Insights Volume 3 April 2008

INSIGHTS Melbourne Economics and Commerce volume 3 april 2008

Policy making in an uncertain world

By Nilss Olekalns Did business matter?

Australia in the twentieth century

By David Merrett Financial shell games

By Satyajit Das Drugs policy: a role for economic research?

By Steve Pudney Our schools...our future

By Stephen Sedgwick Occasional addresses

by Alumni

By James T Riady and Laurence Cox AO

Welcome Insights publishes condensed and edited versions

of important public lectures connected with the Faculty of Economics and Commerce. By presenting these lectures in a language and format accessible to the general reader, we hope to share their substance with the wider public and especially with alumni of the Faculty.

We also aim to establish archival material for future researchers.

In this Volume, we publish a number of interesting and important lectures. Aspects of the current international monetary crisis are discussed in two articles, while the importance of business in Australian economic development features in another paper. The Downing Lecture explores a serious social issue and gives valuable insight into the challenges of developing effective public policy on illicit drugs. Once again, we publish a summary of various contributions to one of the Melbourne Institute’s conferences. Finally, two distinguished alumni

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

share their professional experiences in their remarks to new graduates.

In addition to these contributors, this Volume has benefited from the work of many. As in the past, we complement the intellectual content with an artistic element. On this occasion, we are fortunate to include Christopher Nielsen’s lively illustrations expressing the themes of the papers.

Special mention should also be made of the contribution and constant support of my associate, Brooke Young; of Rebecca Gleeson for sub-editorial assistance; and of Sophie Campbell for the attractive design of the journal.

Insights is in its second year of publication and we hope that it is becoming a welcome addition to your business reading. Your suggestions and feedback on the publication would be most welcome.

Joe Isaac Editor

insights vol 3 Table of contents 03 Policy making in an uncertain world

21 Drugs policy: a role for economic

By Nilss Olekalns

research?

Uncertainty was a key premise in Keynesian theory – and it remains an important variable in macroeconomics today

By Steve Pudney

09 Did business matter? Australia in the twentieth century

By David Merrett

With business neglected in the narratives that describe Australian economic development, the US story may offer a new perspective on why business mattered here

15 Financial shell games

By Satyajit Das

The gigantic liquidity bubble is now deflating. The sub-prime problems were merely the trigger for a major adjustment in the availability and cost of borrowings globally

Drugs policy has a long and inglorious history and has often been driven less by reason and evidence than by prejudice and sentiment, moral panic and conviction, and political fear and opportunism

27 Our schools...our future

By Stephen Sedgwick

Every primary school pupil should be able to read and write at least at the minimum levels specified

32 Occasional addresses by Alumni at University of Melbourne graduations 32 Pursuing talents and confronting

burdens Graduates should regard today not as the omega point but as the alpha point of their lives

By James T Riady 34 The importance of vision and

people Seek to work alongside the best people who will challenge your ideas and assure your vision is achieved

By Laurence Cox AO

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policy making in an uncertain world Uncertainty was a key premise in Keynesian theory – and it remains an important variable in macroeconomics today by nilss olekalns A condensed version of his Inaugural Lecture delivered at the University of Melbourne on 11 March 2008.

Keynesian and other views on uncertainty John Maynard Keynes, founder of macroeconomics, made uncertainty a key theme of his General Theory of Employment, Interest and Money. Keynes saw uncertainty as a market failure, most apparent in what we now call coordination problems. These coordination problems were a key reason for what Keynes saw as a tendency for economies to become trapped in a low employment-low output equilibrium.

The problem as Keynes saw it was the inability of firms to coordinate their investment decisions.

Individual firms who perceived a lack of aggregate demand for their product would, understandably, refrain from investment spending. If enough firms acted in this way, there would indeed be an insufficiency of aggregate demand, in this case caused by firms’ lack of investment spending. On the other hand, if firms could coordinate their investment spending – that is, collectively agree to increase their expenditure – the very existence of this spending might generate sufficient aggregate demand in the economy to make that investment profitable. However, uncertainty about whether other firms will increase their spending discourages each firm from going ahead with its own spending. This is a classic coordination problem; one that Keynes thought could be resolved through government management of the economy to place a floor beneath aggregate demand. In Keynesian economics, policy acts in a very pragmatic way to resolve uncertainty.

There are other views of uncertainty. Fischer Black, for example, viewed uncertainty as something that could be to firms’ advantage. The idea here is that uncertainty is associated with volatility, and in times of volatility one often finds the largest possible returns from investment. In this framework, uncertainty, perhaps paradoxically, may yield desirable macroeconomic outcomes.

Examining different aspects of uncertainty Here, I want to discuss two themes in my research on very different aspects of uncertainty. The first, which is collaborative work with my colleagues at the University of Melbourne, Ólan Henry and Kalvinder Shields, looks at how we might model the creation of uncertainty. Our research also looks at how that uncertainty might then affect the dynamic interrelationships that exist between macroeconomic variables. In contrast, the second strand of my research involves the destruction of uncertainty, attempting to strip away some of the uncertainty confronting policy makers when they are reviewing the current (and past) state of the economy. I am currently engaged in this research with Kalvinder Shields and another colleague, Kevin Lee, from the University of Leicester.

Let us step back for a moment and think about why a policy maker might be interested both in the effects of uncertainty and the ways to alleviate that uncertainty.

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All decision making, including that undertaken at the national level by policy makers, involves some initial processing of past and present information.

Against the background of this information, decisions are made that are expected to have particular outcomes in the future. The future, however, is uncertain. As the Roman philosopher and playwright Seneca said, ‘We let go the present, which we have in our power, and look forward to that which depends upon chance, and so relinquish a certainty for an uncertainty.’

models, none of the models predicts undesirable consequences.

The ultimate outcome of such decisions depends on what economists call the ‘state of the world’, but this only emerges with clarity some time after the decision is taken. For example, a decision such as that recently undertaken in Australia by the Reserve Bank to tighten monetary policy, will have an effect on the Australian economy that cannot be predicted precisely unless we know how the state of the world will unfold. Will China continue to boom, for example? The answer to that question will go a long way to determining whether current monetary tightening will push the economy into recession. Yet, although China’s continued growth is probable, it is by no means certain.

– Models how uncertainty is created through the arrival of new information (news) that could not have been anticipated on the basis of current or past information;

Modelling the effect of uncertainty on the economy To what extent does uncertainty affect the economy? To answer this question, at least in a formal sense, requires a modelling strategy, preferably with a framework that is sufficiently general to encompass the origins of the uncertainty and how, once created, the uncertainty affects the economy. Empirically, measuring uncertainty is straightforward, especially if one is working with a properly specified model. Uncertainty is simply that which is not explained by the model and hence could not have been predicted.

However, this begs a host of important questions, not the least of which is: how does one know if one is working with the correct model of the economy?

Given the number of competing models, this is not a trivial question. One approach has been the practice of model averaging. For example, it might be reasonable to advocate a policy change if, when the change is introduced into a series of competing

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Policy making in an uncertain world

An alternative approach is to work with a single model that is as general and flexible as possible; a model that can encompass a variety of possible structures of the economy. Using a very general type of modelling approach known as vector autoregressions, we have developed a framework that: – Exploits the dynamic relationships that bind economic variables together;

– Allows that uncertainty to impact on the future realisation of economic variables; and – Differentiates between the effects of good and bad news in terms of how much uncertainty is created (with bad news creating more uncertainty than good news).

Our approach is inherently non-linear; that is, it takes account of the state of the world. This is entirely consistent with the decision making process noted earlier, where what unfolds after a decision is made depends on the state of the world.

Thus, in our non-linear model, the state of the world matters as to how the economy responds to a particular piece of news. News that arrives in a recession, for example, may have an entirely different effect on the economy than if the same news arrives when the economy is booming. By way of contrast, most empirical economic models are not like this; they are linear in nature and, in such a framework, the response to news is independent of the state of the world. As our model includes the state of the world, it is a more general representation of how the economy responds to the creation of uncertainty.

Interactions between the share market and economic growth One application of these techniques has been to look at the interactions between the share market and economic growth. Does uncertainty about economic growth affect the share market? Does share market uncertainty affect economic growth?

And does it matter when in the business cycle the uncertainty occurs? Our findings suggest that the consequences flowing from the occurrence of uncertainty depend a great deal on the state of the economy. In particular, the arrival of news about economic growth (and hence the creation of uncertainty) has a much larger impact on the share market just after the economy has peaked as well as just after the economy has troughed. These results reinforce the view that the state of the world matters for the dynamics of the economy.

