Why is income inequality, a pervasive feature of human history since there have been humans to have history, a persistent matter of public concern? And if income inequality is an important public concern, why does it persist?

Sometimes tough questions have surprisingly easy answers.

In its mildest forms, excessive income inequality makes people unhappy, and that is no small thing when it comes to public policy or anything else. Happiness is an important part of social well-being. What makes us unhappy is the alternative: a feeling of powerlessness, of inability to succeed and to share in the life we see around us. This situation may breed envy, a sin, and can make us despair, a condition from which it is difficult for humans to recover.

Taken to an extreme, income inequality and its routine companion, wealth or asset inequality, lead not just to unhappiness but to lack of faith and trust in the world around us, and what follows from that is disillusionment with the public institutions that govern us. This has been the lot of several countries in Central America in the past century or two, and so it is of several in Africa today.

It does not stop with lack of trust. From 1789 at least, populist uprisings have arisen from a lack of faith in public institutions and the restraints that governments have placed on citizens’ abilities to pursue their dreams and fulfill their individual capacities. While governments may sometimes find such restraints necessary to retain power for a time, they routinely have led to revolution, with governments violently overthrown and replaced by superficially egalitarian regimes.

We know there is a point where excessive inequality and individual disempowerment lead to upheaval – a line which, once crossed, may lead to human disaster. Yet there are no numbers that political scientists or economists can assign to a tipping point that defines “excessive” inequality, of the degree that triggers revolution, nor is there any assurance that revolution will bring something better.

Revolutions, though sometimes necessary, do produce dystopias. There are many dystopian products of revolution around us, among which North Korea of course stands out. Equality of extreme poverty is the norm, wealth and power are reserved to the politically privileged few, and hopelessness defines the life most citizens endure. In such dystopian states, most starkly the one ruled from Pyongyang, the social harm is no longer inequality but the relentless poverty generated by the state’s relentless determination to snuff it out.

In a relatively modern democracy like Canada’s, what drives inequality? Why do we see it in a society like ours, where we try to make opportunity available to everyone, and the state taxes the well-to-do and provides money and support to the less fortunate?

To see why inequality arises, consider a world where everyone starts out equal. Let’s say we all finish school at age 20 and get jobs paying $25,000 a year, to pick a number that is at once modest and one that many 19-to-29-year-olds might be happy to have. Not only that: we all have the same opportunities and the same ability and willingness to seize them, and we do equally well in work and in life.

In this egalitarian dream world, we all start out equal and, because we all have the same skills, drive, opportunity and luck, after 40 years, say, we are still equal. The lowest-earning 20 per cent of the population earns 20 per cent of all income, so does the middle 20 per cent, and so does the top 20 per cent, and the top 1 per cent gets 1 per cent of all income; see the leftmost column in figure 1, labelled “Harrison Bergeron.”

“Harrison Bergeron” is a 1961 story by Kurt Vonnegut describing equal starting places and equal outcomes, even after a lifetime of work and no matter what one’s effort. Vonnegut knew what it would take to deliver complete equality. The athletic and graceful would need weights to burden them, to slow them to the pace of the graceless; the keen-eyed would be fitted with glasses that blurred their vision; and the bright would wear noise-making headphones that stopped them from thinking clearly.

Vonnegut’s vision was a vision of hell, not a meritocracy but a mediocracy, one so numbing that human hope and ambition are squelched to the point of despair.

3_Poschmann_figureFigure 1: Income distributions – simulated and real

For the arithmetically inclined:

To capture the idea of skill, effort and one’s start in life, or luck, I assigned income starting points and skill and effort parameters from mutually independent lognormal distributions. Skill is represented by an income growth rate sampled from a distribution with mean 2.5 per cent and sigma (more or less a standard deviation) equal to 0.5; effort is assumed to have the same impact and to be drawn from a similar but independent distribution. The starting point, meaning starting income, or luck, is drawn from another distribution with mean $25,000 and sigma equal to 0.5. I assume growth rates are fixed over time, with no cohort effects; the reported results reflect the distribution after 40 periods (years).

Now, suppose instead that we start people off in life at identical levels, meaning incomes, but we let them be free. In this world, we are able to take advantage of our skills. Having “skill” can mean you’re bright, or well educated, or you know to grab an opportunity when you see it, or you remember your mother’s wise words or otherwise follow the good common sense that God gave you. Such “skill” is not evenly distributed among us – most of us are middling, many are guileless or have little or no capacity to learn from error, a few of us have plenty of skill, and fewer still are truly rich in it.

In this freer world, effort counts too – hard work can look a lot like brains. Do you stay a few minutes late to finish a project, do you remember to treat every customer like gold and get promoted to shift manager in your first six months on the job? Like skill, the drive to work hard is not evenly distributed among us, but it is distributed differently from skill. That is why there are bright but lazy people who never amount to much, and slow movers who nonetheless rule business or political empires.

Even so, life is not rosy. We are not all dealt the same cards. Some of us fail to finish high school, we are not all good at arithmetic, some of us had parents who sniffed gasoline and some of us had no parents at all. Most of us start life in the middle of the pack, many of us are not quite that well off in starting out, and a few of us have every opportunity available from the get-go, are brilliant and know to take advantage of it. There is an inherited component, and that too is part of the luck of the draw.

These things matter, and when we have different skills and drive, income inequality arises from year one, even if every one of us starts out with the same income. As years go by, small differences mount, and the income difference between those at the top and bottom steadily rises. That happens, as I said, even if starting incomes are the same. If the starting points differ, a little more inequality arises and remains after, say, 40 years. But the starting point is not the main determinant of outcomes – skill and effort matter more over time. In life, having a good start does not mean you’re bright; having a lousy start does not mean you’re lazy; and whether you have a lousy start or a great one does not define what happens for the rest of your life.

To illustrate this, I created a numeric sample of tens of thousands of individuals, and assigned them skill, effort and the start we get in life – meaning starting income, which reflects skill, effort and the luck of the draw when we enter the workforce – using representative, random distributions that look a lot like what we know about the data.

I assumed that these assignments are fixed over time, and let them grow over 40 years, producing the middle bar in the income distribution figure, labelled “Skill, effort and luck matter.”

How well does this statistically driven thought experiment represent real life? That is what I show in the right column, which represents a recent Statistics Canada estimate of pretax market income, distributed by quintile. The similarity between the two columns suggests the processes I describe do a decent job of painting a realistic picture.

My model assigns more income to folks at the low end, relative to “real life.” There are two statistical reasons we might see very low incomes in real-life distributions. One is that the young and old have different earnings patterns from others, and I do not try to model the population’s age composition. The other is that skill, effort and having a clean start might not be independent – put another way, if your parents did not finish high school, the odds go up that you won’t either. What is remarkable, though, is not that there are differences between the middle and rightmost columns, but that they are so similar.

What to do, however, if we think the inequality these processes produce is “too much” inequality?

The likely policy answer seems to be to ensure opportunity. Make it hard for kids to avoid finishing high school. Do not make it too hard to take on an apprenticeship. Make it easy to move from province to province in chasing opportunity. Make sure work has its rewards. Do not punish success, or savings. Pursue open trade and knowledge exchange. Create opportunity where there was none before.

We know that complete equality is at once a chimera and a vision of an impoverished hell. Complete inequality leads to suppression, revolution or most likely both. In between lies opportunity.

A tale told by idiot, full of sound and fury, signifying nothing.

— Macbeth, Act 5, Scene 5

As this edition of Inroads heads to press, the outcomes of loud, divisive and ostensibly important elections in Europe have rolled in.

In France, the charming and occasionally conservative Nicolas Sarkozy fought a losing rearguard action to protect his presidency from the steady assault of his Socialist challenger, François Hollande. Sarkozy’s loss signals the obstreperous French electorate’s rejection of post-crisis fiscal austerity measures, measures which were set in motion by Sarkozy and which, for the most part, they have yet to experience.

Perhaps more than that, the result signals populist resentment and the French elite’s attempt to take a stand against what they see as an overbearing German electorate’s self-righteousness, arising from Germany’s relative fiscal competence. In France, a vote for Hollande was a vote against Chancellor Angela Merkel and thrifty Swabian housewives, one which carried the bonus message of a rejection of the arriviste Sarkozy. German voters in Schleswig-Holstein shared some of this populist sentiment, on Sunday rejecting Angela Merkel’s candidates in a regional election.

In Greece, riots have given way to ritual electoral comedy. In the past 38 years Greece has run elections with four different flavours of proportional representation. The 2009 episode produced a Socialist majority of seats, but not a strong one, owing to the division of votes between the Coalition of the Radical Left and the Communist Party. And the Anticapitalist Left Cooperation for the Overthrow, the Communist Party (Marxist-Leninist), the Marxist–Leninist Communist Party, the Workers Revolutionary Party and the Organization for the Reconstruction of the Communist Party of Greece all won votes, but not seats.

