Insights Volume 1 April 2007

INSIGHTS Melbourne Economics and Commerce volume 1 april 2007

China in international imbalances

Yu Yongding International trade and poverty: cause or cure?

L. Alan Winters Making the boom pay

John Freebairn Australian labour market reforms

Joe Isaac Andrew Leigh Mark Wooden The corporate political environment and big business response

Geoff Allen Stock return predictability in rational markets

Bruce D. Grundy Passive profits from accounting indicators

John D. Lyon Occasional addresses by Alumni

Tom Elliott and Peter Yates

Welcome Welcome to the first issue of Insights, a new publication of the Faculty of Economics and Commerce at the University of Melbourne.

Every year, distinguished visitors and academic staff give important public lectures at conferences and seminars connected with the Faculty. Some of the lectures find their way into learned journals. Others are lost to those who were not present at them. The developments in the various disciplines within the Faculty are an ongoing process and for many, it is a challenge to keep up with new findings and ideas relevant to their professions and the community generally.

Insights: Melbourne Economics and Commerce ISSN:1834-6154 Editor: Emeritus Professor Joe Isaac, AO Associate Editor: Ms Brooke Young Sub-editor: Ms Rebecca Gleeson, Squidink Communications Advisory Board: Dr Robert Dixon Professor Bruce D. Grundy Associate Professor Bryan Lukas Illustrator: Ms Max Maxfield Design: Ms Sophie Campbell

The aim of Insights is to record condensed and edited versions of these lectures in a language accessible to the general reader, and to be both informative and enjoyable. In some cases, reference will be made to where the lectures are printed in full. This will provide an opportunity for sharing knowledge and ideas from a variety of perspectives with a wider public. Business and community leaders, alumni, students and researchers will have easy access to contemporary material. For future researchers, the journal will be an archival resource of Faculty events.

I hope you will find the articles in this inaugural issue of interest and we look forward to receiving your comments and feedback.

Professor Margaret Abernethy Dean

insights vol 1 Table of contents 03 China in international imbalances

By Yu Yongding China’s fast-growing economy faces an unprecedented problem: how to deal with its unsustainable ‘twin surpluses’ without damage to itself and the global economy

31 The corporate political environment and big business response

By Geoff Allen The complex task of corporate management in the modern world

35 Stock return predictability in rational 09 International trade and poverty: cause or cure?

markets: on the impossibility of informationally inefficient markets

By Alan L. Winters The impact of trade liberalisation on poverty is not black and white; different countries experience different effects

By Bruce D. Grundy Understanding the debate between behaviouralists and neo-classicists pays dividends for all researchers

15 Making the boom pay

By John Freebairn As Australia enjoys riding a prosperous wave, key economists and strategists examine how it can be sustained long into the future

21 Australian labour market reforms 21 Reforming Australian industrial

relations?

By Joe Isaac The debate over WorkChoices will continue for some time as its effects are felt across the workforce 25 Minimum wages and inequality

By Andrew Leigh Are minimum wages justly promoted as a crucial tool in the battle against poverty?

41 Passive profits from accounting indicators

By John D. Lyon Can superior long-term share market returns be earned from basic accounting indicators?

43 Occasional addresses by Alumni at University of Melbourne graduations 43 A ‘Battle of Ideas’ is taking

place around the globe Graduates of the University of Melbourne can assist in its resolution

By Tom Elliott 45 On painting one’s life picture

By Peter Yates

28 Does the Fair Pay Commission

decision matter?

By Mark Wooden Employers and unions have differing opinions about the merits of a minimum wage rise on both employment levels and living standards

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china in international imbalances China’s fast-growing economy faces an unprecedented problem: how to deal with its unsustainable ‘twin surpluses’ without damage to itself and the global economy by yu yongding A condensed version of the 2006 David Finch Lecture delivered on 17 October at the University of Melbourne. The Lecture was established through the generosity of C. David Finch, a distinguished alumnus of the University. The full paper has been published in Australian Economic Review, March 2007, 40: 1.

Global imbalances

China’s ‘twin surpluses’

The global economy is suffering from serious imbalances characterised by a persistent deterioration of the US current account deficit, marked increases in oil and raw material prices and excessive international liquidity. The US Bureau of Economic Analysis announced on March 14 2006 that the US deficit reached seven per cent of GDP in 2005. The deficit is expected to increase further in the future, due to growing consumer demand for imports and to a rapid growth in interest payments to foreign holders of US government securities. Rapidly rising oil prices and imports explained about two-thirds of the increase. But US trade deficits increased with every major region of the world and the largest increase was with China, from whom the US does not import oil.

The economics of development assumes that developing countries should run current account deficits and capital account surpluses, using foreign saving to achieve an investment rate higher than what their domestic saving rate can support. As their economy matures they will reduce their debt liability until finally they become a country with a positive net international investment position.

At the same time, the Chinese economy is suffering from serious imbalances of another kind, characterised by a rapid increase in the so-called ‘twin surpluses’ (where China has, at one and the same time, both a current account surplus and a capital account surplus), a persistence of excess investment, acute energy shortages, a deterioration of the environment and a rapid widening of income gaps, while the economy is growing at breakneck speed.

Few people in China believe that its current account surplus is sustainable in the long term and even fewer believe that running a large current account surplus is desirable for the country. The changes we are likely to see in China’s growth strategy will have major implications for global imbalances and international finance.

China does not fit this pattern. Although a developing country with a very large capital account surplus every year since the early 1980s, China has also been running a current account surplus consistently since the early 1990s. These persistent ‘twin surpluses’ have resulted in a continual increase in foreign exchange reserves.

By the end of 2006, China’s foreign exchange reserves will have surpassed 1 USD trillion, making it the largest foreign exchange reserve holding country in the world.

The twin surpluses imply that foreign funds obtained through foreign direct investment (FDI) and exporting are not fully utilised to buy foreign goods, technology or managerial skills, but instead have flowed back to the US government bond market. So why does a developing country like China run a large current account surplus and why does it attract so much FDI given that it has excess savings?

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The current account surplus The first and most popular explanation for China’s current account surplus is the saving-investment gap. While China’s investment rate is very high, its saving rate is even higher.

The second factor contributing to China’s current account surplus is government policies – especially the three export promotion policies, the so-called ‘self-balancing’ regulation, exchange rate policy and tax rebates. In the early stage of reform, the government demanded foreign investors guarantee the self-balancing of foreign exchanges for important foreign investment projects. In other words, FDI was to be entirely export-oriented. It is also undeniable that China’s exchange rate policy is conducive to China’s trade surplus and current account surplus.

Before the Asian financial crisis, China’s exchange rate was set according to the production costs of exports in order to maintain these exports’ competitiveness.

During the Asian financial crisis, the Renminbi (RMB) was pegged to the US dollar. Besides a relatively undervalued currency, tax rebates are another very important policy instrument. Tax rebate-related frauds are rampant and as a result many enterprises export solely in order to obtain tax rebates.

The third factor is China’s position in the global division of labour. Commencing in the late 1980s, a new international division of labour began to take shape. The lowering of communication and transportation costs together with the liberalisation of trade and investment regimes enabled corporations to fragment and internationalise the production process. As a result of the development of international production networks, processing trade became the dominant form of trade among less developed countries.

China’s current account surplus and trade pattern were shaped to a large extent by FDI that flowed in as vehicles for the formation of international production networks. The destination of FDI inflows into China was in turn facilitated by the Chinese government’s policy in favour of processing trade, which was motivated by its fear of a current account deficit and its desire to allow China’s comparative advantage in labour intensive products to have full play. Because of the increasingly important role played by multinationals from developed countries and by

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Taiwanese Original Equipment Manufacturer (OEM) firms, the bulk of FDI flowed into manufacturing sectors such as electronics, automobiles, family appliances, office machines, measuring and checking instruments, telecommunications equipment, pharmaceuticals and chemicals. As a result of changes in the regional and sectoral distribution of FDI, China was more and more deeply locked into the international production networks and its trade became increasingly dominated by processing trade.

Since China entered the World Trade Organisation (WTO) in December 2001, FDI from multinationals has increasingly been concentrated in capital-intensive heavy chemistry, large-scale infrastructure, highly technological industry and the service industry. Each of these bear less relation to the international production network. At the same time, multinationals grow more interested in China’s domestic market rather than using China as a platform for re-export. However, these new developments will not change the dominant position of processing trade in China in the near future.

The FDI puzzle We can see that China attracts plenty of FDI. The question is why, given that it has excess savings?

First, due to the under-development of the financial markets, though there may be excess savings for the economy as a whole, it is very difficult for many potential importers of capital goods to raise funds domestically to finance imports. Yet it is easy to attract foreign funds thanks to preferential policy towards FDI. Sometimes enterprises simply sell their foreign exchange obtained via FDI to the central bank (the People’s Bank of China) and use RMB to buy capital goods produced locally. As a result, while there are increases in the levels of FDI and in foreign exchange reserves, there are little or no changes in the current account. Essentially, China’s domestic savings are being intermediated by foreign capital markets for domestic investment.

Second, even if funds can be raised domestically, due to capital controls it is difficult for potential importers to convert their RMB funds into foreign exchange so that foreign goods can be brought.

Attracting FDI is still a better option.

Third, despite the fact that the returns required on FDI are much higher than the yield on US treasury bills, FDI is the cheapest form of foreign capital for myopic enterprises and local governments. In other words, under current governance arrangements, from the point of view of local governments and individual state-owned enterprises, FDI is a ‘free lunch’. Who cares about payments in the form of investment income, if the payments are due in five to 10 years’ time? Faced with excessively lavish concessional conditions – low tax rate, long tax holiday, hidden subsidies in energy use, lax regulations of environmental protection, free infrastructure and low or negative rents on land use – what more can foreign investors hope for? So the interests of local governments in attracting FDI and those of foreign investors in providing FDI coincide perfectly.

Fourth, China’s fiscal system and institutional arrangements give local governments great incentive to attract FDI. One reason is that FDI is indispensable for increasing tax revenues at local levels.

Another reason is that it is a common practice in China that officials at all levels of government are assigned targets for FDI attraction. Those who attract the largest amount of FDI are the most likely candidates for further promotion.

Fifth, in order to give new impetus to the recent reform of state-owned enterprises and commercial banks, the merger and acquisition of Chinese firms by foreign investors and the acquirement of shares by ‘international strategic investors’ in China’s commercial banks are encouraged. Consequently, capital flows in and adds to the existing stock of foreign exchange reserves.

Where does all this FDI come from? The single biggest FDI provider is Hong Kong, followed by the Virgin Islands. The latter alone accounted for more than 19 per cent of China’s total attraction of FDI in 2005. Though difficult to verify, anecdotal evidence suggests that a very large proportion of China’s FDI is rent-seeking round-tripping FDI.

Why China must take action Inside China, a consensus has been reached that the twin surpluses are neither desirable nor sustainable.

There are a number of reasons why China will take

action to correct its imbalances, and these actions will undoubtedly have important consequences for the global imbalances.

First, as already explained, China’s current account surplus is achieved as a result of severe market distortions. For example, the competitiveness of energy-intensive export products is achieved through hidden subsidies in the form of the under-pricing of energy resources. The same is true of land-intensive export products.

Second, the over-dependence on processing trade for the current account surplus, which in turn is based on the availability of low-skilled but well-disciplined cheap labour, is damaging the potential for future improvement in China’s human capital and risks permanently locking the Chinese economy into a low level on the ladder of the international division of labour.

Third, with trade being dominated by processing trade, China’s economy can be very vulnerable to external shocks.

Fourth, trade frictions will worsen as a result of the increase in the current account surplus. China’s exports are already targeted by the US, the European Union and many developing countries, such as Mexico, Brazil and so on. China’s economic growth will be gravely damaged if these countries take action to restrict Chinese imports.

