insights volume 8 november 2010

insightsMelbourne business

and Economics

volume 8 november 2010

Farewell to the invisible hand? A global financial system for the

twenty-first centuryWhat Nobel Laureate Joseph Stiglitz

said in the 2010 David Finch Lecture

The new Australian resource rent tax: the resources super profits tax

By Ross Garnaut

Designing realistic climate policyBy Warwick J McKibbin

Managing a multiple reserve currency world

By Barry Eichengreen

An efficient and fair industrial relations system

By Bruce Kaufman

The dismal science? Thomas Carlyle v John Stuart Mill

By Robert Dixon

Disadvantage across the generationsBy Deborah A Cobb-Clark

Equality, well-being and the work of the Victorian Equal

Opportunity and Human Rights Commission

By Ian McDonald and Helen Mitchell

Rethinking financial regulation By Kevin Davis

Greening consumers: is the prospect blue?

By Angela Paladino

Occasional Address By Robert Officer

Insights: Melbourne Economics and CommerceISSN:1834-6154

Editor: Emeritus Professor Joe Isaac, AOAssociate Editor: Ms Brooke YoungSub-editor: Ms Rebecca Gleeson

Advisory Board: Professor Robert DixonProfessor Bruce GrundyProfessor Bryan Lukas

Design and illustration by: Ms Sophie Campbell

Insights Melbourne Business and Economics 01

insights vol 8

Table of contents

02 Welcome

By Joe Isaac, Editor

05 Farewell to the invisible hand? A global financial system for the twenty-first century

What Nobel Laureate Joseph Stiglitz said in the 2010 David Finch Lecture

‘The reason that the invisible hand often seems invisible is that it’s not there’

11 The new Australian resource rent tax: the resources super profits tax

By Ross Garnaut The future prospects of the resources industries

and the living standards of the Australian people depend on the assertion of private interests being balanced by considered, independent and soundly based assessments of the public interest rather than the political context

21 Designing realistic climate policy

By Warwick J McKibbin The almost religious focus on targets and

timetables – no matter what it costs – is the biggest hurdle to overcome in the climate change policy debate

29 Managing a multiple reserve currency world

By Barry Eichengreen The development of a global reserve system

in which several national currencies have consequential roles is to be welcomed

35 An efficient and fair industrial relations system

By Bruce Kaufman An efficient and fair industrial relations

system gives a balanced weight to the two sides of labour

40 The dismal science? Thomas Carlyle v John Stuart Mill

By Robert Dixon The circumstances in which Economics

was first labelled ‘the dismal science’

45 Disadvantage across the generations

By Deborah A Cobb-Clark Recent evidence from the Youth in Focus

Project indicates that growing up in socio-economic disadvantage has important consequences for the education, health and wellbeing of young Australians

51 Equality, wellbeing and the work of the Victorian Equal Opportunity and Human Rights Commission

By Ian McDonald and Helen Mitchell New approaches by economists to measuring

wellbeing, such as self-reported happiness and measures of freedom and opportunity, give guidance on how human rights and equality can improve individual wellbeing

Alumni refresher lecture series 55 Rethinking financial regulation

By Kevin Davis For Australia, the proposed international

regulatory influences appear most significant in the prudentially regulated banking sector, even though the GFC had most impact on the non-prudentially regulated capital markets and investments sector

60 Greening consumers: is the prospect blue?

By Angela Paladino As researchers, we still need to understand

a number of factors better – why consumers postpone green decisions, and whether they are aware of their true attitude towards green products or whether they have issues at subconscious levels that we need to discover

Occasional Address 66 Career paths, options and risks

By Robert Officer The consequence of exercising options may

mean that, at retirement, you finish working in a career that is far removed from what you may be considering today with your newly minted degree

02 Welcome

The Faculty’s public lectures continue to provide a rich harvest for Insights. Important public policy issues dominate this issue.

Nobel Laureate Joseph Stiglitz heads the list with a spirited analysis of the deficiencies of the financial market, especially of the US, and argues for better regulation not only of the US but also of the global financial system.

Ross Garnaut examines the controversial proposal for a resource super profits tax in the light of alternative resources rent taxes, applying neutrality, government revenue maximisation and stability criteria. He proposes a tax arrangement that would distinguish between the exploration stage and the mine development and production stages.

On climate change policy, Warwick McKibbin discusses the need for a carbon price and various ways of fixing this price. He maintains that climate policy should have a short run carbon price goal and a long run carbon quantity emission goal. Pricing carbon is a necessary but insufficient condition for dealing with climate change and he proposes a ‘hybrid’ system involving ‘constituencies’ – corporations and individuals – driven by ownership of long term rights to minimise carbon emissions.

Insights publishes condensed and edited versions of important public lectures connected with the Faculty of Business and Economics. Its object is to share these lectures with the wider public, especially Alumni. The issues presented and developed generally relate to research findings on public economic and social policy. Insights also constitutes an archival source of an important part of Faculty life. Suggestions and comments from readers on any feature of the journal are welcome.

Welcome

Developing part of Stiglitz’s proposals, Barry Eichengreen argues that the continued domination of the US dollar in international monetary and financial transactions is no longer justified. While aware of certain difficulties associated with a multi-currency reserve system, nevertheless, he expects that the dollar, the euro and the renminbi will form the basis of such a system. Distinguishing between centralised and decentralised industrial relations systems, Bruce Kaufman submits the case for combining efficiency in production with fairness in procedural and income distributive outcomes in order to give balanced weight to the two sides of labour – a human being at work and a costly production input.

The concept and measurement of ‘wellbeing’ comes under scrutiny in the lecture by Ian McDonald and Helen Mitchell. They argue that the commonly accepted measure of wellbeing – GDP per capita – should be replaced by ‘self-reported happiness’ derived from happiness surveys. They maintain that this measure is more robust and avoids the deficiencies of GDP per capita as a measure of wellbeing.

In his Inaugural Lecture, Robert Dixon engages in the history of economic thought, in particular on the label ‘the dismal science’ being hung on


economics by Thomas Carlyle, who also coined the term ‘Captains of Industry’. The background to these expressions and the ensuing criticism by John Stuart Mill of the appropriateness of the dismal science label, tell an interesting story of expressions still in common use but whose authors are largely unknown to most economists.

In her Inaugural Lecture, Deborah Cobb–Clark examines various aspects of intergenerational mobility: its importance, measurement, evidence on various aspects of social and economic mobility in Australia – education, social and health risks, and attitudes – and how to deal with the challenges that are evident.

Aspects of the regulation of financial markets, national and international, following the global financial crisis, are discussed by Kevin Davis in one of the Alumni Refresher Lectures. He examines the severity of the GFC on banks and other financial institutions in a number of countries and analyses the financial interactions and global reform agenda of the G20 countries.

In another Alumni Refresher Lecture, Angela Paladino asks whether all the publicity given to the likely catastrophes of ‘climate change’ has

led consumers to re-evaluate their behaviour and consumption patterns. She finds that research shows a wide variation between consumer intentions and their behaviour. While changes are positive, they are small and slow. What does this portend for the future behaviour of consumers? Will it be ‘blue’ or ‘green’? She concludes with suggestions of what actions governments and organisations can take to speed the change in consumer behaviour.

Finally, in his Occasional Address to graduands, Robert Officer advises that career paths are not pre-ordained. A graduate should consider many options and it is unwise to be too settled too early in a career. While there are risks, seizing opportunities for change may produce positive outcomes.

My special thanks to the team – Brooke Young, Rebecca Gleeson and Sophie Campbell – for their assistance in producing this issue.

Joe [email protected]

Article heading here4


lending policy as ‘predatory’ and directed mostly at the ‘least educated and poorest Americans’. These institutions charge ‘very high’ interest rates – from three-quarters of a per cent to three or four per cent – for products ‘that were inappropriate’ to these customers. Further, the banks were making $30 billion a year through anti-competitive practices in connection with credit cards. They charged high interest rates that effectively constituted a transaction tax on consumers. In contrast, through better financial regulation, Australia avoided this problem.

Banks and other financial institutions are important institutions for a well-functioning economy. The role of finance is to make the rest of our economy more efficient. By allocating capital more efficiently and by absorbing risk, it allows other people to undertake more risk and seek higher return investments. The principle is that, in return for providing these core services, they get a fraction of the increment in the societal efficiency that results from their activities. Their task is to ‘allocate capital, manage risk, and run payment mechanisms’ efficiently. Instead, they misallocated capital, directing it not to productive use but to poor Americans to buy homes beyond their means. Instead of managing risk, they created risk. In doing so, the financial sector took 40 per cent of corporate profits in the US. Also, American banks acted deceptively in their accounting practices and they marketed these ‘creative’ practices to the rest of the world.

Joseph Stiglitz presented a talk in two parts, both focused on the US. First, on how the financial sector has been functioning. Second, on the need for more and better regulation of financial markets, including the global financial system.

How market economies function

On the operation of markets, Stiglitz referred to Adam Smith’s concept of the ‘invisible hand’ as being ‘probably the most influential in economics’, which underlies the belief that the pursuit by individuals of their self-interest in ‘free market economy’ would lead to economic efficiency.

Kenneth Arrow and Gérard Debreu, who both received the Nobel Prize, proved in the 1950s the conditions under which this would apply. One of the lessons of their research was that in fact the conditions under which Adam Smith’s insight would hold were actually much more limited than is properly understood. Besides, if ‘the proof of the pudding is in the eating’, then:

I [Stiglitz] don’t think anyone really believes that the pursuit of self-interest by American bankers, which might be called greed, led to the wellbeing of everybody in our society. Quite the contrary, it actually led to what you call in Australia the GFC, the Global Financial Crisis.

He saw the financial institutions as being engaged in anti-competitive practices and described their

farewell to the invisible hand? a global financial system for the

twenty-first century

‘The reason that the invisible hand often seems invisible is that it’s not there’

An edited version1 of the David Finch Lecture delivered at the University of Melbourne on 28 July 2010. The Lecture was established through the generosity of David Finch, a distinguished alumnus of the University.

what nobel laureate joseph stiglitz said in the 2010 david finch lecture


investors. So the people who are making those decisions are not doing it on their own behalf, they are doing it on behalf of others. So the consequence of all this is that in making those decisions they may have incentives, but those incentives are not well aligned with those on whose behalf they are supposed to be acting.

The compensation structures of bank officials, often based on stock options, were designed to encourage maximum risk-taking and ‘short-sighted behaviour’ in order to raise stock prices. This is a perverse incentive system – officials receive a large share of any gains but do not bear any losses. Moreover, in a bull market, all stocks would be rising not because of the superior performance of executives. A well-designed compensation scheme would reward executives based on their performance relative to that of other firms.

The second problem – externalities – is that the failure of the financial sector has consequences for the rest of the economy, putting the whole economy at risk. Experience had shown that the financial market needed to be regulated to avoid these consequences. Yet many regulations were stripped away in the belief that the market is self-regulating and efficient. Further, when the financial sector changed with the entry of derivatives2, new regulations necessary to deal with them were not introduced. ‘We appointed regulators who didn’t believe in regulation’ and:

One company with an exposure of $1.5 trillion put at risk the whole global financial economy as a result of derivative trading, and the response of the US Congress and a couple of people in the US Treasury was to make sure we don’t regulate it.

Reagan sacked Paul Volcker, who, as chairman of the Federal Reserve, had done ‘an A-plus’ job in bringing inflation down, because he wanted somebody who would repeal the Glass-Steagall Act3, ‘regulation that had worked so well in protecting our economy.’ Following the collapse of the housing boom, his successor, Alan Greenspan, who had been held ‘as a paragon of virtue’, issued a mea culpa – saying ‘he thought the banks would have managed risk better.’ If he had looked at the risks they were taking, he would have realised

What does economic theory have to say?

Adam Smith had said that the pursuit of self-interest would lead to an efficient allocation of resources. Under such efficiency, ‘nobody could be made better off without making somebody else worse off.’

The question Stiglitz asks is: what does modern economic theory have to say about all this? Actually, 25 years before the crisis, modern economic theory had argued that Adam Smith was, to put it mildly, wrong. Now, obviously he had a very important insight – that the pursuit of self-interest provides these incentives. But his argument was not that they were part of making an economy work; rather, that they led to an efficient allocation of resources, or what economists call Pareto efficiency.

Stiglitz’ research on the functioning of an economy with imperfect information or asymmetric information and imperfect risk markets shows that in general the market economy is not efficient. And that’s particularly true in those sectors like finance where information is very important. Within these particular sectors, there is a clear need for government regulation, or some other form of intervention. This is why, for a modern society to function, a balance between the market and the government is needed.

Making the market system perform better

Imperfect information is important in the finance sector because the ‘agency’ issue and ‘externalities’ are significant elements of the sector.

The agency issue is very simple – the people making the decisions on behalf of others, acting in effect as agents, do not bear the ‘full consequences of their actions’. The CEOs of modern corporations are such agents, giving rise to a ‘disjunction’ between the private rewards of the CEOs on the one hand, and the consequences for the shareholders, the bondholders and society on the other. Berle and Means pointed this out as far back as the 1930s, and the problem has intensified since then. Since those days, most of the investment banks were partnerships; now they are joint stock companies. As Stiglitz said:

Much of the savings in our society go through pension funds and other institutional


of the Treasury and financial sector’s resistance to sensible innovations, Stiglitz referred to their resistance to his proposal for US Government inflation indexed bonds. Why? Somebody in the financial sector explained:

The problem is that when people buy these bonds they hold them…When you hold them you don’t make any transaction fees. We make money from transaction fees. We want people to buy and sell, buy and sell, buy and sell. And if they buy it and hold it for 30 years there’s nothing in it for us. We’re not interested in that.

These bonds finally came into the market by the action of the more public-interested financial companies.

‘that [the banks] were too big to fail…the taxpayer would pick up the loss.’ Greenspan ignored the externalities. He didn’t seem to understand why we have regulation in the first place. The presence of externalities is why it is important to have regulations, and why some of these regulations have to be global in nature.

It was argued that regulations would stifle financial ‘innovations’. But innovations were mostly ‘directed at circumventing regulations, taxes, and accounting standards.’ The banks should have focused more on managing the risk of what is the most important asset for most people – owning their house. Instead, ‘they actually made innovations that were worse risk products’ at the expense of ‘poor home owners.’ As an example


The main principles of regulation are threefold – transparency and incentives that avoid conflicts of interest, short-sighted behaviour and excessive risk-taking. Associated with risk-taking is excessive leverage favoured by the financial sector. Nobel Laureates Modigliani and Miller have shown that greater leverage increases the risk of bankruptcy and the resulting social costs.

As for derivatives, some 80 per cent of about $60 trillion were issued by four or five companies but were in effect underwritten by the US taxpayer. It was described by the derivatives industry as ‘insurance’ but it was more like gambling. The

Stiglitz also referred to another innovation – ‘micro-second’ trading, also known as ‘flash trading’, through the use of computers – which, as we have seen recently in the US, can cause great market instability with attendant social costs.

Why financial markets need to be regulated

The fundamental problem is whenever there’s a misalignment of social and private returns, Adam Smith’s invisible hand doesn’t work. And the problem is that this problem is rampant today in the financial sector.


Joseph Stiglitz is Professor at Columbia University, New York, and Chair of Columbia University’s Committee on Global Thought. He has taught at Yale, Princeton, Stanford and MIT and was the Drummond Professor at All Souls College, Oxford. He was awarded the Nobel Prize in Economics in 2001 for his analyses of markets with asymmetric information, and he was lead author of the 1995 Report of the Intergovernmental Panel on Climate Change which shared the 2007 Nobel Peace Prize.

1 Based on the verbatim transcripted version of the Lecture and the slides displayed at the Lecture. The Editor is responsible for paraphrasing and quotations from these sources.

2 A derivative is a security that is based on one or more or assets – including shares, bonds, currencies, and commodities. Its price is ‘derived’ from the value of the assets on which it is based and it tends to be highly leveraged.

3 An Act passed in 1933 prohibiting commercial banks from participating in investment banking activities. It was repealed in 1999.

4 For a detailed development of this point, see the article by Barry Eichengreen in this issue.

exceptions in the current Bill to deal with this problem with greater transparency weaken its effectiveness.

The need to distinguish between commercial banking and investment banking, recognised as far back as 1933 in the Glass-Steagall Act but abandoned in 1991, has come back to some extent under the ‘Volcker rule’. There is also provision to protect consumers and investors, to prevent the excesses that occurred before the crash. However, the legislation is full of exceptions, especially in relation to loans on car sales.

Finally, the creation of a global financial system is also needed to avoid country circumvention, a challenging objective. ‘Economic globalisation has outpaced political globalisation’, and greater political ‘harmonisation’ is necessary. When each country has its own financial protective rules, the global financial market is weakened, as shown by the experience of the US and Iceland. One element in managing global risk better is a new global reserve system that is not dependent on the currency of a single country.4

Stiglitz concluded on the following hopeful note:

The silver lining on the global crisis is that it has brought home the need for global cooperation, and it has also brought home the risks of a failure. In the aftermath of the Great Depression and World War II we realised the problems, the risk of not having global cooperation, and we created the current international institutions. But that’s more than 60 years ago, and those institutions are really not up to the task of the current global economy. So the hope…the silver lining on this crisis, is that we will now recognise this problem, that we will seize this opportunity to try to create more effective global institutions to address the problem of global financial stability.


that the quest for neutrality in taxation reduces itself to finding ways of extracting what is called the ‘economic rent’.1 This rent can be extracted by the owner of the resource or the taxation authority without affecting the amount of investment or production.

The effects of a tax on investment and production cannot be ascertained by examining only the amount of revenue that it collects. As Anthony Clunies Ross and I said on the first page of our book (Garnaut and Clunies Ross, 1983):

Many people believe that the only important characteristic of a tax is how much it takes. This is far from true. The form of the tax may have extremely weighty effects in encouraging some activities or discouraging others. It is easy to assume, as governments often seem to have done in meeting the question of taxing mining companies, that there is a simple dilemma between heavy taxation, which discourages mining, and light taxation, which yields little in the way of revenue. On the contrary, provided that the form of the tax regime is chosen prudently, it is possible to improve the trade-off considerably...

The more that taxation can be concentrated on economic rent rather than on transaction, income, consumption and other tax bases that in varying degrees introduce distortions, the less the economic burden of taxation.

The Resource Rent Tax proposed by the Henry Tax Review, labelled the Resources Super Profits Tax (RSPT), has drawn a powerful negative response from businesses in the resources sector. The Henry Review raises a public policy issue of great complexity and importance. The Australian Government has taken a position based on the Committee chaired by the Secretary of the Treasury, the Henry Review, supporting some hard propositions about the national interest at the expense of some private interests.

However, the manner of public disclosure of such a new, large and complex policy was not world’s best practice, taking industry by surprise with the announcement of changes of immense financial consequence. Given the manner of the announcement, the immediate industry reaction was understandable. Nevertheless, the quality of the policy proposal is not determined by the manner of its announcement. The future prospects of the resources industries and the living standards of the Australian people depend on the assertion of private interests being balanced by considered, independent and soundly based assessments of the public interest and not on the political context.

