A Nobel prize for breaking through the hurdles placed by economists

This year’s Nobel Prize in Economics has been shared by Bill Nordhaus and Paul Romer for “integrating innovation and climate with economic growth.” That is one way to thread the needle to link these fine recipients and I applaud the Nobel Committee for finding a way to do it. That said, there is a real reason that Nordhaus and Romer should be linked and it turns on the way they have made their ideas persuasive — not to the general public or even politicians but to economists.

Back in the 1980s, both climate policy and science/innovation policy faced significant barriers moving forward. In each case, the main constituents who were holding up such policies were economists — they were trained in textbook tools of economics and had very strong influence throughout governments due to their ability to frame arguments. In the case of climate policy, while the science pushed for action, the big unknown was precisely what the economic cost of mitigating greenhouse gases would be. In the case of innovation policy, while the costs were known, the big problem was what the return would be. Thus, for each type of policy, economists who had won the push for cost-benefit analysis in government, were able to point out — somewhat accurately — that one-side of the equation was missing in each case. My personal opinion is that uncertainty should not necessarily be a barrier to action but when it comes to dealing with policy advocacy uncertainty is a weapon that can be used by special interests to generate inaction and, at the time, economists were the, perhaps unwitting, wielders of that weapon.

Let me start will Bill Nordhaus. If we choose to mitigate greenhouse gas pollution, it will impact all manner of activity in the economy. From energy to food production to transportation networks, the effects would be widespread and profound. They would impact on different regions differently. In other words, the economic impact was complex and hard to think through. And there was a possibility the costs could be overwhelming.

What Nordhaus did was embed climate change and climate policy into our general equilibrium models of economic growth. He then found ways to quantify the costs that everyone was hitherto conjecturing about. As it turned out, the costs were significant but nowhere near the doomsday assertions that interested parties opposed to climate policy were claiming. Even without technological change, there were existing ways economies could adapt to climate policy and, in the process, self-limit the costs that many were worried about. It moved the debate away from economic assertion and I guess pushed interested parties from “reasonable” arguments to “denialism,” thereby, exposing their naked interests more clearly. While progress has been far from what we would want, the progress that has happened can be attributed to this critical work.

Moving on now to Paul Romer. I have known Paul for 30 years since I was a graduate student. I was deeply interested in economic growth as an undergraduate and felt it had been neglected and was fortunate to be doing my PhD soon after Paul’s work had been published. It drove my interest further and into the fields of innovation and entrepreneurship that I have worked on since. There was even a time I contemplated an offer to join Paul’s education startup but that is another story.

Romer’s contribution is the inventing of what has become termed, endogenous growth theory. The first real theories of economic growth — starting with Robert Solow and Trevor Swan — examined how investment could generate growth and found that it could not explain the growth we had seen over the past two centuries. The missing component was technological change but they had no theory of it. It was well-known that science and innovation were not costless and so such activity would likely be driven by markets, competition and prices just as other economic activity was. But it was also known that these activities were special in that they generated positive externalities although some returns could be internalised through the use of formal intellectual property protection. Many people knew this was the missing ingredient in growth as documented by David Warsh’s terrific history of economic thought (including the contributions of Romer). As an undergraduate in Australia, even I saw this piece of the puzzle and, without knowledge of Romer and others, wrote my thesis about it leading to my very first published article.

I wasn’t the only one. Phillipe Aghion, Peter Howitt, Gene Grossman and Elhanan Helpman all saw it too and made their own separate contributions to endogenous growth theory. Those models, however, still, in many respects, had a microeconomic flavour that meant their main contribution would be to an understanding of how competition (and its potential limitors including patents) would impact on innovation in a growth context. This is very important but it was not as closely related to the growth puzzle that Romer was tackling.

Romer took his time making progress. His PhD thesis led to some technical advances that showed it was possible to have a balanced growth path — consistent with what we knew about economic growth — and also have a role for increasing returns. But to do things properly, the standard assumption of perfect competition was not going to cut it. And so in 1990 Romer published his most famous paper that (a) put the foundations of growth on a model of monopolistic competition (as those in trade theory and economic geography had done previously) and (b) divided the economy into a real and an ideas sector (something that no one had really done). In so doing, the Romer model was able to articulate and identify the key determinants of the returns to innovation.

