Insights Volume 16 November 2014 by The Faculty of Business and Economics, The University of Melbourne

insights Melbourne business and Economics volume 16 november 2014

Pathways to growth: the reform imperative

By Deborah Cobb-Clark, Barbara Broadway, Melisa Bubonya, Hielke Buddelmeyer, Abraham Chigavazira, Markus Hahn, Nicolas Herault, Paul Jensen, Jinhu Li, Gary Marks, Kyle Peyton, Tim Robinson, Chris Ryan and Sam Tsiaplias Future of work: people, place, technology

By Elisabeth Lopez and Peter Gahan Why we need more powerful multinational corporations

By William H. Starbuck Lessons from a career in banking

By Harrison Young Starting points for a next-generation social contract

By Thomas A. Kochan Resolving energy policy dilemmas in an age of carbon constraints

By Ross Garnaut Celebrating luminaries in the field of accounting

By Gunther Burghardt What can economics tell us about guns and crime?

By Andrew Leigh

Insights: Melbourne Business and Economics ISSN:1834-6154 Editor: Associate-Professor Geoff Burrows Associate Editor: Ms Danielle Roller Sub-editor: Ms Rebecca Gleeson

Advisory Board: Professor Kevin Davis Professor Emeritus Ian McDonald Design: Ms Sophie Campbell Illustration: Mr Gregory Baldwin

insights vol 16 Table of contents 03 Welcome

By Geoff Burrows, Editor

05 Pathways to growth: the reform imperative

15 Future of work: people, place, technology

By Elisabeth Lopez and Peter Gahan Twentieth century futurists certainly had a sense – whether of foreboding or optimism – of looming technological disruption, a phenomenon rippling through entire industries and which leaders in 2014 ignore at their peril.

23 Why we need more powerful multinational corporations

By William H. Starbuck It may be possible to make governance changes that render large global corporations more beneficial – and less costly – to humanity.

39 Starting points for a next-generation social contract

By Thomas A. Kochan Without more proactive efforts the economy will neither close the jobs deficit nor change the 30-year pattern of wage stagnation and growing income inequality.

47 Resolving energy policy dilemmas in an age of carbon constraints

By Ross Garnaut Australia can return to its traditional position as a low-cost energy producer even in a world of renewable energy.

57 Celebrating luminaries in the field of accounting

By Gunther Burghardt To entice our youth in the future to enter the important profession of accounting, we need to tell the inspirational stories of the discipline’s pioneers and we need to tell them well and often.

63 What can economics tell us about guns and crime?

By Andrew Leigh Your chance of being a victim of homicide in the late 2000s was around half of what it had been in the late 1980s.

31 Lessons from a career in banking

By Harrison Young Banking is not just a business.

Insights Melbourne Business and Economics

Welcome 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. This edition opens with summaries of the proceedings of a pair of important two-day conferences. Since April 2002, the Outlook conferences co-hosted by the Melbourne Institute and The Australian newspaper have provided a major forum for leaders from politics, academia, business, the media and the community to discuss priorities for economic and social reform in Australia. Melbourne Institute director Deborah Cobb-Clark and her colleagues summarise contributions to the ninth conference in the series, held in July 2014, on the theme of ‘pathways to growth: the reform imperative’. In March 2014 the Department of Management and Marketing’s Centre for Workplace Leadership hosted its inaugural conference on the ‘future of work: people, place, technology’ in conjunction with the Australian Chamber of Commerce & Industry, Cisco Systems Australia and Clayton Utz. Elisabeth Lopez and the Centre’s director, Peter Gahan, outline the contributions of almost 50 domestic and international speakers. All teaching departments now have programs in which leaders from business, the media and the professions spend time in departments, making their knowledge and expertise available to staff and students. Earlier this year, banker Harrison Young was executive-in-residence in the Department of Finance, and in the course of his visit gave a talk on ‘lessons from a career in banking’. In 2012, one of the Accounting Department’s executives in residence was Gunther Burghardt, who followed his visit with an address to the 2014 induction ceremony for the Australian Accounting Hall of Fame, an initiative partnering the Department with the Institute of Chartered Accountants in Australia and CPA Australia.

Multinational corporations and the power they exert – real or imagined – frequently receive a bad press. Counter to this conventional wisdom, William Starbuck argues that, with appropriate governance changes, more powerful multinational corporations can be highly beneficial to humanity. Concerned at three decades of stagnating real wages and growing income inequality, particularly in the US, Thomas Kochan offers some starting points for a ‘next-generation social contract’ aimed at reversing these trends. Ross Garnaut sees opportunities for Australia’s energy sector, even in a world of carbon constraints, arguing that through implementing appropriate policies, Australia can return to its traditional position as a low-cost energy producer. Finally parliamentarian-economist Andrew Leigh used the occasion of the launch of his book, The Economics of Just About Everything, to give a public lecture on several topics covered in the book, including what economics can tell us about guns and crime. Sadly, Insights has to report the death on 18 March 2014 of Professor Colin Ferguson, a member of the journal’s advisory board since 2012. Colin, who also contributed to Insights as an author, only joined the board in late 2012 but was already making an impact with his ideas for raising the journal’s profile. A condolence message has been sent to his family. Again, thanks must go to Gregory Baldwin whose vivid illustrations give each article added character. Geoff Burrows Editor ghb@unimelb.edu.au

Insights Melbourne Business and Economics

Article heading here

Pathways to Growth: The Reform Imperative BY DEBORAH COBB-CLARK, BARBARA BROADWAY, MELISA BUBONYA, HIELKE BUDDELMEYER, ABRAHAM CHIGAVAZIRA, MARKUS HAHN, NICOLAS HERAULT, PAUL JENSEN, JINHU LI, GARY MARKS, KYLE PEYTON, TIM ROBINSON, CHRIS RYAN AND SAM TSIAPLIAS

A selective summary of the highlights of the ninth Economic and Social Outlook Conference, ‘Pathways to growth: the reform imperative’, which was hosted by the Melbourne Institute and The Australian on 3–4 July 2014 at the Grand Hyatt Melbourne. Many of the presentations and recordings of each speech can be found on the Melbourne Institute website.

Currently, the Australian economy is underperforming. Employment is growing relatively slowly, Commonwealth and state budgets are in deficit, and the great resources boom is starting to wind down. Internationally, recovery from the Global Financial Crisis (GFC) has been slow, frustrating the efforts of the industrialised world to close massive budget deficits. Against this backdrop, discussion at the ninth Economic and Social Outlook Conference centred on the reform options for returning the Australian economy to economic growth.

Opening The conference was jointly opened by the University of Melbourne Vice-Chancellor, Glyn Davis, and Paul Kelly, Editor-at-Large for The Australian. Kelly began by noting that The Australian newspaper is proud of its long relationship with the Melbourne Institute and the University of Melbourne. He said that policy reform is more vital now than ever, arguing that there is a need to rekindle public support for reform. Unfortunately, the public has never been more disengaged. Davis congratulated The Australian newspaper on its 50th anniversary, praising it for consistently writing about higher education and Indigenous disadvantage. He argued that it is very important that each side of an issue needs to be heard and debated, noting that the 2014 Outlook Conference provided an important opportunity for that to happen.

Facing the headwinds Warwick McKibbin argued that the environment is uncertain and policy has to be flexible enough to respond. Short-term uncertainty is created by the end of quantitative easing in the US and structural adjustments in China. Interest rates are likely to rise and expectations need to be managed. Mediumterm challenges are fiscal sustainability, with high debt-to-GDP ratios in developed countries. As to the longer-term challenge of demographic change, what matters is demographic change relative to everyone else. While the floating Australian dollar has worked brilliantly in previous crises, doing what it was supposed to do, this time it is not falling. We need to lower input costs and increase productivity, and take the high Australian dollar as a given. Chris Richardson noted that during the last decade, Australia not only had a boom because of increased demand (and prices) for minerals, but also because of mining construction gearing up for the increased mineral production. The headwind for the next five to 10 years is the deterioration in the terms of trade for minerals, despite Australia having a competitive advantage in some industries: agribusiness, gas, tourism, (international) education and wealth management. Unfortunately, the temporary gains from the boom have coincided with permanent increases in expenditures, which have resulted in a budget that is not necessarily in crisis but needs much more repair than many realise. Insights Melbourne Business and Economics

Deborah Cobb-Clark said that in seeking to bring the budget back into line, we also need to maintain the social contract in the face of economic reform by improving labour market access and outcomes for disadvantaged groups. Labour market barriers for youth, such as high penalty rates, need to be reduced. Greater opportunities for apprenticeships, dedicated school-to-work programs, and workexperience programs are needed too – but need to be rigorously evaluated to ensure they provide a good use of taxpayers’ money. Moreover, an increasing proportion of the labour force suffers from poor mental health. We require much closer cooperation between mental health and employment services, making sure that work pays. Finally, through the reform process, we need to bear in mind that as we roll back the social safety net many disadvantaged individuals will not be in a position to rely on family support if they cannot find suitable employment.

Sustainable budgeting: tailoring what we want to what we’ll pay for Shadow Treasurer, Chris Bowen MP, said that growth and social inclusion are mutually reinforcing, and the current budget does not satisfy the tests of fairness and equity. The budget is unsustainable because many proposed measures, such as the new Paid-Parental Leave and Direct Action schemes, are expensive. Other measures, such as the copayment for GP visits, will save money in the short run but will be costly in the future. The next budget proposed by the Labor Party will be realistic and non-divisive, and foster entrepreneurship. John Daley highlighted that correcting for the tailwind from the mining boom, there has been a structural deficit for seven years caused by tax cuts in 2007, a shrinking tax base due to the GFC, and increased spending on infrastructure and health services. Any improvements in the cash balance of the current budget are largely due to ‘bracket creep’, which is not a solution in the long run. Sustainable budgeting should save money while avoiding negative collateral impacts. Peter Boxall urged governments to run small surpluses of about one per cent of GDP, and proposed that government spending of 24 per cent of GDP 06

Pathways to growth: the reform imperative

is a good target. For specific budget measures, he proposed continuously increasing the pension age as life expectancy increases, slowing the growth of pension rates, and excluding high-income earners from Medicare coverage (who should take out private health insurance instead). There should be some transfer of income-taxing power from the Commonwealth to the states to tackle vertical fiscal-imbalances.

Lunch address (day one): the budget challenge The Treasurer, Joe Hockey MP, noted that 50 years ago the government had an enormous influence on the economy and people took prosperity for granted. Australia now stands at the dawn of another grand age of prosperity, but we must accept the changing and reduced role of government in producing a deregulated and more competitive economy. He then gave an overview of the government’s initiatives in this direction, covering welfare, tax and health reforms as well as infrastructure policies.

How to get early childhood education right The Assistant Minister for Education, Sussan Ley MP, welcomed early childhood education and child care as a discussion topic in a mainstream economics conference. While also an issue for social policy, the topic had implications for individual productivity, both in terms of the current workforce participation of parents, as well as the future productive capacity of children themselves. The government has commissioned a Productivity Commission inquiry into child care and early childhood education, and awaits its recommendations before attempting any major reforms in this area. However, any future reforms would need to support parental choice, workforce participation and child development. Some issues associated with the National Quality Framework, such as supervisor licensing, were being addressed in the interim by Commonwealth and state ministers, given their costs for providers with little associated benefits. Julia Davison also welcomed the inclusion of early childhood care and development in the economic

agenda. The deteriorating performance on PISA tests by Australian students relative to some toptier countries was linked to poorer early learning arrangements. Australia needs to start learning earlier, support the development of vulnerable children with additional resources, and make early learning affordable, especially for low-income families. Stephen Zubrick presented research that indicated gaps associated with disadvantage opened up early in children’s lives and persisted over time. He identified the elements of the ‘toolkit’ people need to lead successful lives and the ways in which education might contribute to their development, even where the attributes were not measured well within education. Additional resources were required to help schools develop these important attributes, but these resources needed to be committed in ways that mean we learn something (via experimentation) about the impacts of particular interventions.

Can the Commonwealth drive infrastructure? Malcolm Turnbull MP argued forcefully that the private sector is in a better position than the public sector to mitigate and price the risks associated

with infrastructure investments. The public sector was often conflicted in both owning assets and attempting to regulate appropriate rates of return on those assets. However, privatisation is often politically unpopular because of perceived higher prices. Time-consistent policies were important with infrastructure because of the large-scale and often irreversible nature of these investments. Paul Broad emphasised the importance of using prices to manage infrastructure use, citing traffic congestion – both rail and car – across Sydney Harbour Bridge as a major bottleneck in Sydney’s traffic that could be managed by using prices to smooth demand over a longer period. Such policies may mean that other large rail infrastructure investments were not required. However, there is still wide-scale objection to using prices to manage infrastructure usage. Finally, Henry Ergas explained the rising costs of building road infrastructure by reference to competition for construction resources, the difficulty of developing infrastructure in increasingly populated areas, the costs of environmental/ workplace regulation, the increased use of detailed input-driven specifications, and an increase in largeInsights Melbourne Business and Economics

scale (mega) projects. There has been some variation in construction costs across the Australian states, but this has largely been because some states (for example, Western Australia) did not engage in mega projects. One area for improvement in the future is better coordination between long-term transport and land-use planning.

with China. He highlighted three key stages in relationship development:

Trade and investment: how to build regional relationships

– Getting value from synergies.

Senator Penny Wong, Shadow Minister for Trade and Investment, noted that trade liberalisation has been one of the most important reforms of the modern era. The global economy’s centre of gravity is shifting to our region. For Australia to realise the potential gains (growth, living standards and employment), we need progressive economic reforms such as trade agreements which open markets, increase cross-border investment and foster deeper international integration. The largest benefits will come from freeing up trade multilaterally, through WTO agreements like Doha, although progress to date has been disappointing. Bilateral and regional trade agreements are second-best options so they need to be as ambitious as possible – in the scope of goods and services and in reducing deep trade barriers, especially with China. Further, ‘mega-regional’ trade agreements that are properly designed, such as the Trans-Pacific Partnership (TTP) and the Regional Comprehensive Economic Partnership (RCEP), are in everyone’s best interests. Kerry Brown highlighted the intimate links between China’s and Australia’s economies, noting that we either sink or swim together. The current trade/economic relationship is unsustainable due to China’s growth model and Australia’s reliance on resource exports. A key objective for China is the development of its domestic market which holds great potential for Australian growth, but which will involve strong competition. Australia can no longer rely on ‘luck’ and physical assets; instead we must focus on developing and exporting services to China and thinking very hard about tactical entrances to the Chinese markets. Finally, Andrew Michelmore offered the perspective of someone closely engaged in building relationships 08

Pathways to growth: the reform imperative

– Establishing a trade/investment relationship with China, which Australia and many businesses have already done; – Deepening those relationships through time and understanding cultural differences; and With the real value lying in the third stage – which very few Australian businesses have reached – Australia needs to get back to the reform agenda and show Asia that Australia is ahead of the competition. Meanwhile, businesses need to seek out partners and develop relationships over time.

End of the age of entitlement Kevin Andrews MP, Minister for Social Services, argued that work is a social good and the foundation for an expression of human dignity. National policy should focus on finding work for everyone who wants to work. The resources sector’s shift from construction to production, large Commonwealth deficits and debts, and the ageing of the population are challenges that Australia currently faces. Welfare reform should be aimed at enabling all people to contribute to economic life according to their abilities. Quoting British banker Stephen King, he said that ‘consuming tomorrow’s income today’ would jeopardise Australia’s ability to provide for the vulnerable and needy. Long-term recipients of welfare have higher risks of poor health, lower selfesteem and social isolation, and are more likely to stay on welfare. A welfare system with adequate payments to encourage people to work where it is reasonable to do so is required. Jenny Macklin MP, Shadow Minister for Families and Payments and Disability Reform, argued that investing in the Australian people – including in the safety net – is the key to economic prosperity. Poverty, inequality and social exclusion are not just bad for the individual but also for the economy. She criticised the current proposed budget and said that the Treasurer’s talk about the ‘end of the age of entitlement’ short-sells Australia’s potential by downgrading its human capital investment.

The government’s proposal to prevent those aged under 30 years who are unemployed and not in education from receiving any unemployment benefits for at least six months would push these young people into extreme poverty, not build their skills or make them ready for work. In Europe, austerity had caused lower wages and skills, rising unemployment and inequality, and social fragmentation. Mr Andrews responded that a reform of minimum wages would be difficult and would need public support. Ms Macklin replied that cutting minimum wages would not put young people back into work. Both speakers favoured income management, which especially helps Aboriginal communities, and agreed that mutual obligation (of the government and the individual) is important.

Dinner address: seizing the opportunity Prime Minister Tony Abbott MP began his address by asking whether a reforming prime minister can succeed any more in this country given the decisive shift in the system and culture against reform. His answer was a resounding ‘yes’. He emphasised the successful reforms the government has implemented since the election, such as stopping the boats, repealing the carbon tax, creating an infrastructure boom unmatched in the last century, and getting the budget back under control. Although Australia has had strong economic growth over the past 23 years, growth is not a given; it is earned by the continual decision to stay competitive. The past six years have been lost years of economic drift; and the new government has inherited a debt and deficit disaster, as well as an unsustainable budget with undeliverable spending promises. Australia needs long-term structural reform to face these challenges and stay competitive which is why the current budget shifts spending from short-term consumption to long-term investment. This $50 billion investment addresses the end of the resources-boom investment, improves longterm competitiveness and productivity, and builds confidence in Australia’s future. He stressed that the

global infrastructure gap, the difference between needs and spending, is growing and that financing infrastructure projects must come not only from the government but from the private sector and foreign investment. The Prime Minister concluded by saying that this government has embarked on a great and necessary task, and as a government and a nation, we will not fail.

