Is the world ruled by ideas or by interests?

Most economists believe John Maynard Keynes (rhymes with "brains" not "beans") was the greatest economist of the 20th century. But his most famous quote is one I've never been sure I agree with.

He claimed that "the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.

"Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

"Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

One man who definitely agrees is Barry Schwartz, a professor of psychology at Swarthmore College in Pennsylvania. He writes in his book Why We Work that, where once our ideas about human nature may have come from our parents, our community leaders and our religious texts, these days they come mostly from social science.

"In addition to creating things, science creates concepts, ways of understanding the world and our place in it, that have an enormous effect on how we think and act," Schwartz says.

"If we understand birth defects as acts of God, we pray. If we understand them as acts of chance, we grit our teeth and roll the dice. If we understand them as the product of prenatal neglect, we take better care of pregnant women."

Schwartz says that because ideas aren't objects, to be seen, purchased and touched, they can suffuse through the culture and have profound effects on people before they are even noticed.

And ideas, unlike things, can have profound effects on people even if those ideas are false.

I don't doubt that, in this, both Schwartz and Keynes are right. The social world is far too complex for any of us to really understand how it works. So we observe what's happening and then come up with theories - "models" - about how it works.

Those theories inevitably influence the way we think about the world, the way we react to it and the way we try to get some control over it.

But the world is so complex that we can have lots of different theories about it, or different aspects of it. Many of those theories will have an element of truth and an element of error.

We probably should have a toolbox full of theories, choosing to use the one that best fits the particular issue we're focusing on.

But human nature - our limited cognitive processing power - leads us to simplify things, settling on the one that seems to work best and apply to most circumstances. We remember it, and forget the others.

Often, of course, we don't do a lot of thinking about which theory is best, we just go along with the one most of the people around us seem to believe.

It's also true that the theories and models we rely on, consciously or unconsciously, become, as the sociologists say, "performative" - if enough people believe the world works in certain way and act on that belief, to some extent the world does start to work that way.

There are limits to this, of course. For a few decades economists allowed their dominant model - their group's way of thinking - to convince them the deregulation of the banks had brought us to the era of Great Moderation, of low inflation and unemployment with ever rising prosperity.

Their model blinded them to the global financial crisis that was coming and the years of economic malfunction that would follow.

There could be no more costly demonstration of the inadequacy of their theory about how the world worked.

So no argument: ideas have a huge effect on the world - for good or ill. But does that mean "the world is ruled by little else"?

I doubt it. The main rival for that title is the thing economists exalt above all else: self-interest. What happened to the rich and powerful, don't they have any influence on how the world is ruled?

The more I observe our politics, the more I see it as an unending battle between powerful interest groups. The political parties, contending for their own share of power, negotiate their way around the most powerful of the various interest groups.

The problem is the power democracy still gives to ordinary punters. Should I try to win votes by promising a royal commission, or should I keep in with the banks - and their generous donations to election funds - by promising to bash them with a feather?

So, do ideas really trump vested interests? Surely we're ruled by some combination of the two.

But the more I understand the weaknesses in the economists' dominant ideas about how the economy works and should work, the more I see what a bad predictor their model is, the more I wonder how such a flawed theory remains so dominant, largely impervious even to stuff-ups as monumental as the Great Recession.

Then a terrible thought strikes: maybe their ideas remain so influential in politics and the community because they happen to suit the interests of the rich and powerful.

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How behavioural economics got started

One night in 1975, Richard Thaler invited a bunch of his graduate economics student mates over for dinner. While they waited for the cooking to finish he put out a bowl of cashews.

But noticing everyone was getting stuck in, he decided he'd better take them away. His mates thanked him for doing it. It was a lightbulb moment for the young economist.

Why? Because the assumptions of the conventional economics they were studying said such a thing couldn't happen.

Each of us is assumed to have complete control over our appetites and urges. We eat no more cashews than we know is good for us.

We certainly don't need some agent of the Nanny State to limit our freedom by stepping in and taking the bowl away.

Were such a thing to happen, we wouldn't be pleased. We certainly wouldn't thank the perpetrator of this intervention.

So why did it happen? Because, contrary to the conventional model, all of us have problems stopping ourselves from doing things we know we'll regret. In one part of our lives or another, we have a problem with self-control.

And we're grateful rather than resentful when someone steps in to help us with our problem.

From then on the young Thaler – obviously a bit of a rebel and troublemaker – began compiling a list of what he came to call "anomalies" – things people actually did that the conventional model assumed they didn't.

Thaler tells the story of those cashews in his latest book, Misbehaving. It's an apt title because the book charts the development of a new school of economic thought known as "behavioural economics".

Behavioural economics studies the differences between the way people in the economy actually behave and the way the model assumes they do.

In deference to academic economists' obsession with mathematics – a preoccupation that began only after World War II, led by men such as Sir John Hicks, Kenneth Arrow and Paul Samuelson – younger behavioural economists search for ways to make more realistic the assumptions on which mathematical models of the economy are built.

Thaler says behavioural economics has three essential elements: bounded rationality (see below), bounded willpower (see above) and bounded self-interest – we can be more generous to others than the model assumes.

So what are the origins of "BE"? In their book, Animal Spirits, George Akerlof and Robert Shiller argue that John Maynard Keynes was the first behavioural economist.

Thaler says Keynes was "a true forerunner of behavioural finance". (Behavioural finance is the part of behavioural economics that focuses on behaviour in financial markets.)

Keynes argued that individuals' "animal spirits" – his word for their emotional responses – played an important role in their decision making. At times this could discourage business from investing, thus strengthening the case for governments to use their budgets to stimulate the economy.

Keynes wrote his magnum opus in 1936. But Thaler takes BE's origins back to the founder of economics, Adam Smith, and the less famous of his two books, The Theory of Moral Sentiments, published in 1759.

Smith was "an early pioneer of behavioural economics" because of his detailed description of problems of self-control.

A more obvious forerunner is the American academic Herb Simon who, in 1957, coined the term "bounded rationality" and was later awarded the Nobel prize in economics for his trouble.

Bounded rationality is the idea that people's ability to make "rational" – coolly calculating – decisions is limited by the information available to them, the trickiness of the decision, the brain's inadequate processing power and the time available for thinking about it.

Many people probably assume, however, that the true originator of BE is the Princeton psychologist Daniel Kahneman who, with his late partner, Amos Tversky, began in the early 1970s identifying the many "heuristics" (mental shortcuts) and biases that cause humans' decision making to be less than rational.

Behavioural economics has long been about incorporating the insights of psychology into economics. So it was no great surprise when the psychologist Kahneman was given the economics Nobel in 2002.

Thaler moved to California in 1977 to work with Kahneman and Tversky for a year, but that was because he'd already done a lot of thinking about "anomalies". His book leaves me in little doubt that he's the economist who should get most credit for establishing BE as a respectable subject for economists to study.

Thaler began writing a column about "anomalies" from the first issue of the American Economic Association's new Journal of Economic Perspectives in 1987.

In 1991 he teamed up with Shiller (who in 2013 got the Nobel for his work in behavioural finance) to organise a semi-annual workshop on behavioural finance under the auspices of the National Bureau of Economic Research.

One breakthrough in BE came when it was demonstrated that people's mental biases were systematic – that we were, in the title of Dan Ariely's book, Predictably Irrational.

If non-rational behaviour is predictable, it can and should be incorporated into economists' models.

And if people make predictable mistakes when buying shares and so forth, there ought to be scope for other investors to make a buck by betting against them.

Little wonder behavioural finance quickly gained a following in financial circles.

In economics, however, it's said that new ideas gain ascendancy "one funeral at a time". Oldies have a vested interest in preserving the received wisdom, but young academics are attracted to new and interesting ideas that seem to better explain the world.

