TALK TO TREASURY MACROECONOMIC GROUP’S PLANNING DAY

Old Parliament House, Canberra
July 18, 2007

David Gruen has asked me to talk about the policy issues I believe Treasury should be thinking about in briefing an incoming government, new or returning. I’m not convinced I could give you much useful advice on that score, but I’m going to address the topic quite broadly in the hope of saying something that gives you something to think about, even if - as I suspect is often the case - all I do is help you realise why you don’t agree with me. I’ll also focus fairly heavily on my special subject: the politics of economics.

In thinking about the next government I’m going to err on the side of envisaging a change of government, not because I think it’s a sure thing - I don’t - but because it gives us more interesting things to think about and because preparing a briefing for a new government is a more challenging exercise. It’s possible I may have had more experience than some of you of observing change-overs. In my career I’ve seen three at the federal level: from Whitlam to Fraser in 1975, from Fraser to Hawke in 1983 and from Keating to Howard in 1996.

Thinking about a change of government

At one level you might think that a change-over from Howard to Rudd would be a relatively simple affair given that the remarkable success of existing policies means there’s broad agreement between the two parties on the question of macro management - on the medium term frameworks for monetary policy and for fiscal policy, including balancing the budget on average over the cycle and limiting the growth in revenue as a proportion of GDP. In case any of you have any doubts, I’d remind you that politicians’ behaviour in opposition usually offers a poor guide to their behaviour in government, so that the behaviour of Labor when last in government offers the best guide to its behaviour when next in government. We can expect a Rudd government to be quite conservative and responsible, anxious to lay to rest the popular stereotype that Labor is no good at economic management, anxious to avoid getting offside with the financial markets, anxious to be seen as ‘pro-business’ - more anxious about it than the Libs ever need to bother being - and anxious to avoid being seen as the lackeys of the (in any case, hugely politically weakened) union movement. The more the Libs push that line against Labor in the run up to the election, the more determined a Labor government would be to disprove it in practice. This time there’d be no Accord to give the unions a seat at the Cabinet table.

But it would be a mistake to see the lack of significant difference between the two sides on macro policy as making the briefing of an incoming Labor government a ho-hum affair. That’s because a change of government represents a rare and vitally important point of challenge and opportunity for Treasury. It’s a quickly passing opportunity for Treasury to establish a relationship of two-way trust and loyalty with the new administration. Treasury does so by demonstrating its commitment to apolitical service to the government of the day, by demonstrating that it’s already been giving much thought to the new government’s problems from the new government’s perspective and by demonstrating its competence (including its detailed knowledge of the new government’s stated policies). The more politicised the public service becomes, the more important this welcoming-committee role becomes.

But there’s a second reason the first few days of the new government’s term are of such strategic significance: they represent an unparalleled opportunity to get action on all those issues the outgoing government had consigned to the too-hard basket, including those that most offended the interests of its core constituency.

The first duty of Treasury is to immediately present the incoming government with evidence of a budgetary crisis that demands an immediate and radical response. That’s what John Stone did for the incoming Hawke government even before it had been sworn in and what Ted Evans did for the incoming Howard government in 1996. I’ve seen it done at the state level many times and incoming CEOs of major companies almost invariably do something similar. I call it ‘doing a Mother Hubbard’: we came to government, looked in the fiscal cupboard and were shocked and appalled to discover it was bare. It’s actually a time-honoured trick that will be much harder to pull off in the era of the PEFO. The first point of it is to get all your predecessor’s dirty fiscal linen out in the open while the recognition of those presently hidden, unacknowledged costs can be blamed on your predecessor. It has to be done in an atmosphere of high-drama crisis, so your alibi will stick in the mind of the electorate and so any early economic setback or lack of progress can be excused.

But the second purpose of the crisis is to provide a cover for a process by which the incoming government slashes away at those budget measures aimed at its predecessor’s political heartland so as to make room for those measures it has promised to grant its own political heartland. The process also allows the new government to defer or abandon some of its non-core promises. This is a vitally important exercise from Treasury’s perspective because of the need to prevent the new government from merely adding its pet projects on top of its predecessor’s pet projects.

A common practice is for the new government to establish a committee of audit to reinforce the message that it inherited a fiscal mare’s nest, but the Howard government’s experience shows that the auditors need to be selected with care. Give the job to a bunch of academics and they’ll give you a report whose recommendations are too radical to your taste.

On a related theme, I have to tell you that the older I get the more I doubt the pertinence of the old cry in response to election promises, ‘where’s the money coming from?’. The honest answer - which no politician would dare give - is, ‘if and when we win the election, Treasury will tell us’. Why? Because that’s what Treasury’s paid to do: tell the government of the day how it can cover the cost of the policies it wishes to pursue. Hidden in that is a more subtle task: to take the incoming government’s election promises and explain to it how, by adding qualifications and limitations that were not mentioned or explicitly ruled out before the election, it can significantly curtail the budgetary cost of the promise. It may also be able to gain some budgetary leeway by fiddling with the timing of commencement of the program.

Thinking about the next recession

I have a feeling this election won’t be a good one to win. Why not? Because of the high chance that the record expansion phase finally comes to an end sometime in the next few years, leaving us in recession. Think about it: we have a history of governments being thrown out of office after they’ve presided over a recession. That’s true of the Whitlam, Fraser and Hawke-Keating governments, although in Paul Keating’s case there was a one-term lag thanks to John Hewson’s GST/Fightback package. Parties that are in government generally have good reputations for economic management, then lose it during their recession and leave office being regarded as pretty hopeless. The incoming government then does its best to rub in their predecessor’s bad reputation and live off it for as long as possible. The Hawke-Keating government suffered this fate notwithstanding its unprecedented record of economic reform. I might add that, though the Labor government’s poll ratings on economic management weren’t too bad during most of its term, the voters’ views on which party is good at which policy area are terribly stereotyped, meaning that the Liberals’ identification with business gives them a big inbuilt advantage.

But now consider what would happen if the Libs lost office this year and a recession occurred during the new government’s term. The Libs would have managed to enjoy a completed period of more than 11 years in power without a recession, whereas Labor would have plunged the economy into recession within a year or two of regaining power. Nothing could be more calculated to reinforce for the long term the perception Peter Costello has been so successful in inculcating with all his talk about Labor’s Beazley Budget Blackhole, deficits and debt, that the Libs are God’s gift to economic management, whereas Labor simply can’t be left in charge of the till.

So that’s why I say I’m not sure this would be a good election to win. I’m sure that wouldn’t discourage Labor from wanting to win, but I’m equally sure the scenario I’ve just outlined would have occurred to Labor and that, should it win, it will quickly turn its mind to this potential problem. It will do all in its power to blacken the economic reputation of its predecessor in the hope that, should a recession occur reasonably soon after the change of government, it will be able to shift the blame back on the Libs. If I’m right, it will be expecting Treasury to play its part in this exercise.

But now let’s turn out minds to the possible nature of the next recession (and remember that this discussion applies equally to Liberal or Labor governments). Dr Don Stammer, formerly of Deutsche Bank, says no economist or economic journalist is worth feeding unless they’ve lived through at least four recessions and, if they have, they’re entitled to charge a premium for their advice. In my working life I’ve experienced the recession of the mid-70s, the recession of the early 80s and the recession of the early 90s - and they’ve left a lasting impression on me.

The first thing to say is that I don’t see any signs that a recession in imminent. But I don’t believe for a moment that the business cycle has been abolished and nor do I believe our luck can hold forever. Equally, however, I don’t think you ever get much warning that a recession is on the way. They tend to be brought on by what Don Stammer famously calls the X Factor - the factor no one had been expecting. But I do think there are a few things we can say. One is that I don’t think we’ve ever had a recession of exclusively domestic causes. Equally, I don’t think we’ve had a recession of exclusively external causes - though in 2001 we did have a mild world recession that didn’t lead to a downturn here.

I deduce from this that our economy goes into recession when some external disturbance combines with some domestic imbalance or vulnerability. I don’t think we have to look far to find the most likely source of domestic vulnerability: our extraordinarily heavily indebted household sector. It’s highly vulnerable to a sudden fall in employment - from whatever cause - which would make it impossible for affected households to maintain their mortgages. This threatening atmosphere could put the wind up many employed but heavily indebted households which, in their efforts to reduce their exposure, could significantly slow their consumer spending. The contraction would come not so much from the direct effect of newly unemployed households as from the indirect, contagion effect on other indebted households.

I believe that, when it comes to dealing with recessions, it’s important not to get caught fighting the last war. I say this because of my painful experience with the recession of the early 90s. Early in that process, despite widespread gloom and doom in the business community, Treasury was confidently predicting just a ‘soft landing’. Treasury argued that the prime domestic cause of the two previous recessions - in the mid-70s and early 80s - had been wage explosions and, since this time wages were well under control thanks to the Accord, this downturn was not likely to be severe. I bought that argument and loudly and confidently predicted a soft landing, knowing to ignore all the contrary anecdotal evidence I was hearing. As it transpired, the landing was anything but soft. So that proved a terribly wrong call on my part and caused me a lot of grief in the office, where all the anecdote merchants tried hard to convince the editor of my incompetence.

The problem with that analysis was that, as is the bias of most macro economists, it sought evidence and explanations for recession only in the real economy, ignoring the financial economy. But, as Ian Macfarlane was the first to explain publicly, financial factors were the key cause of that recession and its severity. The deregulation of the financial system and the admission of foreign banks had led to an orgy of business borrowing associated with successive asset price booms in the stock market followed by the commercial property market. When high interest rates eventually caused the music to stop, the corporate sector found itself heavily leveraged and highly exposed, many with assets that were no longer worth what had been paid for them. The response was that the corporate sector, including the banks themselves, entered a protracted period of ‘balance sheet repair,’ which involved running down debts by cutting investment spending, cutting staff and otherwise cutting expenses. The problem with this, of course, is that it spreads the problem to other firms, which deepens and prolongs the adjustment period.

