James Morley

Australian Treasurer Joe Hockey and billionaire Rupert Murdoch recently made impassioned speeches expressing their deep concern about the problem of rising inequality – the rich are getting richer, while the poor are suffering from stagnant or even declining real wages.

I was surprised when I heard about these speeches. For some reason, I had a preconceived notion that Ayn Rand’s Atlas Shrugged would have a more prominent place on Hockey and Murdoch’s bookshelves than Thomas Piketty’s Capital in the Twenty-First Century.

Some semblance of order was returned to the universe when I later read that Hockey and Murdoch were arguing that lower taxes and smaller government are the best ways to address inequality. Rand could still be proud of these highly talented and successful individuals, despite their heartfelt and possibly religious-motivated concern for the poor.

However, Hockey and Murdoch did not just provide a predictable ideological policy solution to rising inequality. They went out of their way to articulate a new and genuinely surprising economic theory as to why inequality has been increasing in the first place.

According to their theory, rising inequality is driven by the quantitative easing (QE) programs undertaken by the Federal Reserve (the Fed) in the US and some other central banks after the global financial crisis (GFC). Hockey and Murdoch believe the expansion of money supply associated with QE resulted in inflated asset and real estate prices, making the rich richer and leaving the poor behind.

This might sound plausible on the face of it and, if true, it is certainly a good thing the Fed just announced the end of QE. However, it is unlikely that inequality will suddenly start to decline because this theory doesn’t hold water.

QE has actually mitigated rising inequality, rather than caused it, because QE prevented deflation. Deflation is an ongoing decline in prices and wages which occurred in the Great Depression in the 1930s and Japan in the 1990s.

Basically, no one likes deflation, except for those lucky few people with no debt and lots of assets. The rest of us with some of both and even those with neither would have been much worse off had the GFC led the world into what macroeconomists call a “debt-deflation spiral”.

To understand this grim-sounding descent into macroeconomic hell, let’s say I borrowed $10,000 from Murdoch just before the GFC to help me buy a house. I would still owe him $10,000 afterwards, but if the crisis had led to deflation, my wages, assets and the value of the house would have fallen. So it would be much harder for me to pay back the $10,000 even if I liquidated my assets by selling my house.

I would have to cut back on my spending and save more to bring my real debt burden back under control. Meanwhile, if everyone (except Murdoch) tried to deleverage in this way at the same time, it would result in a deeper economic depression. Overall, there would be more deflation, more unemployment, and a larger increase in the real burden of debt.

This debt-deflation spiral is a pretty good description of what happened in the Great Depression and, to a much lesser extent, Japan in the 1990s. Fortunately, former Fed chairman Ben Bernanke and other central bankers facing the GFC applied lessons from the past. They didn’t tailor their policies exclusively to the needs of debt-free lenders who just want a high real return on their assets and so don’t mind deflation.

Instead, during the GFC, Bernanke and others undertook QE to stabilise inflation expectations. By avoiding deflation, QE prevented borrowers from getting poorer and lenders getting richer.

To be clear, monetary policy can have large distributional effects, but only when it leads to unanticipated deflation or inflation. For example, high inflation in the 1970s was a surprise and resulted in huge benefits for the baby boomers who borrowed to buy houses before the worst of the inflation hit.

They still owed the amount borrowed, but their wages and the nominal value of their houses went up considerably with inflation. For example, the median house price in Melbourne went up from A$12,800 in 1970 to A$39,500 in 1980 – a 200% increase over the decade, meaning the real burden of debt declined dramatically during the period. This was just the reverse of the debt-deflation spiral in the 1930s, a spiral avoided during the GFC due to the QE policies implemented.

If QE and monetary policy didn’t cause rising inequality, what did then?

Technology has shifted the nature of work dramatically during the past century from farms to factories to office buildings. It has also increased the returns to certain specialised skills and cognitive ability.

This technological change has greatly improved standards of living. However, it has left many people who do not have higher-education degrees with stagnant real wages or long-term unemployment. As a result, inequality has increased.

This skill-biased technological change has been going on for a while, as has the resulting rise in inequality. Bernanke highlighted its role in driving inequality in a speech back in 2007. By contrast, QE has only been on the scene for the past five years or so (not counting the Bank of Japan’s sporadic and generally limited forays into such policies since 2001), further undermining its potential to explain rising inequality.

But if rising inequality is due to skill-biased technological change rather than QE, what can be done?

Improving access to higher education seems like an obvious answer. But this is far from a panacea, especially to the extent that higher education serves more as a signal of high cognitive ability than it actually develops skills. We could give everyone in the world a PhD, but there would still be a lot of inequality.

Instead, fiscal policy, rather than monetary policy, can reduce inequality via progressive taxes. Fed chairwoman Janet Yellen said as much in a recent speech on inequality, targeting inheritance in particular as a source of persistent gaps in economic opportunities for the rich and poor.

Hockey may try to advocate that higher taxes kill the goose that lays the golden egg. Yet there is surprisingly little evidence of this, at least not at the level of taxes presently in place in most advanced economies. Countries with higher and more progressive tax rates have less inequality, but still grow just as fast or faster than countries with lower taxes and more inequality.

