the budget the smoke and mirrors edition

Federal Finance Minister Jim Flaherty faced a particularly tough challenge as he presented his fifth budget yesterday: convincing the bond market that he was serious about reducing our record deficit, while at the same time minimizing voter outrage at bud

Federal Finance Minister Jim Flaherty faced a particularly tough challenge as he presented his fifth budget yesterday: convincing the bond market that he was serious about reducing our record deficit, while at the same time minimizing voter outrage at budget cuts.

Flaherty probably achieved his objectives and at the same time gave us a fine practical lesson in the power of “behavioural economics.” For those who missed last week’s column, this is an emerging field of economics that studies how the human brain can be systematically irrational in financial matters. It’s a scientific guide to the dark art of mathematical manipulation and spin.

Flaherty appears to have been reading up on the topic.

A key behavioural economics finding is that people are “loss averse.” In studies where people are given choices between various 50/50 bets, we generally need twice as much potential upside to compensate for a loss. Consider your own response to these choices:

*Choice 1. You can choose (A) to have a 100 per cent chance of losing $100 or (B) a 50 per cent chance of losing $200.

*Choice 2. You can choose (A) to have a 100 per cent chance of winning $100 or (B) a 50 per cent chance of winning $200.

Star Trek’s Mr. Spock would choose the same in both cases.

This is why so many of the stimulus programs were presented to Canadians as temporary. We are not losing the Home Renovation Tax Credit (a “loss”), we are simply not getting it given to us again (absence of a “gain”).

The same with some handouts to provinces and territories. We are not having the Territorial Health System Sustainability Initiative cut, but it will stop. We can thank Flaherty that, to assuage the pain of this non-loss, he did extend its expiry date. But come 2012 it will end.

Money illusion is another source of irrationality, where we focus too much on nominal figures. People will grudgingly accept a one per cent raise when inflation is three per cent but will fight viciously to stop a two per cent cut when inflation is 0.

Thus Flaherty was careful to freeze senior salaries, departmental operating budgets and the foreign aid fund. He also granted small nominal increases that were cuts in real terms. The Social Sciences and Humanities Research Council got an extra $3 million, which sounds nice until you realize their budget is $335 million and that they needed $6.7 million to keep up with two per cent inflation.

“Framing” is another huge mental weak spot for Homo sapiens. A common example is choosing between two different vaccination programs for an epidemic which is expected to kill 6,000 people:

*Choice 1. You can choose vaccine (A) which will save 2,000 people or vaccine (B) which has a 1/3 chance of saving everyone and a 2/3 chance of saving no one.

*Choice 2. You can choose vaccine (A) which will allow 4,000 people to die or vaccine (B) which has a 1/3 chance of saving everyone and a 2/3 chance of allowing all 6000 to die.

People choose A or B differently depending on how the same question is framed.

For example, Flaherty doesn’t say that he is increasing the defence budget while freezing elsewhere. Instead, he says he is reducing planned future growth to generate “expected savings” of $525 million.

And Employment Insurance rates on workers and businesses are not being raised. Instead, a freeze is being ended. And by the way, in case you have a job or own a business, it’s likely the increase will be 15 per cent given the increased revenue projections on page 176 of Flaherty’s budget plan.

Some of Flaherty’s verbal gymnastics are more reminiscent of Bill Clinton than behavioural economics. For example, he claims repeatedly that the budget deficit will be slain without tax increases. This, of course, requires one to define the $9.7-billion increase in Employment Insurance payments forecast by 2014/15 as “premiums” and not “taxes.” Many economists consider these payments to be a regressive tax on jobs.

And to put this slippery language in perspective, the GST reduction from seven per cent to five per cent which Flaherty trumpets is about the same amount of money, give or take a billion or two.

Flaherty also claims that “this government will return to a balanced budget,” while his own charts show a deficit for all years projected.

This budget will probably be relatively well received by financial markets and voters. But it is heavily reliant on a return to solid economic growth. If that doesn’t happen, it may not be possible to disguise the cuts coming in next year’s budget. Even with the help of behavioural economics.

Keith Halliday is a Yukon economist and author of the Aurore of

the Yukon series of historical

children’s adventure novels.