insights volume 5 april 2009

Melbourne Economicsand Commerce

volume 5 april 2009

The causes and consequences of the

current financial turbulence

By Raghuram G Rajan

A tumultuous yearBy John A Fraser

Voodoo bankingBy Satyajit Das

Reversing the divergence of the bottom billion

By Paul Collier

Reflections on microeconomic

policy frameworks and a suggestion

about fairnessBy Jonathan Pincus

What’s been happening to United States

income inequality?By Richard V Burkhauser

Occasional adressesBy Anthony R Burgess,

Michael Andrew and Rupert Myer AM

I N S I G H T S

Welcome

Our last issue went to press when the financialcrisis had burst on to the world. We were too latethen to include the public lectures given to theFaculty – we make up for it in this volume. Thesubstance of the crisis is represented dramaticallyon the cover by the panicking bull fallingprecipitously down the wall of the stockexchange; while the bear, its claws drawn open,rises aggressively to take its place.

The first three articles deal with the crisis,complementing each other by analysing in detaildifferent aspects of it. Each makes tentativesuggestions for avoiding such a disaster in thefuture. The next article, drawing on the MarshallPlan experience, discusses what needs to be done to lift the living standards of the onebillion people who are at the bottom of theworld economy. Introducing an element ofbehavioural economics, the following articleargues in favour of qualifying economicefficiency measures in micro-economic publicpolicy by considerations of ‘fairness’. This is

followed by a statistical exercise based on USstatistics, which shows that a more meaningfulaccount of changes in income inequality isprovided by excluding the top one percent ofincomes from the calculation. Finally, threeOccasional Addresses by distinguished alumnigive us the benefit of their professionalexperiences.

Once again, we have been most fortunate withthe design and illustrations of the journal. SoniaKretschmar has applied her talent to give life andvisual meaning to the articles. My thanks are alsodue to the team for another stimulating issue.We are encouraged by the continued favourableresponses from readers. The interest in Insightscontinues to be reflected in the large number ofindividuals who access the journal in its onlineform at http://insights.unimelb.edu.au/.

Joe IsaacEditor

[email protected]

Insights: Melbourne Economics and CommerceISSN:1834-6154

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

Advisory Board: Professor Robert DixonProfessor Bruce GrundyProfessor Bryan Lukas

Illustrator: Ms Sonia KretschmarDesign: Ms Sophie Campbell

Insights publishes condensed and edited versions of important public lectures connected withthe Faculty of Economics and Commerce. Its object is to share with the wider public –especially alumni – the issues presented and developed in these lectures. Our goal is to providereaders with access to expert opinion on complex issues and make available some of theextensive resources that are freely available. Insights also constitutes an archival source of animportant element in Faculty life.

03 The causes and consequences ofthe current financial turbulence

By Raghuram G RajanWe should accept that competitivefinancial systems carry the risk that theywill collapse periodically. The task shouldbe how best to deal with this risk.

11 A tumultuous year

By John A FraserThe crisis in global financial markets has raised a welter of critical issues forfinancial institutions, regulators andgovernments that cover all aspects of the financial industry and approaches to macroeconomic policy

17 Voodoo banking

By Satyajit DasElite athletes often use performanceenhancing drugs to boost performance.Voodoo banking operated similarly,enabling banks to enhance short-termperformance whilst risking longer-termdamage.

25 Reversing the divergence of thebottom billion

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

31 Reflections on microeconomicpolicy frameworks and a suggestion about fairness

By Jonathan PincusIn assessing economic efficiency,economists need to take into account thatmost people value losses more negativelythan they value gains positively

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

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

Occasional Addresses

42 Navigating the world of opportunity

By Anthony R BurgessPractical pointers to the challenge of navigation

44 How your university experience willshape your future life and career

By Michael AndrewWhile education in the classroom isimportant, much of the learning at a university takes place outside theclassroom

48 On leading more than one life

By Rupert Myer AMAcknowledge the personal sacrifices of others, think creatively and beimaginative, give of yourself in public service and exercise humility

insights vol 5Table of contents

Insights Melbourne Economics and Commerce 01

03Insights Melbourne Economics and Commerce

The proximate causes of the crisis

The global financial crisis has two basic elements.One is that bad loans and bad investments weremade, especially by the banks, resulting inexcessive credit. The second element is that thesewere financed with a substantial amount ofleverage based on short-term borrowing. I willargue that these two elements led to a sequence ofevents. But first, a number of questions need to beconsidered: Why were these bad loans andinvestments made? And why were they financedon such a short term?

To answer these questions, it is necessary to goback in time. In the late 1990s, the emergingmarkets faced yet another financial crisis. Thisoccurred in Asia, especially East Asia; in LatinAmerica, especially in Brazil; and Russia. Theresponse this time was a little different fromearlier responses. A number of countries, in EastAsia in particular, decided to protect theireconomies effectively by managing their exchangerates to keep them as competitive as possible. Thiswould increase exports and build up reserves as abuffer against any possible future turmoil.

So rather than absorbing savings from the rest ofthe world, many of these countries began to exportsavings, becoming net exporters of capital. TheLatin American countries eventually also followedthis course, both Brazil and Argentina running

large surpluses. The upsurge of commoditiesprices generated surpluses in a number ofcommodity exporters. Where were those savingsbeing absorbed? A good use of such financialsavings in one part of the world would be ifinvestment somewhere else increases to absorbthose savings.

For a time, that happened in the industrial world.In the case of what became known as ‘theinformation technology bubble’, a lot ofinvestment took place in industrial countries,perhaps excessively so. When that bubble burst,corporations in industrial countries became verycautious about investing. Nonetheless, stimulatedby expansionary monetary policy, demandincreased in two areas. One was householdconsumption, especially in the US, and the otherwas residential investments. A lot of money wentinto expanding housing, increasing asset pricesand construction. All this was to the good, at leastfor a while.

Prices of houses rose in a number of countries –Ireland, Spain, the UK and Australia. The crisisfirst emerged in the US. Why the US? It had anextremely innovative financial sector. It saw amismatch between the investment opportunitiesthat were emerging in the real estate sector, andthe financial savings that the rest of the worldwanted to supply.

the causes and consequences of thecurrent financial turbulence

by raghuram g rajan

We should accept that competitive financial systems carry the risk that theywill collapse periodically. The task should be how best to deal with this risk.

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

The alchemy of turning lead into gold

However, a central bank in Asia or an insurancecompany in Germany, for example, would beextremely reluctant to buy a local mortgage froma US bank because they would know nothingabout the borrower and would be concerned aboutthe liquidity of such an asset. To get over thisproblem, the local mortgage needs to be convertedinto a financial asset that the rest of the world iswilling to buy. The US financial sector was verygood indeed at this conversion process. Itconverted local mortgages into AAA-ratedfinancial assets that the rest of the world would bewilling to buy – a process of alchemy by which thelead of local mortgages was turned into gold thatthe rest of the world wanted to buy. These ‘sub-prime’ mortgages, made to borrowers who hadlittle credit history, no employment security andno asset backing, were packaged together and thensold to international markets!

The driving elements

How was this possible? One element driving thisprocess was that house prices were rising. Initially,those who got loans were credit-worthy; but ashouse prices kept rising, the risk of lending evento borrowers with no credit standing disappeared.Houses were effectively liquid assets and ifborrowers defaulted, their houses could be soldwithout loss to the lender because house priceswould have appreciated further. Alternatively,borrowers for housing could be attracted by lowinterest rates because they could sit comfortably atthe end of the year on a ten per cent equityappreciation that would allow them to refinance atthe lower rates.

Thus, on the one hand, rising property priceswould cover all potential credit risks; and, on theother hand, banks had the ability to package andsell these loans in the international market.

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

first lot of defaults could be absorbed by buffers,called the equity tranche. Where there is verylittle risk of further default, higher rated securitiescould be issued.

For example, assume that $100 of mortgages are taken out. Against these mortgages, thefollowing are issued: $10 of equity tranche, $10 of BBB-rated securities, $5 of A-rated securities,$5 of AA-rated, and $70 of AAA-rated securities.Why seventy dollars? Because the risk ofdefaulting for the AAA-rated securities requires30 per cent default on the mortgages. This isunlikely, and was hence the logic behind themortgage-backed securities.

However, the innovators were not happy to stophere. Having squeezed $70 of AAA-ratedsecurities out of the mortgages, they could gofurther. The BBB-rated securities issued by thepackages were then put together in a freshpackage called collaterised debt obligation(CDO), against which 70 per cent of AAA-ratedsecurities could be issued. The process ofconverting into AAA-rated securities could go on– CDO squared, CDO cubed – so that $100 ofmortgages could be converted into $85 of AAA-rated securities and sold to the rest of the world.This was the process of securitisation and it wenton for some time.

Consequential problems

There are, however, at least two problems. One isthat these are very complicated securities withvarying degrees of risk. They trade easily only ifthe chance the borrower will default is small.Once substantial defaults occur, these securitiesare in serious trouble because they are relativelynew to the market. Moreover, when house pricesfall across the US, the diversification that investorsfelt they had by buying packages of mortgagesfrom all parts of the country becomes irrelevant.

The complexity is magnified by the fact that thereis very little information about the borrowers andtheir credit worthiness. As was noted earlier, thatdid not matter when house prices were rising andmortgages continued to be serviced. However,once house prices stopped rising, such informationmattered a great deal – but was not readily available.

The causes and consequences of the current financial turbulence04

The other problem, which the originators ofthese securities did not understand fully, is thatas the securitisation process goes on, the value ofinformation about the credit worthiness ofpackages also starts to drop off. In the late 1990swhen a loan officer made a loan to somebodywith a certain credit quality, they did not stop atasking what the credit quality was. They wentfurther to assess more subjectively the reliabilityand honesty of the borrower in a process knownas seeking ‘soft information’. In thecircumstances, the result of this form ofinformation-gathering is that there was verylittle correspondence between the public creditrating of the individual and the interest ratesthat were charged for different individuals. Thecredit rating was only the first step in the processof gathering information to be supplemented by‘soft information’.

However, by 2005 there was a very closecorrespondence between credit ratings andinterest charged. Why? Because banks made loansknowing that they were not going to hold on tothem but were going to sell them to thesecuritised market. So they had no incentive toqualify the credit rating by soft information.Thus, the credit quality of the loans looked betteron paper than they actually were.

In the US, there is a credit rating called theFICO Score (Fair Isaac Corporation) as a measureof the borrower’s credit quality. This is theguideline used by Freddy Mack and Fannie Mae.1

A credit quality rating at and above 620 wouldallow the loan to be securitised and sold in themarkets. Two things happened when this wasintroduced. One, not surprisingly, was that thenumber of loans just above 620 took a quantumleap, suggesting that securitisation made moreloans available. The other, and unexpected,outcome was that those with a score above 620(with securitised loans) were more likely todefault than those below 620 (not securitised).This suggests that securitising reduces theincentive for lenders to be concerned about thequality of the loans. Thus, there was a steadydeterioration in the quality of loans – eventhough, on paper, their credit score was higher.

Who is to blame?

When did the system break down and who is toblame?

One factor is a lack of knowledge about thequality of the securities. Buyers of securities inAsia and Europe were willing to accept securitiesso long as they were highly rated. However, it wasdifficult, even for the financial experts, todistinguish between triple-rated securities thatwere CDO, CDO squared or CDO cubed. Thedegree of risk varies greatly between them. AnAAA-rated mortgage-backed security wouldprobably be trading at 60 or 70 cents in the dollarwhile an AAA-rated CDO cubed would betrading for 20 cents in the dollar.

The second factor is the work of the ratingagencies. Product rating became a big part ofbusiness for agencies like Moody and Standard &Poor, and they had very little incentive to driveaway business by being tough on ratings. It isarguable that they should have recognised thatthis was a new kind of financial instrument whichthey had little experience with, and that it wasdifferent from corporate debt securities. Therefore,they should have been more cautious about theirratings. Alarm bells should have rung as thesesecurities were paying 50 and 100 basis pointsabove AAA-rated corporate securities.

Investment banks were also to blame. Theyshould have known that they were packagingsecurities with varying risks, which the marketwas prepared to buy. Their confidence wasreinforced by the fact that the investment banksthat put together and sold these securities heldon to the riskiest portions themselves as a sign ofgood faith on the quality of the packages,although many sold these holdings later.

Finally, many of the homeowners cannot beabsolved from blame. They would have knownthat they could not afford the loans they incurredbut were perhaps deluded by the prospect of a‘free lunch’.


06 The causes and consequences of the current financial turbulence

A puzzle – the case of Citibank

One of the intriguing questions is why the banksheld on to these securities? They had hugeamounts of them, not just for inventory purposesbut also as investments. One possibility is thatthey really believed in their product. Any riskwould be in the category of a ‘one in a thousandyear flood’. But this is surely an illusion because itseems to happen every 10 to 15 years withregularity. Citibank has been in trouble threetimes in the last three decades – in the mid-1980sbecause of loans to developing countries; in the1990s because of real estate loans, until it wasrescued by a Saudi prince, who injected asubstantial amount of equity into the bank. Andnow because of loans made in the mortgage-backed market. It is a worry when the largest bank– indeed perhaps the icon of American banking –is in trouble every 10 to 15 years.

One possible explanation is that there was a greatdeal of competitive pressure. In the words of theChairman of Citibank, ‘When the music stops, interms of liquidity, things will be complicated.But so long as the music is playing, you’ve got toget up and dance.’ Merrill Lynch went intomortgage-backed securities in a big way becauseit saw Goldman Sachs making a great deal ofmoney from it. The ‘herd mentality’ seems toplague financial markets.

