Would it be costly to require banks to raise equity to 30 percent of total assets?

In their recently published book, 'The Banker's New Clothes', Anat Admati and Martin Hellwig make a strong case that in order to reduce the risk of insolvency in major financial institutions, shareholders should be required to fund their lending and other investments to a much greater extent.

The authors argue that government regulation to reduce the risk of insolvency of major financial firms is desirable because failure of such firms has adverse effects that are analogous to those that can arise from accidents in nuclear power plants. When I discussed that analogy in an earlier post, I accepted (somewhat reluctantly) that it is appropriate. As a result of the interconnectedness of financial markets, it would probably not be possible to avoid major economic disruption if large financial institutions were allowed to fail when they became insolvent. That makes it desirable to find the least cost way of regulating them to make it less likely that they will become insolvent. Governments are thus presented with problems that are similar to those involved in regulating the nuclear power industry to reduce the risk that serious nuclear accidents will occur.

Admati and Hellwig suggest that the best way to reduce the risk of insolvency of major financial institutions is to require them to raise shareholder equity from current levels (which under Basel III can apparently still be as low as 3 percent of total assets) to 20-30 percent of total assets. The higher ratio of shareholder equity to total bank assets would provide greater scope for any future fall in the value of bank assets to be accommodated without insolvency.

The authors suggest that requiring banks to rely more on equity funding would impose little, if any, cost to society. In this post I want to focus specifically on the reasons they give for that view. I encourage readers who are interested in a broader discussion of this important book to read John Cochrane's review.

The authors argue that requiring banks to rely more on equity funding would impose little cost on society because it would offset the bias in favour of borrowing provided by government guarantees and tax systems. Banks and their creditors benefit from explicit guarantees to protect depositors as well as implicit guarantees associated with the 'too big to fail' concept. These guarantees enable banks to borrow on more favourable terms than would otherwise be possible. Tax systems tend to favour borrowing because they make interest paid a tax deductible expense.  (The dividend imputation system in Australia reduces this bias to some extent but, as acknowledged by the Henry Tax Review, there is still a bias in favour of foreign borrowing and Australian banks rely heavily on this source of funds.)

The authors point out that equity ratios of banks were generally much higher in the 19^th century, prior to the existence of government guarantees.  In the US, until the middle of the 19^th century, equity levels around 40-50 percent of banks' total assets were typical and early in the 20^th century it was still common for banks to have equity of around 25 percent. The picture seems to have been broadly similar in Australia. Data presented in an article by Charles Hickson and John Turner shows (apparently) that the average equity to deposit ratio of Australian banks declined from around 60 percent in the 1860s to around 20 percent in 1892. The subsequent depression would presumably have substantially depleted the equity of those banks that managed to remain in business. Adam Creighton, a journalist, implies that the surviving banks re-built their capital ratios following the depression, so that a century ago they maintained capital ratios of between 15 per cent and 20 per cent. (See: 'Time to Force the Big Banks to Hold More Capital', 'The Australian', 23 November, 2012.)

Admati and Hellwig point out that the proposed increase in bank equity would not interfere with core banking functions of accepting deposits and making loans. Given the current structure of balance sheets, the increase in equity levels would tend to displace additional borrowing from sources such as money market funds rather than bank deposits.

The authors point out that bankers' claims that equity is more costly than debt are flawed because they don't take account of the effect of increased equity in reducing the risk of bank failure and thus reducing the rate of return required by shareholders. Equity only seems costly because government guarantees provide an implicit subsidy on debt. The increase in equity could be accomplished without significantly disadvantaging existing shareholders by requiring banks to retain earnings rather than pay dividends, until equity levels have reached the minimum level.  

I am normally sceptical of claims that governments can improve matters when they attempt to offset the adverse effects of previous interventions by adding a further layer of regulation. It seems, however, that Anat Admati and Martin Hellwig have found an instance where the theory of second best provides a valid guide to policy action. There are strong grounds to argue that if governments cannot credibly bring the 'too big to fail' policy to an end, they should take decisive action to offset the effects that policy has had in encouraging banks to become more fragile.  In my view the authors' proposals deserve strong support.

How can individuals learn to manage their self-control problems?

The essential characteristic of a self-control problem is failure to do what you want to do, even though you have sufficient knowledge, skill and opportunity. If you opt to have an additional glass of wine after weighing up the short term pleasure against the longer term pain that might result, that doesn't qualify as a self-control problem. But if after choosing to deny yourself the additional glass you often give in to an impulse and have it anyhow, you may have a self-control problem.  

Opinions differ about the extent that individuals can exercise will-power to deal with self-control problems, with support from their families, friends and professional advisors. For many thousands of years self-control problems were often viewed as evidence of possession by evil spirits. More recently, the observation that action precedes thought has brought into question the concept of free will and provided many people with a pseudo-scientific reason to doubt their own capacity to exercise will-power. This has been accompanied by a tendency for many people to re-define individual self-control problems as social problems. For example, individual health problems associated with nicotine addictions, alcoholism and obesity are frequently referred to as public health problems.

The advent of behavioural economics and happiness economics has unfortunately contributed to the view that individual self-control problems are social problems that should be dealt with by public policies. In my view, the efforts of economists to move beyond MaxU, the profession's conventional assumption that individuals maximize their utility, should be welcomed. It has become increasingly difficult to defend MaxU in many contexts in the face of evidence (e.g. a paper by Alois Stutzer and Bruno Frey) that people who are experiencing self-control problems tend to be relatively unhappy.

However, practitioners of behavioural and happiness economics take a step too far when they imply that identification of self-control problems is sufficient justification for government intervention to control people's lives, or remove temptations from them. I have presented my views on why that is so in Free to Flourish. In brief, the nature of humans is such that individuals need to exercise their capacity to make choices and to accept responsibility for them if they are to realise their potential. In other words, humans need to be in control their own lives if they are to flourish. It is also in the nature of humans to make mistakes, but the experience of learning from mistakes has potential to make individuals more competent in making decisions. By contrast, attempts by governments to protect people from themselves run the risk of making them increasingly dependent on government.

One possible objection to the view that people should be free to flourish is that this would be likely to result in worse outcomes for those who have had self-control problems from an early age. The famous marshmallow experiment, conducted at Stanford by psychologist Walter Mischel, suggests that children who have difficulty in deferring gratification to obtain greater reward at four years of age are likely to be prone to self-control problems throughout their lives. Findings of the Dunedin longitudinal study, reported byTerrie Moffitt et al, suggest that childhood self-control predicts such things as physical health, substance dependence and personal finances later in life (at age 32) about as well as intelligence and social class origins.

The findings of the Dunedin study also suggest, however, that it is possible for people to learn to exercise greater self-control. Some children moved up in self-control rank over the years of the study and this had a positive impact on their well-being as adults.

There has been previous discussion on this blog of research findings relating to ways in which people can learn to exercise greater self-control. For example, on the basis of extensive psychological research, Roy Baumeister argues strongly that individuals have the potential to exercise a great deal of self-control if they know how and want to do so.

Research by another psychologist, Tim Wilson, suggests that autonomy support can be helpful. This involves helping young people understand the value of different alternatives facing them and conveying a sense that they are responsible for choosing which path to follow.