For example, despite higher taxes, Australia, Canada, and Sweden have all grown faster than the US during the past two decades.

So next time a Treasurer, a billionaire or anyone else tries to argue that QE is responsible for rising inequality and the best solution is lower taxes, I recommend being more than a little sceptical.

James Morley is a professor of economics and associate dean (research) at UNSW Business School. A version of this post appeared on The Conversation.

Richard Holden

THE founder of modern economics, Adam Smith, pointed out that the “invisible hand” of competitive markets leads to an efficient allocation of resources. When markets are competitive government should just “get out of the way”.

Yet most markets are not perfectly competitive – the extreme case being where there is a single monopolist.

This opens the door to government interventions making markets work better. But which interventions are best? What tools should be used? Which markets should be targeted?

This year’s Nobel Prize in Economic Sciences was awarded to Jean Tirole for “his analysis of market power and regulation”. Tirole’s work provides answers to these vexing questions – it has deepened our understanding of how markets actually work, and provided policymakers with a playbook for how to make them work better.

As one example, imagine you are a government regulator of a monopolist, such as a power company. The large fixed costs involved might mean that having multiple competing firms is not sensible, but one large monopolist will charge high prices and hurt consumers. What do you do?

One answer is to control the prices they charge. But to do this effectively means knowing what their true costs are – something that is typically very difficult for a regulator. Worse still, you would like the firm to work hard at lowering their costs, but this won’t happen if they don’t capture some of the benefit of those lower costs.

In path-breaking work in 1986, Tirole and co-author Jean-Jacques Laffont (who might have shared the Nobel award had he not sadly died, too young, in 2004) showed how a regulator can best balance providing incentives to reduce costs with the use of public funds – perhaps raised through inefficient taxes, since incentives cost money.

Remarkably, Laffont and Tirole showed that offering the monopolist a menu of possible regulatory schemes does the trick. You, the power company, can have a cost-plus contract or a fixed-price contract, or something in between. You choose.

And just like a good magician’s carefully designed scheme, you will always choose the card he expects. This cunning trick makes it in the interest of the monopolist to implicitly reveal its costs through its choice of regulatory scheme.

Part of what makes Tirole’s work so remarkable is that he has been able to analyse complex markets such as credit cards, telecommunications and banking, yet use a general analytic approach from which broad lessons can be learned. It is social science at its absolute best: using mathematical rigour to illuminate real-world problems and provide effective policy prescriptions.

And it’s not just academics and students who might benefit.

As Australia embarks on its second great competition policy review, with Ian Harper due to report in March next year, Tirole’s Nobel provides a timely reminder of the importance and power of good competition policy. In many ways there are parallels between the evolution of the economics of regulation, and the competition policy reform process in Australia.

The year Tirole defended his doctoral dissertation at MIT was 1982, the same year that University of Chicago professor George Stigler won the Nobel prize.

Stigler – a towering figure both intellectually and physically – was a pioneer of the study of how firms interact, and how competition policy can achieve efficiencies by driving down prices. In many ways Tirole was his natural extension and intellectual heir – incorporating strategic decision-making and hidden information into the picture.

So, too, might it be with Harper and Fred Hilmer. The 1993 Hilmer report, and the reforms it heralded, was a watershed in Australia. It took a hard line against monopolies and anti-competitive practices, and the results have been hugely beneficial to Australian consumers.

Harper’s Tirole to Hilmer’s Stigler would be to bring Australian competition policy into the 21st century. To deal with complex markets with complex problems – such as firms that know a lot more than regulators do, markets that are hard to define, and markets involving complicated networks of players such as credit cards.

Tirole’s work provides a road map for Harper. But he could do well to use Tirole’s work as a touchstone, much the same way that Stigler influenced Hilmer.

Tirole is a scholar’s scholar – thoughtful, careful, creative and genuinely the smartest guy in the room. He has inspired a generation of young economists around the world. But his work has had impact far beyond the classroom, seminar room and academic journals. He has described how real, complicated markets work, and helped policymakers to make them work better.

Tirole is a kind of engineer for the social sciences. And in highlighting that, the Nobel committee has displayed impeccable taste.

Richard Holden is professor of economics at UNSW Business School. A version of this post appeared in The Australian.

Richard Holden

In the year ahead there will be a national discussion about the future of our taxation system. It will have important implications for economic growth and social policy. The discussion will only be productive if all options are on the table, and if participants don’t resort to what Robert Kennedy called “obsolete dogmas and outworn slogans”.

The quintessential such move in tax discussions is to label a change “regressive”. Raising the rate or broadening the base of the GST is regressive. Increasing the top marginal rate isn’t.

Case closed? Not so fast. To properly assess any tax proposal it’s vital to examine where we are now, and where we are heading.

First, let’s look at the baseline. Australia’s top 10% of earners pay 46% of total income taxes. The top 2% of earners pay 26%; the top 1% pay almost 18%. The bottom 20% pay 2.5%. This makes Australia’s income-tax system among the most progressive in the world.

