Insights Volume 5 April 2009

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INSIGHTS Melbourne Economics and Commerce volume 5 april 2009

The causes and consequences of the current financial turbulence By Raghuram G Rajan

A tumultuous year By John A Fraser

Voodoo banking By Satyajit Das

Reversing the divergence of the bottom billion By Paul Collier

Reflections on microeconomic policy frameworks and a suggestion about fairness By Jonathan Pincus

What’s been happening to United States income inequality? By Richard V Burkhauser

Occasional adresses By Anthony R Burgess, Michael Andrew and Rupert Myer AM


Welcome Insights publishes condensed and edited versions of important public lectures connected with the Faculty of Economics and Commerce. Its object is to share with the wider public – especially alumni – the issues presented and developed in these lectures. Our goal is to provide readers with access to expert opinion on complex issues and make available some of the extensive resources that are freely available. Insights also constitutes an archival source of an important element in Faculty life. Our last issue went to press when the financial crisis had burst on to the world. We were too late then to include the public lectures given to the Faculty – we make up for it in this volume. The substance of the crisis is represented dramatically on the cover by the panicking bull falling precipitously down the wall of the stock exchange; while the bear, its claws drawn open, rises aggressively to take its place. The first three articles deal with the crisis, complementing each other by analysing in detail different aspects of it. Each makes tentative suggestions for avoiding such a disaster in the future. The next article, drawing on the Marshall Plan experience, discusses what needs to be done to lift the living standards of the one billion people who are at the bottom of the world economy. Introducing an element of behavioural economics, the following article argues in favour of qualifying economic efficiency measures in micro-economic public policy by considerations of ‘fairness’. This is

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: Professor Robert Dixon Professor Bruce Grundy Professor Bryan Lukas Illustrator: Ms Sonia Kretschmar Design: Ms Sophie Campbell

followed by a statistical exercise based on US statistics, which shows that a more meaningful account of changes in income inequality is provided by excluding the top one percent of incomes from the calculation. Finally, three Occasional Addresses by distinguished alumni give us the benefit of their professional experiences. Once again, we have been most fortunate with the design and illustrations of the journal. Sonia Kretschmar has applied her talent to give life and visual meaning to the articles. My thanks are also due to the team for another stimulating issue. We are encouraged by the continued favourable responses from readers. The interest in Insights continues to be reflected in the large number of individuals who access the journal in its online form at http://insights.unimelb.edu.au/. Joe Isaac Editor jei@unimelb.edu.au


insights vol 5 Table of contents 03 The causes and consequences of the current financial turbulence

By Raghuram G Rajan We should accept that competitive financial systems carry the risk that they will collapse periodically. The task should be how best to deal with this risk.

11 A tumultuous year By John A Fraser The crisis in global financial markets has raised a welter of critical issues for financial institutions, regulators and governments that cover all aspects of the financial industry and approaches to macroeconomic policy

17 Voodoo banking By Satyajit Das Elite athletes often use performance enhancing drugs to boost performance. Voodoo banking operated similarly, enabling banks to enhance short-term performance whilst risking longer-term damage.

25 Reversing the divergence of the bottom billion

By Paul Collier What America did for Europe after 1945, we must now do for Africa

31 Reflections on microeconomic policy frameworks and a suggestion about fairness

By Jonathan Pincus In assessing economic efficiency, economists need to take into account that most people value losses more negatively than they value gains positively

37 What’s been happening to United States income inequality?

By Richard V Burkhauser Properly adjusted, for at least the bottom 99 per cent of the income distribution, the rise in income inequality since 1993 has been small

Occasional Addresses 42 Navigating the world of opportunity By Anthony R Burgess Practical pointers to the challenge of navigation

44 How your university experience will shape your future life and career

By Michael Andrew While education in the classroom is important, much of the learning at a university takes place outside the classroom

48 On leading more than one life By Rupert Myer AM Acknowledge the personal sacrifices of others, think creatively and be imaginative, give of yourself in public service and exercise humility

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the causes and consequences of the current financial turbulence We should accept that competitive financial systems carry the risk that they will collapse periodically. The task should be how best to deal with this risk. by raghuram g rajan

An edited version of the David Finch Lecture given at the University of Melbourne on 5 November 2008. The Lecture was established through the generosity of C David Finch, a distinguished alumnus of the University.

The proximate causes of the crisis The global financial crisis has two basic elements. One is that bad loans and bad investments were made, especially by the banks, resulting in excessive credit. The second element is that these were financed with a substantial amount of leverage based on short-term borrowing. I will argue that these two elements led to a sequence of events. But first, a number of questions need to be considered: Why were these bad loans and investments made? And why were they financed on such a short term? To answer these questions, it is necessary to go back in time. In the late 1990s, the emerging markets faced yet another financial crisis. This occurred in Asia, especially East Asia; in Latin America, especially in Brazil; and Russia. The response this time was a little different from earlier responses. A number of countries, in East Asia in particular, decided to protect their economies effectively by managing their exchange rates to keep them as competitive as possible. This would increase exports and build up reserves as a buffer against any possible future turmoil. So rather than absorbing savings from the rest of the world, many of these countries began to export savings, becoming net exporters of capital. The Latin American countries eventually also followed this course, both Brazil and Argentina running

large surpluses. The upsurge of commodities prices generated surpluses in a number of commodity exporters. Where were those savings being absorbed? A good use of such financial savings in one part of the world would be if investment somewhere else increases to absorb those savings. For a time, that happened in the industrial world. In the case of what became known as ‘the information technology bubble’, a lot of investment took place in industrial countries, perhaps excessively so. When that bubble burst, corporations in industrial countries became very cautious about investing. Nonetheless, stimulated by expansionary monetary policy, demand increased in two areas. One was household consumption, especially in the US, and the other was residential investments. A lot of money went into expanding housing, increasing asset prices and construction. All this was to the good, at least for a while. Prices of houses rose in a number of countries – Ireland, Spain, the UK and Australia. The crisis first emerged in the US. Why the US? It had an extremely innovative financial sector. It saw a mismatch between the investment opportunities that were emerging in the real estate sector, and the financial savings that the rest of the world wanted to supply.

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The alchemy of turning lead into gold However, a central bank in Asia or an insurance company in Germany, for example, would be extremely reluctant to buy a local mortgage from a US bank because they would know nothing about the borrower and would be concerned about the liquidity of such an asset. To get over this problem, the local mortgage needs to be converted into a financial asset that the rest of the world is willing to buy. The US financial sector was very good indeed at this conversion process. It converted local mortgages into AAA-rated financial assets that the rest of the world would be willing to buy – a process of alchemy by which the lead of local mortgages was turned into gold that the rest of the world wanted to buy. These ‘subprime’ mortgages, made to borrowers who had little credit history, no employment security and no asset backing, were packaged together and then sold to international markets!

The driving elements How was this possible? One element driving this process was that house prices were rising. Initially, those who got loans were credit-worthy; but as house prices kept rising, the risk of lending even to borrowers with no credit standing disappeared. Houses were effectively liquid assets and if borrowers defaulted, their houses could be sold without loss to the lender because house prices would have appreciated further. Alternatively, borrowers for housing could be attracted by low interest rates because they could sit comfortably at the end of the year on a ten per cent equity appreciation that would allow them to refinance at the lower rates.

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first lot of defaults could be absorbed by buffers, called the equity tranche. Where there is very little risk of further default, higher rated securities could be issued. For example, assume that $100 of mortgages are taken out. Against these mortgages, the following are issued: $10 of equity tranche, $10 of BBB-rated securities, $5 of A-rated securities, $5 of AA-rated, and $70 of AAA-rated securities. Why seventy dollars? Because the risk of defaulting for the AAA-rated securities requires 30 per cent default on the mortgages. This is unlikely, and was hence the logic behind the mortgage-backed securities. However, the innovators were not happy to stop here. Having squeezed $70 of AAA-rated securities out of the mortgages, they could go further. The BBB-rated securities issued by the packages were then put together in a fresh package called collaterised debt obligation (CDO), against which 70 per cent of AAA-rated securities could be issued. The process of converting into AAA-rated securities could go on – CDO squared, CDO cubed – so that $100 of mortgages could be converted into $85 of AAArated securities and sold to the rest of the world. This was the process of securitisation and it went on for some time.

Consequential problems

Thus, on the one hand, rising property prices would cover all potential credit risks; and, on the other hand, banks had the ability to package and sell these loans in the international market.

There are, however, at least two problems. One is that these are very complicated securities with varying degrees of risk. They trade easily only if the chance the borrower will default is small. Once substantial defaults occur, these securities are in serious trouble because they are relatively new to the market. Moreover, when house prices fall across the US, the diversification that investors felt they had by buying packages of mortgages from all parts of the country becomes irrelevant.

The process works something like this. A local bank would put together in a package, say, a variety of 2,000 loans it had made to households. It would issue securities against that package. Based on past experience, some two per cent of these packaged loans could be expected to default. So if two per cent of the loans defaulted, then the

The complexity is magnified by the fact that there is very little information about the borrowers and their credit worthiness. As was noted earlier, that did not matter when house prices were rising and mortgages continued to be serviced. However, once house prices stopped rising, such information mattered a great deal – but was not readily available.

The causes and consequences of the current financial turbulence


The other problem, which the originators of these securities did not understand fully, is that as the securitisation process goes on, the value of information about the credit worthiness of packages also starts to drop off. In the late 1990s when a loan officer made a loan to somebody with a certain credit quality, they did not stop at asking what the credit quality was. They went further to assess more subjectively the reliability and honesty of the borrower in a process known as seeking ‘soft information’. In the circumstances, the result of this form of information-gathering is that there was very little correspondence between the public credit rating of the individual and the interest rates that were charged for different individuals. The credit rating was only the first step in the process of gathering information to be supplemented by ‘soft information’. However, by 2005 there was a very close correspondence between credit ratings and interest charged. Why? Because banks made loans knowing that they were not going to hold on to them but were going to sell them to the securitised market. So they had no incentive to qualify the credit rating by soft information. Thus, the credit quality of the loans looked better on paper than they actually were. In the US, there is a credit rating called the FICO Score (Fair Isaac Corporation) as a measure of the borrower’s credit quality. This is the guideline used by Freddy Mack and Fannie Mae.1 A credit quality rating at and above 620 would allow the loan to be securitised and sold in the markets. Two things happened when this was introduced. One, not surprisingly, was that the number of loans just above 620 took a quantum leap, suggesting that securitisation made more loans available. The other, and unexpected, outcome was that those with a score above 620 (with securitised loans) were more likely to default than those below 620 (not securitised). This suggests that securitising reduces the incentive for lenders to be concerned about the quality of the loans. Thus, there was a steady deterioration in the quality of loans – even though, on paper, their credit score was higher.

Who is to blame? When did the system break down and who is to blame? One factor is a lack of knowledge about the quality of the securities. Buyers of securities in Asia and Europe were willing to accept securities so long as they were highly rated. However, it was difficult, even for the financial experts, to distinguish between triple-rated securities that were CDO, CDO squared or CDO cubed. The degree of risk varies greatly between them. An AAA-rated mortgage-backed security would probably be trading at 60 or 70 cents in the dollar while an AAA-rated CDO cubed would be trading for 20 cents in the dollar. The second factor is the work of the rating agencies. Product rating became a big part of business for agencies like Moody and Standard & Poor, and they had very little incentive to drive away business by being tough on ratings. It is arguable that they should have recognised that this was a new kind of financial instrument which they had little experience with, and that it was different from corporate debt securities. Therefore, they should have been more cautious about their ratings. Alarm bells should have rung as these securities were paying 50 and 100 basis points above AAA-rated corporate securities. Investment banks were also to blame. They should have known that they were packaging securities with varying risks, which the market was prepared to buy. Their confidence was reinforced by the fact that the investment banks that put together and sold these securities held on to the riskiest portions themselves as a sign of good faith on the quality of the packages, although many sold these holdings later. Finally, many of the homeowners cannot be absolved from blame. They would have known that they could not afford the loans they incurred but were perhaps deluded by the prospect of a ‘free lunch’.

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A puzzle – the case of Citibank

The regulatory standpoint

One of the intriguing questions is why the banks held on to these securities? They had huge amounts of them, not just for inventory purposes but also as investments. One possibility is that they really believed in their product. Any risk would be in the category of a ‘one in a thousand year flood’. But this is surely an illusion because it seems to happen every 10 to 15 years with regularity. Citibank has been in trouble three times in the last three decades – in the mid-1980s because of loans to developing countries; in the 1990s because of real estate loans, until it was rescued by a Saudi prince, who injected a substantial amount of equity into the bank. And now because of loans made in the mortgagebacked market. It is a worry when the largest bank – indeed perhaps the icon of American banking – is in trouble every 10 to 15 years.

From a regulatory standpoint, as the cycle progresses, risk management becomes less and less able to exercise control on risky activities. As long as the cycle progresses, the risks do not show up. At the point of maximum danger to the bank, risk management may be at its weakest. Risk control mechanisms seem to break down all the time. It is not that boards are stupid. They are made up of clever people. Robert Rubin is one of the smartest treasury secretaries. At Citigroup, though, he looked on while it suffered more than $72 billion in losses.