This latest election, in early May, was to be different, owing to a fifth model of proportional representation: the party gaining the biggest share of the popular vote would be granted 50 seats in the Greek parliament off the top, with the remaining 250 seats divided proportionally to votes cast. Yet it seems that the Greeks do prefer comedy to tragedy. The incumbent socialist party, Pasok, came in third, and the conservative New Democracy party, which garnered a plurality of votes, is unable, even with its 50 bonus seats and the support of Pasok, to outvote the second-place party, the Coalition of the Radical Left, and its Marxist flankers. The anti-immigrant Golden Dawn party will vote in parliament for the first time, and the only certain result is that Greek politics will remain as fractious as ever.

Ultimately these elections signify nothing: they cannot address the toxic economic bonds that make fiscal policy a burning cross-border issue within the eurozone.

The toxic bonds are created by the euro itself, which formally came into being in 1998 and represented what was then to be the key step on the road to making the European Union a true federation. Critics at the time pointed out that a political federation typically rests on common interests and a political willingness at least to get along with the other partners – close friendship not required. The federalists’ hope was that prospective members of the union would first be bonded by a common currency, administered by the new European Central Bank (ECB), and subsequently would forge the political willingness to get along. Europe was set on its federalist road with the cart before the horse.

Because the euro by definition imposes a single exchange rate within the eurozone, it eliminates the capacity of member states to devalue their way into market competitiveness. In the face of rising productivity abroad or elsewhere within the zone, member nations were expected to continuously improve domestic resource allocation, and manage labour costs, to maintain competiveness in trade and access to export markets. Nontraded sectors cannot escape – if barbers, taxi drivers and public sector workers receive exorbitant wages relative to their outputs, other businesses and consumers have less purchasing power available to them domestically or abroad.

Hence the euro would in theory impose discipline on domestic labour and product markets, and on governments. Now, euro member governments might be tempted to borrow in the new currency, and so escape some of the competitive pressure on markets and troubles with unions that might flow therefrom. The governing treaty therefore set limits on the size of deficits governments would be allowed to run, and proposed, perhaps incredibly, to levy large fines for exceeding them.

Trouble was not hard to forecast. Even as the euro was born, French politicians stood ready to blame domestic economic difficulties on “unregulated global markets” and their “untrammelled greed” and Anglo-Saxon neoliberals’ presumed desire to discredit the “European model of a social market economy.” Such words served notice in France, as in Greece, that market competitiveness and fiscal probity would founder on nationalist or populist rocks.

The trouble also arose because currency unions, like those among Canada’s provinces or the U.S. states, normally include a centralized fiscal arrangement, like a federal tax authority, and features to support and complement subnational fiscal authorities, such as equalization in Canada.

But in Europe the federal fiscal structure is weak to the point of nonexistence. Writing in the spring of 1998, David Laidler and I observed that “not only is there no obligation on a central fiscal authority to bail out a member state’s government that gets into difficulty, but there also exists no body with the fiscal capacity and political authority to do so.”

It gets worse. The ECB, because it has an inflation-targeting mandate that could easily be blown off course by tending to regional fiscal matters, is forbidden from offering credit to governments or other public agencies. But, as Laidler and I also pointed out, the marketable debt of member governments and of their banks is involved in day-to-day monetary policy.

The ECB is a system comprising the national central banks of the euro members. Those banks’ daily activities include transactions with private banks, such as “repos,” whereby the central bank accepts securities in exchange for providing cash to the private banks, which agree later to buy back those securities. The securities offered as collateral often include claims on own-country or foreigners’ sovereign debt, and because developed-country debt is taken to be riskless, banks need reserve no capital against it, and the central bank does not apply a significant discount to it in tallying up the value of this collateral.

Now, a short view of history, or a casual eye over the modern eurozone, tells us that not all sovereign debt is the same. As Greece has tottered toward default, no private buyer would pay a price for a Greek bond that reflected certainty of being paid back. As talk of default mounted in early 2011, however, the ECB could not acknowledge this reality; it became a (presumably unwilling) accomplice to politicians’ routine refusal to recognize reality and move on to the “work-out” phase. To have marked down the price of Greek sovereign and bank debt would have placed the capitalization of the European banking system severely at risk. Instead, the ECB has participated in endless patchwork proposals to keep the possibility of Greeks’ honouring their debts alive.

All this has meant heavy pressure on the ECB, resisted mainly by the German government, to accumulate member-nation debt. The solution to Mediterranean-nation indebtedness, beloved of economists who would like to see the eurozone steam toward federation status, is that the ECB issue Eurobonds, jointly backed by all euro member states.

How this will play out is unclear, but what is clear is that the ECB, and banking regulators generally, should stop treating claims on sovereign debt as equally riskless. If they were to do so, the ECB would be on better moral and financial footing for fighting pressure on it, and sticking to its inflation mandate. Meanwhile, the fiscal pathologies are such that neither the Socialists in France nor whatever coalition temporarily rules in Greece will have a cure. There is no ready cure within the fiscal capacities of either France or Greece. Austerity measures cannot fill the bill, and what has been achieved to date in Greece may yet be overturned.

Short-term, the ECB may find itself buying more sovereign debt, under the unhappy eyes of the Germans, who ultimately will finance it. Medium-term, the financing packages that politicians currently are working on internationally may evolve into a form of European Monetary Fund, fashioned loosely after the IMF. Success on either front will depend on fiscal competence winning the day among the troubled southern European nations.

The alternatives are few. One is messy individual exits from the euro, wrenching and problematic because the governing treaty does not contemplate the possibility. Yet exiting the euro has entered the realm of genuine possibility. In the wake of news that the first postelection attempt in Greece to form a new government had failed within hours, German finance minister Wolfgang Schäuble said, “If Greece decides not to stay in the eurozone, we cannot force Greece,” meaning, roughly, don’t let the door hit you on the way out.

Option two is to implement side-by-side euro-like currencies, one for the weak countries, another for the stronger: ugly but doable. Talk of a two-speed Europe, once popular in the northern nations, has reemerged.

The third is a euro implosion, dissolution of the euro and return to national currencies across Europe. On the strength of the election results, and a few years of wrenching fiscal and financial performance, I say that the odds of option three have gone up.

First-past-the-post brought the change that voters were looking for

I write in the aftermath of the May 2 federal election, amid a wide-eyed and surprised electorate. From that surprise I draw some thoughts on voting systems and behaviour, and make some predictions about agenda-setting.

The surprise, of course, is the product of an election that, at its outset, was quite emphatically an election about nothing – one which brought to the surface very few significant policy distinctions among parties and where no scandalous behaviour seized or held public attention. Political leaders and their spokespersons made mistakes, but there was no single vote-polarizing issue evident at the outset, and no single game-changer as the election wore on.

And yet this election-about-nothing drove a meaningful increase in voter turnout, delivered a clear majority mandate to Stephen Harper’s Conservative Party of Canada, dealt a crushing blow to the near-term hopes of the Liberal Party, removed the Bloc Québécois as a political force in Quebec or anywhere else, and firmly installed the New Democratic Party as the official opposition. This unexpectedly clear outcome, this sharp delivery of change to the political landscape, reflects a system that worked. Our archaic first-past-the-post election machinery produced the sort of change that many voters seemed to want and expect.

This rehearsal of numbers pitches actual results against those that would flow from a purely hypothetical proportional norm, fully recognizing that if our system was in fact proportional then parties and voters might have behaved differently. My message, however, is that the existing first-past-the-post mechanism delivered profound change, when so many observers argued that it could or would not.

To be clear, the regional dimension to Canadian voting, and likewise the distinction between Quebecers and voters elsewhere, is hardly new. Nor is it new that vote splits should matter. The regional results of the actual vote, however, do matter in interpreting the political message. One key point is the newly gained, or regained, confluence of political interests between Ontario and the western provinces. As distinct from a generation ago, the Conservative Party’s voting strength, its majority, derives from seats in the west and Ontario, not the west plus Quebec. And this is a result not of change in the west or Quebec, but of Ontario voters’ at least temporary rejection of the federal Liberal Party’s agenda. Things are different in Quebec, where all the usual parties were rejected but the NDP resonated as a resting place for discouraged voters. Hence Quebecers will now be represented by a party mostly lacking operational infrastructure within the province and, for the near term, the ability to operate in French. An odd state of affairs, but one chosen resoundingly by those same voters.

