Should wasteful competition for positional goods be taken into account in tax policy?

In my last post I began my review of Robert Frank’s ‘The Darwin Economy’, by outlining how Adam Smith viewed the strivings of people to better their condition as being motivated to a large extent by concerns about their relative position in society. I suggested that if there are negative externalities associated with strivings to improve relative position, these should be balanced against the positive externalities relating to technological progress identified by Smith.

The negative externalities that Robert Frank is most concerned about arise when people forgo something that they value (e.g. leisure or workplace safety) in order to engage in competition for positional goods. The basic idea is that while this competition makes sense from the perspective of each individual, it is socially wasteful because individuals are forgoing something they value in order to compete for positional goods.

There is an important definitional issue, which I will come to later, about whether the supply of positional goods is fixed. Let us assume initially, however, that there is only one positional good which is fixed in supply – housing land with views – and that humans have such a strong urge to obtain a house with a good view that, once their subsistence needs have been satisfied, all their efforts go into obtaining better views. If we now make the additional assumption that the government has to raise a certain amount of revenue to fund provision of public goods (e.g. defence, law enforcement) I think it would probably be reasonable to suppose that a tax on income above a certain level, which causes people to substitute leisure for income, would be an efficient tax to use in such circumstances. (This runs counter to my prior view which would have been in favour of a tax, or combination of taxes, with a neutral impact on income-leisure choices.)

Now, let us add some complications relating to the real world. Account should be taken of the fact that different people have different preferences and tastes. Some people are particularly interested in houses with views, some like to live near water, some are interested in living near good educational facilities and some like to live near their work. Then, there are the people who prefer to spend additional income on goods other than housing.

House sites in good locations are not the only good for which there is a relatively high income elasticity of demand. In the case of most high income elasticity goods, however, an increase in demand tends to result in a supply response and a reduction in price. Moreover, many studies suggest that there is a relatively high income elasticity of demand for leisure. Such considerations suggest to me that potential economic losses associated with competition for positional goods are likely to be quite small.

At this point I should introduce the further complication relating to the definition of positional goods. Frank adopts Fred Hirsch’s definition of positional goods ‘as ones whose evaluations are particularly sensitive to context’. House sites with views would be considered to be strongly sensitive to context if people would generally prefer to live in a location where they have better views than their neighbours, than to live in a location where the views are generally much better, but their neighbours have better views than they have.

On the basis of thought experiments he has asked students to undertake, Frank suggests that size of house is strongly sensitive to context, whereas workplace safety and time spent on vacation are not strongly sensitive to context. Frank argues that positional concerns are stronger for luxury goods than for necessities. He suggests that since ‘luxury is an inherently context-dependent phenomenon, it’s uncontroversial to say that the last dollars spent by those who spend most are most likely to be spent on luxuries’. This reasoning leads him to argue in favour of a steeply progressive consumption tax to replace personal income tax.

In the end, it seems to me that the view Frank is presenting boils down to an assertion that those fortunate (or silly) enough to have high levels of consumption spending impose an externality on the rest of the community who feel that their relative standing is diminished unless they make the sacrifices required to emulate this behaviour. The main problem I have with this this line of reasoning is that people can choose not to get involved in such emulation games, and many people have made such choices.

Furthermore, I don’t think relative income or consumption levels are nearly as important to life satisfaction as people might suggest in their responses to thought experiments. A rough calculation I reported on this blog a few years ago suggests that the probability of a poor person in a rich country being satisfied with life is about 60 percent higher than for a rich person in a poor country.

International migration patterns are also inconsistent with the view that relative position is of huge importance. Many people seem to be willing to migrate from poor countries, where they are relatively wealthy, to wealthy countries, where they are relatively poor, in order to give better opportunities to their children.

My bottom line is that while I think there may be a grain of truth in the idea that competition for some positional goods (goods which are fixed in supply) is wasteful, Robert Frank has not succeeded in establishing a case on efficiency grounds for a steeply progressive consumption tax.

What did Adam Smith think of externalities associated with the efforts of individuals to improve their relative position?

I have enjoyed reading Robert Frank’s new book, ‘The Darwin Economy: Liberty, Competition and the Common Good’, more than I thought I would. This may be because I felt that the book had been written for people like me - the author seems to want people who have a strong regard for individual liberty to give serious consideration to his views.

I had expected Frank to argue that competition for positional goods involves a negative externality because those who are most successful are envied by many of those who are less successful. However, the view he presents of the nature of externalities associated with competition for positional goods is more subtle and less easily dismissed.

The starting point of Frank’s analysis is the ‘invisible hand’ of the market, which Adam Smith had suggested in ‘Wealth of Nations’ leads self-interested individuals to promote the greater good of society, without intending to do so. Frank describes Smith’s invisible hand as ‘a genuinely groundbreaking insight’, even though, as Smith recognized, the invisible hand ‘breaks down’ to some extent in the presence of externalities, public goods, and so forth. The particular negative externality that Frank is most concerned about in this book is associated with circumstances where individual rewards depend on relative performance and result from the strivings of individuals to improve their relative position. He contrasts this striving to improve relative position (which he describes as Darwinian competition) with the benign competitive forces associated with Adam Smith’s invisible hand.

Frank’s discussion of the different views of competition that he attributes to Darwin and Smith reminded me that Adam Smith had actually written about the strivings of individuals to improve their relative positions in ‘The Theory of Moral Sentiments’ (TMS). Smith suggested in TMS that what people hope to achieve by bettering their condition is not ‘ease’ or ‘pleasure’ but ‘to be taken notice of with sympathy, complacency and approbation’ (p 50-51, Liberty Fund edition, 1982). Later in the book, Smith suggests, however, that ‘the poor man’s son, whom heaven in its anger has visited with ambition’ imagines that if he attained wealth and greatness ‘he would sit still contentedly, and be quiet, enjoying himself in the thought of the happiness and tranquillity of his situation’. According to the story, this ambitious man endures a great deal of misery striving to better his position. By the time he achieves his goal, however, he is near the end of his life ‘his body wasted with toil and diseases, his mind galled and ruffled by the memory of a thousand injuries and disappointments …’. At this point he begins to think that ‘wealth and greatness are mere trinkets of frivolous utility’ offering little ‘ease of body or tranquillity of mind’ (p 181).

In my view, Smith’s story understates the benefits that people obtain from wealth because it doesn’t take account of the greater autonomy wealth enables them to enjoy. (I have discussed the link between wealth and autonomy previously on this blog.)

Smith was suggesting that people tend to make cognitive errors of the kind discussed by Daniel Gilbert in his book, ‘Stumbling on Happiness’. This view of strivings to improve relative position differs from that of Robert Frank, who does not rely on departures from the individual rationality assumptions normally used in neo-classical economics.

The similarity between the views of Adam Smith and Robert Frank in relation to strivings to improve relative position lies in the fact that both seem to see this as more or less a zero sum game, with externalities involved. Adam Smith wrote as follows about the externalities associated with the strivings of individuals to better their condition:

‘The pleasures of wealth and greatness … strike the imagination as something grand and beautiful and noble, of which the attainment is well worth all the toil and anxiety which we are apt to bestow upon it.