It also appears that the left hand of the bank did notunderstand what the right hand was doing. Thosewho were packaging the loans did not fully indicatetheir quality to those who were making the loans.For example, the investment banking unit of UBSborrowed at UBS’s cost of capital, investing inAAA-rated mortgage-backed securities, therebymaking a spread of 15 to 20 basis points. This doesnot look like a lot of money, but when multipliedby a trillion it amounts to a great deal.

There is a saying in the financial markets: ‘Thereis no return without risk.’ Why were they making20 basis points extra if there was no risk? Topmanagement did question the wisdom of such alarge volume of investment. But their voices weredrowned by the argument that the investmentbank was making two to three hundred milliondollars in profits every quarter.

The regulatory standpoint

From a regulatory standpoint, as the cycleprogresses, risk management becomes less andless able to exercise control on risky activities.As long as the cycle progresses, the risks do notshow up. At the point of maximum danger to thebank, risk management may be at its weakest.Risk control mechanisms seem to break down allthe time. It is not that boards are stupid. Theyare made up of clever people. Robert Rubin isone of the smartest treasury secretaries. AtCitigroup, though, he looked on while it sufferedmore than $72 billion in losses.

The debate will go on for some time, but it doesseem there was a total breakdown in governanceand in the compensation structures of the banks.To draw a simple analogy: the banking system was writing earthquake insurance – it was takinglong-term risks, but the premiums collected werenot set aside as reserves for the day the earthquakeactually happens. Instead, the premiums werebeing paid out as bonuses and dividends toshareholders. When the earthquake actuallyhappened, the banking systems were grosslyunder-capitalised and there were no reserves todraw from. The compensation structures weresuch that payments were made for short-termperformance.

Leverage

As noted, a critical issue in the crisis is the extentof leverage. Short-term leverage is perhaps thecheapest form of financing when risky activitiesare undertaken. Short-term borrowing was rolledover relatively risk-free because there was anample supply of finance. Moreover, borrowingshort-term was cheaper than long-term, especiallywhere financial institutions were takingsubstantial risks, as it allowed the lender to getout more quickly.

Short-term debt was also preferred because of themarket’s reliance on the ‘Greenspan Put’ policy,which stated that, if a serious downturn eventuated,the Federal Reserve would facilitate liquiditypromptly and cut interest rates sharply. This factormay have added to acceptance of the large volumeof illiquid assets financed with short-term debt.2


The elements of the crisis as itunfolded

Eventually house prices stopped rising andmortgage defaults began to increase. The equitycushion provided by rising house prices inrefinancing loans disappeared. As the mortgagedefaults mounted, the securities issued to backthese mortgages became difficult to price.Suddenly, the market stopped accepting thesecurities that the investment banks had financedby borrowing short in the market. Banks becameilliquid. For example, Bear Sterns was unable to

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

The second stage of the illiquidity problem emergedas these mortgage-backed securities continued tofall in value because the banks were essentiallyinsolvent, the size of the losses having eliminatedtheir capital backing. The maturing of their short-term debts compounded their insolvency.Long-term debts are sustainable because the dayof repayment is some distance away and theinsolvency problem can be deferred. Not soshort-term debts.

The myth that bank deposits or debts can berepaid only holds so long as most creditors of thebanks do not call for their money on the same day– because banks hold most of their assets inilliquid securities. Mechanisms have beendeveloped – such as deposit insurance andborrowing facilities from the Federal Reserve – todeal with any potential run on the banks.However, while these mechanisms were availableto commercial banks, they were not available toinvestment banks. When a run started onLehman, the Federal Reserve and the Treasurywere not willing to support them financially. The result was a run on Goldman Sachs and JPMorgan; and on a number of banks in Europe in panic mode.

With the benefit of hindsight, it appears that theresponse of policy has always been one step behindthe event. Policymakers thought the problem wasinflation when it was illiquidity. They startedtackling liquidity when the problem had alreadydeveloped into insolvency; and they startedtackling insolvency when the problem had turnedinto full-scale panic. Eventually they foundthemselves having to deal with full-scale panic.

In the US – and this may change with the newadministration – the remaining problems in thesystem are not being fixed in time. Ideologicalissues have intervened. Right-wing ideology isresistant to large scale public intervention,despite the fact that the private sector is in greattrouble and needs intervention. To intervenemarginally is the worst form of intervention.While it is desirable to avoid intervention, whenpublic money is at stake, everything necessaryshould be done to ensure the safety of suchmoney and to put the system back on track. Atpresent, this is not being done.

There is a mistaken belief that money pumpedinto the large banks will somehow find its wayinto the rest of the undercapitalised bankingsystem. Such a course could lead to the bankingsystem being cartelised by a few leading banks. Tosome extent, this was happening with the Bank ofAmerica, Wells Fargo and JP Morgan taking overlarge banking assets. However, it is unlikely to gomuch further. The remaining banks that theTreasury is not willing to capitalise will remain in

difficulty. To deal with them effectively willprobably require major intervention in order todecide whether they should be closed down orkept alive with financial infusion. Yet it isunlikely that the US authorities would be willingto undertake such a course, which means theproblems could continue to fester. Recovery maycome in time but it is possible that things couldget worse, and intervention on the scale neededwill be undertaken.

Some lessons

First, it should be understood that the entirefinancial system is integrated not just within acountry, but across the world. Problems canemerge from anywhere and infect the rest of thesystem. We have had runs on banks in India andHong Kong, based on some notion that they maybe exposed to crashing prices, when in fact theexposure was not that great.

Second, in monitoring risks, regulators are oftenfocused on the wrong places. Before this crisis,much attention was on hedge funds in the beliefthat hedge funds were going to be the problem. Infact hedge funds, especially the larger ones, aregenerally well managed. They have fairly goodincentive systems in place and fairly good riskmanagement structures.

Third, there is an increasing tendency to regulatethe financial system more strictly by imposingmuch higher capital requirements on the system.However, this becomes part of the problem. Byimposing large capital requirements, a great dealof banking activity was driven from the regulatedpart of the system to the unregulated part. TheStructured Investment Vehicle3 (SIV) was in somesense a way for commercial banks to arbitrage – as in, to avoid – capital requirements by creatingentities that were not subject to capitalrequirements. These eventually turned out to bebanking risks because they came back on theirbalance sheets.

A great deal of our regulation assumes thatmanagement has control and cares about the longrun. However, the problem has been thatmanagement did not have control and did notcare about the long run. This is a governance

The causes and consequences of the current financial turbulence08

problem, and unless it is fixed, regulation has nohope in doing anything useful. Having a varietyof institutions helps. Things could have beenmuch worse but for the deep-pocketed investors– the sovereign wealth funds and the WarrenBuffets of the world – who have helped tostabilise the system.

A final thought

We keep hoping to create a financial sector that is stable. However, we should accept thatcompetitive financial systems carry the small riskthat they will collapse periodically. Rather thanwriting more and more ‘fire codes’ to prevent thefires, we should recognise that fires will happen.This is not to say that we should not keep tryingto get things right; but it should be understoodthat fires will break out. Accordingly, more timeshould be spent in making sure there aresprinklers to put out the fires, rather than simplywriting fire codes.

In other words, let us make sure that when a crisisoccurs, the private sector does not just dump itinto the lap of the public sector to deal with it.Instead, the private sector should be required todevise a mechanism by which it, rather than thetaxpayer, bears the cost of any breakdown in thefinancial system. This calls for further thought. Inthis connection, it has been suggested that a formof insurance, called capital insurance, should beavailable to enable firms and banks to buy a formof insurance that may help to reduce seriousconsequences of a financial crisis.4


Professor Raghuram Rajan is the Eric J.Gleacher Distinguished Service Professor ofFinance at the University of Chicago’sGraduate School of Business.

Prior to resuming teaching, Professor Rajanwas the Economic Counselor and ChiefEconomist at the International Monetary Fundbetween 2003 and 2006. He currently chairs ahigh level committee set up by the IndianPlanning Commission to propose financialsector reforms in India. Professor Rajan’sresearch interests focus primarily on economicdevelopment, and the role finance plays in it.His papers have been published in all the topeconomics and finance journals, and he hasserved on the editorial board of the AmericanEconomic Review and the Journal of Finance. Hehas also written a book with Luigi Zingalesentitled Saving Capitalism from the Capitalists.

In January 2003, the American FinanceAssociation awarded Professor Rajan theinaugural Fischer Black Prize, given every twoyears to the financial economist under age 40who has made the most significant contributionto the theory and practice of finance.

1 The Federal Home Loan Mortgage Corporation (FreddieMack) and the Federal National Mortgage Association(Fannie Mae) are government sponsored enterprises buyingmortgages in the secondary market, and selling them toinvestors as mortgage-backed securities. Both are directed toassist home ownership of low and middle income families.

2 Data six months ago show that the banks with the greatestshort-term leverage and the least amount of capital were the ones that suffered most in terms of stock prices whenthe crisis hit.

3 An institutional entity based on funds borrowed on short-term securities at low interest rates (close to inter-bankinterest rates) and buying long-term securities at higherinterest rates.

4 See Anil K Kashyap, Raghuram G Rajan and Jeremy CStein, ‘Rethinking Capital Regulation’, Federal ReserveBank of Kansas City symposium on ‘Maintaining Stabilityin a Changing Financial System’, Jackson Hole, Wyoming,August 21-23, 2008.


Background – a euphoric period

Prior to the current crisis, a remarkable 14-year orso economic expansion had produced growth invirtually all parts of the world. This had been a euphoric period with the globalisation of worldeconomies, the attendant reduction in tradebarriers and the massive increase in goods comingfrom new powerhouse economies such as China.There were also huge capital flows from the MiddleEast, Asia and Russia. Growth regularly exceededexpectations, governments saw revenues bloated byasset prices and consumer price increases remainedlow. That prosperity blinded governments, thefinancial sector and the community to what arenow clearly seen as warning signs.

In particular, too many cheered on asset priceinflation. There seemed to be no asset untouched– homes and holiday houses, artworks, racehorses,yachts and companies all became more valuable.And we convinced ourselves that this was due to anew era of global economic interaction – and thatit would somehow last forever. However, assetprice inflation is and was inflation. It was overlyaccommodated by various monetary authoritieswho ignored the very clear signal that theeconomy and, through it, the financial sector wastravelling far too fast – at a pace well in advance ofproper understanding of the systematic risks.

During this period of world expansion, twoindustries did especially well ─ informationtechnology and finance. They were globalised,relied on continuous innovation and grewswiftly in both the new and old economies. But,just as the ‘tech boom’ came to an abrupt end in2000–01, we are now seeing a fundamentalrecalibration of the financial sector. Its long-term average share of total profits within theStandard & Poor 500 was around 15 per centbut peaked in the past few years at 21 per cent.The financial sector is now undergoing acorrection which, by any terms, is a very majorand painful one.

Not only in the world generally but also in thefinancial sector, recognition that a crisis wasbrewing was very slow. Even two or three yearsago, people were lauding the low mortgageinterest rates being provided to low-incomeearners in the US as allowing the disenfranchisedto achieve home ownership. We also saw similartrends in Western Europe. There were a fewvoices that rightly warned about the massiveincrease in household, corporate and financialsector debt levels, but they were generally eitherdisparaged or ignored.

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

a tumultuous year

by john a fraser

The crisis in global financial markets has raised a welter of critical issues for financial institutions, regulators and governments that cover all aspects

of the financial industry and approaches to macroeconomic policy


Emerging problems

For the banking system, the full extent of theproblem started to emerge in the northernsummer of 2007. It was not so much that themortgage-backed securities were starting to failbut that there was growing unease that the hedgesput in place in the event of default were, at thevery least, sub-optimal. The very size of theinvestment banks, the ever-expanding globalstretch, the internal reporting of positions in netrather than gross terms and the complexities of management layers all made recognition of theproblem that much more difficult. Adding to itwas a lack of communication between banksbecause of their fear of being accused of anti-competitive behaviour.

Fear of breaching stringent reporting rules andSarbanes-Oxley (SOX) strictures1 also played apart. By contrast, in the 1980s and early 1990s,the regulatory authorities seemed to have hadgood communication with all the major financialinstitutions. The world and the institutions were less complex, and investment banks did notrely anywhere near as much on proprietarytrading for income. This all made for anenvironment where central banks could overseethe industry at a national level in a more collegialway, and where problems could be more readilyidentified and discussed.

We cannot ignore, however, the fundamentalchange in the financial sector. In the 1990s, aidedby globalisation and accommodative monetaryconditions, investment banks grew dramatically.Moving into new markets, managers had to runincreasingly complex and diverse businesses acrossmore and more countries. Importantly, banks alsostarted to rely heavily on proprietary trading, notjust in fixed income but also in equities andexchange rates. There was also the rapid growth ofcomplex financial instruments – also known as‘structured products’. They put far more risk ontheir balance sheets and this made investmentbanks far more vulnerable, as did the later move toplace risk into off-balance sheet vehicles.

Early assessments in 2007 significantly under -estimated the financial sector problem, which

escalated sharply in 2008. Concerns aboutmortgage-backed securities emerged slowly, butthen rapidly spread to the whole array of so-calledsophisticated instruments. All this was broughtinto sharp relief by the need to mark-to-market2

instruments in increasingly illiquid markets. Thisled to a total breakdown in the confidence thathad previously allowed banks to borrow and lendamong themselves – and clients began to questionthe security of both their deposits and theirrelationships.

Because UBS listed on the New York StockExchange, I sign off many SOX accreditations forGlobal Asset Management; our internal andexternal audit processes have never been moreintrusive; and the legal, compliance and risk areain the financial sector has grown more than anyother. Nonetheless, the problems were all missed.