Changing climate on climate change Regarding climate change, the panel described current international efforts and compared different mechanisms used globally to reduce emissions, agreeing that Australia should commit and actively contribute to the global effort. However, there was disagreement about the optimal mechanism Australia should adopt. Greg Hunt MP, Minister for the Environment, described how internationally there are three approaches to reduce emissions: one regulatory and two market-based approaches, being production tax and incentives for abatement. He foreshadowed that the Australian government would repeal the carbon tax, which is one form of production tax, and move to the Emissions Reduction Fund (ERF) scheme, which provides incentives to reduce emissions on a competitive basis. The government believes the ERF scheme will achieve the maximum emissions reduction in the shortest possible time. Ross Garnaut argued that Australia should do more than marginally reduce emissions. Carbon pricing is a relatively efficient indirect tax and therefore a good solution for the government when facing revenue problems. He suggested retaining the infrastructure of the Emissions Trading Scheme (ETS) in order to move straight to ETS when we are ready for flexible prices; and removing the Clean Development Mechanism (CDM) credit limit, then restoring it when other countries are making an effort comparable to that of Australia. Matthew Warren said that one common challenge in the substantial transformation of the energy sector in recent years is the constant trade-off between sustainability, reliability and affordability. Insights Melbourne Business and Economics

Four challenges in making future climate policy were how to: – Use tariff reform to support the network with a diminishing number of consumers on the network; – Design a market structure to correctly signal investment and exit in the electricity market; – Ensure overall sustainable falling emissions; and – Frame policy to reflect that the growth of energy and GDP are no longer linked in the future.

The productive workplace The overwhelming consensus of the panel was that new changes to industrial relations law would not generate many productivity gains for Australia. Peter Gahan argued that although good institutions were necessary for workplace productivity, governments cannot regulate for a high-performance workplace culture. Australia needs workplace policies that support profit-sharing, gain-sharing and shareownership schemes. He also extolled the virtues of flexible employment and labour-market transitions,

Pathways to growth: the reform imperative

active labour-market policies and income security during periods of transition. Three areas for improvement in Australia were: – Improved workforce capabilities through modern employee job skills and business literacy; – Cultivation of capable management and strategic business leadership with attention to innovation; and – Regulatory reform that appropriately balanced the trade-off between flexibility and security. Judith Sloan argued that although multi-factor productivity has fallen we are not in an era in which low productivity is the new norm. Gains from human-capital investment have been marginal. Australia should instead focus on being costcompetitive because labour productivity on its own is not a useful measure. More research was needed into cost competitiveness in Australia. Future enterprise agreements are unlikely to generate productivity gains and the future role of the government should be to ‘get out of the way’.

Tim Lyons argued that, were history any guide, additional changes to industrial relations law would not change the path of productivity growth in Australia. He addressed myths about the Fair Work Act by using statistics collected from various sources. He outlined an approach to Australian industrial relations that emphasised (i) a rights purpose to correct for the disproportionate bargaining power held by employers; and (ii) a mechanism to improve the distribution of economic outcomes delivered to the poor and middle class.

Putting incentive back into federation Stephen Duckett believes that the reason we have a federalism debate about health service delivery is that the two models (Commonwealth unitary and federation) have strengths and weaknesses. The constitution is also unclear about which level of government is responsible for hospitals. He highlighted the current issues: a significant vertical fiscal imbalance; Commonwealth and state policies concentrating on the health services they themselves fund; the overlapping roles leading to cost and blame-shifting; poor coordination of program design leading to program discontinuities; and reciprocal interdependence. He outlined three reform options: privatisation (to create a social insurance model); clarification and division of responsibilities; and coordination. However, he was pessimistic about these reform options being applied. Vince FitzGerald believed that vertical fiscal imbalance led to centralisation of power in Canberra. However, micro-management resulted in tensions between the levels of government, bloating of bureaucracies, and a lack of incentives to pursue efficiency and blurred accountability. The main lessons from past successes are that (i) the states must be treated as sovereign with clearly defined areas of jurisdiction; and (ii) we need a commitment to national evidence-based policy, good leadership, demonstrations of trust, and open communication about the sharing of resources. The Commonwealth should provide leadership on policy directions, minimum national standards and achieving national consistency, as well as provide funding; while states should tailor services to local needs, coordinate delivery and play a major role in policy and delivery innovation.

Focusing on education, Richard Bolt said that the problem is not the lack of incentives but the lack of coherence between state and Commonwealth policies and programs. Success comes through strategic collaboration; failure comes through disjointed and competing policies and programs. The federation has produced two competing school-funding streams which are not harmonised: the states fund government schools and the Commonwealth funds non-government schools. Increased school funding is necessary but not sufficient: schools should use their core funding to achieve better learning. But unilateral federal grant programs undermine this goal. States should continue to fund school and vocational education; and the Commonwealth should continue to fund early childhood and higher education. But planned collaboration is necessary for the whole education system to work well, with the Commonwealth taking a less directive role.

Wrong tax system for the digital age Rob Heferen focused on the implications of globalisation and digitisation for the Australian tax system. The increased importance of trade in intangibles renders the localisation of profits, and hence its taxation, ever more difficult. The effectiveness, and hence the perceived fairness of the tax system, has important implications in terms of compliance. To Chris Evans, the architecture of the Australian tax system is outdated. The current tax mix, with its high reliance on personal and corporate income tax, has to change. The most desirable reform path requires multilateral action to treat multinational corporations as single entities and tax them accordingly. But this shift in paradigm is made difficult by inertia, multinational corporationsâ&#x20AC;&#x2122; power and the ambivalence of governments. Alf Capito also noted the over-reliance on corporate and personal income tax. The problem is the size of government and we should try to limit government excesses. There is healthy competition among tax jurisdictions and there will always be competition. Overall, the problem does not lie with the Australian tax system; the problem is the Insights Melbourne Business and Economics

global system. In particular, base erosion and profitshifting is a deliberate policy in the US.

Lunch address (day two): the Labor alternative Bill Shorten MP, the Leader of the Opposition, detailed his party’s commitment to informed debate and reform across a range of critical areas such as education, health, labour, retirement and superannuation. He emphasised the importance of common sense, egalitarianism, and open dialogue in policy-setting, and noted Labor’s introduction of significant historical reforms relating to income tax, Medicare and universal superannuation. He criticised the government’s proposed budget, particularly in terms of fairness and social inclusion. The Paid Parental Leave scheme was extravagant; while proposed restrictions on access to Newstart Allowances and the Disability Support Pensions, and the introduction of the co-payment for medical services, would negatively impact on people in need of assistance.

Financing the future Luci Ellis argued that the Basel III regulatory framework is more protective and allows financial risks to be measured more properly compared to the pre-crisis regulatory framework. The Basel III regulations will not hinder the Australian economy as the rules can be tailored to meet country-specific nuances. The new regulatory framework will not distort or change the relativities of the funding of households to businesses. Carsten Murawski wanted to ensure that individuals have adequate savings to fund their retirements. Australians are not saving enough for their retirements and many lack the financial understanding to do so. In order to solve this problem, the focus needs to shift from institutions to individuals. More research is needed to understand individuals’ saving behaviour, using test programs aimed at improving financial literacy to produce evidence-based policy. Barry Sterland saw the two big agendas for the G20 as growth and resilience in the global economy. Growth will need to be driven by structural reform 12

Pathways to growth: the reform imperative

– that is, trade, labour market and fiscal policy rather than just monetary policy. In addition, the new regulatory framework will aim to underpin activity in the real economy and ensure the financial system is able to support investment and real growth.

Bringing the outsiders in Chairing this session, Tony Nicholson noted that as well as 700,000 officially unemployed there is an equal number of underemployed. It does not make economic sense for so many people to be excluded. Warren Mundine expressed disappointment at the negative response to the proposition of moving people from welfare to employment and stated that accusations of unfairness targeting welfare recipients were misguided and partisan. If the word ‘welfare’ was replaced by ‘poverty’ there would be a very different response. The enduring poverty of some Indigenous and non-Indigenous communities can be attributed to a reliance on welfare payments. His personal history was of coming from a large, poor family where work provided dignity, a sense of purpose and a stronger sense of community, as well as financial security. Policies should aim at getting people off welfare to participate in the real economy and avoid marginalisation. The most effective means of escaping poverty is work, not more and more training courses or making welfare participants continually apply for jobs. Patrick McClure believes that Australia’s welfare system is overly complex and is not financially sustainable. The four pillars of welfare reform were: – Creating a simpler and more sustainable system; – Strengthening individual and family support; – Engaging with employers; and – Building community capacity. He proposed a simple architecture of four payment types: tiered payments with rates differing according to circumstances; disability support for those with no capacity to work; child payments that bring together Family Tax Benefits, Youth Allowances, Abstudy and other payments; and the aged pension. Cassandra Goldie emphasised that welfare reform should focus on real rather than imagined problems,

saying that the debates have become overly politicised. Reforms encouraging the transition to work are futile if there are no jobs available. The success of income management policies was not due to income management per se but to individual case management. She advocated greater access to existing data, collaborative leadership and a decent social security system.

Sources of comparative advantage Brian Fisher gave an overview of the terms of trade boom and its macroeconomic consequences. Many Australian mines (for example, iron ore) have relatively low costs and may remain profitable as prices decline due to increased supply. Australia’s lack of valueadding in resources was not problematic as margins tend to be greatest in mineral extraction. Further microeconomic reform to enhance productivity and labour market flexibility is needed as expanding capacity in Australia is relatively expensive. Mick Keogh emphasised that Australia’s comparative advantage in agriculture lay in low-rainfall farming. The growth in demand from the Asian middle class was an opportunity for some Australian producers, such as of meat and wool, given their cost competitiveness and reputation for quality. Many food processors had closed, partly due to the high concentration in Australia’s retail markets. Greater investment in agricultural research and development and in regional infrastructure will be needed. Martin Ferguson focused on the liquefied natural gas industry. He highlighted the imminent rapid increase in exports and discussed what was needed to encourage further investment, given likely continued strong demand from Asia. Several new competitors have lower costs and hence both industry and policy-makers need to focus on increasing the sector’s competitiveness. Possible measures include industrial relations reform, reducing green and red tape, allowing market signals to operate and having a culture of innovation.

to deliver the policies that are needed. Putting good policies in place is much more difficult than it used to be. What aspects of the political process contribute to this situation and what changes in the political process do we need to solve this? Terry Moran argued that Australia went through a very successful reform process in the 1980s because good policy proposals were brought forward and discussed in-depth by the community, and as a result found powerful advocates as well as bipartisan support. They were implemented carefully. Trusted leaders were able to explain the policies to the public. Measures to strengthen accountability, a focus of government departments on policy rather than administration, and a greater involvement of external experts are needed to achieve those reforms again. Senator Nick Xenophon examined the challenges of making policy with the incoming Senate, in which neither major party has a majority. He foreshadowed that this will lead to a gridlock and possibly a double-dissolution. The government has alienated broad parts of the population with some of its policy proposals, and will thus continue to struggle. But as a struggle with a hostile upper house will force the government to readjust its policies, a difficult situation in the Senate might eventually save a government from itself. Michael Woods stressed that problems need to be articulated clearly before the public can accept policy solutions. It was important to involve the community in the process of policy formation to ensure that a policy is understood to be fair and beneficial to the community as a whole. The discussion between the stakeholders also allows politicians to assess the true benefits and costs of a policy for different groups. Vested interest groups and ideologues often get in the way of establishing a transparent process that involves the whole community. The authors are all members of the Melbourne Institute.

The political economy of achieving reform This panel, chaired by Paul Kelly, discussed the impact of political institutions on Australia’s ability Insights Melbourne Business and Economics

Article heading here

FUTURE OF WORK: PEOPLE, PLACE, TECHNOLOGY Twentieth century futurists certainly had a sense – whether of foreboding or optimism – of looming technological disruption, a phenomenon rippling through entire industries and which leaders in 2014 ignore at their peril. BY ELISABETH LOPEZ AND PETER GAHAN

A selective summary of presentations to the ‘Future of Work: People, Place, Technology’ Conference, hosted by the Department of Management and Marketing’s Centre for Workplace Leadership at the University of Melbourne on 9–10 April 2014.

Exactly 60 years ago, Isaac Asimov (1964) – speculating on what work might look like in 2014 – wrote: The world of AD 2014 will have few routine jobs that cannot be done better by some machine than by any human being. Mankind will therefore have become largely a race of machine tenders. Schools will have to be oriented in this direction. The lucky few who can be involved in creative work of any sort will be the true elite of mankind, for they alone will do more than serve a machine … Indeed, the most sombre speculation I can make about AD 2014 is that in a society of enforced leisure, the most glorious single word in the vocabulary will have become work! 1 Asimov’s vision was, in some ways, prescient. Twentieth century futurists certainly had a sense – whether of foreboding or optimism – of looming technological disruption, a phenomenon rippling through entire industries and which leaders in 2014 ignore at their peril. They asked questions that preoccupy societies today: what do we do with our young people? What skills should workers have and how will they get them? How do we provide jobs for everyone able to work? Is technology the road to the good life, dystopia, or both? In April 2014, the Centre for Workplace Leadership held its inaugural Future of Work conference, on the

theme of People, Place and Technology. Part of the Faculty of Business and Economics, the Centre aims to bridge the gap between academic rigour and the real world challenges facing Australian businesses. Nearly 50 domestic and international speakers speculated on how the nature of work is changing, what this means for entire workforces, workplaces and teams, and the sorts of demands these developments are placing on workplace leaders. The event was held in partnership with the Australian Chamber of Commerce & Industry, Cisco Systems Australia and Clayton Utz. The conference enabled employees, managers, business leaders and business owners to access cutting edge technology, research and thinking on the modern workplace and beyond.

On technology and knowledge Trying to second-guess the future can be fun, a chance to let the imagination run free. In 1958, the American illustrator Arthur Radebaugh began a futuristic comic strip called Closer Than We Think2, in which he depicted space-age marvels that would deliver us into an era of high-tech leisure. Some of these were not far off the mark: electronic home libraries, wall to wall television, and ‘bloodless surgery’ using ‘proton beams’. Radebaugh’s jetpackpropelled postmen begin to look positively old fashioned when we consider that drones are now being developed to deliver mail3 and pizza4. Alas, his pogo police car5 never gained traction. Insights Melbourne Business and Economics

Envisioning the future can, however, also be confronting and sobering, with a complexity that can defeat our ability to digest the implications. Perhaps this partly explains why decision making in business and government is notoriously short-term. Keynote speaker Lynda Gratton6, labelled one of the world’s leading business thinkers by the Financial Times, is a consultant and organisational theorist at London Business School. She is also the founder of the Hotspots Movement7, an interactive research project with 200 executives from 23 multinational corporations that, among other things, looks at the Future of Work. Gratton argues five forces have created a ‘perfect storm’ that will require people to embark on massive shifts in their approach to their working lives8: technological developments, globalisation, demographic trends, societal trends and low-carbon developments.

Shrinking technology, expanding knowledge According to conference keynote speaker Dave Evans, chief futurist at Cisco, the sum of human knowledge used to double every century but is now doubling every two years and growing exponentially, especially in fields like nanotechnology and biotechnology. Evans noted some estimates that the world’s data stores will double every 11 hours by 2025. Much of this activity is in rich-text media like photos and video, but data in the workplace, he said, has grown 50 times faster than consumer data. He also told the conference: As of 2008, we’re now creating more new data every 10 minutes than we did in all of human history. If we don’t invest in the tools and technologies to mine this data, we’re going to be buried in so much data we won’t be able to extract the knowledge that we need to make smart decisions. Evans outlined several developments that are ushering in, or are expected to usher in, new waves of digital disruption, especially in health and medicine and manufacturing. Some of them raise serious issues about privacy, although Evans, a self-confessed optimist, prefers to see them as opportunities that can be managed. 16

Future of work: people, place, technology

The first of these is Augmented Reality (AR), in which a view of real-world information (either online or direct) is overlaid by computer-generated input such as text, sound, video or GPS data. Examples include text being overlaid on a driver’s windscreen, navigation and weather data to help pilots9, or imaging on a patient’s body to help guide surgery10. Since the dawn of time, humans have been accustomed to adapting to technology. The future according to Evans is technology that adapts to us. We will move away from actively searching for information to letting information come to us. This technology will transform consumer habits through innovations such as digital signage in shopping malls that recognises, if customers opt in, shoppers’ faces, ages, ethnicities and shopping preferences. Another scenario is television sets that recognise when a small child is in the room and filters out inappropriate content, or recognises when viewers are bored. Evans believes brainmachine interfaces are not far away – devices such as thought-driven wheelchairs, or the ability to download a new skill or even a language – a theme in Nicholas Negroponte’s 2014 TED (Technology, Entertainment and Design) talk11. The second is 3D printing, which has dropped tenfold in price in the past five years. 3D printers can already process 70 materials, including carbon fibre, aluminium and precious metals, to produce objects such as bicycles, jewellery and turbo engines. Online marketplace websites such as Shapeways have sprung up to enable bespoke manufacturing, similar to Etsy (the online marketplace for handcrafted and vintage items), but for plastics and metals. The implications for medical research and transplant medicine are enormous: scientists have already printed a human liver that can survive for 40 days, and miniature organs. Airbus Industries predicts that by 2050, it will be able to print planes using hangar-sized 3D printers. The Zeus 3D printer, expected to be available to consumers later this year, will allow people to insert an object, make a copy and even fax it to another Zeus.