Last, but by no means least, the accumulation of foreign exchange reserves, as a result of the twin surpluses, is making the Chinese economy vulnerable to US policy decisions. According to some American economists, the US dollar should further devalue by 20-30 per cent. If that happens, China’s losses in its foreign exchange reserves will be tremendous as more than half of the reserves are in US dollars. The dilemma facing China’s central bank is unparalleled in history. With such a huge amount of foreign exchange reserves, it is extremely difficult for China to protect itself.

The twin surpluses have compromised China’s macroeconomic management and are harbingers of inflation and asset price bubbles. Since the middle of the 1990s, the increase in foreign exchange reserves has become one of the most important contributing factors to the increase in reserve money.

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In order to control the increase in reserve money, largescale open market operations have been carried out involving the sale of government bonds held by the People’s Bank of China (PBOC). However, owing to the enormous scale of open market operations aimed at neutralising the expansionary impact of the increase in foreign exchange reserves, in just a couple of years the PBOC sold out all the government bonds it had accumulated as a result of the previous open market operations aimed at increasing money supply to stimulate the economy. Commencing in 2003, the PBOC was forced to sell central bank bills to mop up the liquidity.

The sterilisation debate One important question is whether sterilisation can be implemented without limit. This is a debatable question. Theoretically speaking, as long as the interest rate paid by the central bank on its bills is lower than the corresponding interest rate on (say) US treasury bills, the central bank should be able to carry on with full sterilisation indefinitely, and hence maintain an effective control of the monetary base.

However, there are several obstacles to the continuation of full sterilisation. One is that the continuous purchase of low yield central bank bills and the increase in the share of low yield assets in the total assets will worsen the commercial banks’ profitability, which in turn will create a long-term negative impact on the fragile banking system. Therefore, faced with a continuous increase in foreign exchange reserves, the central bank will have to make choices among three contradictory objectives: a tight monetary policy, a healthy financial system and exchange rate stability.

Faced with an extremely high growth rate of fixed assets investment and a steady increase in the investment rate, the PBOC will have no choice but to tighten monetary policy greatly. At the same time, comprehensive policy measures will be taken to reduce the increase in foreign exchange reserves.

Sustainable solutions to restore balance China’s current balance of payments position is not sustainable in the long run. If China fails to utilise foreign capital effectively and obtain a decent return

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on its outbound investment and lending, it may suffer from current account deficits as a result of ballooning investment income outflows.

To reduce the current account surplus, the savinginvestment gap should be reduced by increasing either consumption or investment. Because China’s current investment rate is already too high, the focus should be on increasing consumption. In order to do so, government expenditure on public goods must be increased in areas such as social security, health care, transport infrastructure and education. The government’s recent decision to increase funding for rural development will achieve the result of ‘killing two birds with one stone’.

It is worth noting that the most important source of high saving is not the household sector but the enterprise sector. State owned mega-firms have parked huge amounts of funds in banks. This must be addressed.

Preferential policies towards FDI should be scrapped so that domestic and foreign investors are given equal treatment in terms of credit access, tax arrangements, environmental requirements and so on. As a result, the level of round-tripping FDI will be reduced and the flow of FDI that is not viable without all sorts of subsidies will cease.

The export promotion policy should also be gradually scrapped and policies which particularly favour processing trade should be adjusted. Imports should be allowed to increase, especially of strategically important goods and materials. Of course, while doing so, international markets should not be destabilised.

Financial reforms should be speeded up. Small and medium enterprises should not be discriminated against. Corporate bond markets should be developed and stock markets made more effective. The reforms should seek to allow domestic savings to be channelled effectively to enterprises, therefore reducing the need to attract FDI to obtain credit.

Foreign-funded enterprises should be allowed to tap China’s domestic capital market, reducing the need for new cross-border FDI. At the same time, Chinese enterprises should be encouraged to invest abroad both in the form of greenfield investment and mergers and acquisitions.

Capital account liberalisation should be carried out in a smooth and orderly manner. However, the completion of financial reform and the revitalisation of China’s financial institutions (and banks in particular) must precede the final liberalisation of the capital account, that is, to make the RMB convertible.

The RMB exchange rate should continue to appreciate gradually. However, empirical evidence has shown that the so-called ‘expenditure-switching’ effect of nominal exchange rate changes is small in China as well as in the US. As a result, to use the exchange rate change as an instrument to achieve trade balance might lead to considerable exchange rate volatility. Abundant experience also shows that overemphasis on exchange rate policy in the correction of current account imbalances may not only fail to achieve the goal of correcting the trade imbalance, but may also cause tremendous hardship to the countries concerned. After the 1985 Plaza Accord, and despite the dramatic revaluation of the Japanese Yen and the slide of the US Dollar, the US trade deficit failed to improve in any significant way, but nonetheless caused tremendous hardship to the Japanese economy. While recognising the limitation of exchange rate policy, I personally support action on the exchange rate front.

In conclusion Over the past 26 years, China has achieved tremendous success in reforming and opening up its economy. China has become the fourth largest economy in the world, the third largest trading nation and the largest foreign exchange reserve holding country. Yet it faces increasingly serious structural problems. Its investment rate is approaching 50 per cent of GDP and rising. Its current account surplus surpassed USD102 billion in 2005, and will probably be higher in 2006.

China’s foreign exchange reserves will surpass the threshold of USD1 trillion very soon. China’s environment is deteriorating continuously, and its energy shortage is acute.

dependent on how well the Chinese government is able to balance the short run necessity for high growth with the long run necessity for structural adjustment. On the one hand, China’s twin surpluses are a result of long-term imbalances and cannot be changed overnight. On the other hand, caution is not an excuse for inaction.

Global imbalances are not sustainable in the sense that these imbalances are not in the long-term interests of China and other Asian countries, and they should be and will be corrected, no matter what the US government says and does. However, a drastic correction is neither inevitable nor desirable. To achieve an orderly correction, more international consultation and policy coordination are needed.

To my mind, this is the key task faced by national and international agencies around the world today.

Professor Yongding is Academician of the Chinese Academy of Social Sciences, the Director-General of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, Professor in the Academy’s Post-Graduate School and President of the China Society of World Economics. He was formerly the academic member of the Monetary Policy Committee of the People’s Bank of China and a member of the National Advisory Committee of the 11th Five Years Plan of National Reform and Development Commission.

To correct the imbalances, the Chinese government must adopt a comprehensive program aimed at achieving a more balanced and sustainable growth pattern. Whether this strategy will be successful is

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international trade and poverty: cause or cure?

The impact of trade liberalisation on poverty is not black and white; different countries experience different effects by l. alan winters A condensed version of the Fourth Annual Max Corden Lecture delivered at the University of Melbourne on 12 September 2006. The full paper is to be found in The Australian Economic Review 39(4): 347-58. Max Corden is a Professional Fellow in the Department of Economics at the University of Melbourne, and Emeritus Professor of International Economics at the School of International Studies and John Hopkins University.

This paper asks how we might think about the effects of international trade on poverty, how we might measure these effects and what the results of such measurement efforts have been. The basic argument is that trade liberalisation generally stimulates medium-term economic growth and that this generally alleviates poverty. But it usually creates some losers, some of whom may be poor or pushed into poverty. For public policy, such effects should make us careful to protect the poor, but not stop liberalising our trade regimes.

Economic growth Economic growth is the key to sustained poverty alleviation. It creates the resources to raise incomes, and even if, improbably, ‘trickle-down’ were insufficient to bring any immediate benefit to the poor, it at least gives governments scope for financing investment, by complementary or redistributive measures, to help them.

Economic theory offers many reasons to expect a country’s own trade liberalisation to stimulate its economic growth: for example, specialising in goods for which world prices exceed home prices, reaping economies of scale, improving performance in the face of new competition, and benefiting from better inputs and technologies available from abroad.

None of these is guaranteed, however, so ultimately whether trade stimulates growth is an empirical matter. Over the 1990s several highly visible global cross-country studies suggested that openness was good for growth, but the technical hurdles to absolute proof are very high. These hurdles include: measuring the restrictiveness of trade policy accurately; establishing causation – opening up may stimulate growth, but growing countries might be more willing to liberalise; isolating the effects of trade reform from other reforms that typically come with it, especially if it depends on those reforms to work – e.g., having flexible labour markets in order to respond to trade incentives; and allowing for the effects of openness on other policies and institutions, the latter of which are now universally believed to be critical to growth.

Despite these difficulties, the weight of experience and evidence seems to strongly support the idea that openness enhances growth. And even the critics concede that there is no coherent evidence that openness is bad for growth.

The evidence also strongly suggests that economic growth reduces absolute poverty. This is not the same as saying that it reduces income inequality.

Indeed, some argue that for low-income countries trade liberalisation could be unequalising.

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This probably arises because only the relatively well off are equipped with the skills or locational advantages to capitalise on the opportunities that trade opens up. But these results do not necessarily mean that the poor actually get poorer: all incomes could be rising.

Direct effects of trade shocks Treating the household as the basic unit over which poverty is defined, the question is posed as to how trade reforms impinge on poor households. This is primarily a matter of how the price changes generated by the reforms affect their consumption and sources of income. Three channels of causation may be distinguished – the prices of goods and services, the market for labour and the role of taxation and government expenditure.

The last is important but not very sophisticated analytically. There is no simple link between trade reform and tariff revenues. In many cases tariff reductions increase revenues since they are associated with reductions in exemptions, less evasion and an enlargement of the tax base as trade increases. But, of course, as tariffs fall towards zero, revenue eventually falls to zero. But even this does not necessarily translate into worse services or higher taxes for the poor. That is essentially a political decision.

A more interesting link is between world prices and trade policy, and the prices of the goods that poor households consume and produce. The bulk of the world’s poor are self-employed in either low-level agriculture or the informal sector of the economy.

Thus their incomes are directly affected by price changes induced by international trade. An increase in the price of something that the household sells will increase its real income, while a decrease reduces it. Equally important are the prices the poor pay for what they consume.

An important question, then, is whether trade policy changes, which occur on the border, get transmitted into price changes for poor or nearly poor households.

This depends on factors such as transport costs and other costs of distribution; the structure of markets; and domestic taxes and regulations. Some impediments, such as transport costs, are inevitable although they may be increased by policy decisions such as to levy fuel taxes or provide inadequate infrastructure.

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Others, on the other hand, represent direct economic inefficiency, such as permitting marketing monopsonies or monopolies.

Price transmission is likely to be particularly ineffective for poor people living in remote rural areas and could prevent families from making market transactions almost completely. Such isolation saves the poor from any negative shocks emanating from the international economy but it also prevents them from experiencing the positive shocks and secular benefits that I discussed above. Their problem is too little globalisation, not too much.

A household’s ability to adjust to a trade shock – say to switch production towards goods whose prices have risen – clearly affects the size of any impact it suffers. Hence one needs to ask whether the poor are able to make such adjustments. For many of them, a major constraint on improvements in agricultural productivity following the external liberalisation has been shown to be the absence of key productive assets (draft animals, implements), capital, credit, or information.

For the self-employed, the main determinant of income is the prices commanded by their output and paid for their inputs, but for employees it is wages and employment opportunities. Obtaining employment is one of the surest ways out of poverty, while the loss of a job is probably the most common reason for the precipitate declines into poverty that catch most public attention. The structure of the labour market is critical to how trade liberalisation gets translated into wage and employment changes.

Maybe everyone’s wages are bid up a bit, but if wages are inflexible a positive shock is more likely to show up in the creation of a few new jobs at wages well above subsistence levels. If so, who gets the jobs is important. Sometimes they will be the poor, but other times the jobs will go to additional workers in households that already have formal employment or to more skilled workers.

Where unskilled labour is relatively abundant, the goods it produces will be plentiful and hence relatively cheap in the absence of international trade. These are the goods, then, that will be exported when trade increases and hence trade liberalisation will generally relieve poverty.

However, not all developing countries fall into this class. For example, many Latin American and African countries have large endowments of natural resources and so liberalisation will stimulate these sectors rather than labour-intensive ones.

Testing and measuring poverty effects The obvious questions – at least to an empiricist – are can we test or measure these effects and how important are they? Even the simple direct effects are difficult to pin down with complete confidence because (a) we don’t know what would have happened in the absence of trade liberalisation and (b) it is difficult, as argued above, to separate trade liberalisation from all the other reforms that dynamic governments pursue at the same time.

