Lessons from the Crisis
As the global crisis unfolds, the great gurus of the world economy – those who have presided over its fortunes for much of the last two or three decades – have largely ducked for cover. Some – like Alan Greenspan – have had the courage to admit that there was a “flaw” in his thinking. Others – like Gordon Brown – have made an apparently effortless overnight conversion to Keynesian economics after decades of monetarist orthodoxy. A few – like Bernard Madoff – have been unmasked as fraudulent, as well as foolishly irresponsible. But most have watched from the sidelines, silent and confused, as the results of their handiwork have become apparent.
The immediate task and focus of governments around the world is, of course, to put in place measures which will limit the damage, avoid a depression, and restore the world economy to some semblance of health as soon as possible. In this endeavour, the supposed experts of yesterday necessarily have little to say. It is, after all, their nostrums that have driven us to this point, and the crisis has cruelly exposed the limitations of the monetary policy which they said was all that was needed. What does liquidity matter if no one wants to borrow and spend?
But, once the authorities have done their best, and the course to recovery of a sort is (hopefully) set, the debate will move on. The issue then will be not so much the steps needed for recovery as the lessons to be learned if the disaster is not to be repeated in the future.
At that point, we can expect the champions of “free” markets to re-enter the debate. The battle will then be on to write (or re-write) history, and what now seems undeniable will again become hotly contested. There will be no shortage of explanations and excuses for what has happened, ranging from the nonchalant (the crisis was a minor blip in what has otherwise been a triumph for the “free” market) to the aggressively ideological (it was the failures and mistake of governments that frustrated and distorted legitimate market operations).
It is vital, therefore, that – while reality still imposes itself on perceptions – an account is drawn up of the lessons we must learn from this disastrous episode. Some of those lessons will be widely accepted, but others – even for those who are most critical of the errors of recent times – will be more difficult to digest.
The crisis has been so damaging and so all-engulfing that it might be argued that virtually nothing of past doctrine can survive. There are some particular lessons, however, that absolutely demand attention. I would select six leading contenders.
The first and most obvious is that “free” or unregulated markets are extremely dangerous mechanisms which inevitably go wrong. All markets, left unregulated, will produce extremes, and that is particularly true, as Keynes pointed out, of financial markets, because of their inherent instability. The case for regulation cannot be disputed, but even so, the counter-attack will certainly come. The merits of self-regulation, the salutary effects of competition, and the advantages of a “light hand” will again be rolled out in order to deflect any real attempt at disciplining market operators. That is when our public authorities must be strong-minded, and remind themselves that is their responsibility to the public interest that demands effective regulation.
The second lesson is that government involvement in the management of the economy is essential. After decades of being told that the only thing we should ask of government is that it “get off our backs”, we can now see that it is governments – not banks or the private sector – that, as the authority of last resort, maintain the value of the currency, guarantee appropriate levels of liquidity and credit, and make irreplaceable investments in essential infrastructure. We must not wait again until the eleventh hour before we deploy the power, responsibility and legitimacy of government to keep the economy on the right track.
The third lesson is that fiscal policy, decided by governments, is more important and effective than monetary policy. We have again been told for decades that monetary policy is all that is necessary, and indeed all that is effective, both in controlling inflation and in setting the real economy on a sustainable course. We now know that using monetary policy to ward off recession is no more effective than pushing on a piece of string and that an exclusive reliance on monetary policy to restrain inflation is just another reflection of the view – now surely discredited – that the markets always get it right.
My fourth inescapable lesson is that gross imbalances in the world economy will inevitably cause it to topple off the high wire. The growing gap between rich and poor nations is bad enough, from both an economic and moral viewpoint. But the imbalance between surplus and deficit countries is equally damaging as a strictly economic phenomenon. The surpluses drive us toward recession because they represent resources that are hoarded rather than spent, while those countries with deficits are likely, as Keynes pointed out, to try to control them through deflating their economies, thereby reinforcing the deflationary bias. To the extent that others are willing to finance the deficits (as, for example, China’s financing of the US deficit), this simply encourages uneconomic production and an excessive reliance on credit, meaning that the world economy wobbles perilously on an unsustainable foundation.