‘The entire physical world is becoming digital,’ Evans said. ‘We will download things as easily as we download music today. Who will be the manufacturer, the innovator, tomorrow? How will this shape the workforce?’ Evans is optimistic about the prospects for future workforces as a result of these digital innovations, acknowledging that jobs will be lost, but that new opportunities will emerge. ‘The top 10 jobs in the next six years don’t yet exist… we’re training kids for jobs that don’t yet exist, using tools that may not yet exist. It would be quite easy to move into a dystopian future. I don’t think that would be

the case.’ In any case, he says, as outlandish as talk of virtual people and 3D printing sounds, all of this is underway. ‘It’s not science fiction, it’s science fact. And every single thing was enabled by the internet.’

Are we creating coin-operated employees? Technology disrupts and transforms, but it does not do away with the eternal conundrum that is people, and questions such as how best to lead, manage, follow and work with others. The way we work is changing. Australians are increasingly employed Insights Melbourne Business and Economics

in non-traditional industries, working flexible hours and using technology to work anywhere. Expectations of leaders are changing with an ever-increasing imperative to innovate and build dynamic workplace cultures. Employees, too, are feeling buffeted by technological advances and globalisation. In survey results released to coincide with the Future of Work conference, 49 per cent of Australian workers aged under 55 reported feeling worried about what the future holds for them at work. Executive and middle managers were more fearful than non-managerial employees. Despite this, the survey also revealed

Future of work: people, place, technology

79 per cent of Australians are open to change in their workplace to improve productivity. Better leadership and new technology were the two key areas that Australian workers identified to increase productivity, with government workers in particular highlighting more effective leadership and management as a change that would most likely increase productivity. What makes for a productive or â&#x20AC;&#x2DC;high performanceâ&#x20AC;&#x2122; workplace might be called the holy grail in management and business research, especially in the area of human resources management and industrial relations, where a great deal of effort has been

expended in investigating the relationship between different types of workplace and management practices, and higher productivity and other workplace performance measures. The Centre for Workplace Leadership has just completed a literature review of prior research12 to underpin the Centre’s own research agenda and inform the development of programs and events. There is abundant international research on the effectiveness of different leadership styles and approaches, but a significant gap in our understanding of leadership capability in the Australian context. The last 20 to 30 years of research on the ‘high performance workplace’ consistently shows that better workplace productivity and performance is associated with the deployment of management practices that invest in skills and capabilities, enable employee discretion and involvement, and engender employee motivation and engagement. Paradoxically, however, the evidence also indicates that a minority of workplaces deploy them. There are many reasons that explain this paradox, but clearly, developing the ability of business leaders and managers to translate these principles into their workplace practices presents a great opportunity to lift productivity significantly. Anecdotally, we know that many firms are still stuck in a nineteenth-century approach to leadership, and this was a theme taken up by conference speakers who explored motivation and incentives. Terry Lee, Director of Leadership Psychology Australia, whose clients include Wesfarmers and Bunnings, said many organisations were finding themselves in a cultural cul-de-sac at a critical time. ‘We’ve spent 100 years designing organisations not to change, to dumb down initiative, to structure people into compliance, and now we’re trying to transform those very structures into high-performance organisations which unlock the potential of people’, he said. Lee expressed scepticism about financial incentives, arguing they work only in a narrow range of circumstances. They can discourage employees not traditionally rewarded in this way. For example,

small businesses that reward sales staff with bonuses are signalling that they value this class of worker more than others. While these incentives are measurable, clear and do work, they have ‘a demeaning effect on people who operate in a support capacity’. When financial incentives are used to stimulate innovation, Lee argues they have a perverse effect in drawing out mediocre contributions from people keen to harvest financial rewards rather than those genuinely passionate about an idea. Motivation, Lee says, is about carrots and sticks, ‘whereas inspiration is to awaken something in the person… If you’re paying people to do the thing they love to do, then you demean the thing they love to do.’ Jason Clarke, author, consultant and founder of Minds at Work, charted a common demotivation trajectory, saying: When you hire someone, guess what they bring to the job? Their heart, their mind, their body. The first couple of days you get the whole package. And do you know what happens when we say we’re not interested in your ideas? They leave their mind at home. You know what happens when we say we don’t care about your passions? They leave their heart at home. And you know what’s left? We’ve thrown away all the best bits, and this husk turns up and we become coin operated.

Diversity, collaboration and reluctant leaders Mid-century futurists like Arthur Radebaugh emphasised technology but seldom speculated on how it might shape us. People might have been portrayed as taller, shinier and happier, but their roles defaulted to the mid-century American norm: the women were at home and the faces were white. The reality Australian leaders face today is much more diverse. Geoff Aigner, former management consultant and now director at Social Leadership Australia, told conference attendees that leaders and managers need to understand diversity in much broader terms, not only because the make-up of our workforce is changing but also because collaboration is a much more significant part of our working lives. Insights Melbourne Business and Economics

Beyond the familiar categories of race, class and gender there are also age, experience, psychological outlook, confidence, and connection to a deeper purpose. Australian managers are, he says, too conflict averse to navigate through this diversity. He says: The way through collaboration is anything but capability. You can have as much technical capability as you like – great processes, great nous, a great project plan and lots of money. But what’s missing is that we haven’t been educated or rewarded to work across differences. We’ve been rewarded to work with similarity.

Future of work: people, place, technology

Aigner is the author, with Liz Skelton, of The Australian Leadership Paradox, which argues that Australian leaders are reluctant to acknowledge the power they have and are unsure what to do with it. He told the conference that every day, society sees the effects of misused or unacknowledged power in child abuse, domestic violence and workplace bullying. ‘The people who are throwing their weight around or bullying and harassing people are not people who are owning their power,’ Aigner said. ‘They’re generally people who don’t understand their power

and as a consequence abuse it or neglect it. We see a repeated dynamic in Australian workplaces where people use too much firepower: ‘I don’t think I have any power so I turn up the heat’.’ Neglect might seem a benign alternative to misuse, but Aigner argued that disavowing power is not the answer: it is crucial to use it well. And in collaboration, there is no escaping power: Collaborative efforts are essentially a negotiation of power, a movement of power between individuals. Collaborative efforts are necessarily shifting power because the (preexisting) hierarchies which have much clearer power structures are being shaken up. This ambivalent attitude to leadership was echoed by Jason Clarke: ‘We keep asking for leadership and it’s the thing we’re most cynical about; ‘Tell us, oh mighty one – you idiot – what are we doing?’‘ Clarke too advocated an expanded view of diversity: ‘Great minds don’t think alike. You want change? Then you want cynics, idealists, pragmatists and lunatics, panic junkies, devil’s advocates. You need them all, they’re all beautiful. The trick is knowing how to get them to work together.’

Conclusion Envisioning the future of work requires both examining the past but also recognising that there are, as Lynda Gratton argues, limits to what the past can tell us about the future in times of massive volatility. The forces shaping new worlds of work not only shape the macroeconomy, but have significant and often disruptive effects ‘on the ground’. They are destroying old businesses and prompting the development of new ones. Of particular interest for understanding productivity, we can say that these changes are reshaping labour markets and workplaces. These developments challenge managers and business leaders, as well as workers. They are altering models of work and employment, changing our attitudes towards different forms of employment and sense of careers over the life course.

Elisabeth Lopez is a former print and broadcast journalist and Federal parliamentary advisor and researcher. Peter Gahan is Professor of Management and Director of the Centre for Workplace Leadership in the Department of Management and Marketing, University of Melbourne. 1 http://www.nytimes.com/books/97/03/23/lifetimes/ asi-v-fair.html, accessed 11 August 2014. 2 http://www.smithsonianmag.com/history/arthurradebaughs-shiny-happy-future-127216952/, accessed 11 August 2014. 3 http://news.ie.msn.com/business/uae-developing-retinascanning-drones-to-deliver-government-mail, accessed 11 August 2014. 4 http://www.bloomberg.com/news/2013-10-30/dronesdelivering-pizza-venture-capitalists-wager-on-it.html, accessed 11 August 2014. 5 http://media-cache-ak0.pinimg.com/736x/14/c9/f6/ 14c9f6d3198b7d48518051a1801a9ac5.jpg, accessed 11 August 2014. 6 http://lyndagrattonfutureofwork.typepad.com/, accessed 11 August 2014. 7 http://www.hotspotsmovement.com/, accessed 11 August 2014. 8 http://www.lyndagratton.com/uploads/BSR - LG investigates the FOW.pdf, accessed 11 August 2014. 9 http://www.augmentedrealitytrends.com/augmentedreality/aero-glass.html, accessed 11 August 2014. 10 http://www.augmentedrealitytrends.com/augmentedreality/doctors-perform-surgery-with-augmented-realitytechnology.html, accessed 11 August 2014. 11 http://blog.ted.com/2014/03/17/back-to-techs-futurenicholas-negroponte-at-ted2014/, accessed 11 August 2014. 12 http://www.workplaceleadership.com.au/app/ uploads/2014/07/Workplace-Leadership-A-Review-ofPrior-Research-2014.pdf, accessed 11 August 2014.

References Aigner, G and Skelton, L 2013, Australian leadership paradox: what it takes to lead in the lucky country, Sydney: Allen & Unwin. Asimov, I 1964, ‘Visit to the world’s fair of 2014’, New York Times, 16 August 1964.

Insights Melbourne Business and Economics

Article heading here

WHY WE NEED MORE POWERFUL MULTINATIONAL CORPORATIONSi It may be possible to make governance changes that render large global corporations more beneficial – and less costly – to humanity. BY WILLIAM H. STARBUCK

A condensed version of a public lecture given at the University of Melbourne on 10 March 2014.

Management scholars should be among the leaders of debates about desirable changes in the governance of corporations, an important task that should not be left solely to judges and politicians. Although debates about governance should involve all stakeholders, academics have special responsibilities as both thought leaders and sources of reasoned analysis. Even if it takes many years and millions of words, contemporary academics can reshape humanity’s understanding of corporations’ properties. History indicates that academic debates significantly influenced today’s governmental and legal policies and actions regarding corporations (Starbuck, 2003). During the 1800s, proprietorships and partnerships were much more prevalent than jointstock companies and corporations, and people saw little distinction between these organisational forms (Lamoreaux, 2000; Mark, 1987). Each business had to have a unique charter, and these charters did not limit the liabilities of owners. It was academic debates, especially during the late nineteenth and early twentieth centuries, that established the differences between partnerships and corporations. A four-volume work (1868–1913) by Gierke proposed that each corporation possessed personhood and a distinctive personality. Gierke’s idea spread worldwide and influenced government policies and legal decisions in many nations. Machen (1911, p.259) amplified this idea, arguing that a house could not be ‘merely the sum of the bricks that compose it’ for one could ‘change many of the

bricks without changing the identity of the house’. Rathenau (1917, p.121) pointed out that everchanging ownership through stock-exchange trades implies ‘the enterprise assumes an independent life, as if it belonged to no one’. Later, Berle and Means (1932, p.313) showed that ‘all stockholders held very small fractions of the stock, with the result that stockholders of about half of the largest corporations could not exert effective control’. It would be a mistake to lump all corporations into a single category. Uniform governance policies would not serve the interests either of most corporations or of humanity in general. Large global corporations deserve special thought and distinctive policies. An approach to governance that serves the interests of one corporation in the short run may be incompatible with long-run peace and prosperity in the world as a whole. Trying to change corporations’ behaviours solely by altering their boards of directors is likely to be ineffective because the truly powerful governance processes operate inside management hierarchies. Contemporary corporations are only starting points for evolution toward future corporations that will almost certainly differ greatly from those that now exist.

Large global corporations deserve special handling Just as people in the early nineteenth century did not draw clear distinctions between types of business Insights Melbourne Business and Economics

firms, people today do not draw clear distinctions among types of corporations. The unitary term ‘corporation’ implies that laws and governments should treat all corporations in much the same ways, yet the behaviours of small, closely-held local corporations differ in content and effect from the behaviours of large global corporations. Effective policies toward business firms require cognitive categories and labels that make useful distinctions – and academic debates have historically exerted strong influence in the construction of these categories. The geographic scope and economic power of large global corporations place beneficial changes in their governance among the most important challenges for humanity. These corporations both create and mitigate the world’s serious long-term stresses. It may be possible to make governance changes that render these corporations more beneficial – and less costly – to humanity. Many large corporations wreak harm on their social and natural environments. Some focus on exploitation, armaments, and short-run windfalls. Almost all have behaved badly on occasions. Many corporate executives act selfishly or dishonestly; corporations lie, cheat, and steal. However, such behaviours occur at least as often in the non-governmental and governmental sectors. Organisations everywhere are composed of people, and those who work in corporations resemble those who work for governments and NGOs. Practical solutions to earthly problems must allow for inconsistencies, imperfections, and failed strategies. Indeed, it may be that inconsistencies, imperfections and failed strategies are essential elements to longrun improvements. Large global corporations warrant special attention not so much because of their current behaviours but because of their potential for future benefits. Overall, existing social institutions have failed to create a better world. Changes are essential. Starbuck (2004, 2013) described important global trends in population, wealth stratification, communication technology, transportation, cultural identities, armed conflicts, and corporate governance. These trends challenge the premises on which 24

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contemporary societies operate. The UN and the World Bank predict that starvation, warfare and social stratification will all increase; and that people are going to devote increasing attention to short-run instead of long-run goals (National Defense Council Foundation, 2002; Shell International, 2002; Starbuck, 2004, 2013; United Nations, 2010, 2012; World Population Awareness, 2003). Some large global corporations have been making important contributions toward better futures in all of these areas. These contributions include transfers of wealth from more affluent to more impoverished people, reductions in the frequencies of armed conflicts, increases in social equality, and investments to create future options (De Grauwe and Camerman, 2003; Doering et al., 2002; Omae, 1999; Starbuck, 2004, 2013). Indeed, large global corporations are practically the only societal institutions that are spanning national boundaries, mitigating internation conflicts, attending to global issues, and linking the world into a cooperative system. Because large global corporations have already proven themselves extremely effective, they could become tools for mitigating or solving the looming global problems. Humanity clearly needs more effective tools than currently exist. However, powerful tools can be dangerous and inflict great harm, just as they can create great benefits. The key question is: who controls these corporations? Global corporations have shown strong tendencies to collaborate with national and local governments, tendencies that generally favour the interests of wealthier versus poorer nations, prioritise warfare instead of peacemaking, and emphasise short-run instead of long-run goals. Current institutional structures have resulted from interactions between corporations and legislators in which the corporations offered incentives to legislators to pass laws that favour the corporations. Nations and states have competed with each other to win the favour of corporations. Because humanity usually fares better when businesses and governments serve distinct purposes, a major challenge is how to increase the differentiation between large global corporations

and national governments. Historically, close cooperation between corporations and governments has taken resources away from average citizens and employees, present and future. National governments have geographic definitions that embody the interests of contemporary holders of power and wealth, so when national governments exercise control over corporations, the controls favour inequality of wealth and power.

contending interests fight over spoils. Such fights have driven many corporations out of business. Diversity on boards may slow decision-making, particularly reactions to threats or opportunities. Involvement of many outsiders who change frequently may mean that directors do not understand corporations’ internal operations and do not accurately evaluate consequences of proposed actions (Kristie, 2009).

Humanity must decide what goals are most important

Contemporary corporations gain considerable advantages from focusing on a unitary goal – corporate profits. Pursuit of profit is not simple – profit integrates multiple sub-goals, some of which contradict each other. The apparent simplicity actually represents the net effect of diverse institutionalised conventions about how to resolve conflicts among goals. A profit focus enables corporations to resolve conflicts between political interests both within and between corporations and their environments; and facilitates the resolution of conflicts between contending technologies, strategic options and competing corporations. Thus, a profit focus reduces pre-decision debates. Swift decision-making has enabled global corporations to comprehensively outsmart national and local governments.