One effort from my own work concerns Vietnam, which liberalised and experienced dramatic declines in poverty over the 1990s. Observing the same 4,300 households both early in the process (1992/3) and later (1997/8), we looked at the influence of certain obviously trade-related factors on households’ ability to escape from poverty. For example, rice production, where the removal of Vietnam’s export restrictions caused an increase in prices by 29 per cent and a huge export boom; fertilizer use, where trade liberalisation reduced real prices by 23 per cent over our sample period; coffee production – Vietnam hugely increased coffee output and exports, partly responding to a large increase in world prices; and employment in one of the booming manufactured/processed export sectors – seafood, food processing, footwear and clothing.

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All of these proved statistically significant in explaining the escape from poverty and overall, it was estimated somewhat heroically that they cut poverty by about 17 per cent.

A second approach to estimating the importance of trade reform is simulation modeling, in which the possible consequences of future trade reform using numerical models are explored. Remembering, of course, that these are hypothetical not factual exercises, this is also attractive in allowing the effects of trade liberalisation to be isolated precisely – it is the only change made in the simulations. One recent exercise tries to estimate the poverty effects of reforming developed countries’ agricultural policy – both a total liberalisation and what we might get if the Doha Round comes to a successful close.

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Effects on different countries The current apology for preserving European and American agricultural protection and support is that it supports poor farmers in the North and that liberalisation would benefit only rich land owners in the South. Both assertions contain grains of the truth but the predominant effects are the very opposite.

In the US, only two per cent of the population lives in farm households and on average only eight per cent of their income comes from the farm. If we array farms by total wealth, the poorest half make almost no income from farming, but the higher wealth brackets get a large share of their income from it.

The richest farmers specialising in the most protected commodities – rice, cotton, sugar or dairy – get up to 90 per cent of their income from farming. Thus liberalisation hits richer farmers far harder than poor ones (up to 20 per cent losses of income), which explains the strong political opposition to reform.

Turning to developing countries, which vary considerably, and recognising the many different ways in which the poor earn their living, there are great differences between countries. Rich country agricultural trade liberalisation raises world agricultural prices and boosts real returns in agriculture – for land and farm workers. In Brazil, for example, this greatly reduces poverty, whereas in Mexico, with its much larger non-agricultural workforce (who now pay more for food) it increases poverty. In Zambia, farmers gain, and there are lots of them, but they start off so poor that very few actually make it above the poverty line as a result of these reforms. Overall, agricultural liberalisation would be poverty reducing, but country experience varies hugely.

L. Alan Winters is the Director of Development Research Group of the World Bank and Professor of Economics at the University of Sussex. He is one of the world’s leading specialists on the empirical and policy analysis of international trade, having published over two hundred books and articles in areas such as regional trading arrangements, non tariff barriers, European integration, transition economies’ trade, international labour mobility, agricultural protection, trade and poverty, and the world trading system.

The findings, interpretations and conclusions expressed in this note are entirely those of the author and do not necessarily reflect the views of the Board of Executives of the World Bank or the governments they represent.

Another interesting result is that the package of reforms discussed in the Doha Round could be made more poverty alleviating. It contains the abolition of rich countries’ export subsidies – which does little or nothing for poverty in most developing countries because the poor are either isolated or net purchasers of the commodities affected. It also calls for little liberalisation by developing countries themselves – which we find would have had very strong povertyreducing effects in nearly all countries.

One final observation: Not only are the poverty effects of trade reform heterogeneous, but they are also far from sufficient to remove the scourge of poverty altogether. Trade reform will be more effective if it is accompanied by policies to relax constraints on the productivity of the poor – for example, access to credit and information – and longrun growth requires advances in other areas such as education, security of property, infrastructure and financial development. Even the staunchest advocates of trade liberalisation recognise that it is not the only thing needed for development.

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making the boom pay As Australia enjoys riding a prosperous wave, key economists and strategists examine how it can be sustained long into the future by john freebairn

A personal summary of the 37 papers presented at the Fourth Economic and Social Outlook Conference jointly organised by the Melbourne Institute and The Australian newspaper, held at the University of Melbourne on 2-3 November 2006. Copies of the Conference program, papers and presentations are available at: www.melbourneinstitute.com/conf2006/

The 2006 Economic and Social Outlook Conference brought together 37 of Australia’s leading thinkers.

Under the rubric ‘securing the next generation of prosperity’, presenters supplied answers to some pressing economic questions.

Drawing on the expertise of speakers from politics, business, not-for-profit organisations, the public service and academia, the focus of the Conference was on the economic policy challenges and options facing Australia over the next decade.

After two decades of a reform program that has transformed the Australian economy, the lucky country currently finds itself blessed by a Chinadriven resources boom. Previous commodity booms have ended in tears, and raise many questions. How can we manage the boom properly? What policies and strategies should Australia adopt to set itself up for continued prosperity and opportunity for all?

In the process, how might we best tackle areas of entrenched disadvantage? What are the pros and cons of different options for confronting the longer term challenges associated with increased pressures on natural resources and the ageing of the population?

How can we use the windfall fruits of the boom to best invest in education and training to provide skills

for the future workforce in an evolving global economy, and at the same time provide for equality of opportunity?

Looking at the broader picture of economic growth, several presenters concluded that Australia has learnt to become a good manager in times of prosperity. Fourteen years of sustained economic growth has moved us up the international relative income league ladder from the bottom third of OECD countries to the top third. In part, the sustained economic growth reflects good economic management associated with the productivity gains and greater flexibility encouraged by microeconomic reforms of the 1980s and 1990s.

In addition, credible monetary and fiscal policies have provided a low inflation and stable economic environment. We have better managed the housing and commodity price booms of the last decade when compared with preceding booms in the last century.

Slower economic growth Looking to the future, there was general agreement that Australia faces lower rates of economic growth and more urgent challenges from lower productivity growth, an ageing population and new environmental tests.

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Several speakers were optimistic that China will continue to experience rapid economic growth, as will other countries including India, and that global economic growth will further push the demand for Australia’s resources and maintain downward pressure on the prices of low technology and labour intensive manufactured goods and services. However, over the medium term, supply is expected to catch up with demand and current high commodity prices will fall back towards, but not as low as, historical averages. Inevitably, the rest of the traded sector of the economy will need to undergo structural change and respond to changes in Australia’s comparative advantage.

Other potential drivers of longer term structural change are likely policy responses to the challenges of climate change, and then changes in relative prices, with the possibility of carbon taxes or tradeable credits; the further development of water markets; some internalising of the costs of urban congestion; and changes in the demands by and the labour supply responses of an ageing population. Many international comparisons find that productivity in many parts of the Australian economy is below world best practice, and often by 20 per cent or more.

However, whether it is reform fatigue, complacency or because further microeconomic reforms are more challenging, over recent years governments at all levels and the general community appear less willing to accept the structural and other changes that go hand in hand with productivity growth. A new wave of productivity growth will require new political thinking and courage, and it will require governments to draw the electorate into an open and transparent discussion of the options and their comparative effects.

Unfortunately, business cycle fluctuations from the global economy and our own making are unlikely to disappear, although they may become more moderate than in the past. Also, the Australian economy of the future will have to adjust to irregular short term shocks such as droughts and other natural phenomena, and political instability in key global markets.

16

Making the boom pay

The benefits of the rapid economic growth of recent decades have spread to most Australians, although there are significant pockets of continued disadvantage. On average, real disposable incomes have increased by about a quarter over the last ten years associated with increased employment levels, higher wages, and some re-jigging of the tax and social security systems. Couples with children and the elderly have gained more than single adults and sole parents on low private incomes. The distribution of disposable incomes by level of income has remained fairly constant.

By conventional measures of poverty, including the Henderson measure of an income less than a half of the median, up to 15 per cent of households are assessed to be in poverty in any one year. Alternative, and arguably better, measures of poverty based on consumption or on income over several years reduce the measured incidence of poverty to around seven per cent of households. More graphic signals of particular pockets of unfairness include the statistics for indigenous Australians (with very much lower life expectancy and school completion rates, and much higher unemployment and incarceration rates), the 100,000 homeless, the 700,000 children in households where no one has a job, and long waiting lists for public dental care. Low capabilities, particularly of education and health, were shown to be highly correlated with, if not causal forces of, those not sharing in the fruits of the boom. Perhaps of most concern is that such measures of extreme disadvantage have, if anything, become larger in recent years, and in terms of the policy debate there is concern about whether we have the policy levers to achieve significant changes for the better.

Education opens doors Education was pinpointed as critical to both future prosperity and equity in many sessions of the conference. Here, education extended from pre-school and school to vocational and tertiary education. Skilled labour – as the largest production input by cost – will become even more important in the future to support higher labour productivity and real wages in an evolving and more competitive global economy.

Links between the quantity and quality of education on both participation and productivity rates that drive the level of GDP and its growth rate are now well established. At the individual level, there is ample evidence that more educated people experience higher employment rates and lower unemployment, higher wage rates, better health, and more agreeable social lives. Education for both economic growth and equity has to be seen as a long term investment with high rates of return – probably in excess of 20 per cent.

On several criteria, the provision of education in Australia was found to be deficient and falling behind world’s best practice. Australian funding of education as a share of GDP is in the second half of OECD countries. In terms of outputs, Australian completion rates for secondary schooling and tertiary education are below the OECD average, and 20 per cent below the best performers.

For example, and perhaps of most concern, is that a third of students did not complete secondary school, and for those who did not complete year 10, only a half of those of workforce age were employed.

Many suggestions were made to change policy towards education over the next decade, affecting pre-school, school and vocational and tertiary education. More funding, while clearly important and requiring better delineation of Commonwealth-State responsibilities, was only a part of the picture. Other areas of structural change to address included: enhanced community and other support for parenting; curriculum; a better pay and career structure for teachers; opening up greater competition between alternative suppliers, providing more autonomy to providers who are more accountable for education outcomes, and allowing for specialisation among providers; and providing funds more attuned to the needs of individual students and the different costs of supply.

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In many cases the links between different actions and outcomes are not well understood, and several speakers emphasised the need for experiments, measurement and monitoring to improve knowledge of what works better.

The combination of technological change and an ageing of the population is expected to increase the share of GDP allocated to health and aged care to well above the current 10 per cent, with much of this growth being government-funded. While the current arrangements, together with the importance of equity objectives, make major structural reforms for incumbent governments a daunting task, the independent speakers argued that considerable efficiency gains in the costs of the supply of health and aged care are available. In particular, there are costs of duplication and overlap between the different levels of government.

Other candidates for policy reform within each level of government were also identified, notably unclear

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Making the boom pay

and confused objectives, the lack of appropriate incentives in payment schedules facing public-funded suppliers to improve efficiency, and inconsistent regulations, especially for aged care.

Current policies towards the environment, including water, greenhouse gas emissions and urban congestion were placed high on the reform agenda over the next decade. While these are areas of classic market failure, speakers argued that where possible a combination of market forces and government interventions to internalise external costs was desirable.

Prices reflecting social marginal costs elicit private information on preferences and new technological opportunities in reaching better allocations of scarce natural resources, and they provide incentives and rewards for investment, including R&D, to expand supply at minimum cost. Government inaction creates uncertainty and defers required investment, which, in turn, hampers both economic growth and the achievement of better environmental outcomes.

Inter-government coordination A key to achieving improved productivity in the future repeatedly turned to the area of Commonwealth-State (and to a lesser extent Local) government relations. In the areas of health and education, regulations, finances, water, other infrastructure and climate change, many speakers took the view that the current system is a major block to future prosperity.

Current arrangements are characterised by unclear and questionable objectives with government policies, overlaps, duplication and complexity, unwarranted differences and excessive regulation, and lack of accountability, buck-passing and blame shifting between the different levels of government.

It was conceded that the constitution will not be changed, and therefore any solution must involve continuation of the three tiers of government working together in more effective ways.