While claiming success for the first-past-the-post electoral mechanism, owing to its demonstrated ability to capture regional dynamics, I hasten to add that mixed-member or multimember proportional systems, a common mechanism for implementing proportional representation, are capable of capturing some of these elements. But in doing so, they are simply capturing what first-past-the-post already does well. The bottom line for this election is that Canada’s creaky old mechanism delivered change where little might have been expected. And lest the point be missed, the new configuration reflects a regional division that again leaves Quebec with a limited role within government. That will matter on some important agenda items that the Conservative majority may wish to address:

  • On corporation income tax relief, the Conservatives’ program clearly has the approval of voters. However, it is one of the few economic areas where the cleavage among parties is abundantly clear, and Quebec’s views will be represented through the NDP’s opposition to the government and to the tax relief agenda. Yet it seems likely that this is one area where the government’s view will dominate easily, and one unlikely to generate significant public unrest in Quebec.
  • The Conservative government’s agenda also contains a commitment to a national regulator for securities markets. The issue is before the Supreme Court at the time of writing; if the Court sides with the government, the Conservatives will be emboldened to push forward their plan, which will be supported in Ontario. However, the push for federal paramountcy runs headlong into a traditional area (property) where provinces’ constitutional primacy has historically been recognized. It is an understatement to say that such a push will not be well received in Quebec, and it may achieve some resonance among the public for that reason.
  • Agricultural supply management, particularly with respect to dairy and poultry farming, holds back the development of Canada’s food processing segment, raises prices to consumers and presents a barrier to international trade liberalization. The Conservatives have committed themselves to defending the dairy cartel, but this is one area where economics may successfully militate for a change to the political agenda. It is a mercantile issue for Quebec farmers, and they represent a powerful political constituency; proposals for change, however incremental, will attract fiery opposition. That said, if there was a time and opportunity for a government to implement change in this realm, it is now.

Taken together, Canadians’ voting choices have delivered extremely interesting change to the political landscape. This fact, I believe, will defuse the calls for electoral reform that might otherwise arise from unusual vote splits. Whether important policy changes will arise from the current configuration of government is another question, which only the passage of time will answer.

Economists have not had a good war. In the battle over how to understand and respond to the recent financial crisis and recession, few have emerged covered in glory and medals. Indeed, some economists and economic ideas have been tarred as the proximate causes of the waves of financial destruction that swept the Western world and elsewhere.

As is often the case, some of the sharpest shots have been unfriendly fire from within the profession. The most prolific – and prominent – sniper is surely Paul Krugman, an eminent Princeton University economist who for years has been shooting from his perch as a regular columnist in the New York Times and an occasional contributor to the paper’s weekend magazine.

Paul Krugman

Professor Krugman is brilliant, and there are few students or instructors of economics who have not read carefully his work on trade theory, to pick one area in which his influence has been significant. Even his polemics are well done. His much-circulated essay on the state of macroeconomics1 is a useful overview of the divides within the economics business – even if it did suffer from his tendency to employ straw-man caricatures of financial economists, his choice bêtes noires, who are all described as idiots savants whose naive trust in economic models to assign prices to financial assets was obviously silly.

But since taking on the role of public intellectual in the past decade, Krugman has allowed his passionate distaste for everything connected to George W. Bush to distort his writing and perhaps to undermine his credibility.

One example, a recent New York Times column,2 begins by attacking Republicans for expressing doubt about the value of a public health insurance option, in other words a government-run health insurance component similar to what prevails in Canada. The Republicans are, I submit, undertaking a legitimate debate over health care funding and insurance (a debate mostly absent in Canada, I feel compelled to point out). Krugman quickly shifts to an attack on growing income inequality in the United States since 1980:

Moreover, most of whatever gains ordinary Americans achieved came during the Clinton years. President George W. Bush, who had the distinction of being the first Reaganite president to also have a fully Republican Congress, also had the distinction of presiding over the first administration since Herbert Hoover in which the typical family failed to see any significant income gains.

And then there’s the small matter of the worst recession since the 1930s.

There’s a lot to be said about the financial disaster of the last two years, but the short version is simple: politicians in the thrall of Reaganite ideology dismantled the New Deal regulations that had prevented banking crises for half a century, believing that financial markets could take care of themselves. The effect was to make the financial system vulnerable to a 1930s-style crisis – and the crisis came.

Here we have one more sharp poke at George W. Bush, embodiment of a “Reaganite” ideology that supposedly bears the blame for all that has gone awry in America – from income inequality to the current recession. On this telling, a misguided trust in markets lay at the root of the United States’s recent financial and economic debacle. What is intriguing about this passage is how political animus has led to selective historical omissions.

So some background. The primary “New Deal regulations that had prevented banking crises for half a century” are embodied in the Glass-Steagall Act of 1933. In the 1990s, a series of mergers put the companies that had become Citigroup, a bancassurance conglomerate, offside of Glass-Steagall owing to the combined firm’s wide-ranging financial activities. A congressional initiative – led, yes, by Republicans – sought to bring the legislation to where the market had already moved. (The ordering and timing was different, but much of the same happened in Canada in the last two decades, enabling chartered banks to buy brokerage houses and engage in a range of other activities.)

The key U.S. reform legislation was passed in 1999, which I remark because the President of the day was of course neither George W. Bush nor Ronald Reagan, but Bill Clinton. President Clinton, in his second term, faced a Republican congressional majority. The House of Representatives and the Senate had clashed over the contents of the reform bill, but Congress agreed on changes that gave financial regulatory reform an overwhelming bipartisan majority. There would be some deregulation, but it would be coupled with consumer-oriented measures intended to give a broader mandate for the Consumer Reinvestment Act. Under this legislation, banks could do more lending than before, primarily mortgage lending in lower-income neighbourhoods, specifically to racial minority borrowers.

And there is the rub. Readers of my last essay in these pages3 may recall that I gave some of the history of the dramatic expansion of government-insured mortgage lending in the United States, which more than any other single factor lay at the root of the financial debacle we have just witnessed. Arguably well-intentioned members of Congress, who saw political favour in directing more credit into disadvantaged neighbourhoods, entered an unholy alliance with neoconservatives, also arguably well-intentioned, who also encouraged home ownership for people who perhaps ought not to buy a house because they could not afford to do so. The initiative drove up the U.S. home ownership rate, notably at the low end of the real estate market.

The alliance that underpinned these changes benefited numerous lenders and securitizers, who became very rich by bundling together doubtful and good mortgages and selling them on to government-controlled mortgage underwriters and insurers who were encouraged, or required, by Congress and the White House to take on enormous risks on behalf of taxpayers. The key state agencies, Fannie Mae and Freddie Mac, now insure or hold on their own books $5.5 trillion in mortgages.

In turn, investment banks in the United States, plus organizations like state-controlled German banks, traded and invested heavily in the securitized mortgages that backed the lending I just described. Investment banks such as Bear Stearns and Lehman Brothers, as well as the large mortgage lenders, many of them government-backed, came under the gun as the lending market they had facilitated unravelled over the course of 2007 and 2008. These investment banks and financial institutions found themselves in trouble because they had imagined they fully understood the risks in the government-sponsored mortgage securities markets they had helped create. They didn’t.

And that brings me back to Professor Krugman. The history I have just summarized is hardly obscure, but neither is it well understood. This history is required to parse the “Reaganite” and George W. Bush roles in the financial meltdown and recession. Krugman, in his political animus, does not provide it. Thereby, he ceases to be a “public intellectual” and becomes more of a partisan ideologue.

Consider this Web addendum to his summer 2008 defence of Fannie Mae and Freddie Mac, the state-sponsored mortgage lenders:

What you need to know here is that the right — the WSJ editorial page, Heritage, etc. — hates, hates, hates Fannie and Freddie. Why? Because they don’t want quasi-public entities competing with Angelo Mozilo.4

Angelo Mozilo was head of Countrywide Financial, the largest of the aggressive private mortgage lenders. No honest assessment would conclude that Fannie and Freddie were Countrywide’s competitors; they were mutual enablers. The people who ran these institutions did business with each other and became rich doing so, and they lobbied and funded the legislators who oversaw their activities. A misunderstanding of this underlying political economy seems to have led Krugman down a garden path.

Academics’ getting excited and motivated by politics is nothing new. Yet there is always a cost, and that is the trouble when partisan animus overshadows thoughtful policy discourse. An early victim can be the truth.

Continue reading “The Hubris of the Public Intellectual”

Western governments have pumped trillions of dollars into financial markets in the past few months in an attempt to shore up trust in them. This expense exceeds by many multiples anything ever spent on recovery from an earthquake or hurricane, and is more on the scale of a largish modern war. Such a scale indicates the value of trust to financial markets, and its key role in enabling modern society to function.

Society requires financial markets so that people can do things like use credit to buy a car or house, or build retirement funds in pension plans, or invest personal savings. One crucial part of the system is financial intermediation. For example, I might like to borrow to buy a house with an interest rate that is fixed for five years, but on my own it might be hard to find someone willing to lend to me on those terms, or to communicate the reasonable certainty that I will pay that person back. That is where intermediaries, such as banks, come into play.