Large global corporations have many degrees of freedom. They can sidestep or influence government efforts to control them. Changes in their governance are unlikely to occur unless the affected corporations perceive these changes to be advantageous. However, recent trends suggest that large global corporations are losing their national identities and gradually becoming citizens of the entire world, and their behaviours are creating bonds between individual people and institutions that span national boundaries (Starbuck, 2004, 2013). Thus, corporations may see value in governance changes that reflect their broadening geographic ranges. Nevertheless, there are serious disadvantages to promoting governance changes based on benefits offered to current corporations. Many current executives have extracted personal short-run benefits to the disadvantage of other current stakeholders (employees, customers, suppliers, neighbors). Current executives are not tomorrow’s executives, and in solving current problems they may create future problems. Costs and benefits from the perspective of one lone corporation are nearly always different from those seen in retrospect by citizens and corporations of the future. The survival and success of individual business firms may well prove harmful from a long-run global perspective. What matters for the world at large is the distribution of evolving capabilities across the entire population of business firms. Proposals that call for corporate governance by heterogeneous boards of diverse stakeholders risk turning corporations into arenas in which

However, profit computations depend on institutionalised accounting conventions that ignore many issues. These conventions change slowly via governmentally-approved boards and courts; they ignore the particular circumstances facing individual corporations; and they bias corporations’ perceptions toward the past and the present, and away from the future. Thus, governance changes that encourage corporations to engage in internal debates about consequences would also transfer power to corporations and weaken professional bodies, courts, and national and local governments. Insofar as large global corporations attend to issues that span national boundaries, such changes would tend to integrate the world and shift thinking toward the future. Academic debates and research can influence corporate governance by influencing accounting conventions. Insights Melbourne Business and Economics

Effective governance structures need to operate at several levels Everyone can think of instances in which boards of directors have fired CEOs or demanded major changes in corporate strategies. These events draw attention because they are so rare. Directors rarely take strong actions contrary to management because they are subordinate to management and have monetary and social incentives to endorse management proposals and strategies. Frequently, senior executives nominate all the candidates for board membership – people whom they expect to make no waves. Most stockholders do not purchase shares themselves; they purchase mutual funds or they manage pension funds. Usually 70 to 80 per cent of shareholders return proxy ballots that give senior executives control over the actual elections of directors. Matters that boards discuss usually come through corporate hierarchies that make sure disruptions do not occur. In many instances, the corporate CEO is the only person from inside the corporation who participates in board discussions consistently, making the CEO the board’s dominant source of information about events inside the corporation. Senior executives who want the opinions and insights of various external experts can obtain these from consultants or informal advisors as well as from boards of directors. Given that senior executives dominate daily operations in large global corporations and dominate the composition of boards of directors, it seems naïve to think that changes in non-managerial governing boards are likely to have enduring effects. For governance changes to have lasting and significant effects, the changes should focus on managers themselves: what is the right composition of a managerial hierarchy; what are productive ways for management to operate and interact? As corporations have expanded globally, they have become more reliant on native-born hostnation executives, who are increasingly rising to the tops of managerial hierarchies. This process of internationalisation has contributed to the trend in which corporations increasingly lack national 26

Why we need more powerful multinational corporations

identities. It also reduces corporations’ propensities to exploit host nations. These changes seem likely to expand as more and more corporations spread globally. Nevertheless, managerial governance can be better. As many critics have pointed out, senior executives in large corporations are quite self-confident and accustomed to receiving deference. A few become so used to deference that they are prone to rambling monologues and to interpreting dissent as criticism or even disrespect. Although hierarchical deference allows fast decisions and reduces intra-organisational conflict, it also hides information and alternative interpretations that might improve decisions. The censored inputs include extra-organisational issues, externalities and potential threats. Thus, senior executives need exposure to dissenting views to help them remain grounded. They also need opportunities to discuss topics that are not yet sufficiently relevant for discussion by boards of directors, such as speculation about future challenges and opportunities – technological trends, possible changes in government regulation, or global politics. Governance by management is more effective when senior executives receive inputs from people they perceive as their peers – senior executives in other corporations and government agencies. Managers at all levels are more likely to heed those they perceive as peers. CEOs can challenge the thinking of fellow CEOs without appearing disrespectful. People speaking to peers tend to phrase their ideas and criticisms in ways that listeners are willing to hear. Currently, a handful of venues draw senior executives from different corporations to discuss topics of mutual interest in settings where participants can speak freely without risk of public observation. For example, the World Economic Forum in Davos, Switzerland, offers presentations about global social issues that stimulate discussions (http://www.weforum.org/). The forum draws 2000 participants from large organisations worldwide. However, its presentations and the discussions that ensue receive press coverage, which tends to suppress free expression in public meetings.

Although forum sessions do not attempt to link global issues to the policies and practices of individual corporations, such linking may occur when participants engage in informal evening discussions.

potential participants have identified during oneon-one conversations. These events and issues then become springboards for a daylong evolution from global toward local, from the world at large toward participantsâ&#x20AC;&#x2122; own corporations.

By contrast, the Yale CEO Summits occur with no press coverage because participants agree to publish or report nothing that they hear during the event (http://celi.som.yale.edu/ceo-summits). The summits seek to create â&#x20AC;&#x2DC;safe havensâ&#x20AC;&#x2122; in which 100 participants can speak very freely. In addition to CEOs, the participants include various kinds of experts, government officials, legislators, regulators and shareholder-activists. Once, a US President brought his entire cabinet. They begin by discussing recent events and global issues that

Yale has offered to help other business schools to start similar programs, so far without any response. One reason may be that such meetings diverge from the ways universities normally operate. Although participants pay fees that cover the costs, it takes considerable work to create meetings that seem relevant to senior executives. An unstable roster of conventional professors cannot perform these activities well; they probably require decades of commitment and professors with distinctive abilities (Rifkin, 2011).

Insights Melbourne Business and Economics

Beyond today’s corporations The twenty-first century has begun turbulently with social disruption, wars, and global environmental threats showing no sign of abating. Indeed, forecasters say that turbulence is likely to grow (UN, 2013). However, such disruption brings the potential for change, as past turbulence has fostered social innovations. For example, industrialisation and geographic migrations during the nineteenth century led to experiments with new organisational forms that eventually produced contemporary corporations. Social innovation during the twenty-first century will change legal and popular concepts about corporations. There are many reasons to challenge the usefulness and validity of current concepts, including concepts about corporate governance. Widespread but incorrect myths say corporations operate for the benefit of stockholders and are subordinate to local and national governments. Myths also claim that managers serve the interests of stockholders, and that other stakeholders should have no voice in corporate governance. Reality says that owners’ voice in corporations comes indirectly through financial markets, and that some other stakeholders – mainly large powerful organisations – have stronger voices in corporate governance than stockholders. Frequently, small groups of managers control corporate policies and resource allocations and choose their own successors. Thus, it is time to rethink ideas about large corporations. Corporations fall into several distinct categories that already have different rights and responsibilities. Large global corporations have different rights and responsibilities in different nations. Powerful social and technological forces are also pressing corporations to innovate. Cellphones have spread faster than any previous technological innovation and are multiplying communication to a degree that could prove socially transformative. Increasing education, telework, diversity, globalisation and technological change are making traditional hierarchies less useful and making intraand inter-organisational networks more useful. This implies that alliances and inter-organisational networks will replace many organisations and that 28

Why we need more powerful multinational corporations

senior executives and governing boards will need to focus on culture-building and the management of trust (Baumard and Starbuck, 2001). As alliances and networks replace corporations, formal corporate governance will become less relevant for actual behaviours. One radically different organisational form has already emerged: Islamic countries have spawned organisational force-fields that cause people to spring into action almost at random over large geographic areas (Bell, 2002). Force-fields perceive an organisation not as a control structure or system of rules but as a potential for actions that hover just below the brink of actualisation. Which people actually act and which actions occur can be quite random because they are specific instances from very large pools of latent possibilities. The emergent activities may take different forms and involve different missions in different ways at different times. Some of these force-fields have been the media for societal revolts, including terrorist activities, political revolutions, and financing of product innovations. However, force-fields have numerous applications in a globalising world where much low-cost, high-speed communication occurs between people who have never met face-to-face. Indeed, Facebook and Twitter are operating largely in force-field mode. William H. Starbuck is courtesy professorin-residence at the University of Oregon and professor emeritus at New York University. He has held faculty positions at universities in the US and abroad, and was President of the Academy of Management. i This paper benefits from the valuable insights of Rick Goings and Jeffrey Sonnenfeld.

References Baumard, P and Starbuck, WH 2001, ‘Where are organizational cultures going?’ in Cooper, CL, Cartwright, S and Earley, PC (Eds.), The International Handbook of Organizational Culture and Climate, Wiley, Chichester.

Bell, JB 2002, ‘The organization of Islamic terror: The global Jihad’, Journal of Management Inquiry, vol. 11, pp.261-266. Berle, AA, Jr and Means, GC 1932, The Modern Corporation and Private Property, Macmillan, New York. De Grauwe, P and Camerman, F 2003, ‘Are multinationals really bigger than nations?’, World Economics, vol. 4, no. 2, pp. 23-37. Doering, DS, Cassara, A, Layke, C, Ranganathan, J, Revenga, C, Tunstall, D, and Vanasselt, W 2002, Tomorrow’s Markets: Global Trends and Their Implications for Business, World Resources Institute, Washington DC. Gierke, OF, von 1868-1913, Das deutsche Genossenschaftsrecht (4 volumes). Diverse publishers. Portions of this large work have appeared in English, as follows: Selections from volume 1, translated by M. Fischer, 1990, Community in Historical Perspective, Cambridge University Press, New York. Selections from volume 3, translated by Maitland, FW, 1900, Political Theories of the Middle Age, The University Press, Cambridge; and 1996, Thoemmes Press, Bristol, England. Five sections of volume 4, translated by Barker, E, Natural Law and the Theory of Society, 1500 to 1800, 1934, The University Press, Cambridge; and 1957, Beacon Press.

National Defense Council Foundation 2002, World Conflict List 2002, http://www.ndcf.org/ Omae, K 1999, The Borderless World: Power and Strategy in the Interlinked Economy, (revised edn), HarperBusiness, New York. Rathenau, W 1917, Von Kommenden Dingen, Berlin. Fischer, S, Paul E, and Paul, C, published an English translation in 1921 as In Days to Come, Allen & Unwin, London. Rifkin, G 2011, ‘CEO master class’, Briefings on Talent and Leadership, Korn/Ferry Institute, Winter 2011, pp. 35-40. Shell International 2002, People and Connections: Global Scenarios to 2020, Shell International: London. Starbuck, WH 2003, ‘The origins of organization theory’, in Tsoukas, H and Knudsen, C (Eds.), The Handbook of Organization Theory: Meta-Theoretical Perspectives, Oxford University Press, Oxford. Starbuck, WH 2004, ‘Four great conflicts of the twenty-first century’, in Cooper, CL (Ed.), Leadership and Management in the Twenty-First Century, Oxford University Press, Oxford. Starbuck, WH 2013, ‘Un autre regard sur quatre des grands conflits du XXIe siècle (Another look at four of the great conflicts of the twenty-first century)’, Outre-Terre, Number 38.

Kristie, J 2009, ‘Rick Goings: “We’ve got an incredible board”’, Directors & Boards Magazine, Second Quarter (Spring) 2009, pp. 18-23.

United Nations 2010, World Population Prospects, United Nations, New York, http://www.un.org/ popin/data.html

Lamoreaux, NR 2000, Partnerships, Corporations and the Problem of Legal Personhood, Manuscript, UCLA and National Bureau of Economic Research.

United Nations 2012, The State of Food Insecurity in the World, Food and Agriculture Organization of the United Nations, Rome.

Machen, AW, Jr 1911, ‘Corporate personality’, Harvard Law Review, 24, pp. 253-267, pp. 347-365.

United Nations 2013, World Economic Situation and Prospects 2013: Global outlook, http://www. un.org/ru/publications/pdfs/2013%20world%20 economic%20situation%20and%20prospects.pdf

Mark, GA 1987, ‘The personification of the business corporation in American law’, University of Chicago Law Review, 54, pp. 1441-83.

World Population Awareness 2003, World Population Awareness and World Overpopulation Awareness, http://www.overpopulation.org/ Insights Melbourne Business and Economics

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LESSONS FROM A CAREER IN BANKING Banking is not just a business. By Harrison Young

A condensed version of an address given at the University of Melbourne on 14 March 2014.

I became a commercial banker because I didn’t get into law school, and when I got out of the Army I needed a job. Citibank taught me accounting, corporate finance and credit analysis. Then, when I arrived at Morgan Stanley four years later, I became a specialist in financial institutions because I joined a team advising a commercial bank in Cleveland that was feeling queasy.

healthy risk culture includes both a passion for accuracy and regard for instinct.

Risk culture

What ultimately put the bank in Cleveland in mortal peril was double leverage. It had borrowed at the holding-company level to inject equity into the bank. If the bank couldn’t pay dividends, the holding company would not be able to pay interest. A bank with the bad loan problems our client had shouldn’t have been paying dividends, and the Fed wanted it to stop. But if its parent couldn’t service its debt, the bank’s depositors would start pulling their money out of the bank, which would face a liquidity crisis and might easily fail. Our job was persuading the Fed to be pragmatic.

The bank in Cleveland was my first exposure to the important concept of risk culture. They had lovely offices. They were polite and amusing. But they tolerated muddle. The poet Randall Jarrell once defined the novel as ‘a prose narrative of some length that has something wrong with it.’ In that spirit, a bank could be defined as a mismatched institution with a data problem. The sincerity of its struggle against that problem tells you a lot about a bank’s risk culture. The bank in Cleveland had three overlapping lists of problem loans floating around their headquarters, compiled by different departments under different criteria. I had to draw the chief executive a Venn diagram. ‘Oh my’, he said. But knowing what you have is just the start. Most of the assets and liabilities on a bank’s balance sheet have embedded options, which don’t necessarily get exercised when you’d expect. Banks must be perpetual students of their assets and liabilities – developing a sense of how they ‘normally’ behave, and how they might behave under stress. So a

One reason I decided I was happy to be pigeonholed as a banker to banks is that banks are heavily regulated. I found the interplay of commercial and public policy considerations interesting – and gravitated to assignments where you had to wrestle with both.

One of the most memorable transactions I worked on was the insurance broker, Marsh & McLennan, buying its London equivalent, C. T. Bowring. In 1979, when we started work on the project, the city was on the threshold of big changes, but traditional eccentricities were still alive and well. We stayed in Claridge’s, admired the hall porter’s eighteenth century livery, ate grand dinners, read the Financial Times each morning, learned the names and functions of dozens of tiny specialist firms – brokers, stock-jobbers, discount houses, accepting houses, underwriters, names agents – and met some Insights Melbourne Business and Economics

extremely clever men who could have been invented by Charles Dickens. In the ensuing years, ‘Big Bang’ happened. Merchant banks bought brokers and jobbers. Commercial banks bought merchant banks. Compensation exploded. The hall porter stopped wearing kneebreeches. For the most part it was exhilarating, but it left me both sadder and wiser. The wisdom part is a persistent expectation of discontinuous change, a conviction that banks can never entirely relax. The barbarians may not be at the gate, but they are somewhere in the forest across the river. The sadness involves the disappearance of S. G. Warburg & Co. To do a takeover in London, we needed the help of a London merchant bank, so we brought them in, and they were superb. Sigmund Warburg died in 1982. As the city changed, the firm grew rapidly, faltered, and was absorbed into what is now UBS.

Capital and volatility In 1982, I had the opportunity to play investment banker to my employer. Morgan Stanley had traditionally been an underwriter of high-quality stock and bond offerings, which required good judgment but very little capital. A handful of partners would sit around a table in a wood-paneled room, study a meticulously prepared exhibit called a ‘multi-company comparison’, and decide whether the coupon ought to be 6 ¼ or 6 ½ per cent. The firm’s prestige was such that the market tended to accept their decision. In the early 1970s, however, with markets getting more volatile, it became clear that you needed to have at least a modest sales and trading operation to make such judgments. That required capital. In fact, it required two kinds of capital. ‘Regulatory capital’ requirements were determined by the Securities and Exchange Commission (SEC), ‘cash capital’ requirements by the commercial banks which financed our inventory of bonds and shares. These requirements could differ significantly and required attention to both. The chief financial 32

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officer of Morgan Stanley had set up a management information system that allowed him to track them in real time. Then one day he asked a harder question: ‘How much capital should we have?’ Someone decided I was the person to answer that question. The problem for an organisation accustomed to consulting multi-company comparisons was that most of the major securities firms were private partnerships. There weren’t any points of reference. I asked several senior partners how to proceed and got what amounted to elegant shrugs. A meeting was arranged with the chief financial officer of Goldman Sachs, which had more significant sales and trading operations than we did. I asked, ‘How much capital should a securities firm have?’ His reply: ‘More than it thinks.’ The approach I eventually settled on was to sit down with the men running each of Morgan Stanley’s 17 lines of business, try to understand how they did what they did, examine their monthly results over the past three years, and agree on a reasonable worst-case loss. I suggested that we should have equity equal to the sum of those 17 worst cases. I said it was unlikely that everything bad we could think of would happen at once. This is actually not true. In a crisis, everything does go wrong. But I hadn’t learned that then. What I did say was that there were probably bad things we hadn’t thought of. And if people felt I was being too aggressive or too conservative, they could adjust my figure up or down. At least I had given them a point of reference from which to apply judgment. I guess the partners liked my answer. ‘Hmmm,’ they said. Anyway, I was never asked to do any follow-up work. I wish I had been – not because I would have come up with a better answer, but because it would have given me a glimpse of how this collection of experienced businessmen wrestled with the problem. That would have been interesting. I took several lessons away from my stint as Morgan Stanley’s investment banker. First, the need for capital is primarily a function of the volatility of the

business. Second – reinforced by watching events since then – is that forecasting volatility is hard. Markets are more like weather than like dice, where the odds are known. What bankers call risk carries a large element of uncertainty. Third, that ignoring regulations clears the brain. Perhaps because the regulatory- and cash-capital perspectives so often differed – but also, I think, because their personal reputations and fortunes were chained to Morgan Stanley – the firm’s partners didn’t start by asking what the SEC or the financing market required. They asked themselves what they felt comfortable with. Chained as they are to the ‘Basel Enterprise’, banks can have difficulty doing that. A prerequisite to determining capital policy is understanding the business models being pursued. Having expanded fairly quickly by bringing in practitioners from other firms, Morgan Stanley’s partners knew less about what they were doing than they thought they did. Part of my work consisted of describing those 17 business models as simply as possible. Lesson number four was how helpful that can be.