To predict how a particular economy might respond to uncertainty requires knowledge about the state of the world.

Uncertainty about the state of the world This leads to the second theme in my research – the uncertainty that exists about the state of the world. Do policy makers actually know, with

certainty, about current economic conditions? The answer to this question is a fairly emphatic ‘no’.

What policy makers have is an imperfect snapshot of the recent past and little or no information about what is happening in the present. They have no choice but to operate in a climate of uncertainty about the state of the world.

This uncertainty has its source in the technology available to statistics bureaus when they gather information about the economy in real time; that is, data available at a particular point in time. There are two sources of uncertainty in this connection.

First, the information is subject to a time lag.

Thus, the information on Gross Domestic Product for a particular quarter is available only in the subsequent quarter. Secondly, the information is revised, sometimes well after the quarter to which it relates. Both sources of uncertainty create problems for policy makers who require information on the contemporaneous state of the

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economy. Indeed, without this information, it will be difficult to predict exactly how the economy might respond if, for example, macroeconomic policy were to be changed.

The research with my colleagues Kalvinder Shields and Kevin Lee is a response to this element of uncertainty. The research involves nowcasting; that is, constructing a model that explicitly incorporates information about the timing of data releases and the nature of revisions that the data subsequently undergoes. By incorporating this information into the model, it may be possible to infer information about the actual state of the economy from the first release of the data. In

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China in International Imbalances

addition, we have supplemented this with other sources of real time data – specifically, information from financial markets as summarised in the spread between long and short term interest rates, and the views of professional forecasters concerning the current state of the economy. This data, available in real time, is not subsequently revised, and may well be informative about the contemporaneous state of the economy.

The practical usefulness of this approach can be illustrated by reference to current developments in the US economy. At present, there is considerable public debate about the prospects for the US economy in the wake of the sub-prime mortgage

crisis. Some commentators have expressed the view that the US economy is already in recession.

The most recent data we have relates to Gross Domestic Product (GDP) in the December Quarter of 2007. This is first release data – we know that it will be revised. By adopting the modelling strategy as described above and then using simulation techniques, we are able to build up a picture of how likely it is that the preliminary data is consistent with the view that the US economy is currently in a recession. In this instance, we define a recession to be two successive quarters of negative GDP growth. This would be regarded as a severe slowdown.

We find that once we take into account (i) the dynamic interrelationships that exist between macroeconomic variables, (ii) the patterns that exist in the way variables are revised and the timing of their release, and (iii) the contemporaneous information contained in interest rate spreads and professional forecasts, the probability that the latest figures are consistent with a recession in the first quarter of 2008 is around 30 per cent. This is a large enough figure to give cause for concern.

Summary Uncertainty is a pervasive feature in economics.

I have described two modelling approaches that have, as their unifying feature, a requirement to take uncertainty seriously. Uncertainty matters for the economy and the way that macroeconomic variables evolve through time. Further, policy making requires techniques to peer through the uncertainty to establish the real facts behind it.

Professor Nilss Olekalns is Professor of Economics in the Department of Economics at the University of Melbourne.

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did business matter? australia in the twentieth century With business neglected in the narratives that describe Australian economic development, the US story may offer a new perspective on why business mattered here by david merrett A condensed version of his Inaugural Lecture given at the University of Melbourne on 20 September 2005.

Did business matter in the twentieth century?

What a silly question. Of course it did. Privately owned businesses have been the bedrock of the Australian economy. Firms, small and large, provided employment and generated the goods and services the country consumed or exported. Their collective health has been a measure of our prosperity.

The neglect of Australian business history The question has a different shade of meaning when posed to economic and business historians, and perhaps explains why business has been neglected in the narratives that describe and explain Australian economic development. Scholars have concentrated on the big picture issues such as inflows of migrants and population growth, inflows of capital and patterns of investment, the growth of natural resource industries, depressions and wars, and the changing role of the state as a regulator, protector (via tariffs and subsidies) and economic manager. In these narratives, the most important private sector institution in the economy, the firm, was marginalised.

The Australian story Our understanding of the critical importance of firms in national economic development owes much to Alfred Chandler. In The Visible Hand

(1977), Chandler recast the interpretation of the growth of the US from the last third of the nineteenth century. Up to the Civil War, the economy was a network of small farms, workshops and stores linked by merchants. It was a world of local and regional markets, whose business enterprises were predominantly family-based, sole proprietorships or partnerships. There was minimal distinction between ownership and control or between family owned and managed.

The technology, particularly in manufacturing, still favoured small scale enterprise and the capital needed was not beyond the means of individuals and their social networks.

Technological change let the genie escape from the bottle. The steam engine, steam ship and electric telegraph transformed the US economy at both the macro and micro level. The revolution in transport and communication, reducing the costs and time taken to move people, goods and information, allowed the creation of a national market. Businessmen could buy and sell in wider markets, and opportunities beckoned. A parallel revolution occurred particularly within factories.

The combination of improved motive power, first steam and then electricity, and advances in metallurgy, metal working and chemistry brought forth the second industrial revolution. New industries emerged and the old were transformed: primary metals, chemicals, glass, petroleum, rubber, processed foods, beverages, electrical

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machinery and equipment. These industries were described by Chandler as ‘science-based and capital-intensive’.

The old style of firm – family-owned and controlled – could not use the new technologies effectively. The new industries required new forms of knowledge about science and engineering that increasingly came from university graduates.

Moreover, the new industries required capital on an unprecedented scale for the construction of huge factories. First movers in industries such as iron and steel or oil refining captured the benefits of economies of scale. Per unit costs tumbled as volumes rose. The long and the short was that the successful firms in industries such as the railroads, telegraph, steel and oil changed form. They incorporated, hired professional managers with a wide range of functional skills ranging from engineers and chemists to accountants and lawyers, and they raised capital from the share market, bankers and bond holders. The modern corporation had arrived.

Building an appropriate organisational form, or ‘structure’ in Chandler’s parlance, to exploit the new technologies was an entrepreneurial act of the highest order. Only a few succeeded. The new ‘giant industrial enterprises’ differed from what went before in a number of important respects.

First, a small number of very large firms came to dominate key industries. These monopolies and oligopolies enjoyed enormous market and political power. Their owners and their bankers – people like the Morgans, Rockefellers and Carnegies – were typecast as ‘robber barons’.

Second, a less obvious but more important consequence was the emergence of a new occupational class: the salaried manager. These men operated companies they did not own; the nexus between the risks of ownership and rewards of control had been broken. The new owners, the shareholders, had no say in the management.

Third, new knowledge was accumulated by those in charge as they dealt with the scale and complexity of the enterprises. Over time basic principles of management emerged and the firm became a hierarchy with overall control at its apex

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Did business matter? Australia in the twentieth century

in the form of a board of directors. Communication flows to the separate functional departments, such as purchasing, production and sales, were vertical and carried instructions and reports.

Head office housed staff functions, personnel, audit and legal. Many firms had numerous plants, warehouses and factories in different locations.

The collection and transmission of information up and down the hierarchy and between units became standardised and regulated, and accounting data and particularly ratios became the shorthand that prevented information overload at the top. The role of senior management was to coordinate the work of the departments so as to maximise the flow of work through the organisation and onto the market.

The large ‘industrial enterprises’ continued to expand after the application of the late nineteenth and early twentieth century technologies. Having dominated particular markets through the erection of massive barriers to entry, they diversified into new markets that were usually closely related in terms of underlying technologies or used similar distribution channels. The key to continued expansion was the ability to create new products and to find new markets, particularly overseas.

The story told by Chandler resonates with the resource-based theories of the firm. His giant enterprises had pools of resources, tangible and intangible, financial, physical and human capital, that set them apart from each other not only in size but in how they were used. He referred to the necessity of investments in building ‘organisational capabilities’, a term not far removed from the more familiar ‘competencies’ and ‘capabilities’. In Strategy and Structure (1962) Chandler showed how in the 1920s large US firms learned to manage product diversification by adopting a multi-divisional or M-form organisational design. He went further in Scale and Scope (1990) to argue that by the mid-twentieth century the American system of management, ‘competitive managerial capitalism’, was superior to both that of its major industrial rivals, Germany’s ‘cooperative managerial capitalism’ and Britain’s ‘personal capitalism’.

Lessons from US experience The end point of Chandler’s enormous contribution to business history is that the quality of management matters and, as a corollary, how the firms they managed are organised matters.