Within this constraint, a number of ideas were suggested as options for further consideration.

These options included: referral of powers to one level of government to improve accountability and reduce overlapping responsibilities; and greater cooperation between the different levels of government accompanied by measurable, transparent and accountable objectives of performance. The cooperative model may need to be supported by independent performance reviews which provide for financial incentives and rewards, and by an independent body charged with providing the different levels of government with research-based assessments of the case for government intervention, the form such intervention should take, including which government level does what, and ways to measure and monitor performance.

In some cases more flexible and family-friendly work conditions can be as, or more, important than higher wage rates. Supportive government policies can provide information, ensure recognition of qualifications, provide funds for people to gain generic skills (as grants or as income contingent loans), actively encourage competition and innovation in the supply of training, and assist the short term bridging of areas of particular skill shortages via immigration. In the case of physical infrastructure, where government regulations are imposed, it was argued that they should be based on sound principles of demonstrated market failure, and that they be national regulations.

It was recognised that markets will not always anticipate areas of infrastructure and skill shortages, but they are likely to make less mistakes than government planners, and when forecast errors are made, markets provide their own corrections.

Professor Freebairn is Professor of Economics in the Department of Economics and Director of the Melbourne Institute of Applied Economic and Social Research.

Other potential roadblocks to prosperity discussed at the conference were the supply of appropriate skills and infrastructure. In both cases it was proposed that market forces be given the primary role in signalling areas of relative shortages and in providing the incentives for additional investment in both human and physical capital. In the case of workforce skills, this means allowing relative wages to vary over time, and in the event of higher wages for particular skills and regions of labour scarcity not to have these increases flow onto higher wages in other parts of the economy.

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australian labour market reforms

reforming australian industrial relations?

The debate over WorkChoices will continue to rage for some time as its effects are felt across the workforce by joe isaac A condensed version of the 21st Foenander Lecture delivered at the University on 28 August 2006. The full paper will appear in The Journal of Industrial Relations, 49, 3, June 2007.

The WorkChoices legislation has produced the most radical change in our industrial relations system in 100 years.

Prime Minister John Howard says that the Australian economy has performed very strongly in recent years.

Australians have enjoyed higher living standards from a combination of prudent economic management, strong jobs growth, higher real wages, low inflation and interest rates, lower taxes, increased family benefits and improved Government services.

– A smaller safety net; – More limited powers for the Australian Industrial Relations Commission (AIRC), whose main function now is voluntary mediation and administering industrial action; – New Australian Workplace Agreements (AWAs); – Unfair dismissal rights confined to firms with 100+ workers; – More restrictions on collective bargaining and right to strike; and

In such circumstances, why do we need WorkChoices?

– Several anti-union features.

The case for change

The various pieces of legislation need to be considered jointly because they are inter-related and their combined effect will change the balance of industrial power greatly in favour of employers.

The Government rests its case on assertions rather than evidence. The Prime Minister has said that we ‘must press ahead with economic reform if we are to prosper in the 21st Century.’ He maintains further that the measures in WorkChoices represent ‘the next logical step towards a flexible, simple and fair system of workplace relations…Only through this will the full potential for productivity gains in the Australian economy be realised.’

WorkChoices in context

The main elements of the change include:

This paper examines WorkChoices against a number of conditions/assumptions regarded as necessary for an economically efficient and socially fair industrial relations system. Some of these conditions may be disputed but this would at least allow the basis of any disagreement on the new system to be identified.

– A substantially national system;

In summary, the suggested conditions are as follows:

– A new tribunal, the Australian Fair Pay Commission, to fix the minimum wage;

1. A system that promotes economic growth through higher employment and productivity.

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2. Recognition that labour is not a commodity but a human resource. On certain issues, economic considerations may need to be balanced against social considerations, especially in view of the imperfections of the market.

3. Norms of fairness are a feature of most labour markets and need to be recognised in the interest of long term economic efficiency.

4. There needs to be provision against unfair dismissal and discrimination in accordance with ILO Convention 158, which Australia has ratified.

5. While there is a great deal of common interest between workers and their employers, there are generally differences on the terms of employment that need to be resolved.

6. Generally, individual employees have weaker economic power than do employers. To rectify the unbalanced power, collective bargaining with the right, within limits, to industrial action, should be available to the parties in accordance with Conventions 87 and 98, which Australia has ratified and which underlies the UN 1948 Universal Declaration of Human Rights.

7. Legislation is necessary to provide limits on industrial action and to override the strictures of

the common law on unionism and effective collective bargaining.

8. There should be machinery to mediate by compulsory conciliation and arbitration in industrial disputes.

The Government’s argument for a national system is that the present dual system is complex and costly.

While there is a good case for a national system, the complexity and costs of the existing arrangement are exaggerated. The obvious reason for the incorporation of State systems is to prevent State governments and tribunals from frustrating the Federal government’s industrial relations objectives.

The Government has decided to establish a new tribunal to fix the minimum wage on the spurious argument that the existing procedures under the AIRC are ‘adversarial and legalistic’. Even if true, which it is not, the remedy is to rectify it by legislation rather than setting up another body.

The most plausible explanation is that the Government believes that the AIRC has pitched minimum wage increases at too high a level at the expense of employment growth. The figures below do not support such a view. Unemployment has come down to its lowest rate for many years.

Relevant statistics on movements in the minimum wage (percentages) May 1996–June 2005 Real minimum wage (C14)

Real AWOTE full-time adults

Labour hourly productivity per person annual average

Real unit labour cost non-farm

*

*

**

**

+12.6

+20

2.0@

minus 7

2.5#

* May Quarter. Safety Net Review, 7 June 2005 AWOTE = Average Weekly Ordinary Time Earnings ** Years ended June. @Non-farm sector. Treasury Website # Market sector. ABS Cat. No. 5206.0. Multifactor productivity = 1.3%

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Reforming Australian industrial relations?

The role of AWAs and bargaining Individual bargaining has taken place over the years and can continue to do so as common law contracts between employers and individual employees, subject to relevant minimum awards. They have provided scope for flexibility in pay and working conditions.

AWAs are a more formalised version of common law contracts. The object of the new legislation is to increase their number, and various provisions in the Act will facilitate this. The new AWAs are, of course, a downgraded version of the old AWAs because the No Disadvantage Test base on the old Safety Net has been replaced by the more limited standard. The new ‘safety net’ will be limited to five items known as the Australian Fair Pay and Conditions Standard, in contrast to the previous 20 award items. The standard 38-hour week is now an average over 12 months. This will allow various established conditions of work – overtime and other penalties – to be taken away from workers in the name of flexibility. Those employers who may be disinclined to resort to cost cutting in the ways facilitated by the legislation, may be pushed by competitive forces to follow suit.

The expectation that the new system will generate higher productivity growth is illusory. Indeed, it may even reduce the pressure for productivity growth and allow employers instead to rely on costcutting through wages and conditions. Historically, productivity rises and falls from year to year, largely unrelated to the wage fixing system. The sources of sustainable productivity growth are technological developments, increased capital and skills, and a competitive market.

Until WorkChoices, the size of the employer was not relevant to the application of the unfair dismissal provision, defined as ‘harsh, unjust and unreasonable’. What constitutes ‘harsh, unjust and unreasonable’ depends on the circumstances of each case but in general it means that dismissal is not genuinely connected with the performance and conduct of the worker in relation to the requirements of the firm. Casual workers (some 25 per cent of employees) and those with less than six months (increased under the new law to 12 months) of employment with a firm, would not be protected by this provision.

Now well over 90 per cent of firms and well above 50 per cent of employees will be excluded from the provision. Even a portion of the small minority of large firms may be able to escape this provision if there are ‘genuine operational reasons’, defined as ‘economic, structural or similar reason’, for termination. However, the anti-discrimination provision will still apply to all firms. The Government’s justification for the substantial exclusion of the unfair dismissal right is that the provision discourages employment. The evidence for this argument is thin, to say the least. There are, of course, many cases where the provision has been misused by employees who see it as an opportunity of squeezing a cash settlement out of the employer. The same may be said of some discrimination claims, yet these are still allowed. Furthermore, even if an employer is willing to include an unfair dismissal procedure in an agreement, the Act forbids it from doing so.

In dealing with the unfair dismissal issue, it is a matter of striking a fair balance between the respective rights of employer and employee, and providing speedy and less costly proceedings, particularly affecting small employers whose activities may be seriously disrupted by having to engage in such proceedings. There is undoubtedly scope for procedural improvements. It is arguable that, for reasons of expediency, small firms, say, with less with than 10 employees as applies in some European countries, would seem to be a reasonable compromise on size for exclusion from the provision.

Beyond AWAs There has been a tendency in public discussion to regard AWAs as the main issue in the legislation.

However, AWAs as such are not a problem. It is important to consider the combined effect of the various pieces of legislation rather than to focus on one in isolation. Thus, the restriction of the unfair dismissal provision should be considered in conjunction with the ability of employers to avoid collective bargaining as well as intervention by the AIRC, and to foist AWAs on workers on a more restricted safety net protection. Together, these provisions provide the potential for employers with less than 101 employees, on the expiry of an existing agreement, to dismiss workers and to provide them with re-employment on AWAs subject only to the new lower safety net standard.

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These provisions together with others – employer ‘greenfields’ agreements enabling employers to set wages unilaterally, placing undue restrictions on industrial action, and so on – have the potential to marginalise unions and blunt the bargaining power of collective action in violation of ILO Conventions. It is ironic that one of the stated objects of WorkChoices is ‘to give effect to Australia’s international obligations in relation to labour standards’. All this despite the fact that over the last 10 years, the annual average loss from strikes is barely one hour per person – a small fraction of the loss from absenteeism and industrial accidents.

There have been occasions in the past when certain unions misbehaved in an industrially and socially destructive manner. This has been occasionally true also of business corporations. For both, restraints and sanctions are appropriate when they misbehave.

However, it is difficult to justify making occasional lapses in the behaviour of some unions the basis for a set of restraints, particularly when these restraints have the potential to substantially frustrate their capacity to achieve objectives by procedures in keeping with our international obligations. The fall-out in these circumstances is not simply felt by unions, but especially on those who are disadvantaged by weaker union power and those who are forced into individual bargaining.

In conclusion Trade unions, collective bargaining and collective action have gone hand in hand to rectify the unbalanced bargaining power in favour of employers under individual bargaining. In most developed countries, this development has been supported by legislation consistent with ILO Conventions. In Australia, the balance has also been underpinned by compulsory conciliation and arbitration. Overall, the economy has done well under these arrangements, and certainly so in the last 10 years. The object and philosophical basis of WorkChoices appears to be to unravel these arrangements and open up the prospects for a return to the master and servant mentality of the 19th Century.

The Government asserts that WorkChoices will provide a ‘flexible, simple and fair system of workplace relations’. It is neither simple nor fair. Its legal provisions are complex, running into 1300+ pages.

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Reforming Australian industrial relations?

The choices are mostly for employers. The degree of labour market flexibility in Australia is already among the top five of the OECD countries. The assertion that only through WorkChoices will ‘the full potential of productivity gains’ be realised does not rest on any persuasive argument or economic evidence.

The new system goes against the Australian ethos of a fair society. It will result in uncertainty and litigation. These consequences will not be evident for a year or two because a large number of agreements were processed before WorkChoices came into effect and because of the prevailing shortage of labour. However, the straws blowing in the wind since the new legislation came into being give an indication of what could happen on a large scale.

In 1992, Mr Howard, then in Opposition, announced JobsBack, an industrial relations programme substantially in line with WorkChoices. Yet, since 1992, without that programme, we have enjoyed the economic benefits noted by the Government itself.

There are no signs on the economic front, at least in the medium term, suggesting the case for such a radical change in our industrial relations system.

Joe Isaac is Professorial Fellow, Department of Management and Marketing, University of Melbourne.

minimum wages and inequality Are minimum wages justly promoted as a crucial tool in the battle against poverty? by andrew leigh

A condensed version of the paper ‘Does Raising the Minimum Wage Help the Poor?’ which Andrew Leigh delivered at a Symposium on the Australian Fair Pay Commission’s Minimum Wage decision on 15 November 2006.