Good internal communications, which those simple descriptions facilitated, turns out to be a core competence of successful banks. Studies done in the wake of the GFC suggest that ‘siloed’ institutions did worse than those where information was shared among senior executives and collective judgment could be brought to bear on major risk decisions. Even when banks get very big, those whose culture has a ‘partnership feel’ tend to make fewer mistakes.

Washington What may have been the crucial turning point in my career occurred in July of 1984, when Bill Isaac, who was then chairman of the Federal Deposit Insurance Corporation (FDIC), called to say that he had to ‘do something’ about Continental Illinois, and could we be in his office that afternoon? I won’t describe the complex structure by which Continental Illinois was kept open while its shareholders lost their investment – as they should have. Suffice it to say that spending the summer of 1984 in Washington made me a life member Insights Melbourne Business and Economics

of the ‘too-big-to-fail’ Debating Society. More significantly from a personal standpoint, it gave me an insider’s understanding of bureaucratic jargon and process, and made me the FDIC’s natural choice as an advisor on major resolutions. Eventually, late in 1990, Bill Seidman, who succeeded Bill Isaac, persuaded me to quit my Wall Street job and join the FDIC to establish and lead a division of resolutions. I spent almost four years in Washington, where we handled 266 bank failures. It was the lowest paid and most rewarding job I’ve ever had. Even before my first trip to Washington, I had read Bagehot’s Lombard Street and Kindleberger’s Manias, Panics and Crashes, and knew a bit about the way central banks and other supervisors use market

Lessons from a career in banking

discipline, signaling and ambiguity to preserve systemic stability. The history of bank regulation can be summarised as ‘more risk, then less risk, and now more risk’, and I can probably talk about the subject longer than most people want to listen. But let me leave you with two memories, images that characterise the challenges of the ‘system-minding’. The first is an example of overkill. It was 1998, a few years after I’d moved from Washington to Asia. I was calling on Bank Indonesia, that country’s central bank. In the front lobby of their headquarters, there was an enormous pile of carrying bags, each stuffed with bricks of paper currency. Workers were carrying the bags to a long procession of panel trucks in the parking area. The trucks were being dispatched to branches of banks all over Jakarta. The IMF had

insisted, as a condition of its assistance during the Asian Financial Crisis, that Indonesia purge itself of ‘moral hazard’ by closing 16 small, unquestionably insolvent private-sector banks. Indonesia had no deposit insurance, so this meant significant losses for those banks’ customers. The result was that there was a run on the rest of the country’s private-sector banks. The panel trucks were trying to meet the demand for currency. The other memory is of the press conference, in 1984, at which Bill Isaac announced the resolution – or as the press called it, the ‘bailout’ – of Continental Illinois. It wasn’t the only major bank that had made a lot of bad loans. Most had large unreserved exposures to developing countries. Much depended on the market’s collective response being, ‘Oh good, that’s taken care of.’ The Fed, which takes the lead in system-minding, was particularly worried, but it was not in a position to provide concrete reassurance. The strategy they adopted was elegantly simple and happily it worked. Paul Volcker, the Fed Chairman, attended the press conference. He didn’t sit on the stage. He stood at the back of the room. But he’s six-foot-eight and hard to miss. When Bill Isaac finished explaining what was going to happen, Volcker muttered something that sounded like approval and left the room before anyone asked him a question. It was enough.

Banking as a business I do not believe banking can be understood from purely commercial or economic perspectives. This is not an uncontroversial view. You can find plenty of people who believe banks would work much better if the government got out of the way. Some of these people are successful bankers. Some are distinguished economists. ‘Banking is just a business, a business like any other,’ they both tend to say. My 43-year career in banking has convinced me that this is not the case. Banking is special, as Volcker likes to say. The business model of banking reflects the fact that it is not just a business. Society and therefore governments need banks. Economic growth requires credit, which in theory governments might provide, but governments

make terrible owners of banks because they are under political pressure to make what will turn out to be bad loans. Even in the best of countries, government-controlled banks seem destined to fail. I agree with Hyman Minsky that financial systems are inherently unstable because the longer the sun shines, the less risk-averse people become – making crises inevitable. So even the wisest banks benefit from supervision. And banks are only able to do what they do when they have a lender of last resort and potentially capital support. In short, banks need governments. They need each other like an old married couple. Both have their defects. They grumble about each other all the time – and indeed, a little marriage counselling is sometimes necessary. But they will never separate. If you read Edward O. Wilson – the evolutionary biologist and world authority on ants – you can find yourself wondering why the financial ecosystem has come to depend on such fragile entities as banks. They lend long and borrow short. Their assets are opaque. Considering the risks they take, they don’t have that much capital. If you leave them in the sun too long they ‘go troppo’. And there is deliberate ambiguity about what the government might do in a crisis. Why is this a good arrangement? My answer is that banks work best when they are permanently on edge. Anxiety induces thoughtfulness and moderates the Minsky dynamic. The vulnerability of banks requires them to pay attention. When your business model has far more downside than upside you need to do that. For this reason, outsiders have traditionally made the best bankers. Precisely because they are not at home in their surroundings, outsiders tend to be watchful, polite, covertly clever, and skilled at maintaining intellectual and emotional distance.

S.G. Warburg & Co. Sigmund Warburg exemplified this phenomenon. The historian Niall Ferguson describes him as ‘the personification of the rootless cosmopolitan.’ Born into a banking family in Hamburg, he recognised early in the 1930s where the Nazis were headed and Insights Melbourne Business and Economics

opened a small firm in London. After the war, he put his name on it, and cautiously accumulated a collection of brilliant, quirky, driven employees and partners. The firm I encountered in 1979 had risen to the top of the London pecking order in 33 years. Most of Warburgs’ work was advisory. They avoided risk and disliked display. But they had a definite style. In contrast to the long city lunches we had heard about, Warburgs entertained in shifts. Guests came at either 12:30 or 1:30, and were expected to know when to leave. Sigmund wouldn’t have shiny annual reports with photographs. They didn’t advertise. No firm was better at managing the press, but it was considered important not to believe one’s own press clippings. They loved to win, and they often won, but never forgot that disaster lurked around the corner Their utilitarian building in Gresham Street said it all. We were taken to a conference room. There was a battered wooden table surrounded by similar chairs, a matching sideboard with bottled water and glasses, a neat pile of yellow pads and a cup full of sharpened

Lessons from a career in banking

pencils. You knew that famous take-overs would have been concocted there, but none of the framed ‘tombstones’ or other mementos bankers like to give themselves were evident. Every conference room was the same. Their Spartan elegance grew on us. ‘Antiques?’ someone finally asked. We were tourists, after all. ‘Good copies,’ we were told. ‘Bought the lot from a provincial hotel that was going bankrupt.’ Interestingly, they were obsessive about internal communications. Two ladies were employed to come in before dawn, open all the mail and make a summary that would be on every partner’s desk when he came in. If you had breakfast with a Warburgs man in New York, he could tell your what your colleague had said at lunch that day in London. To be clear, Sigmund Warburg was a genius. The bankers who keep the financial system in balance are craftsmen rather than magicians, good workers rather than masters of the universe. If you study men who make their living by physical labour, they never hurry. They aren’t lazy. They just know what works, and what they are capable of in the course of a day.

Good bankers are like that. ‘If you need an answer today,’ an old boss at Citibank used to say, ‘the answer is no.’ Near the top of a very long staircase in the Palazzo Vecchio in Florence, the Latin motto adopted by banker and ruler Cosimo di Medici is engraved on one of the risers: Festina lente. Make haste slowly. I should also mention that while economics may be a dismal science, banking is not. It is prudence and ambition in harness. One’s purpose is helping others achieve their dreams, which is not a bad vocation. And practising a craft is cheerful work. The best bankers are cautious optimists.

The Basel Enterprise, directors and managers Moving to Australia in 2003, I had to spend time catching up on the proliferation of rules generated by the Basel Committee on Bank Supervision. They have spent over 30 years trying to make risk and capital comparisons transparent – with the aim of making the global financial system safer. ‘Basel I’ was little more than an agreement to publish adjusted leverage ratios. We are now on ‘Basel III’. The Basel Enterprise resembles trench warfare in that while it has cost a lot, and the participants sometimes look exhausted, intractable differences remain. The US never adopted ‘Basel II’. And the fog of war has only thickened. I believe that sheer complexity was a contributing cause of the GFC. Boards and senior executives looked at the stream of Greek letters coming out of Basel and stopped thinking about risk, on the basis that the ‘rocket scientists’ their banks employed had everything under control. They didn’t. What has come to interest me more than quantitative tools is the character and employment of boards of directors. If banks are frail reeds for economies to lean on, bank boards can look similarly underequipped. Banking is a complicated business. Most directors have never been bankers. In fact, the majority are supposed to not be bankers. They appoint the chief executive and determine his or her bonus, but most of the time they must follow

that individual’s lead. (As an experienced non-bank chairman once told me, ‘I work for the CEO until I fire him.’) Directors are expected to challenge management without alienating them, but know they will often be asking uneducated questions. There is a lot to learn and a lot to read, but directors have no staff to assist them. And they must limit the time they spend, lest they lose their independence. Why is this a sensible job description? As with the banks themselves, the board’s limitations can be seen as virtues. The institution only needs one management. For the board to shadow management would be inefficient and confusing. The fundamental work of a bank board involves answering five questions: – What is the business model? – What are the inherent risks of that model? – How can those risks be measured? – What is our strategy for managing those risks while earning a return? – How much risk do we want to take? Management will offer answers to all those questions. Non-executive directors add the most value by seeing things from a different perspective, by imagining alternative futures. That can only be done if you aren’t too closely or continuously involved. You won’t smell smoke if you spend all your time in the kitchen. Harrison Young has been a commercial banker, an investment banker and a bank regulator, based in New York, Washington, London, Bahrain, Hong Kong, Beijing and Melbourne. He is a non-executive director of Commonwealth Bank of Australia and served as a member of the Court of Directors of the Bank of England.

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STARTING POINTS FOR A NEXT GENERATION SOCIAL CONTRACT Without more proactive efforts the economy will neither close the jobs deficit nor change the 30-year pattern of wage stagnation and growing income inequality. BY THOMAS A. KOCHAN

An edited version of an address to the University of Melbourne – Monash University Joe Isaac AO Industrial Relations Symposium at the University of Melbourne on 9 May 2014.

For 30 years after World War II, pay and productivity in the US moved up together, creating an expanding middle class and ensuring the baby boom generation would realise their American Dream (see Figure 1). A number of us call it the era of the ‘post-war social contract’ (Kochan, 2000). In the 1980s that social contract fell apart, starting 30 years of stagnant wages, growing inequality and political polarisation. Since then, productivity has grown over 80 per cent, while family incomes grew by about 12 per cent largely due to the increased labour-force participation of wives and mothers, and wages grew by only 6 per cent. As shown in Figure 2, Australia experienced a similar tandem movement in wages and productivity from the 1960s to the 1980s and a similar, but not quite as severe, productivity-wage gap since then (Kumar, Webber and Perry, 2012; Wright and Lansbury, forthcoming). These trends pose a big question for those of us in both countries who were fortunate to benefit from the old social contract: what legacy will we leave members of the next generation? Are they destined to experience a relatively lower standard of living than their parents and grandparents? Or can actions be taken to reverse the trends of the past several decades to provide the next generation with the opportunities to realise their dreams?

We can change these trends but it will take a proactive and sustained cross-generational effort to update and modernise the full range of employment policies, practices and institutions that govern work and employment relations – so they can catch up with the economic, technological, workforce and organisational changes that caused the old social contract to breakdown. While these pressures are perhaps most severe in the US, they are visible to many here in Australia and other parts of the world as well. In what follows, I will draw on the US experience by first outlining what made the social contract work for the 30-year period following World War II and why it broke down, and then use this understanding to discuss actions that might start the cross-generational and multi-party dialogue needed to build a new social contract better fitted to today’s environment. I invite you to consider whether or how some of these thoughts might apply or need to be modified to work in Australia.

Rise and fall of the post-war social contract The US post-war ‘social contract’ was built on the foundation of the labour legislation enacted as part of the New Deal in the 1930s that established a floor of minimum wages and protected workers’ rights to organise and engage in collective bargaining. Then in the mid 1940s, United Auto Workers’ President Insights Melbourne Business and Economics

Figure 1: The Social Contract in the US, 1945-present

Figure 2: Real wages and productivity in Australia, 1965-2007

450

350

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300

Indexed relative to 1965

Index (1947 = 100)

350 300 250 200 150 100

Productivity Real household income Real average hourly earnings

50 0 1945 1955 1965 1975 1985 1995 2005

200

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Productivity Real wages

0 1965 1973 1981 1989 1997 2005

Source: US Bureau of Labor Statistics and Economic Policy Institute

Source: Saten Kumar, Don Webber and Geoff Perry, Auckland University of Technology

Walter Reuther and General Motors CEO Charles Wilson negotiated what was called the ‘treaty of Detroit’, specifying that wage increases would be set to match growth in the cost of living and in productivity (Lichtenstein, 1995). The strength of unions then helped spread this ‘pattern’ bargain across American industry.

CEO pay to median workers’ pay rose exponentially from about 30 to 70 to 1 in the 1960s and 1970s, and is now 250 to 300 to 1 or more.

This worked because the domestic economy was growing, unions were strong, and international competitors were weak. In the 1980s, this all changed: the manufacturing economy fell into a deep recession, management went on the offensive to avoid and (successfully) weaken unions, and international competitors gained expanding shares of American markets and jobs. As technology advanced and markets opened up, well-paying production jobs got outsourced to lower wage countries. Moreover, as American firms began focusing on maximising share prices – the so-called financialisation of the American corporation (Appelbaum and Batt, 2014), CEOs whose incomes were increasingly tied to stock prices gained the lion’s share of the income produced. The ratio of 40

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The crisis of the 1980s spurred significant innovations in American industrial relations ranging from efforts to reform workplace practices to increase flexibility, teamwork and employee participation in continuous-improvement processes; collective bargaining reforms to decentralise negotiations and break out of pattern bargaining and/or reduce wages; and high level ‘strategic’ management changes to either avoid further unionisation or work more closely with unions on long term competitive issues (Kochan, Katz and McKersie, 1986). While these changes provided the seeds of a potential new approach to employment relations, they did not diffuse widely and the public policy changes needed to reinforce and sustain them could not be enacted because of a deep and paralysing business-union political impasse. This was the historical setting prior to the onset of the 2007 financial crisis and subsequent ‘great recession.’

Now, five years after that recession officially ‘ended’, we find the labour market still struggling to replace the jobs lost and the number needed to absorb new labour force entrants. It is clear that without more proactive efforts the economy will neither close the jobs deficit nor change the 30-year pattern of wage stagnation and growing income inequality. There is, however, recognition that we cannot simply try to return to past policies and practices. Today, international competition, technological changes that value skilled workers able to support a knowledge-innovation based economy, union weakness and financialisation of corporate practices are realities that have to be addressed in any effort to build a new social contract for the next generation. While the features of a new social contract can, as in the post-war period, only emerge out of dialogue and negotiation among the key stakeholders – leaders of the workforce, business, labour, government and education – some potential elements, derived from both innovations generated out of the post 1980s crises that have proved their value and a growing array of new experiments involving an expanded array of activist groups, may provide a framework for the necessary dialogue and negotiations.

Education and life-long learning As in the past, education is still the starting point – a necessary but far from sufficient solution to reversing these trends. A highly educated, skilled and innovative workforce is essential to generating the technological breakthroughs and continuous improvements needed to drive productivity and to support an innovation-based economy. Yet there is considerable evidence that the US educational system needs significant reforms and improvements to produce a world-class workforce with both the technical (science, technological, engineering and maths; or so-called ‘STEM’) and behavioural (communications, problem-solving and coordination/negotiations) skills employers are calling for today. US high school students lag behind many of their international peers in science and maths achievement tests; and the number of high school graduates continuing on to obtain technical skills and STEM-related college degrees appears to be inadequate to meet future demand.

