard them as better at dealing with. They try to neutralise – block – those issues the other side is pushing that would leave them at a disadvantage.

The sainted Julia Gillard wasn't too saintly to use her two most popular (and expensive) measures to try to wedge Abbott at the 2013 election.

She proposed a 0.5 percentage point increase in the Medicare levy to help pay for the national disability insurance scheme, hoping Abbott would object and so could be accused of opposing greater assistance to the disabled.

She delayed the Gonski reforms to school finding, hoping Abbott would defend private schools and she could make it a key election issue.

Abbott blocked both wedges. He quietly agreed to the tax increase which, becoming uncontentious, was never mentioned again. On the Gonski reforms he belatedly professed to be on a "unity ticket" with Labor. But the delay meant many Liberal state governments declined to sign up to the scheme so close to an election.

Abbott's efforts to wedge Labor have come thick and fast in recent days. He asked President Obama to ask us to join in the US bombing of Syria because he was hoping Labor would object to such an ill-judged move. It didn't.

In another effort to increase public concerns about national security, he propose stripping certain Australians of their citizenship, hoping Labor would object and so allow him to accuse it of being "soft on terrorists". It didn't.

Abbott is anxious to portray his government as big on "jobs and growth". He cooked up a story about greenies using the law to block a new coal mine in Queensland and proposed amending the federal environment protection act to counter "green sabotage", hoping Labor would object and he could accuse it of putting the environment ahead of jobs.

As became clear at last week's reform summit, there's now widespread agreement that superannuation tax concessions to high-income earners are too generous and need to be cut back, with big savings to the budget.

Earlier this year, Joe Hockey had Treasury working on super changes when Labor announced it would take such a policy to the election. Abbott immediately embarrassed Hockey by insisting the government would countenance no changes to super or any other tax concessions.

Labor may stand for higher taxes, he told us, but the Libs stood for lower taxes. He made it clear last week that, come hell or high water, the government would go into next year's election promising tax cuts.

Great wedge. One small problem: all Labor has to do to block it is promise to match it – just as it did when John Howard tried the same thing at the 2007 election.

Bad policy, but what of it?

If you wonder why our politicians don't seem interested in good government, their addiction to playing the wedge-and-block game explains a lot.

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