insights volume 3 april 2008

Melbourne Economicsand Commerce

volume 3 april 2008

Policy making in an uncertain world By Nilss Olekalns

Did business matter? Australia in the twentieth century

By David Merrett

Financial shell games By Satyajit Das

Drugs policy: a role for economic research?

By Steve Pudney

Our schools...our future By Stephen Sedgwick

Occasional addresses by Alumni

By James T Riady and Laurence Cox AO

I N S I G H T S

Welcome

Insights publishes condensed and edited versionsof important public lectures connected with the Faculty of Economics and Commerce. Bypresenting these lectures in a language andformat accessible to the general reader, we hopeto share their substance with the wider publicand especially with alumni of the Faculty. We also aim to establish archival material forfuture researchers.

In this Volume, we publish a number ofinteresting and important lectures. Aspects ofthe current international monetary crisis arediscussed in two articles, while the importanceof business in Australian economic developmentfeatures in another paper. The Downing Lectureexplores a serious social issue and gives valuableinsight into the challenges of developingeffective public policy on illicit drugs. Onceagain, we publish a summary of variouscontributions to one of the Melbourne Institute’sconferences. Finally, two distinguished alumni

share their professional experiences in theirremarks to new graduates.

In addition to these contributors, this Volumehas benefited from the work of many. As in thepast, we complement the intellectual contentwith an artistic element. On this occasion, we arefortunate to include Christopher Nielsen’s livelyillustrations expressing the themes of the papers.Special mention should also be made of thecontribution and constant support of myassociate, Brooke Young; of Rebecca Gleeson forsub-editorial assistance; and of Sophie Campbellfor the attractive design of the journal.

Insights is in its second year of publication and we hope that it is becoming a welcome additionto your business reading. Your suggestions andfeedback on the publication would be mostwelcome.

Joe IsaacEditor

Insights: Melbourne Economics and CommerceISSN:1834-6154

Editor: Emeritus Professor Joe Isaac, AOAssociate Editor: Ms Brooke YoungSub-editor: Ms Rebecca Gleeson

Advisory Board: Dr Robert DixonProfessor Bruce GrundyProfessor Bryan Lukas

Illustrator: Mr Christopher NielsenDesign: Ms Sophie Campbell

03 Policy making in an uncertain world

By Nilss Olekalns

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

09 Did business matter? Australia in the twentieth century

By David Merrett

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

15 Financial shell games

By Satyajit Das

The gigantic liquidity bubble is nowdeflating. The sub-prime problems were merely the trigger for a majoradjustment in the availability and cost of borrowings globally

21 Drugs policy: a role for economicresearch?

By Steve Pudney

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

27 Our schools...our future

By Stephen Sedgwick

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

32 Occasional addresses by Alumni at University of Melbourne graduations

32 Pursuing talents and confrontingburdensGraduates should regard today not as the omega point but as the alpha point of their lives By James T Riady

34 The importance of vision andpeople Seek to work alongside the best people who will challenge your ideas and assure your vision is achievedBy Laurence Cox AO

insights vol 3Table of contents

Insights Melbourne Economics and Commerce 01

03Insights Melbourne Economics and Commerce

Keynesian and other views onuncertainty

John Maynard Keynes, founder of macro -economics, made uncertainty a key theme of hisGeneral Theory of Employment, Interest andMoney. Keynes saw uncertainty as a market failure,most apparent in what we now call coordinationproblems. These coordination problems were a key reason for what Keynes saw as a tendency for economies to become trapped in a lowemployment-low output equilibrium.

The problem as Keynes saw it was the inability offirms to coordinate their investment decisions.Individual firms who perceived a lack of aggregatedemand for their product would, understandably,refrain from investment spending. If enough firmsacted in this way, there would indeed be aninsufficiency of aggregate demand, in this casecaused by firms’ lack of investment spending. Onthe other hand, if firms could coordinate theirinvestment spending – that is, collectively agree toincrease their expenditure – the very existence ofthis spending might generate sufficient aggregatedemand in the economy to make that investmentprofitable. However, uncertainty about whetherother firms will increase their spendingdiscourages each firm from going ahead with itsown spending. This is a classic coordinationproblem; one that Keynes thought could beresolved through government management of theeconomy to place a floor beneath aggregatedemand. In Keynesian economics, policy acts in avery pragmatic way to resolve uncertainty.

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

Examining different aspects ofuncertainty

Here, I want to discuss two themes in my researchon very different aspects of uncertainty. The first,which is collaborative work with my colleagues atthe University of Melbourne, Ólan Henry andKalvinder Shields, looks at how we might modelthe creation of uncertainty. Our research also looksat how that uncertainty might then affect thedynamic interrelationships that exist betweenmacroeconomic variables. In contrast, the secondstrand of my research involves the destruction ofuncertainty, attempting to strip away some of theuncertainty confronting policy makers when theyare reviewing the current (and past) state of theeconomy. I am currently engaged in this researchwith Kalvinder Shields and another colleague,Kevin Lee, from the University of Leicester.

Let us step back for a moment and think aboutwhy a policy maker might be interested both inthe effects of uncertainty and the ways toalleviate that uncertainty.

A condensed version of his Inaugural Lecture delivered at the University of Melbourne on11 March 2008.

policy making in an uncertain world

by nilss olekalns

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

04 Policy making in an uncertain world

All decision making, including that undertaken atthe national level by policy makers, involves someinitial processing of past and present information.Against the background of this information,decisions are made that are expected to haveparticular outcomes in the future. The future,however, is uncertain. As the Roman philosopherand playwright Seneca said, ‘We let go thepresent, which we have in our power, and lookforward to that which depends upon chance, andso relinquish a certainty for an uncertainty.’

The ultimate outcome of such decisions dependson what economists call the ‘state of the world’,but this only emerges with clarity some time after thedecision is taken. For example, a decision such as thatrecently undertaken in Australia by the ReserveBank to tighten monetary policy, will have aneffect on the Australian economy that cannot bepredicted precisely unless we know how the stateof the world will unfold. Will China continue toboom, for example? The answer to that questionwill go a long way to determining whether currentmonetary tightening will push the economy intorecession. Yet, although China’s continued growthis probable, it is by no means certain.

Modelling the effect of uncertainty onthe economy

To what extent does uncertainty affect theeconomy? To answer this question, at least in aformal sense, requires a modelling strategy,preferably with a framework that is sufficientlygeneral to encompass the origins of the uncertaintyand how, once created, the uncertainty affects theeconomy. Empirically, measuring uncertainty isstraightforward, especially if one is working with aproperly specified model. Uncertainty is simplythat which is not explained by the model andhence could not have been predicted.

However, this begs a host of important questions,not the least of which is: how does one know if oneis working with the correct model of the economy?Given the number of competing models, this is nota trivial question. One approach has been thepractice of model averaging. For example, it might bereasonable to advocate a policy change if, when thechange is introduced into a series of competing

models, none of the models predicts undesirableconsequences.

An alternative approach is to work with a singlemodel that is as general and flexible as possible; amodel that can encompass a variety of possiblestructures of the economy. Using a very general type of modelling approach known as vector auto -regressions, we have developed a framework that:

– Exploits the dynamic relationships that bindeconomic variables together;

– Models how uncertainty is created through thearrival of new information (news) that couldnot have been anticipated on the basis ofcurrent or past information;

– Allows that uncertainty to impact on thefuture realisation of economic variables; and

– Differentiates between the effects of good andbad news in terms of how much uncertainty iscreated (with bad news creating moreuncertainty than good news).

Our approach is inherently non-linear; that is, ittakes account of the state of the world. This isentirely consistent with the decision makingprocess noted earlier, where what unfolds after adecision is made depends on the state of the world.Thus, in our non-linear model, the state of theworld matters as to how the economy responds toa particular piece of news. News that arrives in arecession, for example, may have an entirelydifferent effect on the economy than if the samenews arrives when the economy is booming. Byway of contrast, most empirical economic modelsare not like this; they are linear in nature and, insuch a framework, the response to news isindependent of the state of the world. As ourmodel includes the state of the world, it is a moregeneral representation of how the economyresponds to the creation of uncertainty.

Interactions between the sharemarket and economic growth

One application of these techniques has been tolook at the interactions between the share marketand economic growth. Does uncertainty abouteconomic growth affect the share market? Doesshare market uncertainty affect economic growth?