Thaler's best-selling book with Cass Sunstein, Nudge, showing how governments can nudge people towards making more sensible decisions, led to the setting up of Britain's Behavioural Insights Team and copycat outfits in many countries, including Oz.

These days, BE is offered in most undergraduate university courses. So behavioural economics is now firmly rooted and can only grow in its influence on economists' thinking.

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Herald's move to explanatory journalism is its future

How has the Herald changed in 185 years? How should I know – I've been working for it for less than a quarter of that time. But I dare to claim that, of all the change since 1831, most of it has occurred since I started in 1974.

A few years back, at a staff function to celebrate those of us who'd hung around longer than could reasonably be expected, someone had the idea of presenting us not with a pen or a watch – I'd already had one of each – but with a framed copy of the front page of the paper on the day we started.

Sorry, but it was an uninspiring present that showed how far we've had to travel. It was grey in every sense. That was long before the Herald moved to colour printing, but not before our subeditors had abandoned their sacred duty to drain the colour out of every story before allowing it to be seen by the public.

The Herald stuck to "objective" reporting of the facts – "just the facts, ma'am" – and anything that remotely resembled an opinion – it was a beautiful sunny day, the prime minister seemed distracted, the accident was horrific – was verboten.

It was years before journalists attended university journalism courses, to be reminded that at its core the journalistic task involves subjective judgments: which events get reported and which don't; which facts get used and which don't; which stories get run and which "hit the spike"; which are reported at length and which in brief; which lead the front page and which go up the back somewhere.

It was because journalism was mere description of facts that readers didn't need to know the journalist's byline. They needed to be told only that a story had been written "by a Staff Correspondent" – that is, he (and occasionally she) had been trained by the Herald, and so could be trusted to get everything right.

Nothing of any great interest had happened the day before my first day on the job. The front page was nonetheless terribly busy, as editors crammed in as many stories as they could fit. To modern eyes the page was messy and uninviting.

That was only a few years before the Herald abandoned the unachievable struggle to be a "paper of record". Much better to focus on a smaller number of more interesting or important events – preferably ones other media didn't have – and do justice to them, illustrating them and laying them out on the page in a visually attractive way.

One thing that issue of the paper did have going for it, however: its price was 8 cents. Of course, in those days it didn't have lift-out sections on TV programs, food and restaurants, travel, health and fitness, and gig guides.

Apart from Column 8, still signed by Granny, there were few opinion columns in the paper of the mid-1970s. Comments or analysis sitting beside news reports were rare to non-existent. There were a few bylined feature articles, but for the most part opinion was restricted to unsigned editorials – or "leaders" – written on behalf of the editor.

It was only a little over two years before I was moved from economic reporting to opinion writing. At first my job was to write a leader a day, but by 1980 I was writing three columns a week. I'm still writing those columns, on the same days and the same parts of the paper.

Having checked with the Herald's historian, Gavin Souter, I think I'm safe in claiming to be the longest-serving columnist in the paper's 185 years.

This may tell you something about me, but mainly it says something about how the paper and the world in which it exists have changed. In relatively recent years the Herald – on paper and online –has become chock full of all manner of columns, comments and analyses.

Why? Partly because our marketplace has become ever more competitive. Journalists tend to focus hardest on competition from rival newspapers, but more intense competition has come from the electronic media, radio and television.

This competition started from the moment in the 1930s that radio networks began reporting their own news stories rather than reading out stories from the papers. Eventually radio began delivering news bulletins on the hour, but not before television channels made their nightly news bulletins the chief means by which Australians caught up with the news.

With so many of our readers already having heard the bare bones of so many of our news stories, is it any wonder newspapers had to change their news offering? We tried harder to find our own exclusive stories, provided greater detail and more background information, asked "the next question" – what happens now? how will the authorities react? – as well as adding more commentary and analysis, including the pure opinions of columnists and in-house experts.

For much of the past 185 years there were two things you could do after you got home from work, had dinner and wanted to relax: sing songs round the piano or read the paper. Then came radio and its serials and then the all engrossing idiot box.

On a wider level, therefore, newspapers have long faced greater competition from an ever-expanding array of ways to spend your leisure time. More reason to change our product.

The advent of the internet has added greatly to that array, as well as multiplying rival digital sources of news – not just from other cities and states, but from English-speaking news providers around the world.

By contrast, it's allowed the Herald and other papers to use their websites to get back into "breaking news" – news within minutes of it happening – for the first time since the 1930s.

These days, however, digital sources of breaking news are so plentiful and so freely available –literally – as to greatly diminish the commercial value of ordinary news. How are we to pay the wages of our journalists?

Online advertising is far cheaper than it is in newspapers and free-to-air television. What's more, online advertising is dominated by Google and Facebook, not the traditional news sources.

We need something more than ordinary news, some way of adding value to a product we can ask readers to pay for, preferably by subscription.

The material standard of living of people in the developed economies has risen many times since the Industrial Revolution. This remarkable achievement has been the result of two main factors: technological advance and ever-growing specialisation within occupations.

The inescapable consequence, however, has been to make the workings of our economy and many other aspects of our lives infinitely more complex than they were. There was a time when car owners did much of their own routine maintenance; today, many hardly dare lift the bonnet.

When I joined the Herald it still subscribed to the notion of the "universal journalist" – any Herald-trained journalist was capable of accurately reporting any story on any subject. I doubt if this was true then; it's become less true with every passing year.

Since I became economics editor in 1978, I've worked to ensure that all economic reporting is done by journalists with economic qualifications. Ideally, legal reporters have law degrees, science reporters have science degrees and so forth.

With the growing complexity of daily life has gone an ever-rising level of educational attainment in the workforce. The Herald has always had a better-paid and better-educated readership, but it's never been better educated than it is today.

This means a readership far keener to know how and why, not just who, what, where and when.

But not all "advances" have been for the better. Governments have become bigger, ministers' staffs have become bigger, politicians are far more adept at marketing, more focused on perceptions and appearances, and unceasing in their attempts to "manage" the media.

At the same time, the lobbying of government by business and myriad interest groups has proliferated. A small industry of "economic consultants" has grown up in Canberra just to produce modelling that purports to prove the rightness of lobbyists' claims.

If keeping governments and power-holders honest is one of the primary responsibilities of the quality press, never have its services been more sorely needed.

A more complex world requires more explanatory journalism from more specialised and qualified journalists. The blizzard of information assailing us requires more trusted guides to what's worth worrying about and what isn't.

A world of more active lobbying by powerful interest groups and more manipulative and secretive governments requires more investigative journalism, not just by dedicated investigation teams but also by more specialised journalists who do more than meekly report the claims of politicians and lobbyists.

This is what I've tried to contribute with my "comment and analysis" in my time at the Herald. It's needed far more today than when I started. I confidently predict the need will only grow.

It's why I hope to see the Herald meet the challenge of digital disruption, making whatever adaptations are needed to ensure it continues to serve readers and contribute to the nation's good governance.

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Why the banks' activities should be constrained

Is there any justification for a royal commission into the conduct of the banks? Is it just a political stunt? All royal commissions are called for political reasons and many are stunts, in the sense that their primary objective is just to bring particular issues into the public spotlight.

To me, the best justification for an inquiry into the banks is that they still don't seem to have got the message. They've been caught treating their customers badly, but so far they've shown little sign of contrition - sorry about the few bad apples, but I didn't know - and little willingness to make amends.

For years they've been locked in a race to maximise profits. They've put profits and executive bonuses ahead of the interests of their customers, and seem keen to resume profit maximising as soon as the fuss declines.