And it is well that nature imposes upon us in this manner. It is this deception which arouses and keeps in continual motion the industry of mankind. It is this which first prompted them to cultivate the ground, to build houses, to found cities and commonwealths, and to invent and improve all the sciences and the arts, which ennoble and embellish human life; which have entirely changed the whole face of the globe, have turned the rude forests of nature into agreeable and fertile plains, and made the trackless and barren ocean a new fund of subsistence, and the great high road of communication to the different nations of the earth’ (p 183).

These days many people would be less inclined to count as a benefit some of the ways in which the face of the globe is being changed by the motion of industry. But Smith’s insight that strivings of individuals to improve relative position can encourage technological progress is still relevant. If such strivings also result in negative externalities, those need to be balanced against the positive externalities that Adam Smith identified.

I promise to write about Robert Frank’s views in my next post.

Can measurement of subjective well-being help us to assess whether life is getting better?

The British government has recently taken some steps toward measurement of subjective well-being in the hope that this will provide ‘a general picture of whether life is improving’ and eventually ‘lead to government policy that is more focused not just on the bottom line, but on all those things that make life worthwhile’.

The quoted words are from David Cameron, the British prime minister. I find it interesting that he refers to ‘the bottom line’ as though the bottom line in British politics has always had a pound sign in front of it. Philip Booth, editor of the recent Institute of Economic Affairs (IEA) publication ‘… and the Pursuit of Happiness’, suggests that the prime minister was attacking a ‘straw man’; the British government has always had a multitude of objectives.

Booth makes the point that attempts to ‘centrally direct policy toward improving general wellbeing’ will fail just as attempts to increase GDP growth through use of central planning also failed. I agree with the point, but I suspect that it is also a straw man. I doubt whether David Cameron is proposing to adopt some form of central planning in an attempt to raise national happiness. It seems to me that attempts to obtain a better picture of whether life is improving are no more likely to encourage central planning than was the measurement of national income likely to encourage central planning. Like many happiness researchers, the pioneers in the field of national income measurement were of an interventionist frame of mind. They actually wanted better measures of economic activity as an aid to implementation of Keynesian macro policies.  The central planners were not slow to jump on the national income measurement bandwagon, but there was no slippery slope leading inevitably from national income measurement to increased government intervention.

However, I can’t claim to know what the British prime minister has in mind. Initial survey work by the Office of National Statistics (ONS) has focused on a comparison of different measures of subjective well-being. Some of the results are interesting. For example, there is a fairly high level of correlation (0.66) between responses to a standard life satisfaction question (How satisfied are you with your life nowadays?) and a eudenomic question (Overall, to what extent do you think the things you do in your life are worthwhile?).

Yet, that kind of information will not tell us much about whether life is getting better. As Paul Ormerod demonstrates in his chapter of the IEA publication, levels of life satisfaction in high income countries tend to fluctuate over time without any obvious trend – and despite improvements in many different well-being indicators. I think the metaphor of a ladder attached to a helicopter, which I used in a recent post, is helpful to an understanding of why successive snapshots of life satisfaction cannot measure progress. If I am climbing a ladder that is attached to a helicopter, my height above the ground depends on the height of the helicopter as well as on which rung of the ladder I have reached. The ladder represents the benchmark of possibilities against which I assess my life satisfaction, but upward movement of the helicopter (i.e. expanding possibilities) may be my main source of progress.

In my view, if you want to know whether people feel that their lives are improving you need to provide them with an appropriate benchmark against which to make that comparison. The ONS survey enables this by also asking respondents to rate their life satisfaction a year ago and five years ago. The scores for life satisfaction five years ago and one year ago were slightly lower than those for current life satisfaction. This suggests, somewhat surprisingly, that Brits generally feel that their lives are still improving despite the global financial crisis and its aftermath. That kind of information seems to me to be worth having.

Unfortunately, I couldn’t find any discussion in the IEA publication of what measures of progress would be superior to the successive snapshots of life satisfaction that are targeted for criticism by several of the authors. The publication certainly serves a useful purpose in bringing together the contributions of a range of authors who question false assertions that have been made on the basis of happiness research and caution against government attempts to use the findings of happiness research to introduce policies to promote happiness. Nevertheless, I was slightly disappointed that the editor did not show a little more sympathy for the idea that there could be some merit in the aim of the British prime minister to obtain a better picture of whether life is improving in that country. 

I expect that if government policies were focused more clearly at expanding the opportunities that make life worthwhile, there would actually be less government regulation in most countries, including the UK.

Does GNH measure progress towards a better society?

In my last post, ‘Can happiness be aggregated?’, I suggested that any statement about aggregate happiness or gross national happiness (GNH) involves judgements – explicit or implicit – about the characteristics of a good society.

I used the example of Mary, who is flourishing at level 9, and Jane, who is just surviving at level 1, and asked whether their combined level of flourishing is equivalent to that of two other people who are flourishing at level 5 ( i.e. (9+1)/2).  I suggested that you may feel that combining the ratings of different individuals together should involve value judgements rather than just arithmetic. I argued that if we introduce value weights into the process of aggregating the flourishing of different individuals, we are making a judgement about the extent to which the distribution of flourishing is consistent with our views about characteristics of a good society. 

I think the issues raised by the example of Mary and Jane can be brought into sharper focus if we consider whether aggregate flourishing increases to the same extent if Mary’s level of flourishing rises from 9 to 10 as when Jane’s level of flourishing rises from 1 to 2. I think most people would feel that Jane’s increased flourishing should receive more weight than Mary’s in the assessment of aggregate happiness. As argued above, the assignment of relative weights involves a value judgement. Different people can be expected to have different opinions about this matter.

The people responsible for the GNH survey in Bhutan have taken the position that ‘beyond a certain point, we don’t need to keep adding in higher achievements to the quality of life mechanically’. Their methodology would not count the increase in Mary’s level of flourishing as making any contribution to GNH on the grounds that it is appropriate to confine attention to ‘a middle band of achievements that contribute significantly to human wellbeing for most people’. I am not sure whether these implicit weightings reflect a consensus of the people of Bhutan, but in any case the weightings in the GNH index have validity as an expression of the values of the elected government.

The way I see it, Bhutan’s GNH index is the method that the government of Bhutan has chosen to measure progress toward a better society.

Can happiness be aggregated?

My starting point for this post is take it as given that everyone agrees that for public policy purposes it is appropriate to view happiness in terms of individual flourishing. My reasons for this view have been presented in the draft of chapter 2 of the book that I have been writing.

I doubt whether it is possible to obtain an accurate measure of the extent to which each individual in the community is flourishing because some of the subjective information involved is probably not accessible to people conducting surveys. But let us assume that we have a measure that is good enough to compare the extent to which different people are flourishing in terms of a rating scale from 1 to 10, with a rating of 1 indicating that the individual is just surviving and a rating of 10 indicating that the individual is fully flourishing.

The measurement system that I am assuming would enable us to determine the percentage of people at different levels of flourishing within a particular community. If other communities adopted the same measurement system we could make observations about the percentage of people who are flourishing in different communities. It might be possible to say, for example, that 50 per cent of the population in community A are flourishing at a moderate level (with a rating of 7 or above) whereas the corresponding percentage in community B is only 40 per cent. There could be considerable interest in such observations, particularly if they enabled comparisons to be made between countries and over time.