Another relevant area of research, that I have recently begun to read about, concerns the role of construal. Research by Kentaro Fujita et al suggests that self-control is enhanced by high-level construal (the use of cognitive abstraction to extract the essential and goal-relevant features common across a class of events) rather than low-level construal (the process of highlighting the incidental and idiosyncratic features that render a particular event unique). What that means is that I would be more likely to maintain my resolve to have only one glass of wine with dinner (except for special occasions) if I construe the second glass as a bunch of calories that will require me to make greater sacrifices later to achieve my BMI target, rather than construing it as an immediate pleasure and entitlement.

If high level construal can help people to manage their self-control problems, that suggests to me that it is important for individuals to find ways to inspire themselves to pursue higher level goals. Techniques such as mBraining, discussed on this blog a few weeks ago, could help.

Is the regulatory problem in banking similar to that in the nuclear power industry?

In their recently published book, 'The Banker's New Clothes', Anat Admati and Martin Hellwig suggest that the causes of the global financial crisis were similar in some respects to the causes of the nuclear power disaster in Japan in 2011. In the case of the nuclear power disaster, the authors suggest that corrupted politicians and regulators had colluded with the Tokyo Electric Power Company to ignore known safety concerns. They comment:

'When an earthquake and tsunami occurred in 2011, this led to a nuclear disaster that was entirely preventable.

Weak regulation and ineffective enforcement were similarly instrumental in the buildup of risks in the financial system that turned the U.S. housing decline into a financial tsunami'.

It might seem obvious to just about everyone that government regulation of the nuclear power industry is desirable to prevent outcomes such as those experienced in Japan (even though regulation was spectacularly unsuccessful in this instance) but I feel inclined to step back a little to consider why such regulation is desirable. What is the problem that the regulation is intended to remedy in the nuclear power industry?

The obvious answer is that in conducting their business of providing electric power to their customers, there is a risk that nuclear power firms may accidentally cause harm to other people. But that is also true of many other business activities. Firms have an incentive to take precautions to avoid such incidental harm because they know that potential victims can sue for compensation.

So, why is additional government regulation needed in the nuclear power industry? Leaving aside the possibility of nuclear material getting in to the wrong hands, a need for additional regulation may arise because of the potential magnitude of the harm that might occur as a result of a nuclear accident. The harmful consequences of a nuclear catastrophe might be so great that the responsible firm would be unable to pay full compensation. That would pose a problem for government of whether to step in and help the victims, but it also poses the problem of how to ensure that the managers of the firm have a greater incentive to take precautions to avoid a catastrophe that would bankrupt the firm twice over, than to avoid a catastrophe that would bankrupt the firm only once. So, there might be a case for the government to step in to attempt to ensure that adequate precautions are taken.

Is there a similar case for regulation of major financial institutions? When I looked at this question a few weeks ago I suggested that when the failure of one bank leads to loss of confidence in other banks that have taken similar risks might just reflect a process in which the market is taking appropriate account of new information. For example, if a financial institution becomes insolvent because a decline in property values causes a decline in the asset backed securities in its balance sheet, that information could be expected to bring about a re-assessment of the value of assets of other financial institutions. It should not be surprising that those financial institutions that are considered to be at greater risk of becoming insolvent would suffer from a loss of confidence and have greater difficulty in conducting their business. That is the way an efficient market could be expected to weed out firms that can no longer be trusted to pay their bills. There does not seem to be anything in that scenario that is analogous to the harmful pollution released as a result of a nuclear accident.

Why do the authors argue that major financial institutions ought not be allowed to fail? The main reason they give is contagion, which adversely affects the broader economy. When a major financial institution collapses it is unable to meet its obligations to other institutions, which are also weakened. As more financial institutions anticipate liquidity problems and attempt to sell assets, there is likely to be a further decline in asset values. As financial institutions cut back lending, the broader economy is adversely affected.

Those effects on the broader economy would be dampened, in my view, if central banks were doing a good job of maintaining public expectations of steady growth of aggregate demand. Central banks were slow to use tools such as quantitative easing to do this during the global financial crisis. Even if central banks had made a more determined effort to manage expectations, however, it is doubtful whether they would have been entirely successful in countering fears that failure of several major financial institutions was likely to have severe adverse impacts on aggregate output and employment.

The authors make the point that it would be extremely difficult to allow large complex financial institutions to fail without major disruption when they became insolvent. Proposals that they could be taken over by public authorities until they were placed under new ownership would be difficult to implement because these firms have thousands of subsidiaries and other related entities spread over different countries. Separate resolution procedures would be required for different subsidiaries in different countries. Massive problems of coordination would be involved.

Governments seem to have managed somehow to get us into a vicious cycle where fears of contagion have led them to encourage major financial institutions in the believe that they were too big to fail, while the belief that governments would bail them out has led major financial institutions to take excessive risks. If we can't let big financial institutions fail when they become insolvent, perhaps the next best option is to find the least cost way of regulating them to make it less likely that they will become insolvent. That does present governments with problems that are similar to those involved in regulating the nuclear power industry.

In a later post I will discuss Anat Admati and Martin Hellwig's views of how governments can reduce the risk of insolvency in financial institutions that are too big to be allowed to fail.

Postscript

I am writing this postscript before I have posted the article because I have had some further thoughts about market failure, a concept that I was tempted to mention above. An earlier post about financial crises led to a discussion with Jim Belshaw about the meaning of market failure. During the course of that discussion I conceded that the concept of market failure is of limited use and made the point (attributed to Harold Demsetz) that the relevant choice is not between an existing imperfect market and an ideal norm of a perfect market, but between real world outcomes under current institutional arrangements and a proposed alternative set of institutional arrangements. My new point (new to me anyhow) is that if some feasible outcome is superior to that which exists at present, then past failure to implement the changes necessary to achieve that outcome should be viewed as government failure rather than market failure.

How do you know when your brains are out of alignment?

You might think that is an odd question to ask a person who has only one brain. But how do you know you have only one brain?

In their book, 'mBraining: Using Your Multiple Brains to do Cool Stuff', Marvin Oka and Grant Soosalu have assembled some fairly impressive evidence that we have brains in our hearts and guts as well as in our heads.

At this point some readers might be thinking that a book with such a title is an unlikely place to find impressive evidence of anything. My own scepticism was heightened when I first saw information being presented as a 'cool fact'. I found it hard not to chuckle. Later, I wondered whether Ross Garnaut's laugh test – which he applies to economic modelling - involves the gut brain. At the time, I wondered how I had come to be reading such a book, but I was comforted by the memory that 50 years ago I had a strong desire to be cool. It is better for our heads to be cool, rather than too hot or too cold, even if the optimal temperature for a heart is warm.

The 'cool fact' that we have brains in our hearts and guts as well as our heads is based largely on the observation that the nervous systems in our hearts and guts are relatively autonomous. They perform their functions without a great deal of direction from our brains. They also link strongly to parts of the brain concerned with emotions and instinctive reactions.

The authors refer to the discovery of neural pathways whereby input from the heart can inhibit or facilitate the brain's electrical activity.  Research by Rollin McCraty and his colleagues at Heartmath suggests that as people learn to sustain heart-focused positive feeling states, the brain can be brought into entrainment with the heart, bringing about improvements in cognitive performance. Research findings also suggest that emotion and cognition can best be thought of as separate but interacting functions or systems, each with its unique intelligence. The power of emotion as a motivational force is reflected in the greater number of neural connections going from the emotional centres of the brain to the cognitive centres than vice versa.