The first was that the returns to innovation were limited by competition. Even with perfect patents, knowledge itself would promote entry and compete both for profits and scarce resources that limit the returns to past innovation and, as a consequence, to future innovation itself. The second was that by allocating resources — particularly science and engineering human capital — to the production of ideas, those limitations could be mitigated and economic growth itself would accelerate. In other words, front and centre for the promotion of economic growth was the direct promotion of science. Yes, science had been seen as a public good before. But now science was firmly seen as an engine of economic growth. Things that promoted the creation and, importantly, diffusion of scientific research were not just like the arts — there for consumption — but instead were an economy and indeed world-wide force for economic prosperity. To be sure, identifying the precise returns to any particular project would be difficult. But the idea that it is was critical to have a system for science and innovation promotion was now on a solid foundation.

As a person who was closely involved in economic policy in Australia on both the environment and innovation, it is difficult to understate how important Nordhaus and Romer’s work were. They were present in every, single policy discussion and tipped the balance towards action in cases where there were significant barriers and hurdles. In so doing, each showed how a careful accounting of economic forces can lead to progress, reduce uncertainty and make the case. That is what ties these two together and I am very pleased to see the Nobel committee recognising this long and sustained contribution to our knowledge and discourse.

Prediction Machines

My book with Ajay Agrawal and Avi Goldfarb is out now. It is called Prediction Machines: The Simple Economics of Artificial Intelligence.

We have written some pieces that provide little excursions into the book.

Also, we had a book launch and a video of it is available here.

Suffice it to say, if you like the material in this blog, it is a safe bet that you or your robot partner will like this book.

I guess I can’t run for Australian Parliament

I’m not sure if anyone was hoping I might return to Australia one day and run for Parliament. I certainly never thought about it. But it had never occurred to me that I might be prohibited from doing so. After all, I am an Australian citizen, was born in Australia, and right at the moment am not, to my knowledge a citizen of another country. I did know — thanks to the experience of my long-time co-author, Andrew Leigh, that if I wanted to run for Parliament I could not do so while holding a position at an Australian University as that would make me a government employee. But at least there was something I could do about it.

For those who don’t know, my brother — Jeremy — is a law professor at the University of Melbourne. That hasn’t really impacted on my life although he has lamented the inability to get the coveted ‘j.gans’ username there and previously at UNSW. He mostly writes about criminal stuff and even has a popular book out on some ridiculous jury laws in the UK. But over the past few months he has become somewhat obsessed with s44 of the Constitution which has now caused several MPs — including the Deputy Prime Minister — to be booted out of Parliament with perhaps more to follow. I have been waiting for all this to get on John Oliver but apparently it is still way down the list of Australian craziness.

Anyhow, in the wake of the High Court decision, he went on a rant about how ludicrous it was. The High Court basically decided that, in order to ensure that potential MPs did not shy away from checking whether they are beholden to a foreign power, they had better interpret the Constitution not as some sensible person might but as a strict rule that if you are potentially a citizen of another country — that is, they would be nice to you if you had nowhere else to go — then you had better make sure you have renounced your citizenship so that you cannot be tempted to be their agent in the future. I know that isn’t the legal interpretation but that is the way I read it.

Now Professor Jeremy’s rant — despite a surprising tie in with Gilbert and Sullivan — is mostly legal stuff and is kind of long so I didn’t notice until now this part:

I’m fortunate to have never contemplated nominating for elected office. But, like many Australians, the recent debate has caused me to ponder my own status under s44(i). Despite being born in Sydney and long assuming that I was exclusively an Australian citizen, my eligibility for election to my own nation’s Parliament proves to be quite a puzzle.

The simplest half of the puzzle is my father’s birth as a German citizen in Frankfurt in the 1930s. Thanks to  Adolf Hitler, whose 1941 Eleventh Decree to the Law on the Citizenship of the Reich stripped my Jewish father of his citizenship years after he arrived in Australia, I am certain I’m no German.

But there is a complication: Article 116(2) of Germany’s Basic Law provides that people in my father’s position ‘and their descendants, shall on application have their citizenship restored’. Although I haven’t applied, it seems arguable that I am nevertheless ‘entitled to the rights or privileges of a subject or a citizen of a foreign power’ (a phrase that the current High Court says is part of the same ‘limb’ as s44(i)’s ban on foreign citizens.) This interesting legal question can only be tested if someone like me is first elected as an MP and then has her eligibility challenged in the Court of Disputed Returns.

The trickier part of the puzzle is my mother. She was born during World War Two somewhere on the Soviet side of the front. However, precisely where in the former Union she was born (and hence her potential current foreign citizenship in a former Soviet Republic) is something that only my long-dead grandparents know for sure. My mother obviously can’t confirm her birthplace with any certainty. Her earliest memories are crossing countless borders as a war refugee. (My grandparents themselves were very vague about the details and timelines of their respective wartime ordeals. It is obvious that they were awful.) While none of these facts concern me at all, every single detail would be crucial to determining my current eligibility under s44(i).