And income taxes are just one component of the broader taxation-benefit system. There are other taxes and benefits designed to redistribute income, such as the Family Tax Benefit, the Schoolkids Bonus and the aged pension.

Then there’s a range of ostensibly free services such as healthcare. Finally, there are other taxes, such as the GST. The Australian Bureau of Statistics estimates that when all of this is factored in, only the top fifth of households ranked by income pay any net tax. This makes Australia’s taxation-benefit system among the most progressive in the world.

I’m for this. It’s part of what makes Australia a great country. But it can only continue if the system produces enough revenue. That’s what the debate will be about: how to maintain progressivity by taxing in the right way.

One deeply regressive thing that can happen to income taxes is bracket creep – where the dollar cut-offs for marginal tax rates do not keep pace with rising incomes. This pushes lower-income earners into higher and higher tax brackets.

Those earning a very modest A$40,000 a year are forecast to pay 25% more tax in just four years’ time because of the fixed cut-offs. By contrast, those earning A$200,000 a year would face a less than 2% increase in their tax bill. That’s the epitome of a regressive change in taxation.

Yet perhaps the most regressive part of the whole system is the reliance of many states on poker-machine and other gambling taxes. The NSW and Victorian governments get roughly 10% of their revenues from gambling taxes — pokies accounting for about two-thirds of that. This is staggering, and provides horrible incentives to pander to special interests (that means you, Australian Hotels Association).

But much, much worse is the impact that what may be the most widely available gambling in the world has on lower-income earners. It is estimated that as many as half a million Australians are problem gamblers — each losing about A$21,000 per annum. For three-quarters of them, poker machines are the cause; and lower socio-economic groups are vastly over-represented.

State governments have to pay for schools and hospitals. They need revenue, and they can’t tax incomes. So I understand why they resort to moribund, distorting, socially destructive taxes such as pokies and stamp duty.

But from a system-design perspective it makes no sense to deprive states of the revenues required to fund their mandates and then stand idly by while they use the worst kinds of taxes. To paraphrase Steve Jobs, it is “insanely stupid”.

Taxation-benefit systems are just that – systems. They are made up of many different parts – and looking at any one part in isolation is dangerous and foolish. Those who shriek, “But that’s regressive”, whenever a change to the GST is mooted should think harder.

Doing nothing is regressive because of bracket creep. Doing nothing is regressive because it leaves poker-machine “taxes” on the poor in place. Doing nothing is regressive because benefits that redistribute money to lower-income earners will inevitably shrink without a proper tax base to support them.

Our tax system needs to be reworked to provide the right incentives, to grow the economic pie and to redistribute money to the less well off. To keep Australia’s taxation-benefit system truly progressive means thinking about it holistically. Dogmatically invoking the “R-word”? Refusing to change one component to fix the system? Now that’s regressive.

Richard Holden is a professor of economics at UNSW Business School. A version of this post appeared in The Australian.

Professor Richard Holden

A “yes” vote to Scottish independence on September 18 would mean a great many things for Scotland, and also for the remains of the UK. But what would it mean for Australian business and financial markets?

It’s tempting to say “very little” — what do internal politics half a globe away have to do with us? Yet the Australian dollar strengthened markedly against the pound last week, almost surely due to a poll suggesting that the “yes” vote was ahead 47% to 45%.

To begin to understand what Scottish independence might do to Australian firms and markets, it’s important to understand what it would do to Scotland and the remains of the UK. The key economic question here is what currency the Scots would use.

The pro-independence team has been pretty clear about this. They’ll keep using the pound. And it’s true that the UK can’t stop them — just as Australia can’t stop New Zealand from using the Aussie dollar.

At first this sounds sensible — the pound is a big, liquid currency. The haggis — or whatever a Scottish currency would be called — would not be. Case closed, right?

Actually, no. Having a common currency without economic and political integration is a very, very dangerous thing. Monetary policy would be set by the Bank of England, presumably without reference to Scottish economic conditions. So if there was a recession in Scotland one would want lower interest rates, but unless the UK was also in recession of a similar magnitude the Bank of England would be unlikely to cut rates.

Worse, losing control of the ability to print money means that if Scottish debt got out of control it could not be inflated away. Ask Spain how that works out.

Worse still, Scottish banks would no longer be implicitly guaranteed by the UK. This is a huge deal.

The events of 2008 taught us how quickly modern-day bank runs can happen, how devastating the effects can be, and how only overwhelming credibility can prevent disaster. Scotland wouldn’t have that — and the remains of the UK would have no incentive to help out. Even if it wanted to, markets would have to believe it, and that’s far from a sure thing.

So it’s clear Scotland would be in a dangerous economic position — not obviously in trouble right away, but without any macroeconomic fire extinguishers if trouble arose.

This is a potential worry for major Australian exporters to Scotland — but there just aren’t very many of those. Australian companies with operations in Scotland could be affected.

A notable example is National Australia Bank (NAB), whose subsidiary Clydesdale Bank is located in Scotland and could face higher borrowing costs under independence. NAB has said it would seek to shift Clydesdale bank’s corporate registration to England in the event of a “yes” vote. But even in that case it’s a small part of the NAB.

