The world economy is 'in the red zone', 'navigating in dangerous waters' and a variety of other colourful and depressing descriptions. As the opening sentence of my book Great Crises of Capitalism asserts, the world may still experience a depression as a result of the global crisis that exploded in 2007-08. Indeed the odds of this have risen appreciably since the book was completed in late 2010.
The descriptions of current risks are signs of deep frustration among world leaders. If they are honest they will recognize that they, or their predecessors, are responsible for the current mess. The sad fact is that it is far easier to wreck an economy than it is to fix it.
Here is a bold hypothesis. An economy, even one as complicated and many-layered as the global economy, has its own tides and timetables. Governments can steal (or borrow) from the future by spending more, but the future demands its payment which come in the form of debt that needs to be serviced. Indeed, if markets come to think debt is too large, the debt needs to be repaid or else borrowers need to default. Governments can provide temporary stimulus, but this will be very unlikely to much change the overall level of activity, taking one decade with another.
A similar theorem applies to monetary policy. Stimulus now will increase economic activity now but the cost comes in the form of inflation and the tightening of future monetary policy, both responses that slow future activity.
When nations or banks become insolvent, a bailout now may alleviate the adverse effect on economic activity but, by adding to debt of the government (or a financial institution that acquires the failed institution), future activity will be slowed. And bailouts create 'moral hazard', encouraging a repeat of the foolish behaviour that created the insolvency.
The case for ‘activist’ economic policy is the same as the case for fixing potholes in the road, removing a cause of accident that might end the journey, or at least cause sizeable damage to vehicles hitting the pothole.
The trouble is, economic potholes are frequently filled with wasteful spending that weakens incentives to work, to save and to innovate. Spending or tax relief that does not add to productivity, as is frequently the case when there is unexpected economic trouble, is like filling potholes in the road with loose sand and gravel, likely to do more harm than good, if only by reinforcing the modern delusion that ‘the government will provide’.
The people I call 'bastard Keynesians' have been in charge. Such people rush around looking for potholes to fill and (worse) to fund great projects they described as 'nation building' with no benefit cost or other rational test of value. Keynes himself was concerned with the once in a century case of deep and intractable depression, when no compassionate leader can sit pat without offering policies with some chance of success. But, even in the case of deep depression, if households and businesses reject the attempts to alleviate the situation, 'Keynesian' policies will fail. This point was clearly recognised by my teachers at Melbourne University almost 50 years ago.
My bold ‘intertemporal policy impotence’ hypothesis has probably already been devised by some bright, mathematically inclined young economist at the University of Chicago, and if so I would welcome being sent a relevant reference. But, if it is supported after careful thought, it disposes once and for all of the Keynesian approach to economic stabilization.
Now we have leaders rushing about looking for ways to bail out Greece and other weak Eurozone countries without draconian fiscal restraint and indeed to soften the obvious approach of imposing tight fiscal policy now. The trick is to tighten future fiscal policy without imposing very tight fiscal policy now (= austerity). One way to do this is to reform fiscal policy by removing tax breaks for the rich or, in the case of Greece, remove blatant and widespread tax avoidance and evasion. The rich and the Greeks naturally resent this attack on their accustomed rorts and throw metaphorical or real rocks at their leaders.
I have no doubt that solving the problems of Europe must start with an orderly writedown of Greek debts, and those of other overly indebted nations. (This was the approach in the case of excess debt during the Latin American debt crisis of the late 1980s. Note that people who brought heavily discounted debt made a lot of money, showing the inherent ability of capitalism to solve problems that seen intractable.) Debt write-downs must be accompanied by sufficient fiscal austerity, and a different set of tax and welfare arrangements. The overall object of such policies must be to encourage a return to thrift, responsibility and innovation to get each nation's debt onto a sustainable path. In severe cases, weak nations should devalue their currencies, but only after the overall debt load has been dealt with or there would be a row of falling dominos that the Eurozone would be unable to prevent.
Mr Robert B Zoellick of the World Bank pointed out that, while the original shock in the current crisis was anticipated by few people, there is no such excuse now. He said over the weekend that the problems of the USA, Europe and Japan could spread to the developing nations. Commodity prices (including even gold) have plunged and developing nations are ‘facing fresh headwinds’. This means Australia is not immune and, like other nations, our fiscal position is far less attractive than it was when the original crisis hit.
We must hope that the world’s leaders finally get their act together and find a way through the road of many potholes we are all travelling. Unless and until they do, investment should be conservative, at the very least accumulating cash rather than immediately plunging into the equity market. Henry expects there will be better bargains by the time the current crisis of confidence is finally resolved.
Someone at one of the meetings I attended last week asked me what I would do. The obvious answer is that, like the skeptical Irishman, I would not be starting from where we are now, as the final chapters of Great Crises of Capitalism makes clear. The world needs stable, well understood policies rather than the massive knee-jerk policies applied during the past 3 years. While some fresh pothole-filling may well be justified - especially cleaning up the debt burdens of Greece and the other weak nations of the Eurozone, and the banks who have lent to these nations - the authorities need to rethink their approach.
Confidence of households and leaders will only gradually be improved, but credible plans to implement stable, well understood policies with major reliance on anti-inflationary global monetary policy and greater use of automatic stabilisers would provide a good start.
This paper was written about 6 years ago, inspired by Robert Zoellick's address.
See Robert Zoellick's press conference here
stable, well understood policies with major reliance on anti-inflationary global monetary policy and greater use of automatic stabilisers would provide a good start.