The current High Court’s judges (some of whom would also be my future electoral executioners) saw fit to smugly declare:

“It is necessary to bear in mind that the reference by a house of Parliament of a question of disqualification can arise only where the facts which establish the disqualification have been brought forward in Parliament. In the nature of things, those facts must always have been knowable. A candidate need show no greater diligence in relation to the timely discovery of those facts than the person who has successfully, albeit belatedly, brought them to the attention of the Parliament.”

But, if I was ever elected to a very narrowly divided parliament, then there would be a good many people with much better resources and motivation than me to solve the mystery of my citizenship. Somewhere, there may be an old Soviet record, or a wartime refugee camp form, or a surviving acquaintance of my grandparents, or a genetic link to some ‘atomic globule’ in Central Asia, that could belatedly confirm me as a citizen of one of a potential dozen or so nations, each with their own highly complex and shifting citizenship laws. My own ignorance of these matters (no matter how diligent my personal search) would be absolutely irrelevant to my future eligibility,. So holds Re: Canavan.

And for me to do my constitutional ‘homework’ would, at a minimum, be punishingly expensive, much more so than the truly ridiculous sums that Sam Dastyari had to pay to (probably) rid himself of his Iranian citizenship. Worse, there is every likelihood that I would be unable to ever be sure that I wasn’t a foreign citizen, much less satisfy any party contemplating nominating me. The likely result of any ‘serious reflection on the question’ of my eligibility is that nominating me would not be worth the risk. And I am hardly an unusual case (outside of the ‘came with the First Fleet‘ set, that is.)

Hang on a second I thought as I read this. Jeremy’s mother and father are my mother and father too — sometimes it takes a minute for the ball to drop on that. That means all this crap applies to me!

And not just my but prominent MPs like Josh Frydenberg and several other Jewish MPs.

So I don’t see how I could ever run for Parliament. Well in Australia. If I become a Canadian citizen — and no, they don’t care how many other citizenships I hold in order to do that (phew!) — then I could run for Parliament here. In other words, I am potentially barred — forever! — from running for Parliament in Australia by the High Court decision but can actually do so elsewhere.

But there is another thing. While Malcolm Turnbull and the current government I know did not agree with the High Court’s decision as they put forward an argument that would not have led to this if they had adopted it, I do now wonder what the Opposition’s position really is. From my reading, they have been playing politics in criticising the Government and now taking seriously the idea of contesting the new by-elections etc. That sounds like they accept that interpretation. If that is so, am I to read that they also believe that immigrants and children of immigrants should never run for Parliament in Australia? I think we all deserve an answer on that one.

[Update: it gets worse for Jewish people in Australia. They may all be prohibited. A High Court test case on this is urgently needed.]

Why would banks eliminate ATM fees?

Over the past two days, the four major Australian banks have eliminated ATM fees charged to users who are not their customers who use their ATMs. This is great news for people who do not use ATMs of their own banks. They no longer have to pay the fees — that have been transparent since 2009 — that were charged by ATMs — at least those owned by the four major banks. Not surprisingly, the media is fawning over it as are politicians.

But nothing tickles an economist’s spidy sense like this. Wait a second? Banks have decided to charge nothing for a service, that people who are otherwise not their customers for any other products, use? I have to ask: doesn’t this use impose direct costs on the banks? Aren’t those costs likely to be non-trivial? Aren’t those costs likely to rise substantially as consumers do not suffer the pain at the ATM of paying for those costs? The stench no economist nose is picking up is quite pugnant.

The news articles all say that this was the result of government pressure. To be sure, it is just that. There are no laws preventing such things nor has any government wanted to pass them.

And there is a good reason for that. This will have consequences.

For starters, there are going to be fewer ATMs; at least from the big four banks. They no longer have to roll them out to please their own customers, so they won’t. If you all decide a service will be free, it will be supplied by a free service. In addition, independent ATM operators — who charge the highest fees — will also see returns slashed by the new competitive pressure and so they will pull back to. As for smaller banks and credit unions, they get a gift. People will use their ATMs less but since they likely didn’t earn anything other than covering their costs, they might even expand a little. However, in the aggregate, there will be fewer ATMs.

(Actually, the smaller banks really do benefit from all of this. I am not saying that is a bad thing per se but once again, why are the majors giving them this gift?)