Now, the point I want to make is that, in thinking about the next recession, we shouldn’t focus exclusively on what could go wrong in the real economy, but remember that we could again be clobbered by the financial side. For a long time I believed that we’ve got so proficient at controlling inflation - we’ve become so vigilant - that the next recession couldn’t possibly involve the usual train wreck of inflation getting away and interest rates being held so high for so long that a deep recession becomes inevitable. If so, the next recession would be a mild one. I no longer think that because, as Ian Macfarlane made pretty clear in his Boyer Lectures last year, the smart money is expecting the repair of household balance sheets to be the major domestic cause of the next recession. That means it’s likely to be severe and protracted - especially when measured the way politicians and the electorate measure the severity of recessions: by the effect on unemployment, not the effect on output.

At present, thanks to the long-lasting salutary effect of the last recession our corporate sector is not highly geared. But should the next recession be delayed and the private equity craze continue (which it may not), by the time the next recession does arrive we could find ourselves with a highly geared corporate sector as well as a highly indebted household sector. If so, expect the next recession to be doubly severe.

Here it’s important to remember what I think of as a cross between Goodhart’s Law and Murphy’s Law. When monetary policy manages to get a handle on goods and services price inflation control, it tends to encourage the emergence of a problem it finds much harder to handle, credit-fuelled asset price booms. To put it another way, when the economy has been growing strongly and steadily for some time, businesses in search of ever-growing profits tend to become emboldened to take on more risk by gearing up. We see the perfect demonstration of this in the private equity fashion. Trouble is, we all know it will end in tears. Note that here we see one reason for the perpetuation of the business cycle, where the very success of the expansion phase sows the seeds of its eventual destruction.

Now let me introduce a complication I’ve been thinking about lately, but haven’t yet resolved in my mind. In the past 10 or 15 years it’s become terribly fashionable to analyse the challenges of business life in terms of ‘risk management’. I’ve even seen business types getting climate change and emission trading legitimised in their minds by branding it as risk management. Risk management can be about risk spreading, but easily degenerates into nothing more than risk shedding. Businesses can shift risk to their customers, but for the most part they shift it to their employees. I suspect that the protracted period of companies seeking to maintain double-digit profit growth by eternal cost cutting involves a lot of risk-shifting to employees. It’s not greatly relevant to Australian circumstances, but the classic example of risk-shifting to employees has been the move from defined-benefit to defined-contribution pension schemes - which has made older employees far more vulnerable to vagaries of the sharemarket. Another example is the advent of just-in-time inventory management, where firms’ economising on inventory costs has shifted the risk and cost of supply-chain disruption to their employees - who are now far more likely to find themselves temporarily laid off because of, say, a strike at a supplier’s factory. I don’t think there’s much doubt that Work Choices - including the neutering of the unfair-dismissal provisions and reduction in the availability of redundancy payments - has greatly increased firms’ ability to shift risks to their employees. Added to that you have the growth in casual employment, the conversion of employees into contractors and the widespread use of labour-hire firms.

My point is that this risk-shifting trend may have altered the internal dynamics of recessions in ways that are hard to predict. If in a downturn firms are better able to limit the fall in their profits by more easily cutting their wage bills - and thus their employees’ and erstwhile employees’ incomes - does this make the recession less severe or more? If Work Choices gives employers the upper hand in industrial relations, does this mean a recession is likely to see more lay offs or more workers on four-day weeks - that is, is the pain more concentrated on a few or more evenly spread across the many? Does it make much difference? One possibility is that the greater freedom to dispense with the services of casuals, contractors, labour-hire workers and even permanent employees means unemployment will shoot up much earlier than it did. The corollary, however, should be that the absence of labour hoarding means unemployment recovers earlier. We shall see.

Now for a more positive note. If I’m right in predicting that the next recession is more likely to arise from some disruption giving rise to adverse balance sheet effects than from a loss of control over inflation, that does have one big advantage. It means the macro managers ought to feel free to respond to the downturn by the quick and wholehearted application of stimulus. The Reserve Bank can afford to slash interest rates in the way the Fed did in 2001. That’s one of the rewards from our return to good control. Similarly, with general government net debt eliminated, there’s no impediment to the government adding significant discretionary fiscal stimulus on top of the reversal in the automatic stabilisers. There maybe some political embarrassment arising from the way the medium-term fiscal strategy has degenerated into the promise of eternal surpluses, but in the pressures of the moment that will be quickly cast aside.

Here it may be useful to recall the experience of the last recession, where it was originally argued that all the discretionary stimulus should come exclusively from monetary policy, with fiscal policy holding to its medium-term goal apart from the automatic response of the automatic stabilisers. This is what produced the most amazing budget of my career, the only one delivered by John Kerin who, with Paul Keating skulking on the backbench, proceeded to be more Keating than Keating, and stood up in the middle of the recession (August 1991) and declined to kick-start the economy. (That budget was also remarkable for being delivered in the early afternoon without a lockup, thereby uniquely demonstrating that the lockup serves no economic purpose, but survives purely as an instrument of media management.) The joke of all that, of course, was that once Keating became prime minister a few months later, he lost little time in organising the hugely stimulatory mini-budget of February 1992. And the lesson of all that is that the politician who can resist the temptation to use the budget to stimulate the economy during a recession has yet to be born. That being the case, it makes more sense for Treasury to switch to recommending a stimulatory stance of fiscal policy as soon as possible.

One last point since I suspect that some of you have never experienced a recession during your working lives. The burden of recessions is felt very unevenly. Some people lose their jobs, others lose their businesses, while the great majority of people are little affected. Overtime will dry up and their real wage may slide a little, but you’ll even find the odd person doubting that the recession is real because the restaurants are still full. Even so, recessions are highly unpleasant times for economists (and economic commentators) to be alive. The public turns on economists, history is rewritten to blame them for everything, the public is not prepared to entertain discussion of any economic issue bar getting unemployment down, and the period of gloom and doom - the regular encounters with punters who can’t see how the economy will ever get back on its feet again - lasts interminably. Two or three years. So if you’ve never lived through a recession, be warned: they’re no fun.

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After dinner speech to Social Policy Conference dinner

Australian Social Policy Conference dinner
Sydney, Thursday, July 12, 2007

Peter Saunders - the Peter Saunders I call the original and best Peter Saunders - tried to inveigle me into giving this talk by promising me a free feed, but something in the back of my mind warned me that meals are never free. So then he tried the line that I could use the occasion to plug my latest book - and he had me. Actually, I’m going to plug my last two books.

What do you get when you cross an economist with someone from the mafia? An offer you can’t understand. Both books seek to defy that prediction. If you happen to be interested in finding an easy-read introduction to conventional economics - the economics of inflation and unemployment and interest rates that you find in newspapers - I recommend the book I published last year, the one with the blue cover, Gittins’ Guide to Economics.

But the book I want to talk about is my latest, one that’s not like any conventional economics book in that its focus is on you, not the economy. It’s about how you live your life within the economy and make sure the economy is working for you, not you for it. This is the book with the red cover, modestly titled Gittinomics.

One of the ways I’ve tried to keep the economics practical and interesting is to mix in with it a fair bit of psychology and neuroscience. Conventional economics assumes we’re all coldly calculating and rational in the decisions we make, but over the past 20 years or more psychologists and neuroscientists have demonstrated how far this is from the truth. It turns out that the primitive, more emotional part of our brain often overrides - or beats to the punch - the more recent, more logical part of our brain. This leads to a strange dualism in our minds: we’re often motivated to do things by considerations the more intellectual part of our brain knows to be nonsensical.

The classic example, of course, is advertising. The central proposition of most ads is that mothers who buy a certain brand of margarine - or a certain brand of sliced bread - will have good-looking, healthy, happy families. Intellectually we know such propositions to be absurd. We imagine there must be some simple souls somewhere who fall for such rubbish, but we certainly don’t. Sorry. Advertisers wouldn’t spend millions each year on such ads if they didn’t work on people in general and enough individuals in particular. Clever appeals to our emotions can induce an emotion-driven response from us even though the more reflective part of our brain knows them to be laughably silly.

Once you accept that we’re capable of responding in a quite unthinking way to the opportunities and temptations thrown at us in this consumer economy, various things become clear. For instance, who’d be silly enough to believe you don’t have to pay for stuff you buy with a credit card? Only a few silly teenagers? No, many of us. Consider an experiment undertaken by some marketing professors at MIT. They organised an auction using written bids for some very attractive basketball tickets. They did the experiment twice. The first time they said you’d have to pay for the tickets with cash; the second time they said you could pay by credit card. The people in the credit card auction offered to pay twice as much as the people who had to pay by cash. The trick is that, when you pay by credit card, you can postpone the need to worry about whether you can really afford the thing you’re buying.

Another instance of the difficulty we have keeping control of our money concerns choice. Politicians, economists and business people assume choice is an unmitigated blessing and the more choice we get the better. In truth, the psychologists have demonstrated that when we’re faced with too much choice we find it confusing and debilitating. Consider an experiment in which researchers set up a display of exotic jams in a gourmet food store, offering a saving if you bought a jar. In on case they offered people tastes of 24 different jams; in another case they offered just six varieties. Comparing the two cases, the larger array attracted more people to the table, even though people tasted about the same number of jams in both cases. But get this: when only a small number of jams were offered, 30 per cent of people bought some; when the larger number of jams was offered, only 3 per cent of people bought. In other words, people found the larger array confusing and so avoided making a decision to buy.

This inability to cope with tricky choices makes it fairly easy for retailers to manipulate us. Consider the way theatres sell popcorn.

Or, consider the way we pick wine from a wine list in a restaurant.

Though almost all of us have spent almost all of our lives living in a market economy, many of us don’t know much about how markets work. We have it in our heads that businesses just add a set mark-up to their costs and that’s what they charge us. But often it doesn’t work that way. For instance, the higher prices charged for organic fruit and vegetables or free-range eggs or ‘fair-trade’ coffee commonly far exceed the extra cost involved in producing the item. Why? Because people with tender consciences about the treatment of chickens or third-world coffee growers - or people worried about the chemicals used to produce non-organic food - are willing to pay higher prices to assuage their consciences. When you’re selling free-range eggs you’re selling something extra beside the eggs: conscience balm. And if that’s what you want, the retailers are happy to charge you more and take your money.