His work takes us to the core of the contemporary debates about the sources of sustainable competitive advantage. What matters most are differences in the ability of firms to make strategic decisions about what business to be in and simultaneously to manage a large and heterogenous bundle of resources. The most successful and long lived organisations are those that possess the ability to continuously adapt to new environments, and learn to do new things

with the knowledge and resources at hand. By mid-century, the US possessed more firms with strong competitive advantages in a wide range of manufacturing and service industries than any country on earth. A by-product of this process of competition was that resources were used more efficiently. The US became the world’s economic powerhouse, its citizens enjoyed the highest standard of living and its multinationals took US technology and marketing skills into markets around the world.

The Australian story What of Australia? Did local manufacturing firms undergo a similar transformation to those in the

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US and other mature industrial economies? If they did, we would expect the new organisational forms and the efficiencies inherent in them to have provided a stimulus to productivity in this country. In The Big End of Town, Grant Fleming, Simon Ville and I attempted to answer this question. Our first task was to identify large firms, those most likely to have required sophisticated management of large knowledge based organisations. We compiled lists of the 100 largest firms, measured in terms of assets, in 1910, 1930, 1952, 1964, 1987 and 1997. Then we allocated each firm to an industry classification and noted whether they were Australian or foreign owned each time they appeared in the lists.

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Did business matter? Australia in the twentieth century

Our data confirmed what we already knew.

Australia, at least early in the twentieth century, was a different type of economy from the industrial powerhouses of the northern hemisphere. It was still heavily oriented towards natural resource production and export. Manufacturing was smallscale and technologically unsophisticated. A large service sector served the export and import trade: rail transport, ports, insurance, banking, warehousing, auctioneers and wholesalers. Nearly all farms were still family owned. The government owned and operated the major rail transport and communication systems, and a large number of other business enterprises, particularly energy. A major change took place from the 1920s onwards

as local manufacturers swiftly replaced imports to reach a peak of relative importance in the 1960s.

Thereafter, a resurgent resources and service industry, including government enterprises, refashioned the economic landscape once again.

The changing Australian scene Our changing list of leading firms mirrors these trends in aggregates measures. For instance, the largest firms in Australia before WWI were service providers to the pastoral industry, such as Dalgety and Goldsbrough Mort. By midcentury, new firms had emerged as leaders, nearly all of whom were ‘science-based and capitalintensive’. The pack was led by miners and metal refiners such as BHP and CZC (now Rio Tinto), and cars, glass and paper producers such as GM-H, ACI and APM. The number of foreign firms in the list rose sharply as subsidiaries of multinational enterprises entered Australia in the 1920s and again at higher rates in the 1960s and 1970s. By century’s end, the list had changed radically once more. Firms operating in service industries had come to the fore: News Corp, and the partly privatised Telstra and Qantas. The large miners, BHP and Rio Tinto, were still there and had been joined by WMC. The leading manufacturers included the Coca-Cola bottler, CCA; CSR, which diversified beyond sugar into resources and building products; Amcor (once APM); and BTR-Nylex, a diversified manufacturer.

Comparing Australia with other countries Did the organisational structure of Australian firms change as they had in the US and to a lesser extent in Germany and the UK? Our research suggests that they did, but with a significant time lag. Our study was based on those 354 firms that appeared in at least one of our top 100 lists, and more importantly on a smaller group of 63, our ‘corporate leaders’ which had appeared in at least three lists. The largest and most successful firms evolved, becoming modern corporations by the 1950s and 1960s. They were listed on stock exchanges, their directors did not, for the most part, participate in day-to-day management,

senior staff increasingly possessed some formal qualification appropriate to their role, and the firm’s organisation charts showed the separation of functions between departments.

Moreover, as they diversified, particularly after WWII, these firms adopted a divisional structure.

New knowledge about how to manage came from a variety of sources: observation by Australian business people as they travelled overseas, subsidiaries of American and British firms brought their advanced management skills with them and, particularly from the 1960s onwards, management consultants such as McKinsey & Co provided a template for organisational design.

Australia enjoyed rising living standards during the twentieth century. Output rose faster than the physical inputs, labour, land and capital, used in production. That gap, productivity growth, is usually explained with reference to improvements in technology, better engineering and science.

However, improvements in the quality of management associated with the rise of big business also lifted the productivity with which resources were used. Business mattered because managers learnt through trial and error to design and operate larger and more complex organisations which exploited economies of scale and scope. The cumulative effect of incremental advances in knowledge about how to administer resources within the firm has made an important contribution to the prosperity of Australia.

Professor David Merrett is in the Department of Management and Marketing at the University of Melbourne.

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financial shell games The gigantic liquidity bubble is now deflating. The sub-prime problems were merely the trigger for a major adjustment in the availability and cost of borrowings globally. by satyajit das A condensed version of a lecture given at the Melbourne Centre for Financial Studies and the Financial Services Institute of Australasia on 26 February 2008.

The end of the world?

In Indian mythology, we are in the Age of Kali – the last age, in which the world ends when Kali dances the dance of death. With the sub-prime crisis in the US, which started in 2006, creating a ripple effect in global markets, has Kali begun her dance for financial markets? American television personality Jim Cramer, who launched a ‘we’re in Armageddon’ tirade, seems to think so; while Samuel Molinaro, Chief Operating Officer of a leading global investment bank, pleaded ‘I’ve been out here for 22 years, and this is as bad as I’ve seen it in the fixed-income markets.’ It’s clear that the credit bubble is finally deflating.

The new liquidity factory Where did it all start? The early 2000s was a period of ‘too much’ and ‘too little’ – too much money, too much borrowing, too much complex financial engineering, too little return for risk, and too little understanding of the risks. Steven Rattner (from hedge fund Quadrangle Group) summed it up in the Wall Street Journal: ‘No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since US financial markets reached full flower.’

Liquidity is the amount of money and credit available. In the ‘new liquidity factory’, investors borrowed – hedge funds borrowed against investments; traders borrowed cheap money

(especially Japanese yen at zero interest rates) to fund high yielding assets. Bankers became adept at stripping money out of homes where prices had risen to fund a frantic personal debt addiction in the fast debt nations – US, UK and Australia.

Traditional money, fueled by loose monetary policy, low interest rates, large capital flows from the savers of Europe and Asia, was turbo-charged by ‘financial engineering’. It was this engineering – otherwise known as derivatives – that laid the foundation for the current credit crisis.

Derivatives – highly leveraged commercial bets on movements in prices of financial assets – can be used to manage or create risk. In recent years, more and more investors were turning to derivatives to increase risk for higher returns.

One example we have seen is the Collateralised Debt Obligation (CDO), a mortgage loan secured on steroids. It works like this. A portfolio of loans, bonds or mortgages is assembled. CDO securities, secured over the portfolio, are sold to investors. Interest and principal from the underlying portfolio is used to make payments on the CDO securities issued. The investors receive higher returns than from traditional investments.

CDOs and their kin – structured credit – have helped supersize debt levels using techniques of staggering complexity, incomprehensible to all but a small group of practitioners. The market was so heated that one professional confessed that even his headhunter had been recruited into a

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structured credit role at an investment bank.

Buyers from Switzerland to Slovakia, Boston to Beijing bought up credit risk. A feature of the market was that the investor did not understand the complexity and risk of structures.

The new liquidity machine created a money pyramid that has no parallel in history, as shown in Figure 1.

Now, this gigantic liquidity bubble is deflating.

The sub-prime problems were merely the trigger for a major adjustment in the availability and cost of borrowings globally. Investors, including hedge funds, who borrowed heavily against assets that have gone down in value, have been forced to sell to repay borrowings. However, in the highly leveraged world of the new liquidity factory, the amount that needs to be sold is exaggerated.

This process of deflation will not be quick or painless. A veteran commentator, Ian Kerr

compared the current credit crunch to death from radiation – CDO, particularly those with subprime exposure, now stands for Chernobyl Death Obligations!

Financial ‘shell games’ or the ‘pea and thimble’ trick Markets exaggerate the short-term impact and underestimate the long run impact of events, and the liquidity factories were based on the New Age idea of ‘risk transfer’. Traditionally, banks made loans and then held them on their balance sheets till maturity. In the new money game, banks ‘originate’ (sell) loans, ‘warehouse’ (hold) them on their balance sheet for a short time and then use CDO technology to ‘distribute’ (transfer) them to investors such as insurance companies, pension funds and ubiquitous hedge funds. Central banks believe that if banks sell off their loans in this way, the risk is distributed widely, thus reducing the chance of a crash.

Figure 1 % of liquidity 1%

11%

13%

75%

% of world GDP Central banks

Broad money

Securitised debt

Derivatives

10%

122%

142%

802%

Source: Independent Strategy – this version is adapted from Andrew Cornell’s “The Year of Easy Money” from the Weekend Australian Financial Review, 27 December – 1 January 2007

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Financial shell games

Yet risk transfer is a short con, quick and easy to pull off. It’s like the ‘shell game’, which involves three shells and a small, round ball about the size of a pea. The trickster places the ball under one of the shells, then shuffles the shells around quickly.

