On Tuesday 5 June 2001

When I state publicly in Victoria that I am economic rationalist it is a bit like admitting I regularly beat my wife! My natural instinct is then to find a weak excuse to explain my sins - like the guy who explained on his insurance claim form that the cause of his accident was

• "Windscreen broken. Cause unknown. Probably Voodoo."

Of course, many people do regard economic rationalism (ER) as a sort of economists’ magic that ignores real life. However, from my perspective the critics only rarely appear to understand what ER is about.

Because the 1990s has produced a veritable onslaught on ER, I want to mention some developments in the decade, taking 1992-93 as the starting point and 1999-00 as the end point.

Starting with incomes per head of Australians, we see an average increase of over 3 per cent a year after allowing for inflation. This may not sound much but it compares with only 1.4 per cent a year in the 1970s and 1980s. In fact, during the seven years Australian living standards actually increased by an astonishing 25 per cent.

Second, this was due almost entirely to faster productivity growth. But what caused that improvement in efficiency? Analysis suggests it mainly reflected economic reforms under ER policies rather than the strength of the business cycle or increased usage of more advanced information technology.

Third, notwithstanding the earlier reduction in tariffs driven by ER policies, imports did not grow faster than exports. There was no external crisis and unemployment fell.

Fourth, did these developments disadvantage wage earners and advantage nasty capitalists? Well "no", the increase in incomes was equally shared between wages and profits.

Fifth, it is true that amongst individual wage earners there was a widening in the distribution of earnings. However, the progressive income tax system paid out generous social welfare benefits and this prevented any increase in the inequality of total incomes.

Finally, what about the much-touted rural decline? Well, there was actually an increase in people living outside capital cities between 1995 and 2000 - and at a rate not much below the growth in capital cities. Unfortunately for Hanrahan, the bush was not "ruined".

I suggest, therefore, that there is very strong evidence that in the 1990s ER policies produced large economic benefits for the great majority of Australians and that governments protected the less advantaged through the social welfare system. So, why has there has been so much criticism of ER policies and why have opinion surveys suggested that many think the quality of life has deteriorated?

One problem is that, as there is no "authorized text" explaining ER, common misconceptions develop. The usual one is that ERs are only concerned to get the best economic results and have little regard to social consequences.

This reaction is quite mistaken. There is a failure to recognize that ER does not only have unfavourable initial effects. There are also usually second and third round effects that are favourable - and favourable from both an economic and social perspective.

Reductions in protection of manufacturing, for example, have initial unfavourable effects on some industries and some employees, and that is what most people perceive. But this also leads to expansions of other industries. Why? Because lower protection reduces costs for other industries and it also reduces the prices that consumers have to pay, leaving them with more money to spend on other goods or services.

Accordingly, ER advocates argue that reductions in protection are likely to have net favourable effects for the community as a whole. Lower protection in the 1980s, for example, has been followed by an increase in manufacturing production of 17 per cent and manufactured exports are now 24 per cent of total exports compared with only 16 per cent at the end of the 80s.

It may seem "unfair" that lower protection eliminates or reduces some businesses and their employment. But isn’t it unfair to ask the rest of the community to sacrifice their living standards to keep the protected sector going when there are more efficient alternative businesses and forms of employment? It is also surely more equitable and more socially healthy to have a community that consists of as many individuals as possible who are not dependent on others.

Another misconception arises from the ER policies of financial deregulation and reductions in protection adopted by Labor during the 1980s. Even some economists blame those ER policies for the major recession of the early 1990s.

I argue, however, that the underlying cause of that recession was not those policies but the opposite. During the 1980s Labor tried to stimulate growth by pursuing highly interventionist monetary and budgetary policies. These policies were not consistent with ER. They kept up a high rate of inflation and demand, and this ended in a boom-bust situation. What did the policies leave Australia with? As Mr Keating acknowledged, "the recession we had to have" - but should not have had, of course.

A further misconception is that ER is the same as laissez–faire - the idea that there should be no intervention at all by the government in the free market. But ER is not the same as laissez faire.

ER proponents certainly favour allowing markets and competition to operate more freely than at present. But they also accept that governments should regulate both the economy and society – provided the regulation is minimal.

Experience has shown that, when governments try to "manage" a business enterprise let alone fine-tune the economy, they run into intrinsic practical difficulties. Governments also tend to make decisions in the interests of lobby groups rather than the community as a whole.

This experience led about thirty years ago to the identification of a new phenomenon described as "government failure". The most striking example was the mess produced by the attempts at economic planning in Eastern Europe and the old Soviet Union - but Victorians also experienced government failure on a smaller scale in the 1980s.

The recognition that government manipulation of the economy is much harder than Keynes thought in the 1930s has had major repercussions. Most importantly, it has led to a radical modification of the notion that there is a fundamental flaw in capitalism and that governments need to intervene to prevent or smooth business cycles. In Australia today there is pretty much bipartisan agreement that government budgets should not be operated to try to anticipate and/or offset cyclical swings in the private sector. This is also now widely accepted amongst overseas governments and international economic organisations. It is a development that has given ER a substantial credibility boost.