And does it matter when in the business cycle theuncertainty occurs? Our findings suggest that theconsequences flowing from the occurrence ofuncertainty depend a great deal on the state of theeconomy. In particular, the arrival of news abouteconomic growth (and hence the creation ofuncertainty) has a much larger impact on theshare market just after the economy has peaked aswell as just after the economy has troughed. Theseresults reinforce the view that the state of theworld matters for the dynamics of the economy.To predict how a particular economy mightrespond to uncertainty requires knowledge aboutthe state of the world.

Uncertainty about the state of theworld

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

certainty, about current economic conditions? Theanswer to this question is a fairly emphatic ‘no’.What policy makers have is an imperfect snapshotof the recent past and little or no informationabout what is happening in the present. They haveno choice but to operate in a climate ofuncertainty about the state of the world.

This uncertainty has its source in the technologyavailable to statistics bureaus when they gatherinformation about the economy in real time; that is,data available at a particular point in time. Thereare two sources of uncertainty in this connection.First, the information is subject to a time lag.Thus, the information on Gross Domestic Productfor a particular quarter is available only in thesubsequent quarter. Secondly, the information isrevised, sometimes well after the quarter to whichit relates. Both sources of uncertainty createproblems for policy makers who requireinformation on the contemporaneous state of the

06 China in International Imbalances

economy. Indeed, without this information, it willbe difficult to predict exactly how the economymight respond if, for example, macroeconomicpolicy were to be changed.

The research with my colleagues Kalvinder Shieldsand Kevin Lee is a response to this element of uncertainty. The research involves nowcasting;that is, constructing a model that explicitlyincorporates information about the timing of datareleases and the nature of revisions that the datasubsequently undergoes. By incorporating thisinformation into the model, it may be possible toinfer information about the actual state of theeconomy from the first release of the data. In

addition, we have supplemented this with othersources of real time data – specifically, informationfrom financial markets as summarised in the spreadbetween long and short term interest rates, and theviews of professional forecasters concerning thecurrent state of the economy. This data, available inreal time, is not subsequently revised, and maywell be informative about the contemporaneousstate of the economy.

The practical usefulness of this approach can beillustrated by reference to current developments inthe US economy. At present, there is considerablepublic debate about the prospects for the USeconomy in the wake of the sub-prime mortgage


crisis. Some commentators have expressed theview that the US economy is already in recession.The most recent data we have relates to GrossDomestic Product (GDP) in the DecemberQuarter of 2007. This is first release data – weknow that it will be revised. By adopting themodelling strategy as described above and thenusing simulation techniques, we are able to buildup a picture of how likely it is that thepreliminary data is consistent with the view thatthe US economy is currently in a recession. In thisinstance, we define a recession to be two successivequarters of negative GDP growth. This would beregarded as a severe slowdown.

We find that once we take into account (i) thedynamic interrelationships that exist betweenmacroeconomic variables, (ii) the patterns thatexist in the way variables are revised and thetiming of their release, and (iii) thecontemporaneous information contained ininterest rate spreads and professional forecasts,the probability that the latest figures areconsistent with a recession in the first quarter of2008 is around 30 per cent. This is a largeenough figure to give cause for concern.

Summary

Uncertainty is a pervasive feature in economics. I have described two modelling approaches thathave, as their unifying feature, a requirement totake uncertainty seriously. Uncertainty matters forthe economy and the way that macroeconomicvariables evolve through time. Further, policymaking requires techniques to peer through theuncertainty to establish the real facts behind it.

Professor Nilss Olekalns is Professor ofEconomics in the Department of Economicsat the University of Melbourne.


did business matter? australia in the twentieth century

by david merrett

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

on why business mattered here

Did business matter in the twentieth century?What a silly question. Of course it did. Privatelyowned businesses have been the bedrock of the Australian economy. Firms, small and large, provided employment and generated thegoods and services the country consumed orexported. Their collective health has been ameasure of our prosperity.

The neglect of Australian businesshistory

The question has a different shade of meaning whenposed to economic and business historians, andperhaps explains why business has been neglectedin the narratives that describe and explainAustralian economic development. Scholars haveconcentrated on the big picture issues such asinflows of migrants and population growth, inflowsof capital and patterns of investment, the growth ofnatural resource industries, depressions and wars,and the changing role of the state as a regulator,protector (via tariffs and subsidies) and economicmanager. In these narratives, the most importantprivate sector institution in the economy, the firm,was marginalised.

The Australian story

Our understanding of the critical importance offirms in national economic development owesmuch to Alfred Chandler. In The Visible Hand

(1977), Chandler recast the interpretation of thegrowth of the US from the last third of thenineteenth century. Up to the Civil War, theeconomy was a network of small farms, workshopsand stores linked by merchants. It was a world oflocal and regional markets, whose businessenterprises were predominantly family-based,sole proprietorships or partnerships. There wasminimal distinction between ownership andcontrol or between family owned and managed.The technology, particularly in manufacturing,still favoured small scale enterprise and the capitalneeded was not beyond the means of individualsand their social networks.

Technological change let the genie escape from thebottle. The steam engine, steam ship and electrictelegraph transformed the US economy at boththe macro and micro level. The revolution intransport and communication, reducing the costsand time taken to move people, goods andinformation, allowed the creation of a nationalmarket. Businessmen could buy and sell in widermarkets, and opportunities beckoned. A parallelrevolution occurred particularly within factories.The combination of improved motive power, firststeam and then electricity, and advances inmetallurgy, metal working and chemistry broughtforth the second industrial revolution. Newindustries emerged and the old were transformed:primary metals, chemicals, glass, petroleum,rubber, processed foods, beverages, electrical

A condensed version of his Inaugural Lecture given at the University of Melbourne on 20 September 2005.

10 Did business matter? Australia in the twentieth century

machinery and equipment. These industries weredescribed by Chandler as ‘science-based andcapital-intensive’.

The old style of firm – family-owned andcontrolled – could not use the new technologieseffectively. The new industries required new formsof knowledge about science and engineering thatincreasingly came from university graduates.Moreover, the new industries required capital onan unprecedented scale for the construction ofhuge factories. First movers in industries such asiron and steel or oil refining captured the benefitsof economies of scale. Per unit costs tumbled asvolumes rose. The long and the short was that thesuccessful firms in industries such as the railroads,telegraph, steel and oil changed form. Theyincorporated, hired professional managers with awide range of functional skills ranging fromengineers and chemists to accountants andlawyers, and they raised capital from the sharemarket, bankers and bond holders. The moderncorporation had arrived.

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

First, a small number of very large firms came todominate key industries. These monopolies andoligopolies enjoyed enormous market and politicalpower. Their owners and their bankers – peoplelike the Morgans, Rockefellers and Carnegies –were typecast as ‘robber barons’.

Second, a less obvious but more importantconsequence was the emergence of a newoccupational class: the salaried manager. Thesemen operated companies they did not own; thenexus between the risks of ownership and rewardsof control had been broken. The new owners, theshareholders, had no say in the management.

Third, new knowledge was accumulated by thosein charge as they dealt with the scale andcomplexity of the enterprises. Over time basicprinciples of management emerged and the firmbecame a hierarchy with overall control at its apex

in the form of a board of directors. Communicationflows to the separate functional departments,such as purchasing, production and sales, werevertical and carried instructions and reports.Head office housed staff functions, personnel,audit and legal. Many firms had numerous plants,warehouses and factories in different locations.The collection and transmission of informationup and down the hierarchy and between unitsbecame standardised and regulated, andaccounting data and particularly ratios becamethe shorthand that prevented informationoverload at the top. The role of seniormanagement was to coordinate the work of thedepartments so as to maximise the flow of workthrough the organisation and onto the market.

The large ‘industrial enterprises’ continued toexpand after the application of the late nineteenthand early twentieth century technologies. Havingdominated particular markets through theerection of massive barriers to entry, theydiversified into new markets that were usuallyclosely related in terms of underlying technologiesor used similar distribution channels. The key tocontinued expansion was the ability to create new products and to find new markets,particularly overseas.

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


Lessons from US experience

The end point of Chandler’s enormouscontribution to business history is that the qualityof management matters and, as a corollary, howthe firms they managed are organised matters. His work takes us to the core of the contemporarydebates about the sources of sustainablecompetitive advantage. What matters most aredifferences in the ability of firms to make strategic decisions about what business to be inand simultaneously to manage a large andheterogenous bundle of resources. The mostsuccessful and long lived organisations are thosethat possess the ability to continuously adapt tonew environments, and learn to do new things

with the knowledge and resources at hand. Bymid-century, the US possessed more firms withstrong competitive advantages in a wide range ofmanufacturing and service industries than anycountry on earth. A by-product of this process ofcompetition was that resources were used moreefficiently. The US became the world’s economicpowerhouse, its citizens enjoyed the higheststandard of living and its multinationals took UStechnology and marketing skills into marketsaround the world.