Bets are taken from the audience on the location of the ball. By sleight of hand, the operator easily hides the ball, undetected by the victims.

Like the shell game, risk transfer via the structured credit market is a confidence trick used to perpetrate fraud. And in the current credit crunch, the shortcomings of the new money game are being exposed.

Banks do not sell off their real risks very often, mainly for regulatory reasons. In a CDO, the bank typically takes some of the riskiest securities created. This is ‘hurt money’ or the ‘skin in the game’ to reassure other investors, which the banks must hold until they can be sold. If there is a market disruption and the bank is unable to sell the risk into the market, then the risk remains with the bank.

However, the risk may also return to the bank via the back door. Where it acts as a prime broker – this is where banks execute trades, settle transactions and lend to hedge funds – the bank lends to investors using the CDO securities created as collateral. If the value of the securities falls and the hedge fund is unable to post additional margin to cover the loss, the bank is exposed to the risk of the securities. The bank

assumes that it can sell the securities it is holding to pay itself back. As there are few prime brokers – three dominate the business – the risk is concentrated.

Banks have also created a plethora of off-balance sheet structures – arbitrage or conduit vehicles – known as structured investment vehicles (SIVs).

The vehicles purchase high quality securities like AAA or AA rated CDOs and fund them with short-term borrowing, usually commercial paper (CP) issued to money market funds. Banks provide standby lines of credit to the vehicles to cover funding shortfalls. If CP cannot be issued, the banks may be forced to lend against the assets that they have supposedly sold off. In the current crisis, some banks refused to lend, arguing material changes in circumstances. Others foraged down the back of the sofa for any loose change to add to their dwindling liquidity to meet their commitments. Some bowed to the inevitable and took the assets back onto their balance sheets.

The new money game assumes that the risk moves to stable investors. In fact, credit risk moves from a place where it is regulated and observable to a place where it is less regulated and more difficult to identify. Around 60 per cent of all credit risk is transferred to leveraged hedge funds that may be inadequately capitalised to bear the risk – around one dollar of ‘real’ capital supports between $20 and $30 of loans. In contrast, banks are required to hold $1 of capital for every $12.50 of loans.

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When we see banks setting up hedge funds, and investing in them, the trouble begins. Hedge fund investors can withdraw funds at relatively short notice, typically, one to three months. The hedge fund’s borrowings are also short-term, and this money finances long-term assets, making the hedge funds vulnerable to a credit crisis. When a hedge fund gets into trouble, as we have seen, there is commercial and reputation pressure to support the fund, bringing the risk back into the bank. As one humorist wryly suggested, with more and more funds facing margin calls, they should meet capital calls by using nickels, pennies and quarters.

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Financial shell games

The same model as sub-prime is used, worryingly, for funding highly leveraged private equity, infrastructure and property transactions. As of August 2007, $300 billion of leveraged finance loans made by banks have been effectively orphaned. In other words, they cannot be sold off. One bank recently offered $1 billion to a client to walk away from an underwriting commitment where it stood to lose more if the transaction proceeded. Another bank, active until recently in making multi-billion dollar commitments to private equity transactions, told clients that ‘they were not in leveraged lending business any more.’ It smacked of the day in the late 1980s when the then all-powerful Japanese

banks refused to participate in leveraged financing to meet the cost of acquiring United Airlines. This ushered the end of that era.

Truth in labelling There is a lack of transparency in many of these activities. One trader summed it up using Donald Rumsfeld’s immortal words: the known known was that there were losses in sub-prime mortgages and anything related to them; the known unknown was that everybody knew that they did not know the full extent of the problem; the unknown unknown was that there could be other problems about which we did not then know. Investment banks and hedge funds believe in transparency and disclosure for everybody, except for themselves.

One central banker observed that in the good old days, there would have been no problem as the risk would be where it always was – at the banks.

There are also problems about the models used to value these complex securities, assumptions about being able to buy and sell them, and the role of rating agencies in certifying them.

ideas as in escaping from old ones.’ But as John Kenneth Galbraith observed: ‘faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.’

There are unknown knowns in financial markets – what we did not know we knew. These are things we never admit to ourselves. Ordinary, decent people always pay for financial excesses with their hardearned money and taxes. We all knew that somewhere along the road, the financial shell game would end this way.

Mr Satyajit Das is a risk consultant and author of a number of key reference works on derivatives, including Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider’s account of derivatives trading and the financial products business.

The current crisis points to the need for significant and important changes in financial markets. In its 2007 annual report, the Bank of International Settlements (BIS), the central bank to the world’s central banks, admitted that ‘our understanding of economic processes may be even less today than it was in the past.’

The temptation to seek a scapegoat – such as the brokers that sold sub-prime mortgages and rating agencies – looms large. And the temptation for a quick fix – lower interest rates – is ever-present.

The Federal Reserve System has cut the discount rate. It has also clarified the rules, stating that banks can pledge asset backed commercial paper as collateral for funding at its discount window.

Usually, only government securities are eligible.

The Fed is effectively underwriting the credit risk, and is arguably reverting to type, bailing out banks and investors from poor decisions or irrational exuberance in underwriting excessive risk-taking.

John Maynard Keynes knew the problem well: ‘the difficulty lies not so much in developing new

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drugs policy: a role for economic research?

Drugs policy has a long and inglorious history and has often been driven less by reason and evidence than by prejudice and sentiment, moral panic and conviction, and political fear and opportunism by steve pudney A condensed version of the 20th Richard Downing Lecture delivered at the University of Melbourne on 6 December 2007.

Drug abuse gives rise to intractable and enduring social problems and its policy counterpart, the ‘war on drugs’ continues to be one of the most hotly debated areas of public policy. Economists play a surprisingly minor role in this debate.

Illicit drugs are just market commodities, drug dealers and users are just market participants and – if economists know about anything at all – one would expect them to know about the working and regulation of markets. Economics also has a lot to say about the nature of behavioural responses to incentives created by the policy environment (some of which may be unintended) and about the need to compare social costs and benefits when considering policy options. Despite this potential contribution, the economic research literature on illicit drugs is small and the field remains mainly the province of medical and noneconomics social science research.

The proper basis of public policy I would argue that any policy on harmful substances should be based on reasoned argument and sound evidence – and that we should bear in mind the possibility that there may be some social harms that feasible public policy cannot remedy. Economists are used to the idea of policy ineffectiveness, but this idea is absent from much of the non-economic literature on drug abuse.

Many commentators appear to believe that the demonstration of harmful effects (of cannabis on mental health, for instance) is sufficient in itself

to justify a ‘tough’ drugs policy. Economics teaches us otherwise: that tough policy may be ineffective, may have damaging unintended consequences or may involve a level of cost that outweighs any likely social benefit.

The evidence on illicit drugs The quality of the available evidence is an obvious concern. For most of the substances regarded as ‘drugs’, possession and market transactions constitute illegal activities and drug users therefore have a strong incentive to conceal their behaviour, making measurement highly problematic.

I classify evidence on illicit drugs into three categories: quasi-facts, pseudo-facts and fantasyfacts. Quasi-facts are possibly prone to serious error but they are at least based on a clear and direct measurement process, usually involving large-scale sample surveys. An example is the regular publication of general-population prevalence rates published in the UN World Drugs Report (Figure 1), which portrays Australia as a world leader in the consumption of cannabis, amphetamines and ecstasy. Such ‘facts’ are undoubtedly prone to varying degrees of underestimation through under-reporting and to noncomparabilities across countries.

Pseudo-facts involve some manipulation of directly observed data and further assumptions (or, less charitably, guesswork). An example is my

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own study of the size of the UK drugs market1, which combined multiple data sources to generate an overall estimate of £5.27 billion, equivalent roughly to a third of the tobacco market. Despite the wide range of uncertainty associated with this estimate (at least ±£1.3 billion), this figure has been widely reported as accepted fact in the UK press.

Fantasy-facts are another order of magnitude more uncertain, involving more heroic

assumptions. For example, the UK Drug Harm Index2 combines data from many sources with large assumptions about imponderables like the value of a life cut short by drug-taking (Figure 2).

These attempts at measurement are often very sophisticated and may provide a useful guide to the evolution of the drugs problem and the impact of policy – and they are certainly better than nothing – but it is important to avoid treating them as clearly established ‘fact’.