We need to keep the fuss going until the bank bosses realise how unacceptable we find their behaviour. Only then may they accept the need to stop incentivising​ their staff to exploit their customers' vulnerabilities, even at the cost of a little profit.

But if you think we have trouble with our banks, you should get out more. So far, at least, we've been let off lightly. I've just been reading the latest book about the banks' central role in causing the global financial crisis of 2008 and the Great Recession it precipitated.

Almost eight years later, the recovery has been anaemic and looks like staying that way for years yet. If China's slowdown becomes a "hard landing", it's likely to be because the financial crisis has finally caught up with it, too.

The book is Between Debt and the Devil, by Lord Adair Turner, who took over as chairman of Britain's Financial Services Authority just as the crisis struck.

Among the many reservations that may be expressed about the "financialisation" of the developed economies - the huge expansion in the share of the economy accounted for by the banks and other providers of financial services over the past 30 years - Turner is particularly critical of all the credit creation - lending - the banks have done.

For decades before the crisis, in every developed economy, bank lending grew at two or three times the rate at which the economy grew.

Central bankers and other economists came to believe this was normal and natural; how you achieved a growing economy.

In reality, it just meant that when the mountain of credit finally collapsed, plunging the world into its worst recession since the 1930s, many households and businesses were left deep in debt.

According to Turner, it's this "debt overhang" that's doing most to stop the major economies returning to healthy growth. As part of the initial response to the crisis, governments shifted much of the banks' own debt onto the government's books.

This did nothing to diminish the overall amount of debt, just made governments reluctant to increase their spending to support the economy.

But it's the continuing debts of businesses and households that do most to explain the continuing sluggishness of the major economies. When your debt far exceeds the value of your assets, you cut your spending to the bone so as to use as much of your income as possible to pay down that debt.

Trouble is, when so many others are doing the same, their spending cuts cause your income to fall, leaving you with little to use to repay debt. The economy can't really recover and, collectively, it makes little progress in "deleveraging" - getting its debt below the value of its assets.

This is the bind the North Atlantic economies find themselves in.

Turner says the huge growth in bank-created credit has been particularly pernicious because the banks much prefer to lend for purchases of real estate. They do little lending to big businesses investing in expansion, and much of their lending to small business is secured against the owner's home or other property.

Trouble is, with the banks infinitely willing to lend for housing, but with the supply of land in desirable locations strictly limited, the inevitable result is to bid up house prices.

This explains why - though local economists staunchly reject the thought - when foreign economists look at our stratospheric house prices and record rate of household debt, almost to a person they see an asset-price bubble that must one day burst.

Turner devotes much of his book to proposing radical ways the major economies can extract themselves from their unshakable debt overhang and return to healthy growth, and to proposing ways governments can curb their banks' unending credit creation so as to ensure it's a long time before their excessive lending for real estate brings on the next global financial crisis.

But ever-increasing lending is the main way the banks make their ever-increasing profits. They would put up an enormous fight to stop governments clipping their wings in this way.

Which brings us back to the royal commission. Do we want to be governed by politicians deferring to their generous backers in banking, or do we want to send politicians and bankers alike a message that the interests of customers and the wider economy must come first?

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WHAT DOES THE FUTURE HOLD FOR THE ECONOMY?

Talk to Athenaeum Club, Melbourne, Wednesday, April 20, 2016

Today I want to ask: what does the future hold for the economy? The honest answer to such a question is - no one knows, certainly not me. But I doubt if you find such an answer very satisfying, so I’m happy to give you some opinions. They’re highly likely to be wrong since, as Donald Rumsfeld reminded us, our predictions are likely to be confounded by “unknown unknowns”. By definition, I can’t tell you anything about the unknown unknowns, so I’ll limit myself to known knows and known unknowns.

So, what does the future hold? As you may have gathered from my writings, I’m a congenital optimist - though I fear that, by the time I’m through, you’ll find that hard to believe. Another thing you may find hard to believe is that I’m a reasonably conservative person, in that my default position is to expect that things will continue much as they have been. Recessions will be followed by recoveries; the resources boom will be followed by a return to more normal sources and rates of growth.

But of late I’ve begun to fear that Australia - and the world - are in for a further extended period of weak economic growth. Our longer-term rate of growth in GDP has been about 3.5 per cent a year, but I fear we’ll stay closer to 2.5 per cent.

I’m not a person who believes that, whatever is happening in the rest of the world will be pretty much what happens in Oz. We’re part of the world and are influenced by it, of course, but, equally, the domestic influences on our growth are more significant than many people imagine. Even so, there’s widespread agreement overseas that the outlook for the world economy over the coming decade or so is far from bright.

It’s become almost a ritual for the International Monetary Fund to continuously revise down its forecasts for growth in the world economy. It did the same again last week, but this time the accompanying commentary from the fund’s economists was unusually downbeat. Whereas, in the five years before the global financial crisis, growth in the world economy averaged just over 5 per cent a year, it grew by little more than 3 per cent last year and is expected to grow at the same rate this year.

Many economists see that weak growth persisting for years to come. Why so much pessimism? Any number of reasons. One of particular relevance to us is the relatively high risk that China’s slowdown turns out to be a “hard landing”. But I’ve just been reading the challenging new book by the former chairman of Britain’s Financial Services Authority, Adair Turner, Between Debt and the Devil, which attributes the North Atlantic economies’ anaemic recovery from the Great Recession to the deadening effect of the overhang of debt - private more than public - following the many decades before the crisis in which bank credit creation grew at two or three times the rate that the economy grew.

To that you can add all the complications and inhibitions arising from the ill-fated decision to establish the euro single-currency area.

But if that’s not enough for you we have the American productivity expert Robert Gordon’s prediction that we’re in for a sustained period of weaker growth because, contrary to conventional wisdom, the digital revolution isn’t sufficiently revolutionary to provide the sustained productivity growth we enjoyed from earlier innovations, such as electricity or the motor car. Then there’s the leading American economist and former US Treasury secretary, Larry Summers, with his fear of “secular stagnation” - a sustained period of chronically weak demand, caused by the combination of increased desired saving and reduced desired investment. For good measure there are the reputable economists fearing that the digital revolution is about to displace skilled services-sector jobs at rate far faster than those workers can be reabsorbed in other parts of the economy, leading to mass unemployment.

But that’s enough about death and destruction in the international economy. Let’s turn to factors that suggest weaker growth in the domestic economy. One reason growth is likely to continue below average is that we’re likely to see lower immigration and thus slower population growth, down from a peak of 2 per cent a year in the years of the resources boom, to 1.4 per cent or so more recently. It’s easy to imagine that immigration is “exogenous” as economists say - a lever that can be moved higher or lower by the government - but, as Professor Peter McDonald, our leading demographer, has pointed out, it’s actually largely “endogenous”: it’s set within the system by the economic conditions at the time.

The rise of China as a global powerhouse of manufacturing has long had, and will continue to have, a dampening effect on Australia’s manufacturing. Steel production in Whyalla is the latest example. Competition from Asian manufacturers - and local manufacturers’ very real threats to move their factories overseas - are part of the explanation for a significant structural decline in workers’ bargaining power over recent decades. The present exceptionally low rate of wages growth is a two-edged sword when it comes to economic growth: on one hand, the price of labour being relatively low should encourage growth in employment, particularly in labour-intensive service industries. On the other, low wage growth isn’t doing a lot to bolster household income and consumer spending. Savings ratio.

This next point is less true in Oz than it is in America, but economists are becoming more conscious that rapidly widening income inequality - with incomes near the top growing strongly, while incomes around the middle and lower experience little or no real growth for decades - is working to inhibit the growth in consumer spending, simply because high-income households save rather than spend a much higher proportion of their incomes.

