Governments should nudge, not spend

Governments can use ‘nudges’ instead of spending to drive economic growth. An example is using regulation to expand ASX’s trial Equity Research Scheme that provides broker research for a selected number of small cap companies in order to support institutional investment in this market.

We are entering a new global phase where governments will not have the same fiscal power they once had. Governments can use ‘nudges’ to influence economic and social outcomes instead of traditional government spending on programs.

Over the last 100 years governments across the world started making promises they are now struggling to keep.

The first universal age pension promises were made by German chancellor Otto Von Bismark in 1889. The German Government promised to pay pension at the age of 70, dropping to 65 in 1916.

Bismark was a conservative who was the right hand man of Germany’s Kaiser Wilhelm. Bismark’s was motivated, not to address poverty amongst the aged, but to reduce the attractiveness of the emerging socialist party, which he attacked politically, including by passing the Anti-Socialist Law on 19 October 1878.

Bismark’s legacy has grown over the last 120 years as governments have added to their social contracts, establishing universal health schemes.

The problem that governments’ today face is that previous governments never fully funded their pension their promises at the time. Instead of putting away funds to cover future commitments politicians relied on the ability of future generations to fund pensions, age care and health services.

Life expectancy, which was 72 years when Bismark promised the old age pension at 70 is now 81.9 years at birth for the total population (males 79.48 and females 84.45). The funding requirement for government has expanded from 2 years to 16.9 years.

The ability to finance these commitments had one fundamental flaw. It relied on the structure of society to remain the same, that is, that the numbers of beneficiaries of age pensions and health services would be able to be supported by a larger proportion of the population that was in the workforce.

World War 2 produced demographic distortions that are as pronounced as at any time in human history. The effect was twofold. Firstly 50-70 million people were casualties of the War itself. Secondly following the end of the War soldiers de-mobbed. In Australia almost 600,000 Australians were demobilised in a process that commenced from 1 October 1945. The babies that were born over the next 15 or so years created an unprecedented demographic bulge. For many years this demographic bulge acted in our favour, providing nations with productive workers with an associated appetite to consume and drive economic activity.

The baby boomers are now rapidly approaching retirement. The first are now eligible for the age pension. Over the next 15 years baby boomers will progressively leave the labour force.

Within the decade however a significant proportion will retire. Age pension costs are just one bill governments will pay. Health costs rise with age. Age care costs will also increase significantly, although not as quickly as pension and health costs as the first period of retirement for baby-boomers is a period of relative good health.

None of this is news. Around 250,000 baby boomers turned 65 last year.

It is worth remembering that the first Intergenerational Report in 2002 projected that by 2042 the nation would face an annual budget deficit of $87 billion. One of the report’s central scenarios suggested that spending pressures will begin to rise from around 2017. But indications are that the demographic time bomb is coming early in the form of pressure on the health system.

The pressure on the hospital system is consistent with reports from the National Health and Hospitals Reform Commission who have noted that the two major drivers of demand for health services are an ageing population and higher rates of chronic disease, and that both these demand drivers are expected to accelerate over time, adding pressure across the entire health system.

The last Intergenerational Report in 2010 projected that by 2049-50 net debt would be around 20 per cent of GDP with the Budget in a deficit position of 3¾ per cent of GDP. Deloitte Access Economics has also considered the impacts on State Budgets, which are responsible for most health costs. They model that the State shortfall is almost 2½% of GDP by 2050, meaning that the total shortfall in national fiscal finances by 2050 would be just over 5% of GDP.

The key issue for both Federal and State governments is that no matter who is in power we can expect to see continued Budget pressure due to increases costs associated with the ageing of the population.

The pressure to produce Budgets surpluses is likely to lead to a year by year battle to reduce expenditure and increase revenues in order to pay the mounting pension and health costs. Considered over a medium term period such as 15 years – the period of time in which baby-boomers will transition to retirement – we are likely to see political parties make cuts consistent with their own priorities. This will result in what could be considered a jagged approach to cuts. Coalition Governments will seek to make cuts to welfare expenditure, whereas Labor Governments are likely to seek to pull back wealth concessions including for superannuation.

Overtime fiscal tightening and revenue raising can only go so far.

The question for progressive political parties, both here in Australia and globally is whether there are alternatives to this doom and gloom story. The answer is there is.

The challenge for progressive politics is to firstly understand that the power of governments to spend in order to address social, environment and economics issues will be reduced. Instead of proposing government spending as a solution, progressive politicians need to consider alternatives that produce the same outcomes. This is easier said than done and will require a fundamental change of both policy thinking and structures such as think tanks that can debate alternative approaches.

What may be called ‘Nudge Economics’ represents an alternative way of thinking around stimulating economic activity.

Cass Sunstein and Richard Thaler’s 2008 book Nudge proposed how governments could influence health, wellbeing and happiness through ‘nudges’ that would influence behaviour.

Whilst the book was focused on individuals, it is possible to utilise the nudge framework more widely for governments to ‘nudge’ economic activity.

One example of a ‘nudge’ is that governments could support the development of small cap companies by supporting broker research. Currently the debate on encouraging the development of small business focuses on different incentives that can be provided to entrepreneurs.

One alternative is to support the ability of capital markets to develop small cap listed companies.

There are currently around 2,200 companies that are listed on the ASX. The challenge that Australia’s capital markets face is that there are a large number of companies that are of insufficient size to attract investment from institutional investors. The lack of institutional investment interest in turns means that many companies are not liquid which in turn discourages brokers from providing research as broker research is paid for out of the revenues from share trading.

Academic research has demonstrated that there is a link between broker research and company valuations. Companies with increased valuations find it is easier to raise corporate finance and are likely to have stronger growth prospects.

In order to address the lack of broker research of small cap companies the ASX has established an Equity Research Scheme that provides broker research for a number of selected small and medium cap companies. The ASX Equity Research Scheme trial has the potential to be expanded to cover the whole market with in-depth, regular reports.

There are a number of potential ways that the funding for a small cap broker program can be raised.

State Governments may have an interest in paying broker research for small cap companies listed in their home state. It would certainly be cheaper to finance brokerage research than previous schemes where State Governments have competed for a company head office to be located in a particular city.

Alternatively the Federal Government could use regulation to require ASX to establish a broader scheme. The costs of the program could easily be paid for by the top listed companies in the ASX. Whilst it is difficult in a market environment for ASX to require larger companies to pay for the brokerage of smaller companies, since the program would benefit the overall health of the market there is a justification in regulation being used to require listed companies to support the scheme as part of their listing fees.

Having a program that supported brokerage of small cap companies would create an environment that would encourage small cap companies to list in Australia. It would improve the quality and depth of liquidity of small cap companies which in turn would support increased valuations and the growth of smaller companies.

Over the course of 2015 I will write about more potential ‘economic nudges’ that can drive economic activity.


ASX Equity Research Scheme

Carole Comerton-Forde, David R. Gallagher, Joyce Lai and Terry S. Walter, University of Melbourne – Department of Finance , UNSW Business School , University of New South Wales and University of Sydney, Broker Recommendations and Australian Small-Cap Equity

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