There is evidence that the nervous system in the gut releases chemicals that are capable of relieving anxiety and pain and sends signals to the brain that affect feelings of sadness and stress. There is also evidence that gut bacteria can influence neural development, brain chemistry and a wide range of behavioural phenomena. For example, the balance between beneficial and disease-causing bacteria in an animal's gut can alter its brain chemistry, leading it to become either more bold or more anxious.

Michael Gershen, a pioneer of research relating to the gut brain, argues that while 'gut feelings' originate in the brain rather than the gut, our emotions can trigger a primitive response in the gut. That rings true to me when I remember what disgust feels like. Even though the gut brain is not doing any reasoning it can help us to make decisions.

The way Marvin Oka and Grant Soosala describe them, the prime functions of the various brains line up neatly with common metaphorical usage. The heart brain is the seat of love and desires, goals, dreams and values. The head brain is concerned with cognition and making meaning. The gut brain is concerned with what we should move toward and what we should move away from, with what should be assimilated into the self and what should be excreted from the self, with mobilization, self-preservation and core identity. When we are considering our options we need to be sure our hearts are in the right place, our heads are screwed on properly and that we take notice of our gut reactions. We should follow our hearts, keep cool heads and be gutsy.

So, how do we know when are brains are out of alignment? The answer provided by the authors is much as might be expected. When our brains are out of alignment we experience internal conflict between thoughts, feelings and actions, motivational problems, procrastination, unwanted behaviours and habits, self-sabotage and disempowering emotional states.

The more interesting question is how to get our brains into alignment. The first step that the authors recommend is to allow our breathing to become balanced – calmly breathing in for about six seconds and breathing out for the same length of time. That recommendation is based on the view of breathing as a bridge between mind and body.

In order to deal with motivational problems, the authors suggest that we conduct what seems to me like a high level meeting at which the leader offers inspiration, advisors provide an assessment of the options and the line manager brings the discussion down to earth. As the meeting of minds progresses, we feel the passion in our hearts, entertain curious thoughts about how to express that passion, allow curiosity to harmonize with and enhance our passion, allow our instincts to move us toward action, and then feel how the growing congruence between passionate feelings, curious thoughts and motivated action influences our feelings about who we are and what it is possible for us to achieve.

That is a highly abbreviated version of an exercise suggested by the authors to bring our brains into alignment. In addition to exercises to help bring our brains into alignment, the authors also propose exercises to promote higher expressions of creativity, compassion and courage, and ultimately achieve greater wisdom.

In reading the book I felt that there could have been greater recognition that the central nervous system involves more than just a head brain – it extends down our spines. This links to the importance of proprioception - the sense of the relationship of the body parts to each other – in helping to restore balance between our minds and bodies.

Something else that is missing from the book, in my view, is a discussion of the role of humour in restoring harmony between our conscious and unconscious minds. Since we are fallible humans, it is inevitable that there will be times when our conscious minds get in the way of our unconscious minds. This occurs, for example, when trying too hard (too much conscious effort) adversely affects performance when we are playing sports. If we can see the humour of getting in our own way, that may help us to wipe the slate clean and to trust ourselves to a greater extent in future.

My overall view is that this book is well worth reading to see how that the common metaphors of multiple brains link neatly with both ancient wisdom and modern science. The exercises presented seem to make sense as ways to help people to overcome motivational problems and to manage their own lives. In other words, mBraining is cool!

Should the Australian government continue to guarantee bank deposits?

In a recent post I suggested that government guarantees of bank deposits tend to encourage banks to become highly geared because they make depositors less cautious about depositing their funds with banks that are at greater risk of default. Such guarantees could be expected to make it possible for highly geared banks to obtain access to deposits at lower cost than would otherwise be possible.

A regular reader of the blog, kvd, objected to my reasoning. In his comments he suggested:

 'your acceptance that 'the market' should play any part in the securitisation of depositors' funds (alongside equity participants) offends against my own beliefs. …

I would not seek in any way to regulate or limit the rich investing their money in any way they wish. But government failure to differentiate between the basic needs of their populace, and the desires of a relatively small, select group of players - that I find a complete abrogation of a basic government role - more specifically, a responsibility.

By all means let's limit government involvement and guarantee - but let's first more clearly delineate what it is that government should be obliged to protect.' 

In the subsequent discussion kvd clarified that what offended against his beliefs was the idea that depositors should be expected to take account of differences in the risks involved in placing their funds in different institutions. 

He explained his position further in a later comment:

 'My interest was initially piqued by what I referred to as the 'securitisation' of a significant part of the funds sources available to banking institutions - namely those funds deposited in the ordinary course of getting on with one's life. If you accept my figures, this amounts to somewhere north of 20% of the funds available for them to pursue their objectives.

While I would be the last to suggest any of the 'big four' are in danger of collapse, I do think that in your higher level analysis of 'marketplaces' and 'risk assessment' it begs the question as to just what is represented by the 20+% of unsecured creditors (because that's effectively how depositors' funds are treated; and that's why there were recent queues outside various high street banks and building societies in the UK) which I termed 'transactors'.

My simple point remains that these funds should be regarded more as the old fashioned 'Trust Fund' one sees in any solicitors' practice. Yet that is not where they presently sit in calculation of leveraging. Within that they are subsumed in those funds available to satisfy any higher-secured obligation. Except for shareholders, they are in fact last in the queue, along with any other trade creditor.

When one thinks of such funds, Winton mentions the 'mum and dad investor'; the implication being that the sums are small, difficult to manage, an annoyance really in terms of transaction costs. [Editorial note: I didn't intend to imply that the sums are small or an annoyance to banks.]

But when I think of those funds I'm referring to my working cheque account …  . These funds are sloshing around in the banking system, available (God forbid) at any time for our banks to satisfy secured creditors. Come a crunch, my funds are essentially an unsecured interest free loan to my bank, available for them to pursue (did you term it?) enhanced shareholder returns.

Too much regulation involved to protect such funds? I'd suggest a reclassification of such funds as first charge government backed liability. Would that would necessitate a recalculation of the risk attaching to other funding sources? Yes, and so be it; the market will decide that.'

Before considering the question of bank guarantees, I will first attempt to consider whether it would be possible or sensible to make the status of bank deposits more like that of solicitor's trust funds. I write 'attempt' because my knowledge of the law concerning solicitor's trust funds is rudimentary. My understanding is that solicitor' trust funds remain the property of the client. There is a great deal of regulation about what solicitors can do with those funds but I expect that they would normally be deposited in a trust account at a bank. That would probably be the safest thing to do with them, even though the funds might still be at risk in the event of bank failure. Perhaps that risk might be covered by solicitor's insurance, I don't know.

The underlying point that kvd is making seems to be that, in the event of default, depositors should be accorded the same ranking as secured creditors. My immediate reaction was that it might be difficult to give depositors a lien over a bank's loan portfolio, but further thought led me to the view that there is nothing to prevent bank deposits from being secured by a lien over other bank assets such as holdings of government securities.

The idea of giving a class of depositors a lien over a bank's holdings of a particular class of assets makes a lot of sense to me. In the absence of government guarantees, this could be expected to be most attractive in relation to transaction accounts of those depositors who are most concerned about security. As at present, such deposits would earn little or no interest and transactions charges would apply. The important point is that these deposits could be expected to be fully covered against loss in the event of bank default – unless, of course, shits are trumps and bank default is caused by default by governments (in which case, government guarantees would also be worthless).  