Would such a measurement system enable us to say that the aggregate or average level of flourishing is higher in one country than another? I don't think so. For example if you are told that 50% of the population is flourishing in country A and 40% is flourishing in country B, that doesn’t necessarily mean that the average level of flourishing is higher in A than B. It is possible that 20% are struggling for survival in country A while only 5% are struggling for survival in country B. The average (mean) calculated from the percentages flourishing at each level might indicate that the level of flourishing is higher in B than in A. In this instance, is the mean a better measure of the 'average' than the median?

There is also a more fundamental problem. Let us assume that Mary is flourishing at level 9 and Jane is just surviving at level 1. Is their combined level of flourishing equivalent to that of two other people who are flourishing at level 5 ( i.e (9+1)/2) ? I don’t think so. It seems to me that, other things equal, it is preferable to have two people flourishing at level 5 than to have one person at level 1 and the other at level 9. But that judgement reflects my own values and is not related to the preferences of the people most directly concerned? We should ask Mary and Jane what they think. But their views might differ. Perhaps we could ask a random sample of the population what they think, or conduct experiments to find out what choices most people might make behind a veil of ignorance. (I have in mind the kind of experiment conducted by Hörisch Hannah, which I described in an earlier post.)

The point I am getting to is that even if you can conceive of ratings corresponding to different levels of flourishing, you may have good reasons to feel that combining the ratings of different individuals together should involve value judgements rather than just arithmetic. You may not be comfortable in thinking of the combined level of flourishing of Mary and Jane as though these individuals are just metric stations.

However, if we introduce value weights into the process of aggregating the flourishing of different individuals, are we not then making a judgement about the extent to which the distribution of flourishing is consistent with our views about the characteristics of a good society? It seems to me that any statement about aggregate happiness or gross national happiness involves judgements – explicit or implicit – about the characteristics of a good society.

So, why not ask directly whether society A is better than B, rather than asking whether aggregate happiness is greater in A than B? This would mean attempting to achieve consensus on the characteristics of a good society. I presented some thoughts about this in a post a couple of years ago.

Has the United States become a secular theocracy too?

Secular theocracy is a result of the tendency in the modern world for faith in government to replace faith in God. In the past I have tended to associate secular theocracy with Australia, New Zealand, Britain and other countries in Europe, rather than the United States. When I first visited the US in the 1970s, I remember mentioning to someone that Americans seemed to take religion much more seriously than I had expected. He pulled a bill from his wallet and pointed to the words, ‘In God we trust’, suggesting that those words were a key to understanding America.

Until very recently I thought that the differing influence of secular theocracy in different countries could be explained entirely by the differing influence of collectivist ideas – a desire for security being satisfied by the welfare state rather than by religion. From where I sit, in Australia, it seemed that secular theocracy could be attributed to the varying influence of ideas of people like Karl Marx and J S Mill, leading to establishment of more extensive welfare states in some countries than in others. While I am an admirer of many of Mill’s writings, it seems to me that his introduction of the term ‘social justice’ played a significant role in the development of secular theocracy in some countries. The faith that many people have in social justice seems to me to be much like religious faith.  When people say that social justice demands this or that, it seems to me that they are actually using nebulous secular language to make claims about our religious duties toward other humans.

So, how did I react when it was suggested to me recently that secular theocracy stems from the separation of church and state? My initial reaction was not favourable. From my limited knowledge of history, the separation of church and state seems to be inextricably linked to the history of recognition of religious freedom and individual liberty. According to this view, the separation of church and state stems from recognition that in order to promote and preserve individual liberty it is necessary for religious organizations to be kept away from exercise of the coercive powers of the state.

An article recently published by David Theroux, president of the Independent Institute in the US, presents a somewhat different view of secular theocracy. David suggests that modern America has become a secular theocracy, with a civic religion (nationalism) replacing God. The view he presents is linked to that of C S Lewis, who argued that there is no sacred/secular divide and that a theopolitical world view of hope, joy, liberty and justice enabled Christians to discover objective natural-law principles of ethics, science and theology, producing immense human flourishing.

In support of his view that nationalism has replaced God, David Theroux points to a statement by Supreme Court Justice William Brennan in a land mark case in 1963 relating to bible reading in schools. Brennan argued that the function of public schools is the training of American citizens in an atmosphere in which children may assimilate a heritage that is ‘civic and patriotic’. He went on to suggest that ‘patriotic and united allegiance to the United States is the cure for the divisiveness of religion in public’.

David Theroux argues that in the United States secular theology ‘exalts a sovereign and powerful state that pervades all of life and compels obedience not just to its mandates but to secular nationalism of the Zeitgeist itself, for which the populace is forced to conform to and to fund’. The flag has become the most sacred object in US society. He suggests: ‘The religious-secular split enables public loyalty by Christians to the nation state’s secular violence, including invasive wars, torture, and “collateral damage”, while avoiding direct confrontation with Christian beliefs about the supremacy of God and natural law teachings’.

I have no hesitation in recommending David Theroux’s article. The existence of a pervasive secular theology of nationalism seems to me to be another important key to understanding modern America. 

When can you trust your intuitions?

In my last post I discussed the part of Daniel Kahneman’s ‘Thinking Fast and Thinking Slow’ that I like least. In this post I will to discuss the part that I most enjoyed reading.

At the beginning of his book Kahneman sets up the idea that the human mind can be thought of as being comprised of two systems. System 1 operates quickly, with little effort and no sense of voluntary control. System 2 allocates attention to the effortful mental activities that demand it.

When I read that I immediately began to search for links to Timothy Gallwey’s concept of Self 1 and Self 2. Gallwey is a sports and business coach and author of popular ‘inner game’ books. I have read nearly all of Gallwey’s books and have written about them previously on this blog.

Gallwey observed that when he was playing tennis he seemed to have two identities. Self 2 was playing tennis and Self 1 was constantly interfering by telling him how to play and trying to get him to conform to his instructions.

It struck me that Gallwey’s Self 1 might correspond roughly to Kahneman’s System 2 and that Gallwey’s Self 2 might correspond with Kahneman’s System 1. Anyhow I didn’t find the link until I read Chapter 22 of ‘Thinking Fast and Thinking Slow’ in which Kahneman discusses his collaboration with Gary Klein, who turns out to be an admirer of Tim Gallwey's books.

Klein and Kahneman collaborated in a study directed toward answering the question of when you can trust an experienced professional who claims to have an intuition. Kahneman’s scepticism about intuitions was shaped by observing failures of intuitive judgements by experienced professionals.  He observed that experienced professional e.g. clinicians, stock pickers and political scientists often had too much confidence in their intuitions. He suggests that this occurs because System 1 tends to produce quick answers to complex questions, creating coherence where there is none.

Klein’s optimism about intuitive judgements by experienced professional was shaped by studies of leaders of fire fighting teams who seem to be able to make good decisions in emergencies without comparing options or knowing how they are able to sense the best course of action to take.

Klein and Kahneman agreed that successful intuitive judgement involves pattern recognition. Two basic conditions are necessary for acquiring a skill in intuitive judgement: an environment with sufficient statistical regularity for patterns to exist; and an opportunity to learn these regularities through prolonged practice.

Examples of statistically regular environments include sports, games such as chess, bridge and poker, and professions such as medical practice, nursing and fire fighting. By contrast, the failure of stock pickers and political scientists who make long term forecasts reflects the unpredictability of the events they are trying to forecast.

This all makes sense to me. When I am playing golf I should learn to trust Self 2 (System 1) and when I am trying to understand economic issues I should employ System 2 (Self 1).