Super profits, resource rents and neutrality in taxation

An accepted ideal in any system of taxation is that it should as far as possible be ‘neutral’ – that is, ideally the tax should not alter decisions on investment, production or trade. It is recognised

the new australian resource rent tax: the resources super profits tax

The future prospects of the resources industries and the living standards of the Australian people depend on the assertion of private interests being

balanced by considered, independent and soundly based assessments of the public interest rather than the political context

A condensed version of the public lecture delivered at the University of Melbourne on 20 May 2010.

by ross garnaut

12

various hybrids, and include:

– A flat fee;

– The specific or ad valorem royalty;

– A higher rate of proportional profits tax;

– A progressive profits tax;

– A resource rent tax as in the Australian Petroleum Resource Rent Tax; and

– A Brown Tax.3

With a flat fee, an investor makes a once-for-all payment for rights to extract minerals from a leased area. This is a major source of resource rent tax in many developed countries in which resource industries are prominent – for example, Alberta in Canada and Alaska in the US. In jurisdictions in which the flat fee is a major source of revenue, its level is set through competitive bidding. It was tried for a while for offshore Australia, but was disliked by industry and abandoned in the 1990s. It is likely to be a more effective instrument for taxing rents if it is combined with some form of rent tax based on the outcome of an investment i.e. on the value of production or cash flow or net present value. Competitive cash bidding is recommended for new leases by the Henry Review. It would need to be applied by the level of government with constitutional authority for mineral leasing – the Commonwealth offshore, and the states elsewhere.4

Specific and ad valorem royalties are the form mostly applied by the states. They are applied to the volume or value of production. (There are some instances of profit-based taxes in the states and territories, most importantly in the Northern Territory and Western Australia, but also in South Australia. Western Australia applied a royalty in a form similar to the Petroleum Resource Rent Tax on the Barrow Island petroleum field.)

The Petroleum Resource Rent Tax allows a mining company a deduction for all expenses, current and capital, against revenue in the year in which the expenses are incurred. Financial expenses – most importantly, interest on debt – are not allowed as deductions, as they are part of the return on investment. If in any year, the expenses exceed revenues, such negative cash flows are carried forward at an interest rate equal to the

Mineral taxation is an area in which the identification of rent has a clear and practical meaning. Mineral rent is distinguishable from some other sources of rent in two ways that are relevant to taxation. One is that mineral resources are immobile between countries – the reality that is emphasised as a theme in the Henry Review. The other way is that under the constitutions of Australia and of most other countries, minerals are owned by the state, and their extraction is dependent on an exclusive licence provided by the state. When a state or territory government, or the Commonwealth in the case of the offshore areas, allocates a mining lease, it is giving away a piece of state property to a private party. The community has a reasonable expectation that when some of its property is given to a private party, that party will pay its full value. The value of the mining lease being made available to a private party is its economic rent.2

There are therefore two reasons to expect Australian governments to seek to extract the economic rent as revenue – it has lower economic costs than other forms of taxation; and it represents the value of public property that is being transferred to private ownership. Many Australians would add a third reason – that the recovery of mineral rent from the companies represents a move to more equitable distribution of income, in a way that has lower economic costs than other measures to promote distributional equity.

However, one has to be careful that the apparent rent is not what economists call ‘quasi-rents’. The return that a company expects from investment in mining includes a part that represents a return on exploration undertaken possibly a long time ago. That return is a quasi-rent of exploration. A current mine will not be closed down because a tax does not allow a satisfactory return on exploration; but new exploration will be affected. Thus, while a tax could transfer part or all of that quasi-rent from a mining company to the Government without affecting production at established mines, it would remove the incentive for new mine development.

Forms of mineral rent taxation

Clunies Ross and I identified six main forms of mineral rent taxation. These can be combined in

The new Australian resource rent tax: the resources super profits tax


against negative cash flows, until an investment is abandoned as being unsuccessful, or until there is an assessment for Resource Super Profits Tax against which it can be credited. Any unutilised tax credits are accumulated at an interest rate equal to the Government’s bond rate, and carried forward. The Commonwealth Government has accepted the first of the recommendations.

The Brown Tax and the modified Brown Tax versus the Resources Rent Tax

The Brown Tax is, under specified conditions, almost completely neutral. The essential conditions for neutrality are all to do with uncertainty about whether the investor can rely on the cash offsets when cash flows are negative. This is acknowledged by the Henry Review, which also makes the case that it is appropriate to carry uncompensated negative cash flows forward at the Government’s bond rate, because there is no risk of default.5

Clunies Ross and I accepted that the Brown Tax was more nearly neutral than the Resource Rent Tax if the former were presumed to be credible. Nevertheless, we noted a number of disadvantages that have some echo in the recent discussion of the government’s response to the Henry Review (Garnaut and Clunies Ross, 1983, p100).

The Henry Review’s modification of the Brown Tax requires some additional faith on the part of the investor in the stability of the regime. The Henry Review acknowledges that, to preserve neutrality, any perception of risk that future negative cash flows will not be fully compensated, would need to be compensated by some increase in the rate of interest paid to compensate for the delays in having access to cash from the credits.

There is another issue in the modification. The investor will have to raise finance to carry the delay in recoupment of a proportion of its negative cash flows. To the extent that the actual cost of capital for funding the delayed tax credits to a mining company exceeds the Government bond rate, the modification of the Brown Tax would introduce a disincentive to investment.

Clunies Ross and I acknowledged one clear advantage of the Brown Tax over the Resource Rent Tax. In the pure form of the Brown Tax, since

return on capital considered necessary ex ante by a mining company for investment.

The Brown Tax is structurally similar to this type of resource rent tax, except that instead of carrying forward any negative cash flows with interest, the negative cash flows attract a payment equal to the amount of the negative cash flow multiplied by the tax rate.

Clunies Ross and I evaluated the forms of rent taxation by a number of criteria, of which we emphasised neutrality, government revenue maximisation and stability. Stability is important for neutrality and government revenue maximisation. Perceptions of instability raise the supply price of investment – the rate of return sought in advance by investors to compensate for risk. Some forms of resource rent taxation – principally those that automatically increase their shares of revenues when profitability turns out to be high – are intrinsically more stable than others.

The Resource Rent Tax and the Progressive Profits Tax were judged to be superior for stability, followed by the Brown Tax. The flat fee and the Brown Tax were judged best from the point of view of neutrality, with Resource Rent Tax a close second (Garnaut and Clunies Ross, 1983, p110). It was a conclusion drawn from the 1970s-1980s work of Craig Emerson, Peter Lloyd, Clunies Ross and me, that in the then circumstances of Australia, there were advantages in combining competitive bidding for a fixed fee for leases, with a Resource Rent Tax.

The taxes differ in other important respects, including ease of administration. There is inevitable uncertainty as investors learn the details of a new tax.

The Henry Review advocates a modified version of the Brown Tax, accompanied by competitive bidding for leases. The modifications of the Brown Tax are of two kinds. The first is that rather than providing for a cash payment to the investor on negative cash flows at the Brown Tax rate in any year in which cash flows are negative, it allows for the depreciation of capital expenditure over a number of years as with the standard income tax. The second involves delay in payments

14

early 1970s, and the excise rates were then raised as profitability increased with oil prices. By the time they were replaced by the Petroleum Resource Rent Tax in 1990, there had been a considerable period during which there were more years in which royalty rates were changed frequently. As specific and ad valorem royalties rose to high levels, they blocked production from higher cost parts of the oilfields that could otherwise have been developed profitably. Ad valorem royalties on hard rock minerals were also revised upwards when changes in circumstances made projects highly profitable. Iron ore in Western Australia and coal in Queensland over the recent and current resources boom provide important examples of the tendency for royalty rates to change.

Rent taxes which have a larger impact on more profitable projects, and so adjust automatically to changes in circumstances, can be expected to be more stable. This expectation has been evident in practice in many countries. Since the introduction of the Petroleum Resource Rent Tax twenty years ago, its parameters have been stable.

Thus, the greater stability of forms of resource taxation based on profits or cash flows – the Resource Rent Tax and the Brown Tax – can be expected to

no accumulation of negative cash flows over time is required, there is no necessity for the government to decide upon the appropriate discount rate at which negative cash flows are carried forward. This is a considerable advantage. It would be a decisive advantage if the conditions for neutrality of the Brown Tax were met.

Sovereign risk, stability and transitional arrangements

Perceptions that taxation arrangements may change for the worse for investors, raise the supply price of investment. This reduces the rent value of the resource, and therefore the amount of revenue that can be extracted without deterring the investment.

Instability is an inherent feature of the specific and ad valorem royalties that are the traditional means of collecting revenues from mines. They are typically set initially at low rates, but adjusted upwards if outcomes turn out to be favourable for investors. This was the history of taxation on Australia’s offshore petroleum.

Prior to production in the 1960s, ad valorem royalties on oil were set at around 10 per cent. Taxation rates were raised by the addition of a specific excise with the oil price increases of the

The new Australian resource rent tax: the resources super profits tax14


projects lower than to projects in most other countries with relatively rich endowments of minerals. The prospects for the supply price of investment to Australia remaining relatively low would be enhanced if the current focus on resource taxation settles the matter for a long time, as the introduction of the Petroleum Resources Rent Tax did a generation ago.

The total rate of taxation

The most important limit on the total rate of taxation out of income is the maintenance of incentives to economising behaviour for people working within the industry. Here it is the compound marginal taxation rate out of profit that matters – the combined effects of the corporate income tax and the resource rent tax. The RSPT rate proposed by the Government, alongside a 28 per cent company income tax rate, does not breach that limit.

Implications for investment and production – and optimal rates of depletion

Resource taxation can distort and inhibit investment and production in four ways – it can constrain investment in exploration, investment in new mines, investment in expansion of old mines, and production from each mine (the ‘cut-off’ grade). Specific and ad valorem royalties will raise to some extent the cut-off grade in established mines, leaving some economically valuable material in the ground. Resource Rent Tax and Brown Tax will not.

Specific and ad valorem royalties are likely to have some effect in inhibiting investment in exploration, and, less likely, in new mine development and, less likely again, brown-fields expansion of established mines. The RSPT may possibly do so, especially for exploration but the pure Brown Tax will not, so long as investors have full confidence in the stability of the system. Nor will the modified Brown Tax, so long as investors have full confidence that the tax credits with interest will be recouped, and that investors really can obtain finance for the delayed tax credits at the Government’s borrowing rate.

The Government in its announcement of the RSPT presented the results of private sector modelling of

reduce the supply price of investment and to increase both the level of investment and the amount of revenue generated from the resources sector.

The benefits of stability are evident in all areas of policy, and not only in relation to taxation. However, what to do when established arrangements are unfavourable for economic efficiency, and even for the prospects for stability in the future? It is sometimes asserted that investors have rights to stability of arrangements under which they made investments. Such an approach would rule out much reform to improve national productivity or to inhibit activities that were damaging to the environment or otherwise to the community. There would need to be compensation to individuals and firms for the effects of trade liberalisation on the profitability of protected industry; for the effect of industrial relations reform on the income and working conditions of workers benefiting from anti-productive work practices; and for firms in monopolistic industries for the introduction of competition policies. There are no grounds for expecting permanent stability in established royalty regimes although transition arrangements on the introduction of a new tax system may need to be developed by governments.

The absence of property rights in established arrangements does not mean to say that the transitional arrangements do not matter for perceptions of stability. There will be adverse consequences for the supply price of investment if the treatment of past investments does not pass tests of reasonableness. It would be damaging to perceptions of reasonableness on future treatment if the changes affecting future income from established projects left a company in a less favourable position than it would have occupied if the new laws had been in place from the beginning.

Stability in taxation for the resources industries is one dimension of the wider issue of perception of sovereign risk. Other dimensions include security in property rights, security from civil disorder or of financial instability of a dimension that threatens the operations of resource projects, and stability in regulatory arrangements and taxation beyond resource rents. The combination of factors affecting sovereign risk has made the supply price of investment to Australian resource


rates and highly profitable mines at high rates will not cause one country’s high quality deposits to be developed later than low quality deposits elsewhere. However, inefficient rent tax regimes, which raise the cost of marginal mines, may do so. Australia’s established royalty regimes do this to a small degree. Established rent tax regimes in many petroleum-rich economies and the old specific and ad valorem duties in Australia do and did this to a large extent, holding back development of marginal production.

Other features of mineral leasing policies in many countries, and the effects of perceptions of sovereign and wider country risk on the supply price of investment, also influence the order in which mines are developed on a global scale. Incomplete property rights under most resource management systems can lead to premature development of mineral deposits: firms increase early production for fear of losing their rights or being subject to higher taxation later. This was a major factor causing uneconomically low prices for oil in the early postwar decades. This distortion caused countries which left more of their oil in the ground at that time to realise much higher value at a later date. Differences in the supply price of investment also affect the order in which mineral deposits are developed: poorer deposits are likely to be developed earlier in countries that are perceived as being more stable, and which therefore have lower supply prices of investment. Perceptions of instability and a high supply price of investment have held back resources development in many developing countries.

We have insufficient information on matters affecting current and optimal depletion for this to be an objective of public policy in current circumstances. On balance, I would judge these factors on average to cause resource depletion in Australia to be proceeding now at a rate in excess of that which would be generated in a world of perfect information and markets. An efficient system of resources taxation in Australia would only cause a small acceleration of the rate of depletion. The current uncertainty about the Australian resource rent taxation regime is causing some delay in commitments to new resource developments.

the economic gains from shifting from established resource taxation arrangements to the modified Brown Tax. These were based on the assumption that the modified Brown Tax was perfectly neutral. The modelling is plausible on that assumption, as established arrangements do inhibit investment and production in the four ways noted.

If, however, there were imperfect confidence in the stability of new arrangements, or if the cost of capital to some investors for funding the delayed tax credits exceeds the Government’s bond rate, then the new arrangements, too, will be associated with distortion, and dissipation of economic value. If these departures from the conditions of neutrality are ultimately judged to be considerable in extent, it would be worth considering a hybrid of the pure Brown Tax (applied to exploration), and Resource Rent Tax (applied to all other expenditures and to all revenues). The structure of the Petroleum Resource Rent Tax would be an appropriate starting point in design of the RSPT component. The inherent disadvantages of the Brown Tax – doubts that it would be stable when large payments were required especially in times of extreme budgetary pressure – are not present to any comparable degree at the exploration stage. And it is at the exploration stage that the difficulties are most acute in setting an appropriate discount rate under the RSPT.

Implicit in this discussion is that the rate of depletion of Australia’s resources would be optimal in the absence of distorting taxation. Is there any reason why this might not be the case, justifying intervention to accelerate or decelerate the rate of expansion of production? And, as has been asked in the Australian discussion since the announcement of the RSPT, if the Australian rate of taxation out of resources income exceeds the rate in some competing countries, will this cause the rate of investment and production in Australia to fall? And if so, would this be a good or bad thing?

There is an optimal rate of depletion of any non-renewable resource for the world as a whole, and for the allocation of that depletion across countries. The efficient extraction of economic rent will not change the order of development of mines. A rent tax system that taxes marginal mines at low


any royalties paid to the states under the proposed RSPT. This is expedient, but far from ideal.

For one thing, it introduces a new layer of administrative and compliance cost without removing any of the old. For another, it raises some awful questions of definition. How should we regard the proposed increases in iron ore royalties on the large established producers? Or the increases in gold and coal royalties that have been the subject of recent discussion?

The Western Australian Premier has said that he will not be constrained in his imposition of higher royalties by the presence of the RSPT. Best practice would require fundamental reform of federal-state financial relations, through which the Commonwealth becomes the sole collecting agency for mineral rents while the states of origin share the revenue and perhaps accept some power to vary the RSPT rates, alongside acceptance of the fiscal consequences of variation. In the meantime, good order will require the Commonwealth to err on the side of accommodation of the states in transitional arrangements, but without providing open-ended incentives to pre-empt the Commonwealth revenue.

Where do we go from here?

At first sight, we seem to be at an impasse. The resources industries are responding to the Henry Review and Government proposal with concerted pressure and noise, but not yet with analytical statements. However, we are at an early stage of a long debate, and there is time to get it right. Part of the discussion of the national interest will focus on the neutrality of the proposed RSPT. I have identified two issues requiring analysis. One, will investors come to see the loss offsets, and companies’ capacity to carry them forward with interest and to redeem them in cash in the case of failure of an investment, as a reliable and permanent feature of the taxation environment? Two, is it really the case that, with all their imperfections, Australia’s financial institutions will fund delayed credits at the Commonwealth’s bond rate? If it is reasonable to conclude that the answers are broadly in the affirmative, then the Government’s case for the RSPT will be substantially made.

Considerations of optimal depletion would not seem to be strong enough to seek to change the profile of resource development from that which will emerge from focused continuation of current discussions to a timely and most importantly a sound conclusion.

Federal-state relations

The proposed RSPT raises issues of federal fiscal relations that have the potential to be destabilising to the resource industries and federal-state relations. It is important that they be resolved alongside the settling of the structure of resources taxation. This will not be easy.

The Secretary of the Treasury has said to Australian business economists that Australian resources belong to all Australians, so that the economic rent should be collected for the benefit of all Australians. The Western Australian Premier responded by saying that resources belong to the people of the state in which they are mined. However, while the constitutional responsibility for on-shore mineral leasing lies with the states, the Commonwealth has constitutional authority for corporate taxation and an over-riding authority over fiscal matters.

Why have the states not used their powers over mineral leasing to introduce efficient means of resource rent taxation?

Administrative and political capacity, and misconceived ideas about interstate competition for investment, have held back the states. Even more important has been the destruction of state interest in efficient financial management of the resources under their control because horizontal fiscal equalisation, as developed by the Commonwealth Grants Commission and the consequential transfer to other states of most of any increase in revenue.

While the states have not made good use of their constitutional powers to tax mineral rent, they will not lightly let go of the power. The expedient recommended by the Henry Review and adopted by the Government is as good as can be suggested prior to comprehensive renegotiation of federal financial relations – the rebate to resources companies of


Tax. The special arrangements in the RSPT to cash out past losses with interest and to transfer losses across projects would not be relevant and would not apply.

I hope that the relevant governments would also accept the Henry Review’s recommendations on allocation exploration rights by competitive tender where they can reasonably be expected to generate positive value.

These arrangements would have good prospects for future stability. This would serve the interests of investors and the community. They would be consistent with healthy growth in the resources industries in the period of great opportunity that lies ahead.

However, in line with the public interest, the Commonwealth should be prepared to listen to the debate and to contemplate variations on their approach. My own suggestion for consideration has two elements:

1. At the exploration stage, a full loss offset in cash at the tax rate – that is, a pure Brown Tax. The rebate would cancel any need for carrying forward exploration expenditure against revenue in assessment of the resource rent tax. This is quite independent of the proposed rebate of exploration expenditure within the company income tax system.

2. At the mine development and production stages, a resource rent tax in roughly the form and at the rates of the Petroleum Resource Rent


Professor Garnaut is Vice-Chancellor’s Fellow and Professorial Fellow in Economics at the University of Melbourne. He is also Distinguished Professor at the Australian National University; and Chairman, Papua and New Guinea Sustainable Development Program Ltd.

References:

Brown, E. C., 1948, ‘Business-Income Taxation and Investment Incentives’, in Lloyd A. Metzler, H. S. Perloff and E. D. Domar (eds) Income, Employment and Public Policy, Essays in Honor of Alvin H. Hansen, Norton, New York.

Emerson, C. and Lloyd, P., 1981, Improving mineral taxation policy in Australia, Centre for Economic Policy Research ANU, Canberra.

Garnaut, R. with Clunies Ross, A., 1975, “Uncertainty, Risk Aversion and the Taxing of Natural Resource Projects”, The Economic Journal, June.