So, let us now consider whether the government guarantee of deposits should remain in place. Some recent history might help.

Banking in Australia functioned without a government guarantee of deposits prior to the global financial crisis. The Wallis report into the financial system (1997) recommended against the introduction of government-backed deposit insurance on the grounds that it 'was not convinced that such a scheme would provide a substantially better approach or additional benefits compared with the existing depositor preference mechanism' (p355). According to Wallis, the depositor preference mechanism 'provides that the assets of a bank shall be available to meet depositor liabilities prior to all other liabilities of the bank' (p 354).

An article on depositor protection by Grant Turner (RBA Bulletin 2011) suggests that the recommendation against deposit insurance by the Wallis inquiry 'reflected concerns that introducing deposit insurance could weaken incentives to monitor and manage risk' (p 49).

In my view such concerns are warranted. I can understand that depositor guarantees were considered desirable in the midst of the global financial crisis, but it would be good to be rid of them as soon as possible. The best way to phase out such guarantees would be to make them unnecessary by ensuring that governments will never be called upon to honour them. Could that be achieved by requiring that the guarantees will apply only to deposits that are secured by a lien on government securities held by deposit-taking institutions?

Postscript:

I have had second thoughts on the question of how the deposit guarantee should be removed.

My further discussion with kvd, see comments below, makes it clear that in the absence of the guarantee, deposits would rank after secured liabilities in the event of bank liquidation. This has become particularly important since the guarantee was made 'permanent' because the existence of the guarantee has been used as an excuse to allow banks to raise funds using covered bonds (i.e. secured liabilities).

It is probably reasonable to expect that if the deposit guarantee was removed, the market would eventually find a way to give demand deposits the highest priority in the event of bank liquidation. However, it might take some time before banks began to see it as in their interests to provide sufficient asset backing to demand deposits to enable that to occur.

It seems unlikely that any government would remove the guarantee unless it considered depositors to be adequately protected. I think that could be achieved by giving demand deposits the priority that is currently accorded to APRA in order to recover funds it pays to depositors under the current guarantee arrangement. As I understand the situation, the Banking Act gives debts and liabilities to APRA the highest priority in the event of bank liquidation.

In my view, legislation should give demand deposits the highest priority in the event of bank liquidation in order to maximize the potential for banks to be able to honour the promises that they make to allow depositors to withdraw such funds on demand. 

What questions should the 'science of morality' be seeking to answer?

In a recent article on Scepticblog entitled 'Towards a Science of Morality', Michael Shermer suggests: 'determining the conditions by which humans best survive and flourish ought to be the goal of a science of morality'. I agree, more or less, but see some problems with the reasoning he uses to get to that point, and urge him to consider more explicitly the questions that the science of morality should be seeking to answer or the problems it should be attempting to solve. (By the way, thanks to Steven Pinker for drawing attention to Shermer's article via Twitter.)

Shermer's first proposition is a 'principle of moral good': 

'Always act with someone else's moral good in mind …'.

Why? Perhaps I misunderstand, but that seems to imply that it is always good, for example, to sacrifice your health for the benefit of others. I can think of real world situations where in my judgement such conduct has not been good for either the actor or the recipient. I think an impartial spectator would say that it is good for people to act with some regard for their own needs as well as seeking to benefit others.

What is the basic moral principle? My answer is that we should always seek to act ethically. I guess that stems from a belief that moral instincts and a capacity for moral reasoning are part of human nature and exist for good reasons. Humans have a basic need to feel that they are acting ethically.

Shermer's second proposition is that to find out whether an action towards some other individual is right or wrong we should ask them. I agree. We should recognize the rights of other individuals (adults) to decide whether or not to accept proposed actions that are intended for their benefit. But that proposition seems to me to belong after establishing that 'the survival and human flourishing of the individual is the foundation for establishing values and morals'. Acceptance that we all begin our lives with a passion to survive and flourish seems to me to gives greater moral force to the observation that different individuals have different goals in life and a capacity to take responsibility (as adults) for decisions they make.

Is it defensible to argue that the survival and flourishing of the individual is the foundation for establishing values and morals? That seems clearly defensible if we think of the passion of humans to survive and flourish as a product of evolution. The moral intuitions of our ancestors could be expected to have pre-disposed them to favour theories of morality in which human flourishing is viewed as the purpose of life. It is also defensible if we think in terms of codes of morality and as the outcome of cultural evolution. As Hayek and others have suggested, those groups with codes of morality most conducive to individual flourishing – thou shalt not do things that infringe the rights of other individuals - have tended to be more successful.

If we accept that individual flourishing is the foundation on which our moral intuitions are based, does it necessarily follow that 'determining the conditions by which humans best survive and flourish ought to be the goal of a science of morality'. No! We can't derive an 'ought' statement from an 'is' statement. Nevertheless, there is nothing to stop us from feeling that there is a smooth transition between the two statements, or that the statements are closely aligned.   

As I see it, however, it is worth taking a step back to ask what our purpose is in asserting that some topic ought to be the goal of a science of morality. It seems to me that the purpose is to assert that the science of morality should be aiming to answer a particular question (or set of questions) or to solve some problem.

So, why not simply assert that the science of morality should be concerned with questions relating to human survival and flourishing? The assertion can be justified with reference to evolutionary considerations, by Aristotle's question about the chief good that is desired for itself rather than because it enables us to obtain something else, by introspection or other considerations. The important issue is whether the assertion is able to stand up to criticism.

One possible basis for criticism is that the science of morality should be concerned with questions relating to the survival and flourishing of other living things as well as humans. Perhaps that objection might be overcome by asserting that questions relating to human survival and flourishing are an important part of the science of morality.

However, that still leaves open the potential for confusion over the meaning of 'the science of morality'. What I think it means is that preferences relating to moral proposals should be based on their ability to stand up to criticism rather than that they are falsifiable. (That probably means rejection of the boundary that Karl Popper attempted to draw around science, but it is consistent with his broader views about the importance of criticism.) Some moral proposals involve value judgements that can be criticized, but cannot be proved wrong. Perhaps we can avoid confusion by further rephrasing our assertion along these lines:

Given the importance of human survival and flourishing it is important to for all questions relating to this topic to be fully explored, including the influence of values, social norms, constitutions, laws and regulations.

After asserting that the conditions by which humans best survive and flourish ought to be the goal of a science of morality, Shermer proceeds to provide examples of moral actions directed toward survival and human flourishing. These actions included reducing extreme poverty and facilitating economic growth and hence improvement in average levels of subjective well-being.

I agree with the examples that Michael Shermer provides, but having asserted the importance of exploring questions relating to human survival and flourishing it seems to me to be important to attempt to clarify the nature of the problem. In order to do so it would be appropriate to attempt to consider relevant questions in a sequence which recognizes that the way we answer one question may influence the way we frame subsequent questions.

For example, in Free to Flourish, my first set of question was about whether human flourishing should remain largely the responsibility individuals in voluntary cooperation with others, or whether it should be pursued primarily through government action directed toward achieving national goals. My answers to those questions led me to then consider the characteristics of societies that are most conducive to human flourishing. My answer to that question led to a consideration of the main drivers of progress and the greatest threats to progress.

How can governments stop encouraging banks to be highly geared?