However, that is an over-simplification. It probably isn’t wise to rely entirely on intuition when selecting which club to use when playing golf and the intuitions of economists have probably been the source of many a useful hypothesis about relationships between economic variables.

I particularly liked the way Kahneman ends his discussion of the relationship between System 1 and System 2 in the final chapter of his book. He suggests that System 2 is who we think we are – it articulates judgements and makes choices. (That is presumably why Tim Gallwey labelled it as Self 1.) Kahneman goes on to make the point that while System 1 is the origin of most of what we do wrong, it is also the origin of most of what we do right. The judgements and choices made by System 2 often involve endorsement or rationalization of ideas and feelings generated by System 1. 

Does libertarianism rest on rational actor assumptions?

‘The assumption that agents are rational provides the intellectual foundation for the libertarian approach to public policy: do not interfere with the individual’s right to choose, unless the choices harm others’ – Daniel Kahneman, ‘Thinking Fast and Slow’, Penguin, 2011.

I feel as though I am being somewhat churlish in protesting about Kahneman’s comments on libertarianism, which amount to only a few pages near the end of a 400 page book. In my view Kahneman’s book deserves high praise and it has indeed been widely praised (for example, even in a post on his blog by  David Friedman, who describes himself as an anarchist-anachronist-economist). Having thought slowly about the matter, however, it seems to me that it is important to try to prevent paternalists from getting a free kick from the reasoning that Kahneman develops in this book.

Much of Kahneman’s book is a discussion of research findings relating to biases in intuitive thinking. The view presented is that intuitive thinking (fast thinking) tends to be much more influential than we realize – it is responsible for many of the choices and judgements that we make. The confidence we have in our intuitions is usually justified, but they can lead us badly astray on issues that require deliberation (slow thinking).  For example, most people have particular difficulty in making judgements that require an understanding of probabilities. Kahneman is not optimistic that people can easily learn to recognize when they are in a cognitive minefield in which they need to slow down and question their intuitions. When people feel the stress of having to make a big decision, more doubt is likely to be the last thing they want.

My intuitions tell me that Kahneman may be too pessimistic about our ability to recognize when we are about to enter a cognitive minefield. It seems to me that many people have developed emotional systems that provide ample warnings when they are about to enter cognitive minefields. Since I am feeling such warning signals right now, however, my intuitions about this could well be wrong. I should confine my remarks to matters about which I can write with some confidence.

When I set out to write this post the plan in the back of my mind was to refer to some earlier posts in which I distance myself from the rational actor model employed by people like Gary Becker (whose theory of rational addiction is cited by Kahneman) and then to proceed to demonstrate that the classical foundations of libertarianism do not require the assumptions of that model. However, my early warning system suggested to me that it might be a good idea to check whether Becker actually bases his defence of libertarianism on the rational actor model.  It turns out that in the defence of libertarianism that I found, Becker actually distances himself from rational actor assumptions. (This is a post he wrote on the Becker-Posner blog in 2007 on the peculiar concept of libertarian paternalism - supported by Kahneman, but advocated originally by Cass Sunstein and Richard Thaler.)

Becker presents the view that I had planned to present more eloquently than I could, so I will quote him:

‘Classical arguments for libertarianism do not assume that adults never make mistakes, always know their interests, or even are able always to act on their interests when they know them. Rather, it assumes that adults very typically know their own interests better than government officials, professors, or anyone else ... . In addition, the classical libertarian case partly rests on a presumption that being able to make mistakes through having the right to make one's own choices leads in the long run to more self-reliant, competent, and independent individuals. It has been observed, for example, that prisoners often lose the ability to make choices for themselves after spending many years in prison where life is rigidly regulated. In effect, the libertarian claim is that the "process" of making choices leads to individuals who are more capable of making good choices’. 

Arnold Kling’s views on the implications of the cognitive biases documented by Kahneman are also worth quoting:

‘If social phenomena are too complex for any of us to understand, and if individuals consistently overestimate their knowledge of these phenomena, then prudence would dictate trying to find institutional arrangements that minimize the potential risks and costs that any individual can impose on society through his own ignorance. To me, this is an argument for limited government.

Instead of using government to consciously impose an institutional structure based on the maps of cognitively impaired individuals, I would prefer to see institutions evolve through a trial-and-error process. People can be “nudged” by all manner of social and religious customs. I would hope that the better norms and customs would tend to survive in a competitive environment. This was Hayek's view of the evolution of language, morals, common law, and other forms of what he called spontaneous order. In contrast, counting on government officials to provide the right nudges strikes me as a recipe for institutional fragility.

If Kahneman is correct that we have “an almost unlimited ability to ignore our own ignorance,” then all of us are prone to mistakes. We need institutions that attempt to protect us from ourselves, but we also need institutions that protect us from one another. Limited government is one such institution’  (‘The PoliticalImplications of Ignoring Our Own Ignorance’, The American, December 2011).

In responding to comments on his post, David Friedman has made a similar point that on balance Kahneman's work may actually favour the libertarian position that market decision processes are superior to political decision processes:

‘The arguments suggest that people are more nearly rational when they use the slow mind than the fast and, since the slow mind's attention is a scarce resource, they are more likely to use it the more important getting a decision right is. My market decisions are almost always more important to me than my political decisions, since the former directly affect outcomes for me, the latter do not. That suggests that people will be less rational in their political decisions than their market decisions.’

It is also worth noting that we do not have to choose between relying on our own individual thinking processes and relying on governments to guide us. In those areas of decision-making where we  may not be able to rely on our intuitions and deliberations we have family, friends, representatives of voluntary organizations of various kinds and paid professionals who may be willing to act as our advisers or our agents (as well as the social norms and customs mentioned by Kling). If I need an agent to make decisions for me, it seems to me to be preferable to appoint one to act as my servant than to appoint one to act as my master.

Finally, we should also recognize that when governments make paternalistic laws to criminalize stupidity they don't necessarily stop people from behaving stupidly. They may just add to the problems of the people they are trying to help.

How should we measure progress?

There seems to be a lot of talk about progress, or lack of it, at the end of each year. I tend to get caught up in this even though a year is far too short a period to measure the kind of progress that most interests me.

Two years ago I wrote a post entitled ‘What is progress?’ This was the first post I had written with the ‘progress’ label on it. At the time I intended to read several books and articles relating to the concept of progress and then to write something more definitive about the meaning and measurement of progress.

Since then I have read several books and articles about progress – from an historical perspective and looking towards the future – and have written 38 posts related in some way to the concept of progress. However, I don’t think I have written anything as definitive as my first post on this subject.

The main point I made in that first post about progress is that if progress is to have any meaning from a public policy perspective it must mean movement toward a good society or movement from a good society to a better society.

A fairly obvious response that might come to mind is that it could be just about as difficult to define what we mean by a good society as to define what we mean by progress. As things happened, however, I had just spent a few months in 2009 thinking about the characteristics of a good society.

I had reached the conclusion that just about everyone should be able to agree that a good society is good for its individual members. Such a society would enable its members to live together in peace. It would provide its members with opportunities to flourish. It would also provide its members with some security against threats to their flourishing. I had also come to the conclusion that these characteristics of a good society are measurable.

It follows, or so it seems to me, that the best way to measure progress is to bring together relevant indicators of the peacefulness of societies, opportunities for flourishing (including consideration of economic, environmental and social capital indicators) and security (including consideration of security against misfortunes such as ill health and unemployment).