Garnaut, R. and Clunies Ross, A., 1983, Taxation of Mineral Rents, Clarendon Press, Oxford.

Garnaut, R. with Emerson, C., 1984, “Mineral Leasing Policy: Competitive Bidding and the Resource Rent Tax Given Various Responses to Risk”, The Economic Record, June, Volume 60 (169), pp133-142.

1 Economic rent is the excess of total revenue derived from some activity over the sum of the supply prices of all capital, labour, and other inputs with alternative valuable uses that are necessary to undertake the activity.

2 See Chapter 2 in Taxation of Mineral Rents for an exposition and for the history of thought on mineral rent.

3 The Brown Tax is named after a paper by American economist E Cary Brown, published in 1948 in a now-obscure volume in honour of Alvin Hansen. This tax is the least familiar of the six forms noted. Brown originally suggested it as a substitute for standard profit tax, but it could be applied as a special tax on mining income.

4 The Commonwealth Government’s announcement on 2 May was silent on this recommendation of the Henry Review.

5 This line of argument has ample theoretical justification, for example in the work nearly a quarter of a century ago of George Fane and Ben Smith at the Australian National University, to which the Henry Review refers. In its own terms, it is an elegant answer to a complex question.

Article heading here


and trade’ emission trading market would be a good approach. Cap and trade is based on an assumption rather than a scientific finding about what the annual cap or a cap over a period of time should be. Given a cap, use a market to achieve it. However the initial assumption is wrong – we do not know with any degree of confidence what an appropriate annual cap for a given country should be. Yet, this tends to be the assumption and therefore the economic framework on which many policy reviews are based, for example, the Garnaut Review and Stern Review.2

What needs to be done?

Climate change policy should focus on managing risk and dealing with climate and economic uncertainty. That is the essence of the climate problem. We do not know how much carbon to cut, but we think we should be cutting significantly. We want to manage the risks to the environment, and to the economy. Most importantly, we have to design systems, markets in particular, that let us deal with this fundamental uncertainty. In particular governments need to create markets that are currently missing so that individuals and corporations can manage their own risk in making decisions on technology choice over long time periods.

Pricing carbon is a necessary but not sufficient condition

Addressing climate change calls for a whole range of policies. Carbon pricing needs to be at the core because the carbon price is a way of coordinating

The climate policy problem

Climate policy needs to deal with a problem that is highly uncertain. This is a very difficult policy environment. We see both natural variability and human induced climate change co-existing. To unravel how much of observed climate change is human induced and how much is natural variability is a complex question. Perhaps it will one day be shown that there is no clear link between human greenhouse gas emissions and climate change but it is clear that to do nothing when many experts believe the opposite involves considerable risk. At a minimum, an insurance policy is needed for the climate issue just in case the large body of scientific knowledge is correct.

Science does not tell us exactly what concentration target we should aim for but there is a pretty convincing argument out there that we need to be heading in a direction where we are trying to avoid concentrations of 450 parts per million. Nor are the precise cuts that each country individually should undertake a scientific question even if we knew the global target. The entire climate change issue at the national level is an issue of not just science but of economics, morality, politics and a whole range of other considerations often dominated by religious zeal. Not surprisingly, this is a difficult environment in which to formulate a sensible long term policy framework.

What are the implications of this complexity? Many economists who initially start working on climate policy start with the idea that a ‘cap

designing realistic climate policy1

The almost religious focus on targets and timetables no matter what it costs is the biggest hurdle to overcome in the climate change policy debate

An edited version of the Department of Economics-Melbourne Institute Public Policy Lecture at the University of Melbourne on 26 August 2010.

by warwick j mckibbin


Many ways to price carbon

There are many ways to price carbon. Whatever approach is chosen will require regulations that require a carbon emitter to have a permit to emit carbon or to pay a fee to the government in order to emit. There are different ways of creating a carbon trading system. One way is for the government to limit the supply of permits. This creates a fixed amount of carbon emissions in the economy. The market then determines the price of scarce carbon permits. It is the ‘cap and trade’ permit system as outlined above. An alternative approach is to set a price at which you can buy permits from the government and allow as many permits to be bought from the government as desired in a particular year. This approach is the equivalent to a tax on carbon although it is a permit trading system but with a fixed price. A more direct tax would be not to have a market at all but to charge carbon emitters a fixed amount or tax per unit of carbon emitted.

all the decisions of all agents all over the economy who are making carbon emitting and carbon abating decisions. Therefore, the carbon price has to be designed and implemented very carefully.

There is no doubt that a short-term carbon price is a cost to the economy. On the other hand, a long-term carbon price provides an opportunity for benefits to the economy. These two time dimensions are frequently not distinguished. Many argue that there should be a high carbon price today because that is the only way to stimulate renewable energy. My view is that a high initial carbon price is more likely going to hurt the economy in the short run. What matters for renewable energy sources is not the price of carbon today, but the price that people expect over the next 20, 30 or 50 years. Very clear long term carbon prices for the global and national economy need to be set. This will enable individuals and countries to manage their domestic costs of carbon abatement to suit their national and global self-interest.


Lessons from monetary history

There are some historical lessons to be learnt about linking markets.4 It is possible that once you start trading permits, big transfers from one region to another region of the world can lead to large fluctuations in real exchange rates and trade balances. This volatility can destabilise the global trading system. There are no gains in my view from short term permit price volatility and significant risks in trading across national borders.

The second lesson from historical experience relates to the fact that all attempts to create a single world currency or a system of permanently fixed exchange rates between countries have ultimately failed. The reason there is not a single world currency is the same reason there will never be a single global carbon market trading at a common world price. Emission permits are very similar to national money – they are not a physical commodity. Permits are promises of a government to hit an emissions target in the same way that a unit of money is a promise of a government to maintain purchasing power. The value of that promise depends on the government’s credibility; and because different governments in the world have different degrees of credibility and different incentives over time to debase their currencies, problems could arise with governments reneging on carbon trading markets and debasing the global carbon currency. Indeed there are incentives to do just that in a global carbon market especially when the costs of taking abatement action outweigh the benefits.

The third lesson from history is that many countries have converged in the way they run monetary policy. Economists used to think that you could target the quantity of money and then let short term interest rates fluctuate. In theory, this would lead to a good outcome with the quantity of money tying down the price level. Policymakers discovered very quickly that this did not work very well in practice. In addition, there were substantial costs arising from short-term interest rate volatility. The lesson for monetary policy is that tying down expectations about the policy goal is critical to achieving that goal. In many countries today, the target for monetary policy tends to be inflation, or inflation over the cycle, or

The advantage of the ‘cap and trade’ approach is that once the cap is fixed, the reduction in the level of emissions will be known. The disadvantage is that you do not know what carbon will cost. In fact, a lot of volatility could result in the short-term carbon market because there is no flexibility in the supply of permits. Volatility in short-term carbon markets is good for financial market participants that thrive on making money out of reducing volatility at a price, but does little for the environment or the economy. On the other hand, the advantage of a carbon tax or a market with a fixed price is that you know exactly what the carbon price will be, but you do not know what the emissions outcome will be in any year.

In considering the difference between national markets and global markets, again there are attractions from a theoretical economic point of view in allowing global permit markets to emerge. Using a global market makes it possible to reduce costs in Australia if it proves difficult to hit an annual emissions target. This is the essence of the argument in the Garnaut Review and the White Paper.3 Countries with high marginal costs of reducing carbon emission, can buy permits from countries with low marginal abatement costs. Such trading tends to produce a common carbon price in the global market.

However, while trading is good in reducing the costs of abatement in theory, it does not actually solve the problem of uncertainty. While a target fixed for Australia that turns out to be too expensive can be traded offshore, it does not reduce the global cost of the target fixed for the world. Moreover, there are also some serious problems associated with the global allocation of permits. Trading permits across borders is transferring resources from one country to another through the trading mechanism. This can lead to problems outlined next. A further problem with trading across countries is that it may be associated with considerable short-term price volatility. The European trading system is a good example of how markets can trade from €36 down to €2 just because of some information that is revealed to the market. Shocks in one market would be transmitted instantly to all markets that are linked.


argue that a particular concentrations target is what we are aiming to achieve, but we are not sure when that will be achieved. We also propose a way to distribute this target across countries.

Second, we use this emissions commitment to establish the expected carbon price in a long term market where there is a long term carbon target within each national jurisdiction, in order to drive energy investment decisions. At the same time, we control short-term costs (or carbon prices).

Third, it is also necessary to create markets, which currently do not exist, to enable corporations and households to manage their own climate risks. If a company wants to build a coal-fired power station in the Latrobe Valley, it can hedge that investment in order to proceed despite the risks of having to buy carbon rights today. If the carbon price rises dramatically in the future because emissions need to be cut more quickly than expected, the plant could be closed down, the long term carbon rights cashed in, and a new plant with improved technology built. If, on the other hand, an inventor wants to invest in a new way of sequestering carbon or producing energy that is only economic at a high future carbon price, if the expected future price of carbon is above the required threshold, the investor could fund the project by selling carbon permits forward – hedge – at the expected high price. And if the actual carbon price in the year of delivery does not ultimately reach the threshold price, then the project can be shut down but the carbon rights can be bought at a low price in that year and be delivered at the high contracted price, thus providing a profit to offset the loss of closing the project. Thus, the physical investment can be hedged using financial transaction in the carbon futures market. Financing investment in abatement technology is a key issue that tends to be ignored in the policy debate.

Components of the McKibbin-Wilcoxen Hybrid

First, long term permits are created. These long term permits are a bundle of annual permits with different dates for each annual permit. The quantity of annual permits at each date inside the long term permit become smaller and smaller

other nominal targets, but policy is implemented through manipulating the short term price of money while gradually adjusting to the long term goal. This is exactly the insight and lesson that we should learn for climate policy. Gradually adjust the price of permits to achieve a long term target but let the timetable be the outcome of the process and not part of the target itself.

The lesson is that climate policy should have a short run price goal – the price of carbon to the economy; and a long run quantity goal – atmospheric carbon concentrations. The economy would then move from the short term to the long term in the same way that monetary policy works.

It is clear from the discussion so far that climate policy is more like monetary policy than trade policy. The world and Australia needs a climate policy where there are clear concentration targets, not necessarily annual timetables for emission reductions. Further, as in monetary policy, there needs to be an independent agency at the national level charged with reaching those targets free of political interference but managing the costs of adjustment from where we are to where we want to be. There needs to be a very clear long term price for carbon, because just as it is the long term interest rate rather than the short term interest rate that drives investment, it is the long term carbon price that will drive greenhouse gas-reducing technologies and investment. However, it is necessary to control the short term carbon price in the same way that the short term interest rate is controlled to minimise economic disruptions.

Implementing the analogy between climate policy and monetary policy

The McKibbin-Wilcoxen Hybrid5 is the monetary – inflation target – approach to climate change policy. It can also be implemented as a global system if countries ultimately agree to take coordinated action but it does not require that agreement as a precondition for implementing it as national policy. The Hybrid works in the following way.

First, the aim is to impose a long term carbon concentrations goal – we do not discard emission targets, we only discard annual timetables. We


Think of these long term permits as similar to government bonds of a kind which provides annual coupons that diminish in quantity every year. Thus, if a company owning these emission rights does nothing to change its emissions, the quantity of the coupons disappears in time and more and more rights would need to be purchased in the carbon market to continue under business as usual emissions. The value structure of the bonds provides an incentive for companies and individuals reduce emissions as soon as possible in order to cash in on the bonds.

The second component of the policy – and this is where the central bank of carbon has a key role – is that the central bank should print annual permits in order to maintain a pre-announced price of carbon. The annual price will apply five

over time, so effectively the permits eventually disappear. These permits are equal to the carbon goal. The rights created are a diminishing right to a resource which is the long term target.

These long term permits are allocated freely to households and to industry and can be traded in a long term market. The allocation could be done differently and does not change the basic idea. The permits are owned by consumers and firms who can sell them to generate the revenue needed to reduce their emissions. Why is that important? Because ownership of the right to emit creates a constituency throughout society who own the rights to the carbon and who are empowered to object to any government backsliding on future policy commitment. It also enables those who reduce emissions to gain financially from doing so.


Including developing countries

One of the big problems in international climate negotiations is how to include developing countries, particularly when developing countries are legitimately arguing that they do not want to bear the same costs as industrial countries. What can be done within the Hybrid framework is to negotiate in the international forum, a much bigger allocation of long term rights than a developing country currently emits. This means that the short term price of carbon in a developing country could initially be zero because they are not facing an emissions constraint today. However, they would be facing a transparent constraint in the future. Thus, the long term carbon price in a developing economy will be above zero. Eventually, the short term price would rise over time until they are equal to the price of carbon in developed economies. This is differentiation based on the level of development, but the actual catch-up in price is based on capacity to pay, which is determined by the allocation of long term rights.

Difference between standard approaches and the Hybrid

There are two critical differences between the Hybrid approach and the standard cap and trade approach or a carbon tax. First, the Hybrid creates long term returns to short term actions. If you own the rights for carbon for 100 years and you change your behaviour today to reduce emissions, the benefit you accrue is the present value of a 100-year of emission reductions. Projecting the future reductions in emissions into an asset that can be traded in a market today totally changes the hurdle rates of return for different technologies. It is also a way to finance innovation because it is possible to negotiate with a bank or a venture capitalist on a technology where the investment in this technology can be hedged in the long term permit market. Second, the Hybrid creates constituencies – corporations and individuals – within the domestic economy who own the long term rights to carbon in the economy. Thus, any government that tries to tinker with the future of carbon policy is more likely to face the wrath of the voters who might otherwise under a carbon tax regime lobby for a reduction in future carbon taxes since they do not gain directly from the policy.

years at a time. Every five years the price is reset based on observed emission reductions or as part of a global agreement on the carbon price. If an emitter cannot get enough emissions from its long term allocation, it can obtain an annual permit for a fixed price from the carbon central bank.

What this means is that there is a permanent elastic supply of these annual permits at a fixed pre-announced price in a given year. This acts like a safety valve. It means that in any given year a company can reach its legal emissions requirement either by using an annual coupon from the long term permit or by buying an annual permit – effectively paying a tax – from the central bank of carbon. That is why this policy is called ‘Hybrid’ – it allows trading of the long term permits but with a carbon tax effectively implemented in the form of an annual permit. Thus, emissions can be met from either source.

At a national level, the Hybrid approach controls the short term cost of carbon abatement policy because we currently do not know what the rest of the world will be doing. If the rest of the world has done nothing by way of carbon abatement, the price can be kept low until they undertake serious action. However, if a global agreement eventuates and countries implement policies consistent with it, the short term price would be stepped up over time, based on where global carbon concentration was heading. Thus, this price-stepping approach can be implemented either through national action or through a global agreement.

The way I see the global system evolving is that each country will inevitably have its own system. It might be a carbon tax in a Scandinavian country. It could be a McKibbin-Wilcoxen in the US and EU, but the common element of the system is that there is a uniform price in the short term. Note that this is an efficient outcome because there are no further gains from trading permits across borders because prices are already equalised through domestic action. An American company does not gain by buying from a European company because it can buy the required permits from their own government.


1 Based on joint work with Professor Peter Wilcoxen and Dr Adele Morris as well as on the Lecture published as McKibbin W., 2009, “A New Climate Strategy Beyond 2012: Lessons from Monetary History”, 2007 Shann Memorial Lecture, Lowy Institute Issues Brief.

2 Stern, N., 2006, Stern Review: Report on the Economics of Climate Change, Cambridge University Press, UK. Garnaut, R., 2008, Garnaut Climate Change Review Final Report, Cambridge University Press, Port Melbourne.

3 Department of Climate Change, 2008, Carbon Pollution Reduction Scheme: Australia’s Low Pollution Future White Paper, Department of Climate Change, December.

4 See McKibbin W., Ross, M., Shackleton R. and P. Wilcoxen, 1999, “Emissions Trading, Capital Flows and the Kyoto Protocol”, The Energy Journal, Special Issue, “The Costs of the Kyoto Protocol: A Multi-model Evaluation” pp 287-334.

5 McKibbin W. and P. Wilcoxen, 1997, “A Better Way to Slow Global Climate Change”, Brookings Policy Brief, 17, June, Brookings Institution, Washington D.C.; and McKibbin W. and P. Wilcoxen, 2002, Climate Change Policy after Kyoto: A Blueprint for a Realistic Approach, Brookings Institution; and McKibbin W.J. and P. Wilcoxen, 2008, Building on Kyoto: Towards a Realistic Global Climate Change Agreement, Brookings Institution, June.

Summing up

Climate change policy is a serious issue that all countries have to deal with, especially because of climate change uncertainty. Missing markets need to be created. These are neither short term carbon markets nor a new tax but a long term market in trading climate uncertainty. It is also important to understand that there is still a great deal of uncertainty about where world policy is actually heading. The Garnaut or Carbon Pollution Reduction Scheme type approaches involve a commitment to a precise target or a range of targets on the off-chance that if the target is exceeded, it would be possible to buy cheap permits offshore. What happens if buying abroad is too expensive or the permit market does not develop offshore? Relying on the development of a global trading system without a safety valve domestically is a very risky policy that is acknowledged as a footnote in other policy frameworks but it is at the core of the Hybrid approach.

The final point to stress is that it is critical to get away from the idea that experts know exactly where the world emission profile should be at any point in time and that there are no trade-offs between environmental and economic outcomes in getting there. The almost religious focus on targets and timetables – no matter what it costs – is the biggest hurdle to overcome in the climate change policy debate. There are better ways to generate carbon prices than what is currently being proposed either in a conventional carbon trading market or through a pure carbon tax. One such approach is the McKibbin-Wilcoxen Hybrid.

Professor McKibbin is Professor and Director of the ANU Research School of Economics and Adjunct Professor in the Australian Centre for Economic Research in Health at the Australian National University. He is also a Professorial Fellow at the Lowy Institute for International Policy in Sydney; a non-resident Senior Fellow at the Brookings Institution in Washington D.C where he is co-Director of the Climate and Energy Economics Project; and President of McKibbin Software Group. He is a member of the Board of the Reserve Bank of Australia.


international currency to another, this network-externality characteristic of the international monetary system means that there is room for only one true international unit. Or so it is said.

Favouring a single currency is wrong

In fact, this presumption is wrong, for at least three reasons. First, the notion that importers, exporters and bond underwriters all will want to use the same unit as other importers, exporters and bond underwriters in order to avoid confusing their customers holds less weight in a world where everyone carries in his or her pocket a cell phone that can be used to compare currency values in real time. Once upon a time, comparing prices in dollars and euros may have been beyond the capacity of all but the most sophisticated traders and investors. But this presumption is no longer valid in an age when ‘Currency Converter’ is one of the top ten most downloaded wigits at Apple.com.

Second, the sheer size of the global economy means that there is now room for deep and liquid markets in more than one currency. Once upon a time it may have been plausible that only one treasury market could achieve the scale required to drive bid-ask spreads to low levels and allow investors to undertake a substantial volume of transactions without moving prices. But with the growth of the global economy, the requirements of minimum efficient scale no longer imply that only one currency can support such a market.

The dominance of the US dollar

After World War II, the US economy dominated what was known as the free world, and the dollar dominated its monetary and financial system. Now, six-plus decades later, the US is no longer so dominant economically, but the dollar nonetheless continues to dominate international monetary and financial transactions. I argue that this peculiar situation will not last. Just as the world economy has grown more multipolar, its international monetary system will grow more multipolar. The system that is coming is one in which the dollar, the euro and the renminbi will all be consequential reserve and international currencies. Because old habits die hard, even now the dollar plays a disproportionately important role. But just because this is true today does not mean that it will still be true tomorrow.