Minimum wages are sometimes promoted as a valuable tool in the battle against poverty. Yet the effect of minimum wages on the income distribution depends crucially upon who earns them. If minimum wage earners are disproportionately teenagers from affluent families then a minimum wage rise will have less of an impact on poverty than if minimum wage earners are mostly lone parents.

Analysing the effects of minimum wages is more relevant to inequality and poverty in Australia than in most other developed nations, for the simple reason that Australian minimum wages are high. What is typically referred to as the ‘Australian Federal Minimum Wage’ (the lowest step on a scale of federal awards) is $13.47 per hour, which is approximately 68 per cent of median hourly earnings.

In weekly terms, the Federal Minimum Wage is $511.86. This equates to about 58 per cent of fulltime median weekly earnings, as compared with 45 per cent for the United Kingdom minimum wage, and 34 per cent for the United States minimum wage.

In 2003, the United Kingdom Low Pay Commission found that – relative to median earnings – our Federal Minimum Wage was the second-highest among 12 developed countries, with only France having a higher wage floor. Assuming a similar distribution of hourly wages in these countries, this suggests that the Federal Minimum Wage will affect proportionally more workers than the minimum wage in the United Kingdom or the United States.

Understanding the distribution of minimum wage workers (those earning at or just above the minimum wage) and subminimum wage workers (those earning just below the minimum wage) is also important for knowing what impact an increase in the minimum wage might have on inequality. While there is no disputing the fact that an increase in the wage floor reduces hourly wage inequality among those who keep their jobs, it is possible that minimum wages also have disemployment effects. If these effects are sufficiently large, then it is conceivable that an increase in the minimum wage might actually reduce the total market income received by low-wage workers.

The impact of minimum wage rises The impact of minimum wage rises on the social welfare of low-income households depends on three parameters: the distribution of minimum wage earners across more and less affluent households; the elasticity of hourly wages with respect to the minimum wage (the degree to which minimum wages increase hourly wages); and the elasticity of labour demand with respect to the minimum wage (the degree to which minimum wages reduce employment).

One way of estimating the impact of minimum wage rises on inequality and poverty is to focus on the first question: who earns minimum wages?

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Combining seven Income Distribution Surveys conducted by the Australian Bureau of Statistics between 1994-95 and 2002-03, two categories of near-minimum wage employees are defined.

‘Minimum wage workers’ are those earning between 100 per cent and 120 per cent of the minimum wage.

‘Subminimum wage workers’ are those earning below the Federal Minimum Wage (e.g. juniors, workers on state awards, and employees in the underground economy).

Regression analysis reveals that those who earn nearminimum wage in Australia are disproportionately female, unmarried and young, without post-school qualifications and overseas born. The age distribution of subminimum wage workers peaks around 21, while the age distribution of minimum wage workers peaks around 32. Across family types, subminimum and minimum wage workers are over-represented in single-person families, and underrepresented in couple-only households.

Individuals with and without children are equally likely to be earning the minimum wage (implying that the minimum wage is not a particularly welltargeted instrument for affecting the wellbeing of children). About one-third of subminimum and minimum wage workers are the sole breadwinner in their household.

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Minimum wages and inequality

Another way of asking the question ‘who gets minimum wages?’ is to consider the relationship between hourly wages and family income. If each family had one full-time worker, the correlation between hourly wages and family income would be about one. In practice, the correlation between hourly wages and family income is 0.43.

Comparing hourly wages and family income across the distribution, individuals in poor families are disproportionately likely to be out of the labour force.

If individuals from poor households are in the labour force, there is a greater than 50 per cent chance that they will be in the bottom quintile of hourly wage earners. But due to low labour force participation rates among poor households, subminimum and minimum wage workers tend to be clustered around the middle of the family income distribution. Across all adults, the median subminimum wage worker is at the 44th percentile of the family income distribution, while the median minimum wage worker is at the 53rd percentile of the family income distribution. Even excluding those aged over 55 years, the typical subminimum wage worker is in a household at the 35th percentile of the family income distribution, while the median minimum wage worker is in a household at the 45th percentile of the family income distribution

Using these figures, it is possible to consider how raising the minimum wage might affect the distribution of hourly wages, the distribution of individuals’ weekly earnings, and the distribution of pre-tax family income. As noted earlier, there are three relevant parameters in determining the impact of a minimum wage rise on the distribution of incomes: the hourly wage elasticity, the employment elasticity, and the distribution of minimum wage earners across households.

While there is a robust debate in the Australian literature over the elasticities, most estimates of the hourly wage elasticity lie between zero and one, while most estimates of the labour demand elasticity (extensive and intensive margins combined) lie between zero and -1. In effect, the extreme cases are that a 10 per cent minimum wage rise will lead to all minimum wage workers getting a 10 per cent pay rise, will cause 10 per cent of minimum wage workers to be fired, or both.

Distributional effects of minimum wages Simulations demonstrate that under all scenarios, an increase in the minimum wage reduces hourly wage inequality. It is straightforward to see why this should be the case. If raising the minimum wage boosts hourly wages for the low-paid, and has no disemployment effect, then the minimum wage rise will reduce hourly wage inequality by pushing up the bottom of the distribution. If raising the minimum wage does not boost hourly wages at all, and only has a disemployment effect, then the rise will reduce hourly wage inequality by truncating the bottom of the distribution.

Simulating the effect of a minimum wage rise on the distribution of income assuming a large positive hourly wage elasticity and a zero labour demand elasticity, earnings inequality and income inequality fall slightly. Assuming a zero hourly wage elasticity and a large negative labour demand elasticity, earnings inequality and income inequality rise substantially. And assuming a large positive hourly wage elasticity and a large negative labour demand elasticity, simulations also suggest that earnings inequality and income inequality will rise.

In effect, the disemployment effect in this simulation overwhelms the hourly wage effect, since firings have a much larger impact on the family income distribution than modest wage rises. (Note however that these estimates do not take account of income support and taxation. Since income support and progressive taxation typically act as a buffer against falling family incomes, the disemployment simulations likely overstate the extent to which increasing the minimum wage would raise disposable family income inequality.)

Since the scenarios modelled above are extreme cases, one can also estimate the hourly wage and labour demand elasticities that would be necessary for a minimum wage rise to reduce pre-tax family income inequality (as measured by the Gini coefficient).

Assuming an hourly wage elasticity of one (all minimum wage workers receive the full amount of the increase), a minimum wage rise will lower inequality if the elasticity of labour demand is smaller than -0.4. Assuming an hourly wage elasticity of 0.5 (minimum wage workers receive on average $0.50 for every $1 increase), a minimum wage rise will lower inequality if the elasticity of labour demand is smaller than -0.2. Given that the typical minimum wage worker lives in a middleincome household, it appears unlikely that raising the minimum wage will significantly lower family income inequality.

Dr Andrew Leigh is a Fellow in the Social Policy Analysis, Evaluation and Research Centre in the Research School of Social Sciences at the Australian National University. His academic website is at http://econrsss.anu.edu.au/~aleigh/ and his blog is at http://andrewleigh.com.

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does the fair pay commission decision matter?

Employers and unions have differing opinions about the merits of a minimum wage rise on both employment levels and living standards by mark wooden A condensed version of a paper delivered at a Symposium on 5 November 2006 on the Australian Fair Pay Commission’s first minimum wage decision.

A few weeks ago the new Australian Fair Pay Commission (AFPC) raised the Federal Minimum Wage from $12.75 to $13.47 per hour, a rise of 5.6 per cent.

distribution – only 27 per cent of these employees are living in households in the bottom three deciles (i.e. the bottom 30 per cent) of the distribution.

This decision was received very differently by different sectors of the community. Employer groups were highly critical, claiming that the rise would be harmful to employment, while the Australian Council of Trade Unions (ACTU) was full of praise, believing that the decision vindicated their claims that wage rises for the low paid were necessary to protect their real living standards and would not be harmful for employment growth. So who has got it right?

The picture changes slightly if we focus both on adults (and thus exclude many children who are still living at home with their parents) and on the very low paid – the bottom 10 per cent. The proportion of this group that are in the bottom three deciles of the income distribution now rises to almost 38 per cent, meaning they are slightly overrepresented in the bottom of the distribution. Much of this higher representation, however, can be explained by income support recipients who are able to work part-time while still receiving a government benefit. For most of these people the number of hours worked are relatively small. Further, beyond some very minimal income levels, government income is withdrawn at the rate of either 50 or 60 cents for every extra dollar earned. Together, these two facts mean that minimum wage rises do relatively little to raise the incomes of these types of workers.

The easiest claim to deal with is the oft-heard argument that minimum wage increases help the poor.

The reality is that most of the poor are not employed and so, by definition, rises in the minimum wage can do little to help them. The AFPC, however, appears to support the union view, stating in its decision that ‘lower paid workers are relatively concentrated in lower income households.’ At best, this can only be described as an interesting interpretation of the evidence.

HILDA survey reveals impact of wage rise Data from the 2004 wave of the Household, Income and Labour Dynamics in Australia (HILDA) Survey – the same data source used in the research commissioned by the AFPC – reveals that the lowest paid are actually spread quite evenly throughout the income distribution. Indeed, and as shown in Figure 1, the 20 per cent of wage earners with the lowest hourly wage rates (the group most likely to be reliant on industrial awards for pay increases) are actually underrepresented in the bottom part of the income

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Does the Fair Pay Commission decision matter?

Figure 1: Distribution of low wage employees by equivalised disposable household income decile, 2004 15

10

% 5

0

1

2

3

4

5

6

7

8

9

Income decile

Source: HILDA Survey, Confidentialised Data Release 4.1.

10

Even if low-wage workers were, at a single point in time, heavily concentrated in low-income households, it does not follow that such workers will necessarily benefit much from minimum wage rises.

This all depends on how much they would have earned in the absence of minimum wage rises. We can never know this with any certainty, but with the new longitudinal data gathered from the HILDA Survey we do know how much earnings for low-wage workers have risen in the recent past.

Specifically, the HILDA Survey tracks earnings growth for the same people over the period 2001 to 2004 and reveals an unexpected result. As shown by the solid bars in Figure 2, growth in hourly earnings has been overwhelmingly concentrated among the people earning the least at the start of the period. In fact, the median rate of growth in usual hourly earnings for adult employees (persons aged 21 years or older in 2001) who were among the bottom 10 per cent of wage earners in 2001 was a staggering 66 per cent. For the next 10 per cent the figure is much lower, but still a healthy 28 per cent. These rates of growth gradually fall until we reach the top of the earnings distribution, where median earnings remained unchanged (meaning a fall in real terms).

Provided they remain in employment, the vast majority of low-paid workers have experienced earnings increases that are well in excess of the rate of increase in the minimum wage. Indeed, the HILDA Survey data indicates that about 80 per cent of adult employees in the bottom decile of wage earners who were also in work three years later experienced earnings increases in excess of the rate of growth in the Federal Minimum Wage over the same period. For most lowwage workers the minimum wage is largely irrelevant.

Increases in the hourly wage, however, do not necessarily translate into large increases in annual income. This depends on what happens to the number of hours worked over the year. Figure 2 thus also reports for all adult employees in 2001 how their annual labour earnings changed over the next three years. As can be clearly seen, a focus on annual earnings, as distinct from hourly earnings at a point in time, suggests markedly different conclusions. We can now see that the lowest paid do not stand out so obviously from other employees. While annual earnings growth has been greatest for the low-paid, the differences across the hourly wage distribution are relatively small.

Figure 2: Median % change in earnings between 2001 and 2004 by hourly wage decile, 2001 (adult employees) 70 % change in hourly wage

% change in FY earnings

60 50 40 30 20 10 0

1

2

3

4 5 6 7 Hourly wage decile, 2001

8

9

10

Source: HILDA Survey, Confidentialised Data Release 4.1.

