(Economics) books to read over summer

The Deficit Myth: How to Build a Better Economy

Stephanie Kelton, Hachette Australia

No book prepared ahead of time better targeted the year in economics.

Just as governments including Australia’s were embracing debt (A$800 billion and counting) and creating money out of nowhere ($200 billion scheduled) came a treatise explaining that at times like these (actually, at any time when the resources of the economy aren’t fully employed) that’s entirely responsible.

Stephanie Kelton’s book has rightly been displayed on Alan Kohler’s desk, and Kohler himself has become a convert to modern monetary theory which the book outlines in the clearest of terms.

Kelton explains that in an economy such as Australia’s the purpose of tax isn’t to raise money but to slow spending, and something else: demanding the payment of tax in Australian dollars forces Australians to use Australian dollars.

The example of teenagers not cleaning up around the house that she used in her talk at Adelaide University in January is priceless. You can watch the video here.

Economics in the Age of COVID-19

Joshua Gans, MIT Press

Written as we were coming to grips with what to do, and posted online chapter by chapter to get real-time feedback, the Australian author’s flash of inspiration was that we have experience in shutting down an economy and then restarting it.

We do it every Christmas writes Joshua Gans, and “no-one screams depression”.

That his way of seeing things now dominates talk about the pandemic doesn’t make it less radical. It’s partly because of his insights, published in April, that most governments no longer think that in this crisis they can trade off health against wealth.

He persuades by analogy. Fans of Mission Impossible II, the computer game Plague Inc and the came of chess will appreciate the references.

Radical Uncertainty

Mervyn King, John Kay, Hachette Australia

The idea that every possibility can be reduced to a number, to a probability, is what makes simple mathematical economics work. It’s what makes insurance and credit ratings and assessments of the risk of getting coronavirus work. And it is wrong, as became clear in the devastation caused by the global financial crisis.

By itself, that’s not a particularly useful observation, but what is useful is the author’s discovery of where the idea that probability could be reduced to a simple number came from. The Nobel Prize winning economist Milton Friedman shares much of the blame. He insisted that every uncertainty could be reduced a number that a rational utility-maximising human being could use to make decisions.

Before Friedman and contemporaries, there used to be two numbers, one representing risk, and the other representing uncertainty, which are quite different things and can’t be thrown together.

If you’re too busy for the book, try the London School of Economics podcast.

Fully Grown: Why A Stagnant Economy Is A Sign Of Success

Dietrich Vollrath, University of Chicago Press

Advanced economies may or may not roar out of the recession, but they are unlikely to boom as they did before. For decade after decade throughout the 1900s annual economic growth has been strong, averaging 2% per capita in the US.

In the first two decades of the 2000’s that growth has been weak, averaging 1% – only half of what it did.

Dietrich Vollrath, who blogs on growth and had no preconceptions, approached the puzzle as a mystery and found that the usual suspects (rising inequality, slower innovation, competition from China) didn’t explain enough.

The extra comes from success. The populations of the US and kindred nations have become so rich and (on average) old that having more children and striving for even higher incomes no longer makes sense.

The technical stuff is at the back. The message from the front is that we’ve arrived at our destination, which needn’t be a bad thing.

Economics in Two Lessons

John Quiggin, Princeton University Press

I’ve slipped this one in from 2019 for a reason. John Quiggin is about to publish a sequel, The Economic Consequences of the Pandemic.

Economics in One Lesson, published in 1946 financial journalist Henry Hazlitt, was a homage to the power of prices in a free market.

In lesson one (the first half of the book) Quiggin teases out Hazlitt’s thinking, and in lesson two shows how it follows from it that in many circumstances the market has to be contained.

Central to both lessons is opportunity cost, “what you give up in order to get something”, the most important concept in economics.

Polluters will make the wrong decisions if the cost of their pollution (largely borne by others) isn’t charged for. It’s a persuasive and increasingly-pressing argument.

Peter Martin, Visiting Fellow, Crawford School of Public Policy, Australian National University

This article is republished from The Conversation under a Creative Commons license. Read the original article.

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Hockey's most dangerous idea: We're neither lifters nor leaners

Of all of the factoids bequeathed to us by departing treasurer Joe Hockey, the most dangerous is that the Australian population can be divided into two:"lifters" and "leaners".

Hockey was following in the footsteps of United States presidential challenger Mitt Romney when he used the words in his first budget speech. Romney had claimed the US could be divided into "the 47 per cent" who were dependent on the government, and everyone else who did the work.

Hockey's opposite number in Britain, George Osborne, made the same point about "strivers" and "skivers".

"Two groups need to be satisfied with our welfare system," Osborne said. "Those who need it – who are old, who are vulnerable, who are disabled, or have lost their job. And there's a second group – the people who pay for this system, who go out to work, who pay their taxes and expect it to be fair on them too."

Hockey and Abbott made it crystal clear which side they backed. Days before Abbott was rolled they unveiled a new slogan: "Backing Hard-working Australians".

Lifters versus leaners is a dangerous notion because it seems to contain an element of truth. Many of Hockey's other claims could be dismissed: that "higher income households pay half their income in tax," that Australia might "run out of money" to pay for health, welfare and education, that "the poorest people either don't have cars or actually don't drive very far in many cases". They were just Joe being Joe.

But the idea that a majority of taxpayers work hard to support a large minority of dependents strikes a chord with many of us who pay tax, all the more so because the treasurer sends us "tax receipts" at tax time showing how much of hard-earned is spent on "welfare", on other people...

Except that it isn't like that. Only in the short-term does money flow from "givers" to "takers", from lifters to leaners. Over a lifetime most of us are both. We fund pensions while we work and then receive them when we retire. At any moment we can lose our jobs or lose our health or become disabled. Later we can recover. We can move from being "lifters" to "leaners" and back again.

All it takes is luck. But we seem to be hard-wired to not recognise the role of luck in our lives and to attribute what happens to either our skill and hard work or to our general uselessness.

Andrew Leigh outlines fascinating instances in his new book, The Luck of Politics. Leigh was an economics professor before entering parliament and becoming Labor's shadow assistant treasurer.

He says that in a series of experiments students were asked to play games and randomly made either "lucky" or "unlucky". In Monopoly the "lucky" ones were given $200 for passing go and a double roll of the dice. The unlucky ones got $100 and could only a single roll. Pretty soon the lucky players began taunting their opponents, banging their pieces and eating more food from the snack bowl. They behaved as though they were superior even though they must have known they were not.

And almost everything that happens to us is a result of chance. Joe Hockey would almost certainly not be the member for North Sydney were it not the result of a principled decision by his predecessor to retire early before he was eligible for the parliamentary pension. Leigh would not have got preselection for the seat in Canberra's north had the Australian National University (and his house) been located in Canberra's south.

All it takes is a tiny difference in a chromosome for someone to be born a woman instead of a man and be less likely to get promotion, or to be born shorter and be less likely to become a politician.

British economist John Hills reckons that in Britain at least most people get back roughly what they put into the welfare system. The wealthier are leaners as well as lifters because they are more likely to live longer and take advantage of subsidised health care and tax breaks on investments. The poor get don't get to put in much, but don't get to take out much either.

His book is called Good Times, Bad Times: The Welfare Myth of Them and Us. It's a myth Hockey might like to consider as he ponders what it's like to be treasurer one day, on the political scrapheap the next.