It is widely argued that, since it pays to use the same unit that everyone else uses, there are strong increasing returns to using a single national currency in international transactions. For importers and exporters, quoting prices in the same currency as other importers and exporters avoids confusing one’s customers. For central banks, holding reserves in the same currency in which other central banks hold reserves means holding the most liquid asset. With everyone else buying, selling and holding dollars, it pays to similarly buy, sell and hold dollars. While it is always possible that there could come a tipping point where everyone migrates from one

managing a multiple reserve currency world

The development of a global reserve system in which several national currencies have consequential roles is to be welcomed

A condensed version of the 2010 Corden Lecture delivered at the University of Melbourne on 4 August 2010. This lecture draws on a paper by the same name prepared for an Asian Development Bank-Earth Institute Project on the future of the Global Reserve System.

by barry eichengreen

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markets are a heterogeneous collection of national markets, not all of which are attractive to central banks and governments. German bonds may be attractive, but the market in them is less than a quarter the size of the US treasury market.

The Greek crisis has shown that this status quo is untenable. The decision in the 1990s not to create an emergency financing mechanism for illiquid governments or an orderly resolution mechanism for insolvent governments, but to nevertheless plow ahead with a single currency, leaves Europe in an impossible position. Ultimately it will be compelled to create that emergency mechanism and fund it with subscriptions, using taxpayer dollars, like the subscriptions with which it funds the European Central Bank. This will be the first step in the direction of creating a market in euro area bonds backed by the full faith and credit of euro area governments as a group. It will be the first step toward creating a euro bond market with the depth and liquidity to rival the market in US treasury bonds.

In the longer run, there may be more grounds for worrying about the dollar. Dysfunctional politics continue to undermine efforts to bring US budget deficits under control. Federal government debt will soon reach 75 per cent of GDP. For a federal government that mobilises only 19 per cent of GDP in taxes in good times, this is a considerable burden. Fully a quarter of the tax take will go to debt service once interest rates return to normal levels. And the fiscal situation only darkens after that.

The question is whether the US will come to grips with these problems before things get out of hand or resort to the inflation ‘tax’ to fill the fiscal gap. The fact that foreigners now own a majority of US treasury securities will make it more tempting to pursue the second alternative. But foreigners are perfectly capable of the same calculation. If they see the US as unable to solve its fiscal problem, they will dump their dollars in favour of alternatives. To be clear, this is not my baseline scenario. The US has shown itself capable of dealing with significant challenges before. Hopefully it will do so again. But if it does not, this would spell the end of the dollar’s role as an international currency.

Finally there are the challenges that China must surmount in order to internationalise the renminbi. It will have to build deep and liquid

Third, a careful reading of history is at odds with the notion that there can exist just one international currency at any point in time. Before 1914 there were three: the British pound, the French franc and the German mark. The dollar and the pound similarly shared the international stage in the 1920s and 1930s. That currencies other than the dollar today account for nearly 40 per cent of identified international reserves is again inconsistent with the presumption that there is room for only one true international and reserve currency.

Difficulties with a multiple reserve currency system

The most compelling objection to the argument that we are now moving toward a multiple reserve currency system in which the dollar, the euro and the renminbi all play consequential roles is that one or more of these currencies is an implausible candidate for international currency status.

At the time of writing, pessimism is most pervasive about the euro. The euro area is growing more slowly than the US. European firms undertook less extensive restructuring than their American competitors during the crisis, so their labour productivity is now growing more slowly. The euro area has made less progress in restructuring and recapitalising its banks. A number of euro area countries have very large deficits and heavy debts, raising questions about the sustainability of their public finances. Then there is the crisis in Greece, which has raised questions in some minds about the very survival of the euro.

All this doom and gloom is overdone. While a Greek default cannot be ruled out, neither can a default by the city of Los Angeles. And a Greek default will not mean the break-up of the euro area any more than a default by Los Angeles would mean the end of the dollar. Moreover, Greece would almost certainly make its problems worse by attempting to reintroduce the drachma. Germany, for its part, has too much invested in the European project to turn back now, which is what abandoning the single currency would entail.

The real problem the euro has as a candidate for international currency status is the absence of a government bond market comparable to the US treasury market. Europe’s government bond



The dollar, the euro and the renminbi all have their problems. However, the very fact that there are doubts about all three currencies suggests that there will be a demand for all of them.

The role of Special Drawing Rights1

This is a long way into a lecture on the international reserve system without mention of Special Drawing Rights (SDRs). In fact, the delay is appropriate. For SDRs will remain at best a small player in the international monetary system in the foreseeable future, as relevant to practical policy making. Countries may agree to the issue of some modest additional SDRs. This would be better than allowing a handful of reserve currency countries to monopolise the gains from creating international credit. It would further reduce the ability of the US to run larger current account deficits and allocate foreign funds in riskier ways than would be the case otherwise. It would be a way of advancing other social goals, especially if agreement could be reached on allocating SDRs mainly to poor countries. However, the idea that SDRs may modestly supplement national currencies is different from the view that it can replace them, or that ten years from now SDRs will rival the dollar, the euro and the renminbi as a form of international reserves.

History offers two lessons relevant to the SDR debate. First, central banks do not find it attractive to hold reserves in a unit that is not also widely used in international transactions. Only if a unit is privately used is it also convenient for official intervention in private markets. The SDR is not easily used for foreign exchange market intervention. It is not an obvious unit in which to provide emergency liquidity assistance to banks and firms with dollar-, euro-, or renminbi-denominated liabilities.

Second, creating private markets in SDR-denominated claims will not be easy. The IMF simplified the SDR basket in 1981 with the goal of doing just that, but the effort was unsuccessful. Some investors may prefer a ‘basket’ to a single currency because of its diversification and stability characteristics, but nothing prevents them from creating their own basket out of existing currencies. Markets in those currencies are already

financial markets and make them accessible to foreign investors. It will have to remove many of the financial restrictions that are integral to its development model. It will have to establish rule of law. All this is not something that will be completed overnight.

But Chinese officials are serious about transforming Shanghai into a first-class international financial centre by 2020. They have negotiated renminbi swap arrangements with other Asian countries. They have encouraged use of the renminbi in bilateral trade transactions. They have authorised the issuance of renminbi-denominated bonds in Hong Kong and done a sovereign RMB issue there themselves. The next major step will be when they permit foreign banks and firms to issue, purchase and sell renminbi-denominated bonds in Shanghai.

To be sure, this financial development, deepening and opening, will erode the capacity of the Chinese authorities to channel finance to favoured firms and sectors, undermining one of the traditional pillars of China’s development model. If we know one thing about Chinese officials, it is that they are not inclined toward radical changes. Their move away from the traditional model will be gradual.

That said, observers may be underestimating how quickly the renminbi will be adopted as a currency in which to invoice and settle trade, denominate international financial transactions, and hold central bank reserves. The US moved from a starting point where the dollar had no international role to one where it was the leading international currency in just ten years. In 1914, approximately zero per cent of global reserves were in the form of dollars. Zero per cent of global trade was financed and settled in dollars. Even US exporters and importers went to London to obtain trade credit in sterling. But only ten years later, in 1924, more trade finance was obtained in New York than London and accounted for by the dollar than the pound. The dollar had become the leading reserve currency. US history thus suggests that the transition can occur more quickly than conventionally supposed. Note also, how these facts are again inconsistent with the notion that network externalities tend to lock in strongly the privilege the incumbent international currency has over all others.

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SDRs. A global central bank that was independent, autonomous and held a pool of national currencies could then swap them for SDRs, without conditions on demand. But painting the picture this way makes clear why this is not going to happen. If we know one thing about central bank swaps and IMF programs, it is that they can be either unlimited or unconditional, but not both.

The shareholders in a global central bank will be willing to provide it with large swaps only subject to conditions. The US will provide it with the dollars it needs to swap them for SDRs in an emergency only if it approves the conditions governing the swap. It will allow the IMF to borrow or buy dollars on the market in the quantities needed to be swapped for SDRs only if it approves the conditions governing the swap. A consequential role for the SDR in the international system presupposes the existence of an independent global central bank with autonomy to make decisions concerning its own funding and lending. Putting the point this way shows why the role of the SDR will remain limited.

Will a multiple-international-currency system be unstable?

Some worry that a multiple-international-currency system would be dangerously unstable. With dollars, euros and renminbi all trading in deep and liquid markets and being substitutes for one another, their

more liquid than markets in SDRs. Investors can construct their own bespoke baskets that fit their needs better than the international community’s one-size-fits-all SDR basket.

Some will object that this emphasis on private markets is misplaced. It would be enough, they argue, for governments to commit to accepting SDRs in settlements among themselves and with the IMF, and to stand ready to convert SDRs into national currencies without limit on demand. But this is precisely why SDRs will not play more than a limited role in the international monetary system going forward. For SDRs to play a substantial role, countries like the US would have to accept substantial quantities of SDRs, and pay out dollars in return, on demand, without conditions. This would be equivalent to the international swap lines in which the US Federal Reserve provided $30 billion of dollar-denominated credit to four central banks in response to the dollar stringency that arose in the autumn of 2008. The difference in an SDR-based system is that the US liability would be larger. The US might be prepared to provide larger currency swaps, but only subject to conditions. But then the system would not be characterised by the large, unconditional credit lines that the proponents of an SDR-based system have in mind.

Alternatively, swaps could be provided by the quasi-global central bank responsible for issuing



Indeed, there is reason to think that allowing exchange rates between the major currencies to float would help to stabilise the system. It would allow policy authorities in the reserve-issuing countries to prevent internal and external imbalances from building up. Moreover, it would avoid creating one-way bets for currency speculators, where everyone gangs up against what is currently the weakest currency. The fact that exchange rates between the major currencies can move either way on a day-to-day basis discourages precisely the kind of destabilising behaviour feared by critics of the emerging multiple-international-currency system.

Reform of the international reserve system

In thinking about feasible and desirable reforms of the international reserve system, it is useful to remind oneself of the kind of global economy that we can expect to see develop in coming years. The fact that the world economy will become even more multipolar is the fundamental reason for thinking that the reserve system will become more multipolar. At the same time, national sovereignty will remain a fact of the world economy in the twenty-first century. International relations will continue to be organised on the basis of the interaction of sovereign states – within the framework, one hopes, provided by multilateral institutions.

This points to the development of a global reserve system in which several national currencies have consequential roles. In this lecture, I have suggested that this development is to be welcomed, not feared.

Professor Barry Eichengreen is George C Pardee and Helen N Pardee Professor of Economics and Political Science in the Department of Economics at the University of California, Berkeley.

1 A monetary reserve currency created by the International Monetary Fund to supplement the existing reserves of member countries.

2 Hedge fund managers typically receive a commission of 2 per cent of the value of the assets they manage plus 20 per cent of the profits.

exchange rates could become dangerously volatile. Substitutability will create the temptation to shift erratically between them. Even a limited loss of confidence in the policies of one of the reserve-currency countries could cause central banks to rush out of its currency, aggravating financial difficulties in that country – and elsewhere.

In fact, this view is based on a mischaracterisation of the behaviour of central bank reserve managers. Reserve managers do not seek to maximise returns in the manner of hedge-fund managers. They have social responsibilities, and they know it. They do not have the same high-powered financial incentives – they are not compensated on a 2+20 scheme.2 They do not have to exceed their previous high-water mark in order to draw a paycheck. They have less incentive to ‘herd’ – to sell a currency because everyone else is selling. They can adopt a longer horizon because they do not have to satisfy impatient investors.

Private investors can find it hard to act as contrarians. Even if they think the price of an asset has been beaten down, they find it hard to take a long position without an expectation that the price will recover within a reasonable period. Funding the position is expensive. They face impatient investors who will see the funding cost but not the return. Central bank reserve managers, with their longer horizons and guaranteed funding, are in a better position to act as stabilising speculators, buying an asset whose price has been beaten down.

What can be done, policy-wise, to stabilise a multiple-international-currency system? Sound and stable policies on the part of the reserve-issuing countries are key. In contrast, the system could be set up for a painful fall by chronic budget deficits, lax supervision and regulation of financial markets and institutions, and bubble-ignoring monetary policies.

Futile efforts to stabilise exchange rates between the reserve currencies would not help. Economic conditions and therefore appropriate monetary policies will continue to differ. The idea that the US, the euro area and China are prepared to subordinate domestic policy objectives to the defense of target zones between their currencies is unrealistic. Any attempt to put such zones in place would quickly come undone.


of research in IR, therefore, is to discover the explanatory variables that influence and shape different IR systems’ configurations. Some of these explanatory factors reside internal to firms, such as the nature of the production technology and the size of the workforce; others reside external to the firm, such as the legal framework, the development/prosperity of the economy, and prevailing social norms.

A hallmark of rational choice theory is that people make decisions based on a more-or-less conscious and purposeful weighing of benefits and costs. Calculation of benefits and costs, however, cannot proceed until one specifies the end goal(s) that agents are seeking to attain. At a broad level, the presumption typically made in IR research is that two objectives are paramount – or should be paramount – as guides to choice among alternative IR systems. The first is attainment of efficiency in production; the second is fairness in procedural and distributive outcomes. The priority and meaning of these goals differs considerably across nations and firms, however, depending on the particulars of the social choice process, the interests of the people in power, and the social conceptions of fairness – thus imparting further variation and complexity to the identification and explanation of IR system models. In particular, what is regarded as ‘efficient’ and ‘fair’ depends critically on who is in control of decision-making and thus whose interests are served, and their ethical/social norms and concerns.

The importance of industrial relations

A very large proportion of people work in some form of paid employment during their lifetime. Further, income from work is the major source of financial support for most individuals and families. Not surprisingly, therefore, the world of work and employment – that is, the subject area of industrial relations (IR) – occupies a prominent place in both academic research and public policy. Political debate in Australia during the last two election cycles over the Work Choices legislation amply documents this point.

A key conceptual tool in IR research is the notion of an IR system. An IR system is the constellation of institutions, rules, practices and governance procedures that organise and structure work and employment. A central proposition of IR, in turn, is that workplaces, industries and nation states sort into distinct types of IR systems. At the nation state level, for example, authors often distinguish between the Anglo-American, Rhineland, Mediterranean, and Asian IR systems; at an industry and occupational level, they use other classificatory schemes, such as simple, machine, bureaucratic and high involvement IR systems.

Since organisations, labour markets and employment practices are human constructs, the particular configuration of an IR system, be it at the firm or nation state level, is the product of conscious human choice. A central object

an efficient and fair industrial relations system

An efficient and fair industrial relations system gives a balanced weight to the two sides of labour

An edited version of his keynote speech delivered at the 2010 Isaac Industrial Relations Symposium at the University of Melbourne on 20 August 2010. The Symposium was established by the University of Melbourne’s Centre for Human Resource Management and Monash University’s Faculty of Business and Economics.

by bruce kaufman


services. This economy may be labeled ‘Perfect Decentralisation’ (PD), since it produces GDP at the lowest possible level of aggregation where DS and the ‘invisible hand’ coordinate everything.

At the other extreme is ‘complete make’. Here, the entire division of labour is coordinated by management using CA. This economy may be called ‘Perfect Centralisation’ (PC) since one manager – the nation’s ‘CEO’ or ‘central planner’ – in effect coordinates all economic activity. PD has a plentitude of single person firms; PC organises the nation into one giant firm (or factory).

This distinction between a ‘complete market’ economy versus a ‘complete planned’ economy highlights the two polar cases that societies have swung back and forth between since the advent of capitalism in the seventeenth and eighteenth centuries. Adam Smith made the case for an economy of considerable decentralisation guided by the invisible hand of competition and DS; Karl Marx made the case for an economy of considerable centralisation guided by the visible hand of socialist planners and CA.

Decentralised and centralised IR systems

We now come back to the subject of IR systems. One can appreciate that the systems of employ-ment institutions, rules, practices and governance procedures will differ greatly between an economy of, respectively, PD and PC. Indeed, in the former, the economy has no employees – in the legal/conventional sense – or multi-person firms, so it can likewise dispense with many of the accoutrements of real life IR systems, such as labour laws, trade unions, human resource management (HRM) functions, and employee pension systems. In such a world, the invisible hand of competition in markets perfectly allocates labour resources among firms and occupations, provides opportunities for people to buy desired skills and training, protects labour service providers from work risks and exploitation, and guarantees full employment conditions through flexible price/wage adjustments.

The nature of the IR system in an economy of PC is quite different. The economy is organised as one giant ‘unitarist’ company where competition

Designing an efficient and fair IR system

Choice among IR systems is, therefore, guided by the specification of the efficiency and fairness objectives, the internal and external opportunities and constraints in the work-world faced by decision makers, and the strategic choices made in relating means to ends.

In the theory of IR systems, attention is first directed toward the efficiency goal. Based on insights from institutional economics, IR conceptualises efficiency as a choice of how to best coordinate the division of labour. That is, every firm and society engages in specialisation in production and the problem is how to manage and coordinate the activities of individual people so they ‘add up’ to the most efficient possible output level (e.g. GDP for a nation state).

For theorising purposes, it is useful to recognise that two polar methods exist for coordinating the division of labour at both the micro (firm) and macro (nation state) levels. The first is market coordination by prices and demand/supply (DS); the second is organisational coordination by managers and command/administration (CA). In real life, economies use both methods to coordinate the division of labour; that is, in this type of ‘mixed economy’ some products/tasks are done in Firm A and purchased by Firm B – the ‘buy’ mode; while others are done inside Firm A and then passed up the vertical chain of production – the ‘make’ mode. A concrete example is an auto assembly operation where some components (e.g. tyres) are acquired externally via the market while other components (e.g. headlamps) are made inside according to management command.

Insight is gained if attention is given to the two polar cases of ‘complete buy’ and ‘complete make’. In the former, every individual task and product is coordinated and transferred across people through markets and DS. In such an economy, all firms dis-agglomerate into single person proprietorships and family firms. Thus, the auto assembly plant is a single person firm owned by one person (e.g. Henry Ford) that produces cars with labour services purchased (in product markets) from thousands of independent contractors, such as ‘Joe Jones Windshield Installation Ltd’, who sell specialised


greater collective regulation and coordination (e.g. Japan, Latin America); and yet further to the PC end of the middle are countries with considerable union density, considerable workplace regulation, and extensive training and social insurance programs (e.g. Sweden, France). Finally, altogether outside the middle and located considerably closer to the PC end are countries such as China, where employment is heavily regulated, free labour markets are heavily restricted, and central command and control of HRM policies and practices is pronounced.

The same kind of analysis could be done for IR systems at the firm level. Some firms, such as small retail stores, adopt a ‘simple’ IR system – closer to the PD pole – that is tightly linked to the external labour market, has few HRM practices or employee benefits, and experiences considerable worker turnover. Other firms, such as poultry processing plants, adopt a ‘factory’ type IR system where work is tightly organised and structured. Universities fall into a ‘bureaucracy’ employment model.

It was emphasised earlier that choice among IR systems is made by human beings who are

among firms is replaced by cooperation among production units. The visible hand of a central planner perfectly allocates labour to all jobs and tasks; labour is managed within a system-wide ‘internal labour market’ where horizontal and vertical mobility of workers is coordinated not by wage differentials but administrative directions; and HRM is responsible for all aspects of employment, such as benefits, safety, training and staffing.

