Economics in Uncharted Waters?
Larry Summers has said: ‘If interest rates are negative, all the verities are up for grabs'
Mervyn King has warned: ‘The economy is behaving in ways we did not expect, and new ideas will be needed if we are to prevent a repetition of the Great Recession and restore prosperity’, (The End of Alchemy, P 6)
Robert Gordon notes in The Rise and Fall of American Growth the much slower growth of USA productivity than in the ‘successful century’ from 1870 – 1970. As well as slower productivity now, he discusses ‘a group of headwinds- inequality, education, demography and fiscal- that are reducing growth in median real disposable income well below the growth rate of productivity’. (P xi)
A profession in crisis?
These quotes suggest that economics is a profession in crisis, or lost without a map. Another, far more serious crisis, is possible, indeed inevitable if history is any guide. The correct policies could, however, reduce the madness of future booms and thereby reduce the damage of future busts. But it is not just the financial system that needs to be fixed. The world has to restore a more normal monetary policy and tame borrowing and growth of debt. Doing this without a crisis will not be easy.
Clearly, as Mervyn King documents, modern finance created and then suffered one of the periodic booms and busts so frequently seen in national economies in the past. In the build up to 2007-08 the global financial system ran out of control and created a first world boom that endangered the future of the financial institutions themselves. Only decisive actions by governments saved the global financial system and helped to produce a Great Recession to replace the Great Depression that was the likely alternative.
Many writers have provided sets of policies designed to prevent a repetition of the behaviour of financial institutions that produced the Great Recession. Official action is largely focussed on stronger capitalisation of financial institutions, and this is underway. Other ideas include counter-cyclical capitalisation ratios, return of the rules introduced under the American Glass-Steagall legislation, serious penalties for managements whose institutions require to be bailed out and limits on remuneration of financiers. The last point in this list could be achieved by punitive taxation if shareholders, or different cultural norms, cannot impose sensible restraint.
Counter-cyclical asset ratios would require financial institutions to raise asset ratios in response to rising asset prices. Such action should not be required unless and until asset prices (somehow defined) rose by (say) 10 % per annum for three years in a row, or by 30 % in one year. (1)
This suggestion, and others discussed here, is contained in Jonson, Great Crises of Capitalism, 2011, Chapter 12.
Australia’s banks are better capitalised than most and are probably better regulated generally. After all, two of Australia’s top four banks were in severe trouble in the recession of 1990-91 and we can hope that top managers recall this experience and are more prudent as result. One hopes that managements of major global financial institutions have learned a few lessons also.
A return to the Glass-Steagall Act, or equivalent, would separate ‘commercial banks’ from ‘investment banks’. Commercial banks should focus on lending and borrowing, be run by competent managers and be closely regulated. This part of the financial system would be like a utility providing water or electricity – safe and reliable. ‘Investment banks’ could be freed from supervision and required to make clear their status as part of the wild west of finance. Clearly such institutions could not be allowed to grow to a point of being ‘too big to fail’.
Penalties for top managers of commercial banks who lead their institutions into insolvency, requiring bailout, should be far greater than at present. Now often the failed managers leave with accumulated bonuses plus a large sum for redundancy. Far better that accumulated bonuses be cancelled (to the extent possible) and failed managers leave without a termination payment. Labor laws may need to be changed for this to be possible, but that should be possible for a government implementing far-reaching reforms to the financial system.
Managers of ‘Investment banks’, hedge funds, fund management companies and other speculative enterprises should be subject to rules of remuneration and governance provided by shareholders. Anti-trust action to reduce the size of existing speculative financial institutions would be a wise precaution.
As Robert Gordon so ably describes, America’s ‘successful century’ was built on the major innovations, including development of electricity, running water to most households, greatly improved sanitation and development of modern drugs, far better transport, by road, rail and air. And many other innovative developments.
Many other current ‘first world’ nations, including Australia, have benefitted from following America’s example and developing their own innovative but essentially similar cultures. China and India, and other less developed nations are following this process rapidly, and giving current first world nations serious competition in the process.
Whether a future burst of innovation can produce another period of high growth must be regarded as doubtful. But many modern nations have become sclerotic as a result of excessive and unnecessary regulation of markets, and there is scope for boosting growth by further deregulation of many commercial activities, with the significant exception of finance, where some reregulation is required. (2)
(2) See Morgan et al, ‘Growing the Trade Exposed Industries’, for a discussion of productivity-boosting reforms for Australia.