While we’re on the subject of what’s called ‘behavioural economics’ I want to talk about something that’s not in the book. I’ve been thinking a lot lately that there’s a contradiction at the heart of the capitalist system. The system includes many people who make their living by tempting you to buy things and do things which are fine if you do them only in moderation, but which can bring you down if you do too much of them. So the key to being a winner - a master - in the capitalist system is to possess the self-control to resist the temptations it continually throws at you. If you oblige the capitalists and always buy what they’re pushing, you’ll help to make them rich but, paradoxically, you’ll become a loser - a victim - of the system.

What are these temptations? They’re manifold. The one we’re most conscious of these days is the temptation to eat too much. But there are many more: to get too little exercise, to smoke, to drink too much, to watch too much television, to gamble too much, to shop too much, to save too little and put too much on your credit card, to work too much at the expense of your family and other relationships.

All of those things are being pushed on us by the system. They’re what the capitalists are trying to sell us. A lot of highly paid advertising people, marketers and merchandisers make their living finding ever-more effective ways to persuade us to indulge. In the case of exercise, no one’s selling the lack of exercise, but lots of people are selling ways to avoid exercise - whether it’s going everywhere by car, using the remote or watching sport on telly rather than playing it. Admittedly, people are also selling ways to get fit - from exercise bikes to gym subscriptions and all the right gear to wear - but then you’ve got to make sure you don’t get hooked on being underweight or using steroids to bulk up.

OK, so we need to demonstrate a bit of self-control in our lives. What’s so new and surprising about that? Two things.

First, research by psychologists, neuroscientists and behavioural economists has shown that humans have a great problem exercising self-control. We think it’s up to us to decide how much to eat or how much TV to watch but, in fact, many of us find it very hard to restrain ourselves in the way we know we should. Experiments with people who’ve had the two sides of their brains severed in some accident show that the reasoning part of our brain often doesn’t know why the faster, more instinctive part of our brain decided to do what it did, but is adept at thinking of plausible explanations for its behaviour. In other words, humans are prone to ex-post rationalisation.

It’s as though we have two selves, an unconscious self that’s emotional and short-sighted and a conscious self that’s reasoning and far sighted. We have trouble controlling ourselves in circumstances where the benefits are immediate and certain, whereas the costs are longer-term and uncertain. When you come home tired from work, for instance, the benefits of slumping in front of the telly are immediate, whereas the costs - feeling tired the next day; looking back on your life and realising you could have done a lot better if you’d got off your backside and played a bit of sport, sought a further qualification at tech, studied harder for exams, spent more time talking to your kids etc. Similarly, the reward from eating food is instant, whereas the costs of overeating are uncertain and far off in the future - being regarded as physically unattractive, becoming obese, becoming a diabetic, dying younger etc. As everyone knows who’s tried to diet, give up smoking, control their drinking, save or get on top of their credit card debt, it’s very hard achieve the self-control our conscious, future selves want us to achieve. Many of us may have no trouble controlling ourselves in most of the behaviours I’ve listed, but I doubt there’s anyone much who can claim to have themselves perfectly under control in every area.

The second reason for getting so excited about the problem of self control is the likelihood that the very success of the capitalist system in making us more affluent is serving to heighten our self-control problem. Economics is all about coping with the problem of scarcity. But human ingenuity - including the development of the capitalist system - has increasingly overcome scarcity. These days, most of us in the developed economies have a greater problem coping with abundance than scarcity. For instance, we’ve evolved to eat everything that comes our way, because nutrition was scarce on the African savanna, but now food is abundant and, hence, cheap. So we’ve lost the natural control that, until relatively recently, stopped our instinct to overeat from making us overweight. Similarly, the huge growth in our real incomes over the past century has made it easier for us to afford to overindulge in many of the other vices I listed. Credit is another thing that’s become readily available and relatively cheap.

So I’m beginning to think that overindulgence and difficulties in self control are the big problem of our age. There are solutions to this problem - at the government policy level and at the level of individuals controlling their own behaviour (the latter involving subtle ways of tricking our unconscious selves) - which I suspect will become an increasing focus as the 21st century progresses.

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ENVIRONMENTAL ECONOMICS

July 24, 2007

The environment and economic activity

Mankind's economic activity - the production and consumption of goods and services - adversely affects the natural environment in many ways. It causes pollution, the using up of natural resources and the endangering of species. Linked with mankind's economic activity as a cause of environmental damage is the growth in the human population. More people mean more disturbance to the natural environment.

Economic activity will have a damaging effect on the environment no matter what system is used to organise that economic activity, whether it be a market system, command system or traditional system. However, since our economy is organised using the market system, we will focus on the way a market system affects the environment.

Economic arguments for preservation of the environment

There are four main economic arguments in favour of the preservation of the natural environment:
1) environmental assets. Environmental assets (such as clean air, clean water, attractive views, native species and fish in the sea) are just as much economic resources as the resources on which economics traditionally focuses: land, labour, capital and enterprise. Environmental assets are used in the process of production and consumption and are scarce (in limited supply). They are not 'free goods' because they can be used up. (Note: air can't be used up, but clean air can be.) If environmental resources can be used up, they should not be used wastefully, but used with economy ie allocated to their most efficient use. The main difference between traditional economic resources and environmental assets is that traditional economic resources have clearly defined private property rights, whereas environmental assets are common property. The price mechanism (and economic analysis) has difficulty coping with resources that are common property (ie market failure), but this isn't a reason to ignore environmental assets.

2) satisfaction of wants. The goal of economics is to maximise the satisfaction of the community's wants. It's clear that, as well as its material wants (more goods and services), the community has environmental wants (eg clean air and water, attractive views and the preservation of species). If economics ignores environmental wants because the market mechanism finds it hard to cope with them, it will not help maximise the community's satisfaction. It seems that, as the community's material standard of living rises, the value it places on environmental wants ('quality of life') increases.

3) environmental feedback. Much economic activity depends on the preservation of the environment eg effect of environmental damage on tourism; effect of land degradation on farming; effect of water quality on commercial fishing; over-harvesting of fish. As well, some environmental damage generates private costs eg double-glazing of windows to reduce noise pollution.

4) inter-generational equity. Much environmental damage is irreversible (eg clearing of land, building dams, destruction of native forests and extinction of species) and some resources are non-renewable. Current economic activity has implications for the environmental inheritance of future generations.

Economic arguments against preservation of the environment

There are three main economic arguments against preservation of the environment:
1) opportunity cost. Just as some material wants may only be satisfied at the expense of others, so some environmental wants may only be satisfied at the expense of some material wants. This is the correct way to express alleged economic arguments against environmental protection eg banning the logging of native forests will 'destroy jobs'; banning mining in national parks will 'harm the balance of payments'. A higher 'quality of life' may well involve a lower material standard of living. This is not a problem as long as the community understands the consequences of the choices it makes.

2) distributional implications. The costs and benefits of environmental protection may not be shared equally across the community. eg the people who gain most satisfaction from protecting native forests may not be the same people who lose their jobs.

3) the value of labour. Economists seek to make the most economical use of all resources, including man-made capital and labour. But environmentalists are concerned to make the most economical use (or even minimum use) of only natural resources, including energy. Implicitly, they attach little value to capital and labour. Because of the high cost of capital and labour, the market (and market-based intervention) will not produce as much recycling and avoidance of waste of raw materials as environmentalists desire.

Conflict between economic growth and environmental protection

The mainstream economists' view is that there is a conflict between man's desire to increase his material standard of living (ie produce more goods and services) and his desire to preserve the environment. The conflict arises because resources are scarce but wants are infinite. The opportunity cost of faster economic growth is more damage to the environment; the opportunity cost of less damage to the environment is slower economic growth.

There is, however, an exception to this general proposition: instances of government failure. Underpricing of publicly owned resources (eg forests, minerals) and underpricing of publicly provided services (eg electricity and water) can cause misallocation of resources and faster depletion of natural resources or unwarranted environmental damage (eg land degradation through irrigation; need to build more dams).

This is not to say that we face a mutually exclusive choice between either economic growth or environmental protection. It means the community must decide what trade-off it wants to make, what balance it wishes to strike, between these two valid, but conflicting, objectives. Economists are very familiar with trade-offs between conflicting objectives - which is why they developed the concept of opportunity cost.

Normally, the community determines the trade-off it desires between conflicting objectives in the market place via the price mechanism. It votes with its dollars. However, in the case of the conflict between economic growth and environmental protection, the market mechanism is not very effective in providing the community with the trade-off it desires. This is because environmental assets are common property rather than private property. Economic activity generates environmental externalities for third parties which those third parties lack the property rights to do anything about. This market failure means governments have to intervene in the market to ensure that the community's desired trade-off between economic growth and environmental protection is achieved. However, the political process by which governments seek to implement the community's preferences is an imperfect one where the true opportunity costs of choices may not be understood by the community.

Government policies to preserve the environment

Government policies to preserve the environment can be divided into two broad classes: command and control measures and economic instruments.

Command and control. In practice, most environmental intervention takes the form of legislation to prohibit or limit undesirable emissions and other activities. Local government zoning regulations limit polluting activities to certain areas, generally away from residential areas. State environment protection agencies set emission standards and rules for the disposal of waste and prosecute firms which fail to comply.

To the public, politicians and many environmentalists, regulation is the obvious way to respond to environmental problems. Regulation deals with the problem directly.
However, while economists accept that regulation and prohibition may be the only practical responses in some circumstances, they believe that, generally, regulation will not produce the best trade-off between SoL and environmental protection. This is because regulations impose costs without always creating incentives to find cheaper ways of reducing environmental damage.

Economic instruments. In our efforts to preserve the environment, economists favour the use of instruments which harness market forces to the service of the environment, believing that this will achieve the government's environmental objectives with minimum loss of economic growth. Economic instruments aim to 'internalise' externalities and, in the process, create incentives to meet environmental standards in ways that allocate resources efficiently.

Tradable permits. Governments may set an environmental standard which determines an acceptable level of emission, then award (or auction) permits to emit pollution up to the standard. Producers with low costs of controlling pollution have an incentive to do so, so they can sell part of their pollution rights to producers who face high costs of controlling pollution. The effect is to reduce the industry's overall cost of compliance with the standard. Tradable permits have an advantage over pollution taxes because the rate of emission is certain and the price of the permits uncertain, whereas with pollution taxes the rate of tax is certain and its effect on the level of emission is uncertain. Tradable permits can be used for other environmental protection, such as minimising the economic costs of limits on irrigation or fishing catches.