Risk management

For all the resources devoted to risk, I believe therehad been an undue focus on operational risk andcredit risk in the investment banks, while thegorilla of market3 risk was quietly eating all thebananas in the corner of the room. That was afundamental problem. Few pointed to the over-arching market risks. We had become victims ofundue reliance on quantitative measures of risk.But those measures were necessarily backward-looking, to an era that, in large part, no longerpertained in the financial sector. Securities hadmultiplied in their coverage, complexity andvolume. But we were drawing on 20- to 30-year-old data to work out the probabilities of default.

We need to rethink risk management. The wayforward for risk management should be amarriage of modelling based on past behaviourswith far more forward-looking judgment. Itshould be not unlike how good macroeconomicforecasting is undertaken.

Similarly, we have to make sure risk managementlies at the very heart of business management. Ichair the Risk Committee of Global AssetManagement every month and I do it in anintrusive and often obnoxious way. There is noalternative to really knowing your business in


assessing risk. As CEO, when you know moreabout the businesses of your direct reports thanthey do themselves, then you have a risk issue!Risk is as much about people as about process –and that is especially the case when, as in GlobalAsset Management, we are operating in 27countries with different cultures, regulatoryregimes and market structures.

Some accuse the regulators of not recognising theproblems. But it was an incredibly difficult taskto be a regulator in this environment. The speedwith which the financial sector grew, theglobalisation of that financial sector and

remuneration trends have meant that regulatorsoften really struggle to hire – let alone keep –people who can keep abreast of the financialmarkets. We need to have good regulation andwe need to pay those people appropriately;recognising that it is a small impost relative tothe potential costs. We must also recognise thatthey alone cannot guarantee a trouble-freeenvironment. Senior management and Boardmembers need to be held personally accountable.

While much of the focus of regulation has been oncapital adequacy, that needs to be broadened toinclude the size and the nature of the balance


sheets, the concentration of risk and, mostimportantly, liquidity. We all took liquidity as agiven but, as we have seen with confidence, it isone of the first things that dries up in a crisis.

We must also recognise that investors cannot be protected from poor decisions. Theinvestment community must take responsibilityto avoid stupid actions. Regulation in thisregard must focus on better presentation oflikely risks and, perhaps, a more formal andcomprehensive acceptance by clients that theyunderstand the risks.

After 20 years in the public service and now 15years in asset management, I still raise an eyebrowat the remuneration practices in the financial sector.

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


common denominator. A further observation onremuneration – we are prevented, in large part bySOX regulations and accounting conventions,from smoothing bonus pools from one year to thenext. It seems crazy that, in good years, we couldnot bank some of the bonus pool for the next year.

Government rescues of banks have been very sadfor all who prefer capitalism – whatever thatmeans these days – but they were necessary. I sawthe queues at banks and ATMs in London whenNorthern Rock crashed. The week when LehmanBrothers was allowed to collapse was trulyfrightening. The financial sector has a specialplace within our economy but I think the sectorshould be made to pay heavily for this. Thecurrent crisis will be with us for the next threeyears or more, and governments will increasinglyrun or influence banks for some time to come.Bankers who complain about this are being veryhypocritical – there really is no alternative. It isthe price they must pay for the greed, arroganceand stupidity of the binge of the past decade or so.

The Australian financial sector is better placedthan elsewhere but we should not be too smug.We have had the benefit of living through ourown corporate crisis in the 1980s and a very realbanking crisis in the early 1990s. We have alsohad virtually three decades of good economicpolicy with our fiscal responsibility now standingus in a better position to face a possible recession,unlike much of Western Europe. We have learntfrom all of this, and it is one of the reasons whyour financial sector and the economy moregenerally still look pretty good from the other sideof the world.

Finally, a comment on asset management. There isclearly a much-heightened aversion to risk thatwill remain for some time. That said, the assetmanagement client community has beenremarkably sophisticated in reacting to this crisisand it is a credit to trustees, consultants and theclients generally. The long-term growth of theasset management industry will not change. Theageing of the population will be an even biggerfactor now because many will have to redoubletheir efforts to provide privately for theirretirement savings. Governments will be even lessable to support retirement incomes as the

pressures on public finances intensify in a way notforeseen a year or so ago.

The industry still has a great future; but it has tolearn from its experiences and become a little bitmore sober and more humble. It needs torecognise there are very real social responsibilities.To the extent that asset managers under-perform,people suffer and governments face higher social welfare costs. We should expect moreoversight by regulators and more focus onproviding not just returns but also liquidity andsecurity when needed.

John A. Fraser, Chairman and CEO of UBSGlobal Asset Management, is a member ofthe UBS Group Executive Board andChairman of UBS Saudi Arabia. Prior tojoining UBS in 1993, he served as DeputySecretary (Economic) and spent more than 20years with the Australian Treasury, includingpostings at the IMF and the AustralianEmbassy in Washington D.C. He has beenresident in London since 2002.

1 The Sarbanes-Oxley Act 2002, is a US federal law enactedfollowing the Enron and other financial scandals, in order to raise corporate accounting standards.

2 An accounting method of valuing a financial instrumentbased on its current price rather than on its cost.

3 Risk arising from general economic changes that affect the market.


CitiGroup recently announced that it was seekingBoard members who had ‘expertise in finance andinvestments’. What was the previous experienceand expertise of the CitiGroup Board and seniormanagement – the one that has registered morethan US$50 billion in losses? Banking, especiallyinvestment banking, has delivered strong returnsto shareholders in recent years; but the ‘high’returns of financial stocks and the future earningprospects need careful examination.

Displacing the traditional bankingmodel

Until the early 1980s, banking was highlyregulated. It was the world of George Bailey,played by Jimmy Stewart in It’s A Wonderful Life.Community banking was the rule. The bankercould dip into his ‘honeymoon money’ to stave off a potential bank run. It also fueled jokes – the‘3-6-3’ rule was to borrow at three per cent; lendat six per cent; hit the golf course at three p.m.

Once deregulated, banks evolved into complexorganisations providing varied financial services.Deregulation brought benefits for the economy,including better access to capital and more variedinvestment opportunities; and for the banks,growth and higher profits.

Over the last 15 years, increased competition –within the industry and increasingly from non-banking institutions – and the reduction ofearnings from the standardisation of products,

forced banks to rely on ‘voodoo banking’, orperformance enhancement to boost returns. Focuson risk-adjusted returns – introduced in the early 1990s by JP Morgan and Bankers Trust –changed the ‘business model’.

Traditionally, banks made loans that tied up theircapital for long periods, for example, up to 25 to30 years in a mortgage. In the new ‘originate todistribute’ model, banks ‘underwrote’ the loan,‘warehoused’ it on the balance sheet for a shorttime, and then parcelled it up with other loans andcreated securities that could be sold to investors, a process known as ‘securitisation’. The bank tiedup capital for a short time until the loans weresold off and then the same capital could be reused and the process repeated. Interest earningsover the life of the loan could be discounted back and recognised immediately. In this way,banks increased the ‘velocity of capital’ –effectively ‘sweating’ the same capital harder toincrease returns.

In the traditional model, banks earned the netinterest rate margin over the life of the loan – thiswas their ‘annuity’ income. Yet, when loan assetsare sold off and the earnings recognised up-front,banks need to sell off new loans to maintainearnings. This creates pressure on banks to find‘new’ borrowers. Initially, credit-worthy borrowerswithout access to credit in the regulated bankingenvironment entered the market. Over time,banks were forced to ‘innovate’ to maintainlending volumes.

voodoo banking

by satyajit das

Elite athletes often use performance enhancing drugs to boost performance.Voodoo banking operated similarly, enabling banks to enhance short-term

performance whilst risking longer-term damage.

A condensed version of a lecture given at the Melbourne Centre for Financial Studies andthe Financial Services Institute of Australasia on 12 February 2009.

18 Voodoo Banking

New markets for borrowing

Banks created substantial new markets forborrowing in the following areas:

• Retail clients – expanding traditional lending(housing and car finance) and developing newcredit facilities (credit cards and home equityloans);

• Private equity – providing borrowings inleveraged buyouts and sundry other highlyleveraged transactions; and

• Hedge funds/private investors – providing(often) high levels of debt against the value of assets.

Banks increasingly also outsourced the originationof the loans to brokers, with large ‘upfront’ feesproviding the incentive.

The expansion in debt provision relied increasinglyon complex mathematical models for assessingrisk. It also relied on collateral – whereby theborrower puts up a portion of the price of the assetand agrees to cover any fall in value with additionalcash cover. The model allowed banks to expand thequantum of loans and allowed extension of creditto lower-rated borrowers. Banks did not plan tohold the loan on a long-term basis and were only exposed to ‘underwriting’ risk in the periodbefore the loans were sold off. Where the loan was collateralised, the agreement to ‘top up’ thecollateral whenever the asset value fell wasconsidered to provide ample protection.

The growth in this type of lending wasunderpinned by favourable regulatory rules, as thecapital required was modest; as well as optimisticviews of market liquidity and faith in models.


Casino banking

Banks also increased their trading activities,especially in derivatives and other financialproducts. Initially, this was targeted at companiesand investors seeking to manage financial risk.Over time, they focused increasingly on creatingrisk, allowing investors to increase returns andcompanies to lower borrowing costs or improvecurrency rates. As profit margins eroded, bankscreated even more complex and exotic products,usually incorporating derivatives. Theseincreasingly became a way to provide additionalleverage to customers.

The development of hedge funds was especiallyimportant, which borrowed money againstsecurities offered as collateral. These usedderivatives extensively, traded frequently andaggressively boosted volumes. Prime brokingservices – such as bundling settlement, clearing,financial and capital raising – emerged as a majorsource of earnings for some banks.

As wealth and sophistication grew, investorsincreasingly sought investments other than bankdeposits or even equity, bonds or mutual funds.Banks created or purchased wealth managementbusinesses such as asset managers and privatebanks to service this requirement. The clients ofthe wealth management units were also majorpurchasers of securities or financial productscreated by the banks.

Major banks expanded into emerging marketswhere similar products could be created and soldto a new client base. Global banks had significantadvantages over local banks in terms ofintellectual property and (sometimes) capitalresources. Profit margins in emerging marketswere also larger.

Banks also increased their own risk-taking.Traditionally, banks took little or no risk otherthan credit risk, yet over time they took on marketrisk and investment risk. Whereas originally,banks traded financial products primarily as‘agents’ standing between two closely matchedcounterparties, they soon became principals inorder to provide clients with better, moreimmediate execution and increased profit margins.This increase in risk-taking was also dictated by

business contingencies. Advisory mandates –mergers and acquisitions and corporate financework – were conditional on extension of credit.Banks increasingly ‘seeded’ or invested in hedgefunds to gain preferential access to business.

Clients often sought an ‘alignment’ of interests,requiring banks to take risk positions intransactions. This evolved into the ‘principal’business, as banks increasingly made high-riskinvestments in transactions, rolling back the clock to the days of JP Morgan. Banks convincedthemselves of this strategy on the basis that therisks were acceptable – it was their deal after all!It seemed they believed that the risk could bealways sold off at a price, that markets were liquid,and (the real reason) returns were high.

Regulatory arbitrage as a businessmodel

Enhanced revenues, through growing volumesand increasing risk, were augmented by increasedleverage and adroit capital management.‘Regulatory arbitrage’ evolved into a businessmodel. Required risk capital was reduced bycreating the ‘shadow’ banking system – a complexnetwork of off-balance sheet vehicles and hedgefunds. Risk was transferred into the ‘unregulated’shadow banking system, and the strategiesexploited bank capital rules. Some or all of the realrisk remained indirectly with the originating bank.

Banks reduced ‘real’ equity – common shares – bysubstituting creative hybrid capital instrumentsthat reduced the cost of capital. These structuresgenerally used high income to attract investors,especially retail investors, while disguising the (lessobvious) equity price risk. In some cases, banksused these new forms of capital to repurchase sharesto boost rates of return. For example, CitiGrouprepurchased US$12.8 billion of its shares in 2005and an additional US$7 billion in 2006.

Banks increasingly ‘hollowed out’ capital andliquidity reserves, reducing them to minimumlevels. Concepts of ‘purchased’ capital and‘purchased’ liquidity grew in popularity. Thetheory was that banks did not need to hold equityand cash buffers as these items could always bepurchased in the market at a price.

20 Voodoo Banking

Thus, bank profits in recent history were drivenby rapid and large growth in lending, tradingrevenues and increased risk-taking. Bankingreturns were underwritten by an extremelyfavourable economic environment – a long periodof relatively uninterrupted expansion, lowinflation, low interest rates and the ‘dividends’from the end of communism and growth ininternational trade. Bankers would argue that thesource of higher returns was ‘innovation’.However, John Kenneth Galbraith, in A ShortHistory of Financial Euphoria, noted that:

Financial operations do not lend themselves to innovation. What is recurrently sodescribed and celebrated is, withoutexception, a small variation on an establisheddesign... The world of finance hails theinvention of the wheel over and over again,often in a slightly more unstable version.

Not-so-perfect future

There are reasons for caution regarding theoutlook for banks.

The asset quality of major banks remainsuncertain. Svein Andresen, Secretary General ofthe Financial Stability Forum, which is made upof global regulators and central bankers, recentlytold a conference of bankers in Cannes: ‘We arenow 10 months through this crisis and some of themajor banks have yet to make disclosure in[crucial] areas.’

Despite significant write-downs, sub-prime assetsremain vulnerable. There are substantialdifferences in valuations. Further losses are likelyto merge in portfolios of commercial property,consumer loans and private equity loans as theglobal economy slows. Bank balance sheets havechanged significantly. Traditional commercialbank assets consisted primarily of loans and highquality securities. Traditional investment bankassets consisted of government securities and theinventory of trading securities.