The value of these polar cases is that they highlight conditions underlying different IR systems as encountered in the real world of mixed economies. Some real life IR systems locate closer to the PD pole, some locate closer to the PC pole, and yet others mix and match characteristics of the two and locate somewhere in the middle region. Thus, at a national level the IR system of a country such as Cuba or North Korea is located quite close to the PC pole while the IR system of a neo-liberal economy, such as the US, is located closer to the PD pole. In the broad middle, but starting from the US end, are countries with modestly more collective organisation and regulation of employment (e.g. Canada, UK, Australia); located more toward the middle are countries with still


extensive and formalised. Some countries such as Russia, China and Cuba moved considerably further toward centralisation, adopting some form of a socialist economy; while others – the US being an exemplar – retained a relatively more market oriented employment system.

Economic and political pressures have brought a turn-about in the last three decades. Across nation states, industries and firms we see a movement back toward a more decentralised and market-anchored system. At the national level, this market drift is evident in the collapse of most socialist (‘command’) economic systems, the movement of social democratic economies (e.g. Germany, Sweden) toward a more open and deregulated model, and – at least until the financial crisis of 2008-present – the worldwide intellectual and policy ascendancy of the Anglo-American ‘neoliberal’ market economy model, most evident in and strongly advocated by the US. At a firm and industry level, these same trends are evident in the break-up of large conglomerate firms, dismantling of life-time employment systems, tighter linking of pay and benefits to market forces, and the shift of employment and compensation risk from employers to employees.

The movement toward greater organisational decentralisation and market sensitivity has numerous causes. New computer and tele-communications technologies have made possible more disbursed and flexible production operations; globalisation has exerted strong pressure on companies to reduce cost; and foot-loose capital and scarcity of good jobs have given many companies the upper hand in bargaining with employees.

Also aiding and abetting these trends in the world of industry, are intellectual trends in the world of ideas. Since the early 1970s, the Chicago School of Economics has gained considerable influence and prestige among economists and policy-makers, and the hallmark of the Chicago reform program is a move toward more ‘free’ labour markets. This means, in practice, reduced government regulation of employment, fewer and less powerful unions, greater individualisation of employer-employee relations, and a tighter linkage between market forces and terms and conditions of employment.

guided by certain objectives, face various diverse opportunities and constraints from external and internal factors, and adopt different strategies for best linking means to ends. In capitalist economies, and particularly in the ‘for-profit’ sector, the presumption is that competitive survival forces lead owners/executives to choose employment systems that are cost effective (efficient). To at least some degree, albeit with perhaps considerable imperfection, firm owners and managers are also led to adopt employment systems that are perceived by employees as at least minimally fair – given that perceptions of unfairness lead to employee behavioural responses such as high quit rates, low work effort and desire for unions, that hurt organisations’ efficiency and profit objectives. However, a major area of debate is just how well market forces perform in ensuring fairness. These survival/adaptation pressures are less potent in the public and not-for-profit sectors but, nonetheless, are still present and cause organisations in these sectors to also adopt employment system models that meet their objectives, albeit with more attention to fairness (broadly defined).

Twentieth century trends and current debates

Employment systems at the industry and firm levels exhibit both significant areas of stability and change over time, as one may visualise with regard to the organisation, governance and performance of work a century ago and today in, say, auto plants, mining operations and hospitals. The same trends are also evident at the national level.

As a broad generalisation, national trends in employment systems over the twentieth century have divided into two eras. For the first seven-to-eight decades, countries tended to move from the decentralisation/market (PD) mode to the centralisation/organisation (PC) mode. That is, from 1900 up to the late 1970s employment gradually became less market coordinated and more coordinated by administration and organisation. In Australia, for example, market wage determination became more centralised through the arbitration and award system, union density grew substantially, a plethora of labour laws were enacted, and HRM systems became more


or ‘social minima’ of job security, decent pay, fair treatment, and opportunities for voice and redress of grievances.

The delineation and construction of an efficient and fair IR system is contingent on a variety of technological, economic, political and cultural factors that differ across nations, firms and time periods, thus precluding a ‘one size fits all’ model. The central proposition of IR, nonetheless, is that the best outcome for society, employers and employees is some model broadly in the middle of the market/organisational (or PD/PC) spectrum. Market forces are important to spur employment flexibility, cost control and productivity; likewise, organisational coordination and protection are important to provide stability and security in employment and thereby efficiency through improved cooperation, skill development and esprit de corps.

Thus, the efficient and fair IR system gives a balanced weight to the two sides of labour – a human being at work and a costly production input; and the two sides of economic coordination – demand/supply in competitive labour markets and management command and administration in hierarchical organisations. In such a balancing of economic and human imperatives, some degree of ‘labour protectionism’ is not only good on ethical grounds but also because it makes the employment relationship more secure, stable and fair – and thus more productive and prosperous.

Bruce E Kaufman is Professor of Economics, Georgia State University; Senior Research Fellow at the Centre for Work, Organisation and Wellbeing at Griffith University; and Principle Research Fellow at the Work and Employment Unit at the University of Hertsfordshire.

Implications for an efficient and fair IR system

The interesting policy question in today’s context is how far countries and companies should press on toward the decentralisation/market model. To some degree, they are pressured by global market forces outside their control; in other respects, however, both nations and companies can choose among alternative strategic paths for their IR systems.

Many economists, enamored of the virtues of competitive markets and Adam Smith’s invisible hand, press for further labour market opening and deregulation. The market, in this view, promotes both efficiency and fairness – efficiency because competition provides strong incentives for firms to innovate, contain cost, and serve customer needs; and fairness because workers can move to other firms if ill-treated.

Researchers in the field of IR, on the other hand, are typically opposed to further movement toward the neoliberal free market model and, indeed, often suggest that perhaps deregulation and marketisation of employment have already gone too far. Their central point is that economists – exemplified in the writings of the Chicago School – tend to treat labour as if it is simply another commodity like wheat or coal and thus subject to the laws of supply and demand. From an IR perspective, however, treating workers as a commodity to be traded back and forth in free labour markets is certain to yield neither efficiency nor fairness. That is, efficiency is harmed by a free market approach because workers and employees develop a short-term outlook on their relationship and thus see less reason to invest in hard work, good customer service, training and mutual respect. In academic terms, both employers and employees gravitate to a low performance/low trust ‘prisoner’s dilemma’ outcome. The tendency to move toward this dysfunctional outcome is aggravated by the greater incentives in a short-term employment relationship for each side – particularly employers – to treat the other opportunistically and unfairly, be it working at slow speed, reneging on promised pay/benefit increases, or job termination for no cause. In this view, labour – unlike inanimate production inputs – only produces efficiently when given a reasonable

40 The dismal science? Thomas Carlyle v John Stuart Mill

There are a number of reasons why the ‘plantocracy’ in Jamaica was in trouble. The abolition of the slave trade in 1807 was followed by the Slavery Abolition Act in 1833. The 1833 Act provided compensation for slave owners and a change in the status of slaves – not to complete freedom but to indentured labourers. Difficulties implementing the system – and especially circumvention by the planters – led the British Government to introduce a new system in 1838 where immediate emancipation was granted and, at the same time, a very high preferential tariff on sugar was introduced. Concerned by actions of the planters to circumvent all three pieces of legislation, the British anti-slavery societies began providing financial assistance for former slaves to allow them to move away from the coast, and thus away from the plantations, and become self-sufficient small holders in ‘free villages’. All this resulted in a severe labour shortage for the plantations – a shortage which they blamed on the anti-slavery lobby – and this difficulty was compounded by steady reductions in the level of the tariff as a result of activities of economists inclined, then as now, to free trade in England. The Sugar Duties Act was repealed in 1846 and then the Navigation Acts in 1849 – both encouraged the entry of other suppliers into the British sugar market.

Carlyle, writing in 1849 in support of the plantation owners, puts the view that ‘work’ is morally good and if the Jamaicans would not voluntarily work on plantations for the wages then prevailing, then they should be forced to do so. He writes of those who argued that the

The Social Science ... which finds the secret of this Universe in supply and demand and reduces the duty of human governors to that of letting men alone … is not a gay science … it is a … quite abject and distressing one; [it is] ... the dismal science. (Thomas Carlyle, Fraser’s Magazine, 1849)

When Carlyle named economics the ‘dismal science’ he was asserting the supremacy of ‘human governors’ (including his ‘captains of industry’) over the invisible hand as a means of organising labour. But what prompted this attack on markets as an organising principle and how did the economists respond? It was John Stuart Mill who most strenuously opposed Carlyle’s view. Indeed, one dispute over human governors involving the two was to result in Mill losing his seat in Parliament.

Enter Carlyle

The term ‘dismal science’ is well known to us. But what was it that led Carlyle to describe economics in such a derogatory fashion?

Carlyle introduced the phrase ‘dismal science’ in an article published in Fraser’s Magazine for Town and Country in December 1849. The article dealt with the labour situation in Jamaica where the English plantation owners were complaining that they were unable to obtain enough labour at the prevailing wages and conditions of work to carry on their business. They were also complaining about competition from other sugar producers in the English market.

the dismal science? thomas carlyle v john stuart mill

The circumstances in which Economics was first labelled ‘the dismal science’

A condensed version of part of his Inaugural Lecture given at the University of Melbourne on 24 March 2010.

by robert dixon


Mill is also opposed to Carlyle’s ‘gospel of work’ because ‘work is not a good in itself. There is nothing laudable in work for work’s sake. To work voluntarily for a worthy object is laudable: but what constitutes a worthy object? [E]ven in the case of the most sublime service to humanity, it is not because it is work that it is worthy; the worth lies in the service itself and the will to render it’.

Mill ends his piece by expressing regret that Carlyle had offered substantive support for the institution of American slavery ‘at a time when the decisive conflict between right and iniquity seems about to commence’. By providing such support, Mill concludes, Carlyle has done ‘much mischief’.

These then are the circumstances in which Political Economy (or Economics) was first labelled ‘the dismal science’. I think we would score this bout as a victory for Mill and ‘the modern’ but the second and deciding match between the two was yet to be played.

Carlyle and Captains of Industry: an aside

As an aside – but I hope an interesting one – I would like to point out the connection between all this and ‘captains of industry’. This is another phrase that Carlyle invented and which has passed into popular speech – although the meaning we give to the phrase today is not that which Carlyle intended.

You will recall that Carlyle did not believe that the market was a suitable institution for organising labour. He proposed instead that this was the duty of ‘human governors’. In the colonies, these were the planters and vice-regal Governors while in Great Britain there was a need for ‘captains of industry’ to deal with unemployed, the paupers and the unions.

The phrase ‘Captains of Industry’ first appeared in Carlyle’s Past and Present, published in 1843. Having described the chaos – strikes, demonstrations by unemployed workers, etc – which beset the world, Carlyle says: ‘The mandate of God to His creature man is: Work! … We must have industrial barons, and workers loyally related to their taskmasters, related in God; not related in Mammon alone … Captains of Industry … will reduce [the workers and the unemployed] to order, to just

forces of supply and demand rather than physical coercion should regulate the labour market, that: ‘the Social Science ... which finds the secret of this Universe in supply and demand and reduces the duty of human governors to that of letting men alone … is not a gay science … it is a … quite abject and distressing one; [it is] ... the dismal science’. He mentions the term ‘dismal science’ in a derogatory way a number of times later in this (and other) works, where it is lumped together with other unwelcome (to Carlyle) features of the political scene such as ‘ballot boxes’ and ‘universal suffrage’. Carlyle had seen the future and he did not like what he saw.

In his 1849 article he asserts that the one who is ‘born lord’ must compel the one ‘who is born to be a servant’ to work and, if necessary, use the ‘beneficent whip’ if ‘other methods avail not’. In short, Carlyle was of the view that compulsion, rather than market forces, should regulate the supply of labour on plantations in the West Indies. Why? According to Carlyle, the laws of supply and demand have to be subjugated to a ‘greater law’ as they are contrary to ‘the mutual duties’ of the planters and the Jamaicans – one to be master and the other to be servant – as ordained ‘by the Maker of them both’. Carlyle is adamantly opposed to the approach adopted by the economists because such an approach declares that the planters and the Jamaicans ‘are unrelated, loose from one another, on a footing of perfect equality, and subject to no law but that of supply and demand’.

Enter Mill

John Stuart Mill (who was the one of the objects of Carlyle’s scorn – the other targets will pop up shortly) responded to Carlyle in the next issue of Fraser’s Magazine. In a rather scathing attack on Carlyle’s racism, Mill points out that the ‘law’ which propels Carlyle is ‘the law of the strongest’, ‘a law against which the great teachers of mankind have in all ages protested’; and says that history teaches us that human improvement comes not from the tyranny of the strongest but instead from the struggle against such tyranny. Mill especially objects to Carlyle’s notion ‘that one kind of human beings are born servants to another kind’ and says that if, as Carlyle asserts, ‘the gods will this, it is the first duty of human beings to resist such gods’.

42

In the post-emancipation period, there was a temporary respite in the economic plight of white West Indians with a burst of railway construction, but for the most part, the period was a tense one. In early October 1865, news of a minor scuffle/riot/rebellion – depending upon who we read – in Morant Bay in the south-east of Jamaica, was exaggerated into reports of a fully-fledged ‘black uprising’. Governor Eyre declared martial law on the eastern end of the island and sent British troops into the area, who burned down settlements, flogged a large number of villagers and excuted some four hundred people.

Applauded by whites throughout the Caribbean, Eyre’s activities alarmed the British government. His illegal hanging of one of his prominent political opponents, George William Gordon (son of a Scottish planter and a slave woman, a prominent protestant lay preacher, a magistrate, a member of the House of Assembly and a person in regular contact with the British and Foreign Anti-Slavery Society), was particularly troubling to the antislavery societies and to all who believed in the rule of law. Gordon was arrested in Kingston but taken to the area where martial law was in force so that he could be tried by a small group of military officers and not in a civil court.

Eyre was relieved of his post and recalled to England in 1866 following a Royal Commission into his actions, which found that he used ‘cruel’, ‘barbarous’ and ‘excessive’ punishments, that the declaration of martial law may have been illegal – and anyhow was unnecessarily prolonged – and that he had unlawfully applied the death penalty in the case of Gordon.

Once the report of the Royal Commission was made public, Mill attempted to use parliament to force the government to initiate legal proceedings against Eyre, most particularly for the murder of Gordon. Failing to obtain a majority in parliament, Mill and others formed a group named the Jamaica Committee. The Committee was chaired by Mill and included the economists Henry Fawcett and John Elliot Cairnes together with the distinguished scientists Thomas Huxley, Charles Lyell and Charles Darwin, amongst others. Their purpose was to launch civil actions against Eyre in the

subordination’. As a result, ‘Not as a bewildered mob; but as a firm regimented mass, with real captains over them, will these men march’. These captains of industry are the equivalent in civil life of the ‘red-coated captains of foot’. He urges the British Government to ‘enlist unemployed paupers into Industrial Regiments and under strict military drill find employment for them … The Organisation of Labour is an actual inevitability in every country, and must be taken up ... by military command [and military discipline], and death penalty if needful’.

Thankfully, we no longer use the phrase as Carlyle did.

Carlyle v. Mill: The second and final bout

We left Carlyle and Mill back in 1850 disputing in public the future of servitude in Jamaica. For a time they go their separate ways, Mill to enter parliament as the Liberal member for Westminster supporting Reform and Carlyle to publish his Latter-Day Pamphlets (1850). In these publications he attacks democracy as an absurd social ideal; in Letters and Speeches of Oliver Cromwell (1845) he presents a positive image of Cromwell; and his epic life of Frederick the Great (1858–1865) tries to show how people ‘bend’ to the will of a great man. Carlyle was prone to hero worship and, as we shall see, he was especially prone to admire human governors who put themselves above the law. It was because of this that 1850 was not the last time Carlyle and Mill were to have a public dispute over events in Jamaica. The second and last time was to be brought on by a most unlikely third party, Edward John Eyre.

Now, as every Australian schoolchild knows, Edward Eyre spent the years 1833-44 in Australia, exploring the areas north and west of Adelaide, trekking as far to the west as Albany. For three years, he was resident magistrate and ‘Protector of Aborigines’ for the Murray River territory. After returning to England, he was appointed a Lieutenant Governor in New Zealand before moving from there to a number of vice-regal positions in the West Indies, culminating in his becoming Governor of Jamaica in 1864.1

The dismal science? Thomas Carlyle v John Stuart Mill


Science expressly abstracts itself from moralities, from &c &c: but what you say, and show, is incontrovertibly true, that no “Science” worthy of men (and not worthier of dogs or of devils) has a right to call itself “Political Economy” ... on other terms that those you shadow out for it [i.e. if it abstracts from morality]’.

The attacks by Carlyle and Ruskin on the utilitarian doctrines of political economy were taken seriously by some important economists. Marshall, for example, wrote in his Principles that if the ‘older economists’ had made it clear that they were concerned with money or purchasing power or material wealth only because ‘in this world of ours it is the one convenient means of measuring human motive on a larger scale’ and ‘not because money or material wealth is regarded as the main aim of human effort’, the ‘splendid teachings of Carlyle and Ruskin as to the right aims of human endeavour and the right uses of wealth, would not then have been marred by bitter attacks on economics, based on the mistaken belief that that science had no concern with any motive except the selfish desire for wealth, or even that it inculcated a policy of sordid selfishness’.3

Professor Dixon is Professor of Economics in the Department of Economics, University of Melbourne.

1 On Eyre and his seemingly contradictory behaviour in Jamaica c.f. Australia, see Evans, J., 2005, Edward Eyre: Race and Colonial Governance, University of Otago Press, Dunedin.

2 Semmel, B., 1962, The Governor Eyre Controversy, MacGibbon & Kee, London, p 105.

3 Marshall, A., 1920, Principles of Economics, Macmillan, London, p 22.

courts – specifically to have him prosecuted for murder and for ‘high crimes and misdemeanours’. Mill’s Jamaica Committee was opposed by a hastily formed Eyre Defence Committee – which included, amongst others, Carlyle (who chaired their first public meeting), John Ruskin, Alfred Tennyson and Charles Dickins. They opposed the aims of the Jamaica Committee and provided financial and other support for Eyre. As one historian puts it: ‘All of Carlyle’s views were at stake in the Eyre controversy: his hero worship [Eyre was a symbol of a strong man determined to maintain order], his contempt for democracy, his antipathy towards the negro, his disgust for the philanthropy of the anti-slavery societies and the individualism of the radicals’.2

Various court cases ensued in 1867 and 1868 and, although Eyre was never convicted – magistrates and juries, the newspapers and the British public were too sympathetic – he was pensioned off and never again held any office.

Mill’s behaviour and his perceived ‘persecution’ of Eyre made him so unpopular that he was voted out of office at the next election, held in 1868, despite there being a massive swing to the Liberals in all other electorates. Every constituency in London elected a Liberal member except one – Mill’s electorate of Westminster. Mill moved to France and died five years later in 1873.

Other reflections on Carlyle’s views

The reader will recall that Carlyle stated that economics ‘is not a gay science … it is a … quite abject and distressing one; [it is] ... the dismal science’. In Carlyle’s time the phrase ‘gay science’ was the name given to the art of poetry and so we may see Carlyle as contrasting what he disparagingly refers to as ‘the laws of the Shop-till’ with other and, for him, nobler motivations and sentiments. Encouraged by Carlyle, his friend John Ruskin published his criticisms of economics in his book Unto This Last. In this work, he presented ideas very similar to those of Carlyle, supporting the rule of a good and strong man over all who were weak and incapable, and supporting ‘the natural law of protection and cherishing’ over ‘laissez-faire’. In a letter to Ruskin dated 29 October 1860, Carlyle refers to ‘those unfortunate Dismal Science people’ who ‘will object that their


Why do we care about intergenerational mobility?