A reader of my book, Free to Flourish, is puzzled by a brief comment I made about fundamental weaknesses in the financial system. He asks whether the following passage implies the existence of a fundamental market failure with respect to the financial system:

'The underlying incentives that the system provides for participants to take risks with borrowed funds might even tempt saints to behave imprudently. Another outbreak of gambling with borrowed funds will become increasingly more likely as memories of the recent crisis recede, unless fundamental reforms are introduced. Required reforms include the removal of any implicit guarantees that any financial institutions are 'too big to fail' - by taking action to penalise rather than assist the owners of financial institutions which are at risk of default - and removal of distortions in tax systems which favour debt funding relative to equity funding' (Chapter 8).

I accept that there may be market failure in the financial system. There can be negative externalities associated with bank failures. If the failure one bank leads to loss of confidence in some other banks, there may be a market failure involved. Then again, there may not be. If the failure of one bank leads to loss of confidence in banks that have taken similar risks, leaving other banks unaffected, it would be reasonable to argue that the market is just taking appropriate account of new information. Nevertheless, at an aggregate level, I accept that central banks may be able to play a useful role in sustaining expectations of ongoing growth in aggregate demand when bank failures occur.

However, my concerns about the fragility of the financial system – as it exists at present – cannot be attributed to market failure.

The following hypothetical example might help to begin to explain the nature of the problem as I see it. Let us focus on two banks competing in a free market, without government interventions. Both banks are the same in nearly all respects, but while Bank A is profitable, Bank B is having difficulty competing for deposits. The reason for this is that the level of shareholder equity in Bank A is relatively high and potential depositors feel that the interest rate being offered on deposits in Bank B (the same as for Bank A) would not adequately remunerate them for the additional risks they would be taking. 

There are several options that Bank B might consider to become more competitive. For example, it could offer a higher interest rate to reflect the greater risks involved for depositors; it could reduce the risks in its asset portfolio (perhaps by having a higher proportion of its portfolio in relatively safe government securities); or it could issue more equity capital and become more like Bank A. The optimal level of equity depends on factors such as the riskiness of the bank's asset portfolio and the extent to which depositors require higher interest to compensate for risk.

Is this example plausible? Is it conceivable that it might be possible in a free market for a bank to be profitable with a relatively high level of shareholder equity? Many would argue that the example I have given is unrealistic because an equity risk premium must be paid for access to equity capital. On that basis, it is argued that banks with relatively high equity could be expected to have a relatively high cost of capital and thus to be less profitable than banks with relatively low equity.

Anat Admati and three of her colleagues provided a pertinent response to the suggestion that increased equity would increase funding costs for banks in their paper: 'Fallacies, Irrelevant Facts and Myths in the discussion of Capital Regulation: Why Bank Equity is Not Expensive'.  These authors draw attention to the Modigliani-Miller (MM) analysis which shows that increases in the amount of equity relative to debt financing simply re-distribute risk among investors. The total funding cost is determined by the total risk that is inherent in the bank's asset portfolio and is independent of gearing. In that context, any losses from using less borrowed funds must be offset by the correspondingly lower cost of equity capital.

The essential assumption of the MM analysis - apart from the assumption (discussed below) of no government intervention favouring either debt or equity funding - is that investors are able to take account of portfolio risk and gearing when pricing securities. Admati et al make the telling point that banks make this assumption in managing their risks.

So, what happens if we relax the assumptions of the MM model by introducing a tax system that encourages debt relative to equity, a government guarantee that banks will not be allowed to fail and protection for depositors? We should expect to get banking systems that are highly geared and fragile – like our current banking systems.

How can governments remove those distortions?  The obvious answer is just do it! However, removal of the tax distortions will require major tax reforms in countries that have classical company taxes. The problem in relation to government guarantees and protection of depositors is that announcements  that they will no longer apply are not likely to be credible (except when made by governments that are so heavily indebted already that further bank bailouts would be impossible in any case).

Does that mean that the best option is for governments to regulate bank behaviour to such an extent that bank failure becomes highly improbable? That approach would suggest that if Basel III is not restrictive enough to make bank failure sufficiently improbable, we should be prepared to move on to Basel IV, and then Basel V, and even to nationalisation of banking if necessary.

At that point I begin to see red. If we are not dealing with a market failure, why are we attempting to displace the market? Is it really necessary to put the entire banking system into a regulatory strait jacket, with all the inefficiencies that involves, in order to live with the consequences of past regulatory failure? Would it not be possible for governments to make a credible commitment never to bail out another bank if they were prepared to spell out punitive action to be taken if regulatory agencies assess banks to be at risk of default? For example, why not announce plans for pre-emptive action to install administrators to restructure banks if they are assessed to be at risk of default?  

Postscript:

With the benefit of comments from kvd and Jim Belshaw (see below) it is clear that the line of argument presented above is not as clear as it could be and contains some unnecessary red herrings.

1.      The definition of banks. For the purposes of this discussion, the distinguishing characteristic a bank is that it is a company with relatively low shareholder equity and a relatively high proportion of debts repayable on demand. Later in the post, my focus is narrowed to financial institutions with deposits guaranteed by governments and/or viewed by governments as 'too big to fail'.

2.      The definition of externalities and market failure. The discussion in the paragraph immediately following the quote from Free to Flourish raises issues concerning the technical definition of externalities and market failure that are a largely a red herring from the perspective of the general line of argument I am developing here. All I needed to say was that while I acknowledge that there may be a case for government intervention based on the existence of market failure, that is not the basis for my concerns about the fragility of the banking system. (Nevertheless, the discussion is raising interesting points. There might be something wrong with our definition of market failure if new information about bank solvency that leads to the collapse of the banking system does not qualify as evidence of market failure. The question that kvd has raised about whether there is a case for government guarantees to cover use bank facilities for every day transactions using is alsoof interest to me. I will try to follow that up in a subsequent post.)

3.      My hypothetical example involving Bank A and Bank B. The example seems to have clouded the point I was trying to make, rather than illustrate it. The point the example was intended to illustrate is that in a free market banks would not have an incentive to seek ever-greater leverage. The rate of return on shareholder funds may rise as leverage increases, but depositors and shareholders would have an incentive to take account of the increasing risk of bank insolvency. As leverage increases the cost of borrowing additional funds could be expected to rise (i.e. the interest rate on deposits would need to rise). And at some point the increase in expected return on shareholder's funds will not be sufficient to compensate shareholders for the increased risk of failure of the firm.

4. Should the Australian government continue to guarantee banks deposits? That is the title of a later post in which I discuss issues raised by kvd.

Will 'Lincoln' encourage people to give more thought to modern forms of slavery?

Since seeing 'Lincoln', the movie, I have felt a need to find out more about modern versions of slavery – often described as human trafficking and debt bondage. Why? The movie made me feel that as author of a book entitled Free to Flourish and of this blog about freedom and flourishing, I should be making more of an effort to come to understand the issues involved in modern versions of slavery and similar restrictions on liberty.

'Lincoln' is basically about wheeling and dealing of politics, at a time when politics was possibly even more venal than it is today. Some people (myself included) find that kind of thing intrinsically interesting. This movie manages to entertain a broader audience because it has colourful characters and a story-line in which the goodies have to win in the end. In my view, the story is inspiring because it shows that fallible leaders can sometimes use democratic political processes to overcome entrenched interests for worthwhile purposes.