I have not been following recent regulatory developments but it strikes me that this may be the first act in trying to get a better deal under the hood. Banks are doing this to get lighter regulation elsewhere. Perhaps to avoid a Royal Commission? This is something that Australians will need to watch out for.

Personally, I have not really bought the notion that Australian banks are colluding on things like interest rates. (I looked). But this time, one bank (the CBA) seemingly unilaterally eliminated fees (for people who weren’t their own customers) and then the other banks followed. The only way the CBA’s customers benefited from this was if the other banks followed. Otherwise, there is no benefit coming back to the CBA. So there is no private benefit, only a group benefits. Usually, those things do not happen without explicit coordination.

Is cross-ownership a competition problem in Australia?

Possibly.

First some context. I raised this issue a couple of years ago in a post here. It was motivated by new research in the US on the impact of cross-ownership by institutional investors on competition in US airlines.

So ask yourself: when those shareholders vote on the composition of boards or the management of the firm, or, importantly how the management of the firm is compensated, are they going to vote for managers who will care only about the profits of the firm they manage or about the profits more broadly? The answer is obvious: they will look to managers who manage in the interest of shareholders and so that means they care about all firm profits and not just the one of their own firm.

In a world where shareholders can get what they want, we won’t have competition in this outcome but, more likely, a collusive outcome. What is more, the firms won’t have to go to all the difficulty of violating antitrust laws to obtain this outcome, they will do it unilaterally. There are no laws against that.

That research was recently updated but has also been extended to banks and also executive compensation consistent with a competition-reducing effect (compensation is based on absolute rather than relative performance).

In an op ed, Shadow Assistant Treasurer and my long-standing co-author, Andrew Leigh, took the US approach and applied it to Australia. He looked at cross-ownership patterns but he made a mistake looking at custodial firms (who don’t have voting or influence rights) rather than the core institutional investors that are the core of the theory. Peter Martin pointed out the error. Who knew that determining ownership could be so complicated?

This of course highlights how difficult it is for politicians to research and make arguments. One little error and it is as if the whole hypothesis doesn’t exist any more. But we academics in the real world don’t operate that way. What I wondered was: do the patterns we see in the US match occur in Australia.

Fortunately, for me, I didn’t have to do much heavy lifting to find out. Here are some summary stats provided on Twitter by Martin Schmalz who is a key player in the US studies. First, let’s check out energy retailing:

martincschmalz_2017-Mar-16 3.jpg

The top three investors are the same across the two biggest competitors in Australia.

Let’s turn to grocery and other retailing:

martincschmalz_2017-Mar-16 2.jpg

Wesfarmers (who owns Coles) and Woolworths have some similarities there.

Or petrol:

martincschmalz_2017-Mar-16.jpg

Or investing itself:

martincschmalz_2017-Mar-16 1.jpg

For banking in general, I took a look and NAB’s top shareholders are (Vanguard 2.03% and BlackRock 1.43% and Capital Research and Management Company, 1.13%); Commonwealth Bank has (Vanguard 2.78%, BlackRock 1.46% and Govt Pension Fund of Norway, 0.88%), while Westpac appears to have little shareholder concentration.

Looking at telecommunications we have Telstra (Capital Research and Management Company, 1.13%; Vanguard 1.62%, BlackRock 0.63%) while Singtel is owned by the Singapore government.

This is, of course, far from a comprehensive concern but the pattern is interesting. The very funds — BlackRock and Vanguard — whose ownership changes were related to competition reductions in the US by research there have the same pattern of ‘diversified’ holdings in Australian oligopoly companies.

Now you might say that even so, the ownership of the largest shareholders is low. That is true. It is not like they themselves command a majority for voting purposes. However, as the largest shareholders they have power and their trading behaviour can impact on the returns of others. The very fact that we see cross-ownership patterns in Australia similar to the US where there are concerns that have been measured suggests that this is something we need to watch.

Australian Banks ask for permission to collude against Apple

This news caused me to make a spit-take on my morning coffee.

Several of the country’s big banks are seeking to join forces and negotiate as a bloc with technology giant Apple, which could lead to a collective boycott of Apple Pay, in a bid to offer “digital wallets” on the iPhone.

Commonwealth Bank, National Australia Bank, Westpac and Bendigo Bank have this week applied to the Australian Competition and Consumer Commission, asking permission to negotiate as one with Apple.

Their application also seeks permission to undertake a “limited form of collective boycott,” in which the banks will agree not to negotiate with Apple individually while the collective talks are occurring.