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TALK TO HOPE STREET BUSINESS LUNCHEON

Sydney, Friday, May 26, 2007

Brendan has asked me to say a few words sharing my background and experiences and what I’m really passionate about these days, and I’m happy to do so.

To understand me you have to know that I come from an extended family of Salvationists and that both my father and my mother were Salvation Army officers - ministers - making me a member of a strange group known to the Sallies as OKs - officers’ kids. My father was the minister of a long succession of very small congregations in NSW and Queensland. The Army moved him every two years - sometimes after only one year - and when he moved, we did too. In consequence, I went to five primary schools and three high schools around NSW and one in Brisbane. These days I’m what the Sallies call a ‘backslider’, but I think you can see pretty clear evidence of my upbringing in the things I write and the attitudes I take in my columns.

Both my parents came from big families in Queensland and I’m the only one in the family who’s not a Queenslander. Since I was born in Newcastle and ended my education in Newcastle I’m happy to tell people I’m from Newcastle and proud to say I was educated at the now-defunct Newcastle Boys High. Only when I’m trying to impress people do I say I went to Fort Street - and omit to mention it was only for a year. I did a commerce degree at Newcastle University, majoring in accounting but also doing a lot of economics - which I couldn’t see the point of and struggled to pass. In 1969 I left Newcastle, got a job working for the national auditing firm of Touche Ross (now merged with KPMG) and eventually qualified as a chartered accountant.

Not long after I qualified I took a year off to go back to uni and ended up stumbling into journalism. In 1974 I started at the bottom as a cadet journalist, at what was then considered to be the very mature age of 26. The editor who hired me said he couldn’t believe a qualified accountant would take to being a cadet reporter, but it was worth a try. A Kiwi mate was amazed and appalled that I’d consider giving up the status of being a chartered accountant to become a lowly reporter.

That was 33 years ago and I’ve been at the Herald ever since. I did a bit of reporting from the press galleries in Macquarie Street and Canberra, and wrote a fair few of those unsigned editorials on the same page as the readers’ letters. But I’ve been the Herald’s Economics Editor for 29 years, I’ve been a Herald columnist for 30 years and I’ve been doing exactly the same job I’m doing now for 24 years. I know I should have left the Herald and gone to another paper years ago, but my problem is that my ambition was to become the Herald’s Economics Editor, I achieved that ambition at the age of just 30, and in all the time since then I haven’t been able to think of a job I’d more like to do or a paper I’d more like to work for. I have the best job in the world: I’m paid a fat salary to sit in an armchair and pontificate three times a week. Bernard Levin, when a columnist on The Times, said he could never understand why they paid him for the privilege of publishing his opinions rather than making him pay them - and that’s how I feel (but don’t tell David Kirk I said so).

You should know that a great part of my success in journalism - certainly, my rapid rise to prominence - comes from being in the right place at the right time. The year I joined the Herald, 1974, has since been identified by economists as the great turning-point in the post-war economic history of Australia and the developed world. It was the year we felt the destabilisation of the first OPEC oil shock, the year the post-war Golden Age ended with the advent of stagflation, the year our economy entered a period of high inflation, high unemployment and general economic dysfunction that we didn’t start to emerge from until the mid-1990s, the year the Whitlam Government didn’t have any idea what had hit it, and the year it first dawned on the editors of Australian newspapers that the dominant, unending political story of their times was actually the economy. In such an environment there was a sudden, strong demand for the services of journalists who were capable of writing about the mysteries of economics. There weren’t many takers, so someone with my background was quickly pressed into service and promoted up the line. But I confess I’ve had to learn or relearn most of my economics on the job.

People often refer to me as an economist, but I’m not, and no true economist thinks I’m one. I used to say I was an accountant pretending to be an economist, but I can’t say that any more because, these days, I’d only be pretending to be an accountant as well. So now what I prefer to say is that I’m a journalist who writes about economics. This fits well with my changing views about my role. I’ve always been on about explaining economics and for a long time I saw my role as convincing my readers of the truth of economics. I was an early salesman for economic rationalism. But experience and wider reading has helped me see the limitations of conventional economics, so now I see myself as someone paid to provide my readers with a critique of economics, just as a theatre critic provides his readers with a critique of the latest plays. Economics has strengths and weaknesses and it’s my job to point them out.

As for something I’m feeling passionate about, I been thinking a lot lately that there’s a contradiction at the heart of the capitalist system. The system includes many people who make their living by tempting you to buy things and do things which are fine if you do them only in moderation, but which can bring you down if you do too much of them. So the key to being a winner - a master - in the capitalist system is to possess the self-control to resist the temptations it continually throws at you. If you oblige the capitalists and always buy what they’re pushing, you’ll help to make them rich but, paradoxically, you’ll become a loser - a victim - of the system.

What are these temptations? They’re manifold. The one we’re most conscious of these days is the temptation to eat too much. But there are many more: to get too little exercise, to smoke, to drink too much, to watch too much television, to gamble too much, to shop too much, to save too little and put too much on your credit card, to work too much at the expense of your family and other relationships.

All of those things are being pushed on us by the system. They’re what the capitalists are trying to sell us. A lot of highly paid advertising people, marketers and merchandisers make their living finding ever-more effective ways to persuade us to indulge. In the case of exercise, no one’s selling the lack of exercise, but lots of people are selling ways to avoid exercise - whether it’s going everywhere by car, using the remote or watching sport on telly rather than playing it. Admittedly, people are also selling ways to get fit - from exercise bikes to gym subscriptions and all the right gear to wear - but then you’ve got to make sure you don’t get hooked on being underweight or using steroids to bulk up.

OK, so we need to demonstrate a bit of self-control in our lives. What’s so new and surprising about that? Two things.

First, research by psychologists, neuroscientists and behavioural economists has shown that humans have a great problem exercising self-control. We think it’s up to us to decide how much to eat or how much TV to watch but, in fact, many of us find it very hard to restrain ourselves in the way we know we should. This is because our brain is a complex mechanism, which evolved over millions of years. The older, more primitive part of our brain tends to make instant decisions on an instinctive, emotional basis. The newer, more rational part of our brain tends to make more reasoned judgements, but to be a lot slower off the mark. Experiments with people who’ve had the two sides of their brains severed in some accident show that the reasoning part of our brain often doesn’t know why the faster, more instinctive part of our brain decided to do what it did, but is adept at thinking of plausible explanations for its behaviour. Psychologists call this process ‘confabulation’ - others call it ex-post rationalisation.

It’s as though we have two selves, an unconscious self that’s emotional and short-sighted and a conscious self that’s reasoning and far sighted. We have trouble controlling ourselves in circumstances where the benefits are immediate and certain, whereas the costs are longer-term and uncertain. When you come home tired from work, for instance, the benefits of slumping in front of the telly are immediate, whereas the costs - feeling tired the next day; looking back on your life and realising you could have done a lot better if you’d got off your backside and played a bit of sport, sought a further qualification at tech, studied harder for exams, spent more time talking to your kids etc. Similarly, the reward from eating food is instant, whereas the costs of overeating are uncertain and far off in the future - being regarded as physically unattractive, becoming obese, becoming a diabetic, dying younger etc. As everyone knows who’s tried to diet, give up smoking, control their drinking, save or get on top of their credit card debt, it’s very hard achieve the self-control our conscious, future selves want us to achieve. Many of us may have no trouble controlling ourselves in most of the behaviours I’ve listed, but I doubt there’s anyone much who can claim to have themselves perfectly under control in every area.

The second reason for getting so excited about the problem of self control is the likelihood that the very success of the capitalist system in making us more affluent is serving to heighten our self-control problem. Our brains work the way they do as a result of our evolution. We are what we are because it contributed to our reproductive fitness. We evolved the way we did to protect us from the risk of death, for instance, and to cope with the problem of scarcity. As it happens, economics is all about coping with the problem of scarcity. But human ingenuity - including the development of the capitalist system - has increasingly overcome scarcity. These days, most of us in the developed economies have a greater problem coping with abundance than scarcity. For instance, we’ve evolved to eat everything that comes our way, because nutrition was scarce on the African savanna, but now food is abundant and, hence, cheap. So we’ve lost the natural control that, until relatively recently, stopped our instinct to overeat from making us overweight. Similarly, the huge growth in our real incomes over the past century has made it easier for us to afford to overindulge in many of the other vices I listed. Credit is another thing that’s become readily available and relatively cheap.

So I’m beginning to think that overindulgence and difficulties in self control are the big problem of our age. Even the worries we have about our despoiling of the environment and our excess emissions of greenhouse gases can be seen as problems of abundance. Too much unguided economic activity - which has also led to too much population growth - is upsetting the earth’s natural balance.

There are solutions to the problem of self control - at the government policy level and at the level of individuals controlling their own behaviour (the latter involving subtle ways of tricking our unconscious selves) - which I suspect will become an increasing focus as the 21st century progresses.

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WELLBEING, MONEY, PSYCHOLOGY AND ECONOMICS

Conference on Quality of Life, Deakin University
November 30, 2006

I want to talk to you about the increased interaction between the disciplines of psychology and economics, and focus particularly on the relationship been income and subjective wellbeing, as befits a conference on quality of life. But first I need to explain that I’m not an economist myself. Rather, I’m a journalist who writes about economics.

Psychology and economics

You won’t be surprised to know that the academic discipline of economics is pretty inward-looking and hidebound. It’s still dominated by the neoclassical model of markets developed first by economists such as Adam Smith in the 18th century and Alfred Marshall in the 19th. It’s evolved a bit since then, but not as much as you might expect and not as much as I suspect psychology has. The conventional neoclassical model is built on many debatable assumptions, but most of the academic effort has gone not on trying to improve those assumptions but on mathematising the model, which permits many rigorously logical conclusions to be drawn - given the assumptions. All this maths allows the economists - like psychologists - to believe their discipline is more rigorously scientific than the other social sciences.