Figure 1: Quasi-facts: general population prevalence rates (UN World Drugs Report 2006, proportion of 15-64 year-olds reporting use in last year)

% prevalence

cannabis cocaine opiates amphetamines ecstasy

Figure 2: Fantasy-facts: an index of drug harms (Source: MacDonald et al., op. cit.)

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Drugs policy: a role for economic research?

History of drugs policy Drugs policy has a long and inglorious history and has often been driven less by reason and evidence than by prejudice and sentiment, moral panic and conviction, and political fear and opportunism.

Jessica Warner’s book Craze: Gin and Debauchery in an Age of Reason (2002) draws a clear parallel between the eighteenth century moral panic about gin and contemporary worries about illegal drugs. In both cases, we see policy strongly affected by public outrage, largely fuelled by the media and often based on little or no evidence. Compare these quotations from the London press 250 years apart.

All the elements are the same, only the writing style and the physical substances are different.

This wicked GIN of all Defence bereft And guilty found of Whoredom, Murder, Theft Of rank Sedition, Treason, Blasphemy Should suffer Death, the Judges all agree London Evening Post, March 1751 Drugs take lives and tear apart communities.

They also undermine all our efforts to combat crime. The Government needs to get an urgent grip on this problem.

Daily Mail, August 2006

The gin and tonic drinking Daily Mail reader who deplores cannabis-smoking youth is to some extent the product of random swings in our views about the substances which merit concern, and recent research3 suggests that gin and tonic might in fact be a greater source of health concern than cannabis.

Prevalence

Figure 3: A UK drug surge? (British Crime Survey, self-reported use in last year, 16-59 year-olds)

cannabis cocaine ecstasy opiates

The strong public pressure on policy makers to solve the drugs problem has generated a good deal of tough talk by politicians, but remarkably little evidence of any strong effect on drug use. For example, in his 1989 inaugural address, George Bush Snr. promised ‘there is much to be done and to be said but, take my word for it: this scourge will stop.’ Well, it did not. If we look at quasi-facts from the annual US Monitoring the Future (MTF) survey, the proportion of 12th grade students who reported using marijuana continued its long standing downward trend that began in 1978-9 to a low point of 22 per cent in 1992, before starting a sustained rise to a peak of 39 per cent in 1997. Throughout the period, the proportion of respondents reporting that marijuana was easy to obtain remained well above 80 per cent. Similarly, the UK government’s reclassification of cannabis from class B to class C status in January 2004 (which weakened the penalties for possession) has apparently had no impact on the downward trend in self-reported cannabis use which began in 2003 (Figure 3), despite the dire warnings of possible consequences which appeared in the press.

The apparent ineffectiveness of much drugs policy does not mean that drug consumption is unaffected by events – just that those events are often not under the control of policy-makers. An excellent example from the US is the dramatic fall in selfreported cocaine use (in the year preceding interview) by 12th grade MTF survey respondents.

1986 witnessed the start of a six-year decline in cocaine use from 13 per cent to three per cent, and an unprecedented 16-point single year increase in the percentage seeing ‘great risk’ in using cocaine just once or twice. Was this the outcome of a radical new policy initiative? No. It resulted largely from a media frenzy surrounding the death of a basketball player, Len Bias, reported (incorrectly, as it turned out) to have resulted from his first use of cocaine.

Available data suggest that this is a permanent effect – cocaine use in the US school population has remained below half its previous level.

The gateway hypothesis The most distinctive part of the economist’s contribution to policy analysis is the analysis of behavioural response to the incentives created by policy. A good example is the hotly-debated Insights Melbourne Economics and Commerce

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‘gateway hypothesis’, which asserts that the use of cannabis increases the risk of subsequent use of hard drugs, in a direct causal sense. Superficially, the evidence seems to be consistent with this idea.

For instance, survey evidence suggests that almost all hard drug users had used cannabis before moving on to harder drugs. However, precedence in time does not necessarily imply causation.

(Consider: does the sending of Christmas cards cause the occurrence of Christmas?) We also find that hard drug users on average display higher rates of early family disruptions, psychological impairment, involvement in petty crime and truancy, and so on. It is quite likely that cannabis and hard drug use are frequently joint outcomes of a common underlying set of causal factors, with the earlier onset of cannabis merely a reflection of easier access and lower price.

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Drugs policy: a role for economic research?

A disappointing feature of the research literature on the gateway hypothesis is the absence of analysis of policy design. If we could demonstrate the existence of a gateway effect, what would be the implications for policy? To answer this question, we need to understand the behavioural basis of the gateway effect. There are many possibilities, but an interesting one is the supplyside or access gateway. Some people strongly believe in this theory: for example, in October 2007, a primary school teacher called Nicola Cooper, from the Suffolk town of Bury St Edmunds, was convicted of supplying her own children with cannabis. Kevin McCarthy, defending, told St Edmundsbury Magistrates’ Court ‘she had effectively become a drug supplier to keep her children away from other suppliers.

The reason for the supply was to keep those

cherished children away from the drug culture.’

Mrs Cooper’s belief in the dangers of the access gateway is shared by Dutch policy makers responsible for the tacit legalisation of retail cannabis supply through Amsterdam coffee shops, which can be interpreted as an attempt to segment the drugs market and separate cannabis users from supplies of other drugs.

Although we have no relevant evidence beyond a few fantasy-facts, it is possible to construct a story that illustrates the way incentives might work to produce an access gateway. Comparing the US and UK, the US appears to have a more uniformly tough policy on the supply of all drugs, whereas the UK has a more graduated scale of penalties. In UK courts, the mean sentence for heroin/cocaine trafficking relative to cannabis trafficking is 5.5:1, while in US Federal courts it is only 2.8:1. There is consequently a stronger incentive for UK cannabis dealers to avoid co-supplying hard drugs – which appears to be reflected in a rate of cosupply higher in the US (37 per cent) than the UK (28 per cent). This in turn is reflected in higher proportions of US cannabis users reporting easy access to hard drugs (forty per cent compared with 22 per cent)4. These figures are all profoundly uncertain, but they do illustrate the potential value of insights into incentive effects that an economic approach to policy design provides.

The need to use evidence intelligently Returning to the critical issue of the quality of evidence on drug use, we have to accept that the evidence we have to work with is potentially unreliable, because of the incentive that exists for drug users to conceal their activity. Nevertheless, it would be a mistake to disregard the evidence just because it is imperfect. We need to find ways of using evidence intelligently, making allowance for its imperfections. There is scope for progress here. An example is the case of children’s illicit smoking. The British Household Panel Survey involves annual interviews with a large panel of children aged 11-15. Each year, the children are asked the question: ‘Have you ever tried a cigarette, even if it was only a single puff?’

Examination of the sequence of responses for each child over five consecutive years reveals many inconsistencies, which gives us an insight into the

nature and effects of misreporting. A statistical analysis of reporting error suggests that, in a household where the child’s mother smokes, there is a four per cent probability of over-reporting for a child who has not smoked and a 13 per cent probability of under-reporting for a child who has smoked. In a non-smoking household, the overreporting rate falls to one per cent and the underreporting rate rises to 22 per cent. In other words, there appears to be a tendency for children to misreport their behaviour in a way that brings them more in line with family norms.

This kind of misreporting can have a big impact on research findings. For example, if we treat the data as completely accurate and analyse the link between parental smoking and children’s smoking, we find the child’s annual risk of starting smoking to be more than doubled by having a mother who smokes (4.4 per cent rather than two per cent). On the other hand, if we allow for the possibility of misreporting by children, we find evidence of a much larger risk, which is little affected by parental smoking (8.4 per cent rather than seven per cent)5. Although we cannot trust our data completely, this doesn’t mean we can’t find effective ways of using it.

Professor Steve Pudney is Director of the Research Centre on Micro-social Change at the Institute for Social & Economic Research, University of Essex.

1 Pudney, Badillo, Bryan, Burton, Conti and Iacovou, 2006, Estimating the Size of the UK Illicit Drugs Market, in Measuring Different Aspects of Problem Drug Use: Methodological Developments, Home Office Online Report 16/06, pp. 46-120 2 MacDonald, Tinsley, Collingwood, Jamieson and Pudney, 2005, Measuring the Harm from Illegal Drugs using the Drug Harm Index, London: Home Office Online Report 24/05 3 Nutt, King, Saulsbury and Blakemore, 2007, Development of a rational scale to assess the harm of drugs of potential misuse, The Lancet 4 See Pudney ‘Cannabis and hard drugs: is there a supply-side gateway effect?’, Working Paper, ISER 5 Figures adapted from results presented in Pudney, 2007, ‘Rarely pure and never simple: extracting the truth from selfreported data on substance use’. Institute for Fiscal Studies: CeMMaP Working Paper CWP11/07

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our schools...our future Every primary school pupil should be able to read and write at least at the minimum levels specified by stephen sedgwick

This is a personal summary on the proceedings of a conference hosted by the Melbourne Institute and The Australian on 15 November 2007 at the University of Melbourne. Fifteen speakers drawn from academia, the teaching profession, and commentators addressed the conference on how best to improve the performance of schools and the outcomes achieved by students. A feature of the conference was the staging of the election policy debate between the Minister for Education, Science and Training, the Hon Julie Bishop MP and the Shadow Minister for Education and Training, the Hon Stephen Smith MP. The Victorian Minister for Education, the Hon Bronwyn Pike MP, also addressed the conference.