In The Age and Sydney Morning Herald

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Our best and worst treasurers. Some might surprise you. The Money Men, By Chris Bowen

CHRIS BOWEN
Melbourne University Press, $34.99

In office for only two years, Joe Hockey might like to claim he never had the chance to become one of Australia's truly great treasurers. But shortness of tenure isn't by itself an impediment to greatness. 

When I joined the treasury in the early 1980s I was given a rundown of the best and worst of Australia's treasurers, as remembered by those in the department.

The best surprised me. It was Bill Hayden, a Labor treasurer in the Whitlam government in office for only four months. I had thought that the treasury hated Labor, and I knew that some in the department had helped bring it down.

Things were more complex than I had been led to believe. The treasury liked Hayden because he would take seriously what it had told him, zero in on any weaknesses, and send it back for more work. Then he would take the final agreed position to Cabinet and argue it forcefully.

His predecessor, Labor's Jim Cairns had either ignored the treasury, or treated it as his enemy.

Frank Crean, the Labor treasurer who preceded Cairns, was happy to put the department's position to Cabinet, but most of the time simply left it there. "This is the treasury submission," he is reputed to have said, and then no more, leaving Australia's most important economic manager voiceless.

As soon as I got hold of The Money Men, Chris Bowen's remarkably accessible account of Australia's 12 most notable treasurers, I went straight to the chapter on Hayden.

Bowen agrees with me, and agrees with the assessment of my colleagues at the time. I learned from Bowen that Hayden was the first to properly use the expenditure review committee, asking ministers to offer up cuts as well as spending proposals when pitching ideas for the budget.

And he drilled down into details, sensing whenever something didn't seem right...

The treasury had assured him a cut he planned to make to education minister Kim Beazley's portfolio would have little effect on the lives of teachers. Beazley told him there would be mass retrenchments. Hayden phoned the relevant officials and asked them to convene an urgent meeting with officials in Beazley's department, just to make sure they were right. Embarrassed treasury officers reported back that they had been wrong, and Hayden let Beazley off the hook.

Bowen says there's no greater tribute to Hayden's first and only budget than the fact that after the dismissal, the incoming Fraser government implemented it in full.

Howard, Hayden's successor but one, wasn't highly thought of within the department when I was there. It felt he lacked the strength to stand up to Fraser and argue for what he believed in. It's a judgement Bowen backs, saying if Howard's career had ended when he ceased to be treasurer, it would have been "extremely difficult to regard it as a triumph".

Bowen's book is something of triumph. No other treasurer or would-be treasurer has produced such a complete job application. Bowen is both. He had 12 weeks in the job under a reinstalled Kevin Rudd before Tony Abbott swept to power. Since then he has been the shadow treasurer under Bill Shorten.

Asked by Melbourne University Press to write a standard tell-all book about Labor's term in office he said he wanted to write instead about Australia's most notable treasurers. He was sent a contract the next day.

The book took two years, and it shows. So well told are the 12 stories that I wanted to hear more, about the other treasurers. 

But I also wondered whether it was the best use of Bowen's time as shadow treasurer. Might he have spent it more usefully developing policies?

His predecessor Wayne Swan didn't, or didn't do it enough. He took the job with economic policies far from fully formed, and with tax and superannuation policies I found embarrassing. It turned out to make little difference because within months he was grappling with the global economic crisis.

As Bowen says, Swan was one of the few treasurers able to show his mettle. His work in helping Australia avoid a recession that was widely seen as inevitable - even the budget forecast it - marks him as one of the greats. The resulting deficits are a fair price to pay. If he hadn't avoided a recession the deficits might have been greater.

Peter Costello gets extremely high marks from Bowen. He too avoided a recession - twice. The first was likely as a result of the Asian economic crisis, the second as a result of the worldwide recession that followed the early 2000s tech wreck.

Costello helped bail out Thailand, Korea and Indonesia, making Australia, along with Japan, the only country to have helped save all three. He ensured sound settings at home by formally declaring the Reserve Bank independent and by forcing through the Wallis reforms to the financial system.

And he did it while introducing the goods and services tax, a change so successful that it's impossible to imagine ever going back.

He was lucky to preside over the first mining boom, and Bowen criticises him both for not building up big enough surpluses (handing money back in repeated tax cuts and allowing the public service to balloon) and for convincing the public that continual surpluses are ends in themselves, a great political achievement, but a questionable economic one.

Keating gets the longest chapter and this list of his achievements is dizzying. He floated the dollar, deregulated the financial system, cut tariffs, modernised the tax system (introducing both the capital gains and fringe benefits tax), privatised Qantas and half of the Commonwealth Bank, forced competition on to Telstra, and through his misguided obsession with the current account deficit, pushed interest rates so high he brought on a recession.

And he dragged industrial relations into the modern era, introducing enterprise rather than economy-wide bargaining, and as a byproduct, gave us universal superannuation.

Bowen is more measured in his assessment of Keating than I expected him to be. He is happy to point out that Keating shares much of the credit for what happened with Hawke. He says no relationship is more important.

The early chapters on treasurers Turner, Page, Theodore and Chifley chart the evolution of the job and the rise of Keynesianism and the Commonwealth's power over tax as the dominant modes of economic management.

We know too little about our treasurers and we know too little about the job. Bowen's book fills a gap. It's fun to browse, and is set to become an essential reference work.

The assent of Turnbull means Bowen himself may never again become treasurer, or may have to wait for a very long time. But he has served the office well.

In The Age and Sydney Morning Herald

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Why we partied at Canberra's shops

Me, last night -->

"The shops." They matter more in Canberra than in other cities. They are not on main roads, they are either in big town centres or the centre of small surburbs, tucked away in the folds of interlaced roads, unfindable if you were wizzing past in a car.

The local shops are designed as local centres, close enough to walk to. And we do. They are the focal point of each community. Last night each local shops hosted a "Party at the Shops" to celebrate Canberra's centennary. It was as good as you could imagine.

Or maybe you can't imagine, if you haven't lived in Canberra.

More than 40 years ago in Ideas for Australian Cities Hugh Stretton outlined the thinking behind Canberra's shops.

He got it right:


"The city is built of units, neighborhoods that can support a primary school and a walk-in shopping centre. Three or four of them are grouped to share a larger shopping and service centre. Three or four or five of such groups make a district of 60,000-120,000 people with a major town centre. Any number of these can proliferate around the single metropolitan centre, in a pattern usually called a 'metro-politan cluster'. For communications the Canberra cluster would rely chiefly on a network of roads. From the residential cul-de-sac to the freeways which skirt and link the districts, these roads will be more radically differentiated, safer and-faster than any comparable network in Australia.

But the heart of the scheme is not its method of coping with traffic. The heart of the scheme is its use of leasing powers to distribute the city's activities precisely, thus con-trolling the pattern of journeys which the channels have to cope with. For example, for the Canberra population 12 square. feet of shop floor per head is the provision which seems to balance Satisfied customers and prosperous shopkeepers. Each citizen's ration of shop is deliberately distributed 3-1. square feet to the metropolitan centre, 31 to his district centre, 3 to his group centre and 2 to his neighborhood. Some American advisers, used to locating nothing smaller than drive-in supermarkets for no other purpose than retailers' profit, would abolish most of Canberra's neighborhood shops, leaving all the widows and carless housewives to struggle to the super-markets as best they could. But the Canberra planners keep a wary eye on such alien propaganda. They obstinately con-tinue to build the neighborhood centres; and enjoy showing American visitors how they prosper as half their customers arrive on foot and the other half keep their parking spaces as busy as any at the supermarkets.