 Another factor underlying my fear that we face a future of below-par growth is the knowledge that our record 24-year upswing since the last serious recession in the early 1990s can’t continue forever. Frankly, we’re long overdue for another recession. I don’t know what factor will precipitate that recession - perhaps a sharper than expected fall in Sydney and Melbourne house and apartment prices - but I do know that a year of “negative growth” sometime in the next five would leave average growth for the period looking pretty sick.

One key cause of weakness in the period since the financial crisis is the lack of growth in investment spending in the non-mining economy. There doesn’t seem much sign of this changing any time soon. Some have sought to explain this in terms of business’s lack of confidence thanks to uninspiring political leadership - first under Labor but now, more surprisingly, under the two brands of Liberal leadership. There may be something in this explanation, but I think it can be pushed too far. A rival explanation is that businesses have simply failed to lower their “hurdle rates” of return for new projects to take account of the much lower cost of capital - interest rates - we now face. But I think it’s easier to explain much of the lack of business investment spending more simply: businesses haven’t been investing because they haven’t been seeing many profitable opportunities.

This bring us at last to the econocrats’ long standing argument that what we need to increase the rate of productivity improvement and achieve stronger growth is a new round of economic reform. The business lobbies have taken up this cry with gusto, nominating cuts in rates of personal income tax and company tax, and reforms to industrial relations as top priority. It now seems clear, however, that not even Malcolm Turnbull is prepared to pursue such reforms. Which probably means many of you share my suspicion that growth will remain inadequate in coming years.

I must caution you, however, against the error of believing your own bulldust. It’s not hard to believe lower taxes and a stronger hand for employers would do wonders for the economy when such “reforms” would leave you yourself better off, even if they ended up doing little to benefit the wider economy.

I believe it’s been convenient for the advocates of these reforms to imagine the economic benefits to be greater than they’re likely to be if Treasury and other modelling is to be believed. After all, when Turnbull decided that the huge compensation bill had rendered the plan of using an increase in the GST to pay for income tax cuts too politically costly, he had no trouble demonstrating that the efficiency cost of increasing indirect tax offset almost all the efficiency benefit from cutting income tax. Although I have little faith in the results of economic modelling, I note the finding by Dr Janine Dixon of Victoria University that a cut in the rate of company tax would, after 15 years, cause GDP to be just 0.15 percentage points higher than otherwise.

I believe that a less self-interested search for the most high-potential areas of economic reform would lead us away from tax and wage-fixing towards reform of health, education and infrastructure, particularly big city transportation. But when I say reform I don’t just mean spending more money.

I can understand that many business people will be feeling quite disillusioned at the way Malcolm has shied away from reform in recent days. There must be a great temptation for business people to revert to their earlier diagnosis of the problem: in contrast to earlier times, we simply lack any politicians with the vision and courage - the leadership - to take the risks needed to solve our economic problems. But I’m here to warn you against such a self-serving analysis: the only problem is caused by our politicians’ lack of moral fibre.

You might find this hard to accept, but in all our privatisation, deregulation, globalisation and other reforms over the past 30 years and more, we’ve had a situation where governments in all the developed countries have reshaped their economies in the direction of strengthening markets and making like easier for business. Partly as a result of this process, we’ve seen a widening of the gap between high and low incomes.

In more recent times we’ve also see the rise of unceasing lobbying of governments, particularly by business interests. I think what we’re seeing now is not so much “reform fatigue” or a sudden loss of courage on the part of our political class, but a standoff between business interests on the one side and ordinary voters on the other. It’s the revolt of the punters, with our politicians caught in the middle. Too many voters have compared how well business people seem to be doing with how well they are doing and decided something is badly wrong. They don’t really know what it is that’s going wrong, but they’ve had enough and they’re not going to take it anymore. You can see this in the puzzling rise of Donald Trump and Bernie Sanders in the US, and you can see the same thing going on here in a less dramatic way.

A classic example of this standoff comes with business’s confident expectation that governments will proceed with plans to cut the rate of company tax at the same time as the parliamentary hearings and now the Panama Papers are reminding voters of how successful so many businesses have been in reducing the tax they pay.

I doubt that economic reform will be an answer to the era of below-average growth we face because the era of governments regularly adjusting the regulation of the economy to please business has also come to an end.

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The economy rests on Christian foundations

I can't think why, but Easter always reminds me of Christianity. Not, of course, that Christianity has anything to do with the grubby, materialist world of economics. Or does it?

Australia is the most unbelieving it has ever been, with the most recent census saying that only 61 per cent people identify themselves as even nominally Christian.

Twenty-two per cent say they have no religion and another 9 per cent didn't bother answering the question. People of non-Christian religions account for 7 per cent of the population.

Separate figures say only about 8 per cent of Australians attend religious services regularly. This is about the same as in Britain and France, but a lot less than in Canada or the United States.

With so few people having had much contact with organised religion, it's not surprising that so many people imagine Christianity to have little bearing on the modern world and economy.


But that is far from the truth, as Australian author Roy Williams argues in his latest book, Post-God Nation? I'm quoting him liberally.

Williams says he's sick of being told that religion's influence on our country has been either minimal or malign.

"It is a fact of history that Australia would not exist in anything like the form it does but for Judaeo-Christianity," he says.

"Deep-seated legacies of our religious heritage still endure, and will continue to do so for the foreseeable future."

Sydney Anglican Peter Jensen says "we are . . . secular, in a Christian sort of way".

This might be a new thought for many younger people, but it's not a rare observation. Former British prime minister Margaret Thatcher said "the Christian religion . . . is a fundamental part of our national heritage. For centuries it has been our very life blood."

Historian Geoffrey Blainey has said that the Christian churches did "more than any other institution, public or private, to civilise Australians".

All market economies rest on a foundation of laws, which enforce private property rights, the honouring of contracts and much else. Williams writes that all Western legal systems are grounded in two core assumptions, both from the Bible: that humans have free will and that morality is God-given.

But the English legal system has many other religiously based features, such as the separation of church and state, the jury system, Magna Carta (negotiated by the Archbishop of Canterbury) and the Bill of Rights (asserting Parliament's supremacy over the king, since both were "bound by the laws of God and nature").

The system of common law, based on rulings by judges rather than parliaments, was established by the devout Henry II, who ensured that most of the early judges were clerics, because of their knowledge of canon law.

Economic growth comes mainly from productivity improvement, productivity improvement comes mainly from invention and innovation, and invention mainly involves applying scientific discoveries.
Guess who were the West's first promoters of science and the inventors of universities?

The scientific method – discovery by empirical reasoning – is, Williams writes, unquestionably a byproduct of Christianity. To know the truth of God's creation, it's not enough to rely on human logic. It's also necessary to observe closely what God has created.

Most people today don't realise how many of the leading politicians, judges and business people who shaped the social and economic system we have inherited had religious beliefs or backgrounds.

Most of the founders of the trade union movement and the Labor Party, for example. John Fairfax, who bought The Sydney Morning Herald in 1841, was a deacon of the Pitt Street Congregational Church, who attended up to four services on a Sunday.

Four of the Herald's first five editors were ministers of religion. In his research, Williams found it remarkable how often famous Australians turned out to have been the son of a clergyman (me, too).

But Christianity has permeated our attitudes and values, not just the institutions of our society.
You can be an atheist or a humanist, but if you have any ethical beliefs or moral values they might be influenced by Buddhist ideas, but they're far more likely to reflect Judaeo-Christian thinking.

And though economists keep forgetting it, it's the ethical behaviour of ordinary business people and consumers that keeps our economy ticking over satisfactorily and makes the CommInsures still the exception rather than the rule.

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How signalling helps make the economy work

Why do so many people go on to university after finishing school? Why do some uni graduates get a job, but then go back to uni for further qualifications?