The good news is there is considerable momentum in the US focused on addressing these challenges, starting with efforts to expand access to early childhood education. The Obama Administration and equivalents at the state level have applied pressure and created incentives to either reform and improve public elementary and secondary schools or expand funding of private alternative schools. These actions have generated a wave of innovation aimed at, among other things, promoting collaborative teacher-union-school district improvements (Rubinstein and McCarthy, 2014; Bluestone and Kochan, 2011), diffusion of a new common core of curriculum standards, and expansion of the school day or year. There also is a growing recognition of the need to strengthen the community colleges, vocational schools and labour-management institutions that focus on building technical skills that some employers claim to be in short supply. Indeed, there is ample research and experience about how this can be done by drawing on these institutions. My colleagues and I summarised the elements this evidence suggests are essential to the success of these efforts (Kochan, Finegold and Osterman, 2012): – Multiple employers in a region or industry sector need to cooperate with one another and with educational and labour institutions to jointly design and fund initiatives to train and hire graduates; – Classroom education must be integrated with opportunities to apply new concepts and skills in on-the-job settings, an approach proven to be the way adults learn best; and – Education and training needs to focus on offering workers career pathways, not just skills for initial jobs. Effective programs take a variety of forms, such as joint union-management initiatives or employer consortia that work closely with community colleges or universities. The challenge lies in expanding the number of successful examples to a scale large enough to achieve a national impact. This will require leadership and cooperation from all quarters – government, business, labour and education. Insights Melbourne Business and Economics

Government must do a much better job of coordinating training programs that are not now connected to each other and often have different funding requirements. Rather than a hodgepodge of fiefdoms within the federal government, there must be coordination of the disparate programs controlled by the Departments of Defense, Education, Commerce and Labour. Getting maximum gain for federal dollars can happen only if the President insists these departments follow the three funding criteria above. Business has to face its ‘lone ranger’ problem. Right now, few individual employers want to spend money training people who will be poached by their competitors. But the business community can better serve itself and young people by mobilising peers in their region or industrial sector to share in the costs of educational programs and provide on-thejob opportunities for students/future employees to apply in practice what they learn in the classroom. The education establishment must also change its ways. Too often, academics teach what they know, rather than what’s needed. And too often, educators resist responding to outsiders telling them what to teach. For universities eager to find a funding strategy to sustain their burgeoning online educational platforms and offerings, what better opportunity is there than working with industry leaders to develop courses that give bright young workers a ‘second chance’ at acquiring the specific skills employers say are in short supply? Such courses can teach both basic STEM and behavioural skills that are prerequisite to success in the modern workplace. Labour can do its part by expanding apprenticeships and joint union-management programs, such as proven ones in health care, utilities, hotels and many manufacturing industries, to provide lifelong learning and the opportunity to upgrade skills. Labour is often isolated, but it is an important resource for employers or educators willing to engage. These actions need to be complemented with strategies that promote continued or life-long learning for workers throughout their careers. We 42

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have the tools to do this now. Every university and community college is experimenting with online, blended or distance-education courses. And many employers complain that new entrants don’t have the right mix of skills. The obvious solution is for university, community college and industry leaders to get together and design the coursework and on-the-job experiences young workers need to be productive, learn, grow and gain access to better and higher paying jobs. Retraining and redeployment of workers displaced by advances in technology will also have to be part of the solution. At Kaiser Permanente, no employees have been laid off as electronic medical technologies replaced their ‘chart room’ workers (Kochan, Eaton, McKersie and Adler, 2009). Instead, Kaiser management and unions negotiated retraining provisions to help affected workers learn the skills needed for available jobs or provided generous severance payments to allow them to find suitable jobs elsewhere. This approach both supports the workers affected and motivates others to continue to foster rather than resist productivity-enhancing technological change. Internal promotional and career paths that promote and pay people for obtaining new skills is another way to provide incentives for employees to engage in life-long learning and move up the income ladder as their careers progress. Individual firms benefit from reducing turnover, building long-term commitment and loyalty; and the economy benefits from increasing its stock of human capital.

Alternative wage-setting criteria New approaches to wage-setting at the level of the enterprise will be needed to ensure that everyone who works together to generate productivity and profits has a fair chance of sharing in the gains produced. A set of bedrock pay-for-performance principles were laid out over 60 years ago by Joe Scanlon, a former Steelworkers Union leader, MIT instructor, and father of the Scanlon Plan, a most durable pay-for-performance plan (Lesieur, 1957).

They remain just as relevant as design principles for future pay-for-performance plans: – Include all employees in the organisation in the pay-for-performance plan to encourage crossoccupational and cross-level cooperation, not competition; – Use incentive pay as a complement to – not a substitute for – fair base wages and benefits; – Provide employees an independent employee voice in designing and administering the plan and in generating and evaluating suggestions for continuous productivity improvements/savings; and – Recognise that the Achilles heel of any performance-sharing formula lies in changes in technology, market conditions, product/ service mix, or organisational strategies that require adjustments to the plan. Ensure that making changes in the formulae for calculating productivity, profits and gains to be shared are technically sound, transparent and trusted by all parties (employees, managers and investors).

If a union is present, it can provide this independent voice and monitoring. But that is seldom the case today. Just as it took a new labour law in the New Deal to lay the foundation for twentieth century unions and collective bargaining, America needs a new, modern law that opens up new avenues for worker voice and representation, including but not limited to enterprise-wide works councils where all employees have a right to participate as equals in discussion of pay and other human resource policies. The toughest nut to crack will be changing the corporate ‘norms’ about salary ratios separating CEOs and average employees. New federal rules will soon require publication of these ratios in corporate reports. Transparency is a good first step. Giving workers seats on the board would also help. So would taxing high-level incomes pre-1980s rates (Piketty, 2014). But corporate boards may need stronger pressures to change the ways CEOs are paid. Today, unions aren’t strong enough to do this alone. They need to be joined by a chorus of voices including HR professionals, policy makers, Insights Melbourne Business and Economics

middle managers and professionals (today’s ‘average’ employees), and voters – all calling for more equitable, productive, motivating and sustainable pay setting policies across America.

Alternative corporate forms Alternatives to the standard shareholdermaximising firm are also available. Today over 12,000 Employee Stock Ownership Plans (ESOPs) plans are in place in the US (Blasi, Freeman and Kruse, 2014). The most successful follow the four principles above – they engage all employees as owners and build a culture of shared ownership and commitment that motivates everyone to work together and benefit together from the success of the enterprise. Expanding ESOPs would help. A new corporate form called Benefit Corporation also shows promise and has been authorised in 23 states (Benefit Corporation Information Center, 2014). Benefit Corporations build a commitment to address environmental and social (workforce and community) sustainability objectives directly in their corporate charters, giving these goals equal

Starting points for a next generation social contract

status to achieving fair returns to shareholders. Further innovations along these lines for nextgeneration start-ups and emerging firms would help challenge the financialisation view of the firm that grew out of the 1980s.

Next-generation unions and sources of power One of the biggest open questions facing both America and to some extent other countries is what will fill the void left by union decline. Presently, less than 7 per cent of private sector workers have union representation, down from a peak level of about one-third of the workforce in the 1950s. While reproducing unions and collective bargaining in the mirror image of their past is neither likely nor viable, some alternative means will be needed to provide the next generation workforce with the voice and bargaining power needed to assert and achieve its interests. Indeed, the crisis in worker representation has sparked considerable innovation both within the labour movement, among labour and community group coalitions, and among an

expanding number of networks at local, national and global levels. These range from religious-based groups and worker centres (Fine, 2010; Bobo, 2010), to students mobilising against sweatshop conditions, to international coalitions of NGOs, governments, international agencies, employers and unions aimed at upgrading conditions in global supply chains (Locke, 2013). One common feature of these emerging efforts is their reliance on social media, publicity and information-sharing now made possible via internet and smartphone technologies. Experimentation with ways of using these social media tools as sources of power for workers around the world is likely to continue to grow.

Blasi, J R, Freeman,RB and Kruse, DL 2014, The Citizen’s Share, Yale University Press, New Haven.

Moving from local innovations to national policies

Kochan, T, Finegold, D and Osterman, P 2012, ‘Who should close the middle-skills gap,’ Harvard Business Review, December.

All these developments suggest that there are ample ideas, experiments and options available to support dialogue, discussion and negotiation among future workforce, business, government, education and other leaders. History teaches us that national solutions and foundational policies like those incorporated into the New Deal legislation of the 1930s grew out of innovations first developed and demonstrated to work at local levels. Let us hope that we are now close to the point of choosing from the considerable range of local innovations underway those that are best suited to building a foundation for a new social contract fitted to the future world of work and responsive to the needs of the generations to come. Thomas A. Kochan is George M. Bunker Professor of Management, Co-Director, Institute of Work and Employment Research, MIT Sloan School of Management, Cambridge, USA.

References Appelbaum, E and Batt, R 2014, Private Equity at Work, Russell Sage Foundation, New York. Benefit Corporation Information Center, http:// benefitcorp.net/, downloaded 14 May, 2014.

Bluestone, B and Kochan, T 2011, Toward a New Grand Bargain, The Boston Foundation, Boston. Bobo, K 2009, Wage Theft in America, The New Press, New York. Fine, J 2006, Worker Centers, Cornell/ILR Press, Ithaca, New York. Kochan, TA 2000, ‘Rebuilding the social contract at work’, Presidential address to the Industrial Relations Research Association, Industrial Relations Research Association, Madison, Wisconsin.

Kochan, TA , Katz, HC and McKersie, RB 1986, The Transformation of American Industrial Relations, Basic Books, New York. Kumar, S, Webber, DJ and Perry, G 2012, ‘Real wages, inflation and labour productivity in Australia,’ Applied Economics, vol. 44, iss. 23: 2945-2954. Lesieur, F 1957, The Scanlon Plan, MIT Press, Cambridge, Massachusetts. Lichtenstein, N 1995, The Most Dangerous Man in Detroit, Basic Books, New York. Locke, R 2013, The Promise and Limits of Private Power, Cambridge University Press, New York. Piketty, T 2014, Capital in the Twenty-first Century, Belknap Press of Harvard University Press, London. Rubinstein, S and McCarthy, J, ‘Teacher unions and management partnerships’, Center for American Progress, Washington, DC, http://www. americanprogress.org/events/2014/03/19/85998/ teachers-unions-and-management-partnerships/, downloaded May 14, 2014. Wright, CW and Lansbury, RD, ‘Trade unions and economic reforms in Australia, 1983-2013’, Singapore Economic Review, forthcoming. Insights Melbourne Business and Economics

Article heading here

RESOLVING ENERGY POLICY DILEMMAS IN AN AGE OF CARBON CONSTRAINTS Australia can return to its traditional position as a low-cost energy producer even in a world of renewable energy. BY ROSS GARNAUT

A condensed version of the 2014 John Freebairn Lecture given at the University of Melbourne on 20 May 2014. A fuller version of the lecture will appear in the December 2014 Australian Economic Review.

Australia is the world’s largest exporter of coal, uranium and (energy-intensive) aluminium; and will soon be the largest exporter of natural gas. Amongst developed countries, Australia has by far the greatest per-capita potential for low-cost production of energy from most of the promising renewable sources: solar, wind, biomass, deep geothermal, wave and tidal. It has two developed hydro-electric sources that are large enough to assist substantially in the balancing of intermittent renewable generation. East Gippsland and adjacent Bass Strait possess excellent proven geological structures for storing carbon dioxide adjacent to immense low-cost fossil fuel resources. If capture and storage of carbon dioxide from fossil fuel combustion works commercially anywhere, it will work in southeastern Victoria. For many years, fossil energy endowments have contributed to Australians’ high standard of living as sources of relatively low-cost electricity for households, as coal and gas exports and as inputs into exports of processed metals. However, China’s resources boom – interacting with policy innovations of the early twenty-first century – turned Australia from a relatively low-cost to a relatively high-cost energy provider for domestic users. A timing coincidence caused the beginnings of climate mitigation policies to be blamed for the energy price increases.

Global energy developments Post-2000, global energy markets have received four large shocks, namely: – Unprecedentedly strong growth in demand for energy driven by strong and energy-intensive economic growth in China, forcing big lifts in oil, coal and gas prices; – High energy prices and concern for the environmental impacts of energy use, leading to higher energy-efficiency and lower energyintensity of economic growth, most powerfully after 2008; – High energy prices and incentives to reduce greenhouse gas emissions in developed countries, leading to sharply increased use of renewable energy, eventually leading to reduced costs as the scale of deployment increased; and – High energy prices driving deployment of unconventional gas technologies which increased supply from about 2008 and continues to do so. Into the early 2000s, the standard forecasts anticipated that low global energy prices would endure. Although prices rose steadily as demand increased from China and a robust world economy, expectations of low prices persisted and discouraged investment in new mining capacity. In early 2003, Rupert Murdoch famously declared that the ‘greatest thing’ to come out of the invasion of Iraq Insights Melbourne Business and Economics

would be ‘cheap oil’ – the return of oil prices to $US20 per barrel. It didn’t turn out that way. The global economy expanded strongly, especially in Asia where it was exceptionally energy-intensive. China entered a decade of the fastest expansion in any economy ever. Global energy demand grew prodigiously. Global oil, coal and gas prices rose until the GFC of 2008. Strong developed-country growth and its contribution to energy demand ended with the GFC. Developing-country growth in output rebounded strongly from 2009, but its relationship to energy use changed after 2011. Moderately slower growth in China and the developing world – interacting with improved energy efficiency – increased supplies; and lower costs of renewables and the advent of unconventional gas placed downward pressure on fossil fuel prices. Meanwhile, mining companies’ expectations on price caused massive investments in expanding coal supplies just as the extraordinary growth in demand was concluding. In China there was almost no reduction in energy intensity between 2001 and 2011, despite high global energy prices and increased integration of domestic into international energy markets. Investment shares of expenditure rose to the highest levels ever in any economy over a long period and

Figure 1: Primary energy demand

Quadrillion Btu

500 400 300 200 100

Figures 1, 2, 3, 4 and Table 1 tell the story of changing global energy demand and prices through the early twenty-first century.

Figure 2: Coal consumption of China compared to other countries

OECD World

4000

491

Non OECD

3500

China

3000 277

213

2500

China 2000 1500 1000

107

0 1980 1984 1988 1992 1996 2000 2004 2008 2012 Source: BP Statistical Review of World Energy 2013, International Energy Agency.

From late 2008, China gradually moved towards a new model of economic growth that would increase the consumption shares of expenditure, and reduce the intensity of energy use and carbon dioxide emissions. We are still in the early stages of the new model and investment shares of output have not yet fallen. Still, aggregate economic growth decelerated from an average of 10 per cent per annum in 2001– 2011 to 7–8 per cent. By 2012, structural change and lower growth were substantially reducing the increase in Chinese and therefore global energy demand. Local environmental and global climate change concerns drove a sharp decline in the coal share of energy, and resulted in increases in renewable and nuclear energy. Although the huge upward pressure on global fossil fuel prices from Chinese economic growth ended in 2011 – and will not return – oil prices have stayed high as a result of resource constraints and limits to short-term substitution away from oil in energy use.

Mtoe

600

contributed to high energy- and metals-intensity of economic growth. China’s demand for coal made the first decade of the twenty-first century a time when the world quickly ran out of time for taking action to reduce the chances of dangerous climate change.

Resolving energy policy dilemmas in an age of carbon constraints

Other countries 500 0 1970 1976 1982 1988 1994 2000 2006 2012 Source: BP Statistical Review of World Energy.

Figure 3: Crude oil and coal annual prices

A closer look at electricity demand and supply

140

Coal, Australian (Newcastle) Real 2010 US dollars

120 100

Crude oil, West Texas Intermediate

$92.94

80 60

$68.28

40 20 0 1990 1994 1998 2002 2006 2010 Mar-14

Source: International Energy Agency.

Figure 4: German hub, German oil-linked, and US Henry Hub gas prices, 2008-14 (€/mmbtu)* 20

Germany gas

US gas (Henry Hub)

12% crude oil

14 12 10 8 6 4 2

0 2008 2009 2010 2011 2012 2013 2014 2015

*Prices shown are historic until year-end 2013, thereafter forward curves. From Mark C Lewis 2014, Europe’s Electric Shock: Lessons for Australia.

After many decades when electricity demand grew inexorably, post-GFC there was an absolute decline in electricity use in almost all developed countries. China began to enforce policies designed to reduce the energy intensity of growth by 16 per cent over the five year plan period 2011–2015. China’s focus on improved energy efficiency interacted with efforts to reduce the intensity of greenhouse gas emissions and reduce carbonparticulate emissions for health reasons. Growth in electricity demand fell to an average of 6.3 per cent in 2012–2013 and expansion of coal use in electricity generation fell to an average of 3.25 per cent per annum after a decade of double-digit growth. The majority of the increase in generation came from hydro-electricity, wind and nuclear. Solar increased by 270 per cent per annum and became a significant element in energy supply for the first time. During 2013–2017, China’s generation of wind power is expected almost to double, and its solar power generation to rise more than threefold. These absolute increases far exceed Australia’s total electricity generation capacity of all kinds. China was first involved in this global shift to renewable sources of electricity as a source of capital goods for other countries – solar panels, wind turbines and hydro-electric generators.

Table 1: Renewable-electricity production by source in Germany (GWh) 2007

2009

2012 estimate*

2012 actual

2013 estimate*

2013 actual**

Hydro

21,169

19,147

18,000

21,200

19,000

20,800

Onshore wind

39,713

38,542

51,152

45,325

54,064

46,200

1,903

675

3,250

1,000

Biomass

24,191

30,441

36,710

40,850

38,562

45,320

Solar PV

3,075

6,578

17,397

28,000

20,293

29,700

164

88,238

94,765

125,259

136,075

135,333

143,060

Offshore wind

Geothermal Total

*The 2012 and 2013 figures represent the German Government’s estimate in 2010 of the indicative trajectory for Germany achieving its 2020 target for renewable energy under the legally binding EU-wide targets signed up to by all Member States under the RenewableEnergy Directive. **Preliminary estimates. From Mark C. Lewis 2014, Europe’s Electric Shock: Lessons for Australia.

Insights Melbourne Business and Economics

The increased scale dramatically reduced prices, making renewable energy competitive with fossil energy in some circumstances, especially where the decentralised nature of renewables production allowed investment in transmission and distribution to be reduced or avoided.

South Asian and African economic development is structurally different from Chinaâ&#x20AC;&#x2122;s; and these regions are unlikely to experience the extreme energyintensity of recent Chinese economic growth.

Measures to reduce carbon emissions also favour nuclear power. After more than two decades of stagnation, major expansion programs began to be implemented in China and India. Lowered costs in China meant that in early 2011 the authorities anticipated that nuclear power costs would be competitive with coal in East China as early as 2016.