By accepting deposits from someone else or, for example, selling five-year guaranteed investment certificates (GICs), and lending the proceeds to me, intermediation makes markets work better. The person who invests in GICs is better off than if she lends directly to me, because she does not have to seek out information about my ability to pay off my mortgage, and can rely instead on her assessment of the bank’s reputation – or on its public financial statements and reports to government regulators – to establish her confidence that she can get her money back in five years.

The bank, in our example, takes on a commitment to honour depositors’ potential future withdrawals, or to honour a redeemed GIC, yet it becomes exposed to the risk that I might not be able to repay my mortgage. What if the bank could reduce the cost of bearing that risk? It could then afford to charge me less for my mortgage, or pay depositors a higher rate of interest on their savings, or pay employees more wages or shareholders more dividends.

This is where the next level of intermediation comes into play. The bank could pool together mortgages that it holds on homes in different regions, or of different maturities or sizes. It could then sell partial interests in that pool to other investors looking to earn returns by lending at prevailing mortgage market interest rates – higher than they could earn in a bank account – in exchange for taking on some of the risk that some borrowers may fail to repay. The proceeds of selling these interests would be used to honour the original GICs, and these third-party purchasers would earn their returns from the stream of income generated by monthly mortgage payments. That is why the partial interests they buy from the bank are called mortgage-backed securities.

And that is where it all started

One of the differences between the world as it is now and the world as it was in 2007 is that there are now few people in Western countries who have not heard of mortgage-backed securities (MBS), for it is these instruments of intermediation that lay at the heart of the recent financial market debacle. And it is the failings of the U.S.-government-guided system for generating and distributing MBS, and misplaced trust in that system, which must shoulder the biggest burden of blame.

In a typical mortgage market transaction in the United States, a financial institution’s loan officer receives, sometimes examines, and approves (for a fee) a mortgage loan application. To avoid having the institution retain significant residual risk on its own balance sheet, the loan is often sold on to or insured by one of two government-sponsored enterprises, known as Fannie Mae and Freddie Mac. In fact, the market for underwriting and insuring home mortgages, and hence the market for MBS in the United States, has for years been dominated by Fannie and Freddie which, while shareholder-owned, are governed as to what they can and cannot do, and the terms under which they do it, by federal legislation.

So what could go wrong? The answer appeared in a Steven A. Holmes story in the New York Times on September 30, 1999:

Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers, whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates – anywhere from three to four percentage points higher than conventional loans.

“Fannie Mae has expanded home ownership for millions of families in the 1990s by reducing down payment requirements,” said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer. “Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.”

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.

“From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison, a resident fellow at the American Enterprise Institute. “If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

Fannie and her private-sector coconspirators sought aggressively to expand their loan books, and they generously funded their congressional champions. The market expanded by trillions of dollars, and institutional investors in the United States, Canada, Europe, China and elsewhere invested in the securities that underwrote U.S. mortgage borrowing. Those investors did so because notwithstanding official denials, they guessed – correctly – that the U.S. government would be forced to backstop the loans should anything go badly. And thus did regulation and confused financial and political incentives shatter the ordinary trust that ought to have governed the parcelling out of ordinary mortgage market risk.

Few among us who spotted the risk Fannie Mae posed also guessed how broadly the poisoning of trust could spread thereafter. Financial institutions that ordinarily lend to each other cheaply in the short-term and overnight markets began this summer to hoard cash instead: they needed to be ready to honour debts if called on, and they had a difficult time establishing that their counterparties’ assets were of sufficient security that they, in turn, could repay if called on. More recently, counterparty risk has put sand in the wheels of large banks’ day-to-day currency transactions, potentially limiting the ability of people and businesses to undertake ordinary crossborder trade.

If financial institutions were to become unable to facilitate ordinary buying and selling of houses, cars or groceries, if people could not save or invest with sufficient confidence that they would get their money back when they needed it, then we would be in grave trouble indeed.

That, in turn, is why governments have been feverishly backstopping financial institutions and pumping financial capital onto their books. Banks need to know that their counterparties have the capital to withstand fresh shocks to their asset values, and depositors need to know that their banks are financially stable. It is an unfortunate situation, and one that perhaps did not need to happen, but it is the one we are in. As the months wear on, we will learn how much trust governments can buy with trillions of dollars.

A few blocks north and slightly to the east of the Capitol in Washington, D.C., there is a post office. Around a quarter to midnight on April 15 this year, I happened to be walking by (don’t ask why). One thing, then another, grabbed my attention. The first was that traffic was heavy as I neared the intersection of 1st NE and Massachusetts Ave. Since the downtown office core of Washington goes into a deep, fitful sleep at night, traffic is an oddity.

The second thing I noticed (hardly a feat of observation) was a handful of men and women weaving among the cars that stopped at the light with the seemingly slow ease and fleet steps of squeegee kids. Unlike squeegee-wielders, however, they were not kids, they were wearing reflective vests, and they had a singsong call that I could not easily make out amid the partylike din.

The people moving amid the traffic, no doubt out of sight of occupational health inspectors, were carrying shipping boxes of a very familiar sort – they were stackable bulk mail boxes. On noticing that (pardon me for slowness), I realized what was going on. The squeegee-like crew were postal workers – I assume on time-and-a-half at least, which I could hardly begrudge them – and April 15 is tax day in the United States. The people driving by were meeting their tax-filing deadline, and the singsong call was the posties’ message to “drop returns here, tax returns!”

And that prompted a moment’s reflection. The U.S. Postal Service and the U.S. Internal Revenue Service are institutions that receive almost ritual torment in public, at least some of it justified. They are perceived as slothful, unresponsive, lazy on the one hand and too energetic and vengeful on the other. To liberty-minded Americans, these two institutions also symbolize the overbearing state. They are, one might imagine, not much to be trusted.

Yet here were Americans, whose financial well-being could depend on delivering tax returns by midnight on the 15th, driving down the street near the post office and trusting that dropping their returns, cheques stapled inside, into a box carried by someone wandering among traffic would mean that those same returns would be accepted by the post office within minutes, postmarked, delivered to the IRS promptly and there accepted as delivered on time. There are several risks involved there, and potential points of failure even if good intentions prevail.

The scenario I describe, I thought, was a remarkable display of public trust in institutions well known for their uneasy public images. Why remarkable? In many countries, the transactions I described would be unlikely to happen. If they did, they would require an ex gratia payment, a bribe, to intermediaries. Another way to look at the sight of citizens casually passing important documents to strangers in the middle of the night is to consider the large number of developing countries where the notions of self-assessing and even paying taxes would be all but unthinkable – and that’s not to mention dropping unreceipted documents at the roadside, in the naive expectation that they would arrive whole, at a prescribed pace, at their intended destination.

What is remarkable about successful societies is that non-naive residents do expect transactions involving strangers and casual acquaintances to be successfully completed – and, in the main, happily resolved. Not all of them of course, but a big enough share of them that trust in the system prevails. After all, if such transactions failed too often, the trust that underpins them would swiftly evaporate. The implication would be that more resources would be devoted to verification and enforcement, successful transactions would be more costly to execute and fewer of them would happen. Lack of trust would put sand in the wheels of interpersonal transaction, slowing the flow of human and financial resources to their most valuable uses and making us all the poorer for it.

Which is just another way of saying that trust in one another and trust in institutions is a valuable asset or, in the now well-known economic jargon, a form of social capital. The trust that permits us to engage in transactions with people when we have less than perfect information about them or their ability to execute the commitments into which they enter can be interpreted as a capital asset that a society or community may or may not possess. Social capital improves the ease with which our efforts, our property or our financial capital can be traded with others. That makes the attributes we control more productive. We trade our time, or the things we own or produce, until they find their most valued use. The ease with which we are able to do so raises the usefulness of the resources within our collective possession. Social capital, while an intangible asset, improves a community’s productivity.

Think of two communities, each possessing similar access to natural resources, human and financial capital and people able to work. The community which is able to steer resources more smartly is better able to convert those resources into products and services that they and their trading partners value. Trust, or social capital, facilitates this conversion, so it helps to think of trust as an asset analogous to human capital, which boosts the productivity of a community’s natural resources and physical capital.

That people (much of the time anyway) display trust when dealing with members of their family or tribe, where it is relatively easy to verify and enforce the terms of a deal, is unremarkable. But trust is an enabler when it comes to dealing with strangers and casual acquaintances. It takes on a special value when dealing with new relationships, and when verification and enforcement are not so simple.

Game theory – and simple experience – show that, when engaging with new parties, individuals fare better if they begin by trusting. If both sides to an exchange trust each other initially, more happy exchanges take place. The most successful strategy is tit-for-tat – as in, trust a new pizza shop enough to try it, but if the owner reneges on the implicit deal by delivering a cold pizza with minimal toppings, punish him immediately by shifting your trade elsewhere. The process of building and reshaping trust networks is all around us.