There have been various new developments in economics over the years - most of which have come to dead ends - but the relatively recent developments I find most interesting and most promising are based on borrowings from the work of psychologists. It may surprise you to know that the Nobel Prize in economics has twice been won by psychologists. Herb Simon of Carnegie-Mellon won it in 1978 for his ‘pioneering research into the decision-making process within economic organisations’. Conventional economics assumes economic man - homo economicus - to be a lightning-quick calculator of costs and benefits. Simon argued that people often use rules of thumb that economise on the cost of collecting information and on the cost of thinking. Their rationality was thus ‘bounded’ and rather than maximising their utility they ‘satisfice’ - they do as well as they think possible.

The second Nobel to a psychologist went to Daniel Kahneman of Princeton in 2002. He took Simon’s work a lot further, winning the prize ‘for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty’. It’s not directly relevant to quality of life, but I’ll say a little about it because it is interesting and it does, at present anyway, represent psychology’s most successful incursion into the thinking of economists. With the help of some economists, Kahneman founded a new school of thought within economics, known as behavioural economics, which has attracted a big following among younger academics.

Decision-making

As we’ve seen, behavioural economics challenges one of the central elements of conventional microeconomic theory: the assumption of Homo economicus. Economic man is assumed to be rational and self-interested. She always carefully evaluates all the options before making any decision, and always with the object of maximising her personal ‘utility’ or satisfaction. But cognitive psychologists have demonstrated that humans simply lack the neural processing power to make the carefully calculated decisions economists assume. People aren’t rational, they are intuitive. And altruism is often an important consideration in their decision-making. People can’t chose correctly between three options where the best option is not immediately apparent. Rather than carefully thinking through the pros and cons of every decision, people tend to rely on mental shortcuts (‘heuristics’) which often serve them well enough, but also lead them into systematic biases. People are often slow to learn from their mistakes. They are frequently capable of reacting differently to choices that are essentially the same, just because the choices have been ‘framed’ differently. This means that, rather than being coldly rational, people’s decisions are often influenced by emotional considerations.

All this means that Homo sapiens differs from Homo economicus in many important respects. He doesn’t conform to economists’ assumption of fungibility (one dollar is indistinguishable from another), he is often not bothered by opportunity cost and thus has a strong bias in favour of the status quo. He doesn’t ignore ‘sunk costs’ as he is supposed to and often cannot order his preferences consistently. He is not averse to risks so much as averse to losses and he focuses more on changes in his wealth than on its absolute level.

Unlike Homo economicus, Homo sapiens cares deeply about fairness. Experiments show people will walk away from deals they consider treat them unfairly, even though those deals would leave them better off. People are prepared to pay a price to punish others they consider to have been behaving badly towards the group. Often people are concerned about ‘procedural fairness’ – how things are done, not just how they end up.

Wellbeing and utility

That’s enough about psychology’s first challenge to economic orthodoxy. After Kahneman had made his mark on the theory of decision-making he moved on to join many other psychologists - and a few pioneering economists - in studying subjective wellbeing, quality of life, life satisfaction, happiness, call it what you will. This study ought to be of intense interest to economists because it’s hard to see much difference between psychologists’ subjective wellbeing and economists’ utility or satisfaction. In original intention, neoclassical economics is about studying the way individuals maximise their utility. As you know, conventional economics was heavily influenced by Bentham’s utilitarianism. So if economics has a goal, it’s to help the community maximise its utility.

The problem is that economics has rather lost its way on the question of utility. Sometime in the 1930s it was decided that the trouble with utility is that it’s unobservable - you can’t measure it. You can’t know how much utility A derives from the consumption of a glass of beer relative to B. The most we can hope to know is how they order or rank their choices. A prefers beer to wine, but wine to lemonade. But no mater. Since A and B are rational, and are always seeking to maximise their utility, it’s clear their preferences will be revealed simply by looking at what they choose to buy with their income. Their ‘revealed preference’ will tell us all we need to know about their utility.

Note how this seemingly neat shortcut relies heavily on the assumption of rational choice, that people always know and do exactly what’s best for them. They never do anything they subsequently regret and if occasionally they make a mistake, they quickly realise their error and never repeat it. Note, too, how circular the logic has become. How do we know what people want? From what they do. How do we know they do what they want? Because they do it. And here we see an old prejudice among economists that affect their attitudes towards psychology and its experiments, as well as surveys of wellbeing: ignore what people say they want, just focus on what they do. The other short-circuitry at work is that, though in theory economics is about maximising utility, in practice it ends up being about maximising consumption. Which particular forms of consumption? Doesn’t matter - just consumption. Which consumption is the private business of each consumer and not a fit subject for economists or governments to meddle with. How do you maximise consumption? By maximising the income from which people finance their consumption. How do you do that? By getting the economy to grow as fast as you reasonably can.

Now perhaps you see why the psychologists’ huge body of work on wellbeing is highly relevant to the work of economists - and highly challenging to their conventional views. And the particular pressure-point is obvious: the relationship between income and wellbeing. That’s what the economists who study wellbeing are most interested in. So what have we discovered about income’s role in wellbeing? We’ll get to that in a moment, but first I want to say something about terminology.

Speaking the same language

I think there’s much to be gained from an inter-disciplinary approach to many issues, but I’m constantly disappointed by the lack of contact between academics of different disciplines. They often criticise each other from afar - from the comfort of their own camps - but rarely get together to argue through issues of common interest. As a result, they’re often quite ignorant of the others’ way of looking at things, thus allowing much misunderstanding and incomprehension.

Joan Robinson, perhaps the most famous female economist and a contemporary of Keynes at Cambridge, once said that the purpose of studying economics is to learn how to avoid being deceived by economists. My take on the subject isn’t so defamatory: I think we study economics to learn when to use the many synonyms for the word ‘money’. Money is a vague term, can’t you be more specific? I’ve noticed that many social scientists use the words ‘income’ and ‘wealth’ interchangeably, whereas to economists they have quite specific, and different, meanings. Economists, like a lot of academics, are quite arrogant. So when you use those two words interchangeably, they’re either confused or they conclude you’re ignorant and not worth taking seriously.

Income is what you earn during a period from wages, business profits or investments, plus cash benefits received from governments. Most income is spent on living expenses - consumption - while some is saved. Wealth, on the other hand, is the value of the assets you own, less any money you owe. You add to it by saving some of your income, by gifts and bequests from others and by capital gain. Income is measured over a period of time - a week or a year - whereas wealth is measured at a point in time, such as the first day or the last day of a week or a year. So income is a flow of value over time, whereas wealth is a stock of value at a point in time. Consumer spending is primarily done from income, but the two aren’t the same thing because people spend less than their income when they save, or more than their income when they borrow to finance additional consumption.

It’s clear that what we’re talking about in the wellbeing context is almost always income, not wealth or consumption. Another thing psychologists seem weak on is the distinction between absolute levels of income and relative income. Relative income is how much I earn during a period relative to what other people are earning. A person or household’s absolute level of income is viewed in isolation from other people’s, though it can be compared over time - with how much I earned a year ago or how much I expect to earn in a year’s time. This distinction may seem pedantic but, as we shall see, it’s pivotal to the interpretation of the effect of income on wellbeing.

Income and wellbeing

Let me summarise the research results as I understand them. The first point to make is that, contrary to popular wisdom, money does make us happy - up to a point. Studies of developing countries show that the higher the average level of income per person in a country, the happier the people in that country say they are. So, up to a certain point, rising GDP per person does make people happier. That point, however, is about $US10, 000 or $US15,000 a year per person - a point that Australia and all the other developed countries passed a very long time ago. Studies show that even though the people in rich countries' income per person has doubled or trebled in real terms since the 1950s, average levels self-reported happiness haven't changed - they haven't fallen, but nor have they risen. In other words, and to use an economists' term, when it comes to happiness, money is subject to significant DMU - diminishing marginal utility. An increase in our income adds little if anything to our utility.

Why do increases in absolute income do little to make us happier? Because of a pervasive human trait psychologists call adaptation. It doesn't take long before we get used to our newly improved circumstances and come to take them for granted. They get absorbed into the status quo and we go back to being about as happy as we always were. To put the point another way, soon after we achieve a higher level of material success, our aspirations move up another notch and we go back to being dissatisfied with our achievements.

The second point to make is that if, instead of comparing different countries over time, we look at particular countries at a point in time, we do find that people with higher incomes are happier than people with lower incomes. Particularly in the case of Australia, however, the difference is surprisingly small - that is, on average, rich people are only a bit happier than poorer people. How are these two seemingly contradictory findings reconciled? It's simple: people seem to be a lot more concerned about the level of their income relative to others than about what's happened to the level of their income over time. When all of us enjoy rising incomes at pretty much the same rate - which is what's been happening over the decades - none of us feels any better off. What little satisfaction we get from high incomes comes from having an income that's higher than other people's. We use our income as an indicator of success in life and of our social status. And some research suggests that it's really social status that affects our happiness much more than income as such.

Now, here’s where I beg to differ with my mate Bob Cummins (professor of psychology at Deakin University, Melbourne). When Bob looks at the results from the Australian Unity Wellbeing Index, and in his article in the Journal of Happiness Studies in 2000, he concludes that income has a significant effect on wellbeing. On average, people in the top income bracket report greater subjective wellbeing than those in the middle bracket and those in the middle report greater wellbeing than those in the bottom bracket. Well, I could quibble about whether those differences are big enough to be judged significant - to me they seem quite small. Very large increases in income are needed to produce quite modest increases in wellbeing - my point about income being subject to greatly diminishing marginal utility as income rises beyond the poor-country threshold.

Bob uses this evidence of greater levels of wellbeing for higher income-earners to argue that it supports the homeostatic theory of wellbeing - the theory that subjective wellbeing is held within a narrow range determined by personality. Bob argues that people with higher incomes enjoy higher wellbeing because they suffer less from homeostatic defeat. This is because they can buy the resources necessary to optimise the operation of their homeostatic system. Now, I want to make it clear that I’m not attacking the homeostatic theory as such. Indeed, I think we can drop the homeostatic bit out of the argument completely and we’re left with the standard materialist argument in favour of being rich: the rich are happier because they can afford to buy more than other people - more comfort, more assistance, more everything.