The bigger concern would be if independence affects the remains of the UK in a significant way, since this is a bigger trading partner for Australia. As we saw last week, markets have rightly been concerned. At the very least there would be an 18-month-plus process of “demerging”, a process that would be complicated and distracting.

Yet, whatever the impact on the remains of the UK, it’s hard to see how it would materially impact Australian business. The pound might weaken relative to the Australian dollar, potentially hurting Australian exporters. Having said that, we would all do well to heed former treasury secretary Ken Henry’s advice on Tuesday to be less focused on the real exchange rate in this country. The impact of a modest devaluation of the pound just won’t make much difference.

Could independence lead to a major blow-up of the UK’s economy? As we learnt in 2008, a major problem in any significant economy can quickly reverberate around the world. We are all interconnected now. A big problem in the remains of the UK could be a big problem for world financial markets, Australia’s among them.

This is possible, but it seems highly unlikely. The UK is a very large economy with its own currency and a broad web of international economic connections. Scotland is close, historic, and important – but independence is not likely to lead to an economic meltdown in the remains of the UK.

Perhaps it could change politics in the UK in a big way and this could have an effect. Perhaps a more conservative Tory leader would emerge. And perhaps that would lead to different economic policies. But that’s a lot of perhapses.

Demerging Scotland from the UK would be wrenching. It would affect both entities — especially Scotland — in lots of ways, including economically.

Whatever the pros of a “yes” vote for Scotland, it would bring with it huge economic risks. And some for the remains of the UK, too. For Australia and Australian businesses, the risk is small.

Richard Holden is a professor of economics at UNSW Australia Business School. A version of this post appeared on The Conversation.

Richard Holden

In his victory speech on election night last September, Prime Minister Tony Abbott declared Australia was “under new management and … once more open for business”.

There were, of course, specific promises such as repealing the carbon and mining taxes, balancing the budget, and building lots of new roads. But the “open for business” line foreshadowed a broad increase in confidence in the economy.

In terms of confidence since then, there has been little good news about the economy – and some bad, especially regarding unemployment. The Westpac-Melbourne Institute consumer sentiment index is 10.8% below its post-election peak.

Treasurer Joe Hockey has told us there is an imminent debt crisis, but can’t persuade parliament to pass all of his budget. Minister for Trade and Investment Andrew Robb has said budget blocking puts Australia’s credit rating in jeopardy.

The confidence of those receiving family tax and other benefits has been shattered, as has the confidence of those of us who are happy to see our tax dollars spent to make real the promise of opportunity for those less fortunate – a promise that has always been at the core of Australia’s social compact.

I get it: the first step to recovery is recognising that you have a problem. But so far the government seems to have scared global financial markets a fair bit, but not scared the Australian public and their representatives enough to do anything about it.

And that’s largely because we don’t have an imminent debt crisis. We have a long-term structural budget problem caused by an ageing population — a problem shared by most OECD countries.

Yet, despite the dramatic rhetoric, nothing has been done to address the structural problems. To say the least, this is not great “expectation management”.

A major election promise was to repeal the carbon tax – legislation that was passed last month. It remains to be seen whether the so-called “direct action” policy on climate change will be implemented, but this is one area where business is certainly happy.

And why not? Under a carbon tax or emissions trading scheme businesses pay if they pollute. Under direct action they get bribed not to pollute. It is, however, clearly bad policy for the economy as a whole — a fact that everyone except hardcore climate change deniers acknowledge.

Abbott aspires to be known as “the infrastructure PM”. But investments of the type Abbott promised take a long time – even to start – so it’s too early to tell whether he will be remembered as he wishes to be in this respect.

If we can glean anything, it comes from the yet-to-be-passed federal budget with nearly A$60 billion in infrastructure projects. Abbott has pledged that these and other projects will be subject to “rigorous cost-benefit analysis”.

If so, that’s exactly why some of them might not happen. As an economist I can hardly be against weighing up costs versus benefits. But costs are usually pretty easy to quantify (how much will it cost to build “X”); benefits, not so much.

Projecting how much traffic flow there will be on a road is not so hard, though tell that to AMP which is suing its consultants over forecasts of Lane Cove Tunnel traffic flows. Projecting the benefits of genuinely new types of infrastructure is much harder.

What’s the economic benefit of really fast internet access? It’s tough for even the most seasoned consultant to know what to put in the line in the spreadsheet that reads “stuff we never even knew it could be used for”.

So, paradoxically, Abbott’s legacy as “the infrastructure PM” may actually involve not being so wedded to standard cost-benefit analysis, but being prepared to take an educated guess about what a country such as Australia will need to face the economic challenges of the coming years.

On the mining tax, unlike many economists, I give the government some credit. Although there are intelligent arguments that those who benefit from digging up Australia’s natural resources should pay a good chunk for it, the mining tax was designed as a “super profits tax”.

If that sounds like the last refuge of banana republics that’s because it basically is. “You foreigners are stealing our future.” That is, at best, a cheap caricature of the Australian mining sector.