A related and fifth lesson is that the freedom to move capital at will around the world has exacted a heavy price. The total removal of exchange controls meant that international investors could ignore and, if necessary, blackmail national governments; this became a major factor in allowing market operators to escape and defy any attempt at regulatory controls. We have to make up our minds whether we trust accountable governments, with all their imperfections, or the unrestrained and totally irresponsible market. Our recent experience surely makes this a no-brainer. What we now need is a new international regime, negotiated between governments, to regulate exchange rate volatility, international lending practices, and the obligations of international investors.
My final lesson is that bankers should not be trusted with the most important decisions in economic policy. No policy measure was more widely welcomed than the handing of monetary policy over to “independent” central banks. We now have good reason to know that their decisions are not only likely to be wrong, but will certainly be self-serving – no more reliable or impartial than those of casino operators who will always set the odds in their own favour. If we are truly to grapple with the lessons set out above, we need to restore the main decisions of economic policy, including the effective regulation of markets, to democratic control.
Bryan Gould
18 January 2009
This article was published in the online Guardian on 19 January and the New Zealand Herald on 26 January.
Fiscal Stimulus? Not Quite
The decision by the US Federal Reserve to cut interest rates to virtually zero, and the similar steps taken by other central banks, show how desperate are the world’s monetary authorities to avert a deep and entrenched global recession. This is, in effect, their last throw. There is nowhere else to go. If anything were needed to expose the limitations of monetary policy, it is the fact that even zero interest rates are – in a world where there is increasing reluctance to spend, lend alone borrow – as ineffectual as pushing on a piece of string.
That is not to say that the interest rate cuts overseas will have no effect. We in New Zealand have discovered that sooner than most. The Fed’s unprecedented action has meant that our own meagre cut in interest rates has left the interest rate differential pretty much where it has been all along – offering a standing invitation to speculators to take the New Zealand taxpayer for a ride. The rise in recent days in the Kiwi dollar’s value on the back of a renewed inflow of hot money now threatens to snuff out one of the few bright spots in an otherwise dismal New Zealand outlook.
Our caution in responding to the growing global downturn is part of a wider failure on our part to grasp the true dimensions of what is unfolding worldwide. We assume that the steps we have taken to counter our own home-grown recession (which was well entrenched long before the global crisis struck) will be enough to see us through the impact of the global downturn when it hits us. We don’t seem to recognise that we have yet to feel the full impact of declining export markets, falling commodity prices, more expensive credit, and higher import prices, to say nothing of the deflationary effect in the domestic economy of a foundering housing market, higher unemployment, lower wage growth, more bankruptcies, closures and bad debts, and tighter limits on public spending.
Most importantly, we appear to take no account of what Paul Samuelson calls the “wealth effect” – the impact on consumer confidence and therefore spending of a perceived decline in people’s wealth as house prices fall and unemployment threatens. The result? We are still looking to the early end of a recession that has barely begun.
This picture seems much clearer to policy-makers in other economies. But, in view of the ineffectual nature of monetary policy, little wonder that many overseas governments are now looking more and more to fiscal policy for salvation. Keynes, “thou shouldst be living at this hour!”
Not everyone of course is persuaded of the need for fiscal stimulus. For many conservatives, this use of fiscal policy (or deficit financing or printing money as it is often pejoratively labelled) is absolute anathema. Indeed, the British government’s readiness to create and live with a rapidly growing deficit has provoked a bitter row with German Ministers who would, apparently, prefer to see the recession take its course rather than use Keynesian measures to forestall it.
Yet the accuracy of Keynes’ prescriptions for dealing with recession has brought about what has been in many cases an overnight conversion to Keynesian economics. Our own policy-makers however – like the Germans – seem reluctant to recognise that, if recession is not to become endemic, exceptional measures have to be taken.
Their excessive caution in bringing down interest rates to a level which is still well above world rates has been matched by a similar reluctance to take effective action on the fiscal front. We have been assured that our economy is already benefiting from a large fiscal stimulus but it is difficult to see anything in the current policy stance that is likely to impact greatly on the real economy in the immediate future. True, we had some tax cuts a month or two ago and there are – marginally – more to come in April, and there are proposals (yet to be implemented) for an accelerated public spending programme in infrastructure. But what seems to be offered as the main element of our so-called “fiscal stimulus” is a growing government deficit as a consequence of falling tax returns and writing down the value of government assets.