One possible explanation is that there was a great deal of competitive pressure. In the words of the Chairman of Citibank, ‘When the music stops, in terms of liquidity, things will be complicated. But so long as the music is playing, you’ve got to get up and dance.’ Merrill Lynch went into mortgage-backed securities in a big way because it saw Goldman Sachs making a great deal of money from it. The ‘herd mentality’ seems to plague financial markets. It also appears that the left hand of the bank did not understand what the right hand was doing. Those who were packaging the loans did not fully indicate their quality to those who were making the loans. For example, the investment banking unit of UBS borrowed at UBS’s cost of capital, investing in AAA-rated mortgage-backed securities, thereby making a spread of 15 to 20 basis points. This does not look like a lot of money, but when multiplied by a trillion it amounts to a great deal. There is a saying in the financial markets: ‘There is no return without risk.’ Why were they making 20 basis points extra if there was no risk? Top management did question the wisdom of such a large volume of investment. But their voices were drowned by the argument that the investment bank was making two to three hundred million dollars in profits every quarter.

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The causes and consequences of the current financial turbulence

The debate will go on for some time, but it does seem there was a total breakdown in governance and in the compensation structures of the banks. To draw a simple analogy: the banking system was writing earthquake insurance – it was taking long-term risks, but the premiums collected were not set aside as reserves for the day the earthquake actually happens. Instead, the premiums were being paid out as bonuses and dividends to shareholders. When the earthquake actually happened, the banking systems were grossly under-capitalised and there were no reserves to draw from. The compensation structures were such that payments were made for short-term performance.

Leverage As noted, a critical issue in the crisis is the extent of leverage. Short-term leverage is perhaps the cheapest form of financing when risky activities are undertaken. Short-term borrowing was rolled over relatively risk-free because there was an ample supply of finance. Moreover, borrowing short-term was cheaper than long-term, especially where financial institutions were taking substantial risks, as it allowed the lender to get out more quickly. Short-term debt was also preferred because of the market’s reliance on the ‘Greenspan Put’ policy, which stated that, if a serious downturn eventuated, the Federal Reserve would facilitate liquidity promptly and cut interest rates sharply. This factor may have added to acceptance of the large volume of illiquid assets financed with short-term debt.2


The elements of the crisis as it unfolded

find $41 billion of securities and had to go to the Federal Reserve for financial support.

Eventually house prices stopped rising and mortgage defaults began to increase. The equity cushion provided by rising house prices in refinancing loans disappeared. As the mortgage defaults mounted, the securities issued to back these mortgages became difficult to price. Suddenly, the market stopped accepting the securities that the investment banks had financed by borrowing short in the market. Banks became illiquid. For example, Bear Sterns was unable to

The second stage of the illiquidity problem emerged as these mortgage-backed securities continued to fall in value because the banks were essentially insolvent, the size of the losses having eliminated their capital backing. The maturing of their short-term debts compounded their insolvency. Long-term debts are sustainable because the day of repayment is some distance away and the insolvency problem can be deferred. Not so short-term debts.

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The myth that bank deposits or debts can be repaid only holds so long as most creditors of the banks do not call for their money on the same day – because banks hold most of their assets in illiquid securities. Mechanisms have been developed – such as deposit insurance and borrowing facilities from the Federal Reserve – to deal with any potential run on the banks. However, while these mechanisms were available to commercial banks, they were not available to investment banks. When a run started on Lehman, the Federal Reserve and the Treasury were not willing to support them financially. The result was a run on Goldman Sachs and JP Morgan; and on a number of banks in Europe in panic mode. With the benefit of hindsight, it appears that the response of policy has always been one step behind the event. Policymakers thought the problem was inflation when it was illiquidity. They started tackling liquidity when the problem had already developed into insolvency; and they started tackling insolvency when the problem had turned into full-scale panic. Eventually they found themselves having to deal with full-scale panic. In the US – and this may change with the new administration – the remaining problems in the system are not being fixed in time. Ideological issues have intervened. Right-wing ideology is resistant to large scale public intervention, despite the fact that the private sector is in great trouble and needs intervention. To intervene marginally is the worst form of intervention. While it is desirable to avoid intervention, when public money is at stake, everything necessary should be done to ensure the safety of such money and to put the system back on track. At present, this is not being done. There is a mistaken belief that money pumped into the large banks will somehow find its way into the rest of the undercapitalised banking system. Such a course could lead to the banking system being cartelised by a few leading banks. To some extent, this was happening with the Bank of America, Wells Fargo and JP Morgan taking over large banking assets. However, it is unlikely to go much further. The remaining banks that the Treasury is not willing to capitalise will remain in

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The causes and consequences of the current financial turbulence

difficulty. To deal with them effectively will probably require major intervention in order to decide whether they should be closed down or kept alive with financial infusion. Yet it is unlikely that the US authorities would be willing to undertake such a course, which means the problems could continue to fester. Recovery may come in time but it is possible that things could get worse, and intervention on the scale needed will be undertaken.

Some lessons First, it should be understood that the entire financial system is integrated not just within a country, but across the world. Problems can emerge from anywhere and infect the rest of the system. We have had runs on banks in India and Hong Kong, based on some notion that they may be exposed to crashing prices, when in fact the exposure was not that great. Second, in monitoring risks, regulators are often focused on the wrong places. Before this crisis, much attention was on hedge funds in the belief that hedge funds were going to be the problem. In fact hedge funds, especially the larger ones, are generally well managed. They have fairly good incentive systems in place and fairly good risk management structures. Third, there is an increasing tendency to regulate the financial system more strictly by imposing much higher capital requirements on the system. However, this becomes part of the problem. By imposing large capital requirements, a great deal of banking activity was driven from the regulated part of the system to the unregulated part. The Structured Investment Vehicle3 (SIV) was in some sense a way for commercial banks to arbitrage – as in, to avoid – capital requirements by creating entities that were not subject to capital requirements. These eventually turned out to be banking risks because they came back on their balance sheets. A great deal of our regulation assumes that management has control and cares about the long run. However, the problem has been that management did not have control and did not care about the long run. This is a governance


problem, and unless it is fixed, regulation has no hope in doing anything useful. Having a variety of institutions helps. Things could have been much worse but for the deep-pocketed investors – the sovereign wealth funds and the Warren Buffets of the world – who have helped to stabilise the system.

A final thought We keep hoping to create a financial sector that is stable. However, we should accept that competitive financial systems carry the small risk that they will collapse periodically. Rather than writing more and more ‘fire codes’ to prevent the fires, we should recognise that fires will happen. This is not to say that we should not keep trying to get things right; but it should be understood that fires will break out. Accordingly, more time should be spent in making sure there are sprinklers to put out the fires, rather than simply writing fire codes. In other words, let us make sure that when a crisis occurs, the private sector does not just dump it into the lap of the public sector to deal with it. Instead, the private sector should be required to devise a mechanism by which it, rather than the taxpayer, bears the cost of any breakdown in the financial system. This calls for further thought. In this connection, it has been suggested that a form of insurance, called capital insurance, should be available to enable firms and banks to buy a form of insurance that may help to reduce serious consequences of a financial crisis.4

Professor Raghuram Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Graduate School of Business. Prior to resuming teaching, Professor Rajan was the Economic Counselor and Chief Economist at the International Monetary Fund between 2003 and 2006. He currently chairs a high level committee set up by the Indian Planning Commission to propose financial sector reforms in India. Professor Rajan’s research interests focus primarily on economic development, and the role finance plays in it. His papers have been published in all the top economics and finance journals, and he has served on the editorial board of the American Economic Review and the Journal of Finance. He has also written a book with Luigi Zingales entitled Saving Capitalism from the Capitalists. In January 2003, the American Finance Association awarded Professor Rajan the inaugural Fischer Black Prize, given every two years to the financial economist under age 40 who has made the most significant contribution to the theory and practice of finance.

1 The Federal Home Loan Mortgage Corporation (Freddie Mack) and the Federal National Mortgage Association (Fannie Mae) are government sponsored enterprises buying mortgages in the secondary market, and selling them to investors as mortgage-backed securities. Both are directed to assist home ownership of low and middle income families. 2 Data six months ago show that the banks with the greatest short-term leverage and the least amount of capital were the ones that suffered most in terms of stock prices when the crisis hit. 3 An institutional entity based on funds borrowed on shortterm securities at low interest rates (close to inter-bank interest rates) and buying long-term securities at higher interest rates. 4 See Anil K Kashyap, Raghuram G Rajan and Jeremy C Stein, ‘Rethinking Capital Regulation’, Federal Reserve Bank of Kansas City symposium on ‘Maintaining Stability in a Changing Financial System’, Jackson Hole, Wyoming, August 21-23, 2008.

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a tumultuous year The crisis in global financial markets has raised a welter of critical issues for financial institutions, regulators and governments that cover all aspects of the financial industry and approaches to macroeconomic policy by john a fraser

An edited summary of the Third International Distinguished Lecture to the Melbourne Centre for Financial Studies on 26 November 2008. The full Lecture is available at: http://www.melbournecentre.com.au/files/John_Fraser.pdf

Background – a euphoric period Prior to the current crisis, a remarkable 14-year or so economic expansion had produced growth in virtually all parts of the world. This had been a euphoric period with the globalisation of world economies, the attendant reduction in trade barriers and the massive increase in goods coming from new powerhouse economies such as China. There were also huge capital flows from the Middle East, Asia and Russia. Growth regularly exceeded expectations, governments saw revenues bloated by asset prices and consumer price increases remained low. That prosperity blinded governments, the financial sector and the community to what are now clearly seen as warning signs. In particular, too many cheered on asset price inflation. There seemed to be no asset untouched – homes and holiday houses, artworks, racehorses, yachts and companies all became more valuable. And we convinced ourselves that this was due to a new era of global economic interaction – and that it would somehow last forever. However, asset price inflation is and was inflation. It was overly accommodated by various monetary authorities who ignored the very clear signal that the economy and, through it, the financial sector was travelling far too fast – at a pace well in advance of proper understanding of the systematic risks.

During this period of world expansion, two industries did especially well ─ information technology and finance. They were globalised, relied on continuous innovation and grew swiftly in both the new and old economies. But, just as the ‘tech boom’ came to an abrupt end in 2000–01, we are now seeing a fundamental recalibration of the financial sector. Its longterm average share of total profits within the Standard & Poor 500 was around 15 per cent but peaked in the past few years at 21 per cent. The financial sector is now undergoing a correction which, by any terms, is a very major and painful one. Not only in the world generally but also in the financial sector, recognition that a crisis was brewing was very slow. Even two or three years ago, people were lauding the low mortgage interest rates being provided to low-income earners in the US as allowing the disenfranchised to achieve home ownership. We also saw similar trends in Western Europe. There were a few voices that rightly warned about the massive increase in household, corporate and financial sector debt levels, but they were generally either disparaged or ignored.

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Emerging problems For the banking system, the full extent of the problem started to emerge in the northern summer of 2007. It was not so much that the mortgage-backed securities were starting to fail but that there was growing unease that the hedges put in place in the event of default were, at the very least, sub-optimal. The very size of the investment banks, the ever-expanding global stretch, the internal reporting of positions in net rather than gross terms and the complexities of management layers all made recognition of the problem that much more difficult. Adding to it was a lack of communication between banks because of their fear of being accused of anticompetitive behaviour. Fear of breaching stringent reporting rules and Sarbanes-Oxley (SOX) strictures1 also played a part. By contrast, in the 1980s and early 1990s, the regulatory authorities seemed to have had good communication with all the major financial institutions. The world and the institutions were less complex, and investment banks did not rely anywhere near as much on proprietary trading for income. This all made for an environment where central banks could oversee the industry at a national level in a more collegial way, and where problems could be more readily identified and discussed. We cannot ignore, however, the fundamental change in the financial sector. In the 1990s, aided by globalisation and accommodative monetary conditions, investment banks grew dramatically. Moving into new markets, managers had to run increasingly complex and diverse businesses across more and more countries. Importantly, banks also started to rely heavily on proprietary trading, not just in fixed income but also in equities and exchange rates. There was also the rapid growth of complex financial instruments – also known as ‘structured products’. They put far more risk on their balance sheets and this made investment banks far more vulnerable, as did the later move to place risk into off-balance sheet vehicles. Early assessments in 2007 significantly underestimated the financial sector problem, which

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escalated sharply in 2008. Concerns about mortgage-backed securities emerged slowly, but then rapidly spread to the whole array of so-called sophisticated instruments. All this was brought into sharp relief by the need to mark-to-market2 instruments in increasingly illiquid markets. This led to a total breakdown in the confidence that had previously allowed banks to borrow and lend among themselves – and clients began to question the security of both their deposits and their relationships. Because UBS listed on the New York Stock Exchange, I sign off many SOX accreditations for Global Asset Management; our internal and external audit processes have never been more intrusive; and the legal, compliance and risk area in the financial sector has grown more than any other. Nonetheless, the problems were all missed.