I’m still yet to hear a coherent definition of what a “super” profit is and how exactly it differs from an “acceptable” profit. Oh, and the mining tax didn’t raise any money, either. It was a bad idea, poorly executed. It’s good to see the back of it.

The Abbott economy at year one doesn’t look terrible. But it doesn’t look great, either. Unemployment is up, growth is flat, and confidence is down.

For Australia to really be “open for business” at year two will require a year ahead with: less scaremongering about non-existent debt crises; fewer ad hoc taxes such as the so-called debt levy and the 1.5% tax on the top 3000 companies; and no more draconian cuts to lower-income families struggling to raise kids and get ahead.

Richard Holden is a professor of economics at UNSW Australia Business School. A version of this post appeared on The Conversation.

Peter Swan

Many highly distinguished economists such as my friend Geoff Harcourt come from what is commonly known as the post-Keynesian school. This means they believe the theory of economics and fiscal policy applied to the nation bears little if any resemblance to the brand of economics that you and I as individuals are subject to.

Writing for The Conversation’s recent series on the language of economics, Geoff finds that when treasurers use phrases such as “you are using taxpayers’ money” they are confusing affairs of state with decisions that should be left to individual households.

But every treasurer should be aware each dollar of expenditure must come out of the pockets of taxpayers eventually, even if they borrow to finance the outlay in the short term. Exactly the same is true for you and me. We cannot borrow indefinitely to fund our consumption.

Geoff believes it is fallacious to “balance the budget over the cycle”. But if the government fails to do this, then undoubtedly the outcome is eventually the Greek and Spanish solution. This means more bailouts, massive rises in unemployment, a collapsed economy and departures of the able-bodied to work in economies such as Germany that have displayed better fiscal discipline.

Yes, if on average the economy were growing sufficiently fast, and the government borrowed during recessions and repaid the debt with a sufficient surplus in booms, then perhaps balancing the budget over the cycle could be relaxed slightly.

Of course, what we have seen is massive borrowing when the economy was doing quite well during the global financial crisis (GFC) due to China, and even more borrowing during the subsequent post-GFC period. Now there’s little chance of balancing the budget over any foreseeable period.

Geoff is closer to the mark when it comes to hypothecation – matching specific government expenditures with particular tax sources. For example, if police patrols are rewarded based on fines imposed on speeding motorists, they may become excessively zealous. Medical research funding is more properly determined by its social contribution – not based on a Medicare co-payment.

Countries with as good or better healthcare systems than ours, such as New Zealand and Singapore, rely far more on co-payments. The insurance aspect of Medicare requires subsidies to life-threatening and expensive medical intervention and not to regular GP visits.

Cynically, would the AMA have been more amenable to co-payments if all the revenue raised were to be paid to doctors rather than medical researchers?

Geoff points out that government expenditure has a significant impact on the efficiency and productivity of the nation. Not always beneficial, I might add. He indicates that this may be especially true of capital expenditures.

Geoff then goes on to make the remarkable claim that domestic borrowing to fund such deficits entails no real burden since both the taxpayers and the interest recipients are Australians. I agree, it is true they could in part overlap.

So the government borrows a dollar, perhaps to fund more welfare benefits. I, as the taxpayer, lend a dollar to the government instead of investing it in (say) advances in technical know-how to raise our future living standard. Activities other than welfare suffer in the Australian economy.

The government then raises the tax on me in order to pay the interest it owes me. I now work less hard because leisure and idleness remain untaxed. Taxes are then raised again in order to repay the principal as well as the interest on the loan I have made to the government. I consume more idleness and the Australian economy suffers yet again.

The burden is no different if foreign borrowing funds it. Geoff points out that repayment of principal and interest must come out of export earnings. These additional export earnings have to come at the cost of lower domestic consumption and investment, that is, lower non-welfare related activities. The tax burden is the same as in the case of domestic borrowings.

All borrowing, whether domestically or foreign, entails a tax burden with the burden increasing in the size of the deficit. Only if the borrowing is to fund long-lived public goods that I, and others, benefit from collectively is the borrowing justified. Most federal borrowing is to fund current expenditures and interest payments, not infrastructure.

Geoff concludes that “the end result has been the use of scare tactics over a wide range of issues, tactics which have no foundation in proper economic logic”. Yes, I agree scare tactics have been tried. Not very successfully so far because senators fail to see that in one way or another taxes have to be raised or outlays slashed to fund the repayment of principal and interest.

Are these tactics contrary to the laws of economics when applied to deficits? No. In fact, these laws are rigid and ultimately are little different from that faced by you and me as individuals.

Peter Swan is a professor of economics at UNSW Australia Business School. A version of this post appeared on The Conversation.

Read Geoff Harcourt’s Why treasurers should go back to economics school

Richard Holden

Last Tuesday, the minutes of August’s Reserve Bank of Australia (RBA) board meeting were released. Market participants speculated about what they would say, currency and bond markets responded to what they did say about house prices and future interest rates, and the precise wording was dissected in great detail by the Australian press.

The words of central bankers such as Glenn Stevens attract a huge amount of attention. In the US, analysts have scrutinised even the body language of successive US Federal Reserve (Fed) chiefs.