(FY=financial year)

In conclusion The empirical evidence suggests that the decision of the AFPC is unlikely to do very much to either alleviate poverty or reduce earnings inequality. Most low wage employees are not found living in the poorest households, and among those that are, many are income support reliant and are only working because the income support system enables individuals to combine part-time hours with receipt of a government benefit. The evidence also suggests that minimum wage increases are unlikely to be all that effective in protecting the living standards of the ‘working poor’.

This is because the large increases in hourly wages experienced by most low-wage workers do not always translate into similarly large increases in annual earnings, presumably because low-wage workers are most at risk of both spells of unemployment and of underemployment (working fewer hours than desired).

This last observation leads naturally to the question of whether minimum wage rises do more harm than good, by damaging the long-run employment prospects of both the unemployed and the low-skilled.

The AFPC (correctly) emphasises that effects on aggregate employment depend on both demand and supply responses, and that given our income support system, the incentive to work may not be great for some groups at the minimum wage. In other words, higher wages may be needed to induce some people to work. Nevertheless, this seems small consolation for those people (mostly young single people with few job skills) who want work but are unattractive to employers at the minimum wage.

Professor Wooden is Deputy Director of the Melbourne Institute of Applied Economic and Social Research, University of Melbourne, and Director of the HILDA Survey.

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the corporate political environment and big business response The complex task of corporate management in the modern world by geoff allen A condensed version of a public lecture sponsored by the Melbourne Business School and the Faculty of Economics and Commerce delivered at the University on 26 July 2006.

In the early 1970s, Professor Neil Jacoby of the business school at UCLA was searching for an adequate theory of the firm to describe behaviour as he saw it. Two major theories had succeeded each other in academic discussion.

One was the classical market model, which was built on assumptions of owner entrepreneurs responding to markets to maximise profits in the interests of owners in a competitive environment. The other was the managerial model, which emerged through the 1940s and 1950s on the observation of widespread separation of ownership and control and the perceived power of professional managers – free of effective control of stockholders in an environment only loosely constrained by competition.

His proposed new model was: ... the explicit recognition that corporate behaviour responds to political forces, public opinion, and governmental pressures. Whereas both classical and managerial theory ignored the impact of political forces, the social environment theory analyses corporate behaviour as a response to both market and non-market forces because both affect the firm’s costs, revenues and profits.1

Emerging pressures and responses Since the 1970s many factors have combined to make these social and political pressures more significant for corporate management. These include the growth in participative democracy, distrust of traditional institutions, a more sophisticated and critical media, a growth in the role and status of interest groups, and

the privatisation of former government monopoly businesses, requiring new forms of regulation.

The new and more challenging environment which emerged in the 1970s led to a rise in corporate political activism. Business leaders came to apply concepts and tools of corporate political management as they evolved in a small number of US business schools, and some consultancies.

One was issues management – a structured process for the early identification, evaluation and strategic management of social and political issues critical to the firm.

While issues management was normally seen as defensive and directed at managing hostile agendas, some creative business people used its concepts to set their own agendas and manage those agendas through to desired outcomes, including the achievement of competitive advantage. An obvious example of competitive use of issues analysis was Shell’s early focus on lead in petrol, leading to investment in research that gave a substantial break over other companies for a useful period.

The rapid expansion of multinational companies saw parallel growth in academic publishing on international political risk. Much of this was in search of methodologies to bring down to manageable elements: risk analysis; a maze of facts and judgements concerning the stability of regulatory and political systems; and the complex web of hidden political and social relationships surrounding host government actors.

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Academic attention given to stakeholder theory focused mainly on theoretical and ideological discussion on the role of the corporation in society.

However, attention shifted to the nature of engagement with external stakeholders, and in particular those with social or political agendas. There has been a tendency to move from a confrontationist orientation to initially seeking alignment between influential stakeholders’ real concerns and interests, and so remove barriers to corporate growth.

Related to this have been the findings of risk communication, for example that anxious and upset communities will come at issues from a different perspective than the cold arguments of businesses’ economic and scientific paradigms. It has also demonstrated that listening respectfully to concerned stakeholders not only provides useful information, but is a pre-condition for meaningful communication and influence.

Another pervasive and recent shift has been from ‘cheque over the fence’ philanthropy to the use of corporate social investment for deeper strategic purposes. This acknowledges the business case for social investment and the general concept of enlightened selfinterest. Using social investment to build relationships with business-sensitive stakeholders, including critical NGOs and foreign governments in the developing world, has been one useful application.

There has also been a recent burst of attention on business reputation, its determinants, and attempts to assess its non-tangible value. Such values include being employer of choice, neighbour of choice, investment of choice, business partner or licensee of choice, having enhanced access to political decision makers, and receiving the benefit of doubt in relation to regulatory intervention.

Most of the determinants of reputation relate to the economic and technical aspects of a business including, for example, its products, financial management and treatment of customers. However, a lot also has to do with how a business is aligned with social and political values, and this is frequently put at risk by insensitive management.

The ecology movement has focused community and consequent corporate attention on ‘sustainability’, a concept subsequently broadened to include such issues as community impacts, employment conditions and

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human rights through the whole supply chain. Last year, 70 per cent of Australia’s major companies published reports on sustainability or the triple bottom line.2

Tapping socio-political opportunities There have been a number of examples of business collectively responding to challenges in the social and political environment by proactive adaptation of the concepts and techniques of political activism. These include: reframing issues of ‘protection’ and ‘free trade’ to ‘competitiveness’; centralised versus decentralised wage fixation; enterprise industrial relations; keeping business constituencies together; and winning stakeholder support with agendasetting advocacy for business friendly reform.

But it is socio-political vulnerability and opportunity at the corporate level which I believe is the main game. A glance at the Financial Review on only a random couple of days in 2006 shows how persuasive these issues are and how significant their impacts on corporate performance.

The attitudes of utilities and infrastructure regulators emerge across a range of issues: consumer pricing and competitor access to company railways, entry to the highly regulated aged and child care markets, sugar levies for food and beverages, issues around subsidies for ethanol in petrol and greenhouse emissions, government to government negotiations over live cattle exports, bilateral and multilateral trade negotiations affecting major interests, media rules which have shaped the industry and locked companies into limited structures and technologies, opportunities afforded by business regulation reform arising from Council of Australian Governments, negotiations over criteria for market entry with provincial governments in China, access to new airline routes, the politics of the sale of Telstra equities, liquor and gaming mandates – the list goes on.

Of course, these higher profile issues are in addition to the daily grind of negotiating market entry with a myriad of complex political environments around the world, working through regulatory risk assessment and approvals for new products or major investments, dealing with local communities on traffic or noise, and so on. All the while, the world watches suspiciously and demands ever increasing obeyance to community sentiment.

The capacity to deal with these high profile issues, including managing them better than competitors, has become a key factor in competitive advantage.

grand theory should not deter us from deeper academic analysis of these issues and integration into the training we give business executives.

Australian companies have adapted to these challenges in a variety of ways. Most of the top 100 or so invest in specialist support. One of the best kept management secrets has been the emergence over the past 15 years of a new coterie of public affairs executives acting as ‘strategist’ and ‘corporate coach’ in these areas.

Professor Duane Windsor of Rice University argues there is no overarching theory here, but an intersection of a range of disciplines. These, he suggests, might include:

A majority of executives who head this function are direct reports to the CEO, are members of the senior executive committee, and make regular presentations on issues to their company boards. Where fully matured, the function typically has a specialist staff for public policy and government relations, media, community relations and internal communications, and would have oversight of corporate brand and community investment programs.

CEO of BHP, John Prescott, said of his public affairs team: In essence, they are the acknowledged authority on the social and political environments and their effect on our business. As such they are playing an increasing role in planning, issues management, and the creative use of public policy to further company goals.

Yet it is fundamental that dealing with social, political and industrial issues is integrated into the normal line management role, and becomes part of a company’s culture. Most of the expensive problems for business – and lost opportunities in this area – arise from a lack of sophistication in line management.

Accordingly, performance here is fast having to become a core function of general managers; and in an increasing number of companies it is now an element in assessment of individual performance.

Theory and practice One challenge for management researchers and educators is to develop coherent theories for corporate social and political engagement, and to congeal this fledgling discipline into a fully formed academic discipline.

While frameworks are developed around issues management, stakeholder engagement, ideological theories of the firm, political risk analysis, risk communication and so on, a lack of an integrating

– Business in societies and business ethics (including corporate citizenship and social responsibility, corporate social performance theory and stakeholder management); – Communications theory; – Ecological systems (including appreciation of corporate and stakeholder impacts on natural ecological systems and the issues generated by them); – Economics (including collective action, public choice theory, transaction cost theory and game theory); – Organisational sociology; – Political science; and – Strategic management (including agency theory, behavioural theory of the firm and integrated strategic management theory).

I do not believe it is enough to cobble together isolated specialists in these disciplines to teach in this field. To be useful to business this needs to be integrated in a holistic way and examined from the mindset of management and corporate strategy.

Mr Geoff Allen is Founder of the Allen Consulting Group, Chairman of the Centre for Corporate Public Affairs, and Chairman of two major Commonwealth Government Advisory Councils, Company Director and Deputy Chairman, Melbourne Business School.

1 Neil H. Jacoby, 1974, ‘The Corporation as Social Activist’, in S Prakash Sethi (Ed), The Unstable Ground: Corporate Social Policy in a Dynamic Society, Wiley: New York 2 Centre for Corporate Public Affairs, 2006 Public Affairs Survey, Corporate Public Affairs Newsletter, Vol 16, No 2

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stock return predictability in rational markets: on the impossibility of informationally inefficient markets Understanding the debate between behaviouralists and neo-classicists pays dividends for all researchers by bruce d. grundy A condensed version of his Inaugural Lecture delivered on 3 May 2005.

The apparent predictability of share returns has led many to conclude that share prices are driven by investor behavioural biases. But are they? My research shows that, even when returns are apparently predictable, the final price set after a sequence of trades can fully and rationally reflect all available information and can therefore serve as a clear signal of value.

The primary goal of this paper is to demonstrate how research in finance is influenced by both the minutia of competing theoretical and empirical approaches and the broad sweep of market bubbles and crashes. The secondary goal is to acknowledge the social element of a research career: friendships with co-authors, admiration for past teachers, joy when a former student publishes their own work, and the respect one feels for all protagonists in a debate you find fascinating.

The neo-classical approach Neo-classical finance has long referred to share markets as ‘efficient’ without always being clear as to what the word meant. In its earliest incantation, ‘weak-form efficiency’ was described as a situation where apparent patterns in past share prices and trading volumes could not be used to improve one’s prediction of future returns. The logic seemed compelling: if some past pattern did imply a high future payoff, then everyone would buy that share, bid up its price and any high return would have already occurred. In the 1970s, a view of markets as efficient was revolutionary and largely confined to academia. The profession of technical analysts, also known as ‘chartists’, was vigorously attacked by academics for claiming to be able to use past returns to predict the future.

Academics viewed charting as a bygone relic, no more relevant than the 1830s political movement of the same name.

It was an exciting time to be an undergraduate student of Finance. The subject lecturer could demonstrate his purported proof of weak-form efficiency by inviting a group of technical analysts to view what was described as a recent history of values and then asking them to predict what would happen next. The chartists would obligingly identify ‘headand-shoulders’ and other patterns in the data and give their predictions. Only then would the lecturer reveal that the set of values was not a series of past share prices, but had come instead from a random number generator. The duped share analysts were underwhelmed by the academic’s attempt to educate them through humiliation. Although the students loved it, such encounters hardly encouraged donations from the brokerage industry to fund further academic finance research.

The term ‘semi-strong-form efficiency’ was used to mean that all publicly announced information was fully reflected in stock prices. ‘Strong-form efficiency’ was viewed as the holy grail of capital markets – all public and private information impounded into prices. In other words, shares prices would be equal to the values that would prevail if insider information were instead posted on Internet bulletin boards. Since information is costly to acquire, a conundrum arises if markets are strong-form efficient. If prices do reflect all information, no-one will want to bear the cost of producing information.