The headwinds of inequality do not just emerge from the finance sector. To a greater or lesser extent growing inequality is a feature of all advanced economies. How much equality governments should seek to impose is an essentially political issue with strong global influences upon any single country’s culture. Unless global opinion leaders act to limit the excesses of corporate cultures, inequality of rewards will remain a headwind that will become generally stronger, and Australia will not be immune.
Governments should do their best to make policies that provide a fair go to all. Current outcomes, with high and rising inequality, are in our view simply unsustainable. One factor that helped raise economic growth during Robert Gordon’s ‘successful century’ in America was increases in wages, which encouraged productivity increases. But gross inequalities within companies are hard to influence. As a start, governments can limit their own remuneration and that of people employed by government. Did Glenn Stevens require over one million dollars per annum to come to work at Australia’s central bank? Does Philip Lowe require such a sum to come when Mr Stevens hands over the baton.
If encouragement from government fails to introduce a fairer distribution of rewards (and therefore of incentives) within society, there is always the tax system. Rewards that are judged likely to achieve economic ‘headwinds’ can be taxed away. Serious reform of systems of taxation need to involve enacting a simpler tax system, without loopholes and dodges for smart accountants to devise.
Deflation is a headwind that is worrying many people and negative interest rates are one symptom of this in Europe and Japan. This should not be regarded as inexplicable. The world is in the midst of massive catch up by major nations, including China, India, Brazil and the advancing nations of South East Asia, South America and some parts of Africa. This involves perhaps 3 billion people entering the global workforce, ready and willing to work for lower wages than workers in first world jobs. Jobs are moving to the emerging economies whose costs and prices are lower and this is depressing many prices globally. One net result is low goods and services inflation everywhere. Short of a massive return to widespread (and damaging) protectionism the currently wealthy nations will have to live through an uncomfortable adjustment.
While central banks targeting goods and services inflation want to keep interest rates low, they need to recognise that the excess liquidity being created will ultimately spill into goods and services inflation. In the short run, which may involve at least a decade, there will be asset inflation rising to unsustainable heights, continued volatile asset markets and what Mervyn King calls ‘deep uncertainty’. (Increasing inequality as an unintended side effect.) This will override efforts of financial system regulators to maintain a less volatile set of financial markets, and the eventual return of normal interest rates will involve asset markets crashes that are likely to do great damage.
Far better in my view would be to gradually restore normal levels of interest rates so that capital accumulation and household saving return to normal in the advanced nations. Central banks should deliberately and in a coordinated and announced way restore ‘normal’ interest rates.
Budget deficits and debt.
Fiscal headwinds include unbalanced government budgets, with large deficits that often seem intractable. Worse still, economists do not speak with a single voice. Some say with fragile economies it is no time to be cutting government spending. I say that it would be better to return to normality, with government spending in balance with receipts over the course of normal economic fluctuations.
Clearly announced objectives about the ways budgets are to be balanced, with realistic timetables (rather than the usual ‘optimistic case’ guesses) need to be devised. Should parliaments be disinclined to implement such programs, governments should be willing to stick to their guns and be prepared to go into opposition.
With interest rates at record lows, there is a good case for improvements to infrastructure, an asset class that has been mostly undervalued in advanced nations. Restoring spending on infrastructure to more sustainable levels will boost jobs and improve productivity so long as projects are undertaken only after ruthlessly realistic evaluation by experts without the traditional attempt to buy elections by spending in marginal seats. (Who was it who said every time he hears an announcement of spending on a new dam he feels an election coming on?)
Governments have a role to tell it like it is. At present, governments everywhere in the democratic would have a strong tendency to encourage spending rather than saving, at a time when household debt is at record levels and government debt is headed that way. Here is a key question: ‘Why is it that governments never tell the voters what most parents tell their children’ Work hard, save sensibly and think carefully about your career?’
And in conclusion …
To this writer this is the major failing of modern democratic governments. So ingrained is it that one piece of conventional wisdom is that sensible policies require a serious crisis before they begin to be considered.
However, problems foreseen will usually be problems mitigated. If democratic nations do not soon restore budgets and interest rates to normality, after explaining why this is being done, and reforming the rules of finance as indicated, the next crash is likely to make previous crashes seem small.
The first step in a return to an enhanced normality is for government to debate and accept the logic espoused in this essay. In summary, what the world needs is:
A more sensible set of rules of engagement for global finance.
Careful deregulation of many other commercial activities, to boost productivity in many industries.
A coordinated restoration of normal interest rates and balanced budgets.
Greater equality of incomes and wealth.
A culture that more seriously embraces the verities of hard work, smart work and saving rather than spending