It’s not surprising that what central bankers do is closely followed. After all, interest rates have a big effect on economic activity, a range of different markets and investment strategies.

But what is, at first glance, surprising, is that what central bankers say is perhaps as closely scrutinised as what they do. Of course, what they say is informative about what they might do in the future — but there’s more to it than that.

Perhaps the most striking feature about how central bankers communicate is that they are typically quite vague. This is so widespread and has become such an art form that it has been dubbed “Fedspeak”.

For example, former Fed chairman Alan Greenspan in 2005 told the US House Committee on Financial Services:

“Risk-takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. But long periods of relative stability often engender unrealistic expectations of it[s] permanence and, at times, may lead to financial excess and economic stress.”

Even the RBA’s comparatively plain-spoken Stevens said recently to the Australian House Standing Committee on Economics:

“At some point, if these responses start to gather pace, the sorts of forecasts we are setting out at the moment will very likely prove to be conservative. The frustrating thing is that no one can say when that will happen, or just what might be the proximate trigger.”

Why are central bankers so abstruse? Surely it would be better for them to communicate clearly. Actually, no.

Central banks have all sorts of information about the economy that investors and the general public do not. They use that information to inform future policy. So wouldn’t it be best if they could credibly communicate that information so the market could incorporate it into their decision-making as soon as possible?

Yes, but the key word here is “credible”. Imagine for a moment that a central bank could make a pronouncement that was both credible and precise. Being credible, markets would believe it. And being precise, markets would have no doubt what it meant about future policies.

But this very fact would give the central bank a reason to lie. Why? Because there is a trade-off between inflation and output (or unemployment). Different central bankers will have different appetites for how much unemployment they are willing to tolerate in order to keep inflation low.

So, as Nobel laureates Finn Kydland and Edward Prescott noted long ago, policy-makers (such as central banks) suffer from an inherent time-consistency problem. In this setting, all central bankers want to be seen to be “tough on inflation”, but then bankers with less tolerance for unemployment will still want to mimic bankers with more tolerance — so they can be believed to be tough and enjoy low inflation expectations.

But that’s a logical contradiction. So central banks cannot be credible and precise at the same time.

If you think this logic sounds complicated, airy-fairy and academic, then you are right. And wrong. It is exactly the reasoning laid out by a Harvard University economics professor in a paper in 1989 in the world’s leading economic journal, the American Economic Review. That Harvard professor, Jeremy C. Stein, later went on to become a governor of the Fed. So he’s seen theory and practice.

And his argument is perhaps more pertinent today than ever before – a time where central bankers are trying to balance multiple competing objectives with just one concrete policy instrument: short-term interest rates.

Poor Stevens is trying to juggle inflation, growth, unemployment, the exchange rate and housing prices all at the same time. He needs more than just the cash rate to do that. And to influence expectations at all he must balance the precision and credibility of his language.

What central bankers say communicates a lot more information than the interest rates they set. That’s why central bankers are so careful in their language, and masters of the art of Fedspeak.

Personally, I think Fedspeak sells the immutable economic logic behind it a little short. I prefer to think of it as “Greenspan’s uncertainty principle”. You can either know what he’s saying, or whether he really means it. But you can’t know both at the same time.

Richard Holden is a professor of economics at UNSW Australia Business School. A version of this post appeared on The Conversation.

Geoff Harcourt

Although money and financial factors are integrated in complex ways in the workings of the economy, ultimately it is real resources – work forces (sizes and skills), capital goods and natural resources – that set the upper limit at any moment in time on the size of the community’s standard of living.

And yet that hasn’t stopped successive Australian federal treasurers, and their counterparts in other advanced capitalist economies, from increasingly using terms that reflect misunderstandings of the role of fiscal policy in economic policy.

When used by treasurers, phrases such as “we cannot afford it financially” or “where is the money to come from?” or “you are using taxpayers’ money”, confuse affairs of the state with what should be left to the workings of individual households.

Obsessed with the relationship of government expenditure and taxation, many treasurers suffer from deficit size fetishism, and fall victim to the “balancing the budget over the cycle” fallacy. Many also get caught up with hypothecation – matching specific government expenditures with particular tax sources.

Some confuse the significance of the national debt to income ratio for the present and future operations of the overall economy, especially the supposed link between them and the welfare of future generations relative to the welfare of the present generation. The “we’ll all be ruined” fear.

Deficit size fetishism reflects the view that government expenditure and taxation are always bad, regardless of the absolute sizes and compositions of the two and the overall state of the economy – for example, the rate of unemployment, the rate of growth, the rate of inflation (or deflation, as Japan has experienced in recent decades). Both the sizes and compositions of government expenditure and taxation need to be assessed by other criteria.

The composition of taxation, the contributions to the whole of indirect, direct and other forms of taxation and their incidence on different groups in the community, ought to reflect equity (fairness) – for example, which groups can least or most afford to pay particular forms of tax and taxes overall.

The total tax take should reflect the impact required on overall levels of spending in the economy, these in turn determining the levels of output, income and employment both prevailing and what the government would like to see prevail.