New communication and information technology has a role to play in reinforcing and extending trust networks. EBay’s scoring system for establishing sellers’ reputations is an electronic trust network built from scratch, and built precisely to facilitate the growth and profitability of the exchange web. Improved, computerized consumer credit scoring systems facilitated a boom in U.S. home ownership and a huge securitized mortgage market.

These examples point to something else – trust networks can be gamed. Shady sellers try to puff up their online identities through phantom trades and adopt multiple identities, specifically to steal some of the benefit of others’ trust in the trust network itself. Mortgage originators, who profit from connecting borrowers to lenders but whose financial incentives are unaffected by whether debts are repaid, routinely failed in recent years to verify borrowers’ abilities to carry credit, contributing to an inflated (and eventually deflated) U.S. housing market.

The message is a familiar one from international arms negotiations: “Trust, but verify.”

Of course, trust with verification can feel like not much trust at all. A border security officer inquiring after your travel documents hardly conveys an initial stance of trust. But it is part of the process, because once credentials are established, personal travel and trade can proceed apace, and border agencies make significant investment in information systems to facilitate exactly that.

Frequent travellers across the Canada-U.S. land border take advantage of special identification cards, electronically establishing that they are who they say they are, and they travel to and fro across the border all but unimpeded. Businesses that trade goods across the border likewise take formal steps to establish their credentials, and comply with reporting procedures so that their shipments quickly cross the border. And a good thing, too, because visual inspection of every Canada-U.S. crossborder shipment would be tantamount to closing the border, impoverishing both sides. That means verification is an essential part of keeping the trust system working to our mutual benefit.

Now what about those late-night taxpayers, dropping their returns by the roadside? They are relying on the credibility of the postal service, and personal experience indicating that when you give an envelope to someone who looks like a postal worker, it will be postmarked and delivered on time and unmolested. More and more, such exchanges will be supplanted by computer communications verified by electronic signatures, and the trust network will be less visible to us. Meanwhile, we should be happy to see that trust exists and can be traded on, even on dark corners in the dead of night.

I suspect that millenarianism surrounds us: not a radical or religious millenarianism, although these thrive in numerous trouble spots around the world, but a muted and diffuse strain. It is a mode of thinking in Western culture that wears disguises and creeps into political thought and speech and into our daily lives.

This muted millenarianism keeps many of us ticking, and is not a bad thing. It helps us through mundane, material and sometimes manifestly important moments in our families and careers. Such a moment could be a cosmically modest but nonetheless life-changing event such as buying a house or car or moving neighbourhoods. It could be as straightforwardly material as a promotion that will make all the difference, we think – perhaps rightly so – between where we are and the professional happiness and financial stability that we seek. Or it might be a cusp in our personal lives, a defining event such as a marriage or divorce that distinguishes the known, imperfect past and present from a possible, presumptively happier future.

So I paint a picture of a muted millenarianism. It is not a grand millenarianism that predicts an end to the familiar world and, after the last cataclysmic battle, a perfect peace. My millenarianism is a simpler, casual observation: many of us, individually and collectively, routinely allow ourselves to be driven by the sometimes correct notion that there is a hump to be got over, after which everything will get better.

Do you see yourself yet? You might not be an aggressive socialist or an Islamist or a harsh evangelist of the Christian right – these are clearly grand millenarian tendencies, and perhaps linked to the new millennium in the case of the Christian right. But perhaps you support Quebec nationalism. Or proportional representation. Or fundamental tax reform.

Let’s take them in turn.

Quebec nationalism, although now at a weak juncture, has always found its strongest support among the middle-class, vaguely left intelligentsia, and among rural residents, especially in the north and east of the province where income and education levels are low. While Quebecers are far better off, materially, than rural counterparts in southeast Asia or the Middle East, populations of relatively low socioeconomic status tend to be fertile ground for apocalyptic movements. The Quebec nationalist movement, while not apocalyptic, is millenarian in political or cultural terms.

Among the political and academic elite – more intertwined in Quebec, arguably, than elsewhere in North America – nationalism has been an avant-garde or politically enlightened stance, and especially attractive to young voters. However, the appeal of the movement has hinged on the notion that, absent the English oppressor or the cultural imperialism of English-speaking North America or, more coolly, a domineering centralist hand in Ottawa, political and personal fulfilment would be more readily achieved.

By implication, the political success of the nationalist movement has depended little on the economic, political or cultural arguments of the nationalists, whatever their merits. Instead, in elections, where the Quebec rural vote counts heavily, millenarian themes hold great sway. To be blunt: on this view, the electoral success of the nationalists has depended on convincing voters that, once over the particular political and legal hump of achieving sovereignty, then cultural freedom, family happiness and economic security (or getting that personal promotion) all fall into place. Any of these things might be true, if unlikely, but it is their millenarian appeal that draws in votes.

Consider next the champions of proportional representation – now commonly known as electoral reform – whether in Canada or other first-past-the-post jurisdictions. They allege or believe many things, such as that voters’ happiness is impaired if their ballots are “wasted” in voting for unsuccessful parties or for successful candidates whose success did not require their vote. To supporters, proportional representation offers more fairness by making political representation for small parties more likely or by putting more female or minority candidates into office or, more generally, by ensuring that the views of those whose votes were too few to elect a legislator in a particular region might nonetheless win legislative representation in proportion to their numbers across the entire electorate.

Viewed dispassionately, these hopes are unlikely to be realized. For instance, it is hard to imagine how quality of life could be improved significantly if more small parties were represented in Parliament, or how that would boost “fairness” in political life in an objectively measurable way. And an increase in representation for women and minorities would be possible only if parties happened to choose their electoral lists in a fashion that produced such a result (empirically speaking, they do not tend to do so under proportional representation any more frequently than under first-past-the-post).

Yet taken together, the hopes attached to proportional representation generate evangelical fervour among supporters, however implausible the individual claims. Group dynamics count for much in this arena. Millenarian impulses have repeatedly overtaken the “citizens’ assemblies” that governments have sometimes selected to vet ballot proposals. That this would happen is scarcely surprising: when individuals offer to serve on such bodies, when they give freely of their evenings and weekends to hear lectures and supplications on the evils and benefits of one or another electoral system, they inevitably form mental images of a better life after the reform. And to the extent that citizen-assemblers select themselves, they will be those with a predisposition to contemplate reform. As we saw recently in Ontario and British Columbia, it can be no surprise that the respective citizen assemblies overwhelmingly plumped for a new system. To opt for the status quo would have been to imply that their commitment to the process was a forlorn cause: far better for the soul, instead, to believe that political salvation is ready to hand, if only other voters could see it.

Now consider fundamental tax reform, another common cause that is vulnerable to millenarianism. Fundamental tax reformers’ salvation is economic. They believe that once the tax rate is flat and excessive progressivity is stamped out of the income tax system, or once a national sales tax has displaced the income tax entirely, or once the capital gains tax is lifted completely, then our individual economic fulfilment and thereafter personal happiness can finally be achieved. The appeal of the tax reform impulse has driven successful political movements, though not as many as has nationalism. Fundamental tax reform has been implemented in some jurisdictions, though not in as many as proportional representation.

A supporter and beneficiary of proportional representation recently said to me that after making the switch, the electorate found that the worst fears of the fiercest opponents were not realized – and neither were the fondest hopes of the earnest reformers. Could the same be said of fundamental tax reform? Perhaps: economists have wrestled to demonstrate the economic benefits of tax reform empirically, but with only small success.

It seems clear to me that millenarianism should be tamped down in policymaking. It clouds thinking and risks confusing hopes and dreams with likely outcomes. But we cannot eliminate it, nor should we to: hope and optimism give politics its energy and, without that, beneficial change cannot happen. Bernard Shaw claimed (I paraphrase) that the possibility of change depended on the existence of unreasonable people.

The way to harness millenarianism, in tax policy for example, is to focus on the merits of incremental gains. If changes to the tax system improve the ease with which human and financial resources flow to their best use, then our economic potential is indeed increased. And small increases in the potential for economic growth translate at the national level into very large dollar amounts. Small, permanent gains in growth equate to huge gains in broad social welfare – but they may not be readily visible to every family’s eye. That these gains might fail to transform the world is no reason for forgoing them.

Readers would be right to suspect that there is a warm spot in my heart for millenarianism in tax reform, a warm spot I do not have for nationalism or proportional representation. In the last two cases I do not see incremental gains offsetting the costs and risks of sweeping change. My stance is not a half-cheer for millenarianism, but rather a grudging admission that I am a cautious optimist. Sadly, this is a stance that seems unlikely to launch a political movement.