Commercial office needs are similarly predictable, and government and institutional employments are negotiable. The planners put them where they'll prosper best, and. do most good to the town around them. So also with land uses and employments in industry, service trades and higher education.

Perhaps private enterprise should complain about this tyranny. In practice most private enterprise revels in it, with what adjustments of its enterprising conscience I don't know. Planning reduces many investors' risks. It need not reduce those that are economically and socially productive — risks with new products, processes, methods. But it reduces the useless risks which arise from uncertain forecasting of other people's land uses. There is nothing efficient about a private enterprise that guesses wrong about the future spread of residence, the build-up of rival or complementary businesses near by, the location and timing of public investment in roads, power, water and sewerage. But in Canberra, if private enterprise bids for a site, it knows exactly when its services will be connected, it knows the customers will be housed around it in predictable numbers by predictable dates, and it knows that a watchful (but reasonably incorruptible) eye will limit the release of competing sites to the number the custom can genuinely nourish.

Of course there are policy problems. Producers and consumers sometimes have contrary interests in the level of competition. There are novel business projects for which it is sometimes difficult to provide appropriate land fairly by public auction. In time there will be problems of re-use and redevelopment. So far these problems have been solved in Canberra without impeding innovation — except objectionable innovations, impeded deliberately. Consumers sometimes complain — there's not much chance for any cheap-jack, wild-cat, road-side or tin-shed competition. But the degree of 'producer protection' is no more than a mild case of the general bias of Australian policies towards protected production and employment, at some cost to consumers where ther necessary."


Thank you Hugh. Thank you Canberra's founders.

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Conformity. The candid camera experiment

Here's the experiment:





Broadcast in 1962, it was designed by psychologist Solomon Asch.

It's just the start of some shocking truths about ourselves. Such as why, when grouped together in meetings, we make shocking decisions.

In this public lecture Tim Harford outlines how to avoid the trap.

Here's the key bit. I liked it.

10 minutes, play or CLICK THEN CLICK AGAIN to download mp3



Tim Harford is the author of Adapt, a book I have recommended before.


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See. This. Movie. Moneyball

It was the best book ever written about sport and the best book ever written about business.

It's now potentially the best movie ever made about sport and the best movie ever made about business.





I can't wait.

And see Red Dog.

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The economic history of the world in four astounding minutes

From Sylvia Nasar, whose new book Grand Pursuit: The Story of Economic Genius tells the story of modern economics.

Thanks Justin Wolfers, Greg Mankiw, Daily Beast


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The world is in good hands, Chinese hands - Michael Spence

Ask the Nobel Prize winning economist who has advised China on its latest five-year plan the question on every Australian economists’ lips and he doesn’t flinch.

“How long have we got? How much longer can China’s extraordinary explosion of economic growth continue,” I ask Michael Spence down a phone line to Italy where he lives six months of the year.

“I think the answer is something like two decades, in the later part of that they will start to slow down,” he says ahead of his book tour of Australia to promote The Next Convergence - the Future of Economic Growth in a Multispeed world.

He is a good person to ask. As well as actually advising China on its growth strategy, for the past four years he has chaired the World Bank sponsored Commission on Growth and Development set up to distill all that is known about how to drive economic growth and cut poverty.

His key insight about China is striking - that the sudden burst of growth that has revolutionised global economics and politics was the result of a conscious decision made by just a handful of people.

Deng Xiaoping and a few comrades could have decided to throw the switch to growth later - perhaps even in 20 years time; they could have decided to do it earlier, although not before Mao died and the Gang of Four were arrested in the late 1970s.

Deng and cronies decided first to allow the limited use of market prices for farmers selling production over and above what was required, saw the results were impressive and then semi-secretly invited experts including the then president of the World Bank Robert McNamara to give them advice on what steps to take next. Some of the meetings took place on boats on the Yasngtze River.

“What Deng asked for was not primarily financial capital, even though he was talking to the World Bank,” Spence writes. “Rather, it was knowledge. He realised intuitively the missing piece was know-how.”

Spence himself is now providing that know-how. When he sent over his thoughts for latest the five-year plan that began this year he felt his ideas being sucked out of him.

“They ingested. They didn’t just kind of get a couple of people read it, they sent to everyone involved in the five-year plan. It doesn’t mean they believe it. This is an economy that ingests ideas,” he tells the Herald...

It is the ability to take what works from the West that has seen China’s industrial revolution spark growth rates far faster than those during the first and second centuries of the West’s revolution. Starting very late has allowed it to use ideas, processes and machines that have already been tested to supercharge what used to happen more sedately.

When will it stop? Greenhouse gases might put a stop to it. More on that later. But otherwise it is hard to see a roadblock.

“This is a country with a per capita income of $5000. That’s a huge improvement over $300 but it is a long way from $25,000,” he says.

“What happens when you get to $20,000 - whether you turn out to be Italy or the United States or Germany - depends on a whole new set of factors. But the immediate challenge over the next two decades is to get over the middle income transition, to get to $10,000.”

“There are risks, the thing could blow up politically. It’s not a done deal. But if income is $5000 now, in 15 years it could easily double twice, even if things slow down a bit in the later stages. By then China will be a middle income country. In terms of sheer economic size all China has to do is double once more, then it will be comparable in economic size to the US or to Europe, depending what happens to Europe.”

But doesn’t China’s sustained growth depend on the rest of the US and Europe saying out recession.

Not any more says Michael Spence.

“Right now the emerging economies that are trading with each other are self-sustaining. They can grow even if the major industrial powers just plug along.

“If you go back ten years that wouldn’t have been possible. Weak growth in Europe or the United States of 1 or 2 per cent would have dented growth in China and associated emerging nations. But not now. China will become increasingly decoupled as time moves on. Its own emerging middle class will drive its own growth.”

But surely its billions of citizens will never get to the stage where they pump into the air pollutants at the rate of around 20 tonnes per person per year as do Australians and Canadians and residents of the United States.

No, they never will, says Michael Spence.

They will use much more energy per person. At the moment it is less than 5 tonnes. “But the realise they will have to deviate from our growth pattern before they get to 10 tonnes per person, where the Europeans are now. They will never get to Canadian or Australian emissions.”

“This is a new realisation, maybe just two years old. They are set to become so big economically, to have such a big stake in the planet, that they realise they will have to save the planet.”

“In the US people find China’s growth confronting. I know Australians don’t. It looks as it could work out well.”

Michael Spence will speak at the Grattan Institute in Melbourne on August 15 and at the National Press Club in Canberra on August 17.

Published in today's SMH and Age


China is preparing to take the lead from developed nations in saving the planet from climate catastrophe according to an advisor to the nation who worked on its most recent five year plan.

Nobel Prize winner Michael Spence who is about to visit Australia has told The Herald there has been a sharp change of attitude in the world’s fastest-growing big economy.

While it was set to continue to grow very strongly for two decades, underpinning Australia’s prosperity it would aim to approach developed nation standards of living without developed nation emissions per household.

“China and is starting to internalise these things,” he said.

“They are coming to realise that they will soon be big enough economically to put pressure on the entire globe’s environment. In a sense they will become much of the globe.”

“They are moving away from the free-rider problem you have in smaller places such as Australia where you say - why should we do anything, the US is not doing anything we are just shooting ourselves in the foot.”