The approach I am suggesting is similar to that followed by the Australian Bureau of Statistics (ABS) in its ‘Measure of AustralianProgress’ (MAP). The difference is that ABS offers a smorgasbord of social, economic and environmental indicators which could, in principle, cover everything that anyone has ever suggested might have some relevance to the question of whether life is getting better. I think attention should focus on indicators that nearly everyone would agree to be closely related to important characteristics of a good society.

I strongly support the ABS’s approach of recognizing that progress is multidimensional and refraining from any attempt to combine indicators into a single measure. It seems to me that so called ‘genuine’ progress indicators which reflect the value judgements of individual researchers relating to such matters as income distribution and environmental values are useless. The relative importance of progress in various dimensions must remain a matter for public discussion and judgement by individual citizens. If a collective judgement is required about the priority that should be given to various dimensions of progress, we have constitutional processes including elections and parliamentary processes to perform this task.

Since the combining of progress indicators must involve individual value judgements, why not just ask individuals to make an evaluation of their own lives (on a scale of 1 to 10), combine these evaluations in some way and use this as our measure of progress? There are several problems with measurement of subjective well-being in this way, as discussed elsewhere on this blog. As I see it the main one is in ensuring that respondents have an appropriate benchmark in mind for measuring progress when they make their evaluations. If you ask people to assess their own lives relative to ‘the best possible life’ as in the Gallup surveys, the results of successive surveys cannot provide a measure of progress because perceptions about ‘the best possible life’ can be expected to rise as a result of progress. If I am climbing a ladder that is attached to a helicopter, my height above sea level depends on the height of the helicopter as well as on my ability to climb the ladder.

So, I think our measurement of progress should focus on widely accepted criteria that are relevant to the question of whether we are making progress toward more peaceful societies that offer greater opportunities and more security. There is also a more fundamental question, however, of whether the institutional drivers of progress – for example, institutional factors leading to productivity improvements - are also moving in the right direction. Perhaps I should write more about that next year.

Have important factors been omitted from the HALE index of well-being?

The aim of the Fairfax organization in sponsoring the development of the Herald/Age - Lateral Economics (HALE)  index of the well-being of Australians seems to have been to publish a broad indicator of social progress in the hope that this will help people to avoid viewing GDP as ‘the supreme indicator of our wellbeing’.

In contrast to some previous attempts to create ‘genuine’ progress indexes for Australia, which seem to have been aimed at maximizing the weight placed on possible negative spillovers associated with economic growth, the authors of this index seem to have adopted a fair-minded approach. However, I still have some concerns about the methodology adopted. I discussed one of those concerns in my last post – namely that it would be desirable for the index to take into account changes in uncertainty about the economic situation if it is to be taken seriously as an indicator of short term changes in well-being. In this post I want to identify important factors that have been omitted from the HALE index that might affect its use as an indicator of longer-term changes in well-being.

It seems to me that the most important factors affecting individual well-being are social capital (respect for person and property, quality of governance, individual safety, inter-personal trust) national security (peacefulness of the international environment, relations with other countries, security threats) physical and financial capital (financial wealth, housing, infrastructure, indebtedness, economic security) human capital (skills, health, personal relationships and emotional well-being) and natural capital (natural resources, environment). The relatively importance of different factors must ultimately be a subjective judgement, but this does necessarily mean that all important factors are taken into account when people are asked to rate their satisfaction with their lives. For example, there is empirical evidence that even though personal safety is obviously fundamental to individual well-being its contribution to measured life satisfaction is negligible in Australia (see, for example, a study I have undertaken using the Australian Centre on Quality of Life data set). One possible explanation is that most people feel so safe living in Australia that safety concerns do not even register in their minds when they are asked about their life satisfaction.

The most obvious omissions in the HALE index are social capital and national security. Those factors are unlikely to affect well-being much from year to year, but their impact over several decades could be substantial. For example, looking back over the last 40 years, there has arguably been a substantial improvement in the well-being of Australians as a result of improvements in relations among countries in the Asia-Pacific region.

Some less obvious omissions in the HALE index may also be important. The starting point of the index, net national income, reflects some flows of services from human, physical, financial and natural capital and one source of change in capital stocks (net investment in physical capital). Subsequent adjustments to take into account changes in environmental capital and human capital are presumably aimed at measuring changes in capital stocks more comprehensively to obtain a comprehensive income measure (based on the Haig-Simons definition of income i.e. consumption plus change in net wealth). I use the word ‘presumably’ because change in human capital from improvements in school education is measured in terms of the estimated effects of an improvement in current PISA scores on long-run GDP, without any discounting to take account of the passage of time required before improved PISA scores could possibly be reflected in the human capital of members of the labour force. It seems to me that, rather than fluctuating widely depending on literacy and numeracy skills of the current crop of school children, the value of human capital stocks probably changes gradually over time as people with differing skill levels enter and leave the labour force.

The market values of some forms of wealth obviously fluctuate fairly widely from year to year, but this is not taken into account in the methodology used in calculating the index. Changes in the value of financial capital and housing are ignored in calculating the index. This raises the question of whether the effects on well-being of such unrealized capital gains and losses are as great as for changes in current income. My feeling is that they are probably not as great. Investors are likely to view capital gains and losses in a different light to changes in dividends. Home owners who obtain unrealized capital gains on their homes would probably not generally feel that there has been much change in their well-being – their home still provides the same services to them as it did previously. Their lives probably remain largely unchanged unless, of course, they run down their liquid assets of borrow funds in order to spend their capital gains.

However, this brings me to what seems to be an important omission in the HALE index - it doesn’t make any allowance for changes in debt levels. Well-being is more closely related to net wealth than to total physical and financial assets. Looking at Australia as a whole, debts cancel out to a large extent – the liabilities of one person are the assets of another – but they do not cancel out completely. Changes in net foreign debt levels may have important implications for the average well-being of Australians. Changes in interest rates on foreign debt should also be taken into account because they influence the extent to which current income is available for purposes other than debt servicing.

Research by the Australian Centreon Quality of Life several years ago shows that people who have difficulty in repaying debt tend to have lower subjective well-being than those who do not have such problems (Survey 11, Report 11, August 2004). In the light of current debt problems in many developed countries it seems remarkable that happiness researchers have not given a great deal more attention to the effects of excessive debt on personal well-being. 

What factors should be taken into account in assessing short term changes in well-being?

This is one of the questions I have been pondering as I have been reading about the Herald/Age - Lateral Economics (HALE) index of the well-being of Australians.

The aim of the Fairfax organization in sponsoring the development of this new index seems to have been to publish a broad indicatorof social progress in the hope that this will help people to avoid viewing GDP as ‘the supreme indicator of our wellbeing’.

The timing of publication – a few days after quarterly GDP data are published – is clearly intended to invite comparison with quarterly GDP data. Indeed, a report in the Sydney Morning Herald makes such a comparison:

‘Wellbeing grew twice as fast as GDP in the September quarter thanks to a big rise in national income from the boom in commodity prices and cheaper imports’.

The HALE index rose by 2.2% in the September quarter primarily because net national income (NNI) is the starting point for calculation of the index and NNI reflects terms of trade movements. I don’t have any problem at all with the idea that well-being is more closely related to NNI than to GDP, but I can’t help thinking that the relationship between well-being and short term fluctuations in the terms of trade must be tenuous, at best.