In recent years, asset credit quality hasdeteriorated. High quality borrowers have dis-intermediated the banks by financing directlyfrom investors. Banks also hold lower quality

assets to boost returns. Bank balance sheets nowalso hold investments – private equity stakes,principal investments, hedge fund equity,different slices of risk in structured financetransactions and derivatives of varying degrees of complexity. Sometimes, the assets do notappear on the balance sheet, being held incomplex off-balance sheet structures with variouscomponents of risk being retained by the bank.Moreover, further write-downs in asset valuescannot be discounted.

Banks require re-capitalisation in order to deal withthe consequences of the financial crisis. The capitalrequired is in excess of US$1,000–1,500 billion(50–75 per cent of total global bank capital prior to the crisis) to cover losses. Capital is also neededfor assets returning onto their balance sheet as the vehicles of the ‘shadow banking system’ areunwound. This capital is required to restore bankbalance sheets. Additional capital will be needed tosupport future growth. Availability of capital, thehigh cost of new capital and dilution of earningswill impinge upon future performance.

Earning! What Earnings?

The aftermath of the financial crisis may beexpected to have the following consequences forthe earnings prospects of banks.

• Earnings growth in recent years has been drivenby a rapid expansion of lending – bothtraditional and, as shown above, disguised formssuch as securitisation and derivatives activity.Bank balance sheets have expanded at rates wellabove GDP expansion. Lower volumes in thefuture will mean lower earnings.

• Lack of lending capacity may also affect otheractivities. Corporate finance and advisory feesare driven by the capacity to financetransactions as well as co-investing in riskpositions. Lower origination of lending-drivendeals may reduce this income significantly.Banking fees for leveraged finance deals aredown 90 per cent.

• The use of complex financial products – usuallyreferred to as ‘structured finance’ – hascontributed strongly to earnings in recent years.


Securitisation, including CDO (CollaterisedDebt Obligation – a type of asset-backedsecurity) activity, has been a major growth area.Volumes have collapsed. The slowdown instructured finance has complex effects. Banksgenerated large earnings from off-balance sheetvehicles in the shadow banking system. Thesevehicles provided banks with the ability to ‘park’assets and reduce capital requirements. They alsoprovided significant revenue – management fees,debt issuance fees and trading revenues. Recoveryin these earnings is unlikely any time soon.

• Trading revenue has also been a bright spot.Increased volatility and a much wider bid-offerspread have generated increases in both client-

driven and proprietary trading earnings. Severalfactors may limit trading income. Revenuesmay diminish as investors and borrowers curtailtheir use of such instruments, preferringsimpler products that are less profitable to thebank. Trading revenues relied heavily on hedgefunds and financial sponsors. Hedge fundactivity is likely to slow down throughredemptions, consolidation and reducedleverage. Reduction in financial sponsor activitywill limit revenue from this source.

• Banks have increasingly relied on proprietarytrading to supplement earnings. This increasesrisk and depends on the availability of capital. Itrelies on the availability of people to trade with

22 Voodoo Banking

and liquidity. Concern about counterparty riskand reduction in market liquidity in someproducts increases the risk of this activity andreduces its earning potential.

• Future earnings will also be affected by theavailability of risk capital. The banks may notbe able to access capital to the extent needed.The demise of the shadow banking system willmean that purchased capital will not beavailable. Regulators may also increase capitallevel requirements for some transactions,exacerbating the capital problem.

• Risk models in banks are a function of marketvolatility. The low volatility regime of recentyears reduced the amount of capital needed.Increased market volatility will increase theamount of capital needed. This may restrict thelevel of risk-taking and, therefore, earningspotential.

• Higher costs will further limit earningsrecovery. Bank funding costs have increased.Most firms have been forced to issue substantialamounts of term debt to fund assets returningto balance sheet and protect against liquidity

risk. To the extent that these costs cannot bepassed through to borrowers, the higherfunding costs will affect future funding.

• Banks have issued high cost equity to re-capitalise their balance sheets. Hybrid capitalissues paying between seven and 11 per cent perannum will be a drag on future earnings.Highly dilutionary equity issues – often at adiscount to a share price that had fallensignificantly – will impede earnings growth pershare and return on capital.

• Banks also face additional short-term costs.Litigation and prosecution present likely, butunknown, costs. In the longer term, banks facehigher regulatory and compliance costs.

• Accounting factors may further affect anyearnings recovery. For example, bank balancesheets have substantial goodwill on acquisition asfuture income tax benefits – particularly as aresult of the losses in the last year. The carryingvalue of these assets may need to be adjustedsubstantially as the market environment changes.

• FAS157 (Financial Accounting Standardestablishing the basis for assessing ‘fair value’ on


accepted accounting principles) allows theentity’s own credit risk to be used in establishingthe value of its liabilities. Changes in the entity’scredit standing are therefore reflected as changesin fair value. This results in gains for creditdowngrades and losses for credit upgrades.

• As credit spreads increased, banks revalued theirown borrowing – which were now trading belowthe original price – allowing them to recordlarge gains. If markets stabilise and the creditspreads for banks improve, then banks willhave to reverse these gains. There may besignificant unrealised losses especially on newdebt issues by banks at high credit spreads sincemid-2007.

From ‘go-go’ banks to ‘no-go’ banks

Investors are looking for a rapid recovery in bankearnings. Earnings may recover but the ‘gildedage’ of bank profits may be difficult to recapture.Glamorous banks reliant on ‘voodoo banking’ mayfind it difficult to achieve the high performance of the ‘go-go’ years.

Banks with sound traditional franchises that haveavoided the worst excesses of the last 10 to 15 yearswill do well in the changed market environment.Interest rates that they charge customers haveincreased. Bank deposits have become far moreattractive than other investments. Stronger banks have also benefited from a ‘flight to quality’in attracting deposits.

Elite athletes often use performance enhancingdrugs to boost performance. Voodoo bankingoperated similarly, enabling banks to enhanceshort-term performance whilst risking longer-term damage. The big question remains: will therecovery graph in bank stocks take the form of ‘V’or ‘U’? With the various bailouts, central banksand governments have signaled that major banksare ‘too big to fail’. This is a necessary butinsufficient condition for the recovery of bankearnings and stock prices. And so, we may wellsee the recovery taking the form of an ‘L’ (KristenITC font) – note the small upturn at the far rightof the flat bottom.

© 2009 Satyajit Das. All rights reserved.

Mr Satyajit Das is a risk consultant andauthor of Traders, Guns & Money: Knownsand Unknowns in the Dazzling World ofDerivatives (2006, FT-Prentice Hall). Atthe time of this publication, the author or his firm did not own any directinvestments in securities mentioned in thisarticle, although he may be an ownerindirectly as an investor in a fund.


Introduction

The Third World has shrunk, but it has notvanished. The ‘New Third World’ – the hard core of the economic development challenge – iscomposed of some 50 countries that are home to a billion people. Most of the bottom billionlive in Africa, but others are scattered across the continents – in Haiti and Bolivia in LatinAmerica, Yemen in the Middle East, many of the‘Stans’ in Central Asia, and Laos and East Timor inEast Asia. This group of small countries hassheered off from the rest of mankind, and as theworld becomes more socially integrated, this giantpool of poverty will be both unacceptable andexplosive. It is the world’s biggest economicproblem and we need to do something about it.

Four distinct traps

To know what to do, we need to start with adiagnosis. While the common fate of the bottombillion has been stagnation and poverty, there hasbeen no single cause. I think there are four distincttraps that between them account for the problem,each requiring a distinct remedy.

One trap is paradoxically to be poor but abundantin natural resources. The revenues from theseexports usually distort the political system intopatronage. Another trap is to be landlocked withbad neighbours. To be small is also to be at themercy of your neighbours, especially if you arelandlocked. Suppose that Australia was not unitedbut each state had remained as a separate small

country. Or even more dramatically, suppose thatthe United States had been the Divided States,with each state sovereign and self-serving. Thegreat manufacturing and agricultural heartlandstates of America would have been strangled atbirth by the absence of interstate highways,railways and canals. Consider the plight of Niger,which is dependent upon Nigeria, and of Uganda,which is dependent upon Kenya. Both arelandlocked and located in the Divided States ofAfrica, and one third of Africa’s population live insuch countries. A third trap is civil war. Many ofthe countries of the bottom billion are plagued bycivil war because they are not only poor but toosmall to maintain internal security. Imagine ifIndia or China were divided into 50 countries. Doyou think they would all be at peace? The finaltrap is to start with bad policies and governanceand to lack the critical mass of educated peopleneeded for the society to be able to correct errorsover a reasonable time scale. These four traps havebetween them delayed the development of abillion people.

Globalisation is not working for thebottom billion

Will globalisation automatically help thesepeople? Globalisation is propelling China andIndia toward wealth, and they are closing in onthe rich world with unprecedented speed. Butglobalisation is not working for the bottombillion. Incomes in the bottom billion have beenvirtually stagnant. For the four decades from 1960

reversing the divergence of the bottom billion

by paul collier

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

A condensed version of the Max Corden Lecture delivered at the University of Melbourneon 15 October 2008.

26 Reversing the divergence of the bottom billion

to 2000, the New Third World experienced nogrowth at all. Meanwhile, the rest of thedeveloping world has enjoyed acceleratinggrowth, decade by decade. At first gradually, thenrapidly, the bottom billion have fallen away fromthe rest of mankind.

To date, globalisation has left the bottom billionbehind. During the golden decade of the 1990s,between the end of the Cold War and 9/11, thebottom billion’s divergence from the middle fourbillion people on Earth had accelerated to five percent a year. By the millennium, the income gapbetween the average citizens of the bottom billionand those of the middle four billion was five toone. And if you think that income gap is alarming,think about the lucky billion – in Europe, NorthAmerica, Japan and elsewhere – at the top. Onepart of the problem is the World Bank and theUnited Nations, which focus on poverty like abean-counter. That only confuses the real issue. Itis not enough that absolute levels of poverty start tofall in the New Third World. The further that abillion people fall behind the rest of humankind,the more it will present the world of our childrenwith unmanageable pressures. Even as the world’seconomies are bifurcating, the world continues todraw closer together socially – through informationand migration – and the youth in the bottombillion know they are being left behind. To catchup, they will need spectacular increases in growth.

So how can the international community help thebottom billion catch up? In each country of theNew Third World, reformers are struggling withentrenched interests and to catch up to the rest of the world they must win these struggles. Wecannot do it for them, but we can make theirstruggle a whole lot easier than it has been to date.

In 1945, the US got serious about rebuildingEurope, with aid through the Marshall Plan. Butthere was also trade. Washington reversed theprotectionism of the 1930s and created theGeneral Agreement on Tariffs and Trade, therebyintegrating Europe into the US economy. Andthere was also security: Washington reversed theisolationism of the 1930s and created NATO,stabilising Europe by placing more than 100,000US soldiers on European soil for decades. Andthere was also a shrewd attempt to create systems

that produce good governance. Washingtoncreated the OECD and encouraged the formationof the EEC, thereby starting the process ofmutually setting standards that help lock Greece,Spain and Portugal into democratic marketeconomies, followed by much of Eastern Europe.We, as the fortunate inhabitants of the OECD, areall now ‘America’, and our equivalent of Europe in1945 is Africa. What America did for Europe after1945, we must now do for Africa.

How to get the bottom billion on amore prosperous track

It is feasible to get the bottom billion on a moreprosperous track, but it will require a seriousapproach that utilises all the instruments at ourdisposal and is sustained for at least two decades.Indeed, we will need the same toolkit as we usedin the recovery of postwar Europe – aid, trade,security and good governance – although, ofcourse, utilised differently.

Aid will probably be more or less as important tohelping the bottom billion as it was to savingpostwar Europe – part of the solution but notdecisive. The exclusive reliance upon aid hasdistorted what should be a focus on institutionsand energy devoted to development. Instead ofdevelopment agencies, we have aid agencies.Instead of pressure from the street for develop-ment, we have pressure for aid.

The distortion of institutions and citizen pressureis self-perpetuating because it crowds outconsideration of the other approaches. What, forexample, do you imagine aid agencies lobby for?Our utter neglect of trade, security andgovernance policies for the bottom billion is ascandal – and an opportunity. Properly used, thesepolicies have real potency, which is why they wereused for the recovery of Europe. Australians whocare about world poverty have to learn how to usethe full array of policies, rather than pretendingthat it can all be done by aid.

Saving the bottom billion will also require theOECD countries to work together. The emergingeconomies will need to do the same. To producethis unity of serious purpose, caring will not be enough: goodness is in limited supply.


Fortunately, it can be reinforced by the lessmorally demanding and, therefore, better suppliedmotivation of enlightened self-interest. Moved asI am by the miseries of life at the bottom, I toohave a self-interested stake here. I am fearful of the world that my seven-year-old son will inheritunless we wake up. A previous generation rose tothe challenge of restoring Europe and gave us all a safer world. Our own generation now has its own choice to make: whether to face up to ourresponsibilities or, like the generation of the1930s, go into collective denial and sleepwalkinto a nightmare.