“This is a real change. It is very recent. It forms part of their new five-year plan. It would date back a couple of years at most.”

Asked whether a small nation with big per capita emissions such as Australia should bother cutting those emissions Professor Spence said it was more important to take part in global discussions.”

“Australia can be influential, but it is not smart to get too far ahead. The Europeans are pertty aggressive, but they are suffering push back from their business community, and that will get worse with Europe’s growth problems.”

China’s new approach was part of a journey rather than a fixed outcome and it might still decide not to assist the rest of the planet and go for western-style emissions.

“At some time in the future China may face a choice between draconian measures to restrain emissions for the good of the planet and further growth. It may chose to go for growth regardless. If it does that I don’t know how my grandchildren are going to do.”

China’s emissions per capita remain a fraction of the West’s at less than 5 tonnes per person per year compared to 10 tonnes in Europe and near 20 in Australia, the United States and Canada.

China was reaching the stage where its growth would be self-sustaining. It would no longer depend on consumers in any other nation, relying solely on demand from its own middle class.

Published in today's SMH


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Fighting pollution without using prices is like...

Wednesday column

I bet you think you know where greenhouse gasses come from.

So did “Geoff,” a creation of the British economist Tim Harford who uses him to skewer politicians such as Tony Abbott who hold out hope of fighting climate change using so-called direct action and also those such as Julia Gillard who understand the power of prices but are at risk of screwing things up for Australian businesses by not properly applying them.

Back to Geoff, hero of chapter five of Harford’s new book Adapt.

Geoff has just seen An Inconvenient Truth and wakes up the next morning determined to take direct action to cut emissions.

He starts his day as he always does, “filling the kettle for a coffee”.

“But then he remembers the kettle is an energy-guzzler, so he has a cold glass of milk instead. He saves more by eating his usual two slices of bread untoasted. As he leaves the flat - pausing to unplug his mobile phone charger - he picks up his car keys, then thinks again and walks to the bus stop instead. By the time he hops off the bus, the lack of morning coffee is getting to him so he pops into Starbucks for a cappuccino.”

Deconstructing the day, Harford notes it wasn’t as successful as Geoff would have wanted.

“Let’s start with the milk, which requires a critical piece of equipment to manufacture: a cow. Cows emit a lot of methane. And methane is a more potent greenhouse gas than carbon dioxide... In producing about 250 ml of milk, a cow belches 7.5 litres of methane, which weighs around 5 grams, equivalent to 100 grams of carbon. Add all the other inputs to the milk - feed for the cows, transport, pasteurisation - and the 250 ml that Geoff drank produced the equivalent of around 300 grams of carbon dioxide. By not boiling his kettle he saved only about 25 grams of carbon dioxide. His first planet-saving decision, eschewing a coffee in favour of a glass of milk increased his greenhouse gas emissions by a factor of twelve. Dairy products are so bad for the planet Geoff would have done better to toast his bread but not butter it rather than buttering it but not toasting it.”

Needless to say Geoff’s cappuccino on the way to work was a greenhouse gas disaster. It’s almost all milk. Calculations by the UK government-funded Carbon Trust suggest that milk is responsible for two-thirds the emissions embodied of a block of Cadbury chocolate even though it makes up only one-third its mass. By contrast unplugging the mobile phone saved as little as 6 grams of carbon dioxide a day.

Harford’s point isn’t that we are ignorant. It is that no matter how much we knew - even if we had an app that used barcodes to correctly display on our mobile phones the emissions created by each the 10 billion products and services we commonly use - we couldn’t do the calculations. Our brains aren’t that powerful.

Fortunately we have already come up with something that is. This month in Melbourne the Institute of Public Affairs will host a symposium celebrating the Genius of Western Civilisation. That genius has perfected the system of market prices, what Harford describes as a “vast analogue cloud computer, pulling and pushing resources to wherever they have the highest value”.

Imagine, he says, a tax on carbon dioxide and equivalent emissions. It would lift the price of petrol a few cents a litre, creating a small incentive to drive less and more efficiently. A $14 per tonne tax would lift the price of an electricity kilowatt hour “by about a cent and a half if the energy came from coal, but only by three quarters of a cent if it came from natural gas, creating a small incentive to use less electricity and for power companies to build natural gas instead of coal-fired power stations”.

“This would not be because of any grand plan,” he says. “It would just happen: a trucker who ignored the higher price of diesel in setting his shipping charges would simply go out of business; so would a tomato cultivator who tried to absorb the cost of heating a greenhouse rather than raising his prices.”

“Geoff, arriving at the supermarket intending to buy tomatoes, wouldn’t have to point his smart phone at any barcodes: he could just look at the price. What the carbon tax would do is recreate the fantasy carbon calculator app, and give it teeth. Every decision maker, from the electricity company to Geoff himself would be given an incentive to reduce their carbon footprint using whatever tactics occurred to them.”

Harford is a making the same point as Australia’s Productivity Commission did last week, if more engagingly.

The take-home message for Tony Abbott is obvious. If he thinks using public money to hand out grants to worthy carbon abatement projects is better than setting a price for emissions and leaving things to the market, he is turning his back on the genius of western civilisation.

The message for Gillard is that, to a lesser extent, she is falling into the same trap. Agriculture won’t be in her scheme. Cows, beef cattle and sheep can belch greenhouse gas intensive methane as much as they like and Geoff can drink as much milk as he likes without paying the price that will face lesser emitters. The signs are that petrol won’t go up in price either. Without a price firms won’t find it as worthwhile to cleanup our farms and our cars.

Harford again:

“If there was some way to reduce the methane being belched out by cows and sheep - almost a tenth of the total gas emissions - that would be a huge achievement. Australian scientists have realised that kangaroos don’t emit methane and are now to trying figure out how to get kangaroo-gut bacteria into the stomachs of cows. It be a blind alley. It may not. But a proper price on greenhouse gases would encourage every path to be explored, even if one of the quests is to make cows belch like kangaroos.”

It would be a great business opportunity, if the price was right.

Published in today's SMH and Age


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Books everyone should read. Guess what wins.

Information is Beautiful prepared this "consensus-cloud" of most mentioned titles from various book polls & top 100 lists for The Guardian.

Data and analysis here.

You can buy a high-quality PDF here.


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Quiggin, the Musical

Why not?

As he enjoys the success of Zombie Economics - How Dead Ideas Walk among Us, he is already considering the movie rights.

It is being translated into French and Portuguese and Japanese, Korean and Chinese.

It began its life as a series of blog posts as we were recovering from the financial crisis, several of which I reposted here.

It's a great read, the best cover of any economics book, and potentially as important in Freakonomics in popularising economic concepts.

And now it's easy listening.

Here's John Quiggin at the London School of Economics in November.

And here he is in surprisingly agreement with Hayek fan Russ Roberts on EconTalk:

(The Econtalk link has a virtual transcript, so hardworking is Roberts)


Want to check out Zombie Economics? Here's the Introduction, to get you started:

Zombie Econoics Introduction

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Books for Christmas

From my other blog, Peter's Bookshelf:

Six months of panic - Trevor Sykes

Few Australian writers can match Trevor Sykes' understanding of the murkier waters of Australian business, as readers of his Pierpont column and his magisterial works The Bold Riders and Two Centuries of Panic have shown.