Risk management For all the resources devoted to risk, I believe there had been an undue focus on operational risk and credit risk in the investment banks, while the gorilla of market3 risk was quietly eating all the bananas in the corner of the room. That was a fundamental problem. Few pointed to the overarching market risks. We had become victims of undue reliance on quantitative measures of risk. But those measures were necessarily backwardlooking, to an era that, in large part, no longer pertained in the financial sector. Securities had multiplied in their coverage, complexity and volume. But we were drawing on 20- to 30-yearold data to work out the probabilities of default. We need to rethink risk management. The way forward for risk management should be a marriage of modelling based on past behaviours with far more forward-looking judgment. It should be not unlike how good macroeconomic forecasting is undertaken. Similarly, we have to make sure risk management lies at the very heart of business management. I chair the Risk Committee of Global Asset Management every month and I do it in an intrusive and often obnoxious way. There is no alternative to really knowing your business in


assessing risk. As CEO, when you know more about the businesses of your direct reports than they do themselves, then you have a risk issue! Risk is as much about people as about process – and that is especially the case when, as in Global Asset Management, we are operating in 27 countries with different cultures, regulatory regimes and market structures. Some accuse the regulators of not recognising the problems. But it was an incredibly difficult task to be a regulator in this environment. The speed with which the financial sector grew, the globalisation of that financial sector and

remuneration trends have meant that regulators often really struggle to hire – let alone keep – people who can keep abreast of the financial markets. We need to have good regulation and we need to pay those people appropriately; recognising that it is a small impost relative to the potential costs. We must also recognise that they alone cannot guarantee a trouble-free environment. Senior management and Board members need to be held personally accountable. While much of the focus of regulation has been on capital adequacy, that needs to be broadened to include the size and the nature of the balance

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sheets, the concentration of risk and, most importantly, liquidity. We all took liquidity as a given but, as we have seen with confidence, it is one of the first things that dries up in a crisis. We must also recognise that investors cannot be protected from poor decisions. The investment community must take responsibility to avoid stupid actions. Regulation in this regard must focus on better presentation of likely risks and, perhaps, a more formal and comprehensive acceptance by clients that they understand the risks. After 20 years in the public service and now 15 years in asset management, I still raise an eyebrow at the remuneration practices in the financial sector.

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A tumultuous year

They have become bloated, very short-term in focus and fixed rather than variable costs. In many respects, the total remuneration has been well beyond what would be necessary to retain and motivate the key people – and this has cascaded throughout the organisation so that support and other staff are paid well in excess of what is needed for recruitment and retention. These remuneration practices are now under review – yet one of the things that has boosted this hike in remuneration levels, perversely, has been the pursuit of transparency in remuneration. It has provided a comprehensive databank that every CEO or senior executive can reference, pointing to competitors’ remuneration levels, locally and globally – all providing a highest


common denominator. A further observation on remuneration – we are prevented, in large part by SOX regulations and accounting conventions, from smoothing bonus pools from one year to the next. It seems crazy that, in good years, we could not bank some of the bonus pool for the next year. Government rescues of banks have been very sad for all who prefer capitalism – whatever that means these days – but they were necessary. I saw the queues at banks and ATMs in London when Northern Rock crashed. The week when Lehman Brothers was allowed to collapse was truly frightening. The financial sector has a special place within our economy but I think the sector should be made to pay heavily for this. The current crisis will be with us for the next three years or more, and governments will increasingly run or influence banks for some time to come. Bankers who complain about this are being very hypocritical – there really is no alternative. It is the price they must pay for the greed, arrogance and stupidity of the binge of the past decade or so. The Australian financial sector is better placed than elsewhere but we should not be too smug. We have had the benefit of living through our own corporate crisis in the 1980s and a very real banking crisis in the early 1990s. We have also had virtually three decades of good economic policy with our fiscal responsibility now standing us in a better position to face a possible recession, unlike much of Western Europe. We have learnt from all of this, and it is one of the reasons why our financial sector and the economy more generally still look pretty good from the other side of the world.

pressures on public finances intensify in a way not foreseen a year or so ago. The industry still has a great future; but it has to learn from its experiences and become a little bit more sober and more humble. It needs to recognise there are very real social responsibilities. To the extent that asset managers under-perform, people suffer and governments face higher social welfare costs. We should expect more oversight by regulators and more focus on providing not just returns but also liquidity and security when needed.

John A. Fraser, Chairman and CEO of UBS Global Asset Management, is a member of the UBS Group Executive Board and Chairman of UBS Saudi Arabia. Prior to joining UBS in 1993, he served as Deputy Secretary (Economic) and spent more than 20 years with the Australian Treasury, including postings at the IMF and the Australian Embassy in Washington D.C. He has been resident in London since 2002.

1 The Sarbanes-Oxley Act 2002, is a US federal law enacted following the Enron and other financial scandals, in order to raise corporate accounting standards. 2 An accounting method of valuing a financial instrument based on its current price rather than on its cost. 3 Risk arising from general economic changes that affect the market.

Finally, a comment on asset management. There is clearly a much-heightened aversion to risk that will remain for some time. That said, the asset management client community has been remarkably sophisticated in reacting to this crisis and it is a credit to trustees, consultants and the clients generally. The long-term growth of the asset management industry will not change. The ageing of the population will be an even bigger factor now because many will have to redouble their efforts to provide privately for their retirement savings. Governments will be even less able to support retirement incomes as the Insights Melbourne Economics and Commerce

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voodoo banking Elite athletes often use performance enhancing drugs to boost performance. Voodoo banking operated similarly, enabling banks to enhance short-term performance whilst risking longer-term damage. 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 12 February 2009.

CitiGroup recently announced that it was seeking Board members who had ‘expertise in finance and investments’. What was the previous experience and expertise of the CitiGroup Board and senior management – the one that has registered more than US$50 billion in losses? Banking, especially investment banking, has delivered strong returns to shareholders in recent years; but the ‘high’ returns of financial stocks and the future earning prospects need careful examination.

Displacing the traditional banking model Until the early 1980s, banking was highly regulated. It was the world of George Bailey, played by Jimmy Stewart in It’s A Wonderful Life. Community banking was the rule. The banker could dip into his ‘honeymoon money’ to stave off a potential bank run. It also fueled jokes – the ‘3-6-3’ rule was to borrow at three per cent; lend at six per cent; hit the golf course at three p.m. Once deregulated, banks evolved into complex organisations providing varied financial services. Deregulation brought benefits for the economy, including better access to capital and more varied investment opportunities; and for the banks, growth and higher profits. Over the last 15 years, increased competition – within the industry and increasingly from nonbanking institutions – and the reduction of earnings from the standardisation of products,

forced banks to rely on ‘voodoo banking’, or performance enhancement to boost returns. Focus on risk-adjusted returns – introduced in the early 1990s by JP Morgan and Bankers Trust – changed the ‘business model’. Traditionally, banks made loans that tied up their capital for long periods, for example, up to 25 to 30 years in a mortgage. In the new ‘originate to distribute’ model, banks ‘underwrote’ the loan, ‘warehoused’ it on the balance sheet for a short time, and then parcelled it up with other loans and created securities that could be sold to investors, a process known as ‘securitisation’. The bank tied up capital for a short time until the loans were sold off and then the same capital could be reused and the process repeated. Interest earnings over the life of the loan could be discounted back and recognised immediately. In this way, banks increased the ‘velocity of capital’ – effectively ‘sweating’ the same capital harder to increase returns. In the traditional model, banks earned the net interest rate margin over the life of the loan – this was their ‘annuity’ income. Yet, when loan assets are sold off and the earnings recognised up-front, banks need to sell off new loans to maintain earnings. This creates pressure on banks to find ‘new’ borrowers. Initially, credit-worthy borrowers without access to credit in the regulated banking environment entered the market. Over time, banks were forced to ‘innovate’ to maintain lending volumes.

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New markets for borrowing Banks created substantial new markets for borrowing in the following areas: • Retail clients – expanding traditional lending

(housing and car finance) and developing new credit facilities (credit cards and home equity loans); • Private equity – providing borrowings in

leveraged buyouts and sundry other highly leveraged transactions; and • Hedge funds/private investors – providing

(often) high levels of debt against the value of assets. Banks increasingly also outsourced the origination of the loans to brokers, with large ‘upfront’ fees providing the incentive.

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The expansion in debt provision relied increasingly on complex mathematical models for assessing risk. It also relied on collateral – whereby the borrower puts up a portion of the price of the asset and agrees to cover any fall in value with additional cash cover. The model allowed banks to expand the quantum of loans and allowed extension of credit to lower-rated borrowers. Banks did not plan to hold the loan on a long-term basis and were only exposed to ‘underwriting’ risk in the period before the loans were sold off. Where the loan was collateralised, the agreement to ‘top up’ the collateral whenever the asset value fell was considered to provide ample protection. The growth in this type of lending was underpinned by favourable regulatory rules, as the capital required was modest; as well as optimistic views of market liquidity and faith in models.


Casino banking Banks also increased their trading activities, especially in derivatives and other financial products. Initially, this was targeted at companies and investors seeking to manage financial risk. Over time, they focused increasingly on creating risk, allowing investors to increase returns and companies to lower borrowing costs or improve currency rates. As profit margins eroded, banks created even more complex and exotic products, usually incorporating derivatives. These increasingly became a way to provide additional leverage to customers. The development of hedge funds was especially important, which borrowed money against securities offered as collateral. These used derivatives extensively, traded frequently and aggressively boosted volumes. Prime broking services – such as bundling settlement, clearing, financial and capital raising – emerged as a major source of earnings for some banks. As wealth and sophistication grew, investors increasingly sought investments other than bank deposits or even equity, bonds or mutual funds. Banks created or purchased wealth management businesses such as asset managers and private banks to service this requirement. The clients of the wealth management units were also major purchasers of securities or financial products created by the banks. Major banks expanded into emerging markets where similar products could be created and sold to a new client base. Global banks had significant advantages over local banks in terms of intellectual property and (sometimes) capital resources. Profit margins in emerging markets were also larger. Banks also increased their own risk-taking. Traditionally, banks took little or no risk other than credit risk, yet over time they took on market risk and investment risk. Whereas originally, banks traded financial products primarily as ‘agents’ standing between two closely matched counterparties, they soon became principals in order to provide clients with better, more immediate execution and increased profit margins. This increase in risk-taking was also dictated by

business contingencies. Advisory mandates – mergers and acquisitions and corporate finance work – were conditional on extension of credit. Banks increasingly ‘seeded’ or invested in hedge funds to gain preferential access to business. Clients often sought an ‘alignment’ of interests, requiring banks to take risk positions in transactions. This evolved into the ‘principal’ business, as banks increasingly made high-risk investments in transactions, rolling back the clock to the days of JP Morgan. Banks convinced themselves of this strategy on the basis that the risks were acceptable – it was their deal after all! It seemed they believed that the risk could be always sold off at a price, that markets were liquid, and (the real reason) returns were high.

Regulatory arbitrage as a business model Enhanced revenues, through growing volumes and increasing risk, were augmented by increased leverage and adroit capital management. ‘Regulatory arbitrage’ evolved into a business model. Required risk capital was reduced by creating the ‘shadow’ banking system – a complex network of off-balance sheet vehicles and hedge funds. Risk was transferred into the ‘unregulated’ shadow banking system, and the strategies exploited bank capital rules. Some or all of the real risk remained indirectly with the originating bank. Banks reduced ‘real’ equity – common shares – by substituting creative hybrid capital instruments that reduced the cost of capital. These structures generally used high income to attract investors, especially retail investors, while disguising the (less obvious) equity price risk. In some cases, banks used these new forms of capital to repurchase shares to boost rates of return. For example, CitiGroup repurchased US$12.8 billion of its shares in 2005 and an additional US$7 billion in 2006. Banks increasingly ‘hollowed out’ capital and liquidity reserves, reducing them to minimum levels. Concepts of ‘purchased’ capital and ‘purchased’ liquidity grew in popularity. The theory was that banks did not need to hold equity and cash buffers as these items could always be purchased in the market at a price. Insights Melbourne Economics and Commerce

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Thus, bank profits in recent history were driven by rapid and large growth in lending, trading revenues and increased risk-taking. Banking returns were underwritten by an extremely favourable economic environment – a long period of relatively uninterrupted expansion, low inflation, low interest rates and the ‘dividends’ from the end of communism and growth in international trade. Bankers would argue that the source of higher returns was ‘innovation’. However, John Kenneth Galbraith, in A Short History of Financial Euphoria, noted that: Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design... The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.