In our democracies, politicians will ultimately dowhat we ask of them. It is our collectiveresponsibility to grasp the challenge posed by thebottom billion – and, critically, to get sufficientlyup to speed with the issues and to understandwhat can be done about them. Only then will ourpoliticians move from gestures to serious, effectiveactions. That is why, although The Bottom Billion is

a serious book, I wrote it in a style that makes iteasy to read. I tried to do so because I realised that,inadvertently, the same process that has succeededin getting economic development onto thepolitical agenda – lobbying of rock stars andNGOs – risked trivialising its policy content. It istime for academics to set aside their tendency towrite only for each other, and to reach out to theirfellow citizens in communicating their expertise.While the style of the book is light, its content isabout research, essentially pulling together myrecent research with a number of colleagues. Thispulling together is also increasingly rare inacademic behaviour. Our work is nowoverwhelmingly presented in article-sized nuggetswith few serious outlets for more sustainedanalysis. Does the book have any ideas beyondthose familiar to any academic developmenteconomist? Professor Brad de Long’s assessment,taken from his blog page says, ‘The Bottom Billionis a very exciting and important book. It is rare to

28 Reversing the divergence of the bottom billion

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

The key policy issues for helping thebottom billion

So what are the key policy issues? One is thatwhile Africa has failed to develop jobs in exportmanufactures, this same strategy has beentransforming Asia. Bangladesh has generatednearly three million jobs by exporting garments.If Kenya could do the same, it would betransformed; but Asia’s success has made itharder for Africa to get started. We can help bygranting Africa better access to our markets. Atpresent most of the G8 countries impose tariffson imports of garments from Africa. America isthe one exception. This is embarrassing for therest of us since we pretend that America does not‘care’ about Africa. But the US allows Kenya toexport shirts duty-free and with generous rules-

of-origin into its market, which is not true ofeither Australia or Europe. Even the few Africancountries that are allowed duty-free access getblocked by absurd technical requirements:Lesotho sells thousands of shirts to America, butthey do not satisfy the regulations of theEuropean Union. As a result, over the last fiveyears, Africa’s garments exports to Europe havedeclined while increasing sevenfold to the US.The G8 could easily adopt a common set of rulesfor these African exports that would generatejobs across the region.

A second policy issue is that many of the countriesof the bottom billion have been benefiting fromrevenue booms from oil and other minerals thatdwarf any conceivable aid flows. The last time this happened was 30 years ago and it proved adisaster. The money corrupted the local politics so badly that not only was it wasted, but itimpoverished people, sometimes even leading to


civil war. Can the governments of developedcountries do anything to reduce the risks ofrepetition? Australia and Canada could take thelead on this issue since they are the two keyresource-rich countries of the OECD. Where docorrupt politicians put their money? Theycertainly do not leave it in their own banks. Itcomes to our banks. And what do our banks do?Basically, they keep quiet about it. Is this anecessary consequence of banking secrecy laws?No, it is not. If the money is suspected of havingterrorist associations then, very sensibly, we nowrequire the banks to blow the whistle on it. But ifit is stolen from the ordinary citizens of thebottom billion, that is just too bad. It cost thereforming government of Nigeria huge legal feesto track down some of the previous president’smillions in a Swiss bank, and even when they wontheir court battle, the Swiss Minister of Justiceblocked sending the money back. There is muchmore that we can do to support the struggle ofreformers within the bottom billion to use thepresent resource bonanza well, but cleaning up ourbanks would help.

A third policy issue is security. Quite possiblythe most effective ‘aid’ Australia has everprovided are the troops that have secured peacein Timor Leste. Similarly, Britain has providedtroops that have secured peace in Sierra Leone.Both countries in effect guarantee the peacethrough an ‘over-the-horizon’ commitment – ifthere is trouble, troops will fly in. Civil warshave been devastating to the bottom billion. Theone in Sierra Leone delivered the coup de grace toan economy that had already been wrecked byrevenues from diamonds. Across the region thereare now several post-conflict situations that needthis sort of commitment. To date, nearly half of all post-conflict countries revert to war withina decade, and we should surely be able to make a difference here. Unfortunately, along came thewar in Iraq, which closed down seriousdiscussion of security needs. The OECD powersare afraid that sending troops abroad will beunpopular, and the governments of the bottombillion fear that OECD involvement wouldlicense pre-emptive invasions.

Trade in shirts, the governance of resourcebonanzas, and security commitments are moresophisticated agendas than simply doubling aid.However, I should stress that I do not see themas alternatives to aid – rather they complement it.Think how seriously America responded to theneed to rebuild Europe after 1945 – it used thefull range of policies. The challenge posed by thedivergence of the bottom billion is evidentlymore difficult than that of rebuilding Europe. Itwill take that same full panoply of policies,although obviously the content of each policywill be different.

The message of The Bottom Billion

The message of The Bottom Billion is to narrow ourfocus and broaden our instruments. Narrow ourfocus to the divergence of the countries now at thebottom of the world economy – a one billionperson problem – because our efforts will bespread too thin if we continue to fuss about theentire five billion people in developing countries.Then we must broaden our instruments beyondthe exclusive reliance upon aid, to recognise thatother policies are likely to matter more. Our aid agencies need to be re-thought as genuinedevelopment agencies.

Paul Collier is Professor of Economics atOxford University and Director of the Centrefor the Study of African Economies. Hisbook, The Bottom Billion: Why The PoorestCountries Are Failing and What Can Be DoneAbout It, won the 2008 Arthur Ross BookAward and the 2008 Lionel Gelber Prize.The book, which is the basis of this lectureand published by Oxford University Press in2007, is now in paperback.

Introduction

Too many economists interpret ‘fairness’ as anunfortunate constraint on public policy-making oras a regrettable fact of political life. I make sometentative suggestions about how to systematicallyincorporate aspects of fairness into the frameworkthat economists use for judging the economicefficiency of policy changes.

Only in recent decades has competition beenaccepted as a policy instrument or framework inAustralia. However, neither the process ofcompetition itself nor the emergent outcomesfrom the process of competition is accorded thereverence by the general ‘informed public’ that isgiven to them by many economists.

One reason for this difference in perspective is thateconomists do not tend to pay systematicattention to ‘collateral damage’ – the individuallosses that necessarily occur in the process ofpolicy change designed to achieve improvementsin economic efficiency, that would not otherwisebe deliberately imposed by government. They are not losses imposed for the sake of incomeredistribution. When estimating the conse-quences of economic policy, economists tend toconcentrate on the aggregate or average effect, onthe assumption that gains can be offset against

losses, dollar for dollar. Such symmetricaltreatment of gains and losses would be consideredunfair by many non-economists, even if the gainsand losses fall randomly with respect to economicstatus, health status, or whatever index is used tomeasure the initial levels of personal well-being.

Moreover, it is standard economics that, because ofrisk aversion, losses weigh more heavily in people’sminds than do gains, dollar for dollar. Thus, thedistribution of gains and losses should be anintegral part of the economic evaluation of micro-economic policy.

Growth and competition

The Australian economic development strategyimplemented after Federation had an anti-competitive ethos. Competition from imports wascontrolled by a made-to-measure system of tariffs;competition from non-European immigrants wasrestricted through racist laws; wage competitionamong Australian workers was regulated; privateoligopolies and monopolies were encouraged;Parliament attempted to prevent the take-over ofAustralian enterprises by foreigners, especiallynon-British ones; competition of motor transportagainst state railways was restricted; and so on. Theanti-competitive framework reduced market risks.


reflections on microeconomic policyframeworks and a suggestion

about fairness

by jonathan pincus*

In assessing economic efficiency, economists need to take into account that mostpeople value losses more negatively than they value gains positively

A short version of the Inaugural Department of Economics – Melbourne Institute Lectureon Public Policy delivered on 7 October 2008 at the University of Melbourne. The fulllecture will be published in the Australian Economic Review (2009) Vol 42, No 2.

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

32 Reflections on microeconomic policy frameworks and a suggestion about fairness

All this was based on the belief that it wasimprudent to rely heavily on vigorous privatecompetition to achieve socially-desirableoutcomes – high living standards and rapideconomic development including rapidpopulation growth. Instead, competition wastypically regarded as a transitional stage leading tothe creation of monopolies by private action or bynationalisation or as properly confined to arenaswhere it would do no great harm.

In its 1912–13 judgment in the (coal) Vend case,the High Court declared that:

Cut-throat competition is not now regarded by a large portion of mankind as necessarilybeneficial to the public... [T]he intention ofthe parties was to put the Newcastle coal trade on a satisfactory basis, which would enablethem to pay adequate wages to their men and sell their coal at a price remunerative to themselves.

The strategy of extensive development, with itssuspicion of markets and the risks that they entail,persisted through the 1970s. The shift to a new policy regime was slow, and it was not tolaissez faire. Competition eventually gained wideacceptance in political and policy circles as being a socially-beneficial force generally, but one to bejudged primarily on its effects, not on proceduralor moral grounds. The list of relevant consequencesincluded not only the economist’s obsession –economic efficiency – but also the distributionalconsequences, including collateral damage.

However, the greater reliance on competitivemarkets was accompanied by an increase in economic planning and moderated by a hugeexpansion in economic regulation.

Estimating policy effects

With the notable exceptions of floating the dollarand de-regulating financial markets, most of theimportant policy changes, designed to initiate or improve markets, have been informed bymodelling of the effects.

When challenged to ask ‘Where will all the jobscome from, when tariffs are cut?’, the Tariff Boardpulled out its new CGE tool, a quantitative

computable general equilibrium model of theAustralian economy. Via the input-outputrelationships and simulated market responses, theCGE model showed that, when tariffs were cut,some industries contracted and other expanded in terms of output and employment. Thatinformation was useful for devising programs forstructural adjustment that often accompaniedmajor changes in tariffs and the like.

However, the general-equilibrium models couldnot give a convincing answer to the question ofwhat would happen to employment overall.Rather, the aggregate or national employmentnumber followed from the decision the model-builder made when choosing ‘the labour-marketclosure’ of the model. Usually the model was‘closed’ by assuming that the labour marketcleared, so that then wages adjust untilemployment equals labour force supply, thuseliminating any effects on unemployment as aresult of the tariff cut.

So the Tariff Board and its successors, instead ofemphasising the effects of policy change onnational employment or unemployment, focusedon national results that the models generated asby-products, namely, indices of national economicwelfare, like real GDP, or real GNE, or realConsumption. Hanging in the ProductivityCommission in Canberra is a fading poster fromThe Australian newspaper of Thursday 24September, 1970, inscribed with the signatures of the major players. It reads ‘Tariffs cost us$2,700 million a year!’ This was more than 7.5 percent of GDP. Today’s posters would featuredifferent policies, but use a similar metric.

Losses and gains

My central concern is with how to evaluate apolicy change which is designed to improveeconomic efficiency when it produces thoseincidental income re-distributions that I earliercalled ‘collateral damage’. It is not enough to lookat aggregate or average outcomes.

Here is a thought-experiment. Consider twoalternative policy changes, each with the sameaverage or aggregate effect. Under the first policy,every household gains. Under the second policy,


most households gain a bit more than under thefirst policy, except that a few randomly-chosenhouseholds would lose greatly. The usual criterionof economic efficiency would tell us that the twopolicies are equally valued, because they have thesame aggregate effect as reflected by the usualindices of national economic efficiency.

However, risk-averse people would prefer thefirst option – with no losses. Moreover, they maywell continue to prefer it, even if the secondoption promises a somewhat bigger aggregatebenefit. Rationally, on economic grounds, a lessefficient option may be preferred over a moreefficient policy, given the way economicefficiency is usually measured.

Most policy economists follow the (pretty good)Harberger rule that ‘A dollar is a dollar is adollar’. That is, A’s loss of $10,000 is exactlycancelled by B’s gain of $10,000. However, thisrisk-neutral trade-off does not reflect howindividuals react. Instead, individuals require a

risk premium to engage in uncertain ventures.That is, in order to accept a 50/50 chance of a lossof $10,000, individuals require a prospective gainof greater than $10,000.

Unfortunately, almost all of the Australianquantitative models used to evaluate policychanges are based on a single household earningall private factor incomes and making all privateconsumption decisions. In calculating whathappens to this aggregate household, losses areweighed exactly as heavily as are gains.

Likewise, while the quantitative CGE models doprovide information about the distribution of gainsand losses by industry, by region and by factor ofproduction, the overall index of national economicwelfare still uses the rule that ‘a dollar is a dollar’ –losses are not weighed more heavily than gains.

It is often argued that what is relevant is a series ofpolicy changes, taken as a whole, and not just asingle change. Colloquially, what you lose on the

34 Reflections on microeconomic policy frameworks and a suggestion about fairness

roundabouts, you more than gain on the swings.But there are some losses that are so damagingthat they cannot be compensated by the prospectthat the wheel of fortune will later spin your way.

Individuals may hedge or insure against largeprospective losses either through private marketsor through public processes. However, for someentities – particularly unincorporated businessand all classes of workers – fair insurance againstthe risk of change in government policy is notreadily available in private markets. So, my centralcontention about the policy relevance of ‘collateraldamage’ seems to survive consideration of privateinsurance markets.

It may be asked ‘Does all this amount to a hill ofbeans?’ If the asymmetry of gains and losses wastaken into account, could it make a difference to decisions about public policy? The answer is

in the affirmative when losses are highlyconcentrated and relatively large; for example, ifanti-competitive regulations were relaxed forpharmacies, newsagents and taxis. More generally,the creation of what the Business Council ofAustralia calls ‘seamless national markets’, by thereduction or removal of State-based commercialregulation, will cause some highly-concentratedand large losses to vested interests. Similarconsiderations may apply to effective action toreduce Australia’s carbon footprint.

Conclusions

Recently, microeconomic policy has beendominated by what could be called ‘moderncentral planning’. To achieve social and politicalgoals in recent decades, markets and market-likemechanisms have been more heavily relied upon,although this change has also been accompanied


by or caused a vast increase in economicregulation. Markets and market-like mechanismshave been judged by their outcomes, rather thanby their processes. They have been assessedaccording to their quantitative effects oneconomic efficiency, defined as gains minuslosses. I have suggested the need for a refinementof that definition to take account of the pointthat most people value losses more negativelythan they value gains positively. The refinementis most needed when the policy change will causerelatively large losses to a section of thepopulation.