He has now turned his eagle eye on what has become known as the GFC, and the waves of panic that began with the subprime crisis in America and flowed with tsunami-like force across Europe, Asia and Australia. This was a crisis which was borne from an excess of greed, and immorality, and Sykes singles the Wall Street banks out for particular blame.

He explains how the subprime phenomenon came about, and how the fall of Lehman brothers marked the beginning of the slide. Inevitably the crisis reached Australia, with Centro and MFS the first dominoes in the chain. With the same blowtorch he earlier applied to the likes of Alan Bond he dissects the questionable dealings which caused the fall of high flyers like Allco, Babcock and Brown, ABC and many more, and summarises the pain and harm caused by the myriad small companies and individuals feeding from the frenzy.

Zombie Economics - John Quiggin

In the graveyard of economic ideology, dead ideas still stalk the land.

The recent financial crisis laid bare many of the assumptions behind market liberalism--the theory that market-based solutions are always best, regardless of the problem. For decades, their advocates dominated mainstream economics, and their influence created a system where an unthinking faith in markets led many to view speculative investments as fundamentally safe. The crisis seemed to have killed off these ideas, but they still live on in the minds of many--members of the public, commentators, politicians, economists, and even those charged with cleaning up the mess. In Zombie Economics, John Quiggin explains how these dead ideas still walk among us--and why we must find a way to kill them once and for all if we are to avoid an even bigger financial crisis in the future.

The Plundered Planet - Paul Collier

Paul Collier's The Bottom Billion was greeted as groundbreaking when it appeared in 2007. The Economist wrote that it was "set to become a classic," the Financial Times praised it as "rich in both analysis and recommendations," while Nicholas Kristof of the New York Times called it the "best nonfiction book so far this year."

Now, in The Plundered Planet, Collier builds upon his renowned work on developing countries and the poorest populations to confront the global mismanagement of nature. Proper stewardship of natural assets and liabilities is a matter of planetary urgency: natural resources have the potential either to transform the poorest countries or to tear them apart, while the carbon emissions and agricultural follies of the rich world could further impoverish them. The Plundered Planet charts a course between unchecked profiteering on the one hand and environmental romanticism on the other to offer realistic and sustainable solutions to dauntingly complex issues.

Sex, Lies and Pharmaceuticals - Ray Moynihan

Hard-hitting and provocative, this powerful expose of the birth of a new 'disease' - and the multi-million dollar machine unleashed to market - takes us inside the corridors of medical power from Paris to Melbourne to Manhattan to witness the creation of 'female sexual dysfunction' as a twenty-first century epidemic.

The characters in this corporate thriller are the global drug giants, the doctors and psychologists working with them, and the critics trying to untangle medical science from marketing who argue the new disorders of desire are a misleading and dangerous distraction from the real problems in sexual relationships.

I really really really really recommend each.



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Tanner to tell all?

Here's hoping

From Scribe:

Scribe has reached a multi-book publishing agreement with Lindsay Tanner, who was finance minister and a member of the cabinet in the Rudd government. Mr Tanner stepped down from the seat of Melbourne at the recent federal election.

The first book with Scribe has the working title of SIDESHOW, and will be about the increasing dumbing down of Australian politics. It is due to be published in early 2011.

Lindsay Tanner said, ‘I am pleased to have entered into a publishing arrangement with Henry Rosenbloom of Scribe Publications, whom I have known for many years. Henry actually commissioned my first book, THE POLITICS OF POLLUTION, back in 1976.’

Of the book’s topic, Mr Tanner said, ‘Many Australians are distressed by the relentless dumbing down of political debate. This book will explore the nature and the causes of this problem, and the threat to our democracy that it poses.’

Scribe’s CEO and publisher, Henry Rosenbloom, said of the deal, ‘I’m delighted that we’ll be publishing Lindsay’s forthcoming books. He has a hard-won reputation as a person of integrity and a thinker of substance, and his insights should be especially valuable in the light of the recent election campaign and the formation of a minority Labor government.’


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James Hardie - the video and audio

Matt Peacock's interview on today's Radio National Breakfast is here.

Gee it's worth a listen.

I learned that James Hardie even stole its name. It has no connection with the loved yachtsman, winemaker and republican Sir James Hardie.

It sought out older Australians as workers because it thought they would die before their asbestosis became apparent.

The video of Matt's Monday 7.30 Report story is here. Click on broadband or dial-up at the right of the screen.

Or click on this link. It should start the video immediately.

Killer Company: James Hardie Exposed, by Matt Peacock

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Australia's James Hardie - close to evil

It's in the book, out now.

As the author Matt Peacock explained to me over a cup of coffee in Parliament House, you can trace every stage of James Hardie's asbestos production process and find a trail of death that is continuing still, in places most people - quite reasonably - don't suspect.

Such as carpet.

The hessian bags that carried the asbestos James Hardie transported were subsequently sold to carpet companies (among others) who used them to make carpet underlay.

Only now, two or three decades later, is that carpet being ripped up and replaced.

The Australian workers or families who rip up their carpets are being exposed to asbestos fibres and a high risk of a painful lingering death.

Here's the extract from my friend Matt Peacock's formidable book, printed in the Weekend Australian:

Bernie Banton, the former James Hardie employee who died from cancer in 2007, became the public face of victims of the company's asbestos products but, as Matt Peacock writes, the company spread the risk across the community -- where it remains

IN late 2005 James Hardie's embattled chairwoman Meredith Hellicar spoke warmly to me of a letter of support she'd received from an elderly woman. "This wonderful 93-year-old woman ... was married to two James Hardie plant managers in a row," Hellicar said. "She said they both loved asbestos. One of her husbands lined their driveway with asbestos."

For Hellicar, the letter provided reassurance that she was continuing an honourable company tradition set by her predecessor John Reid and his family, one that reflected the best moral corporate behaviour. But what neither Hellicar, nor anyone else from Hardie, said publicly was that such innocuous-looking driveways might kill. They are yet another part of the deadly legacy kept secret from an unsuspecting public by a company determined to minimise its legal liabilities.

The corporate culture of deceit identified by the NSW special commission of inquiry headed by David Jackson QC in 2004 developed many decades ago and persists to this day. Hardie's victims will continue to accumulate because the company has never told the full truth about the asbestos hazards left in its wake. Some, quite literally, have been swept under the carpet.

Until the 1970s it had been common practice to build such domestic driveways, paths and garage floors using Hardie's asbestos waste. The company encouraged its employees to help themselves to the "fines", as it was called. The compacted waste still remains in people's driveways. I have seen one in a quiet suburban street bordering the old industrial area of Elizabeth in Adelaide, where the Hardie factory had produced its asbestos pipes and sheets. It had the appearance of concrete, with its grey colour and hard surface. Only a close examination at the edges revealed the telltale fraying fibres, glistening in the grime.

According to Neil Gilbert, the former Hardie engineer who established Hardie's dust extraction system and medical surveillance scheme before quitting in 1971, thousands of driveways would have been built this way, but he shrugged at the suggestion that something should be done about it.

"That's fate," he told me. "I know where there's one or two. It would take a massive amount of publicity to track them down. Most people wouldn't recognise them. You couldn't tell the difference between it and concrete."

