GLOBAL FINANCIAL CRISIS: by Colin TeeseNews Weekly
Policy-makers still refusing to face reality
, October 3, 2009
On the first anniversary of the collapse of the Lehman Brothers bank, many people are asking how much policy-makers and economists, looking back, are prepared to admit what precisely went wrong and how it might be corrected.
The inspiration for this article comes from distinguished US economist Professor Paul Krugman's recent essay, "How did economists get it so wrong?" (New York Times
magazine, September 6, 2009). It will be recalled that Krugman was awarded the Nobel Prize for Economics in 2008 for his work on international trade.
Krugman speaks with some authority. He was among a select few who expressed misgivings about the dangers from the imbalances emerging between the spending and saving economies. Given that his field of expertise was international trade, it was hardly surprising.
In his recent article he proceeded to put the pieces together. He examined the basic theory beloved of market fundamentalists - the belief that markets were frictionless and infallibly self-correcting mechanisms, capable of perfectly managing themselves, and that market players could be depended upon to act rationally upon universally available information and so permanently stabilise market operations.
This belief was formulated into a new creed of market economics by its advocates. The older Keynesian idea that markets could fail and needed corrective intervention by government was utterly rejected in favour of a new ideology which championed unfettered free markets. Without the "dead hand of government intervention", markets would supposedly deliver a new and permanent equilibrium, thereby erasing the possibility of anything beyond mildly corrective, and short-lived, economic downturns.
When this proposition was disproved by the events of the recent US economic crash, frictionless market proponents, desperate for a scapegoat, asserted, absurdly, that the economic fundamentals had not been disturbed. True, 6.5 million people had been made jobless, but this arose because they had deliberately chosen not to work.
Only by maintaining this fiction could the validity of their discredited theory (which went by the name of "rational expectations theory") be sustained.
Krugman's characterisation of the rational expectations theory as frictionless economics is especially apt. Back in the dim past, it will be recalled that a body of quite serious scientists devoted some of their attentions to examining the possibility of creating a perpetual motion machine.
The belief was that if the effect of friction could be eliminated, such a machine, once started, could generate energy in perpetuity. According to usual practice, scientists, however, began their experiments without the baggage of ideology. So they quickly came to grasp that friction could never be eliminated, and thereupon concluded the impossibility of establishing perpetual motion.
Unhappily, some macro-economists cannot face the reality that their frictionless system of economics is equally beyond reach. The essential distinction between scientists and economists is that the former, though often not the latter, understand the difference between scientific experiment and ideological commitment.
All of this becomes obvious once we realise the full extent of the damage done to the world economy by the malfunctioning of financial markets. Only now is the air becoming clear, and Krugman and a few others have been helpful in making the crisis better understood.
Associate editor and chief economic commentator of London's Financial Times
, Martin Wolf, is another. Wolf, among the most authoritative of commentators on the crisis, recently revealed that, in Europe and the United States alone (forget the rest of the world), governments have spent a total of US$9 trillion - that is, nine times one thousand billon dollars - on bail-outs of financial institutions. That sum, in total, adds up to about one sixth of the world's total income.
A breakdown of the expenditure is as follows: $2 trillion in recapitalisation (in other words, gifts to institutions), $2.5 trillion in buying up bad debts, and $4.5 trillion in guaranteeing of depositors. All of this is because those running the financial system - and being paid enormous sums to do so - had watched as a supposedly self-regulating market system spun hopelessly out of control.
Wolf emphasises that these vast sums were used, not to stimulate demand and so help restart the "real" economy (i.e., the production of actual goods and services and the creation of jobs), but entirely for the purpose of averting total collapse of the Western banking system.
Furthermore, these enormous outlays represent a charge against the future incomes of working families in all of the countries involved. And, unlike stimulus investment by governments to keep the economy turning over, these bail-outs offer no prospect of an offsetting return on the outlay.
Looking back, it seems that only the first of the US institutions to announce itself in difficulties, the Lehman Brothers bank, was allowed to go under. Some have asked why.