It is certainly true that the government’s books look a lot less healthy than they did a year ago, (though it is also true that they are in better shape than in most countries). But declining tax revenues are simply the inevitable consequence of recession – not a stimulus to economic activity – while falling values for government funds are accounting provisions which have no immediate impact on the real economy. Neither is a substitute for a real boost to spending power, which – as Keynes explained – is the only factor that will really counteract a threatened recession. Without it, we are in for a long hard road.
True to form, our policy-makers are sticking to the obsessive orthodoxy that has handicapped our economic performance over more than two decades, even when that orthodoxy has been identified as responsible for a recessionary crisis and has therefore been abandoned on a global scale. It will be a real test for the new government to see whether it has the courage to seek different and better advice.
Bryan Gould
19 December 2008
This article was published in the New Zealand Herald on 22 December.
Post-meltdown
The horror stories keep coming but – even so – it is doubtful whether we have yet grasped in New Zealand the scale and seriousness of what is happening in the global economy, and how greatly we will be affected by it. We know that others are in deep trouble but we see ourselves so far as transfixed spectators rather than actors (or victims) in the drama.
We may not remain in that comfort zone for long. As the world enters recession, and the markets for our goods are decimated, we will feel the pain. And, although our financial system seems unscathed for the moment, the price we will inevitably pay for being one of the world’s most indebted countries is waiting just round the corner. As foreign investors take their money home, and as our banks have to re-negotiate the credit arrangements on which they rely, stand by for a succession of damaging body blows to the already fragile underpinnings of our economy.
There is little sign yet that our political and business leaders have grasped the dreadful vulnerability of our position. The cool reception given to the thoughtful paper issued last week by Mark Weldon and David Skilling – with Peter Dunne expressing concern about the impact on the government’s deficit, as though that was the foremost of our worries – shows that we do not yet recognise the imperatives that have driven governments around the world to take steps that would have been unthinkable just a couple of months ago.
There is of course room for considerable discussion about the precise recommendations of the Weldon/Skilling paper. But it does at least represent the first awareness of the scale of the problem and of the need for new thinking. Even more interestingly, it points the way to a post-meltdown future where the world will (hopefully) never be the same again.
The paper is notable mainly for its (perhaps unconscious) willingness to slaughter some sacred cows to which we have been solemnly assured for nearly three decades “there is no alternative”. Governments must be kept well away from the main levers of economic policy? No. As the paper now asserts (and as even George Bush agrees), government action is essential. Monetary policy is all that matters? No. The paper says that fiscal policy is now the most important weapon in the armoury. Bankers should be entrusted with the important decisions in our economy? No. As is apparent to everyone, banks worldwide have failed us and must in many cases be taken into public ownership. “Free” markets must be left unregulated and will always produce the best results? No. The market has failed and created a catastrophe. All that matters is the bottom line? No. The goals of economic activity are wider than profit for a few.
The truth is, in other words, that if we are to survive the crisis in reasonable shape, we must now abandon the nostrums that have proved so self-destructive. We need governments to acknowledge their responsibilities, to take a major role in the rescuing of our economy, to use a much wider range of policy instruments, and to treat markets as hugely valuable servants but dangerous masters.
We should be in a better position than most to recognise this, since we have given those nostrums a longer and more comprehensive trial than anyone else. While the great super-tankers and luxury liners of the big economies have plied their trade on the great ocean of the global economy, and amassed large fortunes until they suddenly sprang a leak and began to sink, our tiny craft has been waterlogged for years. For us, the dogma of the unregulated “free” market has not led so much to sudden collapse as to long decline.
We now have the chance, if our leaders have the necessary wit and imagination, not only to change direction in order to escape the worst of the world recession in the short term, but to set a new course which will produce in the medium term a better balanced economy in a world where markets are no longer regarded as infallible.
The lesson of this crisis is that unregulated markets lead to economic disaster and – even more importantly – that they are incompatible with democracy. If markets are always right and must not be challenged, the result is not only economic meltdown but government by a handful of greedy oligarchs rather than by elected representatives.