One of Hardie's biggest fears has been that litigation against it could extend beyond simply paying for the deaths and injuries it has caused to cleaning up the dangerous materials it has left behind. "The establishment of a broadly defined duty to remediate, whether at common law or by statute, could have a catastrophic effect on the company," Hardie's litigation manager Wayne Attrill warned in 2001, just before the company shed its asbestos subsidiaries and moved offshore. The prospect of such claims for remediation also featured in the early discussions held by Hardie's counsel Peter Shafron and Michael Gill when they first canvassed the idea of separating the company's asbestos subsidiary. In the protracted battle with the NSW government that followed, Hardie extracted unique legal protection from just such a duty.

No one knows how many people have been exposed to lethal doses of Hardie's asbestos waste. What is certain is that many thousands could have been; what is equally certain is that the company has known that their lives have been endangered.

For Hardie, the driveways were part of a bigger problem. Thousands of tonnes of its asbestos waste were dispersed in all sorts of places: in rivers and creeks, on vacant blocks, on roadways, even on football ovals. Wherever fill was needed, Hardie's waste was available.

The practice was made even more dangerous because a large percentage of the waste came from moulded products such as pipes, which had contained the deadly brown and blue asbestos.

As a Hardie memo in 1977 about its Camellia factory in Sydney noted: "It is understood that our dust was a sought-after item and was even sold. It was particularly useful for light duty paths, garage floors and general filling.

"Our reject and broken scrap was also very useful as a filling for driveways, etc in many of the market gardens west of our factory."

Father John Boyle, whose father worked at the factory, remembered the asbestos driveway and garage floor from his family house near Parramatta. His mother, Molly, had helped his father lay the asbestos waste and for years later used to sweep the garage floor clean: "I know well what it looks like. It's a fibrous, powdery material that along with water becomes as hard as concrete. It was a cheap fill and in those days it probably wasn't seen to be so bad.

"It's good for 10 or 20 years, but then it breaks up, and that's when the fibres are released. From the mid-70s James Hardie knew about them but didn't warn people."

In fact Hardie had known long before that, but it was only during the 70s that it began to do anything about it. The company's reaction, as Boyle noted, was not to alert people to the dangers; instead, it set about quietly stopping the practice.

Boyle's mother died from mesothelioma. She had also been exposed to asbestos from her husband's overalls, but it seemed likely that her greatest exposure was from the driveway and garage floor. Hardie settled her compensation claim.

I asked Hellicar if she was concerned about the possible danger to the public, especially given that children could be exposed. She was quick to answer: "If you're saying, `Should James Hardie pay for a clear-up?' No, at the end of the day. And why no? Because we cannot be a bottomless pit.

"The fact of the matter is ... this was not some James Hardie conspiracy to foist a product on the world. Governments were there, companies were there. We all were party to this great new product and at some point we have to just all recognise there was a big mistake made about asbestos."

APART from the driveways and paths that employees and others were encouraged to construct, the company also had deposited bulk asbestos waste in a multitude of locations across the country.

I first became aware of the practice in 1978, when former Hardie engineer Fred Sandilands contacted me after my ABC radio series about the industry had aired and I helped publicise his story.

Sandilands was 49 and had worked at Hardie for most of his life. He had remarried in 1975 and left the company to start a new life in Singapore, where he got a job with Humes, another asbestos manufacturer. After a medical check-up at Humes he was told that he had mesothelioma. He called me just after he had returned to Australia.

He knew he was dying. He spoke calmly, but slowly, as one suffering a lot of pain. Sandilands expressed disbelief that the company for which he had felt so much affection could be so tough in its compensation negotiations with him. The enormity of the Hardie cover-up was dawning on him. As his death grew closer it weighed on his mind.

Sandilands had supervised the dumping of thousands of tonnes of asbestos waste throughout the suburbs surrounding Hardie's Sydney factory. When his story went public in the newspapers and on ABC TV, Hardie's chairman Reid circulated a letter to shareholders and staff because, he wrote, "unfortunately the facts have not always been presented in full or objectively". Under the heading "Setting the Record Straight", Hardie set out a response carefully crafted by its PR consultant, Bill Frew: "Because the small amount of asbestos fibres in our products is locked in by cement, it cannot escape into the atmosphere as dust, and therefore poses NO RISK TO HEALTH."

Behind the scenes, Hardie and the Health Commission were scrambling for cover. There were many more sites than the two mentioned. Frank Stewart, the NSW health minister, urged householders not to be alarmed. "Asbestos dust does pose a health hazard, but it requires exposure over a long period of time," he said soothingly and inaccurately. The government soon identified dump sites at other Sydney suburbs, among them North Rocks, Wentworthville, Granville, Silverwater, Homebush and Parramatta Park.

Early this decade, Hardie waste in Perth was still being dug up in the road and rail reserves at Burswood, where the company had dumped it from its nearby factory. Other landfill excavated from Goodwood Parade in Riverdale to help construct a new freeway was discovered to be "massively contaminated". West Australian health authorities expressed surprise but played down any possible dangers, expressing satisfaction that test results had demonstrated "no risk to public health".

Federal and state government authorities had failed to regulate the safe disposal of asbestos until the late 70s. Hardie had been able to exploit this omission.

The practice was the same throughout the country. Hardie knew the public was at risk. Its secret monitoring in Adelaide during November 1974 revealed that even 20 minutes after tipping had stopped, there was an asbestos dust count of 30 fibres per cubic centimetre. Hardie's nominal safe level of exposure for a worker during a shift in its factories at the time was four fibres per cubic centimetre, soon to be halved. Hardie's dust committee warned of "the harm that such an event could cause to the company's good public relations" if the news leaked out.

The number of people killed by Hardie products in the course of their work, whether in the company's factories or outside, was sooner or later likely to become public knowledge. So, too, was information about the products that had killed them.

Many at the top of the firm, though, were also aware of those less visible potential hazards, in places such as driveways and dumps, where most of those exposed would have no knowledge of its presence. Yet time and again Hardie directors and executives chose silence. One example starkly demonstrates the company's continuing failure to warn the public of a danger that still lingers, possibly in thousands of homes.

For many decades the millions of tonnes of raw asbestos shipped into Australia and transported from mines at Wittenoom in Western Australia and Woodsreef and Baryulgil in NSW were carried in hessian bags. Once the asbestos had been emptied from the bags, many millions were recycled for other uses. Cleaning the bags did not make them safe.

John Downes worked for the Active Bag Company, based near Sydney's Mascot airport, for about three years until 1965. Downes, who later developed asbestosis, remembered picking up hessian bags from Hardie's factory at Camellia. His company sent two trucks over to the factory every week, each of which returned with 10 bales on the back containing 800 to 1500 hessian bags.

After the bags were tumbled in a machine to remove the obvious raw asbestos, Downes said, they were sold to various firms for use as "carpet underlay or onion bags". Just this company alone would have processed about a quarter of a million asbestos bags every year.


This is an edited extract from Killer Company: James Hardie Exposed by Matt Peacock, ABC Books, $35, available from September 1. Peacock will appear on September 13 at the Brisbane Writers Festival, which runs from September 9 and is co-sponsored by The Australian.

ASBESTOS USE AND ITS EFFECTS

ASBESTOS is a fibrous mineral used for heat and fire protection and for insulation.

It was used in many kinds of products, including airconditioning ducts, ceiling tiles, bitumen-based waterproofing such as malthoid or roofs, floors and brickwork, roof tiles, cement render, oven door seals, compressed asbestos used in brakes and gaskets, compressed asbestos panels for floorings, verandas and demountable buildings, electric heat banks, flexible hoses, fire-door insulation, fire blankets, beverage and wine filters, insulation around the heating elements in hair dryers, lift shafts, pipe insulation and other products.