The Australian story

What of Australia? Did local manufacturing firmsundergo a similar transformation to those in the

US and other mature industrial economies? If theydid, we would expect the new organisationalforms and the efficiencies inherent in them to haveprovided a stimulus to productivity in thiscountry. In The Big End of Town, Grant Fleming,Simon Ville and I attempted to answer thisquestion. Our first task was to identify large firms,those most likely to have required sophisticatedmanagement of large knowledge basedorganisations. We compiled lists of the 100 largestfirms, measured in terms of assets, in 1910, 1930,1952, 1964, 1987 and 1997. Then we allocatedeach firm to an industry classification and notedwhether they were Australian or foreign ownedeach time they appeared in the lists.

Our data confirmed what we already knew.Australia, at least early in the twentieth century,was a different type of economy from the industrialpowerhouses of the northern hemisphere. It wasstill heavily oriented towards natural resourceproduction and export. Manufacturing was small-scale and technologically unsophisticated. A largeservice sector served the export and import trade: rail transport, ports, insurance, banking,warehousing, auctioneers and wholesalers. Nearlyall farms were still family owned. The governmentowned and operated the major rail transport andcommunication systems, and a large number ofother business enterprises, particularly energy. Amajor change took place from the 1920s onwards

Did business matter? Australia in the twentieth century12

as local manufacturers swiftly replaced imports toreach a peak of relative importance in the 1960s.Thereafter, a resurgent resources and serviceindustry, including government enterprises,refashioned the economic landscape once again.

The changing Australian scene

Our changing list of leading firms mirrors thesetrends in aggregates measures. For instance, thelargest firms in Australia before WWI wereservice providers to the pastoral industry, such asDalgety and Goldsbrough Mort. By mid-century, new firms had emerged as leaders, nearlyall of whom were ‘science-based and capital-intensive’. The pack was led by miners and metal refiners such as BHP and CZC (now RioTinto), and cars, glass and paper producers suchas GM-H, ACI and APM.

The number of foreign firms in the list rose sharplyas subsidiaries of multinational enterprises enteredAustralia in the 1920s and again at higher rates in the 1960s and 1970s. By century’s end, the list had changed radically once more. Firmsoperating in service industries had come to thefore: News Corp, and the partly privatised Telstraand Qantas. The large miners, BHP and RioTinto, were still there and had been joined byWMC. The leading manufacturers included theCoca-Cola bottler, CCA; CSR, which diversifiedbeyond sugar into resources and buildingproducts; Amcor (once APM); and BTR-Nylex, adiversified manufacturer.

Comparing Australia with othercountries

Did the organisational structure of Australianfirms change as they had in the US and to a lesserextent in Germany and the UK? Our researchsuggests that they did, but with a significant timelag. Our study was based on those 354 firms thatappeared in at least one of our top 100 lists, andmore importantly on a smaller group of 63, our‘corporate leaders’ which had appeared in at leastthree lists. The largest and most successful firmsevolved, becoming modern corporations by the1950s and 1960s. They were listed on stockexchanges, their directors did not, for the mostpart, participate in day-to-day management,

senior staff increasingly possessed some formalqualification appropriate to their role, and thefirm’s organisation charts showed the separation offunctions between departments.

Moreover, as they diversified, particularly afterWWII, these firms adopted a divisional structure.New knowledge about how to manage came from a variety of sources: observation by Australianbusiness people as they travelled overseas,subsidiaries of American and British firmsbrought their advanced management skills withthem and, particularly from the 1960s onwards,management consultants such as McKinsey & Coprovided a template for organisational design.

Australia enjoyed rising living standards duringthe twentieth century. Output rose faster than the physical inputs, labour, land and capital, usedin production. That gap, productivity growth, isusually explained with reference to improvementsin technology, better engineering and science.However, improvements in the quality ofmanagement associated with the rise of bigbusiness also lifted the productivity with whichresources were used. Business mattered becausemanagers learnt through trial and error to design and operate larger and more complexorganisations which exploited economies of scaleand scope. The cumulative effect of incrementaladvances in knowledge about how to administerresources within the firm has made an importantcontribution to the prosperity of Australia.


Professor David Merrett is in theDepartment of Management and Marketing atthe University of Melbourne.


financial shell games

by satyajit das

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

cost of borrowings globally.

A condensed version of a lecture given at the Melbourne Centre for Financial Studies andthe Financial Services Institute of Australasia on 26 February 2008.

The end of the world?

In Indian mythology, we are in the Age of Kali –the last age, in which the world ends when Kalidances the dance of death. With the sub-primecrisis in the US, which started in 2006, creatinga ripple effect in global markets, has Kali begunher dance for financial markets? Americantelevision personality Jim Cramer, who launcheda ‘we’re in Armageddon’ tirade, seems to think so;while Samuel Molinaro, Chief Operating Officerof a leading global investment bank, pleaded ‘I’vebeen out here for 22 years, and this is as bad asI’ve seen it in the fixed-income markets.’ It’s clearthat the credit bubble is finally deflating.

The new liquidity factory

Where did it all start? The early 2000s was aperiod of ‘too much’ and ‘too little’ – too much money,too much borrowing, too much complex financialengineering, too little return for risk, and too littleunderstanding of the risks. Steven Rattner (fromhedge fund Quadrangle Group) summed it up inthe Wall Street Journal: ‘No exaggeration isrequired to pronounce unequivocally that moneyis available today in quantities, at prices and onterms never before seen in the 100-plus yearssince US financial markets reached full flower.’

Liquidity is the amount of money and creditavailable. In the ‘new liquidity factory’, investorsborrowed – hedge funds borrowed againstinvestments; traders borrowed cheap money

(especially Japanese yen at zero interest rates) tofund high yielding assets. Bankers became adeptat stripping money out of homes where prices hadrisen to fund a frantic personal debt addiction inthe fast debt nations – US, UK and Australia.Traditional money, fueled by loose monetarypolicy, low interest rates, large capital flows fromthe savers of Europe and Asia, was turbo-chargedby ‘financial engineering’. It was this engineering– otherwise known as derivatives – that laid thefoundation for the current credit crisis.

Derivatives – highly leveraged commercial betson movements in prices of financial assets – canbe used to manage or create risk. In recent years,more and more investors were turning toderivatives to increase risk for higher returns.One example we have seen is the CollateralisedDebt Obligation (CDO), a mortgage loan securedon steroids. It works like this. A portfolio ofloans, bonds or mortgages is assembled. CDOsecurities, secured over the portfolio, are sold toinvestors. Interest and principal from theunderlying portfolio is used to make payments onthe CDO securities issued. The investors receivehigher returns than from traditional investments.

CDOs and their kin – structured credit – havehelped supersize debt levels using techniques ofstaggering complexity, incomprehensible to allbut a small group of practitioners. The market was so heated that one professional confessed thateven his headhunter had been recruited into a

Figure 1

structured credit role at an investment bank.Buyers from Switzerland to Slovakia, Boston toBeijing bought up credit risk. A feature of themarket was that the investor did not understandthe complexity and risk of structures.

The new liquidity machine created a moneypyramid that has no parallel in history, as shownin Figure 1.

Now, this gigantic liquidity bubble is deflating.The sub-prime problems were merely the triggerfor a major adjustment in the availability and costof borrowings globally. Investors, including hedgefunds, who borrowed heavily against assets thathave gone down in value, have been forced to sellto repay borrowings. However, in the highlyleveraged world of the new liquidity factory, theamount that needs to be sold is exaggerated.

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

compared the current credit crunch to death fromradiation – CDO, particularly those with sub-prime exposure, now stands for Chernobyl DeathObligations!

Financial ‘shell games’ or the ‘peaand thimble’ trick

Markets exaggerate the short-term impact andunderestimate the long run impact of events, andthe liquidity factories were based on the New Ageidea of ‘risk transfer’. Traditionally, banks madeloans and then held them on their balance sheetstill maturity. In the new money game, banks‘originate’ (sell) loans, ‘warehouse’ (hold) them ontheir balance sheet for a short time and then useCDO technology to ‘distribute’ (transfer) them toinvestors such as insurance companies, pensionfunds and ubiquitous hedge funds. Central banksbelieve that if banks sell off their loans in this way,the risk is distributed widely, thus reducing thechance of a crash.