Why do sensible people dress up for a job interview – or wear a suit and tie if they're in court charged with an offence?

For that matter, why do people engage in conspicuous consumption – buy flash clothes or cars or houses, or send their kids to flash private schools?

Why do so many businesses put so much money and effort into protecting and projecting their brands?

Short answer to all those questions: because they're trying to signal something. What? Usually, their superior quality – although in the case of conspicuous consumption they're signalling their superior social status.

Signalling is something you don't read about in economics 101 textbooks, even though it occurs in all real-world markets.

That's because the simple neo-classical model makes the unrealistic assumption of "perfect knowledge" – buyers and sellers know all they need to know about all goods and services – not just the range of prices on offer but also the characteristics of the goods offered by various sellers, including their quality.

For many years, progress in economic theory has involved relaxing the various assumptions of "perfect competition" to see what we can learn from more realistic assumptions – which, by the very nature of theory and models, will still be a fairly simplified version of reality. (If a model was as complex as the real world, it would tell us nothing about what causes what in that world.)

Since the early 1970s, economic theorists have been studying "imperfect knowledge" (which in econospeak means "far from perfect", not "almost perfect"), recognising that there's much relevant information people don't know and that information is often costly to collect (in money or time).

As well, information is often "asymmetric", in that the people selling something, usually being professionals, know a lot more about it than buyers, usually amateurs, do.

In 2001 three American academic economists – Michael Spence, George Akerlof and Joseph Stiglitz – shared the Nobel prize in economics for their seminal contributions to the relatively new field of "information economics".

Akerlof (who's married to a certain central bank chairwoman) got his gong for a paper he wrote in 1970 called The Market for Lemons, aka used cars. Spence got the gong for a paper he wrote in 1973 about signalling in the job market.

So let's start again: why do people delay their income earning to get educational qualifications?

If you say it's because they want to gain knowledge and expertise in some field to make their labour more valuable – to increase their "human capital" – and help them get a better-paid job, you're not wrong and Spence wouldn't disagree with you.

But he focuses on a different, less obvious motivation. Employers are looking for intelligent workers and are willing to pay more for their services. But when you're hiring workers, it's hard to know how smart they really are. As economists say, it's an "unobservable characteristic".

So how do workers who know they're smart demonstrate that to potential employers? By using their educational qualifications to signal the fact. Employers are impressed by qualifications because they know they're not easy to obtain – they're costly, in a sense.

Of course, people who aren't so smart can gain qualifications if they try hard enough. But genuinely smart people don't have to try as hard, so they can gain higher, better qualifications than the less-smart can, and employers know this.

You're in line for a Nobel prize when you open up a new field and then other, more junior academics come along behind you to elaborate and expand on your discovery, eventually making it look pretty primitive.

By now thousands of academic papers have been written about signalling in various markets. It's become part of the study of "industrial organisation" (industry economics, as we used to say) but is also a branch of game theory.

Theorists have looked at cases of people sending signals implying they possess qualities that they don't and cases where signals are distorted by "noise" (say, you struck it lucky in the exams). And whereas in simple theory markets only ever have one equilibrium point – where everything is in balance – with signalling there are multiple equilibria.

One signalling theorist is Dr Sander Heinsalu, a bright young Estonian now in the Research School of Economics at the Australian National University.

In a recent paper he develops a "repeated noisy signalling model", quoting examples such as a politician giving speeches intended to make him appear competent, a firm buying positive product reviews, and a male deer growing antlers every mating season.

He finds that, if the cost and the benefit of signalling are constant across periods, the degree of signalling effort falls over time. This fits with the way conspicuous consumption falls with age.

In another paper Heinsalu says the conclusion of most signalling papers is that people for whom gaining more of the valued characteristic would be costly don't exert as much signalling effort as those for whom it is less costly.

But in his own paper he demonstrates that in some circumstances it can be the other way round.

With corruption, politicians face minor temptations and big ones. A pollie who is "too clean" may be avoiding minor misdeeds so he can survive long enough to engage in major graft when the opportunity arises, whereas another planning to avoid graft may not worry about small misdemeanours.

The guilty may deny accusations more strenuously than the innocent do because the innocent know they'll have less trouble proving it later.

As Shakespeare said, "the lady doth protest too much, methinks".

But if you want more proof than a quote from the bard, read the paper on his website. Hope your maths is up to it.

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Business - and customers - pay for bad business behaviour

It's remarkable the way the Business Council of Australia constantly lectures us on the "reform" we should be accepting to improve our economic performance (and, purely by chance, their profits), but never seems to lecture its big-business members on their manifest need to "reform" their own standards of behaviour.

Among its most profitable members would have to be the four big banks. But the litany of scandals over their bad treatment of customers never seems to end.

The latest was CommInsure's denial of legitimate life insurance claims, but there's also been ANZ's alleged manipulation of a key commercial interest rate and the Commonwealth Bank's bad financial planning advice that lost money for many customers.

Now the chairman of the Australian Securities and Investments Commission, Greg Medcraft, has joined Australian Prudential Regulation Authority boss Wayne Byers in demanding the finance industry fix its corporate culture.

"Time and again, we have seen firms blaming [behaviour] on a few bad apples driving bad outcomes for consumers, rather than taking responsibility by looking more closely at their organisation and implementing the necessary changes to address the cause of the problem," Medcraft said on Monday.

"At the end of the day, you need to have a culture that your customers can believe in."

The captains of finance have not reacted well to the bureaucrats' admonition. David Gonski complained about the corporate regulator being the "culture police", while someone from the Institute of Company Directors offered the uncomprehending advice that corporate culture could not be imposed by law.

It would be wrong to focus only on the bad behaviour of the banks, of course. There have been other instances from other industries. Take 7-Eleven's underpaying of foreign workers.

Or take the many notorious cases of businesses rorting government subsidy schemes in ceiling insulation, childcare and vocational education and training.

It's possible what we're seeing is merely greater exposure of the bad behaviour of big business thanks to a surge in business investigative journalism, with Fairfax Media's Adele Ferguson at its head.

But I've been in and around businesses since I left school 50 years ago, and I think bad corporate behaviour is definitely worse than it was. As executive remuneration has headed for the stratosphere, so the willingness to exploit customers and staff has grown.

But why? One reason is the rise of a more fundamentalist approach to economics. "Economic rationalism" has prompted much deregulation, privatisation and outsourcing, which has made competition a lot more intense in many industries.

That's not necessarily a bad thing, but as managers have experienced greater pressure to perform – as it's become harder to keep profits high and rising – they've passed the pressure on to staff and customers.

Economic fundamentalism is both a product of the greater materialism of our age and a cause of it, with all its emphasis on monetary values and view of "labour" as just another resource to be exploited along with other raw materials.

What's worse is that economic fundamentalism has had the effect of sanctifying selfishness. When I put my own interests ahead of other people's, I'm not being greedy or self-centred or antisocial; I'm just being "rational".

One effect of the greater pressure to perform is the present "metrics" fad – the obsession with measuring aspects of the firm's performance, then using those measures to improve performance, such as by setting targets based on "key performance indicators".

What the KPI obsession is saying is: just get results; how you get them is of lesser interest. I'd lay money that the reason people at CommInsure were knocking back legitimate claims was they were being encouraged to do so by KPIs or other "performance incentives". (That's why it's dishonest for people at the top to blame "a few bad apples".)

Most people's sense of what is acceptable, ethical behaviour is determined by what they believe their peers are doing. If they do it, it's ethical for me to do it; if they don't do it, maybe I should feel guilty about it.

The trouble is, studies show that adults, like children, often harbour exaggerated impressions of how many others are doing it.