Let’s unpack this. Apple has an NFC solution on its iPhone (just as Google does) but in order for Australian consumers to use it, they need permission of their banks. The banks claim that because Apple controls the phones of some of its customers, they need to negotiate as a block on access to the NFC component on the iPhone.  Of course, not all banks. ANZ has already signed up to Apple Pay.

But here is what I don’t get. First, what does negotiating for access to the NFC component mean? Do the banks think that Apple will open it up to them when they haven’t opened it up to anyone else in the world? The reason Apple keep that close knit is because of security. It is unlikely there is anything else going on.

Second, the idea apparently is for the banks to agree not to sign up to Apple Pay until this is done. Then they will negotiate terms of access individually. In other words, a collective boycott.

The Australian law has provisions to allow this sort of thing if there are public benefits. But in this case, the public benefits only arise (potentially) if it is in the public interest for Apple to open up access to NFC. However, that decision would lie elsewhere with a much more detailed process. Also, because Apple is not a dominant handset maker — it has much less than 50% market share in Australia and elsewhere — opening up access through the usual route won’t happen. Put simply, Google have already developed this and so access to NFC is possible.

Instead, the idea here is to allow for something blantantly anti-competitive. One of the forces the drives banks to adopt new technologies that are provided by others is competitive pressure between them — that is, their customers want it. That is why AmEx and ANZ are already on board with Apple Pay. What the remaining banks want to do is ensure any one of them doesn’t break ranks and adopt Apple Pay and activate a competitive response.

In summary, the banks are using the wrong part of the law to deal with a public interest question precisely because Apple is not dominant in the Australian market. And they are doing it to protect what is likely a poor set of investments on their part and because they are unwilling to throw their weight behind Google alone. In other words, it is classic undermining of competition to benefit the interests of competitors and not the interests of consumers. Hopefully the ACCC will deal with it quickly because it is pretty clear that while the regulators deliberate, the same effect as a collective boycott is actually occuring.

The NBN needs emergency triage

Now that the election is done and sorted and there isn’t a hung parliament, it is time for Australia to get on to the job of urgent policy-making. There are lots of areas in need of help but I am going to focus here on one close to my heart: broadband.

By any measure, broadband policy in Australia has been an abject failure. Despite brief moments of hope, we moved from a regulatory morass dominated by a private monopoly to a set of deals and politics dominated by a government monopoly. No one advocated for this but in the reality of political mess that is what happened. As a result, broadband has not improved in almost a decade. Indeed, much of regular internet use by ordinary Australians has moved to wireless.

I know the Prime Minister agrees with me about this because he and I had a public conversation on it in 2011 before the Coalition was in government. You can read the transcript here. But I suspect that political truths have prevented progress. Thus, the first course of action is to cut out those political truths.

The first one is that one size cannot fit all in broadband. There is variation in demand. There is variation in the costs of supply. That means setting equal terms in urban and rural areas won’t cut it. It is far better to explicitly subsidise than cross-subsidise. Full stop. But because it takes time, a period of unequal pricing and quality is necessary. Any solution that tries to do otherwise will only continue the morass.

The second one is that the NBN’s active role needs to be diminished. It needs to retreat to the backbone. I am not sure what architectural requirements would be needed but taking any customer facing role of the NBN (they may not be any but it is hard to tell from the media reporting) and divesting it — and yes privatising it — is probably the right way to go. If you don’t want privatisation, then split it up into local areas and hand it over to local government. Broadband is not a national public good it is a local one. It shares more in common with garbage collection than defense. Treat it that way.

The third is that it then needs a clear open access regime. We need to encourage retail competition at the local level. Full stop.

The fourth thing is that we need to diminish any sort of exclusivity the NBN has. Any sort. Mobile should be able to compete with it fully. Other wired providers should be able to build over the top of it.

The fifth thing is that a temporary sacrifice in local environmental regulations on wires not in the ground needs to be nationally suspended. The idea is to allow these unsightly things for 5 years on the condition that they be then grounded. Sorry. That is what the rest of the world has done. If local governments want to pay to speed up grounding them then fine. It should not slow down any rollouts.

The final thing is a big one. After all these years we have learned that the biggest broadband use is video consumption mostly for private purposes. The wholesale pricing model and also retail ones will need to switch to something that ensures that those consumers using the most video have to pay more. That means no ‘under the count’ options. You will find them willing. The only thing is that means broadband caps as a default. That sucks — I know — I pay to have mine removed but the economics require it.

If it is wanted to make this more politically compatible then the basic free account is something that can be offered. That will open up the notion of broadband as a citizen right.

[Updated to reflect user comments and clarifications]