Perhaps the terms of trade improvement in the September quarter raised the well-being of some people by enabling them to enjoy an overseas holiday that they might not otherwise have been able to afford. People who purchased imported consumer durables might also have benefited. In general, however, it isn’t obvious to me that changes in the terms of trade have much effect on living standards unless they are sustained over several years. It is even possible that short term improvements in the terms of trade could have a negative impact on well-being by adding to uncertainty in the context of concerns about possible effects of increased import competition on jobs in some industries. Such impacts might, of course, be offset by optimism about improved employment prospects elsewhere in the economy.

It seems to me that uncertainty is a factor that should be taken into account in assessing short term changes in well-being. Research based on surveys data relating to subjective well-being suggests that increased uncertainty can have a substantial short-term impact on well-being. For example, Carol Graham has reported that average life satisfaction in the US fell by 11% during the 08-09 financial crisis, mirroring a larger fall in the stock market. However, life satisfaction bounced back to previous levels once the immediate crisis was over, even though the stock market remained relatively depressed (‘The Pursuit of Happiness’, pp 88-89). A fall of 11% in life satisfaction is a very large change in a statistic that is normally very stable over time.

In an earlier post I noted that there was even a blip in life satisfaction data for Australia at the onset of the global financial crisis. A much larger decline in consumer confidence occurred at that time reflecting, amongst other things, increased pessimism about the economic outlook for the next five years. Pessimism about the economic outlook hasincreased again over the last year or so and now stands at levels almost comparable to those during 08-09.

If the HALE index is intended to be taken seriously as an indicator of short term changes in well-being it seems to me that it would be desirable for it to reflect changes in uncertainty about the economic outlook.

Is there a house price bubble in Australia?

An article in ‘The Economist’ last week suggests that the ‘bursting of the global housing bubble is only halfway through’ (‘Economics focus: House of horrors, part 2’, November 26, 2011).  On the basis of the measures used, the authors claim that home prices are over-valued by 25% or more in Australia, Belgium, Canada, France, New Zealand, Britain, the Netherlands, Spain and Sweden.

How did the authors arrive at this conclusion? Two measures of valuation were used in the analysis: the house price to income ratio, which is a gauge of affordability; and the house price to rent ratio, which reflects the relationship between house prices and the benefits of home ownership i.e. rents earned by property investors and rents saved by owner-occupiers.

The reasoning seems OK so far. If the price to income ratio is above an appropriate benchmark of affordability and the price to rent ratio is relatively high compared with an appropriate benchmark of returns available from owning other assets, then there might possibly be some grounds to suspect the existence of a housing bubble.

The critical issue is what benchmark should be used to make such comparisons. ‘The Economist’ asserts: ‘if both of these measures are well above their long-term averages, which we have calculated since 1975 for most countries, this could signal that property is overvalued’. In the chart below I have graphed the data from the table that the authors use to make their assessment.

The chart shows that the price to income and price to rent ratios for a heap of countries, including Australia, are well above long-term averages for the period from 1975 to the present. I think mean reversion (sometimes referred to as regression to the mean) deserves some respect. If we don’t have good reasons to expect a variable to remain substantially above or below its long term average at a particular point, it is often sensible to assume that deviation from the mean is more or less random and that the variable is more likely to return to the mean than to remain at extreme levels.

So, do we have good reasons to expect rental yields (the inverse of the house price to rent ratio) in Australia to remain below their long term average for the period since 1975? In order to answer this question it might be helpful to consider the level of rental yields in Australia at present and how much capital appreciation (expected growth in house prices) is implicit in current rental yields. The underlying reasoning is that if potential home buyers – including investors - perceive that there is likely to be substantial capital gain in the years ahead they will tend to bid up house prices to a greater extent (other things being equal) and thus tend to depress rental yields. You need to work out how much capital appreciation they anticipate in order to assess whether or not their expectations are excessively optimistic.

Current rental yields in Australia - of the order of 3% to 4% in net terms – do not seem to me to imply unduly optimistic expectations about future capital appreciation if we use an annual nominal return on investment of say 8% per annum as a benchmark. One way of looking at this is to ask yourself whether you would expect average house prices and rentals to grow more or less rapidly than nominal GDP. I expect average house prices and rentals to grow more rapidly than nominal GDP in Australia because the effects of growth of population and incomes will tend to intensify the locational advantages of the median house relative to houses in the outer suburbs. A recently published Reserve Bank research discussion paper by Mariano Kulish, Anthony Richards and Christian Gillitzer  (‘Urban Structure and Housing Prices: Some Evidence from Australian Cities’) uses a model to illustrate, among other things, how growth in population tends to raise house and land prices to a greater extent in suburbs that are closer to the CBD of large cities. This is consistent with the empirical evidence presented in the paper that house prices in the inner suburbs in Australia rose by about 1.3% more per annum more than in the outer suburbs over the period 1992/3 to 2009/10.

Why are rental yields in Australia currently so much lower than the long term average over the period since 1975? The most plausible reason, it seems to me, is that as in many other countries high nominal interest rates (reflecting high inflation rates) were suppressing demand for housing over the first half of that period. As inflation rates and interest rates came down, housing affordability improved markedly during the 1990s, but this led to increased demand for housing, a sharp rise in house prices and a decline in rental yields. Mean reversion doesn’t apply in this instance because the mean was distorted.

Why should we expect house prices in Australia to avoid the fate of house prices in the US in recent years? Luci Ellis of the Reserve Bank gave some reasons why the US housing market is different in a speech she made last year. Unlike other developed countries, mortgage arrears on home loans in the US started to rise in 2006, more than a year before the unemployment rate began to rise. The leverage of the housing stock in the US was substantially higher than in Australia before the global financial crisis.

In addition, the decline in housing prices in the US that resulted from the bursting of the housing credit bubble was exacerbated by deflationary monetary policies that led to a major recession. This suggests to me that current rental yields in the US (of the order of 8% to 12% in some areas) should be viewed as being extraordinarily high at present and unlikely to persist in the longer term.

The final sentence of the article in ‘The Economist’ states: ‘A credit crunch or recession could cause house prices to tumble in many more countries’. Well yes, that does seem quite possible. If it does happen, however, I think there is a good chance that rental yields in Australia will eventually return to somewhere near the ‘normal’ levels that currently exist in this country.

What is the inner game of stress?

‘The Inner Game of Stress’, by Timothy Gallwey (with Edward Hanzelik and John Horton) is the latest of a series of inner game books.Tim Gallwey has previously written books about the inner game involved in several sports, including tennis and golf, and the inner game of work - based on his experience as a coach and trainer. Hanzelik and Horton are medical practitioners who conduct stress seminars drawing on their understanding of the inner game as well as on their medical knowledge.

I think it would be fair to say that all of Gallwey’s books are to a large extent about avoiding the adverse effects of stress on our ability to function. This book is as much a pleasure to read as Tim Gallwey’s other inner game books. Gallwey is an expert in getting his message across by telling interesting stories based on his own personal experience. I have read all but one of his books. I wrote an article a few years ago describing how the books had helped me in dealing with a stress-related problem.

The main point in this book is that stress involves an inner game as well as external stressors. The inner game arises largely from trying to live with illusions about our own identities. It is as though an internal ‘Stress Maker’ has stolen our identities and substituted an illusion in order to create fear, doubt and confusion. The illusions woven by the ‘Stress Maker’ originate from the concepts, perceptions and expectations of other people.