Social conformity (aka "culture") is such a powerful influence that it's always been hard for people to follow their own "moral compass". With the decline of religious adherence, it's harder even to have one.

The Business Council and its members ought to be a lot more worried about the decline in their standards of behaviour than they seem to be.

One fundamental the economic fundamentalists keep forgetting is that market economies run best on widespread trust: mutual trust between management and staff, and between businesses and their customers.

Allow declining standards of behaviour to erode trust and the economy suffers. Customers become harder to persuade, argue more with counter staff, are surlier with call-centre staff and more inclined to take their business elsewhere. They resist "upselling".

With less trust you have to waste a lot of money on increased security in its many forms. And governments react by multiplying laws and legal requirements.

When so many companies demonstrate their contempt for other taxpayers by the way they manipulate the tax they pay – their ethic is that if it's (barely) legal, it's ethical – it becomes much harder for governments to get voter support for cutting the rates of those taxes.

Who knew?

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Let's 'reform' lack of satisfaction at work

Has it ever occurred to you that, in all our economic striving, most of us – almost all our business people, economists and politicians, but also many normal people – are missing the point?

It occurred to me years ago, and I've thought about it often, but reading a little book by one of my gurus, Barry Schwartz, a professor of psychology at Swarthmore​ College in the US, has revved me up.

In my job I have to focus mainly on whatever issues everybody else is getting excited about. I've written a lot lately about the budget deficit, mainly because I see the Coalition swinging from exaggerating the size and urgency of the problem while in opposition, to virtually ignoring it now it's in government.

They had one big ill-considered and ill-fated attempt to fix the problem in their first budget, but now they don't even want to think about it.

Of course, getting the budget back to surplus is really just a housekeeping measure. It doesn't advance our cause in any positive sense, it just stops problems building up for the future.

No, the more positive efforts to improve our lot have focused on the need for "reform". The economists have noticed that the rate of productivity improvement has slowed and, since improving our productivity is the main way we keep our material standard of living rising, they're casting around for something we could do to improve matters.

When economic-types look for things to improve, their first thought is to "reform" taxation in a way that does more to encourage people to "work, save and invest".

Sorry, but all this is missing the point. Schwartz's little book is called Why We Work, and he asks us to reconsider the most basic question in economic life: why do we work?

To most people that's a stupid question. We work to make money, which we then use to keep body and soul together and buy the other things we need to give us a happy or satisfying life.

Next question: do we enjoy our work? Answer: sometimes yes, sometimes no. Some people do most of the time; most people don't.

The basic economic model assumes that people don't enjoy work; they do it only for the money. And, except perhaps to the individual, whether they do or they don't isn't of great consequence.

Most employers organise work in ways designed to maximise their employees' productivity – their productiveness. If their workers happen to enjoy their jobs, that's their good luck. If they don't, that's not something a boss needs to worry about.

Schwartz's argument is that we've allowed money – and the economists' way of thinking about work, which goes back to Adam Smith in 1776 – to get us muddled between means and ends.

Money is merely a means, not an end in itself. The end money is meant to be a means to is life satisfaction. But if satisfaction is the object of the exercise, why on earth would we organise the economy on the basis that whether or not people get satisfaction from their jobs doesn't matter?

Why fixate on earning money to buy satisfaction when we could be doing much more to gain satisfaction while we earn?

When you remember how much of our lives we spend working, think what a fabulous "reform" it would be if more of us got more satisfaction from our work.

If we got more satisfaction from our work, economists and politicians wouldn't have to worry quite so much about ensuring our money income kept growing strongly so we could keep attempting to buy more satisfaction. (Tip: the satisfaction you get from enjoying your job and doing it well is more powerful than the satisfaction you get from buying more stuff.)

And if bosses got more satisfaction from their own jobs, maybe they wouldn't be so obsessed by achieving ever faster-growing profits so as to justify ever-bigger bonuses.

You'd think that, with all the status and executive assistants to wait on them and people to boss about, bosses would be rolling in job satisfaction.

But when I see how obsessed they are with pay rises and bonuses, it makes me wonder if they actually hate their jobs more than most of their employees do.

Of all the company's workers, they're the ones showing most sign of only doing it for the money.

By now, I know, many managers will be thinking, if I made making sure my workers had a good time at work an objective, their productivity would suffer.

That's certainly why many jobs have been designed in the soul-destroying way they have been, and the mentality that informs the way many managers manage. Treat 'em mean to keep 'em keen.

But consider the reverse possibility. There's growing evidence that workers who gain satisfaction from their jobs try harder and think more about how they could do their jobs better. Is that so hard to believe?

I'm convinced greater effort to make jobs more satisfying could leave most of us better off with, at worst, no loss of efficiency.

How do employers go about making jobs more satisfying? How can someone with a deadly job make it more emotionally rewarding?

These questions have been well studied by industrial psychologists and Schwartz has lots of useful things to say. But I'll leave that for another day.

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CHINA'S ECONOMY: AN UPDATE

Comview 2016

As you may have noticed, earlier this year I went on a journalists’ junket to China, which has rekindled my interest in the rise of the Chinese economy and its influence on our own economy. I know this is a subject of interest to many economics teachers and their students, so I’m going to start with China’s effect on our economy and a discussion of ChAFTA, then evaluate the policies used to promote growth and development in China and, finally, look at the influence of globalisation on China’s economy - though, in the case of China, it makes more sense to look at the influence of China on globalisation. I probably won’t get time to cover all the material in my full paper, so it would be worth reading full version after you get home.

China’s effect on our economy

As I’m sure you know, for many years Australia’s largest trading partner - taking the most of our exports and supplying the most of our imports - was Japan. But Japan’s relative stagnation since the 1990s and China’s remarkable economic reawakening since the late 1970s, caused China to overtake Japan as our major trading partner in 2007.

Even before the start of the resources boom in 2003, China accounted for more than 8 per cent of our combined exports and imports of goods and services. Twelve years later, in 2015, China’s share is more than 22 per cent. Now China’s $86 billion of our exports gives it the largest share, at 27 per cent, while our imports from it of $64 billion give it the largest share at 18 per cent. Note that, as with Japan, we have a perpetual trade surplus with China.

Between China, Japan, South Korea, India, the ASEAN countries and more, Asia takes about 70 per cent of our exports. So we have been highly successful in enmeshing ourselves with the fastest growing region of the world. This has been good for us, since our major trading partners (weighted according to their shares of our trade) are growing by about 4 per cent a year, compared with less than 2 per cent for the developed countries. Of course, having so many eggs in the Asian basket does mean we’d be hit hard if China’s economy were to have a “hard landing”, to which you’d have to attach a reasonable probability. We’re by no means the only country with China as its major trading partner; it’s also true of many Asian economies. Much trade is “intra-regional”. Note, too, that the US is China’s largest trading partner, while China is the US’s second biggest (after Canada) - and its biggest creditor. So any trade war between the US and China would be so mutually destructive as to make it unlikely.

Our economy is highly complementary with China’s. We specialise in exporting the minerals, energy and other primary products they need; they specialise in exporting the manufactures we aren’t good at making ourselves. The past 20 years have seen China become manufacturer to the world, causing slower growth in the manufacturing sectors of all the developed countries.

China’s protracted period of rapid economic growth, which started slowing only about five years ago, combined with its huge size - its population is now almost 1.4 billion - could not help but have involved huge consumption of minerals and energy. China presently accounts for more than half the world’s annual consumption of iron ore and steaming coal, and more than 40 per cent of aluminium, copper, nickel, zinc and lead. So it was inevitable that China’s rapid growth in the years leading up to and immediately after the global financial crisis would have big implications for a major resource exporting country like ours. We benefited greatly from the huge rise in coal and iron ore prices - which peaked in 2011 - and from the consequent boom in mining and natural gas construction activity, which peaked in 2013 and is still falling back.