Given the history of slave ownership in the US it is not surprising that many politicians would have seen powerful reasons to keep deferring abolition, even while claiming to be opposed to slavery. While slave ownership remained profitable, slave owners had an interest in seeking to retain what they would have seen as property that they had acquired legally. Against that background, it seems amazing that sufficient numbers of representatives were eventually persuaded to take advantage of the opportunity to abolish slavery before the end of the civil war. (I still find it hard to accept that the civil war was necessary, but that is another story.)

I was intrigued by the part of the movie in which Thaddeus Stevens (played by Tommy Lee Jones) tempered his remarks in congress to avoid frightening conservatives that abolition of slavery would be a slippery slope leading to full equality. He refused to be goaded by an interjector to support the view that 'all men are created equal', rather than supporting 'equality before the law' even though he was a lifelong advocate of full citizenship rights:

'How can I hold that all men are created equal, when before me stands stinking the moral carcase of the gentleman from Ohio, proof that some men are inferior, endowed by their Maker with dim wits impermeable to reason with cold pallid slime in their veins instead of red hot blood! …

After further castigating the interjector, the passage ends:

' … even worthless unworthy you ought to be treated equally before the law.'

Those looking for further discussion of the movie should read, among other things, Jim Emerson's article, 'It's true because it works'.

I haven't managed to get far at this stage in learning more about human trafficking and debt bondage. Human trafficking has been defined to include a range of nasty activities - some worse than others in my view.

The UN's 'Protocol to Prevent, Suppress and Punish Trafficking in Persons' defines human trafficking as: 

'the recruitment, transportation, transfer, harbouring or receipt of persons, by means of the threat or use of force or other forms of coercion, of abduction, of fraud, of deception, of the abuse of power or of a position of vulnerability or of the giving or receiving of payments or benefits to achieve the consent of a person having control over another person, for the purpose of exploitation'. 

The US State Department's Trafficking in Persons Report (2012) suggests that trafficking doesn't necessarily require movement of people:

'People may be considered traficking victims regardless of whether they were born into a state of servitude, were transported to the exploitative situation, previously consented to work for a traficker, or participated in a crime as a direct result of being traficked. At the heart of this phenomenon is the trafickers’ goal of exploiting and enslaving their victims and the myriad coercive and deceptive practices they use to do so'.

The State Department also uses the ILO's term 'forced labour' to describe human trafficking. The ILO's estimate of the number of people engaged in forced labour throughout the world is 20.9 million – not much less than the population of Australia. Most forced labour apparently takes place in Asia, although prevalence as a percentage of population is higher in former communist countries of eastern Europe and Africa.

It is fairly easy for people in countries like Australia to claim that that human trafficking is a minor problem as far as we are concerned - and largely beyond our influence. However, people associated with the abolitionist movement in Britain in the 19^th century – people such as John Bright who was also a prominent advocate of free trade – did not take that view with respect to slavery in America.

When Lincoln was assassinated he apparently had in his pocket a testimonial from John Bright calling for him to be re-elected.

Is the history of freedom of speech relevant to the current debate in Australia?

Free speech is certainly in the news in Australia. Early in the week we had the reaction to Tim Mathieson's suggestion that the best way to have your prostrate digitally examined would be to 'perhaps look for a small, Asian, female doctor'. I thought George Brandis, shadow attorney-general, struck the right note when he responded:

'I don't think we want to have in this country a culture of finger-wagging and confected outrage every time someone says something that might be better left unsaid'.

A day or so later, Nicola Roxon, the attorney-general (A-G), backed away from the 'offensive behaviour' provisions of her draft anti-discrimination bill, saying that the main purpose of the bill was to simplify and consolidate discrimination laws and that it 'has never been the government's intention to restrict free speech'. That seems to imply that inclusion of the offensive behaviour provision was due to the Minister's incompetence. I suspect, however, that the A-G knew exactly what she was doing and that she still intends to reinforce the restrictions on free speech in existing discrimination laws.

In an opinion piece in 'The Australian' on Jan. 10, the A-G suggested: 'telling a female staff member "shorter skirts would be better for all girls in the office" might well breach discrimination laws'. I am prepared to accept her word for that, but the example seems to me to raise questions about the desirability of discrimination laws that restrict speech to that extent.

Should anti-discrimination law be applied whenever men refer to their adult female work colleagues as girls (or women refer to their male work colleagues as boys, or even 'old boys') and make mildly sexist remarks about their clothing. I imagine that most males who might use words such as those quoted by the A-G would be intending to engage in good-humoured banter with female colleagues - whom they consider as equals, in the sense of being capable of 'giving as good as they get'. (Foreign readers should understand that friendly exchanges of mildly offensive remarks are a characteristic of Australian culture.) Of course, those who make sexist comments, even in jest, run the risk that work colleagues will consider their behaviour unacceptable and ask for an apology.

That is my point. In modern Australia, when people working in offices find themselves subjected to objectionable speech, they do not need to threaten legal action to ensure that perpetrators suffer humiliating consequences. The A-G apparently thinks threats of legal action are the most appropriate response to bad manners.

In the same article, the A-G suggested her aim is to 'get a tricky balance right' by ensuring that freedoms are subject to 'appropriate limits that provide protection in certain circumstances'. She gives the impression that she accepts free speech as the rule, with restrictions only to be imposed in certain circumstances. Yet, her proposed bill reverses the normal burden of proof. Those accused of discrimination bear the onus of proving that their speech has not been for alleged purposes that are contrary to the discrimination legislation.
 

Politicians might be less keen to use the coercive powers of the state to enforce their notions of political correctness if they read In Defence of Freedom of Speech, by Chris Berg. The main point to emerge from the book is that freedom of speech is at one with freedom of thought. When governments restrict freedom of speech they interfere with the rights of individuals to express themselves. The heroes of Berg's story, Benedict Spinoza and Benjamin Constant, did not confine themselves to support for politically correct speech.

Benedict Spinoza (1632-1677) argued that the presumption should be on protecting freedom of expression rather than limiting it, even though espousal of some doctrines could have negative consequences for society. He blended two arguments for freedom of expression: the natural rights argument that the state cannot control thoughts; and the pragmatic argument that attempts to do so creates more problems than it solves. In relation to the latter point he noted that states which limit freedom find their regulations abused by interest groups seeking to benefit at the expense of others.

Benjamin Constant (1767-1830) also admitted the possibility that free speech 'may corrupt manners or shake the principles of morality', but he argued that people 'should be taught to preserve themselves from these dangers by their own efforts and reason'. Constant suggests that governments that try to enforce uniform belief encourage hypocrisy and resistance:

'To prop up an opinion with threats invites the courageous to contest it'.

Berg acknowledges the contribution to development of free speech by a range of other people. He points out, however, that many of those who have been widely quoted as supporters of free speech were only prepared to advocate freedom of speech under certain circumstances or for certain groups of people.

My only qualification about this book is that I would like to have seen greater recognition of defamation as a legitimate reason for restriction of freedom of speech. At one point, Berg suggests:

'The analogy between property and reputation is widely used but deeply incoherent'.

I disagree. Damage to the reputation of a person or business is equivalent to loss of property. This is most obvious when damage to the reputation of a public company results in a decline in its share price. In many other instances there is a loss of future earnings and/or additional costs incurred that have an assessable monetary value. It seems to me that the relevant issue in relation to defamation is whether individuals or firms have a right to expect the state to defend their reputations. Those who have unwarranted reputations for good conduct, should not have those reputations defended by the state.  