Sensible advisory agencies, like the ProductivityCommission, in a rough and ready way, alreadytake into account the balance between aggregateeconomic efficiency, as usually measured, andcollateral damage. To take systematic account ofgains and losses may require economists to takemore seriously the implied risk-aversion that isembodied in the utility functions within thequantitative CGE models used to estimate theaggregate effects of a policy change. The NationalCentre for Social and Economic Modelling(NATSEM) in Canberra, specialises in estimatingthe distributional consequences of policy changes;but NATSEM does not provide a summative(overall) economic valuation of a policy change.To obtain such an index of national welfare, CGEoutputs could be fed into NATSEM models, andthe results fed back into the utility function ofthe CGE model. To go further along this trackwould require more real data – which is not easyto obtain, given current constraints on theAustralian Bureau of Statistics.

While preparing this lecture, I was heartened toread that in formulating policy changes, the Ruddgovernment and its senior economic publicservants are taking distributional consequencesseriously into account. However, no informationwas given of exactly how this is being done.Perhaps it would be useful if economistscontributed publicly on the issue.

Professor Jonathan Pincus is VisitingProfessor in Economics, University ofAdelaide and Senior Adviser, ConceptEconomics.

Introduction

The public-use version of the March CurrentPopulation Survey (CPS), an annual cross-sectional survey of more than 50,000 Americanhouseholds, is the primary data source used bypublic policy researchers and administrators toinvestigate trends in average US income and its distribution. Despite the widely held view that US income inequality has increasedsubstantially since the 1980s, our research, whichderives from unprecedented access to internal CPS data, tells a very different story. Most of theevidence of a large increase in income inequalitysince 1993 has come either from those who do not adjust for topcoding in the public-use CPS or from Internal Revenue Service (IRS)administrative record files that have their ownconsistency problems. In a practice calledtopcoding, for incomes above some value in thepublic-use CPS – the topcode threshold – theCensus Bureau reports income as equal to thistopcode threshold rather than providing the exactrecorded value from the internal CPS.

Using various layers of CPS data (see Table 1 fora more precise definition of the various layers ofCPS data we use) we show why, when you do notadjust for topcoding in the public-use CPS, datawill falsely show that American incomeinequality has been rapidly growing. Onceproperly adjusted, we find that for at least thebottom 99 per cent of the income distribution,the rise in income inequality since 1993 has beensmall and its yearly growth much slower than inthe previous two decades. Our results hold evenwhen we estimate income values for the very toppart of the income distribution missing in theinternal CPS data. Our findings are consistentwith those found using IRS data on the 90th–99th percentile groups, only differing withrespect to the top one per cent of the incomedistribution. It is uncertain to what degree thisdifference is the result of our decreasing abilityto capture income at the very highest incomelevels, even using internal CPS data, or ofbehavioural changes in the way that individualtax units report their adjusted gross income ontheir tax returns captured in the IRS data.


what’s been happening to united statesincome inequality?

by richard v burkhauser

Properly adjusted, for at least the bottom 99 per cent of the incomedistribution, the rise in income inequality since 1993 has been small

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

*Based on research conducted while Burkhauser, Feng and Larrimore were Special Sworn Status researchers of the US Census Bureau at the New York Census Research Data Center at Cornell University. Conclusions expressed are thoseof the authors and do not necessarily reflect the views of the US Census Bureau. This research has been screened to ensurethat no confidential data is disclosed.


Public-use vs. internal CPS data

For confidentiality reasons, the Census Bureaudoes not provide full information in the public-use CPS on the amount of income from eachincome source – for example wages and salary,interest, dividends, etc. – found in the internalCPS. Beginning in 1995, the Census Bureau hasalso provided the mean of all topcoded values forthese income sources. By using the mean value ofall these topcoded values, rather than the topcodethreshold for that source of income, you can moreaccurately capture the income values above thethreshold from that source. But, as we will see,this leads the unwary to confuse an increase in ourability to measure higher income values with areal change in the income of richer people.

For their official work, Census Bureau researchersuse the internal March CPS that is less severelycensored. This is the data set we use. Doing so, weanalyse levels and trends in US inequality usingGini coefficients between 1975 and 2004 derivedfrom the internal CPS and compare them withestimates from several series derived from thepublic-use CPS (see Table 1). The Gini coefficientis the most common way to measure inequality inthe distribution of income across a country’s

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

Measuring trends in incomeinequality

Figure 1 shows that those who simply use theunadjusted public-use CPS (Public-Unadjusted)will find that income inequality jumpsdramatically between 1994 and 1995 – the Ginivalue increases from 0.395 to 0.422, a single yearchange far greater than in any prior or subsequentyear. This is caused solely by an increase intopcoding and the use of a Census Bureau-derivedmean value rather than the topcoded value for allvalues above the topcoded value. Using theunadjusted internal CPS (Internal-Unadjusted),we find no such increase between 1994 and 1995.Rather, what is happening is that prior to 1995the Public-Unadjusted CPS Gini valuessubstantially understate income inequalitybecause they fail to fully account for incomevalues above the topcodes. Once the CensusBureau provided the mean value of all these

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

Acronym Source Method for Addressing Censoring Issues

Internal-Unadjusted Internal Uses internal data as provided in Census Bureau files, without anyadjustments

Internal-MI Internal Topcoded observations replaced by imputations derived from GB2imputation model fitted to internal data; inequality estimates derivedusing multiple imputation combination methods

Public-Unadjusted Public Use Uses public use data as provided in Census Bureau files; includesCensus Bureau cell mean imputations for topcoded observations from 1995 onwards

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

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

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

Insights Melbourne Economics and Commerce

topcoded values, the now more precise Public-Unadjusted CPS Gini values match the higherInternal-Unadjusted Gini values. Failure toaccount for this change in methodology willgrossly overstate US inequality increases beforeand after 1994–1995.

This problem is not solved by simply ignoringCensus Bureau mean values after 1994, as can beseen in the Public-NoMean Gini series. This seriesstill inconsistently topcodes high values andunderestimates inequality after 1994, as can beseen by the way its Gini values fall further andfurther below the Internal-Unadjusted Ginivalues. We solve this problem by deriving a meanvalue for all topcoded incomes in the public-useCPS, for each year back to 1975. When we use thepublic-use CPS together with our extended meanseries (Public-Mean) in Figure 1, we match theInternal-Unadjusted Gini values in every year.

However, the internal CPS data is itself censoredalbeit to a substantially smaller extent than the public-use CPS. Hence, it too has time-inconsistencies, especially in 1992–1993, as can be seen by the jump in the Internal-UnadjustedGini values between these years. To control for

inconsistent censoring and to capture the missingpart of the internal CPS data, we use a multipleimputation approach in which, for each year, out-of-sample values – values that are topcoded in theinternal CPS are imputed on assumptions aboutwhat their distribution would look like – and datafrom the lower in-sample values that we do havein the internal CPS data. Unsurprisingly, as canalso be seen in Figure 1, we find that compared toestimates derived from our multiple imputationapproach (Internal-MI), that contains these higherimputed values, all the other series understate thelevel of inequality in all years.

However, just as was the case for our Public-Meanseries and the Internal-Unadjusted series itreplicated, the Internal-MI series reveal the sametrends: an increase in inequality over the entireperiod 1975–2004, but with a rate of increasenoticeably lower after 1993 compared to before1993. In each series, average inequality is found toincrease much more prior to 1992 than after 1993.And in each series the jump in 1992–1993 is farhigher than in any other period and is consistentwith the argument that a change in the measure-ment of inequality, rather than a real change ininequality, is its cause.

39

Figure 1. Inequality Estimates using Alternative Layers of CPS data, 1975–2006

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

0.45 -

0.44 -

0.43 -

0.42 -

0.41 -

0.40 -

0.39 -

0.38 -

0.37 -

0.36 -

0.35 -

0.34 -1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Public – UnadjustedPublic – NoMeanPublic – MeanInternal – UnadjustedInternal – MI

Internal – Unadjusted

Public – Unadjusted

Public – NoMean

Public – Mean

Internal – MI

Gin

i Coe

ffici

ent


CPS vs. IRS results for the share ofincome held by high income groups

Finally, we compare our CPS-based estimates oftrends in top income shares using our Internal-MIadjusted CPS data to the estimates of top incomeshares derived by Piketty and Saez (2003) fromIRS administrative files. As can be seen in Figure2 both the grey lines’ (our data) and the dottedlines’ (their data) estimates of the income shareheld by the top 90th–95th percentile group havea relatively flat trend during the period1975–2004, although the Piketty and Saez valuesare slightly higher in level. Similarly, for theshares held by the top 95th–99th percentilegroup, despite slight differences in levels, the twoseries exhibit remarkably similar trends over the30 year period. In contrast, while the share ofincome held by the richest one per cent – whichcan be found by taking the difference between thetop two dotted lines for them and the top two greylines for us – increased substantially over thisperiod (according to both our CPS-based and theIRS-based Piketty and Saez (2003) estimates),their estimates are much larger – from 8.0 to 16.1percentage points compared to an increase from5.4 to 9.8 percentage points in our series.

But this difference is even greater when it isobserved that one-third of the increase in theincome share of the top one per cent in our seriesfrom 1975–2004 occurred in 1993, and isprimarily attributable to the CPS redesign. Hencea significant minority of this increase in the shareof income held by the top one per cent in ourseries is likely due to better measurement of theirincome by the CPS rather than by an actualincrease in the share of income they held.

Effect of change in legislation

This same problem of changes in measurementversus changes in real income held by the richestone per cent of the distribution is also likely toexplain at least some part of the rise in incomeshares at the top of the income distribution in thePiketty and Saez (2003) series. As can also be seenin Figure 2, there is a dramatic four percentagepoint jump in the share of gross taxable incomeheld by the highest one per cent of tax unitsreported by Piketty and Saez (2003) between theyears 1986 and 1988. (Compare the change in thedifference between the top two dotted lines overthese years to confirm this.) This finding must, tosome degree, be the result of changes in the way

Figure 2. Share of Income Held by Top 10 Per Cent: IRS vs. CPS, 1975–2004

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

0.45 -

0.40 -

0.35 -

0.30 -

0.25 -

0.20 -

0.15 -

0.10 -

0.05 -

0.00 -1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Internal-MI Gb2 90-95th



PS 90-95th

PS 90-99th

PS 90-100th

Inco

me

shar

e


the very richest tax units chose to report theirincome as a result of the Tax Reform Act of 1986rather than the result of genuine changes inincome inequality. This legislation providedsubstantial incentives for the very richest tax unitsto switch income from Subchapter-S corporationsto wage income. Subtracting the 1986–1988jumps in their series would cut in half the increasein the share of income held by the richest one percent over the whole period. Their data for otheryears may also be subject to this same type ofchange in tax reporting behaviour, albeit to alesser extent.

A further puzzle

Keeping this in mind, it is difficult to determinewhat is going on at the very top of the incomedistribution using either the CPS data or the IRSdata. Piketty and Saez (2003) find greaterincreases in inequality after 1993 than we do,primarily because of greater growth in the share ofincome held by the richest one per cent in theirIRS data. It is uncertain to what degree thisdifference is the result of our decreasing ability tocapture income at the very highest income levels,even using internal CPS data, or of behaviouralchanges in the way that individual tax units reporttheir adjusted gross income on their tax returns.The CPS may be less able to capture this incomegoing to the top of the income distribution. But italso may be the case, as Reynolds (2006) argues,that a greater increase in the use of tax-deferredsavings accounts – 401k plans, Keogh plans andIRA tax shelters – by those in richer percentilegroups, but not in the very richest one per cent ofthe adjusted gross income distribution of taxunits, may also explain part of the rise in the topincome share reported by Piketty and Saez (2003).

Concluding observations

Our results suggest that, for at least the poorest 99per cent of the income distribution, the increase inUS income inequality since 1993 is significantlyslower than in the previous two decades. Based onour Internal-MI series we find the level of incomeinequality rises when we include an estimate thatincludes the very top part of the incomedistribution censored in the unadjusted internal

CPS data. But even in these estimates, the rise inincome inequality slowed after 1993. Ourfindings are consistent with those found byPiketty and Saez (2003) for the 90th–99thpercentile groups. It is only with respect to therichest one per cent that we differ. And it is herethat we are at the limits of current knowledge,both with respect to the CPS because of itsdifficulty in obtaining information on the highestincome households, and with respect to the IRSdata because of behavioural effects caused bychanges in the tax laws. It is difficult to fullyunderstand how much of the yearly changes ininequality are the result of real changes in theincomes of the very richest income tax units andhow much is due simply to changes in the waythey report that income.

References

Piketty, Thomas, and Emmanuel Saez. 2003.‘Income Inequality in the United States,1913–1998.’ Quarterly Journal of Economics, 118 (1): 1–39.

Reynolds, Alan. 2006. Income and Wealth.Westport, Connecticut: Greenwood Press.

Professor Burkhauser is Sarah GibsonBlanding Professor of Public Policy in theDepartment of Policy Analysis andManagement, Professor of Economics in theDepartment of Economics, CornellUniversity, and 2008 R I Downing Fellow atthe University of Melbourne.

A world of opportunity

As you enter the commerce profession with adegree from what is widely acknowledged as oneof the finest universities in the world, the hardwork and sacrifices you have made will beworthwhile. Your degree is a passport to anyoccupation across the globe. And what a world ofopportunity awaits you – a far more sophisticatedand exciting world than the one I entered when Istood in your shoes 27 years ago.