Not-so-perfect future There are reasons for caution regarding the outlook for banks. The asset quality of major banks remains uncertain. Svein Andresen, Secretary General of the Financial Stability Forum, which is made up of global regulators and central bankers, recently told a conference of bankers in Cannes: ‘We are now 10 months through this crisis and some of the major banks have yet to make disclosure in [crucial] areas.’ Despite significant write-downs, sub-prime assets remain vulnerable. There are substantial differences in valuations. Further losses are likely to merge in portfolios of commercial property, consumer loans and private equity loans as the global economy slows. Bank balance sheets have changed significantly. Traditional commercial bank assets consisted primarily of loans and high quality securities. Traditional investment bank assets consisted of government securities and the inventory of trading securities. In recent years, asset credit quality has deteriorated. High quality borrowers have disintermediated the banks by financing directly from investors. Banks also hold lower quality

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Voodoo Banking

assets to boost returns. Bank balance sheets now also hold investments – private equity stakes, principal investments, hedge fund equity, different slices of risk in structured finance transactions and derivatives of varying degrees of complexity. Sometimes, the assets do not appear on the balance sheet, being held in complex off-balance sheet structures with various components of risk being retained by the bank. Moreover, further write-downs in asset values cannot be discounted. Banks require re-capitalisation in order to deal with the consequences of the financial crisis. The capital required is in excess of US$1,000–1,500 billion (50–75 per cent of total global bank capital prior to the crisis) to cover losses. Capital is also needed for assets returning onto their balance sheet as the vehicles of the ‘shadow banking system’ are unwound. This capital is required to restore bank balance sheets. Additional capital will be needed to support future growth. Availability of capital, the high cost of new capital and dilution of earnings will impinge upon future performance.

Earning! What Earnings? The aftermath of the financial crisis may be expected to have the following consequences for the earnings prospects of banks. • Earnings growth in recent years has been driven

by a rapid expansion of lending – both traditional and, as shown above, disguised forms such as securitisation and derivatives activity. Bank balance sheets have expanded at rates well above GDP expansion. Lower volumes in the future will mean lower earnings. • Lack of lending capacity may also affect other

activities. Corporate finance and advisory fees are driven by the capacity to finance transactions as well as co-investing in risk positions. Lower origination of lending-driven deals may reduce this income significantly. Banking fees for leveraged finance deals are down 90 per cent. • The use of complex financial products – usually

referred to as ‘structured finance’ – has contributed strongly to earnings in recent years.


Securitisation, including CDO (Collaterised Debt Obligation – a type of asset-backed security) activity, has been a major growth area. Volumes have collapsed. The slowdown in structured finance has complex effects. Banks generated large earnings from off-balance sheet vehicles in the shadow banking system. These vehicles provided banks with the ability to ‘park’ assets and reduce capital requirements. They also provided significant revenue – management fees, debt issuance fees and trading revenues. Recovery in these earnings is unlikely any time soon. • Trading revenue has also been a bright spot.

Increased volatility and a much wider bid-offer spread have generated increases in both client-

driven and proprietary trading earnings. Several factors may limit trading income. Revenues may diminish as investors and borrowers curtail their use of such instruments, preferring simpler products that are less profitable to the bank. Trading revenues relied heavily on hedge funds and financial sponsors. Hedge fund activity is likely to slow down through redemptions, consolidation and reduced leverage. Reduction in financial sponsor activity will limit revenue from this source. • Banks have increasingly relied on proprietary

trading to supplement earnings. This increases risk and depends on the availability of capital. It relies on the availability of people to trade with

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and liquidity. Concern about counterparty risk and reduction in market liquidity in some products increases the risk of this activity and reduces its earning potential. • Future earnings will also be affected by the

availability of risk capital. The banks may not be able to access capital to the extent needed. The demise of the shadow banking system will mean that purchased capital will not be available. Regulators may also increase capital level requirements for some transactions, exacerbating the capital problem. • Risk models in banks are a function of market

volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk-taking and, therefore, earnings potential. • Higher costs will further limit earnings

recovery. Bank funding costs have increased. Most firms have been forced to issue substantial amounts of term debt to fund assets returning to balance sheet and protect against liquidity

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risk. To the extent that these costs cannot be passed through to borrowers, the higher funding costs will affect future funding. • Banks have issued high cost equity to re-

capitalise their balance sheets. Hybrid capital issues paying between seven and 11 per cent per annum will be a drag on future earnings. Highly dilutionary equity issues – often at a discount to a share price that had fallen significantly – will impede earnings growth per share and return on capital. • Banks also face additional short-term costs.

Litigation and prosecution present likely, but unknown, costs. In the longer term, banks face higher regulatory and compliance costs. • Accounting factors may further affect any

earnings recovery. For example, bank balance sheets have substantial goodwill on acquisition as future income tax benefits – particularly as a result of the losses in the last year. The carrying value of these assets may need to be adjusted substantially as the market environment changes. • FAS157

(Financial Accounting Standard establishing the basis for assessing ‘fair value’ on


accepted accounting principles) allows the entity’s own credit risk to be used in establishing the value of its liabilities. Changes in the entity’s credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades. • As credit spreads increased, banks revalued their

own borrowing – which were now trading below the original price – allowing them to record large gains. If markets stabilise and the credit spreads for banks improve, then banks will have to reverse these gains. There may be significant unrealised losses especially on new debt issues by banks at high credit spreads since mid-2007.

Mr Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall). At the time of this publication, the author or his firm did not own any direct investments in securities mentioned in this article, although he may be an owner indirectly as an investor in a fund.

From ‘go-go’ banks to ‘no-go’ banks Investors are looking for a rapid recovery in bank earnings. Earnings may recover but the ‘gilded age’ of bank profits may be difficult to recapture. Glamorous banks reliant on ‘voodoo banking’ may find it difficult to achieve the high performance of the ‘go-go’ years. Banks with sound traditional franchises that have avoided the worst excesses of the last 10 to 15 years will do well in the changed market environment. Interest rates that they charge customers have increased. Bank deposits have become far more attractive than other investments. Stronger banks have also benefited from a ‘flight to quality’ in attracting deposits. Elite athletes often use performance enhancing drugs to boost performance. Voodoo banking operated similarly, enabling banks to enhance short-term performance whilst risking longerterm damage. The big question remains: will the recovery graph in bank stocks take the form of ‘V’ or ‘U’? With the various bailouts, central banks and governments have signaled that major banks are ‘too big to fail’. This is a necessary but insufficient condition for the recovery of bank earnings and stock prices. And so, we may well see the recovery taking the form of an ‘L’ (Kristen ITC font) – note the small upturn at the far right of the flat bottom. © 2009 Satyajit Das. All rights reserved.

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reversing the divergence of the bottom billion What America did for Europe after 1945, we must now do for Africa by paul collier

A condensed version of the Max Corden Lecture delivered at the University of Melbourne on 15 October 2008. Introduction The Third World has shrunk, but it has not vanished. The ‘New Third World’ – the hard core of the economic development challenge – is composed of some 50 countries that are home to a billion people. Most of the bottom billion live in Africa, but others are scattered across the continents – in Haiti and Bolivia in Latin America, Yemen in the Middle East, many of the ‘Stans’ in Central Asia, and Laos and East Timor in East Asia. This group of small countries has sheered off from the rest of mankind, and as the world becomes more socially integrated, this giant pool of poverty will be both unacceptable and explosive. It is the world’s biggest economic problem and we need to do something about it.

Four distinct traps To know what to do, we need to start with a diagnosis. While the common fate of the bottom billion has been stagnation and poverty, there has been no single cause. I think there are four distinct traps that between them account for the problem, each requiring a distinct remedy. One trap is paradoxically to be poor but abundant in natural resources. The revenues from these exports usually distort the political system into patronage. Another trap is to be landlocked with bad neighbours. To be small is also to be at the mercy of your neighbours, especially if you are landlocked. Suppose that Australia was not united but each state had remained as a separate small

country. Or even more dramatically, suppose that the United States had been the Divided States, with each state sovereign and self-serving. The great manufacturing and agricultural heartland states of America would have been strangled at birth by the absence of interstate highways, railways and canals. Consider the plight of Niger, which is dependent upon Nigeria, and of Uganda, which is dependent upon Kenya. Both are landlocked and located in the Divided States of Africa, and one third of Africa’s population live in such countries. A third trap is civil war. Many of the countries of the bottom billion are plagued by civil war because they are not only poor but too small to maintain internal security. Imagine if India or China were divided into 50 countries. Do you think they would all be at peace? The final trap is to start with bad policies and governance and to lack the critical mass of educated people needed for the society to be able to correct errors over a reasonable time scale. These four traps have between them delayed the development of a billion people.

Globalisation is not working for the bottom billion Will globalisation automatically help these people? Globalisation is propelling China and India toward wealth, and they are closing in on the rich world with unprecedented speed. But globalisation is not working for the bottom billion. Incomes in the bottom billion have been virtually stagnant. For the four decades from 1960 Insights Melbourne Economics and Commerce

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to 2000, the New Third World experienced no growth at all. Meanwhile, the rest of the developing world has enjoyed accelerating growth, decade by decade. At first gradually, then rapidly, the bottom billion have fallen away from the rest of mankind. To date, globalisation has left the bottom billion behind. During the golden decade of the 1990s, between the end of the Cold War and 9/11, the bottom billion’s divergence from the middle four billion people on Earth had accelerated to five per cent a year. By the millennium, the income gap between the average citizens of the bottom billion and those of the middle four billion was five to one. And if you think that income gap is alarming, think about the lucky billion – in Europe, North America, Japan and elsewhere – at the top. One part of the problem is the World Bank and the United Nations, which focus on poverty like a bean-counter. That only confuses the real issue. It is not enough that absolute levels of poverty start to fall in the New Third World. The further that a billion people fall behind the rest of humankind, the more it will present the world of our children with unmanageable pressures. Even as the world’s economies are bifurcating, the world continues to draw closer together socially – through information and migration – and the youth in the bottom billion know they are being left behind. To catch up, they will need spectacular increases in growth. So how can the international community help the bottom billion catch up? In each country of the New Third World, reformers are struggling with entrenched interests and to catch up to the rest of the world they must win these struggles. We cannot do it for them, but we can make their struggle a whole lot easier than it has been to date. In 1945, the US got serious about rebuilding Europe, with aid through the Marshall Plan. But there was also trade. Washington reversed the protectionism of the 1930s and created the General Agreement on Tariffs and Trade, thereby integrating Europe into the US economy. And there was also security: Washington reversed the isolationism of the 1930s and created NATO, stabilising Europe by placing more than 100,000 US soldiers on European soil for decades. And there was also a shrewd attempt to create systems

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that produce good governance. Washington created the OECD and encouraged the formation of the EEC, thereby starting the process of mutually setting standards that help lock Greece, Spain and Portugal into democratic market economies, followed by much of Eastern Europe. We, as the fortunate inhabitants of the OECD, are all now ‘America’, and our equivalent of Europe in 1945 is Africa. What America did for Europe after 1945, we must now do for Africa.

How to get the bottom billion on a more prosperous track It is feasible to get the bottom billion on a more prosperous track, but it will require a serious approach that utilises all the instruments at our disposal and is sustained for at least two decades. Indeed, we will need the same toolkit as we used in the recovery of postwar Europe – aid, trade, security and good governance – although, of course, utilised differently. Aid will probably be more or less as important to helping the bottom billion as it was to saving postwar Europe – part of the solution but not decisive. The exclusive reliance upon aid has distorted what should be a focus on institutions and energy devoted to development. Instead of development agencies, we have aid agencies. Instead of pressure from the street for development, we have pressure for aid. The distortion of institutions and citizen pressure is self-perpetuating because it crowds out consideration of the other approaches. What, for example, do you imagine aid agencies lobby for? Our utter neglect of trade, security and governance policies for the bottom billion is a scandal – and an opportunity. Properly used, these policies have real potency, which is why they were used for the recovery of Europe. Australians who care about world poverty have to learn how to use the full array of policies, rather than pretending that it can all be done by aid. Saving the bottom billion will also require the OECD countries to work together. The emerging economies will need to do the same. To produce this unity of serious purpose, caring will not be enough: goodness is in limited supply.


Fortunately, it can be reinforced by the less morally demanding and, therefore, better supplied motivation of enlightened self-interest. Moved as I am by the miseries of life at the bottom, I too have a self-interested stake here. I am fearful of the world that my seven-year-old son will inherit unless we wake up. A previous generation rose to the challenge of restoring Europe and gave us all a safer world. Our own generation now has its own choice to make: whether to face up to our responsibilities or, like the generation of the 1930s, go into collective denial and sleepwalk into a nightmare. In our democracies, politicians will ultimately do what we ask of them. It is our collective responsibility to grasp the challenge posed by the bottom billion – and, critically, to get sufficiently up to speed with the issues and to understand what can be done about them. Only then will our politicians move from gestures to serious, effective actions. That is why, although The Bottom Billion is

a serious book, I wrote it in a style that makes it easy to read. I tried to do so because I realised that, inadvertently, the same process that has succeeded in getting economic development onto the political agenda – lobbying of rock stars and NGOs – risked trivialising its policy content. It is time for academics to set aside their tendency to write only for each other, and to reach out to their fellow citizens in communicating their expertise. While the style of the book is light, its content is about research, essentially pulling together my recent research with a number of colleagues. This pulling together is also increasingly rare in academic behaviour. Our work is now overwhelmingly presented in article-sized nuggets with few serious outlets for more sustained analysis. Does the book have any ideas beyond those familiar to any academic development economist? Professor Brad de Long’s assessment, taken from his blog page says, ‘The Bottom Billion is a very exciting and important book. It is rare to

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read something on economic development that is true, non-trivial, and potentially useful.’