Financial shell games16

% of world GDP

10%

122%

142%

802%Derivatives

Securitised debt

Broad money

Centralbanks

% of liquidity

1%

11%

13%

75%

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

Yet risk transfer is a short con, quick and easy topull off. It’s like the ‘shell game’, which involvesthree shells and a small, round ball about the sizeof a pea. The trickster places the ball under one ofthe shells, then shuffles the shells around quickly.Bets are taken from the audience on the locationof the ball. By sleight of hand, the operator easily hides the ball, undetected by the victims.Like the shell game, risk transfer via thestructured credit market is a confidence trickused to perpetrate fraud. And in the currentcredit crunch, the shortcomings of the newmoney game are being exposed.

Banks do not sell off their real risks very often,mainly for regulatory reasons. In a CDO, the banktypically takes some of the riskiest securitiescreated. This is ‘hurt money’ or the ‘skin in thegame’ to reassure other investors, which the banksmust hold until they can be sold. If there is amarket disruption and the bank is unable to sellthe risk into the market, then the risk remainswith the bank.

However, the risk may also return to the bank viathe back door. Where it acts as a prime broker –this is where banks execute trades, settletransactions and lend to hedge funds – the banklends to investors using the CDO securitiescreated as collateral. If the value of the securitiesfalls and the hedge fund is unable to postadditional margin to cover the loss, the bank isexposed to the risk of the securities. The bank

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

Banks have also created a plethora of off-balancesheet structures – arbitrage or conduit vehicles –known as structured investment vehicles (SIVs).The vehicles purchase high quality securities likeAAA or AA rated CDOs and fund them withshort-term borrowing, usually commercial paper(CP) issued to money market funds. Banks providestandby lines of credit to the vehicles to coverfunding shortfalls. If CP cannot be issued, thebanks may be forced to lend against the assets thatthey have supposedly sold off. In the current crisis,some banks refused to lend, arguing materialchanges in circumstances. Others foraged downthe back of the sofa for any loose change to add totheir dwindling liquidity to meet theircommitments. Some bowed to the inevitable andtook the assets back onto their balance sheets.

The new money game assumes that the risk movesto stable investors. In fact, credit risk moves froma place where it is regulated and observable to aplace where it is less regulated and more difficultto identify. Around 60 per cent of all credit risk istransferred to leveraged hedge funds that may beinadequately capitalised to bear the risk – aroundone dollar of ‘real’ capital supports between $20and $30 of loans. In contrast, banks are required tohold $1 of capital for every $12.50 of loans.


When we see banks setting up hedge funds, andinvesting in them, the trouble begins. Hedgefund investors can withdraw funds at relativelyshort notice, typically, one to three months. Thehedge fund’s borrowings are also short-term, andthis money finances long-term assets, making thehedge funds vulnerable to a credit crisis. When ahedge fund gets into trouble, as we have seen,there is commercial and reputation pressure tosupport the fund, bringing the risk back into thebank. As one humorist wryly suggested, withmore and more funds facing margin calls, theyshould meet capital calls by using nickels,pennies and quarters.

The same model as sub-prime is used, worryingly,for funding highly leveraged private equity, infra -structure and property transactions. As of August2007, $300 billion of leveraged finance loans madeby banks have been effectively orphaned. In otherwords, they cannot be sold off. One bank recentlyoffered $1 billion to a client to walk away from anunderwriting commitment where it stood to losemore if the transaction proceeded. Another bank,active until recently in making multi-billion dollarcommitments to private equity transactions, toldclients that ‘they were not in leveraged lendingbusiness any more.’ It smacked of the day in thelate 1980s when the then all-powerful Japanese

Financial shell games18

banks refused to participate in leveraged financingto meet the cost of acquiring United Airlines. Thisushered the end of that era.

Truth in labelling

There is a lack of transparency in many of theseactivities. One trader summed it up using DonaldRumsfeld’s immortal words: the known known wasthat there were losses in sub-prime mortgages andanything related to them; the known unknown wasthat everybody knew that they did not know thefull extent of the problem; the unknown unknownwas that there could be other problems aboutwhich we did not then know. Investment banksand hedge funds believe in transparency anddisclosure for everybody, except for themselves.One central banker observed that in the good olddays, there would have been no problem as therisk would be where it always was – at the banks.

There are also problems about the models used tovalue these complex securities, assumptions aboutbeing able to buy and sell them, and the role ofrating agencies in certifying them.

The current crisis points to the need for significantand important changes in financial markets. In its2007 annual report, the Bank of InternationalSettlements (BIS), the central bank to the world’scentral banks, admitted that ‘our understanding ofeconomic processes may be even less today than itwas in the past.’

The temptation to seek a scapegoat – such as thebrokers that sold sub-prime mortgages and ratingagencies – looms large. And the temptation for aquick fix – lower interest rates – is ever-present.The Federal Reserve System has cut the discountrate. It has also clarified the rules, stating thatbanks can pledge asset backed commercial paperas collateral for funding at its discount window.Usually, only government securities are eligible.The Fed is effectively underwriting the credit risk,and is arguably reverting to type, bailing outbanks and investors from poor decisions orirrational exuberance in underwriting excessiverisk-taking.

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

ideas as in escaping from old ones.’ But as JohnKenneth Galbraith observed: ‘faced with thechoice between changing one’s mind and provingthere is no need to do so, almost everyone getsbusy on the proof.’

There are unknown knowns in financial markets –what we did not know we knew. These are things wenever admit to ourselves. Ordinary, decent peoplealways pay for financial excesses with their hard-earned money and taxes. We all knew thatsomewhere along the road, the financial shellgame would end this way.


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


A condensed version of the 20th Richard Downing Lecture delivered at the University ofMelbourne on 6 December 2007.

Drug abuse gives rise to intractable and enduringsocial problems and its policy counterpart, the‘war on drugs’ continues to be one of the mosthotly debated areas of public policy. Economistsplay a surprisingly minor role in this debate.Illicit drugs are just market commodities, drugdealers and users are just market participants and– if economists know about anything at all – onewould expect them to know about the workingand regulation of markets. Economics also has a lot to say about the nature of behaviouralresponses to incentives created by the policyenvironment (some of which may be unintended)and about the need to compare social costs andbenefits when considering policy options. Despitethis potential contribution, the economic researchliterature on illicit drugs is small and the fieldremains mainly the province of medical and non-economics social science research.

The proper basis of public policy

I would argue that any policy on harmfulsubstances should be based on reasoned argumentand sound evidence – and that we should bear inmind the possibility that there may be somesocial harms that feasible public policy cannotremedy. Economists are used to the idea of policyineffectiveness, but this idea is absent from muchof the non-economic literature on drug abuse.Many commentators appear to believe that thedemonstration of harmful effects (of cannabis onmental health, for instance) is sufficient in itself

to justify a ‘tough’ drugs policy. Economicsteaches us otherwise: that tough policy may beineffective, may have damaging unintendedconsequences or may involve a level of cost thatoutweighs any likely social benefit.

The evidence on illicit drugs

The quality of the available evidence is an obviousconcern. For most of the substances regarded as‘drugs’, possession and market transactionsconstitute illegal activities and drug userstherefore have a strong incentive to conceal their behaviour, making measurement highlyproblematic.

I classify evidence on illicit drugs into threecategories: quasi-facts, pseudo-facts and fantasy-facts. Quasi-facts are possibly prone to seriouserror but they are at least based on a clear anddirect measurement process, usually involvinglarge-scale sample surveys. An example is theregular publication of general-populationprevalence rates published in the UN World DrugsReport (Figure 1), which portrays Australia as aworld leader in the consumption of cannabis,amphetamines and ecstasy. Such ‘facts’ areundoubtedly prone to varying degrees of under-estimation through under-reporting and to non-comparabilities across countries.

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

by steve pudney

Drugs policy has a long and inglorious history and has often been driven lessby reason and evidence than by prejudice and sentiment, moral panic and

conviction, and political fear and opportunism

drugs policy: a role for economic research?

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

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

assumptions. For example, the UK Drug HarmIndex2 combines data from many sources withlarge assumptions about imponderables like thevalue of a life cut short by drug-taking (Figure 2).These attempts at measurement are often verysophisticated and may provide a useful guide tothe evolution of the drugs problem and the impactof policy – and they are certainly better thannothing – but it is important to avoid treatingthem as clearly established ‘fact’.

Drugs policy: a role for economic research?

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

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

22

cannabis

cocaine

opiates

amphetamines

ecstasy

% p

reva

lenc

e

History of drugs policy

Drugs policy has a long and inglorious history andhas often been driven less by reason and evidencethan by prejudice and sentiment, moral panic andconviction, and political fear and opportunism.Jessica Warner’s book Craze: Gin and Debauchery in anAge of Reason (2002) draws a clear parallel betweenthe eighteenth century moral panic about gin andcontemporary worries about illegal drugs. In bothcases, we see policy strongly affected by publicoutrage, largely fuelled by the media and oftenbased on little or no evidence. Compare thesequotations from the London press 250 years apart.All the elements are the same, only the writingstyle and the physical substances are different.