There are a number of reasons to be concerned about a lack of social and economic mobility. First, there is likely to be more social cohesion if individuals believe that they are able to move up the social ladder through their own efforts and abilities. Intergenerational mobility can be seen in this light as a measure of equal opportunity. Second, there are also economic efficiency arguments. Lower intergenerational mobility is likely to be inefficient in an economic sense if some individuals’ talents and skills are underutilised. Third, the way that resources are allocated across generations has big implications for overall social welfare through the endowments that each generation inherits. For all these reasons, we need to be concerned about the degree of social and economic mobility between one generation of Australians and the next.

How do we measure intergenerational mobility?

Most of the economics literature on social and economic mobility has focused on measuring the intergenerational mobility in income or earnings – particularly between fathers and sons. Usually

Introduction

The OECD recently surveyed the scientific evidence regarding the extent of intergenerational mobility in OECD countries (d’Addio, 2007). In effect, the OECD wanted to understand what we know – and what we have yet to learn – about the degree to which the key characteristics and life experiences of individuals differ from those of their parents. This report is particularly timely because it provides an international yardstick for measuring social and economic mobility in Australia. Social and economic mobility simply refers to the chances that children’s key characteristics and life circumstances differ to those of their parents. I will begin by outlining some of the reasons that we should be concerned about intergenerational mobility and placing the Australian evidence in the international context. I will then discuss some recent Australian evidence coming out of the Youth in Focus Project – a large project on the intergenerational transmission of disadvantage that researchers at ANU have been running in conjunction with the Commonwealth government. It is early days yet, but I would like to conclude by speculating about some of the challenges that I see facing us.

disadvantage across the generationsRecent evidence from the Youth in Focus Project indicates that growing

up in socio-economic disadvantage has important consequences for the education, health and wellbeing of young Australians

A condensed version of her Inaugural Lecture given at the University of Melbourne on 22 July 2010. The Lecture is published in Economic Record, Vol. 86, No. S1 as ‘Disadvantage across the Generations: What Do We Know about Social and Economic Mobility in Australia?’ The data used for this research comes from the Youth in Focus Project which is jointly funded by the Australian Government Department of Education, Employment and Workplace Relations; the Australian Government Department of Families, Housing, Community Services and Indigenous Affairs; and the Australian Research Council (Grant Number LP0347164). It is carried out by the Australian National University.

by deborah a cobb-clark

46

earnings mobility than do countries such as Italy, the US and the UK. The intergenerational correlation in educational attainment is relatively low (i.e. mobility across generations is high) in Australia, though there appears to be a larger than average negative effect of single parent status on children’s educational test scores. Finally, as is the case in other countries, there is an intergenerational correlation in income-support receipt. Young Australians growing up in families that are reliant on the income-support system are more likely to receive income support when they become adults (Pech & McCoull, 2000).

New evidence from the Youth in Focus Project

The Youth in Focus Project is really motivated by a desire to understand the mechanism – in particular the causal mechanism – underlying this intergenerational correlation in income-support receipt.1 In particular, what are the pathways through which disadvantage is passed from parents to children in Australia? As a first step towards answering this question, it is worth considering how outcomes differ for young people growing up on income support in Australia. I will focus here on outcomes related to education, risky behaviour, health and work attitudes because the international literature tells us that these outcomes are critical for understanding adolescents’ life chances.

Figure 1. Family income support history and youths’ education

we estimate equations of the following form:

where – in an ideal world – captures the permanent income of the children’s generation when they become adults, captures the permanent income of their parents at the same life-cycle stage, and is an error term with the usual nice properties. Of course, any applied economist will immediately see the data challenges in estimating the above model, such as measuring permanent income, linking adult children to their parents, holding constant life-cycle stage, and so on (see Corak, 2006). But generally, the idea is to get a solid estimate of , which tells us the fraction of the income disparity between parents that is transmitted on average to their children: implies complete intergenerational immobility, while implies complete intergenerational mobility. A similar framework can be used to estimate the degree of intergenerational mobility in other outcomes – say education, occupation, or income-support receipt.

Solon (2004) develops a model of parental investment in children in order to shed light on the forces which tie the fortunes of children to those of their parents. He assumes that parents cannot borrow against their children’s prospective earnings so that any investments in children’s education must be financed out of parents’ current income. Intergenerational income persistence will be higher – income mobility will be lower – when: (i) the more valuable education is in the labour market; (ii) the more that personal traits leading to high income can be inherited from one’s parents; and (iii) the less progressive are the government’s investments in children’s human capital. Clearly, there is an enormous capacity for economic and social policy to affect intergenerational mobility.

What do we know about social and economic mobility in Australia?

What is the evidence on intergenerational mobility in Australia? Leigh (2007) calculates the intergenerational earnings elasticity for Australian fathers and sons to be around 0.2-0.3. This puts Australia in the company of other OECD countries such as Finland, Canada, Sweden and Germany, which have substantially higher intergenerational

Disadvantage across the generations

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believe that much of what happens is due to fate or luck.3 Not surprisingly, young people growing up in families with a history of intensive income-support receipt also have poorer outcomes on all these measures. However, there is no effect of income-support receipt on youths’ sense of control, suggesting that growing up in disadvantage does not indirectly constrain educational attainment by altering young people’s beliefs about the extent to which they can influence what happens to them.

Social and health risks

Young Australians growing up in disadvantage are more likely to take a number of health (e.g. smoking, drinking, illicit drug use) or social risks (e.g. running away, coming into contact with police/courts) and to have health problems as they enter adulthood (e.g. asthma, depression) (see Figures 2 and 3).

Cobb-Clark et al (forthcoming publication) investigate these relationships and find that youths who grow up in families that are reliant on public assistance engage in more risky behaviour. Most of this is explained by family structure, mothers’ own risk-taking behaviour (in particular smoking) and investments in children’s education, specifically, reading to them at night. There is no significant effect of parents’ socio-economic status

Education

Figure 1 shows how the education of young Australians is related to their families’ use of income support. This graph compares average outcomes for those 18-year-olds in families that never accessed the income-support system (the left bar) to those for 18-year-olds in families receiving intensive income-support (the right bar).2 Some outcomes are reported by mothers, while others are reported by young people themselves. Young people in families with a history of intensive income-support receipt are more likely to have been suspended from, expelled from, or chronically late to school and less likely to be currently studying or attending university.

Cobb-Clark and Barón (2010) investigate the link between socio-economic disadvantage and youths’ educational achievement. In particular, the authors examine whether or not growing up in disadvantage has an indirect effect on educational outcomes by reducing young people’s sense of control over their lives. They find that those young Australians who believe that what happens in their lives is mainly due to their own behaviour are more likely to complete Year 12, obtain a university entrance rank, and, when they do, have higher entrance rankings than those who

Figure 2. Family income support history and youths’ social and health risks

%

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Figure 3. Family income support history and youths’ health outcomes

% Mother reported Youth reported

Asthm

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48

What are the challenges and where do we go from here?

The Youth in Focus Project is pointing to a large number of channels through which disadvantage might potentially be passed from parents to children in Australia. In particular, disparity appears in a vast range of youth outcomes, some of which seem rather surprising. Why, for example, do children with a family history of income-support receipt not show up to school on time? Why is income support related to higher rates of asthma or hospitalisation during childhood? Will there be enough policy levers if it is not all about income or education?

Going forward, it seems important to bear several things in mind. First, intergenerational mobility seems to differ over time, the income distribution, and domains even within the same country – so we are going to need a broad approach. Second, the development of truly effective policy responses requires that we say something meaningful about causation, not simply correlation. This is challenging given that parents simultaneously pass a lot of things on to their children, some of which – such as values, attitudes and work ethic – are difficult to observe and measure. We need good models and careful estimation which takes the

net of other factors. Most importantly, any effect of family income-support history on risk taking appears to be a spurious correlation stemming from unobserved factors rather than a causal effect of income support per se.

Attitudes

Could the transmission of a weak work ethic from mothers to children lead to the intergenerational persistence in social and economic wellbeing? Barón et al (2009) investigate the link between a family history of income support and the relationship between mothers’ and youths’ views about work vs. public assistance. They find that Australian youths’ attitudes about social benefits for the unemployed and what it takes to get ahead in life, are clearly linked to those of their mothers. Moreover, these attitudes appear to be shaped by the family’s history with the income support system. At the same time, only some of the link between attitudes and income support appears causal. It is also not clear that attitudes can be linked to outcomes, which are relevant for future income support receipt. Thus, at this stage there is no clear evidence that any lack of social and economic mobility in Australia can be linked to the transmission of attitudes about work versus public assistance.

Disadvantage across the generations


Cobb-Clark, D. Ryan, C. and Sartbayeva, A., 2009, ‘Taking Chances: The Effect of Growing Up on Welfare on the Risky Behavior of Young People’, Scandinavian Journal of Economics, forthcoming.

Corak, M., 2006, ‘Do Poor Children Become Poor Adults? Lessons from a Cross Country Comparison of Generational Earnings Mobility’, Institute for the Study of Labor (IZA) Discussion Paper 1993, March.

d’Addio, A.C., 2007, ‘Intergenerational Trans-mission of Disadvantage: Mobility or Immobility across Generations? A Review of the Evidence for OECD Countries’, OECD Social, Employment and Migration Working Papers number 52.

Leigh, A., 2007, ‘Intergenerational Mobility in Australia’, The B.E. Journal of Economic Analysis & Policy: 7, Article 6.

Pech, J. and McCoull, F., 2000, ‘Transgenerational Welfare Dependence: Myths and Realities’, Australian Social Policy, 1, pp 43-68.

Rotter, J., 1966, ‘Generalized Expectancies for Internal Versus External Control of Reinforcement’, Psychological Monographs, pp 80.

Solon, G., 2004, ‘A Model of Intergenerational Mobility Variation Over Time and Place’ in Generational Income Mobility in North America and Europe, Corak, M. (editor), Cambridge University Press, Cambridge, UK, pp 38-47.

1 See Breunig et al. (2009) for information about the Youth in Focus data and www.youthinfocus.anu.edu.au for research results from the project.

2 Families receiving income support, most commonly Newstart Allowance or Parenting Payments (Partnered or Single), for a total of six years or more between 1993 and 2005 are classified as having received ‘intensive’ income support.

3 Psychologists refer to this as ‘locus of control’, a psychological concept capturing a generalised attitude, belief or expectancy regarding the nature of the causal relationship between one’s own behaviour and its consequences (Rotter, 1966).

4 See www.deewr.gov.au for a discussion of the proposed changes.

issue of causation seriously. Obviously, economists have a lot to contribute here.

Finally, the ways that social policy is structured, delivered and paid for all affect the resulting degree of intergenerational mobility. Yet, we almost never evaluate them from this perspective. The way we finance schools and hospitals, for example, drives the progressivity of public investments in children’s human capital and in turn directly affects the degree of intergenerational mobility. The resolution to the current debate about the targeting of Youth Allowance benefits, for example, is also likely to have profound implications for the degree of economic and social mobility in Australia. On the one hand, targeting benefits more directly towards disadvantaged young people is likely to increase intergenerational mobility. On the other hand, making it more difficult for young people to receive Youth Allowance by becoming ‘independent’ more closely ties their fortunes to those of their parents.4 It is time we take an intergenerational perspective when weighing up the costs and benefits of various policy options.

Professor Deborah Cobb-Clark is Director of the Melbourne Institute of Applied Economic and Social Research, University of Melbourne and Professor at the Institute for the Study of Labor (IZA), Bonn.

References:

Barón, J. and Cobb-Clark, D., 2010, ‘Are Young People’s Educational Outcomes Linked to Their Sense of Control?’, Melbourne Institute Working Paper Series, Working Paper 5/10, May 2010, available www.melbourneinstitute.com.

Barón, J., Cobb-Clark, D. and Erkal, N., 2008, ‘Cultural Transmission of Work-Welfare Attitudes and the Intergenerational Correlation in Welfare Receipt’, Institute for the Study of Labor (IZA), Working Paper 3904, December 2008, available www.iza.org.

Breunig, R. Cobb-Clark, D. Gørgens, T. Ryan, C. and Sartbayeva, A., 2009, ‘User’s Guide to the Youth in Focus Data Version 2’, Youth in Focus Discussion Paper #8 December 2009, available http://youthinfocus.anu.edu.au.


leads to a significant loss of wellbeing amongst those who are discriminated against. US data suggests that black people are less happy than white people, to an extent similar to a major life event such as a divorce or being unemployed (Blanchflower and Oswald, 2004). This comparison takes into account economic and demographic characteristics. Thus, the difference in happiness due to race applies to people who otherwise have similar incomes, education, marital status, etc.

Consistent with the findings from happiness surveys, a report by VicHealth found a strong link between race-based discrimination and ill-health (Paradies et al, 2009). In particular, anxiety and depression are associated with individuals experiencing race-based discrimination.

Happiness surveys also reveal that over the last 30 years or so there has been little increase in happiness in rich countries, although GDP per capita has increased substantially. This divergence between happiness and income is known as the Easterlin paradox (Easterlin, 1974). It undercuts arguments against measures to improve equality based on their real or supposed threat to economic growth.

Equality and wellbeing

In fact, equality is something that people in general prefer. For example, an experiment based on an investment game found that 44 per cent of the participants preferred egalitarian outcomes in

The report presented to the Social Justice Initiative Seminar reviewed recent literature on the links between equality and human wellbeing. The aim of the report was to assist the Victorian Equal Opportunity and Human Rights Commission (VEOHRC) to develop a focus on the wellbeing of Victorians as a guide to its activities. At present, the VEOHRC uses mainly a legal approach that emphasises ‘rights’. However, as equality and human rights improve wellbeing, a consideration of wellbeing outcomes would improve the appreciation of the value of the work of the VEOHRC. Indeed, it could be argued that rights are important insofar as they add to human wellbeing.

The measurement of wellbeing

Recent literature has paid particular attention to the concept and measurement of wellbeing. Traditionally, Gross Domestic Product (GDP) per capita has been a commonly used measure of wellbeing. However, it is now perceived that measures of self-reported happiness – derived from happiness surveys – are more accurate measures of wellbeing. Happiness surveys avoid the well-known deficiencies of GDP per capita as a measure of welfare. Furthermore, self-reported happiness is a robust measure of wellbeing (Ng, 2008).

For social policy, findings from happiness surveys help to identify the groups who are unhappy and are deserving of attention. Of special importance for the VEOHRC is the finding that discrimination

equality, wellbeing and the work of the victorian equal opportunity

and human rights commissionNew approaches by economists to measuring wellbeing, such as self-reported happiness and measures of freedom and opportunity, give guidance on how

human rights and equality can improve individual wellbeing

An edited version of the paper presented by Ian McDonald and Helen Mitchell to the Social Justice Initiative Seminar on 9 March 2010.1

by ian mcdonald and helen mitchell

52

and thereby are closely connected with the work of the VEOHRC. We argue that capabilities can be seen as a complement to happiness, as a deeper determinant of wellbeing. For example, happiness surveys reveal that personal freedom and personal values have a positive impact on happiness.

The ability of individuals to generate wellbeing is regarded by economists as an outcome produced with the aid of their human capital. Recent research in the area of human capital has emphasised the importance of non-cognitive human capital in addition to the traditional focus on what might be called cognitive human capital, such as numeracy and literacy skills. The former includes the ability to engage in social relations and to manage oneself.

From the human capital perspective, the unequal distribution of wellbeing is caused by an unequal distribution of human capital. Of special importance is the poor human capital acquisition of children from disadvantaged backgrounds. Studies reveal that programmes aimed at improving the human capital acquisition of young children aged three to five from disadvantaged backgrounds have a very high rate of return. A famous example

which everyone received equal payoffs, regardless of their luck or effort, and a further 38 per cent of participants preferred liberal outcomes where payoffs were equalised subject to variation due to effort. Only 18 per cent of participants preferred libertarian outcomes, where people were allowed to keep their entire payoffs, with no adjustment for effort or luck (Cappelen et al, 2007).

Cross-country statistical studies have revealed that bad socio-economic outcomes are associated with inequality. Wilkinson and Pickett (2008) find that across rich countries, those with high income inequality do worse on a range of socioeconomic indicators, which include life expectancy, mathematics and literacy skills, infant mortality, homicides, imprisonments, teenage births, obesity, mental illness, drug and alcohol addiction, and social mobility. These results suggest that inequality is bad for wellbeing.

Amartya Sen and Martha Nussbaum had argued that human wellbeing should be measured by capabilities (Nussbaum 1998), or a person’s ability to achieve beneficial outcomes and choose a life they have reason to value. Capabilities take into account individual freedom and civil rights,

Equality, well-being and the work of the Victorian Equal Opportunity and Human Rights Commission


have increased self-respect and reduced feelings of stigma associated with discrimination. This can lead to improved wellbeing and happiness.

The VEOHRC produces and disseminates information about equal opportunity, racial and religious vilification, and the Charter of Human Rights and Responsibilities. By taking a positive stand on human rights and equality and by improving compliance with human rights and equal opportunity laws, these activities will lead to people being happier and more productive in their workplaces. Increased respect for workers and a reduction in workplace discrimination will also make workplaces more attractive and thereby enhance employment participation. The latter may be seen as improving opportunities for people who otherwise would have chosen not to enter employment.

The VEOHRC also contributes to Victorian government policy on social and political issues. By enhancing equality and freedom, government policy will be more effective in achieving better outcomes for wellbeing as discussed in this paper.

The VEOHRC’s templates for processes that enhance equal opportunity in the workplace are public goods – their value is not reduced by additional users. For example, consider the publication Pregnancy and Work-Time to Deliver, produced by the VEOHRC for managers in the retail sector. By constructing a set of guidelines and practices for staff work conditions to be followed in the event of pregnancy, and making these available to employers, the VEOHRC saves each employer the expense of developing their own set of guidelines and practices, thus avoiding wasteful duplication. Furthermore, by using the expertise of the VEOHRC, a higher quality set of guidelines probably results.

The report recommends a number of indicators that the VEOHRC could use to evaluate its activities. These indicators are based on those developed by the UK Equality and Human Rights Commission (Alkire et al 2009), which measure aspects of wellbeing in the areas of health, physical security, legal security, education and learning, standard of living, productive and valued activities, identity expression and self-respect, participation, influence and voice, and individual family and social life. Some of the measures are based on subjective

is the High/Scope Perry pre-school programme, a US programme of the late 1960s. Cunha et al (2005) report a return in present value terms per participant of $150,000 in benefits for cost of $16,514, which is a huge ratio of benefit to cost. The major item of benefit in their calculation was a present value of $94,065 from reduced costs of crime and imprisonment. It is notable that these calculations take a very narrow view of benefits and does not embrace the new approaches to measuring wellbeing. It seems likely that the benefit of not being imprisoned extends beyond the pecuniary costs of imprisonment, and that the benefit of improved cognitive and non-cognitive skills extend beyond labour market earnings. Thus, the true returns to these programmes of early intervention are even greater than that measured by Cunha et al.