The whole point of democracy is that it ensures that political power will be used to offset the otherwise overwhelming economic power of the big market players. If democratic governments do not, will not or cannot exercise that power to protect their electorates, the course is then set inevitably not only for the crisis we now face but also for the abuses and failures that disfigured our economies in the years preceding the crisis.
Shouldn’t our politicians be called to account? Shouldn’t these issues be what our general election is all about?
Bryan Gould
12 October 2008
So Much for Liquidity – Now Let’s Have a Serious Approach to Inflation
The Reserve Bank’s announcement of new provisions to improve the trading banks’ liquidity in the face of the world-wide credit crisis will be widely and justifiably welcomed. It is just a pity that the Reserve Bank is not similarly proactive when it comes to the battle against inflation.
Any liquidity problem for our banks is, of course, prospective rather than actual or immediate. It nevertheless makes sense, both for current confidence and as a practical response to the possibility of problems ahead, to ensure that the banks have a wider base of liquidity on which to operate. As the Reserve Bank makes clear in its Financial Stability Statement, we cannot assume that a banking system that relies heavily on borrowing from overseas will remain immune forever from the problems that threaten the liquidity of overseas financial institutions.
While the Reserve Bank deserves a tick for its foresight in this respect, it is less deserving of plaudits when it comes to other areas of its operations. It is reassuring that it has moved promptly to forestall liquidity problems, but this contrasts sadly with its failure to exercise effective prudential supervision over non-bank lenders. The failure of so many finance companies over the past year or so – at a cost to investors of over $1 billion – has left the Reserve Bank seeming more concerned with the viability of the banks than with the savings of ordinary New Zealanders.
Perhaps we should not be surprised at this apparent peculiarity in the spectrum of the Bank’s concerns. The Reserve Bank is, after all, a bank. It owes a particular loyalty to and has a particular concern for the interests of other banks. It has acted quickly, and properly, to ensure that the banks are able to maintain their operations – something that is very much in everyone’s interests of course – but it has been much less assiduous in meeting its other responsibilities.
That criticism applies with even more force if we look at a field of operations that is even more significant than the viability of the banking sector or the prudential supervision of finance companies – the Bank’s role in controlling inflation. It is now apparent to everyone that the Reserve Bank is struggling – and failing – to keep inflation under control except at a price that threatens the rest of us with recession.
The search is therefore on for counter-inflationary policy measures that are both more effective and less damaging than the single blunt instrument of constantly raising interest rates. The Reserve Bank went so far in 2006 as to commission a report on what it described as “supplementary stabilisation measures” – in other words, on further measures that might be taken in addition to what we are usually assured is a policy instrument to which there “is no alternative” – while the Finance and Expenditure Select Committee is currently engaged in a similar exercise in preparing its report on the future monetary policy framework.
In neither case, however, is it likely that the Reserve Bank or those who advise them will notice what is staring them in the face – that the most obvious (and easily dealt with) cause of inflation in our economy is the high and fast-growing volume of bank lending. Private sector credit has grown by six times over the last twenty years, from $44 billion in 1988 to $266 billion in 2008; the largest and fastest-growing element in that credit growth has been bank lending on mortgage for the purpose of buying residential property.
Current interest rate policy actually makes matter worse. As interest rates have risen, the banks have had to market their lending more and more aggressively – and they have protected themselves against the consequent risk of lending inappropriately by concentrating especially on the housing market where they can at least take adequate security over people’s houses.
Why has the Reserve Bank not focused immediately on this and imposed limits on the banks’ freedom to inflate the economy in this way? If the key to controlling inflation is to limit the growth in the money supply, why not deal with the fastest-growing element in that money supply? If the Reserve Bank is ready to improve the banks’ liquidity at times of credit stress, why do they not intervene to restrain that liquidity at time of inflationary pressure? Why destroy the viability of large parts of our productive economy, but leave the banks free to do as they please?
The answer is that there is a perhaps unconscious and certainly unstated bias in the way the Reserve Bank looks at these issues. They are unwilling to act against the banks, and would rather burden the rest of us with the responsibility for grappling with inflation. They see measures such as regulating capital requirements or loan-to-value ratios for bank lending – as amended and sometimes extended by the Basel II international agreement – as appropriate for prudential supervision and for ensuring adequate bank liquidity but not for controlling inflation. This point is made explicitly by the Bank’s External Monetary Policy Adviser in his submission to the Select Committee.