Back then, personal computers and mobile phoneswere in their infancy, the Internet had not yet beeninvented, financial markets were heavily regulatedand the scope of business was very much national rather than international. Today, thecommunications revolution, the deregulation offinancial markets and the globalisation of so manyindustries and businesses means that the world ofcommerce offers a huge variety of exciting careeropportunities which can literally be pursuedanywhere in the world. For example, Moscow,Mumbai and Shanghai are rapidly becomingvibrant and important commercial centres whichone day may challenge the traditional centres ofLondon, New York and Hong Kong.

How to navigate the world ofopportunity

Your key challenge is how to navigate thiswonderful world of opportunity to achieve asuccessful career. It is a genuine luxury to have somuch choice, but that luxury brings with it theburden of decision-making. Drawing from myown career experiences over the past 27 years, Ioffer you a number of practical pointers to aid inthe challenge of navigation.

First and foremost, I encourage you to take controlof the agenda for your own career and toproactively exercise choice over what you do. Donot revert to the default options or unthinkinglyfollow what others say you should do. You mustdecide for yourself, and you must believe inyourself. Only then can you take the risks that youwill need to take to test and stretch your abilities.

Second, the key to real career fulfilment andsatisfaction is to find something you are passionateabout and to excel at it. As a society we areobsessed with wealth and use it as a measure ofsuccess. It is far from being the right measure. Intoday’s world we are blessed by a plethora of careerpaths in which we can earn more than enough to satisfy our material wants and desires.

navigating the world of opportunity

by anthony r burgess

Practical pointers to the challenge of navigation

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

occasional addresses

42 Navigating the world of opportunity


You will only ever experience the innersatisfaction of having achieved your potential ifyou focus on something you really enjoy and workhard at it.

You are extremely fortunate if you have alreadyfound your passion. For most of us, and this is mythird point, we need to explore some alternativesbefore we settle on a vocation. For this reason, Iwould strongly advocate that you get as muchgeneral experience as possible in an area before youspecialise. I am conscious that this is easier saidthan done as we live in an increasingly specialisedworld and there is a significant financial incentivefor you to go immediately into a narrowspecialisation upon graduation. It is important toremember that leaders of organisations have tohave broad experience, and one of the key buildingblocks of leadership is a comprehensiveunderstanding of the principles of business. Thatunderstanding is best gained early. I believe thenew Melbourne Model is designed to help addressthis point of breadth and I applaud it.

Fourth, it is important to gravitate towardstalented people. The talent of your immediatecircle of colleagues and superiors should be thesingle most important criterion in choosing yourfirst job, as they are the ones who will teach you,mentor you and challenge you to achieve yourpotential. Later on, when you are the master ratherthan the apprentice, talented peers andsubordinates will keep you sharp. You only needto look at the number of new world records set atthe Beijing Olympics to comprehend the power ofbringing together talent from all over the world ina competitive environment.

Fifth, every human endeavour is intrinsicallysocial and none more so than business andcommerce. People tend to deal with those whomthey know and trust. As you develop your career,it is important to build and maintain a network ofrelationships with those you interact with. It is fareasier to get a hearing for a new initiative if youhave dealt with the person in the past or if youhave a reference from a mutual friend. On thatnote, now is the time to start maintaining thenetwork you have built here at Melbourne over

the past few years; and I would encourage you tojoin the Commerce Alumni Society. It is a greatway of keeping in touch with your fellow alumni.

The question of trust brings me to my sixth andfinal point, that of integrity. As you build yourcareer and assume leadership positions of greatermagnitude, you will find that your greatest assetis your reputation. People will generally bereluctant to deal with you, to partner with you, tomentor you or to work for you if they do not trustyou. Building a reputation of integrity takes years.It can be destroyed in one foolish act. As thesaying goes, ‘up by the stairs, down by theelevator’. Do not let the siren songs of quick richesor dazzling promotions lure your career onto therocks. Believe me, you will all be tested at somepoint in your career and it will take real courageand clarity of mind to say no.

All that remains for me to do is to wish you bonvoyage. And please carry with you the enduringwords of Virgil: ‘Fortune favours the brave.’

Mr Anthony R Burgess recently retiredfrom the position of Global Co-head ofMergers & Acquisitions for Deutsche BankAG in London and is a Director of DiversifiedUnited Investments Ltd., Melbourne.

Education is a passion of mine. One of theadvantages of addressing you on this occasion is theopportunity to reflect on my own universityexperiences and to share some of the lessons thatenabled me to pursue a fulfilling career and life.

A confession

It also gives me an opportunity to clear myconscience and to make a confession: I was amember of the ‘Otway Ranges AppreciationLeague’. Alas, at the time, issues such as environ-mental responsibility or climate change were noton my agenda.

Some of my friends discovered that Universitymoney was available for clubs and societies withworthy objects, provided they had a constitution,held an annual general meeting and issued financial reports. In consequence, as an enterprisingCommerce/Law student, I joined the Otway RangesAppreciation League or ‘ORAL’ as it came to beknown at the University. We were given a grant of $1,500; an enormous sum of money forimpoverished students in those days. Most of thisgrant was consumed at a celebratory lunch at thenearby Clyde Hotel, where we plotted how to usethe balance of our funds – for an annual MelbourneCup Day BBQ and an annual tennis tournament.

With our first AGM looming, we discovered toour consternation that a professor from the ArtsFaculty wished to address the Otway RangesAppreciation League on some of the environ-mental challenges facing our wonderfulecosystem. It proved very challenging to get aquorum and to listen to what was a very technicaland turgid presentation. However, it did make an

impression on us. We now knew where the OtwayRanges were; and we decided to hold our nextpicnic at the Lorne Pub rather than the Clyde.

An auditor today, examining how the $1,500 wasspent, would regard it as the worst example ofmisuse of university funds. But was it? Let us lookat it more closely.

The lessons learnt

Core competency development

KPMG employs 750 graduates every year – 550positions in Australia and 200 positions in Asia.While academic results are important, the corecompetencies that we look for in our graduates are:an ability to build relationships with people; lateralthinking; analytical skills; resilience; presentationskills; and the ability to work in a team.

While education in the classroom is important,much of the learning at a university takes placeoutside the classroom. I have seen many brilliantpeople with outstanding examination results; yettheir lack of personality, and their inability torelate to people or think laterally, have impairedtheir future leadership prospects. On the otherhand, by taking initiative, thinking laterally, andforming networks, ORAL was one of the besttutorials we ever attended at the University.

Relationships

My time at the University not only gave me theopportunity to meet my wife, my present networkdrawn from those years include two managingpartners of major national legal firms, two judges,two magistrates, senior public servants and other

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

how your university experience will shape your future life and career

by michael andrew

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

An edited version of his Occasional Address delivered at the graduation on 15 December 2008.


captains of industry, and CEOs of not-for-profitorganisations. The point I make is that therelationships that have influenced my life and mycareer were very much formed as part of theUniversity experience and indeed through ORAL.Melbourne is a very relationship-driven city, andthe relationships you start at university are a keysuccess factor moving forward.

When I visit our offices in Shanghai, Mumbai, HoChi Min or Kuala Lumpur, I see that University ofMelbourne students now hold important roles inour Asian offices. Make sure that you maintaincontact with your tutorial groups or syndicates –by email, Facebook or in other ways – as one day,when you travel to cities such as Beijing, Singaporeor Taipei, those contacts will be very valuable.

Thinking globally

My second great education lesson was when Imoved to Amsterdam to run KPMG’s Global TaxCentre. I visited 50 countries in two years, some ofthese ten times. I wrote the strategy for the rise ofthe Asia Pacific economies and had responsibilityfor opening our offices in Central and EasternEurope. I witnessed the opening of the EuropeanMarket in 1992. Not only did my geographyexpand, it was an unprecedented personaldevelopment opportunity to be isolated from myfriends and family in a foreign country. What didI learn from that experience?

Asia Pacific century – location,location, location

Any economist or demographer will tell you thatthis is the Asia Pacific century, which will see therise of emerging markets of the BRIC countries –Brazil, Russia, India and China. You probablywitnessed the opening ceremony of the OlympicGames in Beijing in August. If you read GoldmanSachs’ G11 report, the next emerging countries areKorea, Vietnam, Indonesia, Chile and Mexico. Asthe industrial revolution takes place, there will beenormous appetite for the skills and commoditiesthat we are celebrating today and that you willcontinue to consolidate in the coming years.

At University, I benefited from Geoffrey Blainey’swonderful lectures about the tyranny of distance,which told us that our remoteness in the world

was a curse. Increasingly, it is a blessing in an agewhen technology removes the impediments ofgeographic disadvantage. While cost and speed tomarket become the key internationaldifferentiators, we are in the right place in theworld. Issues such as bio-security, terrorism andcarbon pollution reduction favour island nations.Australia will become more and more attractivefor populations, investment and geographicdiversification. In addition, we must be atechnology-led country that is able to deliver itsservice offerings through the Internet, socialnetworks and regular cultural exchange.

So I ask myself: should students spend two yearsserving in the bars of London’s Earls Court orschmoozing on Wall Street? As an employer, Iwould place less value on these experiences.Instead, you should test yourself in the greatAsian, Middle Eastern or South American cities –Santiago, Beijing, Jakarta, Taipei, Kuala Lumpurand Singapore. These are where future job andeconomic opportunities lie – not to mention theplaces for optimum personal development – andwhere the next set of relationships will be formed.

We are a region, not a country

Melbourne was built during the gold rushes of the1860s. If you walk up the Paris end of CollinsStreet and look at our state’s institutions – thelibraries, museums, Parliament House and theExhibition Building – they are all dividends of thetime when Melbourne was close to being therichest city in the world. That legacy has enduredover the years as the head offices of our majormining companies, agricultural businesses andbanks have settled in Melbourne.

It is fair to say that the most recent ‘gold rush’, thephenomenal commodities boom, is currentlyfaltering. If this current market turmoil hastaught us anything, it is that we can no longerthink of Australia as a quarry and a farm. We alsoneed to recognise that our destiny lies in ourservices sector, our engineering skills, metallurgy,education, medicine. Our future is very muchlinked to the countries in these emerging regions.Even an accounting practice such as ours needs toview intellectual property and resources as asupplied commodity. This view prompted us tomerge with nine of our Asian practices during the

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

year, in order to gain access to those fast growingmarkets overseas and reflect the way our customersoperate. Can KPMG write the banking regulationsin Indonesia, do a treasury review in Korea orconduct due diligence in Japan? The businessmodel that will evolve is not based on geographicboundaries but on fast, agile organisations whichoperate across our region. It is a challenge also foruniversities to operate this way.

Domestic agenda

When I lived in the Netherlands, I alwaysremarked that the first seven pages of thenewspapers dealt with international news, whileDutch news was to be found on page eight. InAustralia, the first and second pages are generallyrelated to football, political and human intereststories, with international news not appearinguntil about page eight. There are some majorhistoric trends happening in our region – thetension between Japan and China, governancereform taking place in Indonesia, the inflationaryproblems in Vietnam, social tensions in theChinese provinces. Yet these issues simply do notrate a mention in our news, and we have toremind ourselves constantly that we are part of anincreasingly global world that is linked to theseproblems. Who would have thought that thehousing problem in the US would flow throughto such catastrophic international consequences?The CEO of the future will have had five overseaspostings and will need to focus on regional andglobal trends, not local football results. ‘GlobalVision’ will differentiate business leaders, and youshould invest your time to think this way.

Tradition is a disadvantage

There is a ‘can-do’ mentality in Australia. We havealways shown a great capacity for innovation. It ispart of our young history; we are not steeped intradition. We tend to challenge existing orders andare prepared to ask the hard, direct questions thatothers may find politically or socially offensive. Forfour years in the Netherlands, I was continually metby those wonderful Dutch words ‘it’s not possible’.To get a driver’s licence online, to go to the doctorwithout a letter of referral – it’s not possible. Can Irestructure or reposition our workforce? It’s notpossible. The ability to constantly look at new

business and social models is a key to movingforward successfully. We have to be flexiblethinkers, avoiding bureaucracy, processes andmethodologies that stifle the development of newand emerging ideas and techniques.

Neutrality

Sitting on KPMG’s global Board, I am amazed athow often I am asked to mediate in disputes andresolve issues, simply because Australia is regardedas a neutral country with a great sense of fairnessand objectivity. We are not aligned to theEuropean bloc, the American bloc or, culturally,even to the Asian bloc. We listen, we speak ourmind and we have a great sense of fairness. We haveearned our reputation for giving people a ‘fair go’.

Every year at KPMG, we roll out our strategicplan and budget to staff. This year we decided todo separate sessions with our junior staff to getthem more involved. Our first session was inBrisbane and, frankly, it was not going well untila new graduate got up and said:

I’ve only been here six weeks – it’s like workingfor a communist organisation. I don’t have anyauthority to do anything for the IT systems.They are old generation, you don’t rewardindividual achievement. What are you going todo about it?

Confronted with such an intelligent Generation Y,we had an hour of the most productive andconstructive feedback. It showed that we had acultural problem in our organisation. It revisedour strategy to focus, simplify, empower andengage our organisation at different levels. Withyour fresh, bright young minds, you will seethings that people entrenched in standardprocesses miss. Your views and feedback areimportant. Try and add value to your organisationand do not just become one of the mob.

Social inclusion

However, there is more to life than you or youremployer. True leadership shows thinking andactions around the disadvantaged and otherproblems in our society. At KPMG, it iscompulsory for every partner to set up aphilanthropic or not for profit board and contributeto the betterment of our society. It is part of our


ethos and superb leadership training. I am currentlytackling the problems of Indigenous education andemployment through various partnerships withcommunities. I recently launched a disabledemployment project, sponsored research intowomen’s diabetes, helped to expand the PrahranMission for the homeless, and raised funds for newcancer centres. It is heartening to see the increasedawareness of social issues among our graduates whowant to address issues such as climate change,Indigenous development and social inclusion – farmore than the Otway Ranges Appreciation Leagueever did. I wish I had become more involved withthese important social issues at an earlier age.