My point is that Bob hasn’t demonstrated, as he claims, that income has a significant effect on wellbeing. Rather he’s demonstrated a much smaller claim, that relative income has an effect on wellbeing. The point is that, if more income makes us happier because we can afford to buy more stuff (or, in Bob’s terms, because we can buy resources to overcome homeostatic failure) then, as everyone’s income rises over time in line with economic growth, all of us can afford to buy more stuff so our reported wellbeing should rise over time. But we know from many studies that though the real incomes of people in the developed economies have risen by a factor of three or four since World War II, their reported wellbeing hasn’t budged. So we’re left with the much more qualified statement that higher relative income increases the wellbeing of those towards the top. And we’re left with the likelihood that the reason a high-income earner feels a little happier has to do not with her ability to buy more stuff but with her knowledge that’s she’s been more socially successful than many others.

Why am I labouring this distinction between increasing absolute income over time and possessing a higher relative income at a point in time? Because it has profound implications for the goals of economic management. From the point of view of economists and politicians, this finding is bad news. Why? Because though the pursuit of economic growth can raise everyone's income in absolute terms, there's nothing it can do to raise everyone's relative income. Obviously, there'll always be some people who come towards the top of the class and some people who come towards the bottom. We might change the order around, but that will produce as many losers as winners, leaving the population no better off overall.

To repeat, this is a devastating conclusion for economists – and particularly economic rationalists – whose whole practical motivation has been based on the assumption that helping the community raise its productivity and increase its production and consumption of goods and services will leave it unequivocally better off. There is no doubt that, materially, we are better off than we were even 10 years ago: our homes are bigger and better, our cars are better, our food and clothing are fancier and we have any number of wonderful new gadgets to save us labour or entertain us. But though we are better off, we don’t feel better off.

Implications for economic policy

This brings us to the implications of wellbeing research for economic policy should economists and politicians someday incorporate them into their thinking. Richard Layard, a leading British economist who has embraced the psychological push says that, beside adequate income, the research shows six main factors affect happiness: mental health, satisfying and secure work, a secure and loving private life, a secure community, freedom, and moral values.

So my first policy implication is that reducing unemployment should be given a much higher priority by the economic policy-makers. Research shows that being unemployed makes people particularly unhappy, a lot more unhappy than can be explained by the loss of income they suffer by not having a job. What people miss is the sense of identity and self-worth that comes from a job, and also, no doubt, the social contact. Economists may protest that they are already giving high priority to reducing unemployment but, in truth, their pursuit of this goal is conditional. Their concern with the efficient allocation of resources means they frown on any solutions (job sharing, job-creation schemes, public sector employment, for instance) that involve modest inefficiencies. The truth is that the overwhelming goal of economists is to hasten the growth in the economy’s production of goods and services, and the jobs generated in this process are just a fortunate by-product.

My second policy implication is that governments and employers could do a lot to raise subjective well-being if they put more emphasis on the enrichment of jobs – increasing job satisfaction by giving workers more personal control, opportunity to use their skills, variety in tasks, respect and status, and contact with others. Taken literally, the economists’ model assumes that all work is unpleasant – a disutility – and is undertaken purely to gain the money to buy the things that bring utility. Like the rest of us, economists know that, in reality, work carries much intrinsic satisfaction. But they don’t follow this realisation through to their policy prescriptions. They are perpetually advocating labour market reform aimed at ensuring labour is used more efficiently, treating labour as though it were just another inanimate economic resource, and ignoring the feelings of the human beings attached to the labour. Various of the ways labour can be used more efficiently make life unpleasant and even unhealthy for the workers involved: ever-changing casual hours, rolling shift work, split shifts and firms continually moving their staff to different cities. When we pursue efficiency at the expense of people, economists have got things round the wrong way, trashing ends so as to advance means.

A third implication is that economic policy-makers should recognise the benefit of stability. People like stability – it makes them feel secure and happy. What’s more, it breeds a highly valuable commodity: trust. People don’t like continuous change. Macroeconomic management is aimed a stabilising the rate of growth in demand, and that’s good. But microeconomists perpetually advocate change (‘reform’) aimed at increasing efficiency, raising productivity and quickening the production of goods and services – the very objective we now know doesn’t make people any happier. Often, micro reform involves ‘displacing’ workers from the reformed industries where their labour wasn’t being used efficiently. This is a process that causes no heart searching among economists because their model: first, assumes alternative employment will be readily forthcoming; second, ignores the intrinsic satisfaction from work and, third, assumes unemployed workers will have a whale of a time enjoying all their new-found leisure.

A fourth policy implication is that the thing economists celebrate as ‘competition’ and are always trying to encourage because it acts as a spur to efficiency and growth, is actually ‘rivalry’ that creates losers as well as winners and thus generates roughly as much unhappiness as happiness. Rivalry is hardwired into our brains, but a case can be made that social comparison is not something we should be encouraging. Seen in this light, we should think twice about the unceasing calls for us to do this or do that to preserve or improve the economy’s international competitiveness. But why? It is just rivalry on a global scale. It is saying, we must make sure foreigners do not get richer at a faster rate than we are, or even, God forbid, overtake us on the league table.

Fifth, instead of merely unquestioningly promoting consumption, economists should be doing something they rarely do: studying it. They need to see whether there are some forms of consumption that that yield more satisfaction than others. It may be that, in our striving for social status, we are devoting too much of our time and income to the purchase of ‘positional goods’ - conspicuous consumption – and too little to activities empirical research now tells us would yield greater satisfaction. Robert Frank of Cornell says the ‘gains that endure’ are more likely to include social life, time with our children, less travel time to work, more job security and better health care. Layard says we should be spending a lot more on fighting glaring evils – and sources of profound unhappiness - such as depression.

Sixth, the evidence that income is subject to diminishing marginal utility strengthens the case for redistributing income from rich to poor, since such transfers should increase total happiness. As yet, however, there is mixed evidence on the question of whether people who live in countries with a narrower gap between rich and poor are happier. Alesina et al. (2001) find that income inequality has a large negative effect on happiness in Europe, but not in the United States.

Finally, we should look sceptically at the incessant calls for lower tax rates to encourage people to work harder. By its very nature, the economists’ model assumes away all non-monetary motives for work. We do it only for the money. But the reminder of the intrinsic satisfaction we derive from work also reminds that higher income-earners in particular have powerful non-monetary motives for working long and hard: job satisfaction and the pursuit of power and status. Reducing tax rates would merely allow us to run faster on the hedonic treadmill, whereas I think we should slowdown. The drive for reduced government spending and lower taxes would leave people with more disposable income they could use to purchase education and health care privately, in the hope that these positional goods would enhance their social standing. Layard warns we should worry lest leisure, public goods and inconspicuous consumption (consumption that is not compared with the consumption of others) are under-produced because people focus so much on conspicuous consumption.

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THERE’S NO BUDGETARY ISSUE BIGGER THAN HEALTH CARE

Talk to Federal Health Department’s Biennial Health Conference
Sydney, Tuesday, November 14, 2006

So far we’ve heard from speakers giving expert and finely tuned comments on technical aspects of acute care funding, but I think the most useful contribution I can make given my own expertise is to help you see acute care funding in a broader budgetary and political context. I’ll also range wider than just hospital funding, partly because outsiders (including politicians) tend to see hospitals as part of the total health care package, but also because it can be a mistake to focus on particular elements of health care spending in isolation. The various elements are interrelated and these linkages can be overlooked if we’re not careful - particularly when different levels of government are responsible for different elements.

Consider the case of hospitals on the one hand and the pharmaceutical benefits scheme on the other. One of the trends of advance in medical technology is for the use of better medicines to keep people out of hospital. The result is we spend more on pharmaceuticals but make savings on the number and length of hospital stays - which, as we all know, are very expensive. When you divide health care funding into silos, however, it’s too tempting for the feds to get overexcited about the rapid growth in the cost of the PBS, and wonder what draconian measures could be taken to slow the growth, while ignoring the savings being generated elsewhere in the system.

I’m sure you’re aware of the many reports econocrats have produced in recent years examining the budgetary pressures likely to arise over the next 40 years as the baby boomers retire and the population ages. Federal Treasury began the fashion in 2002 with its Intergenerational Report, which it will update in next year’s budget. Then the Productivity Commission had a go - trying to add the implications for state as well as federal budgets - and most state treasuries have now completely similar exercises, culminating in the NSW Treasury’s report on long-term fiscal pressures, issued with this year’s state budget.

Although there’s been some attempt to obfuscate matters, all these studies come to the same, surprising conclusion: though population ageing will generate considerable budgetary pressures in most developed countries, the likely pressures in Australia are modest and manageable. This is mainly because our age pension is flat-rate and heavily means-tested. The budgetary cost of ageing will show up more in health care spending than in pensions, but won’t be great. Even so, all the reports have projected considerable upward pressure on government budgets over the coming 40 years. Most of that pressure will be coming in one spending category: health care. The studies show that, whether you look at federal or state, health accounts for about three-quarters of the projected growth in total government spending. At present in the NSW budget, health (mainly hospitals) is the second biggest spending category after education, accounting for 26 per cent of total expenses. In 40 years time it’s projected to be the biggest category, accounting for 37 per cent.

As we’ve seen, this growth will be partly due to the higher proportion of older people in the population. For the most part, however, it will be due to a combination of supply and demand factors unrelated to demography. On the supply side, continuing advances in medical technology will add to costs for various reasons: because improved procedures tend to be more expensive than those they replace, because more conditions become treatable and because safer, less intrusive treatments can be prescribed for a wider range of patients. On the demand side, the public will continue to press for the fullest and earliest possible access to medical advances.

The first point to make is: don’t let anyone tell you this inexorable pressure for increased spending on health care is a bad thing. It’s a good thing. The projections assume real income per person will double over the coming 40 years. And health care is what economists call a ‘superior’ (or merit) good. Superior goods are things to which we devote an increasing share of our income as it rises over time. In the case of health care, that’s eminently sensible and hardly surprising: as we get richer why wouldn’t we spend more on staving off death and disability? What more pressing priority could we have?

If health care was sold in the marketplace like most goods and services, the news that we were likely to significantly increase our spending on it over coming years would attract not the slightest controversy. The contention arises because health care is delivered primarily by the public sector, with its cost funded mainly by general taxation. So the first problem is: will the public be prepared to pay the higher taxation needed to cover the cost of the greater care it will be demanding? Short answer: it will almost certainly be reluctant to but, since the politicians’ desire to please voters will ensure health care spending continues growing strongly, the pollies will have no choice but to keep raising taxes.