The Bank gets away with this bias because the bank economists who dominate the economic policy debate in the media have a vested interest in diverting attention away from it. It is time that the darker corners of this debate saw the light of day and that the banks were brought within the purview of counter-inflation policy.
Bryan Gould
8 May 2008
This article was published in the NZ Herald on 16 May 2008
Let’s Hear It For The Macro Economy
The decisions announced last week by Fisher and Paykel and the ANZ Bank to relocate parts of their operations overseas grabbed the headlines and sent a shock wave through New Zealand industry. What may not be so apparent, however, is that the factors that led to those decisions have been part of our day-to-day experience over 25 years – and they continue to inflict their damage on all of us on a daily basis.
Last week’s news, in other words, is just the tip of an iceberg – just the latest high-profile instalment in the slow-motion but inexorable crumbling away of our economy. Very few understand the damage that has been done to our economic fortunes by the literally counter-productive effects of current policy settings over a quarter of a century. Very few accept that – as long as our macro-economic policy relies on the highest interest rates in the developed world and a grossly overvalued exchange rate – it is inevitable that there will be more news stories like last week’s.
Faced with current policy, even the strongest and most successful of our enterprises are less able to grow and compete than they should be. They do not generate the return on investment that they need to re-invest in future success. Because they are not profitable and competitive in international terms, they are always vulnerable to being bought up at bargain basement prices by foreign buyers or tempted to move their operations overseas. And when the tough times come, they are less able to withstand the shock – rather like tall trees with weak root systems that surprise everyone by keeling over in a high wind.
Weaker enterprises simply close down or fail to get off the ground. Innovation and productivity improvements are inhibited. The economy as a whole is less able to invest in future capacity. Our brightest talents go overseas or seek opportunities elsewhere than in productive industry. Instead of growing and becoming more efficient at the margins, we see loss of performance and decline.
Most of these instances fail to make the headlines but they are constantly happening nevertheless. When these debilitating effects are felt over decades, as they have been in New Zealand, the culture itself changes. People become risk-averse, lose interest in new wealth creation and concentrate on safe investments like housing or on manipulating existing assets in the money markets.
We have lived with this for so long that we no longer realise how sharp has been our comparative decline and how precarious is our ability even to sustain our current disappointing performance. We are fed a constant diet of assurances that our problems are nothing to do with policy; indeed, some apologists for monetarist orthodoxy urge us to push further down a track that we have already travelled further and longer – with correspondingly worse results – than anyone else.
Others tell us that we must simply accept that other economies are more efficient and have lower costs than we do. But, if that is the case, why do we make matters worse by deliberately ensuring that we destroy our own ability to compete?
Perhaps the most commonly touted advice is that no change in macro-economic policy is required and that what we must do instead is boost innovation and productivity by spending more on education and research.
As a former university Vice-Chancellor and the incoming Chair of the Foundation for Research, Science and Technology, I am the last person to question the need for more investment in education and research. That investment is an essential element in improved economic performance. But how is that investment to be made, and how is it to be made effective, if the tide of macro-economic policy is running so strongly against innovation and productivity improvements?
Those who offer this advice are still, it seems, prisoners of the comfortable illusion propagated by monetarist theory that monetary policy has little or no impact on the real economy. We know now beyond doubt that this is simply not true; to believe otherwise is a triumph of ideology over practical experience.
If our producers struggle simply to stay afloat, because the policy settings ensure that they are inadequately profitable and competitive, where is the extra resource to come from to turn things around? How are they to afford the new equipment and technology, the new product development, the skill training for their workforces, the marketing to develop overseas opportunities, the improved after-sales service and all the myriad and hugely expensive elements that go to make up a successful campaign in international markets, including our own? Neither the New Zealand investor nor the taxpayer can produce those resources out of thin air.
The need now is not for glib advice but for positive action. That action must take as its starting point a recognition that the current macro-economic policy settings must change if micro-economic measures are to be as effective as they should be. The search for a better way – and in particular, a better way of controlling inflation – will not be easy but it must not be shirked.
Bryan Gould
20 April 2008