The composition of government expenditure is made up, first, of current expenditures, the salaries of parliamentarians, public servants and government employees generally; transfer payments from taxpayers to recipients of social services such as unemployment benefits, old-age pensions and so on; and interest payments to domestic holders of government bonds.

Second, there is government (public) capital expenditures on social infrastructure, the creation of new railways, roads, hospitals, schools and so on. Ideally, the level and composition of capital expenditure should be determined by the perceived medium- to-long-term needs of the community for the services they ultimately will provide.

As these expenditures have a significant impact on the efficiency and productivity of the nation, there is no reason why they should not be financed, at least in part, by borrowing, even by borrowing from overseas.

The latter does entail a real burden because interest and principal repayments mean higher levels than otherwise of exports to service them would be required. Nevertheless, if the borrowings are used wisely, this burden may be met and the economy can still be better off than it otherwise would have been.

There is no equivalent burden associated with internal debt (owed to lenders within the country) for, as noted, this involves a transfer from taxes to interest payments. The impact on overall demand depends upon the differences in the consumption and saving behaviour between taxpayers, on the one hand, and interest receivers, on the other. They may, of course, overlap. Any fairness considerations associated with such transfers may be tackled through the composition of the structure of tax rates.

So government expenditure and taxation, especially taken in isolation, are not interesting numbers. Certainly not numbers to have a fetish about, even if you are not just an ordinary Joe (Hockey), or an earthbound (Wayne) Swan, or a surplus-lover (Peter) Costello that hands out tax cuts to friends.

The criterion of balancing the budget over the cycle (or, preferably, creating a surplus) is based on a fallacy that the economy is not growing, that it will remain at the same level of activity forever.

At least since the 1940s it has been known that if economies on average grow from cycle to cycle, it is possible always to have deficits (within reasonable limits) without annual deficits exploding; for specific rates of growth, the deficit approaches particular limiting values that are livable within a wide range of values.

One outcome of this discussion is that hypothecation is a fallacy – particular forms and amounts of taxes should not be attached to particular forms of expenditure.

Citizens should pay taxes according to their overall ability to pay and they should receive government payments according to their particular characteristics as citizens – unemployed, aged, disabled and so on. The total of these government expenditures will be financed from the total funds raised by taxation and borrowing.

“Treasurer speak” in recent decades reflects serious conceptual misunderstandings of how economies work and how the functions of the state should be integrated with the workings of the private sector. The end result has been the use of scare tactics over a wide range of issues, tactics that have no foundation in proper economic logic.

Geoff Harcourt is a visiting professorial fellow at UNSW Australia Business School. A version of this post appeared on The Conversation.

Gigi Foster

The Economics of Just About Everything is the latest contribution by ex-ANU economics professor Andrew Leigh MP to the bookshelf of the intellectually curious Australian. The book is a long-overdue Antipodean interpretation of the global wave that took off in 2005 with Freakonomics: a sharing with the smart layperson of “the economist’s lens” on diverse issues from across society.

Along the way, the reader learns that far from being a dismal science, economics is a compassionate yet pragmatic discipline that proposes particular ways of viewing situations in order to understand better where behaviour comes from, and hence how to change it to achieve better outcomes.

Re-branding economics is no mean feat, particularly in this country where arguably most non-economists operate under the delusion that economics is mainly concerned with money, not welfare.

Leigh confronts this misguided view with a raft of citations to research by economists, including himself and many other authors from Down Under and around the world, offering guidance on topics that carry significant implications for social welfare, individual welfare, or both.

Perhaps Leigh’s most uniquely Australian example relating to social welfare documents the effects of the different incentives facing the Second and Third Fleets sent to Australian shores in the late 1700s.

The same firm financed both voyages, but for the Second Fleet it was compensated based on the number of convict heads taken on board in England, whereas for the Third Fleet it was compensated based on the number of convict heads alighting in Australia. With the monetary incentives that previously supported over-crowding now shifted towards survival, the death rate plummeted.

While this example is riveting, such uplifting stories about how incentives can be used to increase aggregate welfare might not be enough to retain the attention of many self-interested readers for 187 pages plus references, and Leigh – as an economist after all – knows that.

Hence, he cleverly includes plenty of examples of how the reader can personally benefit from economic insights, organising his material thematically into creatively titled chapters such as Fit for Tomorrow, which highlights the implications for individual welfare of economic thinking on matters such as obesity (how do I lose weight?) and smoking (how do I quit?).

If you want to know how to behave in the dating market, see chapter one, For Love or Money; if you want to know how to plan your child’s birth so she/he has a leg up in the trials for national sports teams, see chapter three, Starting Lineup.

But true to what is arguably the main agenda of the economics discipline, Leigh also addresses some of the big social welfare questions of our time: how to reduce violence (examining recidivism, firearms access, and terrorism through an economist’s lens); how to understand the persistent gender gap in wages; how to help people in the developing world. He also confronts head-on economists’ famously inaccurate forecasting, using an apt quote from Treasury’s David Gruen: “Economic forecasters aren’t stupid; what we are trying to do is hard!”