The key policy issues for helping the bottom billion So what are the key policy issues? One is that while Africa has failed to develop jobs in export manufactures, this same strategy has been transforming Asia. Bangladesh has generated nearly three million jobs by exporting garments. If Kenya could do the same, it would be transformed; but Asia’s success has made it harder for Africa to get started. We can help by granting Africa better access to our markets. At present most of the G8 countries impose tariffs on imports of garments from Africa. America is the one exception. This is embarrassing for the rest of us since we pretend that America does not ‘care’ about Africa. But the US allows Kenya to export shirts duty-free and with generous rules-

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of-origin into its market, which is not true of either Australia or Europe. Even the few African countries that are allowed duty-free access get blocked by absurd technical requirements: Lesotho sells thousands of shirts to America, but they do not satisfy the regulations of the European Union. As a result, over the last five years, Africa’s garments exports to Europe have declined while increasing sevenfold to the US. The G8 could easily adopt a common set of rules for these African exports that would generate jobs across the region. A second policy issue is that many of the countries of the bottom billion have been benefiting from revenue booms from oil and other minerals that dwarf any conceivable aid flows. The last time this happened was 30 years ago and it proved a disaster. The money corrupted the local politics so badly that not only was it wasted, but it impoverished people, sometimes even leading to


civil war. Can the governments of developed countries do anything to reduce the risks of repetition? Australia and Canada could take the lead on this issue since they are the two key resource-rich countries of the OECD. Where do corrupt politicians put their money? They certainly do not leave it in their own banks. It comes to our banks. And what do our banks do? Basically, they keep quiet about it. Is this a necessary consequence of banking secrecy laws? No, it is not. If the money is suspected of having terrorist associations then, very sensibly, we now require the banks to blow the whistle on it. But if it is stolen from the ordinary citizens of the bottom billion, that is just too bad. It cost the reforming government of Nigeria huge legal fees to track down some of the previous president’s millions in a Swiss bank, and even when they won their court battle, the Swiss Minister of Justice blocked sending the money back. There is much more that we can do to support the struggle of reformers within the bottom billion to use the present resource bonanza well, but cleaning up our banks would help. A third policy issue is security. Quite possibly the most effective ‘aid’ Australia has ever provided are the troops that have secured peace in Timor Leste. Similarly, Britain has provided troops that have secured peace in Sierra Leone. Both countries in effect guarantee the peace through an ‘over-the-horizon’ commitment – if there is trouble, troops will fly in. Civil wars have been devastating to the bottom billion. The one in Sierra Leone delivered the coup de grace to an economy that had already been wrecked by revenues from diamonds. Across the region there are now several post-conflict situations that need this sort of commitment. To date, nearly half of all post-conflict countries revert to war within a decade, and we should surely be able to make a difference here. Unfortunately, along came the war in Iraq, which closed down serious discussion of security needs. The OECD powers are afraid that sending troops abroad will be unpopular, and the governments of the bottom billion fear that OECD involvement would license pre-emptive invasions.

Trade in shirts, the governance of resource bonanzas, and security commitments are more sophisticated agendas than simply doubling aid. However, I should stress that I do not see them as alternatives to aid – rather they complement it. Think how seriously America responded to the need to rebuild Europe after 1945 – it used the full range of policies. The challenge posed by the divergence of the bottom billion is evidently more difficult than that of rebuilding Europe. It will take that same full panoply of policies, although obviously the content of each policy will be different.

The message of The Bottom Billion The message of The Bottom Billion is to narrow our focus and broaden our instruments. Narrow our focus to the divergence of the countries now at the bottom of the world economy – a one billion person problem – because our efforts will be spread too thin if we continue to fuss about the entire five billion people in developing countries. Then we must broaden our instruments beyond the exclusive reliance upon aid, to recognise that other policies are likely to matter more. Our aid agencies need to be re-thought as genuine development agencies.

Paul Collier is Professor of Economics at Oxford University and Director of the Centre for the Study of African Economies. His book, The Bottom Billion: Why The Poorest Countries Are Failing and What Can Be Done About It, won the 2008 Arthur Ross Book Award and the 2008 Lionel Gelber Prize. The book, which is the basis of this lecture and published by Oxford University Press in 2007, is now in paperback.

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reflections on microeconomic policy frameworks and a suggestion about fairness In assessing economic efficiency, economists need to take into account that most people value losses more negatively than they value gains positively by jonathan pincus* A short version of the Inaugural Department of Economics – Melbourne Institute Lecture on Public Policy delivered on 7 October 2008 at the University of Melbourne. The full lecture will be published in the Australian Economic Review (2009) Vol 42, No 2.

Introduction Too many economists interpret ‘fairness’ as an unfortunate constraint on public policy-making or as a regrettable fact of political life. I make some tentative suggestions about how to systematically incorporate aspects of fairness into the framework that economists use for judging the economic efficiency of policy changes. Only in recent decades has competition been accepted as a policy instrument or framework in Australia. However, neither the process of competition itself nor the emergent outcomes from the process of competition is accorded the reverence by the general ‘informed public’ that is given to them by many economists. One reason for this difference in perspective is that economists do not tend to pay systematic attention to ‘collateral damage’ – the individual losses that necessarily occur in the process of policy change designed to achieve improvements in economic efficiency, that would not otherwise be deliberately imposed by government. They are not losses imposed for the sake of income redistribution. When estimating the consequences of economic policy, economists tend to concentrate on the aggregate or average effect, on the assumption that gains can be offset against

losses, dollar for dollar. Such symmetrical treatment of gains and losses would be considered unfair by many non-economists, even if the gains and losses fall randomly with respect to economic status, health status, or whatever index is used to measure the initial levels of personal well-being. Moreover, it is standard economics that, because of risk aversion, losses weigh more heavily in people’s minds than do gains, dollar for dollar. Thus, the distribution of gains and losses should be an integral part of the economic evaluation of microeconomic policy.

Growth and competition The Australian economic development strategy implemented after Federation had an anticompetitive ethos. Competition from imports was controlled by a made-to-measure system of tariffs; competition from non-European immigrants was restricted through racist laws; wage competition among Australian workers was regulated; private oligopolies and monopolies were encouraged; Parliament attempted to prevent the take-over of Australian enterprises by foreigners, especially non-British ones; competition of motor transport against state railways was restricted; and so on. The anti-competitive framework reduced market risks.

*The views expressed are personal, not institutional. Lisa Gropp and Veronica Cosgrove made helpful comments on

earlier drafts. Insights Melbourne Economics and Commerce

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All this was based on the belief that it was imprudent to rely heavily on vigorous private competition to achieve socially-desirable outcomes – high living standards and rapid economic development including rapid population growth. Instead, competition was typically regarded as a transitional stage leading to the creation of monopolies by private action or by nationalisation or as properly confined to arenas where it would do no great harm. In its 1912–13 judgment in the (coal) Vend case, the High Court declared that: Cut-throat competition is not now regarded by a large portion of mankind as necessarily beneficial to the public... [T]he intention of the parties was to put the Newcastle coal trade on a satisfactory basis, which would enable them to pay adequate wages to their men and sell their coal at a price remunerative to themselves. The strategy of extensive development, with its suspicion of markets and the risks that they entail, persisted through the 1970s. The shift to a new policy regime was slow, and it was not to laissez faire. Competition eventually gained wide acceptance in political and policy circles as being a socially-beneficial force generally, but one to be judged primarily on its effects, not on procedural or moral grounds. The list of relevant consequences included not only the economist’s obsession – economic efficiency – but also the distributional consequences, including collateral damage. However, the greater reliance on competitive markets was accompanied by an increase in economic planning and moderated by a huge expansion in economic regulation.

Estimating policy effects With the notable exceptions of floating the dollar and de-regulating financial markets, most of the important policy changes, designed to initiate or improve markets, have been informed by modelling of the effects. When challenged to ask ‘Where will all the jobs come from, when tariffs are cut?’, the Tariff Board pulled out its new CGE tool, a quantitative

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computable general equilibrium model of the Australian economy. Via the input-output relationships and simulated market responses, the CGE model showed that, when tariffs were cut, some industries contracted and other expanded in terms of output and employment. That information was useful for devising programs for structural adjustment that often accompanied major changes in tariffs and the like. However, the general-equilibrium models could not give a convincing answer to the question of what would happen to employment overall. Rather, the aggregate or national employment number followed from the decision the modelbuilder made when choosing ‘the labour-market closure’ of the model. Usually the model was ‘closed’ by assuming that the labour market cleared, so that then wages adjust until employment equals labour force supply, thus eliminating any effects on unemployment as a result of the tariff cut. So the Tariff Board and its successors, instead of emphasising the effects of policy change on national employment or unemployment, focused on national results that the models generated as by-products, namely, indices of national economic welfare, like real GDP, or real GNE, or real Consumption. Hanging in the Productivity Commission in Canberra is a fading poster from The Australian newspaper of Thursday 24 September, 1970, inscribed with the signatures of the major players. It reads ‘Tariffs cost us $2,700 million a year!’ This was more than 7.5 per cent of GDP. Today’s posters would feature different policies, but use a similar metric.

Losses and gains My central concern is with how to evaluate a policy change which is designed to improve economic efficiency when it produces those incidental income re-distributions that I earlier called ‘collateral damage’. It is not enough to look at aggregate or average outcomes. Here is a thought-experiment. Consider two alternative policy changes, each with the same average or aggregate effect. Under the first policy, every household gains. Under the second policy,

Reflections on microeconomic policy frameworks and a suggestion about fairness


most households gain a bit more than under the first policy, except that a few randomly-chosen households would lose greatly. The usual criterion of economic efficiency would tell us that the two policies are equally valued, because they have the same aggregate effect as reflected by the usual indices of national economic efficiency. However, risk-averse people would prefer the first option – with no losses. Moreover, they may well continue to prefer it, even if the second option promises a somewhat bigger aggregate benefit. Rationally, on economic grounds, a less efficient option may be preferred over a more efficient policy, given the way economic efficiency is usually measured. Most policy economists follow the (pretty good) Harberger rule that ‘A dollar is a dollar is a dollar’. That is, A’s loss of $10,000 is exactly cancelled by B’s gain of $10,000. However, this risk-neutral trade-off does not reflect how individuals react. Instead, individuals require a

risk premium to engage in uncertain ventures. That is, in order to accept a 50/50 chance of a loss of $10,000, individuals require a prospective gain of greater than $10,000. Unfortunately, almost all of the Australian quantitative models used to evaluate policy changes are based on a single household earning all private factor incomes and making all private consumption decisions. In calculating what happens to this aggregate household, losses are weighed exactly as heavily as are gains. Likewise, while the quantitative CGE models do provide information about the distribution of gains and losses by industry, by region and by factor of production, the overall index of national economic welfare still uses the rule that ‘a dollar is a dollar’ – losses are not weighed more heavily than gains. It is often argued that what is relevant is a series of policy changes, taken as a whole, and not just a single change. Colloquially, what you lose on the

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roundabouts, you more than gain on the swings. But there are some losses that are so damaging that they cannot be compensated by the prospect that the wheel of fortune will later spin your way. Individuals may hedge or insure against large prospective losses either through private markets or through public processes. However, for some entities – particularly unincorporated business and all classes of workers – fair insurance against the risk of change in government policy is not readily available in private markets. So, my central contention about the policy relevance of ‘collateral damage’ seems to survive consideration of private insurance markets. It may be asked ‘Does all this amount to a hill of beans?’ If the asymmetry of gains and losses was taken into account, could it make a difference to decisions about public policy? The answer is

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in the affirmative when losses are highly concentrated and relatively large; for example, if anti-competitive regulations were relaxed for pharmacies, newsagents and taxis. More generally, the creation of what the Business Council of Australia calls ‘seamless national markets’, by the reduction or removal of State-based commercial regulation, will cause some highly-concentrated and large losses to vested interests. Similar considerations may apply to effective action to reduce Australia’s carbon footprint.

Conclusions Recently, microeconomic policy has been dominated by what could be called ‘modern central planning’. To achieve social and political goals in recent decades, markets and market-like mechanisms have been more heavily relied upon, although this change has also been accompanied

Reflections on microeconomic policy frameworks and a suggestion about fairness


by or caused a vast increase in economic regulation. Markets and market-like mechanisms have been judged by their outcomes, rather than by their processes. They have been assessed according to their quantitative effects on economic efficiency, defined as gains minus losses. I have suggested the need for a refinement of that definition to take account of the point that most people value losses more negatively than they value gains positively. The refinement is most needed when the policy change will cause relatively large losses to a section of the population.

Professor Jonathan Pincus is Visiting Professor in Economics, University of Adelaide and Senior Adviser, Concept Economics.

Sensible advisory agencies, like the Productivity Commission, in a rough and ready way, already take into account the balance between aggregate economic efficiency, as usually measured, and collateral damage. To take systematic account of gains and losses may require economists to take more seriously the implied risk-aversion that is embodied in the utility functions within the quantitative CGE models used to estimate the aggregate effects of a policy change. The National Centre for Social and Economic Modelling (NATSEM) in Canberra, specialises in estimating the distributional consequences of policy changes; but NATSEM does not provide a summative (overall) economic valuation of a policy change. To obtain such an index of national welfare, CGE outputs could be fed into NATSEM models, and the results fed back into the utility function of the CGE model. To go further along this track would require more real data – which is not easy to obtain, given current constraints on the Australian Bureau of Statistics. While preparing this lecture, I was heartened to read that in formulating policy changes, the Rudd government and its senior economic public servants are taking distributional consequences seriously into account. However, no information was given of exactly how this is being done. Perhaps it would be useful if economists contributed publicly on the issue.