It’s a mistake to think mineral commodities are pretty much the only thing we sell the Chinese.  At present, resources account for about two-thirds of the total value of exports to China, leaving 21 per cent for other goods (mainly rural) and 11 per cent for services.

However, China is now facing challenging times. Its annual rate of growth has slowed - to 6.7 per cent over the year to September, 2016 - simply because, when you are coming from a low base, it gets harder and then impossible to maintain a very high rate of growth. At 10 per cent a year, the economy doubles about every seven years; at 6.7 per cent, it doubles about every 10 years.

But China must now move on to a new stage of economic development if its rate of growth isn’t to slow a lot further. Its exports of low-value manufactures have probably reached saturation point in the world market, and its growing prosperity means that real wages are rising strongly (about 8 per cent a year versus 3 per cent inflation) and eroding profit margins.

Because China remains a socialist market economy, the central government uses successive five-year plans setting out its goals, strategies and targets. As summarised by Asialink, the present, 13th five-year plan focuses on increasing China’s competitiveness through more efficient and increasingly advanced manufacturing on the east coast, attracting labour-intensive manufacturing to central provinces, and increasing domestic demand.

As expressed in the recent joint Australia-Chinese expert report, Partnership for Change, China is shifting its growth drivers from investment, exports and heavy industry to consumption, innovation and services. Chinese production is shifting from a model based on adaptation and imitation of goods, services and technologies developed elsewhere, to a model based on domestic innovation. Part of this involves a shift from labour-intensive, low-tech, low-value manufacturing to more advanced, high-tech, high-value manufacturing. This has already started.  Over the 20 years to 2015, low-tech manufacturing’s share of China’s total exports of goods has shrunk from almost half to less than 30 per cent.

So, at a time when our economy must adjust to the end of the resources construction boom and find new sources of growth, China must also make a (more fundamental) transition from investment and exports to consumption and imports. In this challenge our economies aren’t quite the same complementary fit, but there is scope for us to supply the ever more sophisticated demands of China’s rapidly expanding middle class, even if in more intensified competition with other developed countries.

China’s greater demand for imported services certainly fits with our need for greater services-led growth in production and employment. And we are already showing success. Chinese tourist visits to Australia have risen from 350,000 visitors in 2009 to 1.2 million visitors in 2015, and are forecast to exceed 2.5 million visitors by 2024. In 2017 China is expected to overtake New Zealand as our largest source of overseas visitors.

With exports to all countries of almost $20 billion a year, education is our third largest export category (behind iron ore and coal), while tourism is the fifth largest. Chinese student enrolment numbers have risen from 140,000 to 170,000 in the past three years, and HSBC bank forecasts they could exceed 280,000 by 2020. China is the largest source of international students in Australia, accounting for more than a quarter of overall international enrolments. Chinese students spend more during their time in Australia than other international students, only partly because they tend to stay longer. China’s growing middle class mean a growing market for business services such as accounting, legal and financial services, and its ageing population will see rising demand for healthcare. As a whole, business services have risen by a similar amount to tourism and education in recent years.

Most of the growth in exports of “other goods” involves foodstuffs. This had been driven by grain exports, but these have fallen off in the past couple of years. But exports of “finer foods” - such as meat, dairy, sugar and edible oils - have risen. China recently became our largest export market for wine, at almost $500 million over the year to September, up 50 per cent on the previous year.

It is common for our major trading partners to want to invest in our economy, particularly to make direct investments in those of our industries that supply the exports they are buying. Since Australia has been a “capital importing” economy from the beginning of white settlement, this has always been acceptable to our governments, despite recurring popular concerns about “selling off the farm”. Our major trading partners have often been running current account surpluses, making them keen to find profitable investment opportunities in other countries.  There has been some resistance to China’s foreign investment in Australia but, as yet it represents less than 5 per cent of total stock of foreign investment, coming seventh behind the US (27 per cent), Britain (16 per cent), the rest of the EU (16 per cent), Japan 6 per cent), Singapore and Hong Kong. Chinese investment in residential property in Sydney and Melbourne has probably added to upward pressure on prices, but much has been in new apartment developments, which should add to supply as well as demand.

The China-Australia Free Trade Agreement

Like most economists, I am dubious about the benefits of the bilateral preferential trade agreements known misleadingly as “free trade agreements”. They tend to divert trade from to the favoured country from other, cheaper suppliers, while adding to administrative costs through complicated “country-of-origin” rules. The officials negotiating them seek maximum concessions from the other side while making minimum concessions of their own, whereas economic theory says the main efficiency benefits come from reducing your own barriers to imports, rather than achieving reductions in other countries’ barriers to your exports. In practice, many of the preferential agreements made in recent years have involved only modest concessions on either side.

However, the ChAFTA agreement which came into effect in December 2015 was more significant than the other agreements we have reached. This is mainly because China, having been a member of the World Trade Organisation only since 2001, had many more reductions in tariff protection it was able to make than other, more developed economies. China has made trade agreements with several other countries, but its agreement with us is said to be the most comprehensive and liberalising arrangement it has entered into.

China agreed to eliminate immediately or phase out tariffs on Australia coal, alumina, beef, dairy, sheep, pork, live animals, horticulture, wine and seafood. No reduction in tariffs on sugar, rice, wool, cotton or wheat were agreed. Restrictions on Australian direct investment in Chinese businesses have been reduced. For our part, Australia agreed to phase out its 5 per cent tariff on imports from China of various manufactured goods, including electronics and whitegoods. In theory, we liberalised our restrictions on Chinese direct investment in Australian firms, but several highly publicised proposals have been rejected on claimed grounds of national security. It is commonly observed that ChAFTA creates much opportunity for Australian firms to take advantage of in coming years, but it remains to be seen how much they do.

 Policies used to promote growth and development in China

 China has a long and illustrious economic history. It was a major centre of trade more than 2000 years ago with the establishment of the Silk Road in about 200 BC, which connected Asia with Europe and Africa. The Chinese are credited with inventions such as the compass, gunpowder, fireworks, silk, noodles, moveable-type printing and papermaking.

In the centuries since then, however, China became very inward-looking, limiting its trade and contact with other countries. Even so, economic historians estimate that by 1820 China accounted for about a third of world GDP, with India increasing the two countries’ share to almost half. So China and India are former super powers. Today they’re not emerging economies, but re-emerging economic giants. What happened after 1820, of course, was the growth of the European and new-world economies such as America and Australia, following the spread of the Industrial Revolution. By 1970, China’s share of world GDP had fallen to less than 5 per cent (with India’s share even smaller).

After China’s Communist revolution of 1949, led by Mao Zedong, the 1950s were spent expropriating private property and establishing a planned economy. After an initial surge in growth, the economy began to stagnate. But all that began changing after 1978, when Mao’s successor, Deng Xiaoping, began the far-reaching market-oriented reforms that have brought China’s economy to where it is today. He instituted what he called “socialism with Chinese characteristics”, but economists call a “socialist market economy” - one in which a big sector of state-owned enterprises (SOEs) exists in parallel with market capitalism and private ownership - both local and foreign.

The 1980s saw much reform of China’s agricultural sector as the Russian collectivist system was dismantled and farmers incentivised by being allowed to sell their surplus production on the open market. The result has been a huge improvement in the productivity of China’s farms, such that China is the world’s largest producer of agricultural products - including rice, wheat, pork and fish - even while millions of rural workers have moved to the city to take factory jobs. Thus China’s industrialisation and urbanisation have gone hand in hand. Now more than half the Chinese population lives in cities.