It’s not that simple, however. The fact that so much health care is delivered by - or, at least, funded by - the public sector rather than the private marketplace does mean there’s less discipline on spending and greater scope for over-servicing and other forms of waste and inefficiency. Even so, health care is funded primarily by general taxation for good reason: because we’re not prepared to let people who can’t afford health care they need go without. Health care is judged too important to be left to the market. And even though we can expect to see economic rationalists in the bureaucracy and elsewhere urging governments to shift more of the cost of health care off the budget and into private hands, I wouldn’t expect to see that process go very far.

Put all these factors together - inexorable pressure for greater spending, reluctance to pay the higher taxes needed to fund this spending, and well-founded suspicion that our delivery and funding arrangements aren’t as cost-efficient as they could be - and they add up to continuing and increasing pressure on the health system to do more with less.

In other words, I foresee health as the greatest public sector battle ground in coming years. There’ll be unrelenting pressure for improvement - or at least change - in funding arrangements. The likely growth in health care spending makes this inevitable. It’s possible a future federal Labor government could simply replace the now ailing Medicare with a completely new funding system that was just as radical as Medicare - or really, Medibank - was in its day. There’s nothing sacrosanct about Medicare. As Dick Scotton, one of its original designers has remarked, it was state of the health economists’ art when first conceived in the late 1960s, but there’d be something wrong if the health economists couldn’t come up with a vastly improved model 40 years later. There’s nothing sacrosanct about Medicare - save for one not-negotiable design feature: universality; the guarantee that all are covered and no one misses out. Preserve that and all the details are up for grabs. It’s universality that gives national health insurance its fairness or equity. What you’d be hoping for in replacing Medicare is greater efficiency in the allocation of health resources without much loss of fairness - or, in the parlance of economists, a better trade-off between the equally desirable but conflicting objectives of equity and efficiency.

I have to say, however, that if Labor has such a big bang replacement for Medicare up its sleeve, I’ve see no sign of it. The more likely prospect is for governments of either colour to be engaged in a process of continuous tinkering in response to the budgetary pressures I’ve described. We’ve heard from other speakers indications of the directions that reform could take. I’d just make two points. I believe the essential first step on the road to reform is to resolve the division of responsibility for health between levels of government, and the obvious answer is for the feds to take over public hospitals. That wouldn’t solve all problems, but it would make progress in solving them very much easier to achieve. Second, I don’t have much doubt that any progress we do achieve will involve moving the system in the direction of managed care. That’s the only way to achieve the unmentionable objective in every health bureaucrat’s mind: ensuring that too much of the increased spending on health care doesn’t end up lining the pockets of medical specialists.

Finally, it’s worth remembering that, though much of the talk about the need to increase efficiency and eliminate waste will be couched in terms of saving money and reducing spending on health, the reality is that, no matter how successful the economies are, there’ll be no reduction in health care spending nor even much slowing in the rate at which spending grows. Why not? Because of those inexorable pressures I’ve described. Rather, any success in raising efficiency will simply mean better value for the taxpayers’ ever-growing dollars.

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AN OUTSIDER’S CRITIQUE OF THE PERFORMANCE OF TREASURIES

Talk to Australasian Treasury Officers’ Conference, Hobart
November 3, 2006

I’m pleased to be here to talk to you and offer an outsider’s view of the performance of Treasuries - when I say Treasury, please take that to include finance departments where they’re separate from treasury and to refer to the ‘purse-string departments’ at both federal and state level. It’s not my practice in speaking to any group to tell them how wonderful I think that are, so my critique will be fairly critical. Of course, as an outsider it’s quite possible I’m misinformed - but, if so, I’m sure you’ll set me straight. Before I launch into any criticism, however, I should make it clear that I have a great deal of sympathy for treasuries and the vital role they perform in controlling public spending. It’s not a popular job, but someone has to do it and it may be that my original training as a chartered accountant gives me sympathy with those whose lot in life is to be that someone. Any fool can make themselves popular by spending money; it takes character to be the one who often says no. Or it may be my knowledge of economics gives me an acceptance that, despite the unwillingness of so many to accept it, there is a budget constraint, which will make its presence felt one way or another, and it’s much smarter to learn to live within it.

My basic claim, however, is that treasuries could be doing that job a lot better than they are. That, too often, they’re going through the motions using old fashioned budget restrictions to limit the growth in spending, using instruments that either aren’t very effective or that do a lot of collateral damage, whereas they need to be using newer techniques that are a lot more effective, imaginative or, as I like to say, scientific. And in that respect I think we need more than just the latest accounting fad.

But before we get on to all that, first we need to be clear about why we want to control spending and about the challenge that lies ahead. I’m not a believer that everything private is good and everything public is bad, so government needs to be kept as small as possible. Rather, government needs to be efficient and effective whatever its size. Why? Because of nothing more profound than opportunity cost. Because money doesn’t grow on trees and there’s a limit to how much tax people are prepared to pay. And because, to make the high levels of tax we must pay more politically palatable, we need to do more to counter the widespread perception that a much government spending is wasteful.

I don’t think we’ll ever reach a time when most voters have a realistic acceptance that, at least in the long run, budgets must balance, thus producing a clear link between how much governments spend and how much they raise in taxation. Most people remain hopeful that governments will increase their spending - because there are so many worthwhile things the government could be doing - without that requiring them to pay higher taxes.

You’ve probably been labouring under that tension for as long as you’ve been in treasury, but I think it’s clear that tension is likely to intensify rather than abate. We’ve now been through a large number of exercises examining future fiscal pressures, starting with federal Treasury’s Intergenerational Report in 2002, then the Productivity Commission’s report and then studies by most if not all state treasuries, including the NZ dept of finance.

All those studies tell us much the same thing: if you look out over the next 40 years or so, yes, you do see considerable pressure for increased government spending. But only some of this pressure will be coming from the ageing of the population. If it were just population-related it would be quite manageable. According to all the studies, most of the pressure will be coming from spending on health - from the ever-more-expensive advances in medical technology and the public’s demand that it be given access to the benefits of that advance as fully and quickly as possible. It’s paying for health that will present the greatest single challenge to the treasury officers of the next 40 years.

Now, before I go on, I want to make it clear that I do see a bit of treasury propagandising at work here. When before have we had this amazing rash of studies of future fiscal pressures in every jurisdiction? I don’t think it’s been purely because of concerns about ageing. I think it’s also because of treasury concerns about living in an age of strongly growing revenue, budget surpluses and a record length expansion phase in the economy (with resources boom). With spending demands so easily accommodated, with no deficit problem to hold over politicians, where does the discipline come from? It doesn’t. So you have to manufacture it, fashion yourself a stick to wave around people’s heads. I suppose that’s fair enough.

In the process, however, we’ve managed to highlight an important point: many if not most forms of government spending are what I call ‘superior goods’, otherwise known as merit goods and bearing similar characteristics to luxury goods. That is, as our income increases, our spending on them increases at an ever faster rate. The classic example of a superior good is health care spending - and that makes all the sense in the world. As we get richer, why wouldn’t we want to devote a significant proportion of the increase to staving off death and staying hale and hearty for as long as possible? So be clear that the unrelenting pressure for increased health spending is fundamentally a good thing, not a bad thing. It’s a trend to be accommodated, not resisted. And, since we choose for good reasons (mainly to do with equity) to deliver health care mainly through the public sector, there’s no reason we should be unduly concerned about the likely increase in taxation needed to accommodate the community’s desire to live longer.

The wider point, however, is that health care is just one of the superior goods delivered by governments. Education is another obvious example - which is why it will be difficult to realise in practice the savings theoretically made possible by the lower birth rate. Take health and education and you’ve covered at least half of a state government’s recurrent spending. But the superior goods don’t stop there. Think about it and you realise that even something as mundane as law and order is a superior good: the richer I get, the more susceptible I become to worries about my personal safety and to fears that my wealth will be stolen from me.

The point is that, if so much of what governments do is deliver superior goods, then as incomes rise the pressure for increased government spending will be irresistible, and so will be the pressure for higher taxation. All governments have been reluctant to admit the obvious: that the primary solution to the future fiscal pressures their studies have identified will be higher taxation. (Treasuries haven’t wanted to admit it either because it counteracts their use of these studies as a weapon for enforcing discipline on the spending side.) It’s clear, however, that as our real incomes rise over the coming decades and our desire for spending on publicly-provided superior goods grows accordingly, the result will be a steady increase in the share of our incomes devoted to tax.

In principle, there’s no reason for that to be regarded as a bad thing. You’re the people who’ll be responsible for helping the politicians bring about that rise in taxation - or, perhaps, for persuading them that, since they’ve happily acceded to electoral pressure to bring the higher spending about, they must raise taxes to finance it responsibly.

I must concede, however, that while an increase in spending on superior goods is inevitable as incomes rise over time, there are extra risks of inefficient and wasteful spending where those superior goods are delivered through the public sector. Sometimes superior goods are delivered through the public sector because of their public-goods characteristics, but mainly I suspect it’s because of equity considerations. So a major responsibility for treasury officers over the next 40 years will be not simply trying to keep the lid on government spending, but continually searching for better trade-offs between equity and efficiency. If you try simply to impose increased efficiency at the expense of equity you’ll have limited success in getting your proposals adopted and persisted with (because equity considerations are so powerful politically). So, much better to be working on the much more intellectually demanding task of finding a better trade-off between the two.

Before I leave that outline of the likely outlook for both sides of the budget in coming decades, let me make one further point. I think it vitally important for treasury people to become more conscious of Fred Hirsch’s concept of ‘positional goods’. Positional goods or services are those which, along with doing whatever it is they’re supposed to do, are purchased also with the hope that they’ll demonstrate to the world our superior position in the social pecking order. In other words, it’s about conspicuous consumption and keeping up with the Jones. When you think about it you realise that, the more our incomes rise and the cost of necessities accounts for an ever-declining proportion of that income, the higher the proportion we’re likely to devote to the pursuit of social status via the purchase of positional goods - remembering that, when you choose to buy a BMW over a Toyota, the price of the Toyota is the cost of the transport vehicle you bought and the extra you shelled out to get the BMW is the cost of the positional good. Our private spending abounds in the payment of premiums intended to demonstrate our status. You can see it in the clothes we buy for ourselves and our children, the cars we buy, the homes and suburbs we choose to live in, the private schools we send our kids to, the private hospitals we insure for, the restaurants we eat at, the holidays we take and much, much more.