Many of the papers can be found on the Melbourne Institute website: www.melbourneinstitute.com/conf/conf.html

Disparity in performance There is active debate in Australia about whether students achieve as well as they could or should and about the distribution of performance around the mean. Almost 20 years ago a high level agreement was reached between the Commonwealth, State and Territory governments about the National Goals of Schooling. These were last updated in 1999 and contain the aspiration that every primary school pupil should be able to read and write at least at the minimum levels specified in the national benchmarks for the relevant age cohort. Subsequent to that agreement, performance standards were developed for years three and five and a testing process introduced.

Initially based on each jurisdiction’s own regime, the original testing arrangements are soon to be replaced by an alternative based on nationally administered tests. That said, the results to date are concerning. They show that there is considerable disparity in performance against the benchmarks for reading, writing and mathematics amongst equity groups and that the national goal

remains elusive. For example, data published by the Ministerial Council on Employment, Education, Training and Youth Affairs shows that in 2005 the 95 per cent confidence interval for the proportion of year five students who achieved the reading benchmarks was 83.1–87.1 per cent (slightly higher for females), well short of the target, while the interval was only 58.7–66.9 per cent for indigenous students.

International benchmarking Since the economy opened up to global competition – especially following the dismantling of tariff barriers from the mid-1980s – Australian policy makers have increasingly sought to benchmark Australia’s performance against international standards. There are two frequently quoted international benchmarking exercises in respect to the outcomes of education, one of which Professor Barry McGaw of the Melbourne Education Research Institute referred to at the conference. He discussed Australia’s international standing as measured against the Organisation for Economic Cooperation and

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Development (OECD) Program for International Student Assessment (PISA). PISA assesses the ability level of 15-year-olds on a well established cycle of internationally comparable tests. The approach taken is to measure performance independently of the national curriculum by focusing on demonstrated competencies. McGaw characterised Australia as having tied for second place, with eight other countries, in reading (PISA 2000); tied for fifth, with nine others, in mathematics (PISA 2003); tied for fifth, with eight others, in science (PISA 2003); and tied for fifth, with eight others, in problem solving (PISA 2003). He characterised this as ‘high quality, but not gold or silver,’ and suggested we should aim higher. He asked what lessons could be drawn from the international evidence about how to improve performance.

Socio-economic status and performance The OECD argues from PISA evidence that student achievement is correlated, in most countries, with the socioeconomic status of the student’s family. Students from families of higher socioeconomic status tend to perform better in the PISA tests. However, schools in some countries, such as Finland and Canada, are better at reducing the gap in the average performance of students drawn from low socioeconomic backgrounds compared to those from more well off homes. In these countries, overall scores in the PISA tests are relatively high and, in addition, the dispersion of student scores is relatively low.

McGaw characterises these countries as achieving both high quality outcomes and high equity. In drawing lessons for Australia, he noted that one relatively good performer, Finland, devotes significantly more resources than most countries to identify poorly-performing students and to providing targeted support to improve their performance relatively early in their schooling.

He argued that this is most likely why Finland achieves both better average outcomes and more equitable outcomes than many other countries.

Professor Bill Louden from the University of Western Australia presented evidence compiled by others that questioned the relative power of

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Our schools...our future

socioeconomic status in explaining student achievement in any given year of school. While not denying that social background is important, this analysis placed considerably more emphasis on the prior achievement of students themselves and the expertise of teachers. He argued that the extent to which the school’s culture nurtures an evidencebased learning environment and promotes high levels of responsiveness to student needs is as important to student progression each year as social background. Louden posed the hypothetical question: ‘What is amenable to policy action?’ His answer was that the highest and quickest impacts would be achieved by working to improve the performance of students from their earliest school years (thus improving the ‘prior achievement’ of students entering later years of schooling) and by improving the quality of teachers. The former is consistent with McGaw’s argument that part of the reason for Finland’s success lies in its systematic approach to provide early remedial assistance to students assessed as performing poorly.

Teacher quality and school culture Indeed, as is so often the case at such discussions, how to improve teaching and teacher quality was a recurrent theme throughout the conference.

Greg Whitby of the Catholic Schools in the Diocese of Parramatta, in the course of a passionate exposition of the potentially transformative power of information technology, asked why it is that ‘attendance at school is compulsory but learning seems optional.’ He, along with several other speakers, emphasised the importance of creating environments within schools and within communities at large in which parents, teachers and students hold high expectations of what should be achieved at school; and a measurement, reporting and accountability framework that supports their achievement. Dr Chris Sarra, currently Director, Indigenous Education Leadership Institute, Queensland University of Technology but previously principal of Cherbourg High School, recounted his experience in turning around a school culture based on low expectations to one in which indigenous students were expected to meet state standards and were proud when they did so. He

argued that not to insist on high standards – even for students drawn from highly disadvantaged backgrounds – is to condemn these students to achieve at less than their potential. He reported significant improvements in both test scores and student satisfaction during his tenure as principal.

Several speakers noted that there are many, many examples where individual teachers or schools have pursued an approach which has led to extraordinary improvements in the outcomes achieved by students. Dr Sarra’s experience and the success of the Bell Shakespeare Company in engaging students from a wide variety of backgrounds, reflected in Ms Linda Lorenza’s presentation to the conference, are cases in point.

As Dr Wendy Jarvie of the Commonwealth Department of Education, Science and Training noted, the issue is how to make such successes systematic so that they become the norm.

Improving teacher performance How best to improve teacher performance, teacher preparation and the quality of school based culture came up repeatedly in the discussions as important elements in answering Dr Jarvie’s

question. McGaw noted that teachers in Finland have high social status and are required to have a minimum teaching qualification at Masters level.

Indeed, several speakers called for higher tertiary entrance scores for teachers, noting that cutoff scores had declined in recent times. Louden, for example, quoted data from Leigh and Ryan (2006) that showed over the 20-year period to 2003 a significant shift towards lower levels of ability, as measured by entrance scores, in the intake of females into teacher preparation courses. Louden argued that the root cause of the slide in status of teaching (and thus the lower apparent standard of the teacher intake) is a ‘short, flat, low and uniform salary structure in a world of expanding graduate opportunities.’ He and several other speakers supported more generous pay arrangements for both beginning and experienced teachers, though views quickly polarised about how closely pay should be related to performance and how to measure performance, especially the performance of an individual teacher. There was similarly a range of views about the nature of accountability (and associated reporting) of schools to their communities. Amongst other things, this raises issues about how widely test

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scores of individual students, classes or schools should be disseminated; and whether, if the answer is yes, how comparisons should be drawn about the relative performance of individual teachers or schools based on these scores.

Several speakers argued that teacher preparation courses need to pay greater attention to the subject matter expertise of teachers as well as improve their understanding of pedagogy. They argued that deep subject matter knowledge, continuously updated, not only leads to high quality instruction for students but also means, most likely, that the instructor has a passion for the subject which may well be infectious for students. This, it is argued, is especially helpful with the more technically demanding or specialist subjects in secondary school such as English literature, history, mathematics and science.

Christine Ure of the University of Melbourne presented the findings of the Faculty of Education’s review of teacher preparation. The University of Melbourne is moving towards a more clinical approach to teacher preparation – that is, one which requires and supports beginning teachers to develop self-critical skills, which assist them to evaluate the effectiveness of classroom techniques so as to improve the outcomes achieved by particular groups of students. In particular, this approach requires greater coherence between teacher preparation and school life and more active interactions between universities and schools. This has led to a significant redesign of the practicum to improve the relevance of this experience, especially by improving the quality of mentoring and support available to beginning teachers by university faculty members.