ER’s support for minimum government intervention also reflects a view that, in a modern society with relatively high degree of education, individuals should be relatively free to pursue their own interests and should be better able to look after themselves. A better balance is needed between the equity of assisting those on low incomes and the equity of rewarding individuals for their economic contribution.

So, where do economic rationalists draw the line between allowing free play of market forces and individual decision-making, and having the government intervene? In reality, there is no clearly defined line.

The most contentious issue is how far to go in reducing inequalities of income. The perception that the "fairness" of society would be improved by reducing inequalities is part of the supposed Australian culture of egalitarianism – the idea of giving everyone a "fair go". This is even reflected in theorizing by academic economists. But the policy conclusions drawn from this theorizing find little support amongst ERs.

Of course, economic rationalists do agree that governments should assist those on low incomes and that higher income earners should be net contributors. But they are also concerned to minimise the many adverse effects from government involvement in redistributing incomes.

One major problem is the growth in welfare dependency. Since the last economic expansion ending in the 1980s the proportion of the working age population on income support has jumped from 15 to 22 per cent and now covers an incredible 3.2 million people. The principal reason is not increased need. It is action by political parties to make it easier to obtain benefits – and for politicians to obtain votes! If we count in education and health benefits, the top 40 per cent of incomes receive nearly 15 per cent of government benefits and allowances.

Economic rationalists also reject arguments for greater redistribution based on calculations purporting to show up to 20 per cent living below the poverty line. The problem here is that the line is constantly being raised at about the same rate as national income. This means that the standard of "poverty" becomes ever-higher and that, while the population increases, there will always be growing numbers of "poor". That does not provide a sound basis for intervention by governments, particularly as most who were poor at some earlier time would by now have moved up the income scale.

Economic rationalists also oppose the high degree of regulation of employer-employee relations imposed by Australian Governments and the industrial tribunals. The perception that fairness requires such regulation is quite wrong. It reflects the belief that, unless the government regulates the operation of the labour market, there will be a bargaining imbalance between employers and employees that will lead to exploitation of employees and a greater inequality in earnings.

However, this idea is based on a widespread failure to understand that, with over 1,000,000 employers competing for the services of over 9,000,000 employees, there is little scope for employers to impose conditions on workers. The basic problem is that the regulatory system seriously inhibits employers from adding to employment, particularly of low skilled workers. For example, by setting the minimum wage at a high level relative to the average wage, the Industrial Relations Commission has almost certainly kept out of employment many with low skills and earning capacity, convicting them to reliance on social security.

In any event, the existing regulatory system has been unsuccessful in preventing a widening in the inequality of earnings. Moreover, it is nonsensical to try to protect the low-paid by adjusting wages. Why should the majority of low wage earners have their wages protected when they live in households in the upper half of the income scale? It is Government social security, not Commission wage decisions, that makes incomes more equal.

Ensuring competition is another area where economic rationalists have no in principle difficulty in supporting government regulation and intervention. Preventing monopolies or at least regulating them helps to protect consumers and to level the playing field for those who want to be competitors.

This of course leads ER to support the privatization of monopolistic public sector enterprises. Such action will expose the enterprises to competition of various kinds and is most likely to produce a more efficient use of resources that provides a better quality service. Critics need to ask themselves why there has been no significant reversal of the over 15,000 privatisations world-wide in recent years, including under Labour in the UK.

The environment and education areas provide further examples of the ready in-principle acceptance by economic rationalists of government intervention. The basic logic here is that, while such intervention imposes costs on individuals or impinges on their individual freedom, it produces more-than-offsetting benefits for the community at large.

For example, government intervention to regulate and control the level of pollution is usually appropriate because individual factory or car owners have no economic incentive to limit the extent to which they emit pollutants and there would otherwise be excessive pollution. Similarly, government intervention is justified to ensure free and compulsory primary and secondary education because there are net "spin-off" benefits both economically and socially from having an educated community.

Finally, can ER be blamed for the view that the quality of life has declined? My belief is that there is little evidence to support this view. It probably reflects concern at the increase in competition and the associated perception of increased stress. Yet Australians have continued to become healthier during the 1990s.

In conclusion, I hope some things are clearer about ER. First, it is not the same as a free-for-all laissez-faire system. Second, while government intervention and regulation is needed, that needs to be reduced. Third, such a reduction would improve economic efficiency and living standards. Fourth, there would be an improvement in equity resulting from the elimination of government assistance to particular groups that have no needs basis for it.

Supporters of government intervention are often either pushing their own barrows or some barrow that reflects their own interventionist view of how the world should be organised. History tells us that we should be extremely cautious of jumping on to such barrows.