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what’s been happening to united states income inequality? Properly adjusted, for at least the bottom 99 per cent of the income distribution, the rise in income inequality since 1993 has been small by richard v burkhauser

A condensed and simplified version of the Downing Lecture delivered at the University of Melbourne on 23 October 2008. The full paper is published in Burkhauser, Richard V, Shuaizhang Feng, Jeff Larrimore and Stephen P Jenkins, 2008, ‘Trends in United States Income Inequality Using the Internal March Current Population Survey: The Importance of Controlling for Censoring’ NBER Working Paper w14247, August 2008.∗

Introduction The public-use version of the March Current Population Survey (CPS), an annual crosssectional survey of more than 50,000 American households, is the primary data source used by public policy researchers and administrators to investigate trends in average US income and its distribution. Despite the widely held view that US income inequality has increased substantially since the 1980s, our research, which derives from unprecedented access to internal CPS data, tells a very different story. Most of the evidence of a large increase in income inequality since 1993 has come either from those who do not adjust for topcoding in the public-use CPS or from Internal Revenue Service (IRS) administrative record files that have their own consistency problems. In a practice called topcoding, for incomes above some value in the public-use CPS – the topcode threshold – the Census Bureau reports income as equal to this topcode threshold rather than providing the exact recorded value from the internal CPS.

Using various layers of CPS data (see Table 1 for a more precise definition of the various layers of CPS data we use) we show why, when you do not adjust for topcoding in the public-use CPS, data will falsely show that American income inequality has been rapidly growing. Once properly adjusted, we find that for at least the bottom 99 per cent of the income distribution, the rise in income inequality since 1993 has been small and its yearly growth much slower than in the previous two decades. Our results hold even when we estimate income values for the very top part of the income distribution missing in the internal CPS data. Our findings are consistent with those found using IRS data on the 90th –99th percentile groups, only differing with respect to the top one per cent of the income distribution. It is uncertain to what degree this difference is the result of our decreasing ability to capture income at the very highest income levels, even using internal CPS data, or of behavioural changes in the way that individual tax units report their adjusted gross income on their tax returns captured in the IRS data.

*Based on research conducted while Burkhauser, Feng and Larrimore were Special Sworn Status researchers of the

US Census Bureau at the New York Census Research Data Center at Cornell University. Conclusions expressed are those of the authors and do not necessarily reflect the views of the US Census Bureau. This research has been screened to ensure that no confidential data is disclosed. Insights Melbourne Economics and Commerce

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Table 1: Definitions for Income Distribution Series by Source and Censoring Method Acronym

Source

Method for Addressing Censoring Issues

Internal-Unadjusted

Internal

Uses internal data as provided in Census Bureau files, without any adjustments

Internal-MI

Internal

Topcoded observations replaced by imputations derived from GB2 imputation model fitted to internal data; inequality estimates derived using multiple imputation combination methods

Public-Unadjusted

Public Use

Uses public use data as provided in Census Bureau files; includes Census Bureau cell mean imputations for topcoded observations from 1995 onwards

Public-Mean

Public Use

Uses public use data as provided in Census Bureau files; includes cell mean imputations for topcoded observations for all years

Public-NoMean

Public Use

Uses public use data as provided in Census Bureau files, except that no cell mean imputations used for any year (topcoded values used ‘as is’)

Source: Burkhauser, Feng, Jenkins and Larrimore (2008).

Public-use vs. internal CPS data For confidentiality reasons, the Census Bureau does not provide full information in the publicuse CPS on the amount of income from each income source – for example wages and salary, interest, dividends, etc. – found in the internal CPS. Beginning in 1995, the Census Bureau has also provided the mean of all topcoded values for these income sources. By using the mean value of all these topcoded values, rather than the topcode threshold for that source of income, you can more accurately capture the income values above the threshold from that source. But, as we will see, this leads the unwary to confuse an increase in our ability to measure higher income values with a real change in the income of richer people. For their official work, Census Bureau researchers use the internal March CPS that is less severely censored. This is the data set we use. Doing so, we analyse levels and trends in US inequality using Gini coefficients between 1975 and 2004 derived from the internal CPS and compare them with estimates from several series derived from the public-use CPS (see Table 1). The Gini coefficient is the most common way to measure inequality in the distribution of income across a country’s

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What’s been happening to United States income inequality?

population, and must be a value between zero and one. Income that is perfectly distributed across the population has a value of zero, while a perfectly unequal distribution – one person holds the country’s entire income – has a value of one.

Measuring trends in income inequality Figure 1 shows that those who simply use the unadjusted public-use CPS (Public-Unadjusted) will find that income inequality jumps dramatically between 1994 and 1995 – the Gini value increases from 0.395 to 0.422, a single year change far greater than in any prior or subsequent year. This is caused solely by an increase in topcoding and the use of a Census Bureau-derived mean value rather than the topcoded value for all values above the topcoded value. Using the unadjusted internal CPS (Internal-Unadjusted), we find no such increase between 1994 and 1995. Rather, what is happening is that prior to 1995 the Public-Unadjusted CPS Gini values substantially understate income inequality because they fail to fully account for income values above the topcodes. Once the Census Bureau provided the mean value of all these


topcoded values, the now more precise PublicUnadjusted CPS Gini values match the higher Internal-Unadjusted Gini values. Failure to account for this change in methodology will grossly overstate US inequality increases before and after 1994–1995. This problem is not solved by simply ignoring Census Bureau mean values after 1994, as can be seen in the Public-NoMean Gini series. This series still inconsistently topcodes high values and underestimates inequality after 1994, as can be seen by the way its Gini values fall further and further below the Internal-Unadjusted Gini values. We solve this problem by deriving a mean value for all topcoded incomes in the public-use CPS, for each year back to 1975. When we use the public-use CPS together with our extended mean series (Public-Mean) in Figure 1, we match the Internal-Unadjusted Gini values in every year. However, the internal CPS data is itself censored albeit to a substantially smaller extent than the public-use CPS. Hence, it too has timeinconsistencies, especially in 1992–1993, as can be seen by the jump in the Internal-Unadjusted Gini values between these years. To control for

inconsistent censoring and to capture the missing part of the internal CPS data, we use a multiple imputation approach in which, for each year, outof-sample values – values that are topcoded in the internal CPS are imputed on assumptions about what their distribution would look like – and data from the lower in-sample values that we do have in the internal CPS data. Unsurprisingly, as can also be seen in Figure 1, we find that compared to estimates derived from our multiple imputation approach (Internal-MI), that contains these higher imputed values, all the other series understate the level of inequality in all years. However, just as was the case for our Public-Mean series and the Internal-Unadjusted series it replicated, the Internal-MI series reveal the same trends: an increase in inequality over the entire period 1975–2004, but with a rate of increase noticeably lower after 1993 compared to before 1993. In each series, average inequality is found to increase much more prior to 1992 than after 1993. And in each series the jump in 1992–1993 is far higher than in any other period and is consistent with the argument that a change in the measurement of inequality, rather than a real change in inequality, is its cause.

Figure 1. Inequality Estimates using Alternative Layers of CPS data, 1975–2006 0.45 0.44 0.43 -

Public – Unadjusted Public – NoMean Public – Mean Internal – Unadjusted Internal – MI

Gini Coefficient

0.42 -

Internal – MI Public – Mean Internal – Unadjusted Public – Unadjusted

0.41 0.40 -

Public – NoMean

0.39 0.38 0.37 0.36 0.35 0.34 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Internal data was not available for years after 2005. Source: Burkhauser, Feng, Jenkins and Larrimore (2008).

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CPS vs. IRS results for the share of income held by high income groups Finally, we compare our CPS-based estimates of trends in top income shares using our Internal-MI adjusted CPS data to the estimates of top income shares derived by Piketty and Saez (2003) from IRS administrative files. As can be seen in Figure 2 both the grey lines’ (our data) and the dotted lines’ (their data) estimates of the income share held by the top 90th–95th percentile group have a relatively flat trend during the period 1975–2004, although the Piketty and Saez values are slightly higher in level. Similarly, for the shares held by the top 95th–99th percentile group, despite slight differences in levels, the two series exhibit remarkably similar trends over the 30 year period. In contrast, while the share of income held by the richest one per cent – which can be found by taking the difference between the top two dotted lines for them and the top two grey lines for us – increased substantially over this period (according to both our CPS-based and the IRS-based Piketty and Saez (2003) estimates), their estimates are much larger – from 8.0 to 16.1 percentage points compared to an increase from 5.4 to 9.8 percentage points in our series.

But this difference is even greater when it is observed that one-third of the increase in the income share of the top one per cent in our series from 1975–2004 occurred in 1993, and is primarily attributable to the CPS redesign. Hence a significant minority of this increase in the share of income held by the top one per cent in our series is likely due to better measurement of their income by the CPS rather than by an actual increase in the share of income they held.

Effect of change in legislation This same problem of changes in measurement versus changes in real income held by the richest one per cent of the distribution is also likely to explain at least some part of the rise in income shares at the top of the income distribution in the Piketty and Saez (2003) series. As can also be seen in Figure 2, there is a dramatic four percentage point jump in the share of gross taxable income held by the highest one per cent of tax units reported by Piketty and Saez (2003) between the years 1986 and 1988. (Compare the change in the difference between the top two dotted lines over these years to confirm this.) This finding must, to some degree, be the result of changes in the way

Figure 2. Share of Income Held by Top 10 Per Cent: IRS vs. CPS, 1975–2004 0.45 PS 90-100th

0.40 0.35 Internal-MI Gb2 90-100th

Income share

0.30 PS 90-99th

0.25 Internal-MI Gb2 90-99th

0.20 0.15 0.10 0.05 0.00 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Source: http://elsa.berkeley.edu/~saez/ and Burkhauser, Feng, Jenkins and Larrimore (2008).

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What’s been happening to United States income inequality?

PS 90-95th Internal-MI Gb2 90-95th


the very richest tax units chose to report their income as a result of the Tax Reform Act of 1986 rather than the result of genuine changes in income inequality. This legislation provided substantial incentives for the very richest tax units to switch income from Subchapter-S corporations to wage income. Subtracting the 1986–1988 jumps in their series would cut in half the increase in the share of income held by the richest one per cent over the whole period. Their data for other years may also be subject to this same type of change in tax reporting behaviour, albeit to a lesser extent.

A further puzzle Keeping this in mind, it is difficult to determine what is going on at the very top of the income distribution using either the CPS data or the IRS data. Piketty and Saez (2003) find greater increases in inequality after 1993 than we do, primarily because of greater growth in the share of income held by the richest one per cent in their IRS data. It is uncertain to what degree this difference is the result of our decreasing ability to capture income at the very highest income levels, even using internal CPS data, or of behavioural changes in the way that individual tax units report their adjusted gross income on their tax returns. The CPS may be less able to capture this income going to the top of the income distribution. But it also may be the case, as Reynolds (2006) argues, that a greater increase in the use of tax-deferred savings accounts – 401k plans, Keogh plans and IRA tax shelters – by those in richer percentile groups, but not in the very richest one per cent of the adjusted gross income distribution of tax units, may also explain part of the rise in the top income share reported by Piketty and Saez (2003).

CPS data. But even in these estimates, the rise in income inequality slowed after 1993. Our findings are consistent with those found by Piketty and Saez (2003) for the 90th–99th percentile groups. It is only with respect to the richest one per cent that we differ. And it is here that we are at the limits of current knowledge, both with respect to the CPS because of its difficulty in obtaining information on the highest income households, and with respect to the IRS data because of behavioural effects caused by changes in the tax laws. It is difficult to fully understand how much of the yearly changes in inequality are the result of real changes in the incomes of the very richest income tax units and how much is due simply to changes in the way they report that income.

Professor Burkhauser is Sarah Gibson Blanding Professor of Public Policy in the Department of Policy Analysis and Management, Professor of Economics in the Department of Economics, Cornell University, and 2008 R I Downing Fellow at the University of Melbourne.

References Piketty, Thomas, and Emmanuel Saez. 2003. ‘Income Inequality in the United States, 1913–1998.’ Quarterly Journal of Economics, 118 (1): 1–39. Reynolds, Alan. 2006. Income and Wealth. Westport, Connecticut: Greenwood Press.

Concluding observations Our results suggest that, for at least the poorest 99 per cent of the income distribution, the increase in US income inequality since 1993 is significantly slower than in the previous two decades. Based on our Internal-MI series we find the level of income inequality rises when we include an estimate that includes the very top part of the income distribution censored in the unadjusted internal

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occasional addresses

navigating the world of opportunity Practical pointers to the challenge of navigation by anthony r burgess

An edited version of his Occasional Address delivered at the graduation on 23 August 2008.