The 1990s were devoted particularly to the growth of China’s manufacturing industry. It followed the Asian strategy of development first pursued by Japan and South Korea: exploiting the country’s abundance of cheap labour to produce and export low-value manufactures such as textiles, clothing and footwear, and toys. The strategy of export-led growth was promoted by keeping the exchange rate low and attracting financial capital, technology and the transfer of know-how by encouraging foreign investment.

This strategy does most to explain China’s rapid growth over the past 40 years, with annual growth averaging 10 per cent for about the middle 30 of those years. Those 30 years saw the size of China’s GDP multiply by about 48 times. With China’s population growth limited until very recently by its one-child policy, this meant a rapid rise in material living standards, as measured by income per person.

According to the World Bank, more than 500 million people were lifted out of poverty as China’s poverty rate fell from 88 per cent in 1981 to 6.5 per cent in 2012, as measured by the percentage of people living on the equivalent of US$1.90 or less per day in 2011 purchasing power parity terms. Because this is a measure of absolute poverty, however, it has not prevented some people’s incomes rising a lot faster relative to other people’s. China’s official Gini coefficient for the distribution of income is 0.46 (compared with Australia’s 0.33), but some unofficial estimates put it even higher.

Combine these decades of rapid growth with China’s population of 1.36 billion - the largest in the world - and it’s not surprising China is now the second largest economy in the world, when measured in nominal exchange rates, or already the largest when exchange rates are adjusted for purchasing power parity (because $US1 buys a lot more in China than it does in America).

Measured using PPP, China’s share of world GDP is about 16 per cent. It is already the world’s largest trading nation and largest producer of manufactures.

 According to standards set by the World Bank, China already has 300 million people with household incomes high enough to be considered “middle class”. However, when the World Bank compares countries rather than households, and looks at countries’ level of income per person, China is still classed as a middle-income country - no longer low income, but not yet high income. Its income per person is about $US8000 using nominal exchange rates, or about $US15,000 after adjusting for purchasing power parity, thus making it only the 84th richest country in the world. Many developing countries - particularly in Latin America - have managed to make it from poor to middle-income, but been unable to make the transition from middle-income to high-income. China must now break out of this “middle-income trap”, as economists call it.

By land area, China is the fourth largest country (after Russia, Canada and the US, followed by Australia as fifth), covering about 9.6 million square kilometres. It has three levels of government: the central government based in Beijing, 34 provincial-level governments and many local governments. Although we view it as one economy, according to Asialink it can also be viewed as a decentralised collection of several regional economies, with large wealth imbalances between rural and urban populations. The eastern provinces, which contain most of the manufacturing, are the wealthiest. Central China is more agriculture-focused and not as wealthy, although low-end manufacturing is increasingly moving into the region. Western China is the least economically prosperous region, although it has significant natural resources. The three wealthiest and most economically important regions are all on the east coast: the Pearl River Delta, close to Hong Kong; the Yangtze River Delta surrounding Shanghai; and the Bohai Bay region near Beijing.

Influence of globalisation on China’s economy

The story of how, since 1978, China has grown to become the world’s second or first biggest economy is all about how it opened up to trade and investment with a globalising world and, in the process, added greatly to the globalisation process and its effects on many other countries, not least of which is Australia.

China’s economy in the 1970s was poor and slow-growing mainly because it was cut off from the rest of the world. So when its leaders decided to introduce elements of the market system, they were consciously opening up to trade with the rest of the world - imports and well as exports - and to foreign investment in their economy and the acquisition of the latest technology and know-how.

One major landmark in the opening up process was China’s admission to membership of the World Trade Organisation in November 2001. This involved China agreeing to abide by all the rules governing trade between member countries and dismantling certain of its tariffs and restrictions on imports. More recently, China has concluded bilateral “free” (that is, preferential) trade agreements with South Korea, ASEAN, New Zealand, Switzerland, Pakistan and, of course, since 2015, with Australia.

But not all countries have found their economies to be such an easy fit with China’s. Unlike Australia, many developed countries have large manufacturing sectors, which have been threatened and then diminished as China has become the world’s largest trading and manufacturing nation, exporting not just low-value items but, increasingly, more advanced products such as steel and motor cars. Although the manufacturing workers of China have benefitted greatly from increased employment and rising wages, the opposite is true for many workers in developed countries.

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How to get better, not smaller, government

Whether it's a week early or not, it looks a safe bet that this year's budget will do little more than keep the wheels of government turning for another 12 months. If so, it will confirm our worst fears that neither side of politics is capable of improving things.

I hope I'm wrong, but it now seems that the sweeping tax reform we were long promised by the Coalition – with everything on the table, and a white paper to follow a green paper - has shrivelled to some minor tinkering to pay for a minor tax cut.

Which brings us back to the budget's primary macro-economic purpose, achieving "fiscal sustainability". We've been assured – as usual, by leak – that any improvement in revenue estimates arising from the seeming recovery in iron ore prices will be allowed to reduce the budget deficit, not used to fatten the tax cuts or otherwise buy votes.

Considering all the crocodile tears the Coalition shed over "debit and deficit", it's the least Malcolm Turnbull could do.

The Coalition has done little to restrain government spending in its first term for two reasons, one political and one economic. The political reason is that the public and the Senate held Tony Abbott to his last-minute and utterly unneeded promise not to cut any of the key areas of government spending.

The economic reason – which was perfectly sensible and actually began under Labor – was that with the economy growing at well below its "trend" (average) rate, now was the wrong time to weaken it further by raising taxes or cutting government spending.

With forward-looking trend growth now reduced to 2.75 per cent a year and the economy growing by 3 per cent in 2015, we should be getting on with budget repair.

So both those restraints are now inoperative – or should be. It's one thing to avoid nasties in a pre-election budget; it's quite another to lock yourself in for another term with promises not to cut this or that spending, or not to adjust taxes.

Similarly, it's all very well for Turnbull's supporters to say he needs his own mandate to establish his legitimacy and authority with his fractious backbench; it's quite another for him to gain a "mandate" that doesn't include a licence from the electorate to make the improvements we need.

So a key issue will be how much reform Turnbull promises not to make and how much leeway he leaves himself to do what needs to be done.

But after the monumental setback of Abbott's first budget, I worry not just about the character strength of our politicians, but also about the quality of the advice they're getting from the econocrats of Treasury and Finance and the heads of other departments.

One thing the bureaucrats should understand is that the ideological push for lower government spending is a snare and a delusion. It's never gonna happen, because the public won't accept it and there are no pollies mad enough to try.

The key to good spending management is to accept that the goal should be not smaller government, but better government. Delude yourself that we'll soon be seeing smaller government – that there are vast areas of things governments will stop doing – and you're more susceptible to the kind of short-sighted, mindless cutbacks that often involve false economies, mere cost-shifting or savings that don't stick, of which we saw so much in the first Abbott budget.

But accept that we need better government – that government will always be with us, with ever-growing responsibilities and spending – and you see more clearly that the task is to identify and correct specific instances of excessive or ineffective spending – with which the budget no doubt abounds.

You slow the rate of spending growth, reducing the incidence of what the public thinks of as "waste" (it may look like waste to me, but not to whoever's income it's adding to), thus giving taxpayers better value for money and helping to reduce the resistance to paying tax.

Focus on better government and you realise that the "no-brainer", set-and-forget, don't confuse me with the details, approach favoured by econocrats has an appalling record of failure.

You don't bother to think hard about the peculiar characteristics of the service being performed, nor do you wonder about the wisdom of letting private firms "sell" heavily subsidised government services, you just resort to generic, magic answers such as imposing an "efficiency dividend", "getting the incentives right" and making the provision of public services "contestable".

Economic shibboleths are no substitute for detailed knowledge and careful analysis.

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