Indeed, while it has been said that social scientists are prone to “physics envy”, wishing to be but not quite being the hard scientists of their fantasies, Leigh’s presentation is more in line with the claim that economics is harder than physics since economists have no laws to lean upon, but only best guesses.

And Leigh is unafraid to propose some of his own best guesses, such as that Australia would be better off if we paid prisons a bonus for every released prisoner who does not re-offend; and that the rest of the world would be better off if we Aussies concentrated our foreign aid efforts in activities where he argues we have a comparative advantage – namely, assistance in dry-land farming, natural resource management, and security provision in unstable states.

The book is terrific airplane reading, but it stops short at times from a full exploration of what is being revealed. For example, the fact that births dipped before, and peaked just after, expectant mothers became eligible for the baby bonus in mid-2004 implies that there were fewer earlier-term inductions and C-sections in that cohort of births, which in turn should have implications for the health outcomes of that cohort of babies; yet this is not pursued.

It is observed that Australia is comparatively good at keeping the peace in unstable places; but why is this, and how might we teach others to mimic our success?

Obesity is described mainly as a problem of eating too much of the wrong things, and partly as a problem of time-inconsistency. Yet becoming truly obese brings such a dramatic reduction in quality of life that it is hard to believe that most obese people really got to where they are through mindless present-biased munching, correctable via a properly designed array of little nudges: something more must be going on.

In sum, The Economics of Just About Everything manages to be at once a call to action for Australian policy-makers, a fascinating introduction to some of Australia’s most entertaining applied economic research, and a supreme source of cocktail-party banter.

Read it for what it can teach you about economics and ideas, and use it to help make your world a better place.

Gigi Foster is a senior lecturer in the school of economics at UNSW Australia Business School. A version of this post appeared on The Conversation.

Poke a Russian bear with a stick and he will retaliate. That’s the lesson facing Australian exporters today.

When Australia announced it would join the US and Europe in placing trade sanctions on Russia in response to Malaysia Airlines MH17 being shot down in Ukraine, it could do so realising there wasn’t much trade to talk about.

Australian-Russia trade is only worth A$1.8 billion – Russia is our 28th-largest export destination and 30th-largest import source. In fact, Russia’s main export destinations are – wait for it – The Netherlands, Turkey and the Ukraine.

It imports mostly from China (like everyone else), Germany and the US. Australia only accounts for 0.3% of Russian imports as Russia’s 44th-largest import source and we are Russia’s 99th-largest export destination (barely registering on the trade accounts).

But now Russia’s counter sanctions could hurt agricultural exports, particularly in wheat, dairy, beef and kangaroo meat (Russia is our main export market for kangaroo meat). In most cases Australian exporters will be able to sell items such as beef to Japan, Korea (thanks to the new FTAs) or Indonesia.

In any case, Russia had already reduced beef imports from Australia (due to alleged concern over growth hormones). These would be the only sectors adversely affected assuming no further Russian retaliation over energy or financial sector sanctions placed on them by the West.

So how will the trade sanctions play out? Russia’s actions could hurt Russia most of all. A government putting on tariffs or other forms of trade protection is a like a government shooting its own people during peace time. Or as the legendary Cambridge economist Joan Robinson used to say, trade bans are like “putting rocks in your own harbour”.

Putin might well be bringing food shortages back to Russia like the bad old days of the Soviet Union and tsarist regimes – something the poor Russian populace has been used to historically. For a democracy it would be unbearable, but at an 87% approval rating, Putin won’t worry about that.

As he told me at the APEC meeting in Sydney in 2007 when John Howard allowed then Opposition leader Kevin Rudd to speak: “How nice to allow your leader of the opposition to speak. I would do so also, except I don’t have one.”

So will trade sanctions work? In economic history the record is patchy. The evidence shows economic sanctions against South Africa were more “psychologically hurtful” to the apartheid regime than economically damaging, though there is evidence that disinvestment by major institutions such as Chase and Barclays had more of an impact than trade sanctions.

As in the case of Cuba and Southern Rhodesia (now Zimbabwe), trade sanctions did not have as much impact as restrictions to foreign investment. And, in any case, the economic distortions in the domestic economy (like South Africa’s apartheid labour market distortions) were as damaging as external sanctions.

Ironically, the collapse of the old Soviet Union was the key factor in enabling the white minority government to start negotiating with Nelson Mandela and the African National Congress, making South Africa a “special case” in terms of effectiveness of sanctions.

In a well-functioning economy sanctions can bite quickly, but as in South Africa (due to apartheid) and Myanmar (due to having a ludicrously large army for a country of its size) they can have mixed effects.

Russia has an oligopolistic, or we could say “oligarch-istic”, anti-competitive economy so the oligarchs will choose to absorb the sanctions or distort the effects. The West has tried to target Russian funds abroad (in the UAE and London’s Chelsea) as that’s where the Russian oligarchs keep their capital, but that’s going to be a difficult target.

The MH17 Russia–Ukraine crisis has a long way to go in terms of geopolitics, and trade is likely to be just one weapon of choice in the skirmish.

Tim Harcourt is the J.W. Nevile fellow in economics at UNSW Australia Business School and author of The Airport Economist. A version of this post appeared on The Conversation.