It was banned from all further use in 2003.

There is no safe level of asbestos fibre inhalation and cancer from it can take decades to develop.

www.adfa.org.au

www.health.qld.gov.au/asbestos/about--asbestos/default.asp

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Fool's Gold: What actually happened

Gillian Tett is one smart financial journalist

Before I went to Japan as an Australian correspondent a leading financial market figure advised me that her reports from Japan were the only ones worth reading.

Back in London with the Financial Times a few years ago she did what no other financial journalist seemed to have done - gone back to basics and asked, "where is the money actually going" and is that where we are concentrating our reporting resources?

She discovered that massive amounts of money were changing hands buying and selling derivatives, yet nearly all the coverage was about the far less financially important topics of shares and bonds.

"You had a small part of the financial system bobbing above the water but a vast shadowy mass of activity pretty much hidden beneath the waves."

She told the FT and they began to take more seriously where the money was actually going.

Now she's written Fool's Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe, the "gripping tale of how a team of Wall Street bankers led by J.P. Morgan's CEO Jamie Dimon created the world of shadow banking, and then lost control of their creation".

Here are two good reviews. And here she is talking about her book.

UPDATE: Here's an 82-minute podcast

All this, and Gillian Tett has a PhD in social anthropology!

Fools Gold is on sale in Australia.

Here's the extract published in the Financial Times:

Genesis of the debt disaster In the 1990s, a young team at Wall Street investment bank JP Morgan pioneered a new way of making money – credit derivatives. Within a decade, the market for these exotic securities had exploded to more than $12,000bn – and some people later blamed them for fuelling the global financial fiasco. In the first of two extracts from her book, Fool’s Gold, the FT’s Gillian Tett reveals how the innovation genie was first let out of the bottle – and eventually devoured the system, to the horror of its creators...

"The first sign that there might be a structural problem with the innovative bundles of credit derivatives that bankers at JP Morgan had dreamed up emerged in the second half of 1998. In the preceding months, Blythe Masters and Bill Demchak – key members of JP Morgan’s credit derivatives team – had been pestering financial regulators. They believed that by using the new credit derivative products they had helped create, JP Morgan could better manage the risks in its portfolio of loans to companies, and thereby reduce the amount of capital it needed to put aside to cover possible defaults. The question was by how much. (Though these bundles of credit derivatives later went under other names, such as collateralised debt obligations [CDOs], at that time these pioneering structures were known as “Bistro” deals, short for Broad Index Secured Trust Offering). Masters and Demchak had done the first couple of Bistro deals on behalf of their own bank without knowing the answer to their question for sure. But when they were doing these deals for other banks, the question of reserve capital became more important – the others were mainly interested in cutting their reserve requirements.

The regulators weren’t sure. When officials at the Office of the Comptroller of the Currency and the Federal Reserve had first heard about credit derivatives and CDOs, they had warmed to the idea that banks were trying to manage their risk. But they were also uneasy because the new derivatives didn’t fit neatly under any existing regulations. And they were particularly uncertain over what to make of the unusually low level of capital available to cover losses on the derivatives.

When the team did their first Bistro deal, they pooled more than 300 of JP Morgan’s loans, worth a total of $9.7bn, and issued securities based on the income streams from these loans. The lure of the idea was clear: the team had calculated that they only needed to set aside $700m – a strikingly small sum – against the risk of defaults among the 300-plus loans. After much debate, the credit rating agencies had agreed with the team’s assessment of the risks, and the deal had gone ahead on the basis that if financial Armageddon wiped out the $700m funding cushion, JP Morgan would absorb the additional losses itself. To Masters and Demchak, the chance that losses would ever eat through $700m were minuscule.

That argument didn’t wash with European regulators, and some of their US counterparts were uneasy, too. Christine Cumming, a senior Fed official, indicated to Masters and Demchak that JP Morgan should look for a way to insure the rest of the risk – the “missing” $9bn in their original Bistro scheme – if the bank wanted to gain approval to cut its capital reserves. So Masters and her team set out to find a solution. They started by giving the bundle of “uninsured” risk a name. Masters liked to refer to it as “more than triple-A”, since it was deemed even safer than triple A-rated securities. But that was too clumsy to market, so they came up with “super-senior”. The next step was to explore who, if anyone, might want to buy or insure it.

The task did not look easy. As far as JP Morgan was concerned, this risk was not really risky at all, so there was no point paying anything other than a token amount to insure it. On top of that, whoever stepped up to acquire or insure the super-senior risk had to be brave enough to step into an unfamiliar world.

The seeds of AIG’s destruction

Masters eventually spotted one solution to the super-senior headache. In the past, one of JP Morgan’s longstanding blue-chip clients had been the mighty insurance company American International Group. Like JP Morgan, AIG was a pillar of the American financial establishment. It had risen to prominence by building a formidable franchise in the Asian markets during the early-20th century. That business was later extended to the US, making the company a powerful force in the American economy after the second world war. AIG was considered a weighty and utterly reliable market player, and like JP Morgan, it basked in the sun of a triple-A credit rating.

But within AIG, an upstart entrepreneurial subsidiary was booming. In the late 1980s the company hired a group of traders who had previously worked for Drexel Burnham Lambert, the infamous – and now defunct – champion of the junk-bond business under Michael Milken in the mid-1980s. These traders had developed a capital markets business, known as AIG Financial Products and based in London, where the regulatory regime was less restrictive. It was run by Joseph Cassano, a tough-talking trader from Brooklyn. Cassano was creative, bold and highly ambitious. More important, he knew that, as an insurance company, AIG was not subject to the same burdensome rules on capital reserves as banks. That meant it would not need to set aside anything but a tiny sliver of capital – at most – if it insured the super-senior risk. Nor was the insurer likely to face hard questions from its own regulators because AIG Financial Products had largely fallen through the cracks of oversight. It was regulated by the US Office for Thrift Supervision, whose officials had scant expertise in the field of cutting-edge financial products.

Masters pitched to Cassano that AIG take over JP Morgan’s super-senior risk, and Cassano happily agreed. It was a “watershed” event, or so Cassano later observed. “JP Morgan came to us, who were somebody we worked with a great deal, and asked us to participate in some of what they called Bistro trades [which] were the precursors to what [became] the CDO market,” he explained. It seemed good business for AIG.

AIG would earn a relatively paltry fee for providing this service – just 0.02 cents per dollar insured per year. But if 0.02 cents is multiplied a few billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the risk. Once again, the magic of derivatives had produced a “win–win” solution. Only many years later did it become clear that Cassano’s trade had set AIG on the path to ruin.

With the AIG deal in hand, the JP Morgan team returned to the regulators and pointed out that a way had been found to remove the rest of the credit risk from their Bistro deals. They started plotting other sales of super-senior risk to other insurance and reinsurance companies, which snapped it up, not just from JP Morgan but from other banks too.

Then, ironically, just as this business was taking off, the US regulators weighed in again. Officials at the Office of the Comptroller of the Currency and the Fed indicated to JP Morgan that after due reflection they thought that banks did not need to remove super-senior risk from their books after all. The lobbying by Masters and others had seemingly paid off. The regulators were not willing to let the banks get off scot-free. If they held the super-senior risk on their books, they would need to post reserves one-fifth the size of the usual amount (20 per cent of 8 per cent, meaning $1.60 for every $100 that lay on the books). There were also some conditions. Banks could only cut their capital reserves in this way if they could prove that the risk of default on the super-senior portion of the deals was truly negligible, and if the securities being issued via a Bistro-style structure carried a triple A credit rating from a “nationally recognised credit rating agency”. Those were strict terms, but JP Morgan was meeting them.