7-Patrick-Monahan-printA discussion with Patrick Monahan

Patrick Monahan, LLB (Osgoode), LLM (Harvard), has been a member of Osgoode Hall Law School’s faculty since 1982 and Dean since July 2003. Between 1986 and 1990 he was senior policy adviser to the Attorney General and Premier of Ontario and played a key role in negotiating the 1987 Meech Lake Accord. Professor Monahan was also a driving force behind the Clarity Act that established the Quebec government’s duties in any referendum on secession, and in 2004 argued before the Supreme Court on behalf of a group of senators who intervened in the groundbreaking Chaoulli case that has reframed provinces’ health care responsibilities. He spoke with Toronto policy analyst and Inroads associate editor Finn Poschmann in the summer of 2005.

FINN POSCHMANN: A generation of Canadians has now grown up with a Charter of Rights and Freedoms grafted onto a postmodern Canadian constitution. And today we are amid a flurry of major cases in Canada and the United States that test the relationship among the courts, governments and society. It seems time for a retrospective look at Canada’s experience with a written bill of rights, a Charter that has elevated and solidified the role of the courts. Admittedly, it remains incomplete, as it must until the Province of Quebec agrees to sign. The Charter is also somewhat tentative, in fact an oddity among Western democracies, in having retained a notwithstanding clause (section 33) that permits governments to abrogate recognized Charter rights should they explicitly choose to do so.

PATRICK MONAHAN: I had an excellent view of the patriation process, working as I was as a Supreme Court law clerk at the time of the Patriation Reference.1 In fact, I was clerking for the late Justice Brian Dickson, and his position was that an accommodation needed to be made. I was certainly sceptical about the Charter – sceptical about the implications of transferring power from the legislatures to the courts. Ultimately though it is a matter of accommodation and tradeoffs; the provinces were rightly jealous of their legal powers and hesitant about yielding more room to courts in shaping the law. Securing an agreement meant striking a balance that reflected those accommodations, and section 33 was part of that balance.

FINN POSCHMANN: The obvious question is: Did Canadians get what we expected? There was much public debate in the runup to April 1982 – the public and the premiers certainly had a set of expectations about the course we were setting on. Did they expect that course to lead, for instance, to events like provincial courts instructing legislatures on who would be permitted to marry?

PATRICK MONAHAN: While that particular question would not have occurred to anyone in 1982, if the issue is, Did legislators understand that this involved a major transfer of power to the courts?, I think the answer to that is yes.

FINN POSCHMANN: Let us try to look at that straightforward answer through a 1981 filter. As I mentioned, there was a huge amount of public debate on the specific content of the Charter. This included close argument over the grounds under which discrimination would be forbidden – the hot-button example of the day was whether a private landlord could be required to rent premises to a homosexual couple even if he or she passionately disapproved. The answer given by provincial premiers was no, sexual orientation would not be listed among protected grounds, and in fact of course it was not. Yet Canadians learned very quickly, after April 1982, about the concept of like grounds, and discovered that the courts had a broad view of the degree to which the list of protected grounds could or should be given expansive reading. More expansive, at least, than most voters surely expected.

PATRICK MONAHAN: All the same, the premiers were concerned about these issues at the time, and the wording they agreed to was broadly written. That was not an accident, and of course the list of covered grounds in section 15 was intended to be read in a nonexhaustive fashion.

FINN POSCHMANN: But did Alberta Premier Peter Lougheed nonetheless expect the result?

PATRICK MONAHAN: Premier Lougheed was certainly aware of voters’ sensibilities, and that is why he pursued the notwithstanding clause. That clause permits governments to override the fundamental rights discussed in Charter sections 2 and 7 through 15, provided they expressly do so in legislation, which in turn requires reenactment after a five-year sunset, if legislatures so wish. However, Lougheed may not have had a proper understanding of the political difficulty of using the section 33 override. What he and other premiers have since found is that the popular opposition to using the notwithstanding clause to abrogate Charter rights is in fact quite formidable.

Moreover, as you suggested, there were public debates on just these issues, and the bill ultimately reflected those and the various governments’ efforts to accommodate the concerns that were raised. We need today to take seriously that we made those tradeoffs, with eyes wide open, in pursuit of a Charter that did the things we wanted it to do. Hence today we should not be surprised that laws are struck down from time to time; we created the Charter explicitly to empower individuals in exercising their basic rights and to give the courts the tools to ensure that Canadians could exercise those rights.

FINN POSCHMANN: True enough, and at the fall 1981 first ministers’ conference Allan Blakeney said the notwithstanding clause would allow “Parliament and legislatures to override a court decision which might affect the basic social institutions of a province or region and this is fully consistent with the sort of argument we have put forward that we need to balance the protection of rights with the existence of our institutions which have served us so will for so many centuries.” Blakeney’s identification of the tradeoff is reasonable as far as it goes. He does not make clear, however, whether he expects societal gains from a constitutionally entrenched Charter. In your view, what have been the gains? How are Canadians better off?

7-Queen-signingPATRICK MONAHAN: In the long haul, restraint of the executive is where the big gains have been found. An important example is restraint of police practices; without the Charter there would have been little leverage for Canadians seeking to ensure that police forces adhered to Western norms with respect to personal security, privacy or restrictions on search and seizure. Some of the earliest Charter cases were concerned with the manner in which evidence was secured, and Canadians today have a clearer view of their rights in matters such as search and seizure. We would not otherwise have had this clarity.

Another positive development is the discipline the Charter has placed on government decision-making. In other words, the peace, order and good governance directive is a shield for government choices that must be explicitly invoked – governments must explicitly justify restraints on Charter rights, and placing on government of the onus to do so is an important gain. That is what we saw with the Chaoulli decision,2 which we should discuss.

FINN POSCHMANN: Before dealing with this recent decision, I would like to take you back to the reason I described Canada’s constitutional arrangement as postmodern. The people who assembled the Charter in the early 1980s regarded many debates about the shape of society and proper modern law as settled. They perceived themselves as part of the triumphant progressive viewpoint; they felt that “we” knew better than the “they” of the past, and could right past wrongs through measures such as affirmative action. Hence Canada’s Charter has 15(2), the section that permits discrimination on otherwise prohibited grounds if such discrimination is intended to achieve currently favoured goals – such as preferential hiring of people of race x or y. Now some of us may believe that stance unwise, even if it has broad approval, and certainly unwise to enshrine constitutionally, with the result that the stance becomes extraordinarily difficult to shift in law.

Contrast this experience with U.S. history, where such pivotal social questions remain open. The relevant example is Bakke, which placed limits on those who would pursue socially approved racial (reverse) discrimination, and subsequent debates over preferences in university admissions in California, Texas and elsewhere. Social pressure successfully reversed a trend toward burgeoning racial preferences and – this is the important thing – there was energetic public debate that resulted in political choices being made (in California for example) that were subsequently sustained by courts. The courts themselves were not agents of social change, in these cases, notwithstanding complaints from U.S. politicians about judicial activism. Coming back to Canada, our constitutional authors saw such core social questions as settled, and the Supreme Court has subsequently seen itself as an agent of change that would implement the progressive vision of the future set in train by the legal elite of the day.

PATRICK MONAHAN: Again, as time goes by, choices do have to be made. The Charter is malleable and you have to remember that it was intentionally made so – and, accordingly, today we have more room for growth and room for changes to public understanding of things that are and are not in Charter.

Consider section 7’s guarantee of life, liberty and security of the person. At the time it was not clear to everyone, including the Justice Minister of the day, what the section added to similar guarantees already contained in the Canadian Bill of Rights (the Diefenbaker Bill), guarantees which were largely limited to procedural rights. Yet by 1988 the Supreme Court had used section 7 to strike down section 251 of the Criminal Code, which had set limits and conditions on access to abortion. There you have an example of the courts giving life and current contextual meaning in a manner not contemplated at the time the Charter was framed.

FINN POSCHMANN: Indeed, the living tree imagery is ubiquitous. But why should the Supreme Court see vested in itself a role in actively nurturing that tree? Why should it be a gardener of social change? The living tree image, a constantly changing world framework, is an inherently progressive image, and there is no mistaking the Court’s belief in progress. Decisions cite Peter Hogg on progressive interpretation of the Charter, and the Chief Justice has been heard to speak as if the only constraint on judicial activism is not wanting to be too far ahead of the broad public in pursuing a progressive vision. Should not the Supreme Court, vital institution that it is, adopt a more sceptical view of progress, seeking instead to cement in place those rights that we collectively are quite certain to be enduring ones? It is, after all, an institution that derives its authority from custom and tradition, whose authority needs to be jealously guarded – for the Court to have the political capital in hand that permits it occasionally to render controversial decisions.