Similarly, several speakers addressed the importance of continuing professional development for teachers. This is not simply a reference to the need to make available professional extension courses and similar devices to enable teachers to keep their subject matter knowledge current and keep up to date about the latest evidence about effective pedagogy. That is necessary, but in the view of some, not sufficient – and could be viewed as harmful if it is seen as a substitute for a genuinely student-centered approach. Rather, it

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also relates to the provision of school-based mentoring of teachers and the systematic gathering of evidence about the effectiveness of teaching practices at school level. Indeed, there was strong support for basing classroom practice on what research tells us works. These insights, however, represent a significant challenge for many schools. The challenge is to create a school based culture which not only sets high expectations for its students but accepts that students and teachers need both, in their own ways, to be learners. While an individual school may identify, locally, teachers skilled in evaluation and knowledgeable about the latest research on pedagogy, it was suggested that this does not occur routinely across Australian schools. Even more sadly, there are suggestions that reform of teacher preparation needs to proceed in tandem with changes in how schools are managed.

Otherwise, some beginning teachers, who may acquire enhanced appropriate technical skills and enthusiasm through their preparatory courses, may find that their skills are not recognised or valued by more experienced teachers or principals when they join the workforce. In these cases, the value of the society’s investment in better teacher preparation will be lost. The role of heads and their supervisors in providing encouragement and support to young teachers is often remarked upon.

The sadness is that some capable new teachers may lose their skills if not their motivation before they reach positions of influence within the school community if they are not appropriately nurtured in the workplace.

Kevin Donnelly of the consultancy Education Strategies took a stronger position than some on the importance of school autonomy. He wanted to free schools from ‘provider capture – a situation where bureaucrats, teacher unions and professional associations exert too much influence on schools and classroom teachers.’ He favoured a ‘light touch’ approach to regulation, to support school autonomy to ‘hire, fire and reward staff, to better reflect the aspiration of their local communities and to develop curriculum (core/elective) that best suits the needs of their students.’ He favours the employment of tax credits or vouchers to give parents an effective choice about where to send their children to school.

Funding

Concluding thoughts

Funding issues also attracted attention. Donnelly suggested that the OECD’s publication Education at a Glance ‘shows there is little, if any, relationship between levels of investment and performance as measured by learning standards.’ Gerald Burke presented data on funds flowing into government, Catholic and independent schools respectively. Student numbers have grown fastest in the independent sector over the decade to 2005, with primary school enrolments in that sector rising by more than 50 per cent (secondary student numbers rose 40 per cent). The student population of Catholic secondary schools rose 17 per cent, more than five times the growth of the government sector. Burke presented a range of data on the levels and sources of funding for each of the sectors over the period. These show, for example, that average school real income per student in non-government schools rose by 44 per cent in the decade to 2005, compared to 27 per cent in government schools. In absolute terms, real income per head in the nongovernment sector exceeded the level in the government sector in 2005, whereas the rankings had been reversed in 1995. Strong growth in Commonwealth government support, not matched by higher contributions from state governments in respect of public education, contributed to this outcome.

It is hard to fault the logic that higher status for teachers, better quality of teacher preparation, more effective school leadership, and accountability arrangements that reward and promote effective learning environments attuned to meeting legitimately high expectations for student learning outcomes are amongst the prerequisites to ensure that each young person can develop to their potential and participate fully in the economy and our society. At the conference, much of the debate focused on how to design systems and structures that lead to such outcomes.

To my mind, however, there is a large unspoken issue lurking in the background. Good quality teachers, effective teaching practices and demonstrated progress in securing better outcomes for students are clearly necessary to underpin improvements in the status and therefore attractiveness of teaching. The profession and those with leadership responsibilities in education policy have clear responsibilities to improve the policy frameworks within which schools, school systems and teachers work; and to be held accountable for results. But perhaps the community also needs to reassess its relationship with the teaching profession as part of a long term approach to giving children their best chance to reach their potential.

All too frequently, teachers of my acquaintance seem to be fearful that they do not have the support of parents in managing discipline, expecting high learning standards and requiring behaviours in classrooms that are conducive to learning. I wonder whether teachers reasonably believe they need more support than some now get from parents in order to do their job properly. There was no evidence presented at the conference that bears on this aspect. Perhaps this is a field best ploughed at another conference, on another day.

A recurring theme was the desirability of putting additional effort into meeting the needs of students from disadvantaged backgrounds or with personal needs. In addition to students drawn from families of low socioeconomic status, these groups include those with disabilities, students from indigenous backgrounds (especially outside of the major urban centres) and those whose principal language is not English. Tom Karmel of the National Centre for Vocational Education Research, however, focused on the needs of students at risk of failing to complete school and the potential contribution that vocational educating and training, including school-based delivery, may play in prolonging the attendance of certain young people beyond Year 10 and improving the job prospects of students.

Professor Sedgwick is Director of the Melbourne Institute of Applied Economic and Social Research at the University of Melbourne.

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occasional addresses by alumni at university of melbourne graduations

pursuing talents and confronting burdens Graduates should regard today not as the omega point but as the alpha point of their lives by james t riady

An edited version of the Occasional Address delivered at the graduation on 20 December 2007.

My observations over the years lead me to believe that many young people these days are without a clear sense of what they really want to do with their lives – even after graduation. I suggest that each of us has a place in history, and our rightful place will be set by where our skills and talents meet the ‘burdens’ that we confront. I shall explain what these ‘burdens’ are in a minute.

Pursuing our skills is most important. As we grow from childhood, we acquire a great many skills, some innately endowed to us. We should pursue the two or three greatest skills that become apparent in our lives. And when these meet our ‘burden’ – or our calling or vision in life – we then find ourselves a place in history.

Having a ‘burden’ means going beyond ourselves.

There is a tendency among the youth of today to think only of themselves and not beyond, yet I believe it is necessary to combine passion with compassion. You can nurture a passion for certain self-interested objectives but should combine it with compassion for something worthwhile and much bigger than yourselves. You should view the world with the right kind of glasses.

Most people today see the world as being in a state of unprecedented prosperity. All over Asia and Australia, we enjoy economic progress and

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prosperity – despite the current downturn in the stock market. As we look around, we see an unprecedented amount of wealth being created; we see great advancement in knowledge and in technology; and we also see concern for human rights and democracy.

However, I think we would be blind if we did not see the other side of the coin and the many problems around us today – the problems of terrorism and AIDS, the threat of avian flu, armed conflicts, hatred, immorality, divorce and the breakdown of families. I suggest that in contemplating our economic fortunes, we should also look at the other side of the coin. So in participating in and enjoying the growth of the world economy, we should at the same time have a heart for what I have referred to as a ‘burden’, namely, those problems that we see around us.

And we should say to ourselves: I want to take part in solving those problems.

To confront the burden without the necessary skills would lead to a frustrated life. Conversely, if we merely pursue our talents and avoid burden, we turn into machines. For the graduates of the Faculty of Economics and Commerce, there is the potential to turn into money machines. I therefore believe we must pursue

National economic regulation: the cost of (inadequate?) reform – an overview

both objectives – we must pursue and develop skills and accept and confront a burden. The meeting of these two sets will establish our place in history.

The Greek word, kronos, refers to the simple, chronological passage of time. Many things that we do in our lives will not be remembered 20 years later. But there is another word, kairos, which refers to those things in our lives which make a difference. Things that, 10, 20, 30 years later – maybe even a hundred years later – are remembered for making a difference; where people look back and say, ‘That was a wonderful thing to do.’

In today’s society, many people do not accept burdens because they are too focused on themselves – on ‘myself’ and ‘me’, and being at the centre of everything in society. Therefore, my message to you, distinguished graduates, as you go out into the world, is to remember that you should regard today not as the omega point, but as the alpha point of your lives – it’s just the beginning.

Dr James Riady is a Faculty of Economics and Commerce 1978 Alumnus. He is the Deputy Chairman of the Lippo Group, a major Indonesian conglomerate. The Group is involved in commercial banking, corporate finance, property development and investment, financial services, insurance, manufacturing, infrastructure development and investment, fund management and trust services, and venture capital investments.

Dr Riady’s success in developing profitable businesses in areas which promote the common good, such as education and health, and in a manner characterised by good corporate governance principles, was recognised on 16 February 2008 with the Australian Alumni Award for Entrepreneurship.

And as you project yourselves forward 10 or 20 years, you must ask yourselves: what kind of life do you wish to lead and what legacy would you want to leave behind? What kind of impact would you want to make on society? This calls for us to grow, to use our eyes to see things around us more critically and more deeply, not just at ourselves but beyond ourselves. It is by responding to the issues around us that we will establish our identity. I suggest that this is where we will find true joy and true fulfilment in our lives.

I congratulate you and trust you will be a blessing for very many people and make a great contribution to society.