Overall, however, this book seems to me to provide an excellent account of the evolution of free speech in western civilization. 

Postscript:

Soon after this post was written, Nicola Roxon resigned from the position of Attorney-General. We will have to wait and see what that means for the future of free speech in Australia. As James Patterson has noted, the new Attorney-General, Mark Dreyfus is on the record as saying that he considers 18C of the Racial Discrimination Act - the section apparently contravened by Andrew Bolt - is a good law.

I haven't studied the Bolt case, but the judgement does seem to have muffled public discussion of the question of how aboriginality should be defined for public policy purposes. I suspect that potential commentators are now concerned that if they openly express their genuine beliefs on such matters of public interest, they might be required to prove that their remarks constitute fair comment.

Does the value of free speech depend solely on its contribution to democracy?

Several rationales for free speech were discussed in the Finkelstein report on media regulation, which was released in March last year. Incidentally, the report states that it 'must be attributed' as the 'Report of the Independent Inquiry into the Media and Media Regulation'.

Since the report discusses rationales for free speech in a chapter headed 'The democratic indispensability of a free press', it is obvious from the table of contents that Ray Finkelstein sees the rationale for free speech mainly in terms of its contribution to democracy.

I agree that free speech is the life blood of democracy but, as discussed in Free to Flourish, my prior conviction is that the rationale for freedom and democracy rests on their contribution to human flourishing. As I see it, a balanced account of the contribution of free speech to human flourishing would recognize that free speech – freedom of expression - expands the opportunities available to individuals in ways that are not necessarily associated with democratic institutions. It would note that democracy emerged as an outcome of a process intended to protect the rights of citizens (including their right to free speech). It would also acknowledge that the merits of democracy still depend on the potential of democratic processes to defend free speech and the other freedoms that provide the basis for human flourishing.

Defenders of Finkelstein could suggest that 'self-fulfilment and autonomy' and libertarian rationales for free speech are discussed in his report. However, the discussion of self-fulfilment focuses on the views of Katherine Gelber – a follower of Martha Nussbaum– who seems only prepared to defend speech 'that is constitutive of the formation and planning of one's life in ways commensurate with one's informed conception of the good'. Elitist nonsense! Who is to decide what constitutes 'an informed conception of the good'? Are adults who do not have 'an informed conception of the good' to be denied the right to speak their minds?  

Finkelstein's discussion of libertarian theories of the press is under the heading, 'Social responsibility: a theory of the press', so it is not surprising that libertarianism is given short shrift. From what I had previously read about the report, I was expecting that the idea of a free press would be assaulted on the grounds of monopoly, potential abuse or power etc. yawn, yawn. But, after going through all that, Finkelstein asserts that libertarian theory did not provide a workable solution to the challenge provided by broadcasting and that governments 'found it necessary to intervene …'. He adds: 'This amounted to a rejection of libertarian theory'.

Gulp!  So, why doesn't Finkelstein tell us what he thinks, rather than pretending that there was no workable solution other than regulating to control the activities of broadcasters? The workable market solution, as Ray and just about everyone must know, is allocation of the broadcast spectrum, like other scarce resources, to the highest bidder. Does the author have good reasons to believe that would not enable scarce resources go to their highest value use? If the Honourable Ray Finkelstein, QC, former judge of the Federal Court and former president of the Australian Competition Tribunal, thinks that the way government currently allocates the broadcast spectrum is better than the market solution, why doesn't he make the case?

Finkelstein's discussion of the 'search for truth' as a rationale for free speech raises discussion of the 'marketplace of ideas'. He seems somewhat pessimistic about the ability of people to discover truth, but nevertheless remains optimistic about the benefits of democratic discourse – subject to government regulation to ensure social responsibility. He ends up seeing a need to obtain a balance between demands that the media be accountable for exercise of its power and the need for the media to be free to hold governments to account.

I found that discussion to be peculiar. Once the concept of a market for ideas was introduced, it would be logical to expect some exploration of the nature of this market. There is mention of monopoly and competition in the rejection of libertarianism, but no discussion of contestability. Elsewhere in the report, the idea of the conventional media being increasingly exposed to competition from on-line sources is mentioned, as is public scepticism about the veracity of media reports, but the discussion of the rationale for free speech proceeds as though every media outlet has exclusive access to the minds of its customers.

Contestability seems to me to be at the crux of the issue of whether media proprietors and editors have power to exert undue influence on public opinion. The report provides some evidence of media outlets presenting false or misleading reports, but doesn't provide any evidence that these have gone uncorrected elsewhere in the media.

Overall, in my view, the Finkelstein report on media regulation provides an unbalanced account of the rationale for free speech. This part of the report seems to me to display an amazingly brazen degree of bias from an author who favours greater regulation to ensure balance in private media reporting. Some readers might be thinking that comment just reflects the fact that different people have different views of what reporting and analysis is balanced and unbalanced. That is a valid point to make whenever issues of balance arise. In this instance, however, I doubt whether many people who have some knowledge of the topic would view this report as providing a balanced account of the rationale for free speech.

In my last post, I promised to review In Defence of Freedom of Speech, by Chris Berg. Unfortunately, that will have to wait. I thought it would be a good idea to take a quick look at the Finkelstein report before writing my review – and got myself side-tracked!  

Is freedom of speech in Australia protected by international treaty obligations?

A few weeks ago, Jim Spigelman, ABC chairman and former New South Wales chief justice, criticised the federal government's proposed Human Rights and Anti- Discrimination Bill on the grounds that it poses risks to freedom of speech.

Spigelman seems to have been more successful in alerting members of the public to the risks associated with the proposed legislation than have media interests and other advocates of free speech.

Spigelman's drew attention particularly to the provision of the proposed Bill, to be carried over from earlier legislation, that make it unlawful to 'offend' another person. He argued: 

'The freedom to offend is an integral component of freedom of speech.  There is no right not to be offended'.

He went on to say:

'I am not aware of any international human rights instrument, or national anti-discrimination statute in another liberal democracy, that extends to conduct which is merely offensive'.

Spigelman's contribution made me wonder whether the government has considered the incentives that are created when they seek to mute criticism of the practices or attitudes of groups whose members are easily offended and prone to respond to criticism by claiming that they feel insulted or humiliated. When any group can gain advantage by appearing to be easy to offend, insult or humiliate, it is reasonable to predict that other groups will quickly learn how to play that game. Attempts to discuss contentious issues are likely to be increasingly stifled by emotional outbursts of people threatening legal action.

While Spigelman's contribution was welcomed by free speech advocates, James Allan made the interesting observation at Quadrant Online that it was a fairly enervated defence of free speech. He questioned whether it would make would any practical difference if it was lawful to offend people but not to humiliate them. Allan also noted that Spigelman claims to have been influenced by a book by Jeremy Waldron, which actually favours restrictions on freedom of speech in the United States. While arguing for laws to protect 'people's dignity against assault', Waldron suggests that it is not an appropriate objective for the law to 'protect people's feelings against offence'.

Spigelman gives the impression that his defence of freedom of speech is based on the desirability of Australia being seen to comply with its international treaty obligations:

'We should take care not to put ourselves in a position where others could reasonably assert that we are in breach of our international treaty obligations to protect freedom of speech'.