PATRICK MONAHAN: The courts are active at the legal margins, and so they should be in defence of minorities. That is what the Charter is about. Majoritarian or populist views are easily expressed through the political process and ultimately in legislatures. The problem is when those views, or their legal outcomes, begin to infringe on individual rights or what we suspect should legitimately be regarded as Charter rights. If we believe a given right properly belongs on that list, we must rely on the Court ultimately to place it there, exactly because a populist majority might not be so inclined. From the point of view of the popular majority, however, the Court’s actions will be perceived as pushing social boundaries. Again, however, being active at the legal margin is exactly what the Supreme Court must do; courts act against arbitrary actions, in defence of minority rights, exactly because that is their job.

Let me point out, however, that even conservative political scientists like Ted Morton of Alberta use Charter arguments, quite inconsistently in my view. I think you cannot have it both ways – if you want to get your way in court based on Charter arguments, you must accept that the court, if it agrees with you, will assert a position on the margins that is contrary to the one that legislatures, and by extension the population they represent, would otherwise adopt. Were things otherwise, you would not need to assert your case based on the Charter. Hence, in pursuit of Charter rights, we simply must accept, as I said before, that the Supreme Court will from time to time strike down things that elected legislatures have put forward.

FINN POSCHMANN: Yes, and sometimes the Court does wisely defer on important social questions. And the Supreme Court, on the surface anyway, sought to do so in the case of the recent same-sex marriage reference, punting back to the federal Parliament the core question of whether legislation should define marriage as requiring representation from precisely two sexes between two partners. At the same time, lower courts had ruled on Charter grounds, and the Supreme Court so hinted, that the elected government had no such power. And, quoting progressive, “living tree” interpretations of the Charter, the Prime Minister said it was his understanding that the courts would rule such legislation to be unconstitutional, and that he would not thereafter invoke the notwithstanding clause. Through this dance, the courts were able to establish new Charter ground without taking a stand or making a ruling, and the Prime Minister was able to claim that the courts effectively forced his hand. The result was another progressive outcome for which no one was required to accept political responsibility. Is this not an example of the Charter permitting elite political actors to effect a progressive social agenda without first achieving a political mandate for doing so?

PATRICK MONAHAN: Well, the train really left that station with Halpern in 2003, which was successful in establishing in Ontario that the province could not withhold marriage licences from couples solely because they were of the same sex.3 That case ultimately set the course for legal recognition of gay marriage, and if provinces or the federal government did not aggressively defend the rearguard case for the status quo at that time, then the result could hardly be surprising. The governments of the day argued as they saw fit, and no attorney general appealed Halpern. No room for surprise then in 2005 when things proceeded as they did; the Supreme Court had very little to do by the time the case arrived before it.

7-same-sex-marriage-printFINN POSCHMANN: Hence in the case of the gay marriage reference, you see the Court reflecting an evolving understanding of key rights with respect to nondiscrimination. Now, in the Chaoulli case the Supreme Court told Quebec that it must deliver particular health services in a manner sufficiently timely to suit the Court’s pleasure. Here the Court seems to have extended rights talk well into the policy arena. One might say substantive due process has been extended not merely to the writing of law, but to the policy outcome. You must be uncomfortable with that.

PATRICK MONAHAN: I was surprised by the result, delighted and surprised by it because I certainly did not expect it. I am pleased that it has reopened debate about governments’ responsibilities to their citizens when they place restrictions on individuals’ choices. That is the tradeoff or the onus the Charter places on governments. Provincial law has restricted access to private insurance, plainly a restraint on individuals’ ordinary activities, and that restraint needs to be justified under the Charter.

Stanley Hartt and I laid out the section 7 arguments that underpinned the Chaoulli decision in a 2002 paper for the C.D. Howe Institute. In it we explained that when ill Canadians are prevented from using private insurance markets to arrange medically necessary services, at the same time as being denied timely access to public health services, there is a clear violation of section 7’s guarantee of liberty and security of the person. Laws that limit private insurance are intended to protect a public health system so that it, in turn, can deliver needed health services. If it does not do so, if the public system fails to deliver the timely care needed to keep people alive and healthy, the law has failed in its stated purpose, and that is inconsistent with the principles of fundamental justice.

The best part of the Chaoulli result is that provinces cannot fail to respond. Either they find ways to provide appropriate health services, or they must permit individuals to find their own ways of doing so, but governments cannot have it both ways. Governments cannot prohibit one person from using his or her own resources to purchase necessary health services on the grounds that someone else cannot afford to do so, and then fail to provide the needed services to either. That would be an ideological pursuit, serving to treat people as objects rather than as living humans.

FINN POSCHMANN: And yet it seems a worrisome excursion into policy, and potentially an open-ended one. We have seen this in the United States, where high courts have forced states – in a more or less logical extension of the egalitarian reasoning of Brown v. Board of Education4– to equalize local school board spending. The result, years later, is courts’ continuing to closely inspect state and school board spending to ensure that they are spending enough and in a fashion that the courts deem necessary. Are we not facing the prospect of Canada’s Supreme Court inspecting provincial budgets and choosing among priorities, in pursuit of our own egalitarian health vision? Certainly I have heard your coauthor Hartt and others speak of Chaoulli as having established the framework for a “health care guarantee.”

PATRICK MONAHAN: The important thing is that there will be different responses among the provinces. The Court is not telling them what to do or forcing particular choices. Chaoulli is instead another example of requiring governments to explicitly justify restrictions on Charter freedoms. The response provinces choose is up to them – some provinces will opt to improve health services and offer a health care guarantee; others will allow or encourage private insurance markets, as some do already. From this perspective, the policy incursion is modest to the point of nonexistence. The Supreme Court in Chaoulli is simply clarifying a section 7 right in the context of provincial restrictions on health financing, with potential gains for Canadians’ freedom – and their health.

FINN POSCHMANN: Thank you for your thoughts.

Continue reading “The Courts Are Doing Their Job”

by Finn Poschmann and Henry Milner

In the 2001 election that routed the British Columbia NDP government, the Liberals, with slightly over half the popular vote, won fully 77 seats in a 79-seat legislature; the NDP retained a little over a fifth of the vote, but won only two seats; and the Greens, who earned nearly a seventh of the vote, won no seats. It was a classic example of the tendency of our first-past-the-post (FPP) electoral system to overreward the frontrunner. In response to general dissatisfaction with the lopsided outcome, Premier Gordon Campbell invited Gordon Gibson (whose comments on the last federal election can be found on page 70 of this issue) to recommend a process whereby the province could consider alternative electoral systems. He recommended what became the British Columbia Citizens’ Assembly on Electoral Reform. Just as we went to press, it reached a conclusion. Members of the Assembly recommended scrapping FPP in favour of the single transferable vote, or STV (see accompanying box). In the next provincial election, B.C. voters will decide between the assembly’s recommendation and FPP. To change systems requires a supermajority of 60 per cent in favour of STV.

We invited two members of the Inroads editorial board to debate the pros and cons of change.

— The Editors

That darned democratic deficit

by Finn Poschmann

Many countries around the world have turned away from first-past-the-post election systems toward some flavour of proportional representation (PR). Is it time for Canada to take the leap, or is our status quo, the system that has selected Canada’s federal members of Parliament since August 1867, muddling on well enough?

The June 2004 election starts the case for the status quo. Two parties were in the running to form a government: the Conservative challengers received a share of seats in the House of Commons all but indistinguishable from their share of the national popular vote, while the incumbent Liberals, owing to some regional concentration of voters among the minor parties, received a seat share higher than their popular vote. And owing to FPP, the minor parties (the Bloc Québécois and the New Democratic Party) did well enough in their strongholds to hold the balance of power in a minority parliament anchored by the Liberals. A deeply divided electorate selected a deeply divided lower chamber, in which every vote counts and every region will vigorously assert its interests. The result was a minority government that nonetheless has a mandate to govern.

And that is where a discussion of the merits of FPP, versus any particular implementation of PR, must be focused. An electoral system must stand or fall on the basis of its systemic merits or demerits. In choosing an electoral system, the art is to produce results that facilitate governing, while not deviating too far from the distribution of voter preferences. Too large a deviation in too many elections will cost a democratic government first its legitimacy and ultimately its ability to govern.

Of course, many arguments heard for and against electoral reform are driven by tactical imperatives. When Paul Martin ran as an outsider for the leadership of the Liberal Party (despite its having been his lifetime home), his first formal pronouncements spoke of the need for democratic reform because he was aware of the intense regional animosity that had accrued toward the ancien régime. When it came to the general election, however, electoral reform was not front and centre for the Liberals. I find it hard to escape the conclusion that it suited his tactical fortunes to let the issue lie.

Not so for Jack Layton’s NDP, he being able to read polls as well as anyone else. His party’s relatively diffuse support meant that many votes would not turn into seats, and thus for him electoral reform became a call to arms. His call was loud enough that reform made it onto the agenda laid out in the fall 2004 Throne Speech. Layton has followed in the footsteps of the late Lord Jenkins in the United Kingdom, whose Liberal Democratic Party was electorally eviscerated by Tony Blair. Asked to chair a review commission on electoral mechanisms that reported in 1998, Jenkins discovered that with a dose of PR the kingdom would elect — more Lib-Dem MPs, which he clearly saw as a good in itself. Presumably Jack Layton would sympathize.