This wicked GIN of all Defence bereftAnd guilty found of Whoredom, Murder, TheftOf rank Sedition, Treason, BlasphemyShould suffer Death, the Judges all agreeLondon Evening Post, March 1751

Drugs take lives and tear apart communities.They also undermine all our efforts to combatcrime. The Government needs to get an urgentgrip on this problem. Daily Mail, August 2006

The gin and tonic drinking Daily Mail reader whodeplores cannabis-smoking youth is to someextent the product of random swings in our viewsabout the substances which merit concern, andrecent research3 suggests that gin and tonic mightin fact be a greater source of health concern thancannabis.

The strong public pressure on policy makers tosolve the drugs problem has generated a good dealof tough talk by politicians, but remarkably littleevidence of any strong effect on drug use. Forexample, in his 1989 inaugural address, GeorgeBush Snr. promised ‘there is much to be done andto be said but, take my word for it: this scourgewill stop.’ Well, it did not. If we look at quasi-factsfrom the annual US Monitoring the Future (MTF)survey, the proportion of 12th grade students whoreported using marijuana continued its longstanding downward trend that began in 1978-9 to a low point of 22 per cent in 1992, beforestarting a sustained rise to a peak of 39 per cent in1997. Throughout the period, the proportion ofrespondents reporting that marijuana was easy toobtain remained well above 80 per cent. Similarly,the UK government’s reclassification of cannabisfrom class B to class C status in January 2004(which weakened the penalties for possession) hasapparently had no impact on the downward trendin self-reported cannabis use which began in 2003(Figure 3), despite the dire warnings of possibleconsequences which appeared in the press.

The apparent ineffectiveness of much drugs policydoes not mean that drug consumption is unaffectedby events – just that those events are often notunder the control of policy-makers. An excellentexample from the US is the dramatic fall in self-reported cocaine use (in the year precedinginterview) by 12th grade MTF survey respondents.1986 witnessed the start of a six-year decline incocaine use from 13 per cent to three per cent, andan unprecedented 16-point single year increase inthe percentage seeing ‘great risk’ in using cocainejust once or twice. Was this the outcome of a radicalnew policy initiative? No. It resulted largely from amedia frenzy surrounding the death of a basketballplayer, Len Bias, reported (incorrectly, as it turnedout) to have resulted from his first use of cocaine.Available data suggest that this is a permanenteffect – cocaine use in the US school population hasremained below half its previous level.

The gateway hypothesis

The most distinctive part of the economist’scontribution to policy analysis is the analysis ofbehavioural response to the incentives created bypolicy. A good example is the hotly-debated


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

Pre

vale

nce

cannabiscocaineecstasyopiates

24 Drugs policy: a role for economic research?

‘gateway hypothesis’, which asserts that the use ofcannabis increases the risk of subsequent use ofhard drugs, in a direct causal sense. Superficially,the evidence seems to be consistent with this idea.For instance, survey evidence suggests that almostall hard drug users had used cannabis beforemoving on to harder drugs. However, precedencein time does not necessarily imply causation.(Consider: does the sending of Christmas cardscause the occurrence of Christmas?) We also findthat hard drug users on average display higher ratesof early family disruptions, psychologicalimpairment, involvement in petty crime andtruancy, and so on. It is quite likely that cannabisand hard drug use are frequently joint outcomes ofa common underlying set of causal factors, withthe earlier onset of cannabis merely a reflection ofeasier access and lower price.

A disappointing feature of the research literatureon the gateway hypothesis is the absence ofanalysis of policy design. If we could demonstratethe existence of a gateway effect, what would bethe implications for policy? To answer thisquestion, we need to understand the behaviouralbasis of the gateway effect. There are manypossibilities, but an interesting one is the supply-side or access gateway. Some people stronglybelieve in this theory: for example, in October2007, a primary school teacher called NicolaCooper, from the Suffolk town of Bury StEdmunds, was convicted of supplying her ownchildren with cannabis. Kevin McCarthy,defending, told St Edmundsbury Magistrates’Court ‘she had effectively become a drug supplierto keep her children away from other suppliers.The reason for the supply was to keep those

Insights Melbourne Economics and Commerce

cherished children away from the drug culture.’Mrs Cooper’s belief in the dangers of the accessgateway is shared by Dutch policy makersresponsible for the tacit legalisation of retailcannabis supply through Amsterdam coffeeshops, which can be interpreted as an attempt tosegment the drugs market and separate cannabisusers from supplies of other drugs.

Although we have no relevant evidence beyond afew fantasy-facts, it is possible to construct a storythat illustrates the way incentives might work toproduce an access gateway. Comparing the US andUK, the US appears to have a more uniformlytough policy on the supply of all drugs, whereasthe UK has a more graduated scale of penalties. InUK courts, the mean sentence for heroin/cocainetrafficking relative to cannabis trafficking is 5.5:1,while in US Federal courts it is only 2.8:1. Thereis consequently a stronger incentive for UKcannabis dealers to avoid co-supplying hard drugs– which appears to be reflected in a rate of co-supply higher in the US (37 per cent) than the UK(28 per cent). This in turn is reflected in higherproportions of US cannabis users reporting easyaccess to hard drugs (forty per cent compared with22 per cent)4. These figures are all profoundlyuncertain, but they do illustrate the potentialvalue of insights into incentive effects that aneconomic approach to policy design provides.

The need to use evidence intelligently

Returning to the critical issue of the quality ofevidence on drug use, we have to accept that theevidence we have to work with is potentiallyunreliable, because of the incentive that exists fordrug users to conceal their activity. Nevertheless,it would be a mistake to disregard the evidencejust because it is imperfect. We need to find waysof using evidence intelligently, making allowancefor its imperfections. There is scope for progresshere. An example is the case of children’s illicitsmoking. The British Household Panel Surveyinvolves annual interviews with a large panel ofchildren aged 11-15. Each year, the children areasked the question: ‘Have you ever tried acigarette, even if it was only a single puff?’Examination of the sequence of responses for eachchild over five consecutive years reveals manyinconsistencies, which gives us an insight into the

nature and effects of misreporting. A statisticalanalysis of reporting error suggests that, in ahousehold where the child’s mother smokes, thereis a four per cent probability of over-reporting fora child who has not smoked and a 13 per centprobability of under-reporting for a child who hassmoked. In a non-smoking household, the over-reporting rate falls to one per cent and the under-reporting rate rises to 22 per cent. In other words,there appears to be a tendency for children tomisreport their behaviour in a way that bringsthem more in line with family norms.

This kind of misreporting can have a big impacton research findings. For example, if we treat thedata as completely accurate and analyse the linkbetween parental smoking and children’ssmoking, we find the child’s annual risk ofstarting smoking to be more than doubled byhaving a mother who smokes (4.4 per cent ratherthan two per cent). On the other hand, if we allowfor the possibility of misreporting by children, wefind evidence of a much larger risk, which is littleaffected by parental smoking (8.4 per cent ratherthan seven per cent)5. Although we cannot trustour data completely, this doesn’t mean we can’tfind effective ways of using it.

25

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

1 Pudney, Badillo, Bryan, Burton, Conti and Iacovou, 2006,Estimating the Size of the UK Illicit Drugs Market, inMeasuring Different Aspects of Problem Drug Use: MethodologicalDevelopments, Home Office Online Report 16/06, pp. 46-120

2 MacDonald, Tinsley, Collingwood, Jamieson and Pudney,2005, Measuring the Harm from Illegal Drugs using the DrugHarm Index, London: Home Office Online Report 24/05

3 Nutt, King, Saulsbury and Blakemore, 2007, Developmentof a rational scale to assess the harm of drugs of potentialmisuse, The Lancet

4 See Pudney ‘Cannabis and hard drugs: is there a supply-sidegateway effect?’, Working Paper, ISER

5 Figures adapted from results presented in Pudney, 2007,‘Rarely pure and never simple: extracting the truth from self-reported data on substance use’. Institute for Fiscal Studies:CeMMaP Working Paper CWP11/07


Disparity in performance

There is active debate in Australia about whetherstudents achieve as well as they could or shouldand about the distribution of performance aroundthe mean. Almost 20 years ago a high level agree -ment was reached between the Commonwealth,State and Territory governments about theNational Goals of Schooling. These were lastupdated in 1999 and contain the aspiration thatevery primary school pupil should be able to readand write at least at the minimum levels specifiedin the national benchmarks for the relevant age cohort. Subsequent to that agreement,performance standards were developed for yearsthree and five and a testing process introduced.