Why am I telling you this? Partly because I believe much of the pressure on governments to keep taxes down comes from the public’s desire to be left with as much disposable income as possible, to be spent on the pursuit of social status. But the pursuit of status, like an arms race, is a zero sum game. I can advance my place in the pecking order only at the expense of those I pass. So I wouldn’t have thought it an important public policy objective to leave people with as much positional spending money as possible. And yet, if you examine the descent into middle-class welfare by the Howard Government, for instance, I believe you can find examples of Howard providing public subsidies for positional goods: the 30 pc private health insurance rebate is one example, the increased grants to undeserving private schools is another.

To me, this is all the wrong way round. If you’ve got a situation where people are dead keen to spend money on private health and private schools - on things that are superior goods and publicly provided - you shouldn’t be subsidising them you should be exploiting them. In other words, the more we can make people pay privately for their pursuit of status-linked superior goods, the better off we are. Treasury officers forever searching for relatively politically painless ways of increasing taxation should never forget the device I call the ‘voluntary tax’. Private health insurance was a voluntary tax (you didn’t have to take it but, if you did, your public subsidy diminished), sending kids to private schools was a voluntary tax, gambling taxes are voluntary in a sense (though with risks of social costs if their pursuit is overdone) and tobacco tax is, too, in a sense. You should be looking for ways to increase voluntary taxation - which includes ‘taxing’ people pursuing social status - and perhaps it would help if this way of looking at things were explained to politicians tempted to go the other way.

OK, now let’s turn to my critique on the spending side. The conventional means used to try to limit spending - by imposing cuts or caps on agencies - has various disadvantages. It tends to favour existing programs over new programs, even though some older programs could be abandoned or turned over to private provision. It tends to favour cures over prevention - fixing problems after they’ve happened rather than stopping them happening. It often fails to motivate agencies to co-operate in identifying the fat and making sure it gets chopped rather than the bone. Indeed, it can leave governments vulnerable to passive resistance, where cuts are directed to those areas the government is likely to find most politically embarrassing, in the hope of forcing it to relent. I guess many of the new accounting approaches are aimed at overcoming these limitations, but I think we can do better.

One of the great temptations facing treasuries is to get so locked into the annual budget round that they end up focusing on cost containment in the short term rather than cost effectiveness in the longer term. When treasuries’ behaviour becomes too hand-to-mouth - too focused on getting this year’s budget balance looking OK - they can resist spending on the evaluation of programs that could be most informative in subsequent budget rounds, they can resist spending on health prevention and promotion simply because the costs are up front and the savings down the track. In other words, there’s a great temptation to be a short-term maximiser, with the result that you commit the greatest treasury sin: false economy. Public servants tell me of the crazy things agencies do in the name of efficiency - so much so that, to them, efficiency is synonymous with inefficiency. If something done in the name of efficiency is counterproductive or short-sighted, it’s not efficient by definition. I think the public sector abounds with false economy. Sometimes this won’t be the direct result of treasury decisions, it will be a damaging response by the agency to perverse incentives created by treasury.

When we lift our sights beyond this year’s magic budget-balance figure, we’re able to pay greater attention to the quality of government spending. Quality goes to the effectiveness of spending programs, but also to the thing the top-flight treasury officer should be perpetually in search of: the program which, though it’s classed as an expense, is actually an investment - an investment in future cost containment.

It’s important to remember that the spending agencies often have very little vested interest in measures that offer high value for taxpayers’ money. What departments are genuinely keen to have their programs rigorously evaluated? How many doctors would support spending on health promotion and prevention when that money could be spent on their own curative specialty? How many agencies want to do rigorous cost-benefit analysis of their capital works projects? In other words, if treasury isn’t pushing for these improvements, who will be? Now, you may say that if treasury were mad enough, it could support the spending of millions on dubious health promotion advertising campaigns. True - but all the more reason treasury should be pressing for - and paying for - rigorous assessment of what prevention programs work and what don’t.

I don’t know a lot about all the various accounting reforms - I won’t call them fads - I think the latest is performance budgeting. They may carry the answer to some of my criticisms. I have a feeling, however, that what we need is not so much better accounting as more economics. When I say we need a more scientific approach to spending control, the examples I have in mind come from economists, not accountants.

I’m thinking of such innovations as case-mix funding of hospitals. This is where, rather than giving a hospital funding based on an adjustment to what it got last year, it gets a flexible amount based on the known cost of efficiently dealing with particular types of cases, multiplied by the particular mix of cases the hospital encounters. Health economists put an enormous amount of research into developing the cost data needed for such a funding system. I’m not sure how much of the encouragement and funding of this research came from treasuries.

Another example is the advent of income-contingent loans. Australia has been a world leader in this area, with Professor Bruce Chapman’s application of the concept to university fees being the finest example of applied economic rationalism. As is easily seen in the case of HECS, the beauty of income-contingent loans is the superior trade-off they offer between equity and efficiency. You can require students to make a higher contribution towards the private benefits they receive from a university education, without fear of making uni education too expensive for kids from poor families. If Treasury and Finance had been doing their job, the idea would have been developed by them. Now Professor Chapman and his colleagues are elaborating on the many other ways - such as drought assistance - in which savings could be made by replacing grants with income-contingent loans. But it’s not clear the purse-string departments are pursuing this opportunity with any enthusiasm.

To me, however, the cost-effectiveness potential of these ideas is dwarfed by the scope for long-term savings arising from the neuroscientists’ discovery of the crucial importance of an infant’s early years in determining both its IQ and its EQ - its intellectual ability and its emotional ability to fit in socially, apply itself to work or study and generally lead a successful life. I suspect that many of our politicians are better versed on this remarkable research than the econocrats are. But there’s no excuse for the purse-string controllers: the whole thing’s been checked out by the Nobel-winning economist James Heckman, who’s given it a rave review.

Heckman’s studies demonstrate that spending programs aimed at early childhood development (that is, long before school-age) have far higher cost-benefit scores than remediation programs for students, prisoners or the unemployed in later life. If you leave it that late, you’ll be lucky if the benefits exceed the costs. Heckman makes a killer point for economists: spending on early childhood development involves no conflict between equity and efficiency. That is, the things you might do to promote equality of opportunity are just as effective in promoting productivity and human capital formation, and vice versa. In other words, improving on early childhood development is as close as we come to a free lunch.

The implication of this body of research for spending on social programs is profound. It says that, in neglecting babies and spending money trying to help or punish young people and adults once their educational or behavioural problems come to the attention of the authorities, we’re getting it exactly the wrong way round. Whether you care about economic efficiency or about fairness, we ought to be massively re-orienting our social spending in favour of the very young. In fact, the only remaining justification for trying to help non-infants is simply the ethical point of not abandoning people who are victims of our earlier neurological ignorance.

At an intellectual level, many of our political leaders know this. The trouble with modern politicians, however, is that they’re more interested in being seen to be responding to problems than in actually solving them. So they spread their spending too widely and thinly. Explain to them about how babies’ brains develop and they ‘respond’ by initiating a few new early childhood programs, but they never spend anything like enough. Why not? Because they have other interest groups to keep happy and so they’re not prepared to divert funds from social programs where, though we now know the money is largely wasted, the profile is higher and the political pressure greater.

The people who should be throwing their weight behind the neuroscientists, social workers and early childhood educators in helping persuade the pollies to reform their spending priorities are the purse-string controllers. But are they? I doubt it. Why not? Because they’re not applying their brains and they’re not trying hard enough.

I want to finish by adding something different: I believe every up-and-coming treasury officer needs to be familiar with the relatively new school of economic thought known as behavioural economics. BE draws heavily on the findings of psychologists - including the psychologist Daniel Kahneman who won the Nobel Prize in economics in 2002 for founding the school - to study the way people actually make economic decisions in contrast to the conventional assumption of rational self-interest. It finds that most people don’t act on opportunity cost, don’t ignore sunk costs, dislike losses more than they like gains of equivalent size, are more loss averse than risk averse, practice mental accounting which breaks the assumption of fungibility, have big self-control problems and much more.

Why do ambitious treasury officers need to be familiar with this stuff? Various reasons. Because it helps them understand why the conventional model often mispredicts. Because it teaches them to respect and accommodate the electorate’s inescapable concerns about fairness, particularly procedural fairness - economists can abstract from fairness considerations, but the people to whom politicians answer never can. But also because the two professions with an instinctive understanding of BE are the marketers and the politicians. BE helps economists convince themselves of the truth and relevance of propositions politicians simply know to be true. So BE is a counter to the old treasury line that there are always only two policy choices: good economics (ie conventional economics) and political expediency. It turns out the pollies often have good reason to reject advice based on conventional economic assumptions that are normative (how people should behave) but not positive (how they do behave). The point is that when econocrats’ understanding of BE allows them to break out of the good-v-expedient mindset, they’re better equipped to find a better trade-off between what would be ideal in an ideal world and what politicians are likely to accept as doable.

There is much scope to elaborate on this point - to draw out the practical lessons for policy advisers from BE - but let me highlight just one: when you understand BE you realise that hypothecation should be embraced rather than opposed. Treasuries traditionally oppose hypothecation because it’s either a con on the public (it doesn’t actually lead to increased spending in the area in question) or it distorts spending choices (it does oblige more spending in the area than would otherwise occur). The trouble with this logic is that it’s too rational by half. In an era when people’s demands for increased spending are insatiable but their willingness to pay higher tax is limited, hypothecation is a useful tool. At the moment when public demand for new spending is at its height, the politician steps in and says sure I’d like to spend the money but I’d need to cover it by introducing this small levy or surcharge. The public invariably agrees. Why? Because it wants to see what normally is concealed from it: the link between what you pay and what you get. The Howard Government has made extensive use of the hypothecated surcharge. Why? Because it’s unconscious understanding of BE gives it better policy judgement than many econocrats, who’ve been blinded by the unrealistic assumptions of conventional economics.

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