The great strength of the inner game approach, it seems to me, is that it encourages the belief that each of us has a real identity (a natural self) that we, as individuals, are ultimately responsible for developing. Other people may see our identities as illusions that we have created in our own minds, but we should know better. We know intuitively how to be who and what we are when we recognize our inner resources and the opportunities for learning and enjoyment that are available in association with pursuit of our performance goals. We can learn to trust ourselves to function more successfully.

The book provides practical guidance on how to break the momentum of stress – how to stop and become aware of what you are trying to control and what you can control. It discusses the potential we have to liberate ourselves from illusions by re-assessing the meaning of experiences.

From what I have written, some readers might be concerned that the book might encourage people to become too self-centred – to question the social norms that were instilled in them during childhood and to pursue their own interests at the expense of other people. I think such concerns are misplaced. People don't question norms that they have internalized - adherence to such norms is a matter of self-respect rather than fear. The book recognizes that it is important for individuals to have deep relationships with others. One of the exercises in the book involves seeing problems in a relationship from the perspective of the other person – to understand what they may be thinking, feeling and wanting.

Much of the advice presented in the book is based on individual case studies rather than experiments involving large numbers of people. I don't think that is a huge problem as long as the readers who try the exercises suggested in the book approach them as though they are conducting little experiments of their own. That is consistent with one of the themes of the book, which is to encourage readers to become more aware of what they are doing at present and of the effects of doing things differently.

It is possible that this book, and Tim Gallwey’s other inner game books, may benefit some people more than others. On the basis of my own experience, all I can say is that the ideas in Tim Gallwey’s books have served me well.

Postsript:
Anyone interested in learning more about the effects of stress on the body should click here to see a useful interactive chart.

Does the modern world make us feel like powerless creatures in the coils of an invisible monster?

‘What most alarms us in our contemporary world, what unsettles and scares us, is the extent to which the forces that shape our lives are no longer personal – they know nothing of us; and to the extent that we know nothing of them – cannot put a face on them, cannot find in them anything we recognize as human – we cannot deal with them. We feel like small, powerless creatures in the coils of an invisible monster, vast but insubstantial, that cannot be grasped or wrestled with.’ 

That quote seems to me to sum up the main point that David Malouf was making in: ‘The Happy Life; The Search for Contentment in the Modern World’, Quarterly Essay, March 2011.

In the paragraphs preceding the quoted passage, the author argues that it is possible for humans to be happy even in the most miserable conditions if they perceive their world as having human dimensions. He explains that a world with human dimensions is one that humans can recognize and encompass. In his words:

‘We start always from the body, and relate everything back to it. In a way that goes back to our most primitive beginnings, we use it to establish direction – where we are facing, where we might move to; to gauge distance – how far off an object is and how far we have got along the way towards it; to determine how each thing we are observing stands in relation to our own being – its size in relation to ours, how light or heavy it is when we try to lift it or weigh it on our palm; how much it occupies of the space we share; how it smells and tastes, how it feels to the touch or when we roll it between finger and thumb’.

I feel in awe of people who manage to maintain tranquillity in the most miserable conditions. It is probably correct to say that such people do experience the sources of human misery as having human dimensions – they feel uncertainty, discomfort, pain, fear and anger just like the rest of us – but they are not overwhelmed by such feelings. The fact that they have normal human feelings doesn’t mean, however, that they necessarily see major sources of human misery – extreme climatic events, for example – as having human dimensions.

Irrespective of their capacity to maintain tranquillity in the face of misfortune, our ancestors saw God (or the gods) as the most likely explanation for extreme climatic events – and just about everything else they experienced. Malouf acknowledges this, but he suggests that when we were in the hands of the gods we had stories that made these distant beings human and brought them close. Of the gods, he writes:

‘They watched over us and were concerned, though in moments of wilfulness or boredom they might also torment us as “wanton boys” do flies. We had our ways of obtaining their help as intermediaries. We could deal with them’.

By contrast:

‘The Economy is impersonal. It lacks manageable dimensions. We have discovered no mythology to account for its moods. Our only source of information about it, the Media and their swarm of commentators, bring us “reports”, but these do not help: a possible breakdown in the system, a new crisis, the descent on Greece or Ireland or Portugal, like Jove’s eagle, of the IMF. We are kept in a state of permanent low level anxiety broken only by outbreaks of alarm’.

I admire David Malouf’s writing style, but I have a couple of problems with this line of reasoning. First, personal gods left good people bewildered as to why bad things were happening to them. Remember the biblical story of Job, the virtuous man who suffered from ‘acts of God’. Job was not a happy chappy – he cursed the day he was born. My reading of the story is that Job tried to deal with God, but that didn’t work. Job found tranquillity only after he accepted that God was not a person that he could deal with. He had to learn to accept that some factors affecting his life were beyond his capacity to understand and influence.

Second, many people seem to have difficulty in accepting that economic forces are impersonal. Economic crises, in particular, are often viewed in very personal terms – for example, in terms of the excessive greed of human agents, such as Wall Street bankers, or even in terms of conspiracies involving bankers and politicians. Modern conspiracy theories have their demons (and super-heroes) in much the same way as ancient religions had their personal gods.

One of the features of the modern world is that the role of the personal gods has tended to be displaced impersonal scientific explanations of the forces that shape our lives. Do these scientific explanations leave people feeling unsettled? I don’t think so. Psychological evidence discussed by Timothy Wilson (in his book ‘Redirect’, discussed recently on this blog) indicates that people who are affected by negative events tend to feel worse when they are uncertain about the nature of those events and why they occurred.  Reducing uncertainty about negative events is a good way to bounce back from those events.

It seems to me that it is the uncertainty associated with recent economic crises that has made them particularly unsettling. With the onset of the global financial crisis there was a great deal of public discussion among economists about the inadequacy of existing scientific explanations of what was happening. When leading economists admit that they can’t understand an economic crisis, other people have good reason to feel unsettled. Over the last couple of years, however, there has been growing support among economists for the idea that (unconventional) monetary policy can be influential in shaping expectations about the growth of aggregate demand, even when interest rates are very low. This provides grounds for optimism that the world will be able to avoid a major economic downturn over the next few years. (At the same time, as I suggested in a post a few weeks ago, there are still some grounds for concern that the European Central Bank will maintain deflationary policies that will exacerbate the financial crisis in Europe and impact adversely on the world economy.)

More robust scientific explanations of economic crises could be expected to help the people who have adversely affected to adjust to their misfortune, but would they not still feel like small, powerless creatures in the coils of an invisible monster? Quite possibly.  Yet, a better understanding of the economic forces involved may give them reason to hope for better outcomes in future. A surfer who is dumped by a wave might feel like a powerless creature in the coils of a monster, even if he has some understanding of wave mechanics. But his understanding of why he was dumped might give him reason to hope that in future he is more likely to experience the exhilaration of riding the wave.

Why occupy Sydney?

‘So, you think I am in favour of occupying Wall Street, do you? What makes you think that?’

I knew it was Jim as soon as he spoke, but it took me a moment to work out where his voice was coming from. When Jim wants to have a discussion with you, he seems to appear from nowhere and just start asking questions. I suppose he thinks that gives him some kind of advantage. It doesn’t work! Everyone I know just ignores his opening questions and goes through the usual preliminaries of saying hello and asking after his health while they compose a response.