A world of opportunity As you enter the commerce profession with a degree from what is widely acknowledged as one of the finest universities in the world, the hard work and sacrifices you have made will be worthwhile. Your degree is a passport to any occupation across the globe. And what a world of opportunity awaits you – a far more sophisticated and exciting world than the one I entered when I stood in your shoes 27 years ago. Back then, personal computers and mobile phones were in their infancy, the Internet had not yet been invented, financial markets were heavily regulated and the scope of business was very much national rather than international. Today, the communications revolution, the deregulation of financial markets and the globalisation of so many industries and businesses means that the world of commerce offers a huge variety of exciting career opportunities which can literally be pursued anywhere in the world. For example, Moscow, Mumbai and Shanghai are rapidly becoming vibrant and important commercial centres which one day may challenge the traditional centres of London, New York and Hong Kong.

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Navigating the world of opportunity

How to navigate the world of opportunity Your key challenge is how to navigate this wonderful world of opportunity to achieve a successful career. It is a genuine luxury to have so much choice, but that luxury brings with it the burden of decision-making. Drawing from my own career experiences over the past 27 years, I offer you a number of practical pointers to aid in the challenge of navigation. First and foremost, I encourage you to take control of the agenda for your own career and to proactively exercise choice over what you do. Do not revert to the default options or unthinkingly follow what others say you should do. You must decide for yourself, and you must believe in yourself. Only then can you take the risks that you will need to take to test and stretch your abilities. Second, the key to real career fulfilment and satisfaction is to find something you are passionate about and to excel at it. As a society we are obsessed with wealth and use it as a measure of success. It is far from being the right measure. In today’s world we are blessed by a plethora of career paths in which we can earn more than enough to satisfy our material wants and desires.


You will only ever experience the inner satisfaction of having achieved your potential if you focus on something you really enjoy and work hard at it. You are extremely fortunate if you have already found your passion. For most of us, and this is my third point, we need to explore some alternatives before we settle on a vocation. For this reason, I would strongly advocate that you get as much general experience as possible in an area before you specialise. I am conscious that this is easier said than done as we live in an increasingly specialised world and there is a significant financial incentive for you to go immediately into a narrow specialisation upon graduation. It is important to remember that leaders of organisations have to have broad experience, and one of the key building blocks of leadership is a comprehensive understanding of the principles of business. That understanding is best gained early. I believe the new Melbourne Model is designed to help address this point of breadth and I applaud it. Fourth, it is important to gravitate towards talented people. The talent of your immediate circle of colleagues and superiors should be the single most important criterion in choosing your first job, as they are the ones who will teach you, mentor you and challenge you to achieve your potential. Later on, when you are the master rather than the apprentice, talented peers and subordinates will keep you sharp. You only need to look at the number of new world records set at the Beijing Olympics to comprehend the power of bringing together talent from all over the world in a competitive environment.

the past few years; and I would encourage you to join the Commerce Alumni Society. It is a great way of keeping in touch with your fellow alumni. The question of trust brings me to my sixth and final point, that of integrity. As you build your career and assume leadership positions of greater magnitude, you will find that your greatest asset is your reputation. People will generally be reluctant to deal with you, to partner with you, to mentor you or to work for you if they do not trust you. Building a reputation of integrity takes years. It can be destroyed in one foolish act. As the saying goes, ‘up by the stairs, down by the elevator’. Do not let the siren songs of quick riches or dazzling promotions lure your career onto the rocks. Believe me, you will all be tested at some point in your career and it will take real courage and clarity of mind to say no. All that remains for me to do is to wish you bon voyage. And please carry with you the enduring words of Virgil: ‘Fortune favours the brave.’ Mr Anthony R Burgess recently retired from the position of Global Co-head of Mergers & Acquisitions for Deutsche Bank AG in London and is a Director of Diversified United Investments Ltd., Melbourne.

Fifth, every human endeavour is intrinsically social and none more so than business and commerce. People tend to deal with those whom they know and trust. As you develop your career, it is important to build and maintain a network of relationships with those you interact with. It is far easier to get a hearing for a new initiative if you have dealt with the person in the past or if you have a reference from a mutual friend. On that note, now is the time to start maintaining the network you have built here at Melbourne over

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how your university experience will shape your future life and career While education in the classroom is important, much of the learning at a university takes place outside the classroom by michael andrew An edited version of his Occasional Address delivered at the graduation on 15 December 2008. Education is a passion of mine. One of the advantages of addressing you on this occasion is the opportunity to reflect on my own university experiences and to share some of the lessons that enabled me to pursue a fulfilling career and life.

A confession It also gives me an opportunity to clear my conscience and to make a confession: I was a member of the ‘Otway Ranges Appreciation League’. Alas, at the time, issues such as environmental responsibility or climate change were not on my agenda. Some of my friends discovered that University money was available for clubs and societies with worthy objects, provided they had a constitution, held an annual general meeting and issued financial reports. In consequence, as an enterprising Commerce/Law student, I joined the Otway Ranges Appreciation League or ‘ORAL’ as it came to be known at the University. We were given a grant of $1,500; an enormous sum of money for impoverished students in those days. Most of this grant was consumed at a celebratory lunch at the nearby Clyde Hotel, where we plotted how to use the balance of our funds – for an annual Melbourne Cup Day BBQ and an annual tennis tournament. With our first AGM looming, we discovered to our consternation that a professor from the Arts Faculty wished to address the Otway Ranges Appreciation League on some of the environmental challenges facing our wonderful ecosystem. It proved very challenging to get a quorum and to listen to what was a very technical and turgid presentation. However, it did make an 44

How your university experience will shape your future life and career

impression on us. We now knew where the Otway Ranges were; and we decided to hold our next picnic at the Lorne Pub rather than the Clyde. An auditor today, examining how the $1,500 was spent, would regard it as the worst example of misuse of university funds. But was it? Let us look at it more closely.

The lessons learnt Core competency development KPMG employs 750 graduates every year – 550 positions in Australia and 200 positions in Asia. While academic results are important, the core competencies that we look for in our graduates are: an ability to build relationships with people; lateral thinking; analytical skills; resilience; presentation skills; and the ability to work in a team. While education in the classroom is important, much of the learning at a university takes place outside the classroom. I have seen many brilliant people with outstanding examination results; yet their lack of personality, and their inability to relate to people or think laterally, have impaired their future leadership prospects. On the other hand, by taking initiative, thinking laterally, and forming networks, ORAL was one of the best tutorials we ever attended at the University.

Relationships My time at the University not only gave me the opportunity to meet my wife, my present network drawn from those years include two managing partners of major national legal firms, two judges, two magistrates, senior public servants and other


captains of industry, and CEOs of not-for-profit organisations. The point I make is that the relationships that have influenced my life and my career were very much formed as part of the University experience and indeed through ORAL. Melbourne is a very relationship-driven city, and the relationships you start at university are a key success factor moving forward. When I visit our offices in Shanghai, Mumbai, Ho Chi Min or Kuala Lumpur, I see that University of Melbourne students now hold important roles in our Asian offices. Make sure that you maintain contact with your tutorial groups or syndicates – by email, Facebook or in other ways – as one day, when you travel to cities such as Beijing, Singapore or Taipei, those contacts will be very valuable.

Thinking globally My second great education lesson was when I moved to Amsterdam to run KPMG’s Global Tax Centre. I visited 50 countries in two years, some of these ten times. I wrote the strategy for the rise of the Asia Pacific economies and had responsibility for opening our offices in Central and Eastern Europe. I witnessed the opening of the European Market in 1992. Not only did my geography expand, it was an unprecedented personal development opportunity to be isolated from my friends and family in a foreign country. What did I learn from that experience?

Asia Pacific century – location, location, location Any economist or demographer will tell you that this is the Asia Pacific century, which will see the rise of emerging markets of the BRIC countries – Brazil, Russia, India and China. You probably witnessed the opening ceremony of the Olympic Games in Beijing in August. If you read Goldman Sachs’ G11 report, the next emerging countries are Korea, Vietnam, Indonesia, Chile and Mexico. As the industrial revolution takes place, there will be enormous appetite for the skills and commodities that we are celebrating today and that you will continue to consolidate in the coming years. At University, I benefited from Geoffrey Blainey’s wonderful lectures about the tyranny of distance, which told us that our remoteness in the world

was a curse. Increasingly, it is a blessing in an age when technology removes the impediments of geographic disadvantage. While cost and speed to market become the key international differentiators, we are in the right place in the world. Issues such as bio-security, terrorism and carbon pollution reduction favour island nations. Australia will become more and more attractive for populations, investment and geographic diversification. In addition, we must be a technology-led country that is able to deliver its service offerings through the Internet, social networks and regular cultural exchange. So I ask myself: should students spend two years serving in the bars of London’s Earls Court or schmoozing on Wall Street? As an employer, I would place less value on these experiences. Instead, you should test yourself in the great Asian, Middle Eastern or South American cities – Santiago, Beijing, Jakarta, Taipei, Kuala Lumpur and Singapore. These are where future job and economic opportunities lie – not to mention the places for optimum personal development – and where the next set of relationships will be formed.

We are a region, not a country Melbourne was built during the gold rushes of the 1860s. If you walk up the Paris end of Collins Street and look at our state’s institutions – the libraries, museums, Parliament House and the Exhibition Building – they are all dividends of the time when Melbourne was close to being the richest city in the world. That legacy has endured over the years as the head offices of our major mining companies, agricultural businesses and banks have settled in Melbourne. It is fair to say that the most recent ‘gold rush’, the phenomenal commodities boom, is currently faltering. If this current market turmoil has taught us anything, it is that we can no longer think of Australia as a quarry and a farm. We also need to recognise that our destiny lies in our services sector, our engineering skills, metallurgy, education, medicine. Our future is very much linked to the countries in these emerging regions. Even an accounting practice such as ours needs to view intellectual property and resources as a supplied commodity. This view prompted us to merge with nine of our Asian practices during the Insights Melbourne Economics and Commerce

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year, in order to gain access to those fast growing markets overseas and reflect the way our customers operate. Can KPMG write the banking regulations in Indonesia, do a treasury review in Korea or conduct due diligence in Japan? The business model that will evolve is not based on geographic boundaries but on fast, agile organisations which operate across our region. It is a challenge also for universities to operate this way.

Domestic agenda When I lived in the Netherlands, I always remarked that the first seven pages of the newspapers dealt with international news, while Dutch news was to be found on page eight. In Australia, the first and second pages are generally related to football, political and human interest stories, with international news not appearing until about page eight. There are some major historic trends happening in our region – the tension between Japan and China, governance reform taking place in Indonesia, the inflationary problems in Vietnam, social tensions in the Chinese provinces. Yet these issues simply do not rate a mention in our news, and we have to remind ourselves constantly that we are part of an increasingly global world that is linked to these problems. Who would have thought that the housing problem in the US would flow through to such catastrophic international consequences? The CEO of the future will have had five overseas postings and will need to focus on regional and global trends, not local football results. ‘Global Vision’ will differentiate business leaders, and you should invest your time to think this way.

Tradition is a disadvantage There is a ‘can-do’ mentality in Australia. We have always shown a great capacity for innovation. It is part of our young history; we are not steeped in tradition. We tend to challenge existing orders and are prepared to ask the hard, direct questions that others may find politically or socially offensive. For four years in the Netherlands, I was continually met by those wonderful Dutch words ‘it’s not possible’. To get a driver’s licence online, to go to the doctor without a letter of referral – it’s not possible. Can I restructure or reposition our workforce? It’s not possible. The ability to constantly look at new 46

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business and social models is a key to moving forward successfully. We have to be flexible thinkers, avoiding bureaucracy, processes and methodologies that stifle the development of new and emerging ideas and techniques.

Neutrality Sitting on KPMG’s global Board, I am amazed at how often I am asked to mediate in disputes and resolve issues, simply because Australia is regarded as a neutral country with a great sense of fairness and objectivity. We are not aligned to the European bloc, the American bloc or, culturally, even to the Asian bloc. We listen, we speak our mind and we have a great sense of fairness. We have earned our reputation for giving people a ‘fair go’. Every year at KPMG, we roll out our strategic plan and budget to staff. This year we decided to do separate sessions with our junior staff to get them more involved. Our first session was in Brisbane and, frankly, it was not going well until a new graduate got up and said: I’ve only been here six weeks – it’s like working for a communist organisation. I don’t have any authority to do anything for the IT systems. They are old generation, you don’t reward individual achievement. What are you going to do about it? Confronted with such an intelligent Generation Y, we had an hour of the most productive and constructive feedback. It showed that we had a cultural problem in our organisation. It revised our strategy to focus, simplify, empower and engage our organisation at different levels. With your fresh, bright young minds, you will see things that people entrenched in standard processes miss. Your views and feedback are important. Try and add value to your organisation and do not just become one of the mob.

Social inclusion However, there is more to life than you or your employer. True leadership shows thinking and actions around the disadvantaged and other problems in our society. At KPMG, it is compulsory for every partner to set up a philanthropic or not for profit board and contribute to the betterment of our society. It is part of our


ethos and superb leadership training. I am currently tackling the problems of Indigenous education and employment through various partnerships with communities. I recently launched a disabled employment project, sponsored research into women’s diabetes, helped to expand the Prahran Mission for the homeless, and raised funds for new cancer centres. It is heartening to see the increased awareness of social issues among our graduates who want to address issues such as climate change, Indigenous development and social inclusion – far more than the Otway Ranges Appreciation League ever did. I wish I had become more involved with these important social issues at an earlier age.