Initially based on each jurisdiction’s own regime,the original testing arrangements are soon to bereplaced by an alternative based on nationallyadministered tests. That said, the results to date are concerning. They show that there isconsiderable disparity in performance against thebenchmarks for reading, writing and mathematicsamongst equity groups and that the national goal

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

International benchmarking

Since the economy opened up to globalcompetition – especially following thedismantling of tariff barriers from the mid-1980s– Australian policy makers have increasinglysought to benchmark Australia’s performanceagainst international standards. There are twofrequently quoted international benchmarkingexercises in respect to the outcomes of education,one of which Professor Barry McGaw of theMelbourne Education Research Institute referredto at the conference. He discussed Australia’sinternational standing as measured against theOrganisation for Economic Cooperation and

our schools...our future

by stephen sedgwick

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

This is a personal summary on the proceedings of a conference hosted by the MelbourneInstitute and The Australian on 15 November 2007 at the University of Melbourne. Fifteenspeakers drawn from academia, the teaching profession, and commentators addressed theconference on how best to improve the performance of schools and the outcomes achievedby students. A feature of the conference was the staging of the election policy debatebetween the Minister for Education, Science and Training, the Hon Julie Bishop MP andthe Shadow Minister for Education and Training, the Hon Stephen Smith MP. TheVictorian Minister for Education, the Hon Bronwyn Pike MP, also addressed the conference.Many of the papers can be found on the Melbourne Institute website:www.melbourneinstitute.com/conf/conf.html

Development (OECD) Program for InternationalStudent Assessment (PISA). PISA assesses theability level of 15-year-olds on a well establishedcycle of internationally comparable tests. Theapproach taken is to measure performanceindependently of the national curriculum byfocusing on demonstrated competencies. McGawcharacterised Australia as having tied for secondplace, with eight other countries, in reading(PISA 2000); tied for fifth, with nine others, inmathematics (PISA 2003); tied for fifth, witheight others, in science (PISA 2003); and tied forfifth, with eight others, in problem solving (PISA2003). He characterised this as ‘high quality, butnot gold or silver,’ and suggested we should aimhigher. He asked what lessons could be drawnfrom the international evidence about how toimprove performance.

Socio-economic status andperformance

The OECD argues from PISA evidence thatstudent achievement is correlated, in mostcountries, with the socioeconomic status of thestudent’s family. Students from families of highersocioeconomic status tend to perform better inthe PISA tests. However, schools in somecountries, such as Finland and Canada, are betterat reducing the gap in the average performance ofstudents drawn from low socioeconomicbackgrounds compared to those from more welloff homes. In these countries, overall scores in thePISA tests are relatively high and, in addition,the dispersion of student scores is relatively low.McGaw characterises these countries as achievingboth high quality outcomes and high equity. Indrawing lessons for Australia, he noted that onerelatively good performer, Finland, devotessignificantly more resources than most countriesto identify poorly-performing students and toproviding targeted support to improve theirperformance relatively early in their schooling.He argued that this is most likely why Finlandachieves both better average outcomes and moreequitable outcomes than many other countries.

Professor Bill Louden from the University ofWestern Australia presented evidence compiled byothers that questioned the relative power of

socioeconomic status in explaining studentachievement in any given year of school. While notdenying that social background is important, thisanalysis placed considerably more emphasis on theprior achievement of students themselves and theexpertise of teachers. He argued that the extent towhich the school’s culture nurtures an evidence-based learning environment and promotes highlevels of responsiveness to student needs is asimportant to student progression each year associal background. Louden posed the hypotheticalquestion: ‘What is amenable to policy action?’ Hisanswer was that the highest and quickest impactswould be achieved by working to improve theperformance of students from their earliest schoolyears (thus improving the ‘prior achievement’ ofstudents entering later years of schooling) and byimproving the quality of teachers. The former isconsistent with McGaw’s argument that part of thereason for Finland’s success lies in its systematicapproach to provide early remedial assistance tostudents assessed as performing poorly.

Teacher quality and school culture

Indeed, as is so often the case at such discussions,how to improve teaching and teacher quality wasa recurrent theme throughout the conference.Greg Whitby of the Catholic Schools in theDiocese of Parramatta, in the course of apassionate exposition of the potentiallytransformative power of information technology,asked why it is that ‘attendance at school iscompulsory but learning seems optional.’ He,along with several other speakers, emphasised theimportance of creating environments withinschools and within communities at large in whichparents, teachers and students hold highexpectations of what should be achieved at school;and a measurement, reporting and accountabilityframework that supports their achievement. DrChris Sarra, currently Director, IndigenousEducation Leadership Institute, QueenslandUniversity of Technology but previously principalof Cherbourg High School, recounted hisexperience in turning around a school culturebased on low expectations to one in whichindigenous students were expected to meet statestandards and were proud when they did so. He

Our schools...our future28

argued that not to insist on high standards – evenfor students drawn from highly disadvantagedbackgrounds – is to condemn these students toachieve at less than their potential. He reportedsignificant improvements in both test scores andstudent satisfaction during his tenure as principal.

Several speakers noted that there are many, manyexamples where individual teachers or schoolshave pursued an approach which has led toextraordinary improvements in the outcomesachieved by students. Dr Sarra’s experience andthe success of the Bell Shakespeare Company inengaging students from a wide variety ofbackgrounds, reflected in Ms Linda Lorenza’spresentation to the conference, are cases in point.As Dr Wendy Jarvie of the CommonwealthDepartment of Education, Science and Trainingnoted, the issue is how to make such successessystematic so that they become the norm.

Improving teacher performance

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

question. McGaw noted that teachers in Finlandhave high social status and are required to have aminimum teaching qualification at Masters level.Indeed, several speakers called for higher tertiaryentrance scores for teachers, noting that cutoffscores had declined in recent times. Louden, forexample, quoted data from Leigh and Ryan (2006)that showed over the 20-year period to 2003 asignificant shift towards lower levels of ability, asmeasured by entrance scores, in the intake offemales into teacher preparation courses. Loudenargued that the root cause of the slide in status of teaching (and thus the lower apparent standardof the teacher intake) is a ‘short, flat, low anduniform salary structure in a world of expandinggraduate opportunities.’ He and several otherspeakers supported more generous payarrangements for both beginning and experiencedteachers, though views quickly polarised abouthow closely pay should be related to performanceand how to measure performance, especially theperformance of an individual teacher. There wassimilarly a range of views about the nature ofaccountability (and associated reporting) ofschools to their communities. Amongst otherthings, this raises issues about how widely test


30 Our schools...our future

scores of individual students, classes or schoolsshould be disseminated; and whether, if theanswer is yes, how comparisons should be drawnabout the relative performance of individualteachers or schools based on these scores.

Several speakers argued that teacher preparationcourses need to pay greater attention to the subjectmatter expertise of teachers as well as improvetheir understanding of pedagogy. They arguedthat deep subject matter knowledge, continuouslyupdated, not only leads to high quality instructionfor students but also means, most likely, that theinstructor has a passion for the subject which may well be infectious for students. This, it isargued, is especially helpful with the moretechnically demanding or specialist subjects insecondary school such as English literature,history, mathematics and science.

Christine Ure of the University of Melbournepresented the findings of the Faculty ofEducation’s review of teacher preparation. TheUniversity of Melbourne is moving towards amore clinical approach to teacher preparation –that is, one which requires and supportsbeginning teachers to develop self-critical skills,which assist them to evaluate the effectiveness ofclassroom techniques so as to improve theoutcomes achieved by particular groups ofstudents. In particular, this approach requiresgreater coherence between teacher preparation andschool life and more active interactions betweenuniversities and schools. This has led to asignificant redesign of the practicum to improvethe relevance of this experience, especially byimproving the quality of mentoring and supportavailable to beginning teachers by universityfaculty members.