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Everyone will prefer to free-ride on the efforts of others. Less information will then be produced.

Perhaps everything available might be reflected in prices, but there will be little information reflected.

Share prices will prove poor guides for investment decisions.

The Grossman-Stiglitz challenge to market efficiency A rigorous view of market efficiency was published in the American Economic Review in 1980, by Grossman and Stiglitz. That seminal paper’s title, ‘On the Impossibility of Informationally Efficient Markets’, inspires the contradictory title of this paper. The Grossman-Stiglitz model demonstrates that traders with the lowest costs of generating information will find that their information is only partially impounded into prices and that their profits from trading do cover their information costs. Lessefficient information producers will chose not to acquire information, but will condition their trades on the fact that they are at an informational disadvantage. They still trade for liquidity and rebalancing reasons even though they lose money on average to the better informed.

Thus prices in a Grossman-Stiglitz setting are noisy signals of value. Some equilibrium level of noise is necessary for the informed traders to hide behind. For most economists, the elegant Grossman-Stiglitz model has established that markets cannot be strongform efficient. Joseph Stiglitz has since gone on to win the Nobel Prize in Economics and publish many important public policy studies based on his understanding of the flaws in markets. Sandy Grossman has left academia for the millions he now makes as a currency trader.

The empirical challenge to market efficiency For some, the nail in the coffin of efficient markets was sunk on Black Monday, October 19, 1987 when $500 billion dollars was wiped off the Dow. How could so much wealth simply evaporate overnight if prices had been set efficiently on the prior Friday?

And even the faith of stubborn believers happy to describe the ‘87 crash as just one data point, began to falter with the 1993 Journal of Finance publication

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of an empirical study by Jeegadesh and Titman.

This study demonstrated that a simple long-short strategy of buying shares with prior-year winning performance in the top 10 per cent of all firms and selling the prior losers with realised prior-year returns in the bottom 10 per cent was shown to produce subsequent six-month profits of around six cents per one dollar, long and short. Such profits are both statistically and economically significant.

A strategy of buying past winners and selling past losers is known as a ‘momentum strategy’. A myriad of academic studies into other long-short strategies have helped underpin the boom in the hedge fund industry.

The behavioural challenge to market efficiency As the empirical evidence against market efficiency mounted, the field of behavioural finance blossomed and focused directly on individual behaviour as the source of the noise in share prices. Pioneering research was bought together in a 1993 volume edited by the field’s founder, Richard Thaler. Behaviouralists view the battle between their ideas and neoclassical believers in market efficiency as a paradigm shift of the type identified in Kuhn’s classic text, The Structure of Scientific Revolutions. Kuhn has argued that scientific advances are not incremental, but instead involve heated scientific revolutions in which one paradigm supplants another before the profession settles back down to incremental ‘normal science’.

And yet some still believe Some financial economists (often Chicago-trained) remain more enamoured with the beauty of unimpeded capital markets than is fashionable among behaviouralists. As an admirer of markets, I do not see efficiency and costly information as inconsistent. I believe capital markets can in fact solve the twin problems of providing a reward to those who generate information and a guide to those who must make investment decisions. After doctoral studies at Chicago, I took my first academic position at Stanford’s Graduate School of Business. Most of my new colleagues were heavily influenced by their reading of Grossman-Stiglitz and considered efficient markets as a passé 1970s view of the world.

In co-teaching a course with an accounting academic, Maureen McNichols, we discovered a joint interest in just how accounting information came to be reflected in prices. We took Grossman-Stiglitz as given – in other words, we recognised that all information cannot be revealed through just one round of trade.

Yet, we found it interesting to ask what happens if the market re-opens after an initial trading round.

A re-evaluation of the GrossmanStiglitz contribution One apparent answer is that nothing happens: the quoted price will be unchanged from the prior price and no further trade will occur. This possibility is incorrectly believed by many economists to be a simple reflection of the Milgrom-Stokey ‘no-trade theorem’ published in the Journal of Economic Theory in 1982.

The no-trade theorem states that no trade can occur when traders agree on how information should be interpreted and start from an initial pareto optimum allocation given their information.

Grundy and McNichols showed that how different traders interpret a given piece of information and whether an allocation is pareto optimal given their information are endogenous properties of an equilibrium and not something to be assumed. They also demonstrated that further trade can occur at new prices when the market re-opens. And when this does happen, the sequence of prices is fully revealing – the final price is equal to the value that would prevail if any insider information had been posted on Internet bulletin boards. At the end of the first round of trade, traders need not agree on how to interpret the information in the first round’s price and need not

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have traded to a pareto optimum. Our work, published in 1989 in the Review of Financial Studies, demonstrated that the widely-cited no-trade theorem is itself vacuous and should in fact be expressed as: ‘In an equilibrium in which there is no trade, there will be no trade.’ Grundy and McNichols established that producers of costly information can earn their rewards in the early, noisy rounds of trade, while corporations’ investment committees can rely on the final set of share prices as accurate guides for investment purposes. When interpreting the final prices, all traders will be cognisant of the entire price history and all rational traders are in fact chartists (though the reverse need not be true).

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A re-evaluation of the empirical evidence Grundy and McNichols went on to show that rare events like the crash of ‘87 can be the rational reflection of existing information not previously reflected in prices. It is interesting to note that the 1988 Securities and Exchange Commission Report into the ‘87 crash pinned the blame squarely on the portfolio insurance industry. Portfolio insurance was a then-novel product that had not yet established its own lobby group in Washington. The actual evidence underlying the Report’s conclusion is as convincing as that underlying the conclusion in the earlier 1963

New York Stock Exchange Report into the crash of May 1962. That earlier crash wiped 27 per cent off the Dow and was supposedly due to the fact that the pace of selling by women far out-stripped their purchases! By 1987 women were no longer powerless and portfolio insurers were to be burnt in their place.

What about the apparent profitability of momentum strategies? Momentum strategies that pick stocks based on their past returns do on average make money.

If share prices appropriately reflect past prices, prices are at least weak-form efficient, the average profit to a momentum strategy must be an appropriate reward for the risk inherent in the strategy. In joint work with Spencer Martin, a former doctoral student I had supervised after moving to the Wharton School, I documented that a momentum strategy is risky and makes losses 40 per cent of the time. Still, in our 2001 Review of Financial Studies publication, we concluded that the strategy’s average profit is too large to be explained by current state-of-the-art risk measures. As true neo-classicists, we concluded that the fault lies in the finance profession’s present inability to accurately define and measure risk, rather than in a failure of markets to accurately reflect past returns.

Research puzzles continue to fascinate The debate between behavioural and neoclassical finance is misdirected. Just how individuals make investment decisions is important and must affect quantities. For example, an individual’s often biased predictions will affect whether he or she buys lifeinsurance. But an individual’s biases need not affect the price they will be asked to pay for that insurance.

The real promise of behavioural finance lies not in understanding stock prices, but in understanding how best to market financial products to those who must finance their own retirement. The real promise of neo-classical finance is the pleasure inherent in a perpetuity of fascinating research puzzles. With the aid of our colleagues we can solve these puzzles and, in doing so, improve the standard of living for all future retirees.

Professor Grundy is Professor of Finance in the Department of Finance at the University of Melbourne.

Since joining the Department of Finance at the University of Melbourne, I have continued my research into how future returns are related to past returns. In joint work with Wei Li and Joe Zhang, researchers at Louisiana State University and Singapore Management University respectively, I have established that when new information signals both higher profits in this period and an additive increment to next period’s profits, the shares of companies with higher realised returns in this period will be less risky in the future. These shares will be expected to earn lower returns in the future commensurate with their reduced risk. Stock returns should then display contrarian rather than momentum behaviour. But if good news in this period presages a multiplicative rather than additive effect on future profits, returns are likely to display momentum behaviour. Our ongoing work empirically investigates the importance of distinguishing between additive and multiplicative uncertainty.

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passive profits from accounting indicators Can superior long-term share market returns be earned from basic accounting indicators? by john d. lyon A condensed version of his Inaugural Lecture delivered on 30 August 2006.

The research indicates that the answer to the question posed is ‘yes’. Over the past thirty years, research in accounting and finance has generated many cases where above-average returns appear to be earned by taking investment positions based on simple accounting measures. Examples of these measures abound, but they can simply be the proportional increase in year-to-date earnings or a measure of a firm’s level of accruals in a given year.

It is still not clear why this is possible. The current thinking, however, is that persistent above-average returns can be earned by passive investment in share market positions that utilise accounting measures.

The interesting point is that this thinking has stepped beyond the realm of academic discussion, and we now see a growing number of US accounting researchers enjoying significant windfalls as employees of hedge funds designed to exploit these research findings.

Many of these findings have their root in the finance literature. Progressively, over the last 20 years, it has been documented that, for example, ‘small’ firms outperform ‘large’ firms, that stocks with ‘high’ book-to-market ratios outperform stocks with ‘low’ book-to-market ratios, or that stocks with a ‘high’

historical price momentum outperform stocks with a ‘low’ price momentum, to name a few. (The word ‘momentum’ refers to the use of past prices to predict future prices.) These findings are often classified as ‘stock market anomalies’. They are seen to be anomalies since taking a long position in, for example, ‘small’ stocks and selling short ‘large’ stocks, yields consistent positive returns to this zeroinvestment position.1 Many hedge funds have now capitalised on permutations of these findings.

The accounting research literature has also identified a number of so-called anomalies. The most famous are those based on a firm’s ‘earnings momentum’ (using past earnings to predict future earnings) or its level of ‘accruals’ in a given accounting period. The first demonstrates that long investment positions taken in stocks whose earnings substantially beat earnings from the same quarter last year while selling short those that are the worst losers relative to last year will earn positive zero-investment returns over the ensuing twelve months. Similarly, long positions in firms who have a ‘small’ accruals component to their earnings while shorting firms with a ‘large’ accruals component earn positive zero-investment returns over the following twelve months.

1 To explain this concept in lay person’s language by an example. Suppose that you expect stock A to go up in price and B to go down. Acting on this expectation, you decide to buy A (called the long position) laying out $10,000 and, at the same time, buy B for the same amount of money by borrowing that sum on a promise to pay the amount in, say, twelve months time (the short position). These transactions would have effectively put you today in a zero-investment position. Suppose further that in three months time, the long position has risen by 10 per cent and the short position has fallen by 10 per cent. You could sell A for $11,000 and repay the loan from the sale of B, thus making a profit of $2,000 without effectively investing any money! This is the basis of hedge investing.

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There are two schools of thought that try to explain just what is occurring here. The first takes the view that our understanding of risk in the stock market is simply under-developed. That is, each of these investment strategies really just uncovers an element of risk for which we have no formal model at this stage of our knowledge. For example, ‘small’ firms are just ‘more risky’ than ‘large’ firms, even though our formal model of risk encapsulated by the capital asset pricing model does not recognise this. However, just what this element of ‘risk’ is, has eluded researchers to date.

The second school of thought has to do with individual decision-making biases in the stock market. Proponents of this school argue that stock markets are slow to recognise the full impact of information events simply because the nature of the information is not instantly transparent to all stock market participants. For example, the accruals anomaly occurs because stock market participants focus on the profit figure instead of analysing the true future cash flow impact of earnings. Because

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accountants report on dry, statistical information about the underlying operations of a firm, it takes some time for the stock market to fully appreciate the future performance of the firm. And so the stock market ‘under-reacts’ to accounting information.

How these points of view will be resolved is not clear.

However, what is clear is that there is considerable capital currently flowing into hedge funds in the US designed to exploit these apparent excess returns.

Unfortunately for academia, it has also meant an exodus of personnel to the private sector to capture excess returns to the detriment of academic knowledge.

Professor Lyon is Fitzgerald Professor of Accounting in the Department of Accounting and Business Information Systems at the University of Melbourne.

occasional addresses by alumni at university of melbourne graduations

a ‘battle of ideas’ is taking place around the globe graduates of the university of melbourne can assist in its resolution by tom elliott

An edited excerpt of his Occasional Address delivered at the graduation on 15 December 2006.

