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The social and political cost of irrationality

By Kim Sawyer - posted Friday, 5 August 2011

In science, the signal-noise ratio is a statistic used to measure the ratio of information that is explainable versus information that is noise. Through observation and inference, science increases our understanding of what is real and what is random; science filters out the noise. But noise is not just a problem for science; it is one of the great problems of our age. Noise confounds decision-making at every level; in the financial markets, in macroeconomic decisions, and in political discourse. Filtering out the noise is one of the major challenges of our time.

Finance theorists have long recognised the problem of noise in investment decisions. Noise creates irrationality, where investors trade on information unrelated to the cash flows of their portfolios. A common example taught to finance students is the problem of anchoring. When asked to nominate the percentage of African countries in the United Nations, if a student is first asked to draw a random number between 0 and 100, the student who draws 25 is more likely to choose a percentage closer to 25 per cent than a student who draws 50. The random drawing of a number anchors the unrelated decision as to the percentage of countries in the U.N.

Anchoring is one form of irrationality; there are others including the overreaction to bad news, and the tendency to over simplify so that every problem is binary (0 or 1), rather than weighted by probabilities. Investors, in general, do not behave like rational probabilists, particularly when forming portfolios. As a consequence, markets tend to exhibit excessive herding, excessive overreaction and irrational exuberance.


With the rise of the Internet, irrationality has found new relevance. Herding is now common, and the herds often gravitate to propositions that would never withstand the test of time. In a democracy, all voices are equal, but the irrational voice is often louder, more insistent, and less concessionary.

The adversarial system of politics has encouraged irrationality and discouraged rational consensus. In appearances before Parliamentary Select Committees over many years, I have observed how differently politicians behave when the negativity of politics is replaced by the need for rational consensus. If only politicians could cease to be politicians more often. In 1994, for example, the Senate Select Committee on Public Interest Whistleblowing, an all-party committee, made more than 30 recommendations to introduce comprehensive national whistleblowing legislation.

Seventeen years later, and after two more Parliamentary inquiries, Australia still does not have national whistleblowing legislation. A rational society would have enacted whistleblowing legislation in 1994; the failure to act has imposed a cost, a cost borne by whistleblowers. Sometimes the cost of irrationality can be quantified.

In 1996, I first advocated for an Australian False Claims Act based on the U.S. False Claims Act. This Act is designed to protect a country from false claims against the government by allowing whistleblowers to identify waste, to initiate actions against those falsely claiming on the government, and to receive compensation and protection. The False Claims Act is the most effective legislation for combating fraud on the U.S. government and is often called a deficit reduction act.

Since 1986, $28 billion of fraud has been recovered using the U.S. False Claims Act. I have estimated that an Australian False Claims Act would have saved the Australian government more than $1 billion since 1996, particularly as a deterrent to waste, like the waste observed in the recent economic stimuli. But Australia has not adopted a False Claims Act, failing to recognise that whistleblowers are independent regulators who need to be compensated rather than sacrificed.

The opportunity cost of policy foregone can be observed in other areas. In 2001, I proposed a National Education Ombudsman to the Senate Committee on Higher Education. This proposal was adopted by the all-party committee; but never implemented. Some of the problems we have observed in higher education in recent years, particularly in regard to the regulation of training colleges, could have been mitigated if an ombudsman had been in place.


In 2001, I also proposed an education bonds scheme, similar to that used to fund infrastructure in the 1990s. Such a scheme would have reduced our dependence on international student income. But our addiction to international student income continued, similar to an investor who refuses to diversify. We are beginning to pay the price; international enrolments fell 20 per cent last year and with the Australian dollar at its current level, Australian universities are exposed to significant risk. The cost of failing to rationally respond is always met by the future generations.

The debates over both the carbon tax and the resource rental tax have all the hallmarks of the irrational response to whistleblowing legislation and education regulation that I have observed over twenty years. In an economy, there must be appropriate incentives to encourage behavior in the public interest, and disincentives to discourage behavior contrary to the public interest. 

The pricing of carbon and the imposition of a resource rental tax have long been advocated in economics as mechanisms of protecting the national interest, both from excessive environmental degradation and from excessive extraction of monopolistic rents.

As with all tax debates, the argument for and against these taxes should be based on issues of efficiency, fairness and protection of the national interest. But, just as in the estimation of the percentage of African countries in the U.N., the tax debate has been distorted by irrationality. As always, the cost will be borne by future generations.

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About the Author

Kim Sawyer is an Associate Professor in the Department of Finance, Faculty of Economics and Commerce and the University of Melbourne. He is a committee member of Whistleblowers Australia.

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