Similarly, several speakers addressed theimportance of continuing professional develop -ment for teachers. This is not simply a reference tothe need to make available professional extensioncourses and similar devices to enable teachers tokeep their subject matter knowledge current and keep up to date about the latest evidenceabout effective pedagogy. That is necessary, but inthe view of some, not sufficient – and could beviewed as harmful if it is seen as a substitute for agenuinely student-centered approach. Rather, it

also relates to the provision of school-basedmentoring of teachers and the systematicgathering of evidence about the effectiveness ofteaching practices at school level. Indeed, therewas strong support for basing classroom practiceon what research tells us works. These insights,however, represent a significant challenge formany schools. The challenge is to create a schoolbased culture which not only sets highexpectations for its students but accepts thatstudents and teachers need both, in their ownways, to be learners. While an individual schoolmay identify, locally, teachers skilled in evaluationand knowledgeable about the latest research onpedagogy, it was suggested that this does notoccur routinely across Australian schools. Evenmore sadly, there are suggestions that reform ofteacher preparation needs to proceed in tandemwith changes in how schools are managed.Otherwise, some beginning teachers, who mayacquire enhanced appropriate technical skills andenthusiasm through their preparatory courses,may find that their skills are not recognised orvalued by more experienced teachers or principalswhen they join the workforce. In these cases, thevalue of the society’s investment in better teacherpreparation will be lost. The role of heads andtheir supervisors in providing encouragement andsupport to young teachers is often remarked upon.The sadness is that some capable new teachers maylose their skills if not their motivation before theyreach positions of influence within the schoolcommunity if they are not appropriately nurturedin the workplace.

Kevin Donnelly of the consultancy EducationStrategies took a stronger position than some onthe importance of school autonomy. He wanted tofree schools from ‘provider capture – a situationwhere bureaucrats, teacher unions and professionalassociations exert too much influence on schoolsand classroom teachers.’ He favoured a ‘lighttouch’ approach to regulation, to support schoolautonomy to ‘hire, fire and reward staff, to betterreflect the aspiration of their local communitiesand to develop curriculum (core/elective) that bestsuits the needs of their students.’ He favours theemployment of tax credits or vouchers to giveparents an effective choice about where to sendtheir children to school.


Funding

Funding issues also attracted attention. Donnellysuggested that the OECD’s publication Education at a Glance ‘shows there is little, if any, relationshipbetween levels of investment and performance as measured by learning standards.’ GeraldBurke presented data on funds flowing intogovernment, Catholic and independent schoolsrespectively. Student numbers have grown fastestin the independent sector over the decade to2005, with primary school enrolments in thatsector rising by more than 50 per cent (secondarystudent numbers rose 40 per cent). The studentpopulation of Catholic secondary schools rose 17per cent, more than five times the growth of thegovernment sector. Burke presented a range ofdata on the levels and sources of funding for eachof the sectors over the period. These show, forexample, that average school real income perstudent in non-government schools rose by 44per cent in the decade to 2005, compared to 27per cent in government schools. In absoluteterms, real income per head in the non-government sector exceeded the level in thegovernment sector in 2005, whereas the rankingshad been reversed in 1995. Strong growth inCommonwealth government support, notmatched by higher contributions from stategovernments in respect of public education,contributed to this outcome.

A recurring theme was the desirability of puttingadditional effort into meeting the needs ofstudents from disadvantaged backgrounds orwith personal needs. In addition to studentsdrawn from families of low socioeconomic status,these groups include those with disabilities,students from indigenous backgrounds(especially outside of the major urban centres)and those whose principal language is notEnglish. Tom Karmel of the National Centre forVocational Education Research, however, focusedon the needs of students at risk of failing tocomplete school and the potential contributionthat vocational educating and training,including school-based delivery, may play inprolonging the attendance of certain youngpeople beyond Year 10 and improving the jobprospects of students.

Concluding thoughts

It is hard to fault the logic that higher status forteachers, better quality of teacher preparation,more effective school leadership, andaccountability arrangements that reward andpromote effective learning environments attunedto meeting legitimately high expectations forstudent learning outcomes are amongst theprerequisites to ensure that each young person candevelop to their potential and participate fully inthe economy and our society. At the conference,much of the debate focused on how to designsystems and structures that lead to such outcomes.To my mind, however, there is a large unspokenissue lurking in the background. Good qualityteachers, effective teaching practices anddemonstrated progress in securing better outcomesfor students are clearly necessary to underpinimprovements in the status and thereforeattractiveness of teaching. The profession and thosewith leadership responsibilities in education policyhave clear responsibilities to improve the policyframeworks within which schools, school systemsand teachers work; and to be held accountable forresults. But perhaps the community also needs toreassess its relationship with the teachingprofession as part of a long term approach to givingchildren their best chance to reach their potential.All too frequently, teachers of my acquaintanceseem to be fearful that they do not have the supportof parents in managing discipline, expecting highlearning standards and requiring behaviours inclassrooms that are conducive to learning. I wonderwhether teachers reasonably believe they needmore support than some now get from parents inorder to do their job properly. There was noevidence presented at the conference that bears onthis aspect. Perhaps this is a field best ploughed atanother conference, on another day.

Professor Sedgwick is Director of theMelbourne Institute of Applied Economicand Social Research at the University ofMelbourne.

by james t riady

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

occasional addresses by alumni at university of melbourne graduations

My observations over the years lead me to believethat many young people these days are without aclear sense of what they really want to do withtheir lives – even after graduation. I suggest thateach of us has a place in history, and our rightfulplace will be set by where our skills and talentsmeet the ‘burdens’ that we confront. I shallexplain what these ‘burdens’ are in a minute.

Pursuing our skills is most important. As we growfrom childhood, we acquire a great many skills,some innately endowed to us. We should pursuethe two or three greatest skills that becomeapparent in our lives. And when these meet our‘burden’ – or our calling or vision in life – we thenfind ourselves a place in history.

Having a ‘burden’ means going beyond ourselves.There is a tendency among the youth of today tothink only of themselves and not beyond, yet Ibelieve it is necessary to combine passion withcompassion. You can nurture a passion for certainself-interested objectives but should combine itwith compassion for something worthwhile andmuch bigger than yourselves. You should view theworld with the right kind of glasses.

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

prosperity – despite the current downturn in thestock market. As we look around, we see anunprecedented amount of wealth being created;we see great advancement in knowledge and intechnology; and we also see concern for humanrights and democracy.

However, I think we would be blind if we did notsee the other side of the coin and the manyproblems around us today – the problems ofterrorism and AIDS, the threat of avian flu,armed conflicts, hatred, immorality, divorce andthe breakdown of families. I suggest that incontemplating our economic fortunes, we shouldalso look at the other side of the coin. So inparticipating in and enjoying the growth of theworld economy, we should at the same time havea heart for what I have referred to as a ‘burden’,namely, those problems that we see around us.And we should say to ourselves: I want to takepart in solving those problems.

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

pursuing talents and confronting burdens

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

National economic regulation: the cost of (inadequate?) reform – an overview32


both objectives – we must pursue and developskills and accept and confront a burden. Themeeting of these two sets will establish our placein history.

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

In today’s society, many people do not acceptburdens because they are too focused onthemselves – on ‘myself’ and ‘me’, and being atthe centre of everything in society. Therefore, mymessage to you, distinguished graduates, as yougo out into the world, is to remember that youshould regard today not as the omega point, butas the alpha point of your lives – it’s just thebeginning.

And as you project yourselves forward 10 or 20years, you must ask yourselves: what kind of lifedo you wish to lead and what legacy would youwant to leave behind? What kind of impact wouldyou want to make on society? This calls for us togrow, to use our eyes to see things around us morecritically and more deeply, not just at ourselvesbut beyond ourselves. It is by responding to theissues around us that we will establish ouridentity. I suggest that this is where we will findtrue joy and true fulfilment in our lives.

I congratulate you and trust you will be a blessingfor very many people and make a greatcontribution to society.

Dr James Riady is a Faculty of Economicsand Commerce 1978 Alumnus. He is theDeputy Chairman of the Lippo Group, amajor Indonesian conglomerate. The Group is involved in commercial banking, corporate finance, property development andinvestment, financial services, insurance,manufacturing, infrastructure developmentand investment, fund management and trustservices, and venture capital investments. Dr Riady’s success in developing profitablebusinesses in areas which promote the commongood, such as education and health, and in amanner characterised by good corporategovernance principles, was recognised on 16 February 2008 with the Australian AlumniAward for Entrepreneurship.

34 Pursuing talents and confronting burdens

You are the future leaders

Today you join a distinguished club. The impact ofthis University’s alumni on the story of Australia isconsiderable. When I was standing in your shoes in1960, graduating in commerce, my colleagues andI were unaware to what extent Australia’s futureprosperity lay in our collective hands. Little did weknow of the huge and imminent changes thatwould influence our future.

History’s view of Australia in the 1960s can begrim. We lacked confidence in our future. Therewere lingering concerns about communism, theWhite Australia policy was still on the agenda, andthere were fears that emerging technologies weregoing to put us all out of work. Today our economyis booming and we boast one of the most sophis -ticated and envied economic management systemsin the world. We have evolved from a rurally basedeconomy to become a significant player in the newglobalised world, not only supplying valuablenatural resources but also providing education andfinancial services to our region.