I hope Australia's international treaty obligations do protect freedom of speech. Article 19 of the Universal Declaration of Human Rights seems to provide such protection: 

'Everyone has the right to freedom of opinion and expression; this right includes freedom to hold opinions without interference and to seek, receive and impart information and ideas through any media and regardless of frontiers'.

But the Universal Declaration is not a treaty, so it may not directly create legal obligations for Australia.

I don't know whether any other treaty obligations protect freedom of speech. Having just read In Defence of Freedom of Speech, by Chris Berg, I am not confident that they do. Berg describes how our international treaty obligations were contaminated by restrictions on freedom of speech insisted upon by the Soviet Union. For example, in negotiating the International Covenant on Civil and Political Rights, the Western countries proposed limiting restraints on speech to those that were an 'incitement to violence'. The Soviet Union proposed extending those restraints to 'incitement to hatred'. The wording adopted by the UN requires governments to ban 'incitement to discrimination, hostility or violence'. I fear that a government could even use that provision to help justify suppression of speech that it deems to be hostile to itself.

I will write more about Chris Berg's book in my next post. 

'Could these rules have emerged from agreement by participants in an authentic constitutional convention?'

That question is quoted from the 1986 Nobel Prize Lecture of James Buchanan. It is standard practice on this blog for entries to take the form of questions and answers, but this is the first time my question is a quote.

James Buchanan, an outstanding economist, died last week. There have been many tributes published, some of which are included in a collection published by Alex Tabarrok on Marginal Revolution.

Buchanan emphasized the importance of asking the right questions. He implied that economists were answering the wrong questions when they recommended what policy reforms should or should not be made without considering the preferences of citizens as revealed through political processes.

What did Buchanan mean by 'agreement by participants in an authentic constitutional convention'? The convention is a thought experiment. Its focus is on reforming the rules of the game in ways that are in the potential interest of all players. Agreement implies unanimity – the participants perceive that the rules further their interests. Participants expect the constitutional rules to be in place for a long time, so they are placed behind 'a veil of uncertainty' as to their own predicted interests. Constitutional rules have to be workable in a political system in which the players have the interests and frailties of ordinary humans.

In the prize lecture Buchanan asked a question which is unfortunately just as relevant now as when he asked it. He asked whether the debt-financing regimes of modern Western democratic polities could have emerged from agreement by participants in an authentic constitutional convention. His answer:

'It is almost impossible to construct a contractual calculus in which representative of separate generations would agree to allow majorities in a single generation to finance currently enjoyed public consumption through the issue of public debt that insures the imposition of utility losses on later generations of taxpayers'.

On that basis, Australian economists should not complain too loudly that our politicians have tended to be somewhat obsessed over the last year or so with moving government budgets back to balance. An authentic constitutional convention might see the simplicity of a balanced budget rule as having a lot of merit in helping politicians to resist temptation.

 I had forgotten, until a few days ago, that James Buchanan and Gordon Tulloch (B&T) had written about the concept of 'the good society' in the final chapter of The Calculus of Consent (first published in 1958). I was particularly interested to re-read what they had written in the light of discussion of 'the good society' on this blog and in Free to Flourish.

B&T's starting point is that widespread acceptance of moral principles that are necessary for harmonious social life does not guarantee that individuals will not behave badly to gain unfair advantage over others. They then ask:

'Should the social order be organized to allow moral deviants to gain at the expense of their fellows? Or instead, should the institutional arrangements be constructed in such a way that the "immoral" actor can gain little if at all, by his departure from everyday standards of behaviour?'

The answer they provide is that the relevant choice among institutions is that of 'selecting that set which effectively minimizes the costs (maximizes the benefits) of living in association'. In the political arena, as in other aspects of life, rules of the game need to take account of the potential for the players to attempt to exploit one another by diverging from accepted standards of moral behaviour.

The question which Buchanan asked at the end of his Nobel lecture defines the continuing question of social order. It should be an inspiration to everyone:

'How can we live together in peace, prosperity, and harmony, while retaining our liberties as autonomous individuals who can, and must, create our own values?'

What political issues should Australians focus on in 2013?

Free to Flourish, the book I published a couple of weeks ago, ends by suggesting that the most important contribution anyone can make to human flourishing is to help democracy work effectively. So, it would be reasonable to ask what contribution I am planning to make.

That poses a problem because the current state of politics in Australia is so dreadful that I would rather not think about it. Politics in this country seems to have become almost entirely a game of denigrating the leadership of the opposing side. Democratic politics also seems to be fairly dysfunctional in the United States (as well as in most other countries of the western world) but the politicians in the US have at least had the wisdom to devise a mechanism – the fiscal cliff – to help them to focus on some important economic issues.

Unfortunately, I can't claim that I didn't enjoy watching some of the brawling in Australian politics last year - even though, in retrospect, I might have obtained more lasting satisfaction by spending my time watching mud wrestling. The Prime Minister's famous 'hissy fit', directed at the Opposition Leader, was entertaining to watch the first time, even though it was unfair. I also found it entertaining to observe the PM attempting to defend herself against claims of misconduct as a lawyer 30 years ago. At the time it seemed to be entertaining in the same way that watching a cricket match can be entertaining, even when you know it is likely to end in a draw. There was no clear winner, but the Opposition scored more points than expected by establishing that during the 1990s Julia Gillard apparently thought it was acceptable practice for lawyers to help leaders of trade unions to set up legal entities for particular purposes, while knowing that they intended to use these entities for quite different purposes (e.g. as slush funds to help finance their re-election).

However, what bearing does knowledge that the PM may have engaged in some dubious practices a long time ago, while a practising member of the legal profession, have on how she conducts herself now? The same question can be asked of allegations about the behaviour of Tony Abbott in the distant past.

Do political leaders really think that public fascination with alleged misdeeds of their opponents in the distant past is likely to have a strong influence on the way people cast their votes? The standard answer seems to be that votes might change because 'character counts in politics', but the more plausible answer is that the politicians are actually playing 'gotcha' – the game of digging up dirt on an opponent's past life in the hope that he or she will make a false denial and be caught out lying to parliament.

In my view we have more reason to be concerned about the Prime Minister's current attitudes and policies toward the union movement – which are only too obvious - than about her attitudes and behaviour in the distant past. Similarly, we have more reason to be concerned about the apparent reluctance of the Leader of the Opposition to spell out the policies of his party than about his attitudes and behaviour in the distant past.

To answer the question I posed for myself, I think there are two main political issues Australians should all focus on in 2013.

First, where is where the money is going to come from to fund major government spending commitments in such areas as disability assistance and education? Given common usage of expressions such as 'no-brainer' to describe such commitments, it will be interesting to see whether the leaders of either of the major political parties are brainless enough to make firm commitments to proceed without making detailed proposals for funding – either by raising taxes or reducing spending in other areas.

Second, there is the issue of free speech.  The Attorney-General, Nicola Roxon, is proposing to change anti-discrimination laws in ways that will make it illegal to, among other things, offend or insult people on the basis of their political opinions. I believe that these proposals discriminate against me (and many other citizens) and I feel offended and insulted that the government should attempt to restrict my rights in this way.

We live in strange times when political leaders, who seem to spend much of their lives attempting to denigrate opponents, are now seeking to limit the rights of ordinary citizens to express their political opinions. Citizens should assert their right to continue to offend and insult fascists and others who seek to oppress them.