Liveability versus growth

Everyone talks about our city’s wonderfulliveability. It is what keeps and attracts most of ushere. It is fascinating to me to watch debates aroundissues such as channel deepening or the EddingtonInfrastructure Report, or to listen to complaintsabout public transport and road congestion.

Yet to maintain liveability it is necessary to investin future resources and infrastructure. I am notcritical of the Government, because I do not thinkmost people could have anticipated all the issuesarising from the growth in our city and economy.However, the matter is in our hands. We couldsay: ‘We don’t need this, we are content with thesize of our city.’ But, frankly, this will underminethe city’s liveability in the future. You shouldcontribute ideas and be an ambassador for theworld’s most liveable city. Further, you should alsothink of Melbourne as one of the world’s greatuniversity cities. Education is our third largestexport. It should be better understood that thiscity’s educational and research facilities areimportant not only to its local population but alsoto the external markets to which I have referred.

Entrepreneurs

The Business Council has a vision for Australia asthe best country in which to live, learn and work. Itstrives to be one of the world’s top five economies,even with such a small population.

If there was one particular concern I have with this, it is our inability to applaud and assistentrepreneurial talent. This University produces an incredible volume of research and good ideas.

Yet our ability to take these through to themarketplace is significantly handicapped by ashortage of people capable of managing andexploiting businesses. There is no shortage ofcapital – be it venture capital, superannuationmoney or equity markets – to support good ideas.Invariably, however, the person that makes thescientific break through lacks the ability to take itto the marketplace. Equally, some of our entrepre-neurs do not really recognise the real potential ofthe technology and ideas, or the patent problems,access to market and other related problems. This isan issue that really concerns me – whether we havethe right environment here to reward, train anddevelop entrepreneurial talent. I very much hopethat I am addressing that potential talent today.

Conclusion

If I were sitting in your seat, I would want to feelthat I was part of the top five nations in the world,one that performs considerably above its weightby population, by GDP or by size. It does so. It isa country with intellectual capacity and the abilityof its citizens to understand where they are in aglobal world; a country that leverages the skillsand talent promoted by its education system tobenefit this nation; and a country that tries outnew ideas and creates an economic dividend forthe benefit of all society.

I have been very fortunate to have had a career thathas taken me to 90 countries around the world and to accept a leadership position in private,government and philanthropic enterprises. Whetherit was studying the Otway Ranges, living in aforeign country or contributing to this city, myuniversity experience was the foundation for my life.Please take the time to reflect on your education andhow it places you to benefit not only your own life,but also the city and country in which you live.

Mr Michael Andrew is AustralianChairman of KPMG. He is a member of theBusiness Council of Australia’s Task Forceon education and he co-chaired theCommittee for Melbourne’s Task Force intoHigher Education. He was Chairman ofLauriston, one of Melbourne’s leading girlsschools, for many years.


Congratulations and thanks

I would like to begin by saying to the Graduatesand Graduands, ‘Congratulations’. I do so not justout of a sense of duty arising from this occasionand from the role that I have been invited toperform. I do it to reinforce and add emphasis tothe sense of celebration that ought to accompanythe achievements that gather us here today. Thecongratulations of this audience and of the widercommunity have been earned. Shortly, you willreceive some of the highest acknowledgementsthat our education system and others like ourshave created.

There are too few opportunities where we stop andacknowledge achievement. Thankfully, this is oneof them. Our congratulations ought to be spirited,enthusiastic and expressive. There is, after all, areason why your mortarboards are thrown highinto the air at the conclusion of the ceremony.

I add to the word ‘congratulations’ the words‘thank you’. Whilst I well know that universitylife is not all solemn duty and that you will havehad pleasures from the experience that will sustainyou throughout your lives, no one here shouldpresume for a moment that the achievements we celebrate today have been made withoutconsiderable personal sacrifice.

Many of you have lived far away from your homesand families and friends; many of you will haveendured hardship of a different nature includingfinancial anxieties and altered lifestyles. For someof you, you are the first member of your family tohave studied at a university and you have carried

an extra burden of responsibility. Some of youmight have begun life far away, in a place wherethere may have been no expectation that youwould have studied at all. And to you mostespecially, I say thank you.

Your choice to persevere with your academiceducation is of enduring benefit not just to you.The rewards of your training and achievement are also shared by the society in which you will choose to live and work. We are all thebeneficiaries of your hard work and therefore wemust thank you for it.

Our thanks should also be extended to the parentsand families of those being acknowledged, for theymade personal sacrifices as well. And we shouldalso thank the members of staff of this University,who have been responsible for the transfer ofknowledge, skills and understanding.

In our era, we are often not quick to acknowledgepersonal sacrifice. When my grandfather, SidneyMyer, arrived in Australia in 1899, he was almostcertainly a refugee and possibly an asylum seekeras well.

His sacrifice was that along with members of his family, he left his homeland in modern dayBelarus never to return again. The successivepogroms against the Jews had become ever more violent and his community was continuallythreatened. By leaving, he was escapingpersecution and the certainty of a life of fear, loss,grief and despair. He came with few possessions,to a new culture and climate, and to a way of lifethat had very few points of comparison with the

on leading more than one life

by rupert myer am

Acknowledge the personal sacrifices of others, think creatively and beimaginative, give of yourself in public service and exercise humility

His Occasional Address delivered at the graduation on 14 March 2009.


21 years that he had lived as the child of a scholarand a seller of drapery. He arrived virtuallypenniless and without English, something in turnhe tried to remedy by joining the ShakespeareSociety of Bendigo.

His story was an authentic expression ofdislocation, of being disconnected from his nativeland and of having nowhere local that he could callhome. He had felt threatened in his country ofbirth and had sought a better future for himselfhere. The story goes that after getting off the boatin Port Melbourne, he spent the small amount ofmoney that he had on buying a beer for himself.By the time that he died just over 35 years later,he had become a household name in Victoria,having established a department store businesswhich today is still Australia’s largest, trading inmore than 60 locations around the country.

He also established a tradition of practical hands-on philanthropy and public service, whichcontinues to impact the community in a myriad ofways today. His personal story continues to playout in a number of ways, of which I would like tomention three: creative thinking, public serviceand humility.

Creative thinking

The expression ‘creative’ in relation toeconomics, accounting and commerce generallyoften carries with it a somewhat negativeconnotation, the inference being that there issomething dodgy afoot. That is unfortunate.Creativity is the reward for anyone who isinterested or curious. A friend told me lastweekend of a t-shirt she owns, emblazoned withEinstein’s message, ‘Imagination is moreimportant than knowledge.’ Your studieddisciplines are practiced in an environmentwhich is ideal for curiosity and imagination. In J. K. Rowling’s address at last year’s HarvardGraduation, she described imagination as the‘fount of all invention and innovation.’

I encourage you to apply your imagination and acreative mind to your life and careers. You shouldalso use the resources that are at your disposal – Iespecially recommend engaging in art.

Exhibitions and permanent collections presentobjects that have sprung from learning,interpretation, inspiration, hard work, and theapplication of creative thinking. You do not haveto have knowledge of visual arts – nor, dare I say,even an interest in it – to benefit profoundly from the experience of a gallery, an artist’s studio,an art space or a single artwork. You should feelthat you can interrogate anything, say anything,and feel anything. Enduring discernment can bedeveloped. Be critical and questioning of what yousee, and be smart about the way that you expressyour observations. And let your observationspervade your professional work.

Our political leaders and economists, such as theANZ’s Saul Eslake, constantly tell us of the valueof a creative economy. The arts embody andrequire skills and attitudes that are increasinglycalled for in business contexts. Foremost amongstthese are critical thinking, the ability tochallenge conventional wisdom, the capacity tolook at familiar objects from new perspectives,the ability to innovate using new technology andmedia, and the ability to adapt from things thatwork in other settings.

When you are starting out in life and have newand fresh eyes for everything, recall that ‘creativityhappens not with one brilliant flash but in a chainreaction of many tiny sparks while executing anidea. Insight and execution are inextricably woventogether.’1 So, take risks, expect to make lots ofmistakes, work hard, take breaks but stay with itover time. Do what you love, because it’s going totake time to have a creative breakthrough. Forgetall the nonsense about being ‘artsy’ and gifted, anddon’t sit waiting for the moment of inspiration.For, while you are waiting, you may never startworking on what you will some day create.

Public service

At a moment in your lives when you are doubtlessconsumed with the need and desire to work, Iencourage you to look to a slightly wider horizonand think about how you might pursue theprivilege of serving the community more broadly.How do you propose to apply your time, treasure


and talent? What are your key interests and howdo you wish to engage with them – either throughyour workplace or away from it? What publicservice do you wish to perform and how mightyou bring your creativity and talent to it? Many ofyou have concerns about the environment. Whatare you going to do about it? Many of you haveconsidered views on the society of the future, thetype of cities in which you would wish to live andthe way you would like things to be. How are yougoing to influence these? How might you prepareyourself for secondment from your workplace to the community sector? You have studieddisciplines that are keenly sought by many others.You can be optimistic about that and you shoulduse your knowledge for a broader public good.John Maynard Keynes longed for the day wheneconomists were no longer arch-theorists, butwould be consulted to solve everyday problemsand give straightforward advice rather likedentists.2 I believe that we could look to his well-documented views3 about investing to give ussome really good ideas about how each of youmight prepare for public service.

I am sure that he would advise you that serviceshould be approached with a clear focus onproblems and practical solutions. He would adviseyou to search for stunners, that small group ofprojects and organisations that might make aprofound difference. He would encourage safetyfirst, that is, do your due diligence and understandas well as possible the likelihood of success and therisks of failure – but he would caution you not totry to avoid risk. He would tell you to ‘lean in tothe wind’ and run counter to conventionalthinking. It is remarked of him that ‘in everydaylife he delighted in paradoxes, opposed acceptedwisdom and disliked all the commoner gardenthoughts and emotions that bind men in bundles’.He would urge you to keep quiet and not self-aggrandise, but promote the activity and servicebeing supported by you. And finally, he wouldencourage you to remain concentrated in a circle ofcompetence and recognise the bounds of yourknowledge; but not to place all of your publicservice and philanthropic eggs into one basket.

Keynes described Newton as a man who possessed‘in exceptional degree almost every kind ofintellectual aptitude – lawyer, historian,theologian, not less than mathematician, physicist,astronomer.’4 My encouragement to you is to notjust lead one life: get on and have a few.

On the question of motivation, I have a view thatseems to be at odds with current views commonlyexpressed by commentators on philanthropy andindeed many people either self-identifying or identified by others as philanthropists. That is,I do not subscribe to the view that philanthropy isabout ‘giving back’.

The phrase ‘giving back’ conveys a message toothers that an act of benefaction is a considered act of obligation. This is not the language ofgenerosity; it is the language of duty. It reinforcesa view held by some that, in order to ‘give back’,something must have ‘been taken’ in the firstplace. At best, ‘giving back’ reflects careless use oflanguage. At worst, it establishes or reinforces inthe minds of many a dubious motivation. Myadvice is to drop the phrase. There are plenty ofpeople around with a dim view of private wealthin the first place, who will enthusiastically assertthat philanthropy is just giving back. Giving forits own sake ought to be sufficient motivation.

Humility

I have a hope that you will think deeply about andpractice humility. I am reminded of an article thatappeared in Spectator Magazine several years ago,in which the seven deadly sins – lust, gluttony,avarice, sloth, anger, envy and pride – were, withthe exception of pride, referred to as medicalconditions requiring treatment. Pride was referredto as having become a virtue. The articlecommented that it is the absence of pride which isnow presumed to be a medical condition, with somany of our society’s problems being blamed onlow self-esteem. Do not confuse humility with lowself-esteem. In suggesting that you practicehumility, I encourage you to be confident and self-knowing, but also that you consider the value ofbeing humble and genuinely modest.


1 R. Keith Sawyer, (2006) ‘Explaining Creativity: The Science of Human Innovation’, quoted in Time Magazine,January 8.

2 Alex Damchev, (2007) Time Literary Supplement, July 13 p 28, quoting Tim Harford (2007) Undercover Economist,Abacus.

3 Justyn Walsh, (2007) Keynes Mutiny, Random HouseAustralia.

4 J M Keynes, (1947) ‘Newton the Man’.

Mr Rupert Myer AM is Chairman of TheMyer Family Company Pty Ltd and a Directorof AMCIL Limited, DUI Limited, and thedepartment store business, Myer Pty Limited.He is Chairman of the National Gallery ofAustralia, a Board Member of the NationalGallery of Australia Foundation, Chairman ofKaldor Public Art Projects, a Board Memberof The Felton Bequests’ Committee, a Boardmember of Indigenous Enterprise Partner-ships and a Member of The Myer Foundation.

His previous community activities have beenas Chairman of the National Gallery ofVictoria Foundation, International SocialService, WorkPlacement and MissionAustralia’s Youth Strategy and AdvocacyGroup, and as a Board member of TheMuseum of Contemporary Art in Sydney anda trustee of The National Gallery of Victoria.He chaired the Commonwealth Government’sInquiry into the Contemporary Visual Artsand Craft Sector 2002, and was a participantin the Commonwealth Government’s 2020Summit in April 2008.

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]: http://insights.unimelb.edu.au

Published by the Faculty of Economics and Commerce, April 2009© The University of Melbourne

insights volume 5 april 2009

Documents