Many of the business and community leaders oftomorrow are in this Hall. All of you will beinvolved in some form of leadership and with thatcomes great responsibility. Each one of you hasprofessional competence that you are about totake into the community. Take heed of PaulKeating’s advice: ‘Leadership is not about beingwise. It is about being right and being strong.’The extent to which you succeed will depend onmany things. It will not be measured only indollar terms but also by the quality and balance ofyour involvement in the broader community.

Organisations large and small are also assessedtoday on their culture, their ethics and the extentto which they engage with the wider community.Paying lip service to community responsibility isnot an option. Unless ethics and communityresponsibility are part of your way of operating, Ican confidently say you will not enjoy long-termsuccess in the commercial world.

A varied – and valuable – career

So what can I share of my journey, to give yousome insight into the sort of leadership that willbe required of you in the future? Over the years I have worn many hats, which have given meinsights into the things that work in a professionalcareer as well as the things that do not. Arrivingat this University as a student in 1957 as the sonof a Victorian farmer, I could not have dreamt ofthe opportunities that were about to be opened forme by my time here. Let me spell this out.

When I stood impatiently at my conferringceremony over 40 years ago, I was about to jointhe stockbroking firm Ian Potter & Co. I becamea young research analyst and was given theopportunity to work with and learn from thelegendary Ian Potter, who later became a majorbenefactor of this University. His firm wasregarded as one of the leading financial servicescompanies of the day and, with the benefit ofhindsight, it was a great privilege to learn from and watch one of Australia’s most insightfuland visionary financiers at work. He was an oldstyle leader but he lead from the front foot, clearlyarticulating his purpose. He took big but wellthought out risks, and usually ‘got it right’.

by laurence cox ao

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

the importance of vision and people

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

Since those early days, I have had experience as adirector of various listed companies – leadingmanufacturing groups, a pioneer in privateinvestment in important public infrastructureassets, and one of Australia’s most successfulinternational financial services organisations withassets and businesses in 24 countries around theglobe. Each company provided me with an insightinto different industries and hence the broaderAustralian economy.

I have also witnessed the development of theAustralian securities industry through a variety of roles, including chairmanship of the Australianstock exchange and membership of theinternational advisory board of the Nasdaq stockmarket in the USA – the leader in using moderntechnology to recreate markets. I witnessed thetransition of Australia’s closed parochialstockbroking industry as it was when I leftuniversity, into today’s national electronic marketwhich is regarded as one of the most efficient andcompetitive in the world.

These changes were facilitated by well thoughtout deregulation plans from industry leadersworking closely with government. Those leadershad a clear long-term vision for the future of the industry, and their decisions have a directbearing for you as graduates. When you enterfinancial markets in this country, you will bestepping onto a truly global platform. And that isbecause of the foresight of people who helped toposition Australia as a leading financial marketattracting the world’s best players.

The lessons learned from these experiences gaveme greater confidence in playing a leadership rolein the various activities I have pursued.

My professional career has given me theopportunity to give back to the communitythrough the chairmanship of the MurdochChildren’s Research Institute. Based in Melbourne,it is Australia’s largest medical research institutefocusing exclusively on children’s health.

Vision and people are the keys tosuccess

What has emerged from all of my differentactivities is that the ingredients for their successful

outcomes have been almost identical. The twoguiding principles that were vital in the success ofthese endeavours have been vision and people.

To have vision, you must have an idea of yourstrengths and what you want to do with them. Youmust be able to think outside the square and thenhave the courage to implement your ideas. As TonyBlair has said: ‘The art of leadership is saying no, notyes. It is very easy to say yes.’ To succeed in your visionyou must work alongside people who are motivatedand find fulfilment in what they are doing. For me, achoice between a team of brilliant people working ina low growth industry and a mediocre team workingin a booming industry would always be easy – Iwould follow the talented people.

Equally, I have seen what does not work in thecommercial world. One immutable truth thatstrikes me again and again is that those whosuccumb to greed will invariably fall and fail.Sounds pretty obvious, does it not? Yet it is arecurring theme in the commercial world.

When I compare my early days with Ian Potterand my current experience at the MacquarieGroup, most of the basics have changed very little.Potter hired the best people, gave them freedomto innovate and lead them to operate with a highlevel of integrity and independence. Today’sMacquarie model is almost the same and it hasproduced one of our most successful domestic andinternational financial services groups.

The beginning of my business career was a time ofregeneration of the underwriting and investmentmarket in Australia, and also the opening of ourmarket to international investors. I met industryleaders I had only read about in the press, visitedinternational and Australian investors and beganto establish close relationships with key clients. Itwas the strength of these relationships that wouldlater give me the opportunity to be part of theevolution of the Australian stock market.Moreover, in the years I have worked in bothexecutive and board capacities, the importance ofpeople and vision has been underscored.

Macquarie has for many years been more specificthan many other corporates about its goals andvalues. These are not just part of the ‘about us’section on the company’s website – they are


actually set out in the operating manual for allstaff. And they are pretty blunt:– Strive for profitability;– Work hard for clients;– Provide the highest standards of technical

excellence;– Act with integrity;– Encourage teamwork; and– Deliver fulfilment for people.

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

Macquarie’s values are similar to the tenets thatdrove Ian Potter & Co. – which were to hire thebest people and give them autonomy andfulfilment. Of course, there are some strikingdifferences in today’s environment: – Management structures are flatter – greater

responsibility is devolved down the line. As newentrants to the workforce, you would be givenresponsibility at an early stage.

– There is an entirely different level of disclosureand public scrutiny in all parts of the corporateworld and this is impacting significantly ongovernance structures.

But the key elements to success have not changedmuch over the years. Any organisation’s realstrength is its people – their integrity, the way theywork together and the fact that they are fulfilled.

Community responsibilityUsing Macquarie as an example, it becomes clearthat encouraging links with the not-for-profitsector promotes a fulfilled workforce. Macquarie’scharitable foundation encourages staff participationin the not-for-profit sector. Community groups notonly receive grants, they also receive volunteersupport from Macquarie employees. More than 60staff currently serve on not-for-profit boards andthousands more work with not-for-profitorganisations for which they have a personalpassion. Macquarie’s reward is a fulfilled workforce– the broader reward is a transfer of skills anddollars to organisations that need it.

As mentioned above, my experience is with theMurdoch Children’s Research Institute, which hasa close association with the University of

Melbourne’s Department of Paediatrics. TheInstitute has grown from around 100 staff in the1980s to over 750 today, and has led to majorimprovements in child health in areas such assmall pox and polio, and contemporary problemssuch as child obesity and juvenile diabetes. Theexceptional vision and leadership skills of thoseundertaking this groundbreaking research hasenabled the Institute to obtain increased fundingfrom both the government and the corporatesector. I have gained huge personal satisfactionfrom my ongoing involvement in these activities.

Vision for the future

As graduates about to enter the workforce, the nextfew years will be challenging. However you shouldlook further ahead and establish long-term goalsabout how you want to conduct yourself. Remember,you are leading yourself. Take responsibility forthinking through difficult problems, make well-considered decisions, and carry a map of the future.You must be challenged but your vision must beachievable. And above all, it must stand the test oftime. Seek to work alongside the best people whowill challenge your ideas and assure your vision isachieved. This approach has given me the mostimportant thing I value from my career – a sense ofsatisfaction of having helped to make a difference.I hope you find that it works for you.

36 The importance of vision and people

Mr Laurence Cox AO is Executive Director ofthe Macquarie Bank Limited and JointChairman of the Macquarie Corporate FinanceGroup. He is also a Director of OneSteel Ltd andChairman of SMS Management & TechnologyLtd. Prior to joining Macquarie Bank, Mr Coxwas Executive Chairman of the Potter WarburgGroup of Companies in Australia and a Directorof S G Warburg Securities of London. He wasChairman of the Australian Stock ExchangeLimited from 1989 to 1994 and was a Directorof ASX from its formation in 1987. He wasalso a member of the Nasdaq Stock MarketInternational Advisory Board from 1992 to2001 and the Executive Committee of theFederation Internationale des Bourses deValeurs from 1990 to 1992.

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

Mailing Address:The Faculty of Economics and CommerceThe University of MelbourneVictoria 3010 Australia

Telephone: +61 3 8344 2166Email: [email protected]: www.ecom.unimelb.edu.au/insights

Published by the Faculty of Economics and Commerce, April 2008© The University of Melbourne

insights volume 3 april 2008

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