Liveability versus growth Everyone talks about our city’s wonderful liveability. It is what keeps and attracts most of us here. It is fascinating to me to watch debates around issues such as channel deepening or the Eddington Infrastructure Report, or to listen to complaints about public transport and road congestion. Yet to maintain liveability it is necessary to invest in future resources and infrastructure. I am not critical of the Government, because I do not think most people could have anticipated all the issues arising from the growth in our city and economy. However, the matter is in our hands. We could say: ‘We don’t need this, we are content with the size of our city.’ But, frankly, this will undermine the city’s liveability in the future. You should contribute ideas and be an ambassador for the world’s most liveable city. Further, you should also think of Melbourne as one of the world’s great university cities. Education is our third largest export. It should be better understood that this city’s educational and research facilities are important not only to its local population but also to the external markets to which I have referred.

Entrepreneurs The Business Council has a vision for Australia as the best country in which to live, learn and work. It strives to be one of the world’s top five economies, even with such a small population. If there was one particular concern I have with this, it is our inability to applaud and assist entrepreneurial talent. This University produces an incredible volume of research and good ideas.

Yet our ability to take these through to the marketplace is significantly handicapped by a shortage of people capable of managing and exploiting businesses. There is no shortage of capital – be it venture capital, superannuation money or equity markets – to support good ideas. Invariably, however, the person that makes the scientific break through lacks the ability to take it to the marketplace. Equally, some of our entrepreneurs do not really recognise the real potential of the technology and ideas, or the patent problems, access to market and other related problems. This is an issue that really concerns me – whether we have the right environment here to reward, train and develop entrepreneurial talent. I very much hope that I am addressing that potential talent today.

Conclusion If I were sitting in your seat, I would want to feel that I was part of the top five nations in the world, one that performs considerably above its weight by population, by GDP or by size. It does so. It is a country with intellectual capacity and the ability of its citizens to understand where they are in a global world; a country that leverages the skills and talent promoted by its education system to benefit this nation; and a country that tries out new ideas and creates an economic dividend for the benefit of all society. I have been very fortunate to have had a career that has taken me to 90 countries around the world and to accept a leadership position in private, government and philanthropic enterprises. Whether it was studying the Otway Ranges, living in a foreign country or contributing to this city, my university experience was the foundation for my life. Please take the time to reflect on your education and how it places you to benefit not only your own life, but also the city and country in which you live. Mr Michael Andrew is Australian Chairman of KPMG. He is a member of the Business Council of Australia’s Task Force on education and he co-chaired the Committee for Melbourne’s Task Force into Higher Education. He was Chairman of Lauriston, one of Melbourne’s leading girls schools, for many years.

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on leading more than one life Acknowledge the personal sacrifices of others, think creatively and be imaginative, give of yourself in public service and exercise humility by rupert myer am His Occasional Address delivered at the graduation on 14 March 2009.

Congratulations and thanks I would like to begin by saying to the Graduates and Graduands, ‘Congratulations’. I do so not just out of a sense of duty arising from this occasion and from the role that I have been invited to perform. I do it to reinforce and add emphasis to the sense of celebration that ought to accompany the achievements that gather us here today. The congratulations of this audience and of the wider community have been earned. Shortly, you will receive some of the highest acknowledgements that our education system and others like ours have created. There are too few opportunities where we stop and acknowledge achievement. Thankfully, this is one of them. Our congratulations ought to be spirited, enthusiastic and expressive. There is, after all, a reason why your mortarboards are thrown high into the air at the conclusion of the ceremony. I add to the word ‘congratulations’ the words ‘thank you’. Whilst I well know that university life is not all solemn duty and that you will have had pleasures from the experience that will sustain you throughout your lives, no one here should presume for a moment that the achievements we celebrate today have been made without considerable personal sacrifice. Many of you have lived far away from your homes and families and friends; many of you will have endured hardship of a different nature including financial anxieties and altered lifestyles. For some of you, you are the first member of your family to have studied at a university and you have carried

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an extra burden of responsibility. Some of you might have begun life far away, in a place where there may have been no expectation that you would have studied at all. And to you most especially, I say thank you. Your choice to persevere with your academic education is of enduring benefit not just to you. The rewards of your training and achievement are also shared by the society in which you will choose to live and work. We are all the beneficiaries of your hard work and therefore we must thank you for it. Our thanks should also be extended to the parents and families of those being acknowledged, for they made personal sacrifices as well. And we should also thank the members of staff of this University, who have been responsible for the transfer of knowledge, skills and understanding. In our era, we are often not quick to acknowledge personal sacrifice. When my grandfather, Sidney Myer, arrived in Australia in 1899, he was almost certainly a refugee and possibly an asylum seeker as well. His sacrifice was that along with members of his family, he left his homeland in modern day Belarus never to return again. The successive pogroms against the Jews had become ever more violent and his community was continually threatened. By leaving, he was escaping persecution and the certainty of a life of fear, loss, grief and despair. He came with few possessions, to a new culture and climate, and to a way of life that had very few points of comparison with the


21 years that he had lived as the child of a scholar and a seller of drapery. He arrived virtually penniless and without English, something in turn he tried to remedy by joining the Shakespeare Society of Bendigo. His story was an authentic expression of dislocation, of being disconnected from his native land and of having nowhere local that he could call home. He had felt threatened in his country of birth and had sought a better future for himself here. The story goes that after getting off the boat in Port Melbourne, he spent the small amount of money that he had on buying a beer for himself. By the time that he died just over 35 years later, he had become a household name in Victoria, having established a department store business which today is still Australia’s largest, trading in more than 60 locations around the country. He also established a tradition of practical handson philanthropy and public service, which continues to impact the community in a myriad of ways today. His personal story continues to play out in a number of ways, of which I would like to mention three: creative thinking, public service and humility.

Creative thinking The expression ‘creative’ in relation to economics, accounting and commerce generally often carries with it a somewhat negative connotation, the inference being that there is something dodgy afoot. That is unfortunate. Creativity is the reward for anyone who is interested or curious. A friend told me last weekend of a t-shirt she owns, emblazoned with Einstein’s message, ‘Imagination is more important than knowledge.’ Your studied disciplines are practiced in an environment which is ideal for curiosity and imagination. In J. K. Rowling’s address at last year’s Harvard Graduation, she described imagination as the ‘fount of all invention and innovation.’ I encourage you to apply your imagination and a creative mind to your life and careers. You should also use the resources that are at your disposal – I especially recommend engaging in art.

Exhibitions and permanent collections present objects that have sprung from learning, interpretation, inspiration, hard work, and the application of creative thinking. You do not have to have knowledge of visual arts – nor, dare I say, even an interest in it – to benefit profoundly from the experience of a gallery, an artist’s studio, an art space or a single artwork. You should feel that you can interrogate anything, say anything, and feel anything. Enduring discernment can be developed. Be critical and questioning of what you see, and be smart about the way that you express your observations. And let your observations pervade your professional work. Our political leaders and economists, such as the ANZ’s Saul Eslake, constantly tell us of the value of a creative economy. The arts embody and require skills and attitudes that are increasingly called for in business contexts. Foremost amongst these are critical thinking, the ability to challenge conventional wisdom, the capacity to look at familiar objects from new perspectives, the ability to innovate using new technology and media, and the ability to adapt from things that work in other settings. When you are starting out in life and have new and fresh eyes for everything, recall that ‘creativity happens not with one brilliant flash but in a chain reaction of many tiny sparks while executing an idea. Insight and execution are inextricably woven together.’1 So, take risks, expect to make lots of mistakes, work hard, take breaks but stay with it over time. Do what you love, because it’s going to take time to have a creative breakthrough. Forget all the nonsense about being ‘artsy’ and gifted, and don’t sit waiting for the moment of inspiration. For, while you are waiting, you may never start working on what you will some day create.

Public service At a moment in your lives when you are doubtless consumed with the need and desire to work, I encourage you to look to a slightly wider horizon and think about how you might pursue the privilege of serving the community more broadly. How do you propose to apply your time, treasure

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and talent? What are your key interests and how do you wish to engage with them – either through your workplace or away from it? What public service do you wish to perform and how might you bring your creativity and talent to it? Many of you have concerns about the environment. What are you going to do about it? Many of you have considered views on the society of the future, the type of cities in which you would wish to live and the way you would like things to be. How are you going to influence these? How might you prepare yourself for secondment from your workplace to the community sector? You have studied disciplines that are keenly sought by many others. You can be optimistic about that and you should use your knowledge for a broader public good. John Maynard Keynes longed for the day when economists were no longer arch-theorists, but would be consulted to solve everyday problems and give straightforward advice rather like dentists.2 I believe that we could look to his welldocumented views3 about investing to give us some really good ideas about how each of you might prepare for public service. I am sure that he would advise you that service should be approached with a clear focus on problems and practical solutions. He would advise you to search for stunners, that small group of projects and organisations that might make a profound difference. He would encourage safety first, that is, do your due diligence and understand as well as possible the likelihood of success and the risks of failure – but he would caution you not to try to avoid risk. He would tell you to ‘lean in to the wind’ and run counter to conventional thinking. It is remarked of him that ‘in everyday life he delighted in paradoxes, opposed accepted wisdom and disliked all the commoner garden thoughts and emotions that bind men in bundles’. He would urge you to keep quiet and not selfaggrandise, but promote the activity and service being supported by you. And finally, he would encourage you to remain concentrated in a circle of competence and recognise the bounds of your knowledge; but not to place all of your public service and philanthropic eggs into one basket.

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Keynes described Newton as a man who possessed ‘in exceptional degree almost every kind of intellectual aptitude – lawyer, historian, theologian, not less than mathematician, physicist, astronomer.’4 My encouragement to you is to not just lead one life: get on and have a few. On the question of motivation, I have a view that seems to be at odds with current views commonly expressed by commentators on philanthropy and indeed many people either self-identifying or identified by others as philanthropists. That is, I do not subscribe to the view that philanthropy is about ‘giving back’. The phrase ‘giving back’ conveys a message to others that an act of benefaction is a considered act of obligation. This is not the language of generosity; it is the language of duty. It reinforces a view held by some that, in order to ‘give back’, something must have ‘been taken’ in the first place. At best, ‘giving back’ reflects careless use of language. At worst, it establishes or reinforces in the minds of many a dubious motivation. My advice is to drop the phrase. There are plenty of people around with a dim view of private wealth in the first place, who will enthusiastically assert that philanthropy is just giving back. Giving for its own sake ought to be sufficient motivation.

Humility I have a hope that you will think deeply about and practice humility. I am reminded of an article that appeared in Spectator Magazine several years ago, in which the seven deadly sins – lust, gluttony, avarice, sloth, anger, envy and pride – were, with the exception of pride, referred to as medical conditions requiring treatment. Pride was referred to as having become a virtue. The article commented that it is the absence of pride which is now presumed to be a medical condition, with so many of our society’s problems being blamed on low self-esteem. Do not confuse humility with low self-esteem. In suggesting that you practice humility, I encourage you to be confident and selfknowing, but also that you consider the value of being humble and genuinely modest.


Mr Rupert Myer AM is Chairman of The Myer Family Company Pty Ltd and a Director of AMCIL Limited, DUI Limited, and the department store business, Myer Pty Limited. He is Chairman of the National Gallery of Australia, a Board Member of the National Gallery of Australia Foundation, Chairman of Kaldor Public Art Projects, a Board Member of The Felton Bequests’ Committee, a Board member of Indigenous Enterprise Partnerships and a Member of The Myer Foundation. His previous community activities have been as Chairman of the National Gallery of Victoria Foundation, International Social Service, WorkPlacement and Mission Australia’s Youth Strategy and Advocacy Group, and as a Board member of The Museum of Contemporary Art in Sydney and a trustee of The National Gallery of Victoria. He chaired the Commonwealth Government’s Inquiry into the Contemporary Visual Arts and Craft Sector 2002, and was a participant in the Commonwealth Government’s 2020 Summit in April 2008.

1 R. Keith Sawyer, (2006) ‘Explaining Creativity: The Science of Human Innovation’, quoted in Time Magazine, January 8. 2 Alex Damchev, (2007) Time Literary Supplement, July 13 p 28, quoting Tim Harford (2007) Undercover Economist, Abacus. 3 Justyn Walsh, (2007) Keynes Mutiny, Random House Australia. 4 J M Keynes, (1947) ‘Newton the Man’.

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Mailing Address: The Faculty of Economics and Commerce The University of Melbourne Victoria 3010 Australia Telephone: +61 3 8344 2166 Email: gsdir-ecom@unimelb.edu.au Internet: http://insights.unimelb.edu.au Published by the Faculty of Economics and Commerce, April 2009 Š The University of Melbourne

Disclaimer Insights is published by the University of Melbourne for the Faculty of Economics and Commerce. Opinions published are not necessarily those of the publisher, printers or editors. The University of Melbourne does not accept responsibility for the accuracy of information contained in this journal. No part of this journal may be reproduced without the permission of the editors.