Inequality may inhibit social inclusion. Oxoby (2004) suggests that inequality can cause individuals to ‘choose’ social exclusion, by choosing to join the underclass. He argues that societies with greater income inequality will have larger fractions of the population abandoning mainstream norms and adopting ‘underclass’ norms. For individuals with poor potential for earning income from mainstream activity, engaging in mainstream employment will consign them to low social status. By dropping out of the mainstream, these individuals can, to some extent, turn their back on mainstream values and earn social status from underclass activities. For example, absenteeism and tardiness at work are transformed in the eyes of the entrant to the underclass from a negative to a positive. However, it seems unlikely that over a lifetime the wellbeing of these people does not suffer from their decision to reject society.

The work of the VEOHRC

The project report recommends that the VEOHRC consider the implications of its activities for the wellbeing of individuals. For example, the VEOHRC operates a free and impartial complaints handling service and a telephone advice line. This activity can be seen as enhancing people’s capabilities through being better informed, increasing their ability to reject discrimination and thus increasing control over their lives. Through these outcomes, individuals may be expected to

Equality, well-being and the work of the Victorian Equal Opportunity and Human Rights Commission

P., Tsang, T., and Vizard, P., 2009, Developing the Equality Measurement Framework: Selecting the Indicators, UK Equality and Human Rights Commission, Manchester, UK.

Blanchflower, D.G., and Oswald, A., 2004, ‘Wellbeing over time in Britain and the USA’, Journal of Public Economics, 88, pp 1359-86.

Cappelen, A., Hole, A., Sorenson, E., Tungodden, B. (2007) ‘The pluralism of fairness ideals: An experimental approach’, American Economic Review, 97, 3, 818-27.

Cunha, F., Heckman, J.J., Lochmer, L., & Masterov, D.V., 2005, ‘Interpreting the Evidence on Life Cycle Skill Formation’, Working Paper No. 111331, National Bureau of Economic Research, Cambridge, Massachusetts.

Easterlin, R.A., 1974, ‘Does Economic Growth Improve the Human Lot? Some Empirical Evidence’. In R. David and M. Reder (eds.) Nations and Households in Economic Growth: Essays in Honour of Moses Abramowitz, Academic Press, New York, pp 89-125.

Ng, Y-K., 2008, ‘Happiness studies: Ways to improve comparability and some public policy implications’, Economic Record, 84 (265), pp 253-66.

Nussbaum, M.C., 1998, ‘Capabilities and human rights’, Fordham Law Review, 66, pp 273-300.

Oxoby, R.J., 2004, ‘Cognitive dissonance, status and growth of the underclass’, Economic Journal, 114 (October), pp 727-49.

Paradies, Y., Chandrakumar, L., Klocker, N., Frere, M., Webster, K., Burrell, M., & McLean, P., 2009, Building on our strengths: a framework to reduce race-based discrimination and support diversity in Victoria. Full report, Victorian Health Promotion Foundation, Melbourne.

Wilkinson, R., & Pickett, K., 2009, The Spirit Level: Why More Equal Societies Almost Always Do Better, Penguin, Allen Lane, London.

1 The Seminar reported work on the economics of equality, undertaken in a joint project of VEOHRC and the Social Justice Initiative of the University of Melbourne. This project produced a report, written by Helen Mitchell, with the supervision of Michelle Burrell and Slavka Scott, from the VEOHRC, and Ian McDonald, from the University of Melbourne. The report is available at http://apo.org.au/research/economics-equality

evaluations, such as health, fear of crime, respect in education, security of income, self-respect, freedom from stigma, dignity and respect in civil participation, social relationships and freedom to pursue relationships. Objective measures are also available, such as healthy living statistics, percentage of victims of hate crime, literacy and numeracy test scores, participation in lifelong learning, measures of poverty and political participation rate.

Conclusion

By better identifying and measuring wellbeing, economists now consider the determinants of wellbeing not simply in terms of GDP per capita and other income measures but also include self-reported happiness and how much freedom and opportunity individuals have. The work of the VEOHRC addresses these freedoms and opportunities and thereby plays an important role in the wellbeing of society and individuals.

Using happiness and capability measures of wellbeing, as well as more traditional measures, there is evidence that equality can confer benefits on all people in society: individuals prefer more equality; there are multiple benefits of equality in education and health outcomes; equality reduces social problems that exist in unequal societies; and equality in employment can improve productivity, capabilities and happiness. These benefits directly and indirectly relate to the work of the VEOHRC.

The recognition of human rights and equality as important determinants of wellbeing means that the work of the VEOHRC can be justified on an economic basis, as a cost-effective investment, as well as on human rights criteria. Further work could streamline this process by developing a template that identifies the impact of its activities on wellbeing.

Professor Ian McDonald is Professor of Economics at the University of Melbourne and Ms Helen Mitchell is an Arts/Economics honours student and a tutor in the Department of Economics at the University of Melbourne.

References

Alkire, S., Bastagli, F., Burchardt, T., Clark, D., Holder, H., Ibrahim, S., Munoz, M., Terrasas,

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rethinking financial regulation

For Australia, the proposed international regulatory influences appear most significant in the prudentially regulated banking sector,

even though the GFC had most impact on the non-prudentially regulated capital markets and investments sector

A condensed version of an Alumni Refresher Lecture delivered at the University of Melbourne on 7 September 2010.

by kevin davis

which most recent financial regulation had been based, has been questioned by both the scale of the disruption and recognition that governments will not or cannot allow systemically important financial institutions (SIFIs) to fail. Moral hazard is thus entrenched, and market discipline is inadequate to achieve the purported benefits of deregulated financial markets.

At a populist level, high remuneration, including exit benefits, of executives who presided over massive financial failures has fanned support for a ‘reigning in’ of the freedom which financial deregulation had given to the industry. But, particularly as time progresses, the ability of the industry to lobby against restrictive regulation and legislation means that the extent and nature of reregulation may be much less than originally contemplated.

The severity of the GFC

It is important to recognise the severity of the GFC shock to the world financial system and economy. Table 1 presents IMF estimates of anticipated bank losses on loans and securities over the period 2007–2010. It is evident that the GFC was primarily a trans-Atlantic phenomenon.

Introduction

An international agenda for financial reform led by the G20 has developed in response to the Global Financial Crisis (GFC) of 2007–2009. Numerous committees and inquiries have investigated the causes of the GFC and identified failings in financial regulation and financial sector governance and management as two significant influences. But exactly what types of regulatory reform should be enacted is a question not well answered by reference to contemporary economic and finance theory. Developments in and the complexity of the financial sector, have outpaced academic research and teaching, which has tended to treat the finance sector as something of a ‘black box’.

Consequently, regulatory responses to the GFC took something of a ‘belts and braces’ approach, with myriad responses attempting to: restore liquidity and restart frozen capital markets; shore up confidence, such as by guarantees; impose temporary regulations; and introduce fiscal and monetary stimuli.1 While these responses arguably prevented the extreme financial disruption from leading to a major economic recession, they have changed the landscape within which future financial regulation must operate. In particular, the merit of the free-market ideology, upon

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alumni refresher lecture series

Article heading here56 Rethinking financial regulation

The Australian banking sector largely escaped a ‘direct hit’ from the GFC, having little exposure to the ‘toxic’ assets plaguing other global banks.2 However, there were significant flow-on effects and collateral damage. Heavy dependence on offshore capital market borrowings led to an increase in borrowing costs and increased interest rate competition for local deposits, and loan losses increased as many highly levered local entities went to the wall.

Instead, the Australian investors in other financial structures (particularly collective investment schemes and structured products) experienced the most pain. A roll-call of Australian GFC financial failures includes: Basis Capital, Absolute Capital, RAMS, Centro, MFS, Allco, Tricom, City Pacific, Opes Prime, Lift Capital, Chimaera, Storm Financial, Timbercorp, Great Southern Plantations, Babcock and Brown, and Trio/Astarra. Australia, arguably, ‘led’ the world in giving unsophisticated investors the opportunity to invest in extremely complex products, relying on a caveat emptor approach built around reliance on the assumed success of education, advice and disclosure in leading to informed decisions.

The foundations of financial regulations

Several commentators have argued that financial deregulation was based on the Efficient Markets Hypothesis (EMH), and that the GFC showed this conceptual basis to be seriously flawed.3 That argument confuses two concepts. The EMH simply asserts that financial prices reflect available information, not that prices are right nor that the information is correct. While it is difficult to reconcile the magnitude of price movements in the GFC with that theory (i.e. that it all reflected ‘news’ rather than some systemic malfunctioning), it had little to do with the conventional wisdom regarding financial deregulation. Rather, the approach to financial regulation was built upon the longstanding hypothesis that competitive markets will, through the price signals generated, generally lead to optimality of resource allocation. (Of course, the EMH is relevant here in that the price signals reflect available information.) Nevertheless, unfettered markets may not be optimal if there are the classic imperfections of

Table 1: Anticipated global bank losses (per cent): 2007–2010 Other Euro mature US UK area Europe Asia banks banks banks banks banks

Cumulative loss rate (per cent) 8.2 7.2 3.6 5.1 2.1

Source: http://www.imf.org/external/pubs/ft/gfsr/2009/02/c1/table1_2.csv

This translated into dramatic declines in stock market valuations of major banks. Table 2 shows how market capitalisation of the ten largest banks at June 2007 had fallen by March 2009. Some major banks, particularly in the UK, were nationalised; while many received capital injections from government and widespread government support was provided via guarantees of deposits and debt.

Table 2: Bank GFC capitalisation experiences

Stock market capitalisation (USD bill)

June March Bank 2007 2009

Citigroup 254 14

Bank of America 217 44

HSBC 215 97

Indl & Coml Bank of China 211 188

JP Morgan Chase 166 100

Bank of China 155 115

China Construction Bank 155 133

UBS 126 28

Royal Bank of Scotland 120 20

Mitsubishi UFJ Financial 120 56

Source: Financial Times

Capital markets also ‘froze’ as concerns about counterparty (the other party in a transaction) solvency and inability to accurately value complex financial securities became widespread. Movements in corporate bond spreads (margins over the government bond rate) were illustrative of the disruption. In Australia, for example, BBB corporate bond spreads increased from below 100 basis points in the pre-GFC period to a peak of 560 basis points in March 2009. Issuance of new residential mortgage backed securities virtually ceased.

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externalities (spillovers), imperfect information, market power and so on. In these circumstances, regulation may be justified.

From this perspective, the GFC may be viewed as having highlighted that the imperfections were more significant or of different types than previously envisaged – suggesting a need for ‘more of the same’ regulation. But an alternative perspective is to ask ‘Why would you start there?’ Financial markets are characterised by and indeed have their rationale in information deficiencies, incomplete markets, liquidity creation, potential for ‘non-rational’ behaviour, and network interrelationships. There is much new and ongoing research examining what these characteristics mean for the operations of financial markets. For example, it has long been theoretically established that banks are subject to risk of ‘runs’, and more recent work derives similar results for financial markets whereby prices can depart significantly from ‘fundamentals’ – the prices which economic models and available data suggest should exist in an efficient market.4 Such models focusing on liquidity creation tend to generate multiple equilibria (where there is no unique price, quantity combination at which the market might equilibrate), ‘runs’ and market instability, in contrast to the standard model of competitive markets. And ‘limits to arbitrage’ due to wealth constraints mean that financial firms – such as hedge funds – which generally provide valuable liquidity services to financial markets, may at times be unable to take and hold positions which would generate profits due to prices departing from ‘fundamental’ values.5

These models, which emphasise interactions between financial market participants, lead fairly naturally into viewing the financial system as a network, and applying tools of network analysis to identify important nodes and connections which will determine how shocks are transmitted and moderated or amplified in the financial system.6 In the modern financial system, ‘runs’ on banks or markets can involve liquidity crises induced by large ‘wholesale’ institutional rather than household or ‘retail’ investors making margin calls for increased collateral against short-term borrowings, not rolling over short-term funding, and not being willing to invest in new security

issues. Such actions lead to forced asset sales, which can further depress asset prices creating losses for the bank involved, and in turn prompt further margin calls, generating a vicious cycle.

Currently, there is much effort being invested in better understanding the network characteristics of the financial system, and potentially designing regulations to reshape the network to enhance financial stability. Among such measures are:

– Central Clearing Counterparty (CCCP) proposals which would involve over the counterparty derivatives trades being novated (transferred) to the central counterparty and thus creating a ‘hub and spoke’ network of counterparty exposures rather than a ‘spaghetti junction’ network of bilateral exposures between the original traders.

– Enforced Structural Change via proposals such as special taxes or levies related to size or complexity, which would inhibit development of SIFIs as well as compensate governments for implicit guarantees and reduce competitive imbalances resulting from such guarantees. Suggestions for narrow banking or limits on proprietory (own business) trading also have similar origins.

– Subsidiarisation requirements for international operations – some countries (New Zealand is one) require that foreign bank activities in their country be established as a separately capitalised subsidiary rather than as a branch. This gives the host regulator greater power.

Those types of strategies are linked to one aspect of ‘macroprudential regulation’, which is one of the main new regulatory developments fostered by the GFC.7 This generally involves central banks taking on explicit responsibility for the systemic stability of the financial sector. In its cross-sectional dimension, it involves assessing and influencing how the structure of the financial system responds to shocks. In its time-series dimension, it involves taking actions to prevent the build up of systemic risk over time due to over-optimism, excessive risk-taking and so on. But exactly how to do that – and how to identify systemic imbalances from innocuous structural shifts – is another matter.

Article heading here5858 Rethinking financial regulation

can depart from the international standards determined by these organisations, they do so at the risk of inducing adverse consequences in international financial markets should their regulatory framework appear to be weaker than the international standard.

As well as topics such as capital and liquidity standards, the G20 Financial Reform Agenda is addressing issues such as accounting standards, banker remuneration, trading platforms, oversight of hedge funds and ratings agencies.

Implications for Australia

For Australia, there is something of a paradox in the interaction of the global regulatory approach and local experiences. Much of the international focus on cross-country consistency of standards is in the banking area, leading to pressure to implement enhanced regulatory requirements – even though the Australian banks survived the GFC relatively well. In contrast, there is less apparent harmonisation and international pressure for adoption of common standards in the non-prudentially regulated areas of securities markets, funds management and investment – where Australia experienced more of the GFC impact. Nevertheless, substantial changes in the regulatory approach to the non-prudentially regulated sector are in train, involving changes to financial advising arrangements and a somewhat more prescriptive approach to acceptable business models based on an ‘if not – why not’ disclosure requirement by the Australian Securities and Investment Commission.

Professor Kevin Davis is Professor of Finance and Director of the Melbourne Centre for Financial Studies at the University of Melbourne.

1 For further detail see Kevin Davis, 2010, ‘Regulatory Responses to the Global Financial Crisis’, Griffith Law Review, 19, 1, pp 117-138.

2 Analyses of Australia’s GFC experience can be found in Christine Brown and Kevin Davis, 2008, ‘The Subprime Crisis Down Under’, Journal of Applied Finance, 18, 1, Spring/Summer, pp 16-28, and Christine Brown and Kevin Davis, 2010, ‘Australia’s Experience in the Global Financial Crisis’ Chapter 66, in Lessons from the Financial Crisis: Causes,

The global regulatory framework

Figure 1 attempts to provide an overview of how national financial regulation is influenced by international arrangements.8 The G20 has become pivotal in the process with a financial reform agenda espoused in the declaration from the June 2010 Toronto meeting, based on four pillars:

– Strong regulatory framework and financial market infrastructure

– Effective supervision

– Resolution of SIFIs

– Transparent international assessment and peer review

Figure 1. The Global Regulation Process

To achieve this, the G20 replaced the Financial Stability Forum with the Financial Stability Board (FSB), to oversee and coordinate with the IMF, a consistent international approach to financial regulation across the wide variety of institutions and markets within the system. As well as undertaking peer reviews of financial regulation in individual countries to complement the IMF’s Financial Stability Assessment Program (FSAP), the FSB undertakes analysis of topics which are relevant across financial subsectors – each of which has its own international regulatory committees. These include the Basel Committee (banking), the International Organisation of Securities Commissions (securities markets), IADI (deposit insurance), and the International Association of Insurance Supervisors (insurance), each of which has produced numerous reports and guidance on regulations and supervision. Perhaps most well known among these is the Basel Committee, which has modified its Basel 2 framework for banking supervision and regulation in the wake of the GFC to inter alia change capital adequacy requirements and introduce new liquidity requirements for banks. While in principle national regulators

High level assessment, international agreement

‘Thematic’ analysis overview aduit, review

International standards, supervisory principles

National regulation, legislation

Financial Stability Board, IMF

Basel IOSCO IADI IAIS

National Regulators

G20

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Consequences, and Our Economic Future (edited by Robert Kolb), John Wiley & Sons, Hoboken NJ.

3 See, for example Chapter 1.4 of the Turner Review. Financial Services Authority, 2009, The Turner Review, A regulatory response to the global banking crisis.

4 See for example Franklin Allen and Douglas Gale, 2007, Understanding Financial Crises, Oxford University Press, Oxford.

5 This literature is surveyed in Denis Gromb and Dimitri Vayanosy, 2010, “Limits of Arbitrage: The State of the Theory”, http://ssrn.com/abstract=1567243

6 See for example Andrew G. Haldane, 2009, Rethinking The Financial Network, http://www.bankofengland.co.uk/publications/speeches/2009/speech386.pdf

7 An overview of macro-prudential regulation can be found in Jaime Caruana, 2010, Systemic Risk: How to Deal With It?, Bank for International Settlements, 12 February, http://www.bis.org/publ/othp08.htm

8 This figure is based on one presented by Justin Douglas of the Australian Treasury in ‘Bank Remuneration Rules – A Case Study of Post-GFC Regulation Reform’, 15th Melbourne Money and Finance Conference, Brighton, Victoria, May 2010, http://www.melbournecentre.com.au/Douglas.pdf

Article heading here

greening consumers: is the prospect blue?As researchers, we still need to understand a number of factors better – why consumers postpone green decisions, and whether they are aware

of their true attitude towards green products or whether they have issues at subconscious levels that we need to discover

Climate change and environmental catastrophes have prompted consumers to become more aware of their impact on the environment and, accordingly, re-evaluate their behaviour and consumption patterns. Research shows that despite this increased awareness, there is still wide variation between consumer intentions and their behaviour. Accordingly, little credence is placed on these research findings to motivate changes to government policy or encourage corporate innovation.

A number of studies have been conducted across Australia in collaboration with government agencies. This paper will describe the profile of the Australian ‘green’ consumer and examine how it has changed over a period of six years. In doing so, it will illustrate the incremental attitudinal and behavioural changes of the Australian consumer. It will consider whether the future outlook of the environmentally conscious consumer is grim, and whether the prospect is blue rather than green. The paper will conclude with an overview of feasible actions that government and organisations can take to appeal to the evolving consumer group. It ends with a prediction on the outlook for the future green consumer in Australia.

An introduction to green marketing

Understanding environmental consciousness is one of the most important issues facing industry (Dembkowski and Hanmer-Lloyd, 1997). Green marketing is largely concerned with resource conservation and the development

60

and implementation of environmentally friendly strategies (Oyewole, 2001). Climate change and environmental catastrophes have prompted consumers to become more aware of their impact on the environment as issues such as environmental degradation have become increasingly important. As these problems and consumer awareness of the environment continue to grow, consumers re-evaluate their behaviour and consumption patterns, making greater efforts to reduce environmental damage by recycling and purchasing ecologically sound products. Research shows that despite this, there is still wide variation between consumer intentions and their behaviour. This has important implications for government policy and corporate innovations, in particular marketers of consumer products/services and environmental organisations.