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the importance of vision and people Seek to work alongside the best people who will challenge your ideas and assure your vision is achieved by laurence cox ao

An edited version of his Occasional Address delivered at the graduation on 20 December 2007.

You are the future leaders Today you join a distinguished club. The impact of this University’s alumni on the story of Australia is considerable. When I was standing in your shoes in 1960, graduating in commerce, my colleagues and I were unaware to what extent Australia’s future prosperity lay in our collective hands. Little did we know of the huge and imminent changes that would influence our future.

History’s view of Australia in the 1960s can be grim. We lacked confidence in our future. There were lingering concerns about communism, the White Australia policy was still on the agenda, and there were fears that emerging technologies were going to put us all out of work. Today our economy is booming and we boast one of the most sophisticated and envied economic management systems in the world. We have evolved from a rurally based economy to become a significant player in the new globalised world, not only supplying valuable natural resources but also providing education and financial services to our region.

Many of the business and community leaders of tomorrow are in this Hall. All of you will be involved in some form of leadership and with that comes great responsibility. Each one of you has professional competence that you are about to take into the community. Take heed of Paul Keating’s advice: ‘Leadership is not about being wise. It is about being right and being strong.’

The extent to which you succeed will depend on many things. It will not be measured only in dollar terms but also by the quality and balance of your involvement in the broader community.

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Pursuing talents and confronting burdens

Organisations large and small are also assessed today on their culture, their ethics and the extent to which they engage with the wider community.

Paying lip service to community responsibility is not an option. Unless ethics and community responsibility are part of your way of operating, I can confidently say you will not enjoy long-term success in the commercial world.

A varied – and valuable – career So what can I share of my journey, to give you some insight into the sort of leadership that will be required of you in the future? Over the years I have worn many hats, which have given me insights into the things that work in a professional career as well as the things that do not. Arriving at this University as a student in 1957 as the son of a Victorian farmer, I could not have dreamt of the opportunities that were about to be opened for me by my time here. Let me spell this out.

When I stood impatiently at my conferring ceremony over 40 years ago, I was about to join the stockbroking firm Ian Potter & Co. I became a young research analyst and was given the opportunity to work with and learn from the legendary Ian Potter, who later became a major benefactor of this University. His firm was regarded as one of the leading financial services companies of the day and, with the benefit of hindsight, it was a great privilege to learn from and watch one of Australia’s most insightful and visionary financiers at work. He was an old style leader but he lead from the front foot, clearly articulating his purpose. He took big but well thought out risks, and usually ‘got it right’.

Since those early days, I have had experience as a director of various listed companies – leading manufacturing groups, a pioneer in private investment in important public infrastructure assets, and one of Australia’s most successful international financial services organisations with assets and businesses in 24 countries around the globe. Each company provided me with an insight into different industries and hence the broader Australian economy.

I have also witnessed the development of the Australian securities industry through a variety of roles, including chairmanship of the Australian stock exchange and membership of the international advisory board of the Nasdaq stock market in the USA – the leader in using modern technology to recreate markets. I witnessed the transition of Australia’s closed parochial stockbroking industry as it was when I left university, into today’s national electronic market which is regarded as one of the most efficient and competitive in the world.

These changes were facilitated by well thought out deregulation plans from industry leaders working closely with government. Those leaders had a clear long-term vision for the future of the industry, and their decisions have a direct bearing for you as graduates. When you enter financial markets in this country, you will be stepping onto a truly global platform. And that is because of the foresight of people who helped to position Australia as a leading financial market attracting the world’s best players.

The lessons learned from these experiences gave me greater confidence in playing a leadership role in the various activities I have pursued.

My professional career has given me the opportunity to give back to the community through the chairmanship of the Murdoch Children’s Research Institute. Based in Melbourne, it is Australia’s largest medical research institute focusing exclusively on children’s health.

Vision and people are the keys to success What has emerged from all of my different activities is that the ingredients for their successful

outcomes have been almost identical. The two guiding principles that were vital in the success of these endeavours have been vision and people.

To have vision, you must have an idea of your strengths and what you want to do with them. You must be able to think outside the square and then have the courage to implement your ideas. As Tony Blair has said: ‘The art of leadership is saying no, not yes. It is very easy to say yes.’ To succeed in your vision you must work alongside people who are motivated and find fulfilment in what they are doing. For me, a choice between a team of brilliant people working in a low growth industry and a mediocre team working in a booming industry would always be easy – I would follow the talented people.

Equally, I have seen what does not work in the commercial world. One immutable truth that strikes me again and again is that those who succumb to greed will invariably fall and fail.

Sounds pretty obvious, does it not? Yet it is a recurring theme in the commercial world.

When I compare my early days with Ian Potter and my current experience at the Macquarie Group, most of the basics have changed very little.

Potter hired the best people, gave them freedom to innovate and lead them to operate with a high level of integrity and independence. Today’s Macquarie model is almost the same and it has produced one of our most successful domestic and international financial services groups.

The beginning of my business career was a time of regeneration of the underwriting and investment market in Australia, and also the opening of our market to international investors. I met industry leaders I had only read about in the press, visited international and Australian investors and began to establish close relationships with key clients. It was the strength of these relationships that would later give me the opportunity to be part of the evolution of the Australian stock market.

Moreover, in the years I have worked in both executive and board capacities, the importance of people and vision has been underscored.

Macquarie has for many years been more specific than many other corporates about its goals and values. These are not just part of the ‘about us’ section on the company’s website – they are Insights Melbourne Economics and Commerce

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actually set out in the operating manual for all staff. And they are pretty blunt: – Strive for profitability; – Work hard for clients; – Provide the highest standards of technical excellence; – Act with integrity; – Encourage teamwork; and – Deliver fulfilment for people.

Of equal importance to client commitment, profitability and technical excellence is the value Macquarie places on its staff.

Macquarie’s values are similar to the tenets that drove Ian Potter & Co. – which were to hire the best people and give them autonomy and fulfilment. Of course, there are some striking differences in today’s environment: – Management structures are flatter – greater responsibility is devolved down the line. As new entrants to the workforce, you would be given responsibility at an early stage.

– There is an entirely different level of disclosure and public scrutiny in all parts of the corporate world and this is impacting significantly on governance structures.

But the key elements to success have not changed much over the years. Any organisation’s real strength is its people – their integrity, the way they work together and the fact that they are fulfilled.

Community responsibility Using Macquarie as an example, it becomes clear that encouraging links with the not-for-profit sector promotes a fulfilled workforce. Macquarie’s charitable foundation encourages staff participation in the not-for-profit sector. Community groups not only receive grants, they also receive volunteer support from Macquarie employees. More than 60 staff currently serve on not-for-profit boards and thousands more work with not-for-profit organisations for which they have a personal passion. Macquarie’s reward is a fulfilled workforce – the broader reward is a transfer of skills and dollars to organisations that need it.

As mentioned above, my experience is with the Murdoch Children’s Research Institute, which has a close association with the University of 36

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Melbourne’s Department of Paediatrics. The Institute has grown from around 100 staff in the 1980s to over 750 today, and has led to major improvements in child health in areas such as small pox and polio, and contemporary problems such as child obesity and juvenile diabetes. The exceptional vision and leadership skills of those undertaking this groundbreaking research has enabled the Institute to obtain increased funding from both the government and the corporate sector. I have gained huge personal satisfaction from my ongoing involvement in these activities.

Vision for the future As graduates about to enter the workforce, the next few years will be challenging. However you should look further ahead and establish long-term goals about how you want to conduct yourself. Remember, you are leading yourself. Take responsibility for thinking through difficult problems, make wellconsidered decisions, and carry a map of the future.

You must be challenged but your vision must be achievable. And above all, it must stand the test of time. Seek to work alongside the best people who will challenge your ideas and assure your vision is achieved. This approach has given me the most important thing I value from my career – a sense of satisfaction of having helped to make a difference.

I hope you find that it works for you.

Mr Laurence Cox AO is Executive Director of the Macquarie Bank Limited and Joint Chairman of the Macquarie Corporate Finance Group. He is also a Director of OneSteel Ltd and Chairman of SMS Management & Technology Ltd. Prior to joining Macquarie Bank, Mr Cox was Executive Chairman of the Potter Warburg Group of Companies in Australia and a Director of S G Warburg Securities of London. He was Chairman of the Australian Stock Exchange Limited from 1989 to 1994 and was a Director of ASX from its formation in 1987. He was also a member of the Nasdaq Stock Market International Advisory Board from 1992 to 2001 and the Executive Committee of the Federation Internationale des Bourses de Valeurs from 1990 to 1992.

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 2008 Š The University of Melbourne

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