Jim had obviously read a brief comment on my last post in which I had speculated that he might be in favour of occupying Wall Street, but not Sydney. I reminded Jim about our previous discussions about banking and limited liability. In our previous discussion about banking Jim had suggested that it was a scam for banks to promise to repay deposits on demand even though they knew that they would be unable to meet that promise if all depositors asked for their money at the same time. In our discussion about limited liability, Jim had suggested that it was wrong to allow owners of banks to gamble with borrowed money, secure in the knowledge that if their gambles do not pay off then the most they stand to lose is the value of their shares. I also mentioned that when banks have been declared by governments to be ‘too big to fail’, bankers have a strong incentive to take abnormal risks because they know that they will be bailed out by governments if they make large losses. I ended by telling Jim that I could picture him in Wall Street carrying a placard saying ‘Bankers are Wankers!’.

Jim seemed satisfied with my explanation, but when I had finished he asked: ‘So, doesn’t all that apply to Australia as well as the US? Don’t you think I should be in favour of occupying Sydney, too?’

I tried to explain that prudential regulation seems to have worked reasonably well in Australia, so there doesn’t seem to be much to protest about in terms of the way the financial system is working in this country.

Jim’s response was quite robust and is not quotable verbatim. After deleting expletives I think the message he was giving me was that although I tell people that I am a libertarian, he thinks I am actually a neo-socialist because I am in favour of some prudential regulation of the finance sector. (Jim can call me a neo-socialist if he likes – it makes a change from being called a neo-liberal. My views on banking regulation are actually fairly close to those of Adam Smith, so I am in good company.) Jim ended his outburst by telling me that while I was entitled to my own views, I should refrain from misrepresenting his views.

‘Well, does that means you actually support the Occupy Sydney movement?’, I asked.

Jim didn’t respond for a long time. Eventually, he asked, ‘What are the Occupy Sydney people actually on about?’ I wasn’t sure, but I suggested that the main theme of the Occupy movement all over the world seemed to be the injustice of unequal distribution of wealth and power – particularly the idea that the top 1% of the population in many countries tend to benefit disproportionately from economic growth.

‘And who do you think is responsible for that?’ Jim said. ‘It is the 99% who are responsible for making the 1% wealthy. We make a few film stars fabulously wealthy by going to the movies that they star in. We make a few sporting heroes fabulously wealthy by watching the games they play and buying the products they endorse. The same system applies in the business world. The CEO of a successful company develops a reputation as a star performer just like film stars and sporting heroes. Successful companies are only successful because the 99% buy the goods they produce’.

‘So’, I said, ‘you don’t think there is anything to protest about?’

Jim said, ‘No, that’s not what I mean. The Occupy Movement should be protesting about celebrity culture and the vacuousness of consumerism. They should be poking fun at the idea that a good is worth buying just because it is popular and that entertainment is worth watching just because the performer is a star. They should be asking people whether they actually get pleasure by helping Kim Kardashian to become wealthier’.

I was left wondering why Jim was picking on Kim Kardashian. One possibility that crossed my mind is that she might have green hair. Jim doesn’t like green hair.

Does Sophie know she is dumping on free trade?

When Jim asked me to have a drink with him I didn’t expect to be just sitting there watching him read ‘The Australian’ - and certainly not one that was a couple of days out of date. But when I looked more closely, he wasn’t actually reading. He was just scanning as though he was looking for something.

‘Ah, here it is’ he said at last. ‘What do you think of Sophie Mirabella?’

Sophie Mirabella is the federal opposition spokeswoman on innovation, industry and science. I told Jim that I thought Sophie was a clever lawyer. I said I would rather have her on my side of the argument than as an opponent.

‘What about the dumping issue?’ Jim asked.

I said that in my view she was out of order when she dumped on Julia Gillard a few months ago by comparing her to Muammar Gaddafi.

Jim replied: ‘Nah, I mean anti-dumping policy – preventing foreigners from selling goods here at prices lower than they charge in their home markets. Sophie writes here that dumping seeks to exploit Australia’s commitment to free trade and is a distortion of our domestic market’.

‘That’s crap!’ I said. ‘It is quite normal for firms to be able to sell goods in their home markets at prices that are higher than they can obtain in international markets. How could our domestic market be distorted by importing goods at the world price?’

Jim ignored my response and read on. After a minute, he said: ‘Sophie says that when Abbott comes to power she is going to provide for preliminary affirmative determinations (PADs) to “create a shift in the balance of anti-dumping investigations, requiring the foreign producer to prove its conduct hasn’t hurt the Australian industry”. What do you think of that?’

It was hard to know where to start. I could have said it seemed to me to be a peculiar legal principle to ask anyone to prove something that they are not capable of knowing. Instead, I reflected a little on the difficulty that lawyers often seem to have in coming to terms with economic issues. I said: ‘I think Sophie makes the same mistake that a lot of lawyers make when they get involved in economic issues. They see an economic practice that they can’t understand and assume that it must be unfair. In this instance, they see firms selling in export markets at a lower price than in their home markets and jump to the conclusion that they are engaged in some kind of unfair practice, such as predatory pricing. They don’t consider that the firms might be able to obtain higher prices on home market sales because of brand loyalty and other home market advantages. Her efforts to shift the balance in favour of domestic industry will just encourage the rent seekers.

Jim replied: ‘You don’t have a very high opinion of the ability of lawyers to understand economics, do you?’

When I protested to the effect that I think some lawyers have an excellent grasp of economics, he asked me to name one. The name that came to mind immediately was Richard Epstein. (Actually, that stretches the truth a little. I find that names rarely come to mind immediately. Richard Epstein’s name came to mind after just a moment’s reflection.)

Jim asked: ‘So, what does Richard Epstein say about anti-dumping policy?’ I mentioned that I had recently read a short article he wrote about the concept of fair trade that seemed relevant. I suggested that Epstein had made the point that it doesn’t make sense to view business practices in international trade as unfair that would be considered quite normal in inter-state trade within the United States. (When I just re-read Epstein’s article, ‘The “Fair” Trade Delusion’, however, I find that he didn’t quite use those words. And he seems to be implying that FTAs promote free trade – which is hard to sustain. But I am digressing - and at risk of spoiling my story!)

Jim’s line of questioning then took a surprising turn. He asked: ‘Do you think Craig Emerson would understand that the benefits of inter-state and international trade are basically the same?’

Craig Emerson, the current Minister for Trade, has a PhD in economics from a respectable university and knows quite a lot about international economics. I said I was sure that he would know that the benefits of trade between, say, Victoria and Western Australia would not be any less if Western Australia was in a different country.

Jim then said: ‘Then don’t you think you and your mates in Canberra should stop picking on Craig Emerson? How would you like to have Sophie Mirabella running trade policy? Or, perhaps even Doug Cameron, or Bob Katter?’

I responded that it must be time for me to buy Jim a drink.

On reflection, how can anyone respond to a suggestion that what seems to be a disappointment is actually a blessing compared with something worse that might happen? Even the GFC could look like a blessing compared to the aftermath of the European meltdown that the world might experience over the next few months if everything that could go wrong does go wrong. When I think about the approach that Sophie is proposing to take with anti-dumping policy, Craig does seem like a little blessing. My problem is that I thought having Craig in control of trade policy might be a huge blessing for the Australian economy, rather than just a little one.