Unfortunately, despite the importance of understanding the ‘green’ consumer for product innovations and public policy formulation, there is still relatively little known about the Australian green consumer in a number of industries. Accordingly, a number of studies were undertaken to determine the characteristics that define green consumers, and to identify consumer groups that would be willing to pay more for green alternatives.

The green scene

Research clearly demonstrates that environmental concern has spurred an interest in environmentally friendly consumption. Moreover, people are

A condensed version of an Alumni Refresher Lecture delivered on 7 September 2010 at the University of Melbourne.

by angela paladino

Greening consumers: is the prospect blue?


generally willing to pay more for products that provide significant benefits not otherwise obtained from alternate suppliers. Nevertheless, consumers often evaluate environmental attributes after price and quality (Paladino, 2005).

Progress towards sustainability requires stakeholder participation and, in select cases, a willingness to pay more for ‘green’. This willingness to pay is a function of perceived long and short-term risk and responsibility attitudes, such as altruism and environmental concern.

Two key industries were used as the basis of analysis: electricity and organic agriculture.

Two electricity studies were conducted. One was specific to one state in Australia and enabled us to contrast urban versus rural attitudes and behaviour, while the other study was conducted on a nation-wide basis, whereby respondents in each state in Australia were invited to participate. The focus was on ‘renewable electricity’ defined as ‘the advocacy of providing electricity generated through environmentally friendly or sustainable means, which includes solar, wind, hydro, and bioenergy or biomass’ (Rundle-Thiele, Paladino and Apostol, 2008:182).

It is important to note important differences in the electricity industry in Australia – in Victoria, NSW/ACT and Queensland, the industry is deregulated and privatised; in WA, Tasmania and the Northern Territory, the industry is state-owned; while in SA, it is deregulated. As a result of this diversity, the electricity retailer faces distinct challenges arising from different legislation in regulating competition.

The organics study, on the other hand, was based entirely in Victoria. While the organics market is small, representing less than one per cent of the global market, it is growing at 16 per cent per annum, thus representing an increasingly significant market. Organic standards vary between certification providers and, as a result, the industry faces many challenges in their dealings with consumers.

Research methodology

Two research methodologies – qualitative focus groups and quantitative surveys – were employed to address the objectives of the studies. First, the

Australia-wide studies employed focus groups across Australia, to gauge consumer reactions to issues of ecological importance. In addition, it provided the foundation for the questionnaire. The focus groups were conducted in informal settings and were of one to two hours duration. The small groups, facilitated by a moderator, allowed participants to discuss issues freely. The overall aim of the focus groups was to assess the determinants of ecologically sound consumer behaviour and identify potential markets for which to target environmentally friendly energy alternatives.

The second stage of the study used a consumer questionnaire distributed to 3000 households across Australia. This achieved an effective response rate of over 90 per cent, which, after accounting for ineligible surveys, amounted to 2625 useable responses. This was a notable achievement, given that generally the response rate in such surveys is between 10 and 20 per cent. The organics study adopted a survey methodology.

The aim of the surveys was to assess quantitatively the determinants of ecologically sound consumer behaviour and identify potential environmentally-friendly energy consumer markets across a wide section of Australia. Various quantitative techniques, such as regression analysis and structural equation modelling, were employed to assess the research questions.

Sample characteristics of state-wide samples

Renewable Electricity Market (Victoria)

The average age of the rural sample was in the range of 41-55 years, of which 32 per cent was male and 68 per cent female. Of these respondents, the average household income was in the range of $45,000-$60,000 for an average household size of two people. Most participants had completed the HSC/VCE or its equivalent.

For the urban sample, on the other hand, 43 per cent were male and 57 per cent female. While the average household size and age was comparable to the rural sample, the average income per household was lower at $30,000 per annum, and the average level of educational attainment was the TAFE Certificate/Diploma. These characteristics were comparable to the Australia-wide sample.

Article heading here62 Greening consumers: is the prospect blue?

Organic Study (Victoria)

The organic market presented more diverse demographics, with men constituting 34 per cent of the sample and women 66 per cent. On average, participants were 30 years of age, with an income range of $45,000-$60,000 in a household of approximately 3.2 people.

How green are we?

The research allowed us to discover new things about our consumers that, previously, we either did not know or had no evidence of. In particular, we were able to identify the characteristics of consumers that drove the purchases of organic produce and renewable electricity. Importantly, the analyses enabled us to prioritise consumer attributes, providing some guidance for management and policy development. These will be discussed at the end of the paper.

The attributes that influence our attitudes towards green products tend to vary across industries. The rankings are listed in Tables 1-4, in order of priority. The elements affecting each dependent variable (for example, organic attitudes) are listed in each column.

When reviewing the organic market rankings, the following attributes ranked as important influencers of organic attitudes (in rank order): (1) organic knowledge; (2) subjective norms and (3) environmental concern. For intentions, the following were important (in order): (1) organic attitudes; (2) subjective norms; (3) familiarity; (4) health consciousness and (5) quality. Organic intentions and familiarity has the most significant effects (respectively) on behaviours. From the results, we are able to see that subjective norms and familiarity were very important variables for the organic market, influencing each dependent variable, from attitudes through to intentions and behaviour (see also Smith and Paladino, 2010).

Turning to renewable electricity for the rural sample, only subjective norms significantly influenced attitudes. However, many more influenced intentions directly and indirectly through attitudes. The following rankings emerged: (1) willingness to pay a premium; (2) attitudes; (3) green power awareness (noting that the effect

of this variable on intentions took place through attitudes (full mediation); (4) green participation; (5) altruism (with effects felt through attitudes); (6) subjective norms (with a partial effect also taking place through attitudes: partial mediation) and (7) knowledge. Notably, while norms are again important, we find that their effect takes place through attitudes and no longer directly, as for organic food. However, now relative to the organic market, price sensitivity creeps in as a significant variable for renewable energy consumers, as do knowledge and participation in green initiatives. This suggests that the invisible nature of the product and the lack of visible benefit of renewable electricity may be an important consideration. Participation in green initiatives and norms are also significant influencers, suggesting that for the rural community, the influence of neighbours and friends was particularly powerful. This is discussed in greater detail later.

The urban sample presented comparable results with the exception of green participation, which was a pertinent direct variable for attitudes, intentions and behaviour. Its impact was not mediated by an interim variable as per the rural sample. Price sensitivity (as represented by willingness to pay premium) was again a significant consideration. The results revealed the following rankings. For attitudes, only green participation emerged as a significant driver. For intentions, many more drivers emerged, namely, in order: (1) attitudes; (2) green participation; (3) altruism; (4) willingness to pay a premium; (5) green power awareness and (6) knowledge. Finally, for behaviours, willingness to pay a premium and green participation, respectively were significant.

When turning to the Australia-wide sample, the following rankings emerged:

Green Electricity Attitudes1. Subjective norms

Purchase Intentions1. Attitudes2. Altruism3. Green participation*4. Environmental concern*5. Subjective norms*6. Electricity generation impact*


7. Involvement8. Knowledge9. LOC*

Behaviour1. Perceived control*2. Green participation*3. Subjective norms*4. Involvement5. Environmental concern6. Price perceptions*7. Altruism*

*The effect of these variables primarily took place through attitudes (partial mediation).

While a greater number of factors were significant, we still see the emergence of norms and green participation as significant across the board. Moreover, perceived control/loss of control (LOC) over the environmental impact was also important; as was the involvement level of the purchase situation. Consumers generally perceived environmentally friendly goods required more effort to buy.

The Australian environmentally conscious consumer: then and now

We were clearly able to see that the characteristics of knowledge, attitudes, norms and familiarity/green participation and intentions were pertinent to all green purchases. Importantly, the strength of the influence of knowledge, norms and familiarity has been consistent across the studies which have taken place over six years. This points to their increased prominence over time. It is important to note however that this increase in strength was contingent on the levels of involvement of the product, the perceived price by the respondents and the visibility of the benefit when the product was being used.

The results also enabled us to identify some key trends regarding the perceived barriers to environmentally sound purchases. The following factors emerged as preventing or delaying a consumer from purchasing organic food:

– Lack of availability of green alternatives and choice;

– Poor performance and reliability;

– High cost (price);

– Lack of transparency of service benefits and trust in the brand;

– Unknown environmental impact;

– Limited time and need for convenience;

– Unclear labelling;

– Lack of education to increase awareness and interest; and

– The lack of consumer recognition (to make them ‘feel good’).

On the other hand, the green electricity market is particularly challenging. The consumption of electricity is not visible to outsiders. Hence, consumers were less likely to be concerned about what significant others thought about their consumption patterns. In this market, the following factors emerged as barriers to purchase and switching suppliers:

– Lock-in, fixed term contracts with no flexibility to exit without incurring costs.

– Situational factors, lifestyles and the excessive peak rates in WA.

– Set-up costs and usage risks. Perception that technologies have ‘not been proven’, which presents a functional (perceived lack of reliability) and financial risk to consumers, which they are not willing to bear.

– Lack of assistance with installation, use and maintenance of equipment (for example, solar panels).

These are all factors that can be feasibly addressed by organisations and government.

So how do we appeal to the green consumer?

The findings illustrate the emergence of two groups of consumers: those who feel that they can make an individual difference and, conversely, those who feel that everyone must contribute to alleviate the environmental degradation that we all create. Generally, consumers wanted to be educated and sought independent and objective information – for example, simple information and/or coding systems; no complex information or an overload of it; and interestingly, education

64 Greening consumers: is the prospect blue?

– Assist in the establishment of familiarity of products by increasing the visibility of their availability to consumers to make them ‘top of mind’;

– Participate in green initiatives to increase the level of green participation by consumers, which is likely to increase their ‘potential to engage in trial and seek information’;

– Participate in education initiatives to increase awareness and reduce confusion. For example, there was some confusion about what ‘environmentally sound’ and related terms refer to;

– Create social pressures through norms;

– Further reduce confusion through industry unification and the provision of a government supported unified logo; and

– Build new and credible brands that consumers could trust.

These were deemed important to increase use of both renewable power and, to a smaller extent, organics. So is it worth all of this effort? We now turn to the outlook for the green consumer in Australia.

Outlook for the green consumer in Australia

Overall, the findings of various studies over a number of years suggest that consumers are changing, but the pace of change is slow. For instance, they once were not receptive to information about the environment, attributed extremist ‘greenie’ connotations to consumers concerned about the environment, and simply did not consider green products. They are not like this today. Many now pay attention to green products and information provided. Others go so far as to seek this information independently.

In fairness, however, organisations also need to take their fair share of the blame for this slow pace of adoption. ‘Green washing’, misleading consumers through the use of false green claims, played a large role in disenchanting consumers and slowing the rate of acceptance of these products. This effect has been somewhat minimised today by a number of factors including increased product quality, government legislation and industry standards, and clever marketing that highlighted long-term

through children, who were deemed to provide trustworthy information! If consumers felt that the problem of environmental degradation was too large to solve, they would simply not attempt to change their behaviour, believing any such effort to be futile. However, when they were guided on specific, feasible and achievable actions that would assist with the prevention of environmental degradation – such as switching off lights and appliances usually on standby to reduce carbon emissions – consumers became much more amenable to change.

Economic issues are evidently important. For each study, consumers were asked if they would choose the environment over cost savings. While conflicted by the decision that they had to make, all except two people provided the same response – they would consider their budgets and convenience first and foremost. They would not sacrifice money and comfort to become more environmentally friendly. Thus, despite consumers claiming that they would accept a 10 per cent price premium on green goods – and this is consistent with global studies over 20 years – the reality is that quality and price prevail as the primary consideration. Green thoughts come only after this.

So who can help? Both government and organisations have a role to play in appeasing consumers and creating a safer environment to encourage adoption through trial. For instance, the government could:

– Ease cumbersome legislation and decrease the red tape associated with accreditation;

– Introduce temporary monetary incentives to increase renewable electricity adoption, provide more consumer protection against lock-in and payout contracts, and reduce red-tape associated with switching suppliers;

– Introduce visible and accessible green product standards; and

– Be involved in the provision of education to consumers – similar to the black balloon campaign rolled out a few years ago by Sustainability Victoria.

These government actions would complement a few changes that could be implemented by organisations. For instance, they could:


Paladino, A., 2005, Understanding the green consumer: An empirical analysis. Journal of Customer Behaviour, 4, 69-102.

Rundle-Thiele, S., Paladino, A. and S.G. Apostol, Jr., 2008, ‘Lessons learned from renewable electricity marketing attempts: A case study,’ Business Horizons, 51(3): pp 181-190.

Smith, S. and Paladino, A., 2010, ‘Eating clean & green? Investigating consumer motivations towards the purchase of organic food’, Australasian Journal of Marketing, 18(2): pp 93-104.

cost savings to consumers. This is best illustrated through examples such as long-life light bulbs and the fuel savings gained by driving hybrid vehicles. These tactics have contributed to the acceleration of this uptake.

So is the prospect green or blue? It largely depends on the perspective that one adopts. If we see how far we have come and how consumers are increasing their uptake of green products, then surely the future seems green. On the other hand, if we focus on the rate of change and level of government support that waxes and wanes, depending on the global environment – such as the changes to the Kyoto protocol and lack of consensus over carbon credits at the Copenhagen summit in 2009 – then we could equally argue that the prospect is blue!

As researchers, we still need to understand a number of factors better: primarily why consumers postpone green decisions. Is it a question of economics, confusion or something else? We also need to understand implicit and explicit attitudes – for example, are consumers aware of their true attitude towards green products or do they have issues on subconscious levels that we need to discover? Once we uncover these conundrums, we are better placed to further improve product innovations, current product offerings, and value propositions offered to the consumer. Moreover, government would also be better informed to introduce policies to protect consumers, impose standards and sanctions and thereby provide a level of stability in the green product domain.

Angela Paladino is Associate Professor in the Department of Management and Marketing at the University of Melbourne. She is a fellow of many international marketing associations and has received numerous awards for teaching and research from national and international agencies

References

Oyewole, P., 2001, ‘Social costs of environmental justice associated with the practice of green marketing’, Journal of Business Ethics, 29, pp 239-251.

career paths, options and risks

The consequence of exercising options may mean that, at retirement, you finish working in a career that is far removed from what you

may be considering today with your newly minted degree

An edited version of his Occasional Address delivered at Wilson Hall, the University of Melbourne, on 27 March 2010.

by robert officer

occasional address

66 Career paths, options and risks

The process of chance

Career paths, like life’s outcomes, are not pre-ordained. Serendipity can play an enormous part in success, and the career you will make for yourself will be subject to many vagaries. As the statistician would say, life and career paths are stochastic or chance processes. This does not mean that you cannot affect the outcomes. Quite the contrary. But it does mean you will be subject to both good and bad luck, and how you handle the hand dealt to you will have a profound effect on your career.

Bad luck, particularly early in a career when there is plenty of time to recover, can later reveal itself to be good luck. Let me explain this apparent conundrum with an example. Currency exchange rates often change in a seemingly random fashion – clearly a stochastic process. Although there is some skill involved, trading exchange rates can deliver outcomes that we know, with the benefit of hindsight, are random; that is, the outcomes are subject to a good deal of chance where both good and bad luck prevail. It is not uncommon for a trader to be blessed with more than normal amounts of good luck, which they, their peers, and more importantly, their managers, attribute to skill. As a consequence, they are given more funds to invest and controls on their trading

behaviour are relaxed – they are earning good money for the company. However, the result usually ends in tears. In fact, the very large currency trading losses suffered by some banks in recent years began this way.

A few trading losses early in the career will temper the hubris of the trader, encouraging more cautious trading and often more successful outcomes. As a teacher and sometime mentor, I have observed many similar but perhaps not quite so stark examples of careers where people have learnt from mistakes or recovered from bad luck and successfully moved on. Conversely, I can think of examples where luck gave them a soft start and they baulked at the first hurdle.

It may be apocryphal, but there is a story about Kerry Packer interviewing a young man for a job. Packer asked him what his greatest mistake was. The young man proudly responded that he did not make mistakes. Packer dismissed him, saying he would be no good to him, as you only learn from your mistakes. It is not just learning from mistakes –more important is having the fortitude to move on, to keep trying. Success does not come as a single event, nor does failure. The ability to keep trying will eventually overcome any bad fortune. It explains the aphorism that the harder you work the luckier you will become.

67Insights Melbourne Economics and Commerce

has worked overseas, and a number have lived in places as diverse as Alaska and Africa.

As you might expect, the current occupations of this group are diverse, including consultants in marine biology, psychology, business, education and environmental science. At our age, we tend to drift into consulting, as it is less dangerous for both the client and the consultant.

In my own case, I started exercising my options when I was isolated in the country while doing research with sheep, when I filled in time by reading books on economics amongst other things. This led to a Masters in Agricultural Economics at the University of New England. An interest in Bayesian inference resulted in an overseas scholarship at the University of Chicago’s Graduate School of Business, where an extensive stock market database encouraged me to conduct research on the behaviour of share prices. A PhD majoring in economics with minors in finance and statistics followed, and I returned to Australia as the first appointment to the University of Queensland’s Business Department in the Commerce Faculty.

I wish you well as you start or re-start your career. The opportunities, particularly for women graduates, are far greater than when I graduated. Moreover, I wish you the success that will come from taking calculated risks embodied in effort.

Professor Officer is Emeritus Professor of Finance at the University of Melbourne. He is a Fellow of the Academy of the Social Sciences in Australia, a Life Member of the Accounting and Finance Association of Australia and New Zealand and is on the board of a number of companies, mostly in the funds management industry.

Relevance to your degrees

It is in this context of good and bad luck – or the chance processes that occur in carving out careers – that I want to address the relevance to your degrees.

Career options occur in many guises and they are valuable since an option gives you a right without an obligation. Thus, in pursuing a career, it is wise to try to create as many options for yourself as you can. Options are associated with risk and the value in an option is often a function of the risk you take. Chance or stochastic processes create options, as does a good degree. However, combining these sources of options means that even with a good degree it will be difficult to create a career of value without taking on some risk. In my opinion, it is unwise to be too settled too early in a career. You have to take chances to create options for yourself. The risks you take may not work out, but you can benefit by pursuing the next path or option that is presented to you. You should not give up the pursuit of your goals.

The consequence of exercising options may mean that, at retirement, you finish working in a career that is far removed from what you may be considering today with your newly minted degree. Let me illustrate this point.

Career journeys

Forty-eight years ago, I graduated as a Bachelor of Agricultural Science in an almost identical ceremony in this Hall. From memory, there were slightly fewer than 50 people graduating with the Agricultural Science degree. We still keep in touch – the Monday preceding Christmas Day we meet for lunch at Naughton’s Hotel across from the Ag School – usually about half of our original number attend. In fact, only 11 of the total have never made it. Of the original number, a little over half are still involved in agriculture or a related activity but there are only five farmers. We have about 20 PhDs in our number, in a range of topics including nutrition, physiology, soil chemistry, biochemistry, entomology, economics and finance. In addition to the PhDs, there are about seven Master Degrees; and quite a few gathered other degrees or diplomas to enhance their career opportunities. More than half went on to higher degrees pursuing options as they presented. A large proportion of our cohort

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Published by the Faculty of Business and Economics, November 2010© The University of Melbourne

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insights volume 8 november 2010

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