Focusing on the systemic merits of electoral change instead of these tactical considerations lets us address more important questions. FPP tends to consign to defeat the unsavoury extremes, such as the nasty characters that have graced the Austrian and Italian political stages from time to time. Israel’s experience with a 1 per cent threshold for entering the Knesset has produced numerous unholy parliamentary alliances and revolving cabinet games. Now, pointing to one or another embarrassing parliamentarian will not do as a critique of an electoral system, but it is legitimate to point out that, while dubious members inhabit every community, PR makes it easier for them to get elected.

The most common critique of PR is instability: the repeated collapse of the tenuous coalitions that PR tends to produce creates policy uncertainty and doubts about the long-term capacity of any particular government to govern. There is something to this critique, and Italy’s numerous postwar governments and Israel’s fractious cabinets are the usual examples.

PR’s bigger problem is that it entrenches in power the leadership of the major parties. For most of the half century following World War II, no matter how Italian voters might twist and turn, they found themselves ruled, after a fashion, by a government dominated by the Christian Democrats and the Socialists. Governments fell routinely but the same cast of characters shuffled cabinet chairs and rambled on as before. The end came with the emergence of a regionally dominant, business-friendly party that ran on an anti-corruption campaign. The Northern League exploited a sense of regional exclusion and disgust to muscle a place in government. It was important for Italy’s political and economic growth that its aged and habit-encrusted power brokers be turned out, and it was regionalism that did it. However, PR made it harder, not easier, to turf out the broadly unwanted permanent governing parties.

Another strike against PR is the quality of policy choices that cohabitating governing parties make. This is a dynamic problem: a junior coalition partner that supports the dominant party’s position is readily forgotten and electorally unrewarded. Coalition members may oppose socially preferred policy choices precisely because they are the right thing to do. From the perspective of the junior partner, to support the dominant party’s policy choice may be counterproductive – such support demonstrates the irrelevance of the junior partner. This is a systemic flaw in coalition government, and one encouraged by PR.

Placing a high threshold for obtaining parliamentary representation partially addresses the problem of fringe parties’ corrosive power under PR. But it cannot fix the dynamic ills of decision-making within a coalition or the inevitable impact of power politics and party entrenchment. For instance, political affiliation dominates a large part of cultural life in Israel. Certainly, PR in Canada could not be expected to reduce partisanship or the rewards to aggressive regional political activism.

Electoral systems are part of the web of legal and civil institutions that societies construct to govern themselves. The parts of the web interact and co-evolve, and changing one part may have undesired consequences for another.

Thus, New Zealand’s recent experience with PR has delivered a bizarre lesson in institutional change: what happens when members go rogue and the normal constraints of party power malfunction? After living with PR for one term, New Zealand’s parliamentarians realized they needed a law forbidding themselves from crossing the floor. After all, they reasoned, if the share of the national vote a party wins should in principle fix a party’s number of votes in the chamber, then crossing the floor cannot be allowed. But what to do when one of the list members peers into her heart and discovers herself conscience-bound to vote with other parties?

The answer so far has been to sue. Richard Prebble, the otherwise kind and sensible former leader of the ACT Party of New Zealand, is arguing before the Supreme Court that Donna Awatere Huata’s votes and speeches outside the chamber have demonstrated that she is an unfit member, and that the country’s voters deserve another who will vote as expected. It is an embarrassing spectacle, and no one yet knows the outcome. For elected members, what are the implications for the concept of free speech and voting one’s conscience? I am glad that it is they and not we who are posing that question.

Perhaps Canada’s electoral institutions do need repair – we have our share of political entrenchment, corruption and regional angst. What is missing is evidence that any particular flavour of PR, given its well-known systemic flaws, will provide the needed repair. Each step toward PR suppresses local voices and choices and elevates disparate and inchoate ones, which are of course manipulated by party insiders.

PR advocates argue that FPP denies adequate representation to marginal voices that are geographically dispersed. But a political party ought to walk before it runs. And FPP has not barred new voices: from the Parti Québécois and Saskatchewan Party at the provincial level to Reform at the federal level, FPP has allowed new parties to enter legislatures, and in some cases to govern. The recent emergence of the federal Conservative Party reflected the centre-right’s acknowledgement of FPP’s imperative to change from within, in search of broader public support in more regions. This was surely not a bad thing. Under PR the accommodation would have been unnecessary, and the debates in the House of Commons more extreme.

Elements of PR have been used before in Canada’s provinces and may again, but in recent years other jurisdictions have reduced their reliance on PR. Commissions on electoral reform, in Canada and elsewhere, have killed many acres of trees, yet I see no case, let alone a compelling one, for surrendering the requirement that a party command a majority in some geographically defined constituency – somewhere, anywhere – thereby demonstrating its ability to bring a community onside with its policies.

Until the case for change is made, if you want to win a voice in Parliament, convince your friends and neighbours you deserve one. Then the rest of us might hear you.

We need a fair system

by Henry Milner

Finn begins by telling us that an electoral system must stand or fall on its systemic merits or demerits. I agree. But I disagree that, on that basis, our FPP system stands and PR falls. Finn’s accusations against PR apply mainly to Italy and Israel. The reasons for the failings he notes are either unrelated to PR or relate to some specific feature of PR as practised in these countries.

In Finn’s account, PR stands accused of three sins: (1) allowing the election of the “unsavoury extremes”; (2) entrenching in power the leadership of the major parties; and (3) rendering coalitions unstable since small parties need to distinguish themselves. The assertion that PR tends to produce policy uncertainty and weak government reflects conditions in Finn’s two favourite examples, Italy and Israel. These are two countries with effectively no electoral thresholds for obtaining parliamentary representation. All serious PR advocates in Canada want a meaningful threshold – the report tabled in March 2004 by the Law Commission of Canada calls for an electoral support threshold of 5 per cent.

As for entrenching in power the leadership of the major parties, the example brought forward is again Italy. It is true that Christian Democrats dominated post–World War II Italian governments. But this was due not to the electoral system but to the fact that, since the competing large party – the pro-Soviet Communists – was excluded from any role in government, numerically no meaningful government could be established without the Christian Democrats. Moreover, because Italy allowed secret votes in Parliament – a perverse provision unrelated to the electoral system – coalitions negotiated by party leaders were undermined by anonymous backbenchers. In short, judging PR by Italy is similar to judging FPP by India.

Turning to our own experience, Finn and other critics are prejudging the performance of parties under PR by FPP minority situations – like that in the current Parliament. Under FPP, parties know that minority governments are likely to be short-lived, and act accordingly; under PR, they know that provoking the premature fall of a minority government will not bring majority government, but it could very well bring punishment from the electorate.

Finn concludes that the offsetting benefits of PR are hard to see. Perhaps that is because he is not looking for them. Were he to do so, he might begin with FPP’s inherent unfairness: the fact that votes do not count equally. He implies that fairness is more or less irrelevant. It is true that, in the Canadian context, the NDP will benefit from change, and the Liberals will lose, but most people find something deeply unfair in the fact that NDP voters have been consistently underrepresented in seats. To use an Italian metaphor, the leaning tower of Pisa always leans in the same direction.

Moreover, even when the overall result is not too far from overall proportionality – and the 2004 result was unlike the three previous federal elections in this respect – regional distortions are large. For example, in 2004, the Conservatives and NDP, instead of being shut out in Quebec, would have won six and three seats respectively under the Law Commission’s proposed PR model.

The political effects of these distortions should not be ignored. In close ridings, voters are often forced to act against their real preferences. Under a more proportional system, we could have avoided the dismal spectacle of Paul Martin appealing to New Democrats to vote Liberal not because his party’s program was close to their objectives, but to keep out the dreaded Stephen Harper. To avoid FPP’s effects on a divided right, the Progressive Conservatives and Alliance sacrificed their core principles and entered into a forced marriage. Under PR, they need not have done so.

The real advantage of PR is that, unlike FPP, it makes every vote count – even in areas where a voter’s preferred party is weak. Adopting PR should at least slow down plummeting turnout, a problem not to be ignored: the June election, though one of the most competitive in years, drew a record low turnout. PR also tends to make Parliament more reflective of the population’s ethnic and gender composition.

Finn pokes fun at New Zealand’s difficulties in dealing with MPs elected from a party list who abandon their party. In 1993, New Zealand abandoned FPP and adopted the Mixed Member Proportional form of PR. Admittedly, MPs who cross the floor have posed a problem. Nevertheless, New Zealand parliamentarians, required by law to evaluate the new system a decade after having dispensed with FPP, did not consider returning to the status quo ante.