The third major global energy shock came from the application of unconventional gas technologies after 2008, driven by high fossil fuel prices. Production of gas from coal seams had its main early applications in eastern Australia, and from shale in the US. These technologies are gradually being deployed in other countries and will have a large impact where geological conditions are suitable.

The Fukushima meltdown in March 2011 resulted in the closure of all Japanese nuclear plants (with some now reopened) and the closure of some in Germany, with total closure slated for 2020. Elsewhere, China continued with new plants under construction, but with strengthened safety requirements, and Indiaâ&#x20AC;&#x2122;s policy trajectory was broadly similar. China and India are both engaged in large-scale state-supported research on thorium-based nuclear energy. The reduction in the costs of renewable energy capital goods has permanently changed the energy supply choices available to other developing countries. Figure 5: Regional gas prices in the Gas Price Convergence Case

The unconventional gas revolution

Trade restriction in the US has created a fragmented global market. Intercontinental transport of gas is expensive, especially if it involves sea voyages and therefore liquefaction (Figure 6). East Asian prices reflect prices in exporting countries including Australia, plus transport costs; and are the highest in the world. The US once had relatively high prices, but the combination of increased domestic unconventional gas supplies and export restrictions has pushed prices to the lowest amongst developed countries. Eastern Australian prices, once the lowest in the developed world, are on a path soon to be the highest outside East Asia.

Figure 6: Spot the carbon price: electricity price and CPI

900

Electricity price

Gas Price Convergence Case (GPCC): United States Europe Japan

0 2000 2005 2010 2015 2020 2025 2030 2035 From: International Energy Agency 2013, World Energy Outlook 2013. OECD/IEA.

Resolving energy policy dilemmas in an age of carbon constraints

Index, September 1980 = 100

GPCC

Dollars per MBtu

800

CPI, all groups

700 600 500 400 300 200 100 0 1980 1984 1988 1992 1996 2000 2004 2008 2012

Source: Wood, T, Carter, L, and Harrison, C 2013.

Environmental concerns favour gas over coal. The relative ease with which production can be varied in gas-powered generators also increases demand for gas for balancing natural variations in renewable energy output. But gas, like electricity, is experiencing the price effects of slowing demand. With the new technologies rapidly expanding gas supplies, these influences are likely to lower global gas prices. The large price differentials across regions are likely to diminish through the erosion of US export restrictions and the eventual redirection of exports from the former Soviet Union away from European towards East Asian markets. The end point should see similar prices in the export countries Australia and the US, with each lower than European and East Asian markets to an extent that reflects international transport costs. Figure 5 plots one of the possible convergence scenarios.

Abundant cheap energy to abundant expensive energy in Australia

restrictions on trade. The non-tradable component varies with the real exchange rate and the relative efficiency of Australian energy production. Relative efficiency is affected by the regulatory environment. Tradable and non-tradable components of costs have both increased more rapidly in Australia than elsewhere post-2000. The tradable component has increased because export barriers have become less important in Australia and more important in some other countries, notably the US. The increase in the non-tradable component arises from the large appreciation of the real exchange rate through the resources boom and a dramatic fall in the productivity of distribution in Australia mainly due to flawed regulatory arrangements. The Australian Bureau of Statistics estimates the average decline in total factor productivity in Australian utilities at 4.5 per cent per annum between 2007–2008 and 2011–2012. Eventually, a substantial correction will come to the real exchange rate, which will reduce the excess of Australian over international energy costs.

Energy costs everywhere have tradable and nontradable components. The tradable component – the cost of energy raw materials – varies across countries with transport and transactions costs and

A large part of the increased relative costs of electrical energy in Australia derives from the regulatory reform that was completed in 2006. The changes separated eastern Australian wholesale, transmission, distribution and retail markets and

Figure 7: Electricity consumption and unit costs of network and wholesale power

Figure 8: Eastern Australian electricity demand 2005-13*

400 350

210,000

Network revenue per unit sold

205,000

300

200,000

NEM consumption

250 200 150 100 50 0 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13

GWh

Index, 100 = 2005-06

Real wholesale prices

195,000 190,000 185,000 180,000 2005 2006 2007 2008 2009 2010 2011 2012

*12 month rolling average. Source: Wood, T, Carter, L, and Harrison, C 2013.

Insights Melbourne Business and Economics

established a competitive wholesale market for power. This wholesale market is working well and should be left alone. With the transmission and distribution functions, both natural monopolies, we have created difficulties by seeking to regulate price principally by reference to rate-of-return (ROR). Averch and Johnson (1962) demonstrated that setting the ROR too high spawns wasteful over-investment; setting it too low causes under-investment, risking service failure. We have set the ROR too high, and investment and therefore electricity prices have increased at rates beyond both past Australian experience (Figures 6 and 7), and the recent experience of other developed countries. Reducing the regulated ROR would immediately reduce the dominant ‘return on capital’ component of network costs, and lessen incentives for wasteful future investments. The Australian Energy Regulator has taken a first step in this direction. The inherent problem of ROR regulation will remain, and there will still be a massive overhang of excessive investment earning a return, and unnecessarily raising prices. Higher prices reduce demand for all electricity and make self-provision through solar photovoltaics more attractive. Lower demand forces another increase in prices to secure guaranteed RORs for network owners, further reducing demand and increasing prices (see Figure 8). With solar costs continuing to fall and Australians using less electricity, demand for power from the centralised system is likely to continue to shrink and complement an expanding decentralised system. Getting this relationship right will maximise the likelihood of restoring Australia’s position as a lowcost energy economy. The transmission system is straightforwardly a natural monopoly. An oversight planning agency should consider truncating the integrated grid through sales to interested parties of sectors not generating benefits that warrant the spreading of costs amongst all users. Established private owners in South Australia and Victoria could retain their current roles, but extension of private ownership 52

Resolving energy policy dilemmas in an age of carbon constraints

would allow for separation of management from ownership, with rights to ownership being sold by tender to parties seeking low-risk investments without necessarily having management responsibilities. Charges for use of transmission would be related mainly to access to capacity at specified times in the day and year, reflecting the relevant marginal cost of transmission. Reform to the distribution function should involve users being charged for capacity rather than volume of use, with the right to buy and sell access to capacity in specified locations. New users would buy new capacity from others, or pay the marginal cost of capacity to service their requirements. This would bring to account the greater capital costs of energy infrastructure for ‘greenfields’ expansion of cities compared with denser settlement of established areas and create incentives to reduce peak-power requirements and facilitate greater use of storage at the place of use – for example by integrating the energy requirements for households and electric cars. Cost hikes in the retail sector mainly reflect heavy expenditure on marketing. Greater competition in retail services would encourage development of services which focus on overall cost reductions, unaffected by retailers’ interests in established generation capacity. Integration of distribution and retail functions would expand opportunities for cooperation between energy service suppliers and users to reduce electricity costs. The need for large-scale reform argues for caution in privatising network assets that remain in state ownership. New privatisations should await fundamental reform of network pricing systems. Conversely, the competitive wholesale power market provides favourable economic conditions for the sale of generation assets which should be structured to expand competition wherever possible. Increases in Australian energy prices in the immediate future are probably unavoidable. The electricity story is complex. Established policy would see some reduction of wholesale prices, possibly exceeding any upward pressure from

increased prices for renewable energy certificates required for compliance with the Renewable Energy Target. Downward adjustments in regulated RORs should reduce network costs, but this will be outweighed initially by momentum for expanded network investments due to the current ROR distortions. There are longer-term prospects for restoring Australiaâ&#x20AC;&#x2122;s relatively low energy costs. Expanding domestic gas supplies will reduce prices to export parity, which should fall with international convergence. Reform of network regulation and

ownership has the potential to gradually remove the huge excess burden imposed by regulatory distortions since 2006. The eventual reversal of much of the real exchange rate appreciation of the resources boom will see a substantial fall in Australian relative energy costs.

Reconciling environmental, commercial and economic objectives Resources development has negative environmental and positive commercial effects. Good economic analysis takes environmental damage into account Insights Melbourne Business and Economics

in assessing the value of projects. Sound institutional and policy arrangement, based on objective scientific assessments, can reduce the supply price of investment and greatly improve the trade-off between environmental and commercial values, while maximising economic value. It has become difficult to place scientific assessments at the centre of policy in Australia. Big business has never been so directly influential with Government, compounded by an extraordinary fact â&#x20AC;&#x201C; the four business leaders who have been given the most senior advisory roles to the current Commonwealth Government share a strong

Resolving energy policy dilemmas in an age of carbon constraints

view that the science is wrong on the crucial environmental issue of climate change. Objective reading of the science leaves no reasonable doubt that the release of greenhouse gases into the atmosphere imposes costs on humanity. The rigorously calculated assessments range from around $US10 per tonne of carbon dioxide equivalent to well over $US40 per tonne, and rising over time. No legitimate assessment based on the science says that the external cost of carbon emissions is near zero. The relationship between economic activity and carbon emissions is changing â&#x20AC;&#x201C; but not fast

enough to avoid substantial costs from humaninduced climate change, or to be confident that we will hold temperature increase to two degrees Celsius. Virtually all developed countries are now experiencing large reductions in energy-intensity of economic output and absolute reductions in carbon emissions. Particularly for Australia and the US, this represents a radical change in trajectory. The move in Australia to repeal the carbon laws enacted in 2011, and replace them with an ineffective Emissions Reduction Fund does not make sense to anyone who understands the implications of the science on climate change. Policies that take full account of external costs are most likely to be achieved with broadly-based carbon pricing. Australia now has the laws and institutions and administrative systems that can do the job effectively and at low cost. Better to keep the laws and gradually to make them more effective.

Australians doing well through the global energy transition While many factors post-2000 changed Australia from a country with relatively low to relatively high domestic energy prices, this shift was not caused by the introduction of carbon pricing. For Australia to realise its potential to become a relative low energy-cost economy in a low-carbon world will require a depreciation of the real exchange rate, fundamental reforms to the institutional arrangements for transmission and distribution of electricity, and an appreciation of the role of honest science in official policy.

carbon world to which the rest of the world has been travelling gradually and along which it will continue to travel. This is the world for which Australians must construct energy policy for the future. Ross Garnaut AO is Professorial Research Fellow in Economics, the University of Melbourne, and a former Australian Ambassador to China.

References Averch, H, and Johnson, LL 1962, ‘Behavior of the firm under regulatory constraint’, The American Economic Review, vol. 52, no. 5, 1052-1069. Garnaut, R (forthcoming) 2014, ‘China’s role in global climate change mitigation’, Journal of China and World Economy. Lewis, MC 2014, Europe’s Electric Shock: Lessons for Australia. Report prepared for Energy Supply Association of Australia drawing from Deutche Bank Global Energy Research. Wood, T, Carter, L, and Harrison, C 2013, Shock to the System: Dealing with Falling Electricity Demand, Grattan Institute, Melbourne.

Acknowledgements I am grateful for assistance from Veronica Webster, Derek Cheng and Xin Lih Loh.

The reality that others are moving to reduce the energy- and emissions-intensity of economic activity has large implications for Australia. These actions have changed radically the demand for coal, and left ‘stranded’ many billions of dollars of investment in coal mining. The costs of renewable energy have fallen to the extent that the economic foundations of the old centralised power systems have been shaken and cracked. Australia has immense advantages as a producer of energy. We now must use these advantages in the lowInsights Melbourne Business and Economics

Article heading here

CELEBRATING LUMINARIES IN THE FIELD OF ACCOUNTING To entice our youth in the future to enter the important profession of accounting, we need to tell the inspirational stories of the discipline’s pioneers – and we need to tell them well and often. BY GUNTHER BURGHARDT

An updated version of an address given at the Australian Accounting Hall of Fame induction ceremony at the University of Melbourne on 19 March 2014.

‘I have no use for bodyguards, but I have very specific use for two highly trained certified public accountants.’ Elvis Presley (1935-1977) Society’s image of the field of accounting as well as its practitioners is sometimes unkind. At the mention of the word ‘accountant,’ the average layman conjures up mental pictures of a quiet, bespectacled man huddled in a dark room with a calculator and reams of financial information. In decades past, even the contributions of the overall field of accounting were often perceived quite narrowly as revolving around compliance and governance – the internal ‘policemen’ and scorekeepers of the organisations for which these professionals worked. These images need to be challenged. And so, on a balmy evening in March 2014, accounting professionals from across the country gathered at the University of Melbourne to celebrate some of Australia’s pioneers in the field. Their stories made it abundantly clear that not only are the perceptions of the accounting profession changing dramatically, but also that its contributions are vital to the effective functioning of our society.

An age of change In the pre-computer age, the manual nature of accounting – that is, all the work required to

create the debits, credits and financial statements reflecting the activities of companies or individuals – consumed a significant portion of accountants’ time. It also meant that the volume of information available to accountants and the ease of accessing and cross-referencing this information was considerably less than it is today. While the activities of collecting, analysing and communicating financial information remain a cornerstone of the field of accounting, technology has created a quantum shift in how these activities are conducted. With ASX 100 organisations now collecting hundreds of millions of bits of information each year, accountants are rapidly implementing ‘data visualisation’ dashboards to more intuitively manage performance within companies. A small but excellent global example of this ‘data visualisation’ concept is a website titled http://rankandfiled.com. This site takes the SEC filings of the majority of S&P 500 companies in the US and allows easy comparison of dozens of different business metrics in vibrant charts. The accounting profession created the common standards and language enabling these types of comparisons, and technology helped to dramatically improve how these data are communicated and analysed. Technology has clearly been one of the main forces Insights Melbourne Business and Economics

transforming accountants from basic scorekeepers into something much more – but it is certainly not the only force driving this change. The way in which accountants are educated has also undergone considerable change. Early accounting education focused on technical aspects such as the creation and review of transactions in journals, ledgers and, ultimately, financial statements. In the most recent decades however, universities are broadening the training of finance and accounting students. While technical aspects of the field remain a vital foundation, the emergence of case studies and student assignments within industry are giving budding accounting professionals the opportunity to grapple with real-world problems using their skills as toolkits. The focus has shifted from providing scorecards to also providing solutions. Amongst those being honoured at this year’s Australian Accounting Hall of Fame event was Ken Wright. His works, which included the key textbook Financial Management and Policy in Australia, were among the harbingers of these important educational changes. We face an important challenge, however, in educating our Australian youth in the field of accounting. Recent research by Edmund Tadros (2014) published in the Australian Financial Review shows that enrolments in accounting degrees in this country continue to grow, having more than doubled in a little over the decade to 2012. Yet further analysis shows that the number of domestic accounting students has fallen by 20 per cent in the same time period. While it is great news that Australia’s universities are sufficiently well-respected that the export of accounting skills is a market which continues to grow robustly, we need to ask why local interest in accounting appears to be on the wane amongst our own youth while it grows elsewhere. I suspect this may still relate to the layman’s incorrect perception of accounting as a staid and narrowly numerate profession. If we are not able to tell the story that accountants have real viable opportunities to become strategic leaders in their organisations should they so choose to do so, then we may fail to excite our youth sufficiently to 58

Celebrating luminaries in the field of accounting

take up this important calling. Individuals such as Robert Chenhall, who was also honoured with an induction this year into the Accounting Hall of Fame, was a clear international thought leader in how accounting techniques can contribute to effective performance management across all functions in companies as well as to diverse topics such as social capital. Arguably the most important force for change in the role of accountants has come from industry itself. Relentless efficiency-drives within nearly every organisation mean that professions based on manual and mechanical tasks are disappearing rapidly. In this environment, the accounting professional has survived (and indeed thrived) by moving beyond number-crunching to being a vital provider of insights and even strategic directions. This evolution is evident in Australia where recent data show that nearly 16 per cent of ASX 100 CEOs were formerly Chief Financial Officers – an all-time high. This shift is equally pronounced overseas. Even the majority of accountants who remain on an accounting and finance career path find that their success is now determined more by their broad multi-functional understanding and their ability to drive better organisational decision-making than by their grasp and use of the technical aspects of accounting.

Societal impacts Accountants today face challenges which were not even contemplated decades ago. Take the recent and rapid rise of financial derivatives as an obvious example. These contracts enable multiple parties to take different positions regarding the future values of underlying assets or entities. To the extent that these contracts protect companies against underlying risks in their businesses, derivatives are akin to insurance policies. However, it is the tremendous financial leverage these products create that caused Warren Buffet to refer to them as ‘financial weapons of mass destruction’. Imagine the journey that the field of accounting went through in determining how to treat these instruments from a policy and practice perspective. How should one draw the line between risk management and speculation? How

should companies represent the possible future impacts of these financial commitments on current profitability, as well as disclosing adequately the inherent risks to stakeholders? How should fiscal authorities understand and tax these instruments? It has fallen squarely to the accounting profession to provide many of these answers. More recent examples are just as exciting and equally challenging for the field of accounting. The last few years have seen a new breed of â&#x20AC;&#x2DC;cryptocurrenciesâ&#x20AC;&#x2122; rise in the public consciousness. The best known of these is Bitcoin, a digital currency created by a mysterious Japanese programmer

named Satoshi Nakamoto and introduced to the world as recently as 2009. Bitcoin was one of the first of a breed of virtual currencies which are not backed by any government and have neither central repositories nor issuing authorities. In fact, Bitcoins do not physically exist at all but are instead hosted and tracked in the ether of thousands of personal and business computers which form a massive web confirming each anonymous transaction. It would surprise many to learn that an investment in Bitcoins at their inception has been among the best-returning asset classes in the world over the last decade â&#x20AC;&#x201C; but Bitcoins present a whole host of new accounting challenges. How to classify this Insights Melbourne Business and Economics

virtual currency? Is it actually a type of currency or merely a virtual tradeable item which can be bought and sold using normal â&#x20AC;&#x2DC;hardâ&#x20AC;&#x2122; currencies? With companies from Starbucks to Tesla beginning to accept payments in Bitcoins in some countries, governments have turned to their accounting professionals to understand how to set policies and practices in this nascent virtual currency realm.