Ben Bernanke, chairman of the US Federal Reserve Bank, made one reason clear. As bank after bank was demonstrated to be in trouble, Bernanke was asked one weekend, "What happens if we do nothing?" He replied that, in that event, by Monday there would be no US economy. Europeans apparently felt the same.
As far as the US was concerned, some identified a second reason. The Lehman collapse, they believed, was engineered in order to condition the US Congress to make available the enormous sums of public money needed for bank bailouts.
No doubt the US and other Western governments poured money into financial institutions in the belief that there was no feasible alternative. But that was no excuse for allowing the shareholders of most of the West's largest financial institutions to emerge from the crisis unscathed.
Even worse, Western governments have attached no onerous conditions to the bailout packages so generously advanced to institutions. Should not those receiving handouts be required to reshape their operations in ways which would minimise the possibility of a repeat of what we have just experienced?
Financial market capitalism has demonstrated that it cannot function effectively without that kind of discipline. If, for the sake of the economy, governments are obliged to become lenders of first resort - as they now seem to be - then surely they are obliged to impose tough conditions on financial institutions, if for no other reason than to protect the public purse. That, after all, is the primary responsibility of government.
The same economic theory and practice which has prevailed in the US and Europe also held sway in Australia. Macro-economists in our universities have, with no less fervour, embraced the gospel of rational expectations and all that has been said to flow from it. An entire generation of economics graduates, all steeped in the new doctrine, streamed out of all but a few university economics departments around Australia.
Theirs became the received wisdom behind policy development in both government and business. Keynesian interventionist-type economic management fell out of fashion.
To a greater or lesser degree, all Western governments took up the ideas of what became known as the Washington Consensus. These were notions generated in the US Treasury, the IMF and the World Bank, which advocated financial deregulation, privatisation of public instrumentalities and free market fundamentalism - including the free trade notion guiding the economic fortunes of most of the Western developed world, including Australia.
When the financial crisis began to engulf the world at the beginning of 2008, governments watched with alarm as it infected the real economy. With the 1930s Great Depression in mind, they immediately re-read their Keynes. All believed that stimulus packages were needed and these were put in place, although most of the emphasis was on bank bailouts which were not part of the Keynes equation.
Here in Australia, the incoming Rudd Labor Government leapt into action with measures to keep the economy moving. Our banks were in better shape, but still they were showered with guarantees as a precautionary measure.
Now people seem to believe - or hope - that we have escaped the worst of what has happened elsewhere because of clever management. That is a naïve and dangerous notion.
And the future? As always, nobody knows. But we do know that unless the world goes back to the way it was before, with US consumers borrowing money to buy up cheap Chinese goods, Australia - as an economy heavily dependent on Chinese purchases of iron ore and coal - will not prosper.
We should also know that going back to those times is impossible. US consumers and its economy will not be able to be a buyer of first resort underwriting Chinese and world prosperity.
Some at least in our Labor Government appear to understand this but have no plan for dealing with it. And the Coalition Opposition is no help.
Finance Minister Mr Lindsay Tanner - orthodox to the fingertips - recognises the dangerous level of debt overhanging our economy, but offers no suggestions for dealing with it.
Actually the solution is simple. We either import less or export more. As things stand, our commitment to free trade limits our capacity to significantly increase exports. Furthermore, free marketers and free traders, including Minister Tanner, believe we should not seek to balance our trade, much less generate a surplus. In such an economic climate, nothing much but hand-wringing can be done.
Even the Prime Minister Kevin Rudd, who says publicly that he doesn't accept free market fundamentalism, buys the free trade arguments.
The consequences of the problems facing us are unlikely to be solved by policy inputs from either side of politics. Rather, it seems, we might have to wait for events to impose a solution for us. The trouble is that solutions generated in this way are likely to be brutal and nasty.Colin Teese is a former secretary of the Department of Trade.
Paul Krugman, "How did economists get it so wrong?", The New York Times
Magazine, September 6, 2009.