Seventeen years ago, philosopher and historian Francis Fukuyama wrote an essay entitled The End of History, in which he argued the end of the cold war and the subsequent collapse of the Soviet Union meant that the triumph of free markets and liberal democracy was complete.

Yet today, it is painfully obvious that Fukuyama’s prediction is yet to come true, and may yet be proved false.

Unfortunately, many of the qualities that university graduates should hold dear – such as freedom of expression, the right to challenge established beliefs and orthodoxies, and the triumph of reason over superstition – are under threat by such forces as the rise in religious extremism and the watering down of individual liberties by many governments in response to perceived security concerns.

Yet, the outlook is not all bad.

Now, this may come as something of a surprise to graduates who have slaved away at the truly dismal doctrine of econometrics, but economics in its purest sense is not fundamentally a mathematical science, but a social one that attempts to comprehend how individuals and groups interact with each other to maximise welfare.

At its best, sound economics is capable of advancing the worthwhile goal of human freedom, and I would argue that we are at one of those times in history when this is extremely important.

Three important factors should make us all optimistic about the future.

First, the rise of modern communications technologies like email and the World Wide Web mean that, for the first time ever, a majority of the world’s population has relatively free access to ideas and concepts. In many cases, with this access, people realise that a better life is possible.

Second, while they will be with us for some time, the forces of economic protectionism appear to be in retreat around the globe. Even the new leader of the Federal Labor Party, Kevin Rudd, appears to have admitted that socialism and its bedfellow protectionism might not be the welfare enhancing policies they once appeared.

The reduction of economic protectionism, especially in agricultural markets, is important because it gives poorer people in developing countries a chance to lift themselves out of poverty – not by being passive recipients of Western aid, but by more dignified participation in the global economy.

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The final factor that gives me great hope, however, is much closer to home. When I attended Melbourne University in the mid to late 80’s, Australian students were very parochial and unlikely to leave their own state, let alone their own country to study at a tertiary level. Indeed, the presence of students from Tasmania was still considered quite exotic just a generation ago!

Yet, I understand that the proportion of people who now attend this University from interstate and, increasingly, from overseas, has risen dramatically.

This can only further the cause of goodwill between different people, cultures and countries.

So what advice can I give to those graduating today?

First, you should feel justifiably proud of what you have achieved in your academic careers here in the Faculty of Economics and Commerce at Melbourne University. This is clearly the best university in Australia, and amongst the best in the world.

Second, do not ever assume in life that other people, often referred to as the mysterious ‘they’ in markets, know more than you. There’s no reason why you cannot be the best at whatever it is you now choose to do.

Third, stay in touch with the friends and colleagues you’ve made during your time at university, for you have a shared experience here that will appear increasingly valuable as time passes.

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And finally, remember this. Right now, you probably have more information stuffed in your heads than you ever will again. Sadly, much of this will dissipate over time. But what will never leave you is that which is most valuable about your university education, and that is the ability to think, to solve problems in a rational and disciplined manner. Maintain this ability, and there’s nothing you can’t achieve.

Tom Elliott is the Managing Director of MM&E Capital and a University of Melbourne alumnus who graduated in 1989.

on painting one’s life picture by peter yates

An edited excerpt of his Occasional Address delivered at the graduation on 16 December 2006.

The degree being conferred on you today is one of the most valuable tickets available for the journey of professional life. Right now, this professional life is a blank canvas of opportunity with a few titles added today to the frame. I ask each of you: how will you paint your picture?

Managing change is not a value. In facing change, fear or excitement are feelings. Will you let that feeling determine your action when you next confront change or uncertainty? By holding core values and determining your actions from those values, you will see more clearly the signposts to deal with change.

Twenty-five years ago this December, I completed my Commerce degree. Along the way to being given this honour to share in your graduation ceremony, I have found some brush strokes and techniques that have helped paint my life picture.

Learn to overcome failure

I must confess, however, that when it was announced on Thursday that the Company I run, Allco Equity Partners would potentially become the largest shareholder in Qantas, I felt like a 44 Gallon drum of paint had suddenly been used!

But to some more intricate techniques you may find useful.

Be guided by your values First, I encourage you to organise your life around values rather than feelings. Let me explain this internal ordering system. If you organise your actions in response to a feeling, there is danger in responding to those feelings too often. For example, the feeling of hunger motivates you to eat, yet you may become overweight and suffer poor health. If, however, you order your life around values and one of these is good health, then by acting on this value – even though you might feel hungry – you will less likely be overweight.

This simple paradigm of deciding how to order one’s life plays out in so many ways, particularly where our society is experiencing so much change.

Second, learn what it really means to take risk – and what I’m about to say may challenge some of you.

Today’s graduates are some of the most intellectually gifted people in our community. You excelled at school and received an extraordinary TER. You worked your guts out to achieve your degree (party’s aside). You have spent your life learning how to capture the rewards of a known system – the system of education and the methods through which it rewards.

Your next step may well be to join another institution with a known rewards system – a research institute, an investment bank, or a consulting firm. And you will have a very fulfilling and exciting career. And it is very easy to feel comforted by the boundaries of that professional system partly because it feels like the education system, in which you have become comfortable and achieved so spectacularly. But it is not the same. And herein lies the rub.

I expect many of you have not yet experienced failure.

Experiencing failure is to have committed to put your heart and soul into an activity that you really believed would do well; to have then shared your dream with friends and family; and to have benefited from the encouragement and support for that activity from people whose opinion you respect. You may have even boasted about how well your dream was unfolding.

And then, wham, it fails.

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This failure is not like others you have experienced – it is not a failure handed to you by an education system because you did not meet the requirements for the next reward level. You have failed in your own activity; your dream has been rejected. You have failed because of you, not any external system.

It took James almost two years to get over the experience of failure – that he recovered in such a short time, despite the pressure put on him by the Australian media, is a tribute to his strength of character. He has now gone on to achieve even greater things for PBL.

To experience failure is one of the most critical rites of passage, leading to the most important skill in life: getting over failure. Science graduates are probably more experienced in failure than most commerce graduates, because by definition the evidentiary process, which is attached to the process of discovery, requires you to learn to manage failure.

Ironically, the higher up you are on the totem pole, the harder it becomes to experience your first real failure. Successful people spend their life avoiding failure. Accordingly it often comes too late and they are too senior to cope.

Learning to experience failure has two particular benefits. First, it encourages you to take risks.

Australia and all the countries from which our international graduates are drawn require that we expand the pool of business people who are prepared to take a risk.

Second, we need people who are prepared to accept failure, as the necessary escape valve for a system that has gone wrong. The comfortable shift from the system of education and its rewards into a business system is a cloak that can occasionally mask a dysfunctional organisation. A common theme found in some of our most spectacular business disasters was built around the exploitation of the human fear of failure. It is not uncommon for an investment bank to cajole its employees into giving up a sensible work-life balance by using the line, ‘Well, if we don’t promote you it will be seen as a failure for you, as it will mean you were not good enough for our organisation.’ At Enron, the fear of not being seen as ‘successful’ within the company or the fear of losing out on the financial privileges of their bonus system drove undesired behaviours, which blew up the company.

The sooner you experience ‘getting over failure’, the better. It will give you the freedom to make wider choices and the ability to conduct yourself properly under challenging circumstances.

Many of you know that three weeks after I became the CEO of Publishing Broadcasting Limited (PBL), One.Tel, the telephone company partly owned by PBL, was put into administration. James Packer was confronted with a failure. Because of his position, the media blew the One.Tel issue out of all proportion.

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On painting one’s life picture

Learn to communicate well The third brushstroke I recommend you use in painting your life’s picture is communication. This, of course requires you to both listen and speak. I highly recommend equal parts.

The ability to communicate well is probably the determining factor for success between two similarly qualified people. Because if you cannot communicate well, how can you deploy human capital?

Human capital does not respond to a computer program or a baseball bat. It listens, interprets, seeks clarification and then moves. The better you communicate, the greater the prospect of efficient deployment of human capital. We all know a person who makes almost no sense when they communicate.

I had the privilege of undertaking my masters at Stanford University, where the art of communication is a one-semester course involving weekly sessions of sharing how you feel about another class member’s communication skills. It involves the study of what is known as expanding Chori’s Window. The Chori Window is the gap between what a person thinks they are communicating and what the rest of the world thinks they are hearing. Like right now. I am thinking about this speech and seeking to communicate some congratulations as well as share some life experiences. You are the rest of the world and only after this degree ceremony when I check in with one or two of you will I know whether you heard what I thought I said. The course is designed to open one’s own communication window.

Another approach to opening this window is what I call the Kerry Packer approach. One evening not long after I joined PBL, Kerry asked me about my Stanford experience and what I had learned most.

I described Chori’s Window to him and drew the Harvard two-by-two box to explain the theory in more detail. When I had finished he said, ‘Well, son, that’s interesting, but tell me what it cost to do your masters at Stanford?’

I replied, ‘About $150,000.’

He then asked me how many employees I had working at PBL. Including the part-time croupiers at crown, we had about 11,000. His response: ‘Well, son, I can’t afford the $1.6 billion to send them all to Stanford, so you’re just going to have learn to do something really well. Just learn to listen!’

The art of communicating in business is essential for deploying capital. It is even more important in the field of science. Many people in our community are concerned that science is not well communicated, particularly that we have limited exposure to the information we need to assist us make decisions on important issues of science. Issues such as stem cell research and climate change involve non-scientists making decisions about either scientific processes or public policy decisions based on scientific research they do not understand.

Science is more difficult to communicate because as an information genre it has some peculiar features.

Unlike politics or sport, which are two other information genres, scientific stories do not have a beginning or an end. Among scientists, the debate is not about the outcome, but rather the evidentiary process. This makes for challenging newspaper copy.

Additionally, the field is often so specialised that, unlike a media debate on a football match where the information ‘exchange’ can fill up a Sunday Age Sport section and therefore create knowledge, in science there are often so few people who can debate the topic that there is no actual information ‘exchange’. As a result, whilst facts have been exchanged, knowledge is not created. The Australian Science Media Centre, which I chair, was set up one year ago by the Australian media and science industries in response to the adverse impact this lack of science in media is having on our community. I encourage the science graduates to take it upon themselves to develop their communication skills, speak openly and please congratulate those scientists who are prepared to be quoted in the press.

Seek out those smarter than you And finally, may I share with you one more technique for your life’s painting. When I am among a group of people working toward a goal or a decision, I always ask myself, ‘Am I the smartest person in this room?’

Because if the answer is yes, then I get out. For I believe that either I must be kidding myself and have completely lost the plot or else everyone is relying on me. I know that is not a wise thing to do.

As you go out into the world and paint on your life’s canvas, framed with the degree you are being conferred today, I encourage you to order you life starting with values rather than feelings. Look into yourself to realise the golden opportunity you are seeking resides within. It is not in any system – feel liberated to take risk and do it soon. Encourage the art of communication because it is essential for the deployment of human capital and the dissemination of scientific knowledge in our community.

As you make the most of your own life, acquiring further knowledge and wisdom, you will have a greater opportunity to help those that follow you. I can also say without hesitation that effort spent constructively and sensitively helping people less fortunate than yourselves will bring you great personal rewards.

When I completed my degree twenty-five years ago, I graduated in absentia. It is a great honour to be able to share in your graduation today. As you go forward, I hope you will share your life’s painting with me.

Peter Yates is the Managing Director, Allco Equity Partners Limited and an alumnus who graduated in 1983.

Insights Melbourne Economics and Commerce

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Mailing Address: The Faculty of Economics and Commerce The University of Melbourne Victoria 3010 Australia Telephone: +61 3 8344 2166 Email: gsdir-ecom@unimelb.edu.au Internet: www.ecom.unimelb.edu.au/insights Published by the Faculty of Economics and Commerce, April 2007 Š The University of Melbourne

Disclaimer Insights is published by the University of Melbourne for the Faculty of Economics and Commerce. 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.