Accountingâ&#x20AC;&#x2122;s role in beyond crunching numbers The state and progress of our society is based in part on the choices we make. Collectively we make millions of them every day. How will I choose to

Celebrating luminaries in the field of accounting

spend my time? Which shirt will I buy? Where will I take my vacation? Where should I invest my savings? Entrepreneurs and those working for companies or public institutions have an equally complex set of choices: which new products shall be offered; how shall they be priced; how to ensure that potential customers are aware of and excited by these products? Finding the nexus between the needs and wants of consumers, and the ability of our institutions and companies to deliver on those wants and needs in a robust and sustainable manner is indeed a delicate balancing act. The accounting profession plays a significant role in striking this balance.

Choice is about selecting something from amongst a number of alternatives. But how can we even compare seemingly disparate alternatives to reach a conclusion? Whether it is a choice of which shirt to offer to customers or bigger decisions such as where to invest funds, accounting creates a common language and analytical framework to enable us to make these comparisons and ultimately to make our choices. While this may seem self-evident for consumer choices such as which product to buy, it is often also true for social choices such as which services governments should provide for their citizens and the most effective way to provide them. The better our institutions become at making choices on how to provide those services, the more of them they are able to provide to the public.

References Tadros, E 2014, ‘”Fanciful projections” leave accounting grads in the lurch’, Australian Financial Review, 9 July 2014. Van Horne, JC, Nicol, REG, and Wright, FK, 1981, Financial Management and Policy in Australia, Sydney: Prentice-Hall (2nd ed, 1985; 3rd ed (with Davis, K) 1990).

The three Australian Accounting Hall of Fame inductees for 2014 illustrated the current evolution which is slowly transforming the accountant from a technician to a strategic leader. When we gathered to celebrate the three remarkable stories of Robert Chenhall, Ken Wright and pioneering standard-setter John Kenley, their records and those close to them chronicled exploits which spanned decades and contributed in vital ways to the spheres of accounting, academia and industry alike. The evening not only illustrated the successes of these three inductees into the Accounting Hall of Fame, but also showed how their individual achievements had in their own way helped to shape an increasingly important role for the accounting professional within society. This professional evolution from technician to strategic leader is well underway, accompanied by a quantum shift in how society trains its accountants as well as how they are perceived. To entice our youth in the future to take up this important profession, we need to tell the inspirational stories of pioneers such as these and we need to tell them well and often. Gunther Burghardt is the Finance Director for ANZ, Asia-Pacific and Europe, MiddleEast and Africa, for Treasury Wine Estates.

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What can economics tell us about guns and crime? Your chance of being a victim of homicide in the late 2000s was around half of what it had been in the late 1980s. BY andrew leigh

One of the topics covered in an address launching The economics of just about everything: the hidden reasons for our curious choices and surprising successes, at the University of Melbourne on 30 July 2014.

In the wake of the Port Arthur massacre, newly elected Prime Minister John Howard worked with state and territory governments to implement tougher gun regulations. One of the strongest advocates was Walter Mikac, whose wife and two daughters had been murdered by Martin Bryant. Addressing a rally of 3000 people in the Sydney Domain, he said ‘as you know, three months ago to this day, I lost the entire reason for my existence’. To make sure that the tougher rules actually reduced the number of weapons, they were also accompanied by a buyback program. From mid1996 to mid-1997, anyone could take a gun to their local police station, and the police would pay its fair value. In total, nearly 650,000 weapons were handed in to police. While some of these were weapons had newly become illegal (pump-action shotguns and semi-automatic rifles), many people seem to have simply taken the chance to ‘clean out the closet’ by handing in weapons that were legal if the owner had an appropriate licence (such as .22 rifles). In the Northern Territory, police even paid compensation for a set of World War II aircraft cannons. According to one survey, the proportion of Australian households that had at least one gun dropped from 15 per cent to 8 per cent as a result of the buyback.

Did the buyback save lives? The public debate seemed frustratingly simplistic. Some anti-gun campaigners described firearms owners as ‘gun nuts’, and seemed to have difficulty understanding how anyone could enjoy gun collecting, target shooting or hunting. Conversely, gun-rights advocates would say things like ‘guns don’t kill people, people do’, which doesn’t take the debate very far, given that the same can be said for fragmentation grenades, poison gas and surface-toair missiles. With Christine Neill, an expatriate Australian now living in Canada, I set about analysing data on the buyback. One result was rock solid. In the decade before the gun buyback, Australia averaged more than one mass shooting per year (a mass shooting is where five or more people are killed). Between 1987 and 1996, a total of 94 victims were killed in mass shootings. Apart from Hoddle Street and Port Arthur, there were also mass shootings in the Top End (Northern Territory and Western Australia), Canley Vale (New South Wales), Queen Street (Victoria), Oenpelli (Northern Territory), Surry Hills (New South Wales), Strathfield (New South Wales), Terrigal (New South Wales), Cangai (New South Wales) and Hillcrest (Queensland). Insights Melbourne Business and Economics

In the decade after the laws were changed, there was not a single mass shooting in Australia. The chance of this change being due to luck alone is less than 1 in 100. Judged by whether it prevented mass shootings, the Australian gun buyback was an unmitigated success. Yet impressive though this is, the number of people killed in mass shootings has never been particularly large. Even during the worst period for gun massacres, the odds of being killed in a mass shooting were about as large as the chances of being killed by a lightning strike. Neill and I then set about looking at other types of gun deaths. We learnt that the person most likely to kill you with a gun is yourself. The next most likely person to kill you with a gun is your spouse. The next most likely people to kill you are household members, relatives and acquaintances. You are least likely to be killed by a complete stranger. So we decided to look at the impact of the gun buyback on the overall firearm homicide and firearm suicide rates. We approached the question in two ways. First, we looked at national trends. We found that â&#x20AC;&#x201C; notwithstanding the mass shootings â&#x20AC;&#x201C; gun homicide 64

What can economics tell us about guns and crime?

and gun suicide rates had been steadily falling for nearly two decades before the buyback. Some fancy statistical analysis seemed to suggest that the buyback had caused the firearm homicide and suicide rates to fall a little faster, but it was difficult to be sure, so we tried another approach. In some states, the number of firearms per person that were bought back was larger than in other parts of Australia. We asked the question a little differently: did places with more gun buybacks experience a larger drop in gun homicide and suicide? The answer turned out to be a resounding yes. For example, in the case of firearm suicide, the greatest reduction in weapons occurred in Tasmania, which was also the jurisdiction that saw the biggest drop in firearm suicide. Meanwhile, the smallest reduction in firearms per person was in Canberra, which also had the smallest drop in the firearm suicide rate. We did not find evidence of a corresponding increase in other forms of homicide (such as knife killings) or suicide (such as self-poisoning). Overall, we estimated that the Australian gun buyback saved at least 200 lives per year â&#x20AC;&#x201C; mostly suicides.

Was the buyback worth it? But the buyback had been expensive. Around half a billion dollars in compensation was paid to gun owners. Would Australia have been better off putting the money into other lifesaving measures, such as safer roads or better hospitals? To answer this question, we need a way of valuing gun deaths in monetary terms. For non-economists, this is sometimes regarded as a ghastly exercise: how can we put a dollar figure on a life? But for economists, having an estimate of the value of a statistical life helps us decide when a life-saving measure is cost-effective. By looking at how much people are willing to pay for health care and safety measures, economists are able to come up with a figure for the value of a ‘statistical life’. The value of a statistical life most commonly used by Australian policy-makers is $2.5 million. On this basis, the economic value of saving 200 lives a year is around half a billion dollars, so the economic value of the gun buyback every year is about the same as the one-off cost paid in 1996-1997. Since it was implemented, the gun buyback has paid for itself more than ten times over. And the vast bulk of the benefit came not from reduced mass shootings, but from an entirely unexpected source: fewer gun suicides.

Fear of crime and wellbeing While relatively few people die from mass shootings, the fear generated by the Port Arthur massacre should not be ignored. It is true that Australia probably lost as many people to road accidents in the week after the Port Arthur massacre as died on that tragic Sunday. But that simple analysis ignores the fact that fear of crime imposes a real cost on the community. It was the nineteenth-century philosopher Jeremy Bentham who first argued that crime might have an impact on non-victims. A violent crime, Bentham suggested, did a ‘primary mischief ’ to its victim but it also caused a ‘secondary mischief ’. As reports circulated, people would go out of their way to avoid the spot where it happened. Some might spend money to protect themselves. Others could be too scared to leave their homes at all. Bentham

reminded us that the ripples of crime spread out well beyond the event itself. Fear of crime isn’t always proportional to the risk of crime. For example, women tend to be most fearful of violent crime, yet men are most at risk. We probably all know friends whom we think are too worried about crime. Perhaps because people’s worries don’t always match the true danger, the economics of crime has largely ignored fear. To help fill the research gap, I carried out a study with British economist Francesca Cornaglia and US economist Naomi Feldman. In essence, we aimed to test Bentham’s theory in Australia. Matching up surveys of mental wellbeing with data on police crime reports, we found that an increase in crime was associated with lower levels of mental wellbeing for people who were not a victim of any crime. When crime surged, people in the neighbourhood who hadn’t been victims tended to experience more emotional problems, nervousness and depression. Moreover, we found that media reports of crime act as a ‘multiplier’ – causing crime to have an even larger negative impact on mental wellbeing. This finding suggests that crime is yet more serious than we might have thought. As a community, we’ve always known that we need to cut crime to protect the man who might be assaulted, the family whose house might be broken into, and the woman whose car may be stolen. We also know now that we need to cut crime so that families can continue to let their children walk to school, women can go jogging at dusk and older people can feel safe catching the train.

What drives crime? To understand what drives crime, let’s start by looking at crime rates in Australia over recent decades. Ideally, we would look at a wide range of crimes, but shifting definitions and changes in reporting rates have made long-term trends unreliable for some offences (for example, domestic violence is more often reported than in the past). So I’ll focus on the one crime that has the fewest problems in reporting: homicide. From the end of World War II, Australia’s homicide rate climbed steadily – from an annual rate of Insights Melbourne Business and Economics

around 1 per 100,000 in the 1940s to a peak of 2.4 per 100,000 in 1988. Thereafter, it slowly declined, staying below 2 people per 100,000 throughout the 1990s. In the most recent figures, the homicide rate was just above 1 person per 100,000. Your chance of being a victim of homicide in the late 2000s was around half of what it had been in the late 1980s. What caused the drop? One of the lessons of economics is that government policies often have unintended effects, so let’s start with two crimereduction strategies you’ve probably never heard about: legalised abortion and unleaded petrol. The evidence for both effects originates in the United States, where crime has followed a similar pattern to Australia.

Legalised abortion In the case of legalised abortion, the story starts in 1973 when the US Supreme Court decision in Roe v Wade effectively legalised abortion, leading to a dramatic increase in the number of terminations performed. The turning point in violent crime in the 1990s coincided with the period when children born in the post–Roe v Wade era would be reaching their late teens, and crime continued to fall as this generation reached the peak ages for criminal activity. Moreover, the handful of US states that legalised abortion before Roe v Wade were also the first to witness a fall in crime. Researchers John Donohue (Stanford University) and Steven Levitt (University of Chicago) concluded that legalised abortion accounted for a significant share of the drop in US crime rates. When Justin Wolfers and I read the study, we decided to test the theory on Australia. Although Australian crime data aren’t as good as US figures, we found some similar trends. While there is no single Roe v Wade–type decision in Australia, a number of seminal changes can be identified. Court decisions in Victoria in 1969 and New South Wales and the ACT in 1971 substantially broadened the circumstances in which abortions could be legally performed. Legislative changes in South Australia in 1969 and the Northern Territory in 1974 had a similar effect. 66

What can economics tell us about guns and crime?

The changes did not occur in every jurisdiction. In Tasmania, Queensland and Western Australia, the legal status of abortion remained unclear throughout the 1970s. But, for more than twothirds of the Australian population, the change occurred in the late 1960s or early 1970s – or about twenty years before the drop in crime rates. Wolfers and I also found some evidence that the drop in homicide occurred first in the states that legalised abortion the earliest. The reaction to the two sets of findings could not have been more different. In the US, Donohue and Levitt earned the opprobrium of both those who are Pro-Life (who thought the researchers were arguing that the murder of a million foetuses could be offset by 6500 fewer homicides) and those who are Pro-Choice (who thought the researchers were suggesting that we could weed out society’s villains in the womb). In Australia, the publication of my research with Wolfers garnered a single letter to the newspaper. Now that the dust has settled, it’s worth noting that legalised abortion has only a minor effect on the number of children brought into the world – its main effect is to change when they are born. Thus, the main effect is not that families have fewer children, but rather that all of these children are born when the parents feel ready to raise them. In Freakonomics, Levitt (writing with Stephen Dubner) argued ‘when the government gives a woman the opportunity to make her own decision about abortion, she generally does a good job of figuring out if she is in a position to raise the baby well. If she decides she can’t, she often chooses the abortion’.

Unleaded petrol The other major cause of the crime drop was unleaded petrol. In the 1920s, fuel companies began adding lead to petrol to improve performance. At the time, people knew that high quantities of lead could cause poisoning, but didn’t realise that even small amounts of lead can be harmful – particularly for children. Several research papers have found that children with moderately high levels of lead in their blood are more hyperactive, impulsive and easily distracted. With difficulty controlling their

behaviour, children who have more exposure to lead are more likely to commit crimes as adults. Lead exposure increases the chance of ADHD and it boosts the chance of children having a low IQ, a predictor of committing crimes later in life. Although children can also ingest lead from house paint, leaded paints were largely phased out in the 1950s and 1960s, leaving leaded petrol as the largest risk to children. In a careful analysis of the US experience, Jessica Wolpaw Reyes of Amherst College uses the fact that the Clean Air Act phased out lead from petrol over the period 1975 to 1985, but did so differentially across states. When Reyes analysed the changes in violent crime two decades later, she observed that the drop in crime was sharpest in the states that were first to reduce their lead levels. Moreover, the effect is independent of the change in abortion laws, which happened at a similar time, but did not perfectly coincide with the drop in lead levels. In Australia, the phase-out of leaded petrol did not start until 1986, but took place at the same time nationwide (preventing me from replicating Reyes’ cross-state comparison for Australia). Yet if we assume that the impact on crime was similar in both countries, it suggests that unleaded petrol might have been responsible for reductions in crime in Australia as late as the mid-2000s. Tragically, Reyes’ results also suggest that if Australian policymakers had banned leaded petrol when their US counterparts did, then tens of thousands of children may have grown up with better life chances, and thousands of crimes might have been averted. So far, I’ve talked about three factors that affected crime in surprising ways. The gun buyback reduced firearms deaths, but mostly through fewer domestic shootings and suicides, not by its effect on reducing mass murders. In the case of abortion laws, the reduction in crime came because these laws helped women bear children when they felt ready to raise them. And unleaded petrol dramatically reduced young children’s exposure to a substance that we now know is associated with impaired brain development.

Policing and punishment Political debates about crime aren’t generally focused on these more distant causes. When that well-known state candidate Laura Norder is on the ballot paper, it’s typically because voters want more police on the streets and more criminals in jail. So let’s review what we know about the way that policing and punishment affect crime. According to the leading economic studies on the issue, both police officers and imprisonment cut crime. Police numbers affect crime because the more police there are on the beat, the higher the probability that a criminal will get caught. For every 10 per cent increase in police numbers, crime rates fall about 4 per cent. Yet although the number of Australian police officers per person rose in the 1970s, it hasn’t changed much since then. So it stands to reason that police numbers cannot be a major driver of the drop in violent crime over recent decades. Incarceration reduces crime through two channels: deterrence and incapacitation. Deterrence works because would-be criminals look at those behind bars and decide not to commit an offence. Incapacitation works because while you’re locked up, you can’t commit a crime (more specifically, you can’t commit a crime on the general population). Like sports players, criminals tend to have short careers, peaking in their late teens and early twenties. So if you lock up criminals for a few years, you dramatically reduce their lifetime propensity to commit violent crimes. Overall, every 10 per cent increase in the prison population cuts crime by around 3 per cent. Andrew Leigh is the Shadow Assistant Treasurer and Member for Fraser and a former professor of economics at the Australian National University.

Reference Leigh, A 2014, The Economics of Just About Everything: the hidden reasons for our curious choices and surprising successes, Allen & Unwin, Sydney.

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Mailing Address: The Faculty of Business and Economics The University of Melbourne Victoria 3010 Australia Telephone: +61 3 8344 0006 Email: droller@unimelb.edu.au Internet: http://insights.unimelb.edu.au Published by the Faculty of Business and Economics, November 2014 ÂŠ The University of Melbourne Disclaimer Insights is published by the University of Melbourne for the Faculty of Business and Economics. Opinions published are not necessarily those of the publisher, printers or editors. The University of Melbourne does not accept responsibility for the accuracy of information contained in this journal. No part of this journal may be reproduced without the permission of the editors.