The implications were huge. Banks had typically been forced to hold $800m reserves for every $10bn of corporate loans on their books. Now that sum could fall to just $160m. The Bistro concept had pulled off a dance around the international banking rules.

For a while, Demchak’s team stopped transferring super-senior risk from JP Morgan’s books. But then Demchak became uneasy. The super-senior risk was ballooning to a staggering figure, because when the bank arranged these credit derivatives transactions for clients, it typically put the super-senior risk in the deal on its own balance sheet. In theory, there was no reason to worry. But by 1999, the total pipeline of future deals had swelled towards $100bn. Something about that mountain of risk started to offend Demchak’s common sense. “If you have got $60bn, $100bn or however many billions of something on your balance sheet, that is a very big number,” he remarked to his team. “I don’t think you should ignore a big number, no matter what it is.”

The problem with correlation

Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of “correlation”, or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?

Similar doubts dogged the corporate world. JP Morgan statisticians knew that company debt defaults are connected. If a car company goes into default, its suppliers may go bust, too. Conversely, if a big retailer collapses, other retail groups may benefit. Correlations could go both ways, and working out how they might develop among any basket of companies is fiendishly complex. So what the statisticians did, essentially, was to study past correlations in corporate default and equity prices and program their models to assume the same pattern in the present. This assumption wasn’t deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that JP Morgan was dealing with. When Moody’s had done its own modelling of the basket of companies in the first Bistro deal, for example, it had predicted that just 0.82 per cent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 per cent of the pool – the amount that might eat up the $700m of capital raised to cover losses – was tiny. That was why JP Morgan could declare super-senior risk so safe, and why Moody’s had rated so many of these securities triple-A.

The fact was, however, that the assumption about correlation was just that: guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be appreciably higher than the statisticians had assumed, serious losses might result. What if a situation transpired in which, when a few companies defaulted, numerous others followed? The number of defaults required to set off such a chain reaction was a vexing unknown. Demchak had never seen it happen, and the odds seemed extremely long, but even if there was just a minute chance of such a scenario, he didn’t want to find himself sitting on $100bn of assets that could conceivably go bust. So he decided to play it safe, and told his team to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were saying.

That stance cost JP Morgan a fair amount of money, because it had to pay AIG and others to insure the super-senior risk, and those fees rose steadily as the decade wore on. In the first such deals with AIG, the fee had been just 0.02 cents for every dollar of risk insured each year. By 1999, the price was nearer 0.11 cents per dollar. But Demchak was determined that the team must be prudent.

The mortgage time bomb

Around the same time, the JP Morgan team stumbled on a second, potentially bigger problem. As the innovation cycle turned and earnings declined from the early Bistro deals based on pools of corporate loans, Demchak asked his team to explore new uses for Bistro-style deals, either by modifying the structure or by putting new kinds of loans or other assets into the mix. They decided to experiment with mortgages. Terri Duhon was at the heart of the endeavour. Only 10 years earlier, Duhon had been a high-school student in Louisiana. When she told her relatives she was going to work in a bank, they had assumed she was going to be a teller. Now she was managing tens of billions of dollars. She was trained as a mathematician, and she thrived on adrenaline, riding motorbikes in her spare time. Even so, she found the thought of being in charge of all those zeros awe-inspiring. “It was just an extraordinary, intense experience,” she later recalled.

A year after Duhon took on the post, she got word that Bayerische Landesbank, a large German bank, wanted to use the credit derivatives structure to remove the risk from $14bn of US mortgage loans it had extended. She debated with her team whether to accept the assignment; working with mortgage debt wasn’t a natural move for JP Morgan. But Duhon knew that some of the bank’s rivals were starting to conduct credit derivatives deals with mortgage risk, so the team decided to take it on.

As soon as Duhon talked to the quantitative analysts, she encountered a problem. When JP Morgan had offered the first Bistro deals in late 1997, it had access to extensive data about all the loans it had pooled together. So did the investors who bought the resulting credit derivatives, since the bank had deliberately named all of the 307 companies whose loans were included. In addition, many of these companies had been in business for decades, so extensive data were available on how they had performed over many business cycles. That gave JP Morgan’s statisticians, and investors, great confidence in predicting the likelihood of defaults. But the mortgage world was very different. For one thing, when banks sold bundles of mortgage loans to outside investors, they almost never revealed the names and credit histories of the individual borrowers. Worse, when Duhon went looking for data to track mortgage defaults over several business cycles, she discovered it was in short supply.

While America’s corporate world had suffered several booms and recessions in the later 20th century, the housing market had followed a steady path of growth. Some specific regions had suffered downturns: prices in Texas, for example, fell during the Savings and Loans debacle of the late 1980s. But since the second world war, there had never been a nationwide house-price slump. The last time house prices had fallen significantly en masse, in fact, was way back in the 1930s, during the Great Depression. The lack of data made Duhon nervous. When bankers assembled models to predict defaults, they wanted data on what normally happened in both booms and busts. Without that, it was impossible to know whether defaults tended to be correlated or not, in what circumstances they were isolated to particular urban centres or regions, and when they might go national. Duhon could see no way to obtain such information for mortgages. That meant she would either have to rely on data from just one region and extrapolate it across the US, or make even more assumptions than normal about how defaults were correlated. She discussed what to do with Krishna Varikooty and the other quantitative experts. Varikooty was renowned on the team for taking a sober approach to risk. He was a stickler for detail and that scrupulousness sometimes infuriated colleagues who were itching to make deals. But Demchak always defended Varikooty. His judgment on the mortgage debt was clear: he could not see a way to track the potential correlation of defaults with any confidence. Without that, he declared, no precise estimate could be made of the risks of default in a pool of mortgages. If defaults on mortgages were uncorrelated, then the Bistro structure should be safe for mortgage risk, but if they were highly correlated, it might be catastrophically dangerous. Nobody could know.

Duhon and her colleagues were reluctant simply to turn down Bayerische Landesbank’s request. The German bank was keen to go ahead, even after the uncertainty in the modelling was explained, and so Duhon came up with the best estimates she could to structure the deal. To cope with the uncertainties the team stipulated that a bigger-than-normal funding cushion be raised, which made the deal less lucrative for JP Morgan. The bank also hedged its risk. That was the only prudent thing to do, and Duhon couldn’t see herself doing many more such deals. Mortgage risk was just too uncharted. “We just could not get comfortable,” Masters later said.

In subsequent months, Duhon heard through the grapevine that other banks were starting to do credit derivatives deals with mortgage debt, and she wondered how they had coped with the lack of data that so worried her and Varikooty. Had they found a better way to track the correlation issue? Did they have more experience of dealing with mortgages? She had no way of finding out. Because the credit derivatives market was unregulated, details of the deals weren’t available.

The team at JP Morgan did only one more Bistro deal with mortgage debt, a few months later, worth $10bn. Then, as other banks ramped up their mortgage-backed business, JP Morgan largely dropped out. Eight years later, the unquantified mortgage risk that had frightened off Duhon, Varikooty and the JP Morgan team had reached vast proportions. And it was spread throughout the western world’s financial system.

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