In 1976, Chairman Deng made some bold changes in the way that China’s economy is organised. A decade and a half later, China was generating economic growth on a scale never before seen in human history. The lesson from China was learned quickly by the people of Eastern Europe and the former Soviet Union who reformed the most heavily regulated economy since feudal times and began their painful adjustment. India, too, saw that the path it had followed since independence was mistaken.
The result of this movement away from regulated markets was a period of outstanding growth, a process well understood in economics.
This was particularly true in China and India, which together account for more than a third of the world population. They were joined by other developing economies. The non-OECD countries average annual real GDP growth was over 6 per cent in the first half of this decade, compared to 4 per cent in the 1990s.
Developments in China and India formed a virtuous cycle with the globalisation process, which accommodated their growth and which they helped to drive. World trade expanded to new record levels as a percentage of GDP.
The globalisation and growth of the world economy led to a massive reduction in the extent of poverty. The World Bank’s assessment is that the incidence of poverty declined from 42 percent of the world population in 1990 to 26 percent in 2005.
Economists have also understood that long term growth runs into constraints.
In 2008, at the onset of the current crisis, some of those constraints were a significant rise in the prices of food and energy and an increased understanding of the consequences of burning fossil fuels for the environment.
Yet in those constraints were also opportunities. Rising food and energy prices also send signals to redirect investment towards the most promising lines of investigation.
Australia meanwhile had become a major beneficiary of the process of globalisation, and real incomes increased significantly as a consequence of the rises in commodity and resource prices. Household wealth in Australia rose significantly.
Another thing that economists have understood is that financial markets need to be handled with care if short term booms and busts are to be avoided. Further, they have long understood that monetary policy lies at the heart of the problem of financial boom and bust. Every major bubble had its origin in loose monetary policy and had its bust in the over-reaction and tightening of monetary policy. The 2007 crisis is no exception.
Monetary policy must be based on rules if it is to avoid catastrophic outcomes like those we’ve seen in the global financial crisis. But economic policy makers have ignored these advances in understanding, with the US Federal Reserve the worst offender.
Beginning in 2002, the Federal Reserve embarked a policy of low interest rates and easy credit. The Federal Reserve persisted in its unwise monetary stimulus until 2006. During these years, the U.S. mortgage market exploded on this readily available fuel. House prices soared and borrowers and lenders became ever bolder in the bets they placed.
Securitisation of mortgages pushed the risk from the original lender. Derivatives based on mortgage-backed securities pushed the risk further from the originator of the securities. Banks around the world were attracted to high rates of return on instruments but these were investments whose risk they didn’t know.
By 2007, fuelled by the Federal Reserve’s egregious policy errors, markets were moving into unsustainable bubble territory. The Fed by this time had realized the problem was getting out of hand and had moved interest rates up sharply—too sharply—and burst the house price bubble.
A number of other factors exaggerated the consequences of this action.
• The significant increase in the degree of financial market integration over the last decade with its ability to mobilise funds for investment was a critical contributor to economic growth. The sophistication of financial instruments that moved risk around and enabled borrowers and lenders to trade risk also contributed to economic growth. But the new instruments require higher levels of information about what lies behind them so that their value and risk may be accurately assessed.
• The way that earlier shocks had been handled contributed to the situation. Some of these responses at national level, driven by political concerns about the interests of small shareholders or depositors, created expectations of bail-outs if a crunch came, which did not ameliorate the incentives in financial institutions to take risks.
• The volume of funds flow involved had grown dramatically, in part a consequence of the development strategies of the East Asian economies. Their economic policy settings and their high savings rates, in response to their own experience of a crisis in the late 1990s, contributed to the imbalance in the flow of funds across the Pacific and to easier credit in world markets. The oil exporters who benefited from higher oil prices were also accumulating assets.
Evidence of a problem had started to accumulate from early 2007 and economists were already working on scenarios associated with sub-prime problems in the US. In early 2008, the body of academic economists in the US had sessions in their annual conference on exactly that topic. Nouriel Roubini and Paul Krugman were then making their warnings.
The focus at that time was on the sub-prime assets associated with housing loans and it was expected that any shock there would be a relatively small and manageable. That expectation was not met, because of the interconnectedness of the financial markets in different countries, the extent to which banks in other countries were exposed to these assets and the extent of leveraging that had taken place.
The response to the crisis is driven by economists’ understandings about their management.
• At national economy levels, there have been packages of government spending and lower interest rates, plus action to get rid of problem assets out of banks in order to get credit going again. A key message of earlier experiences is that the costs of unemployment are high for young workers and those pushed out of the workforce, and that is the best focus of the immediate policy response.
• At an international level the important contribution of the G20 was to adopt a coordinated response, since the alternative contained severe risks, for example of trade wars.
However, there remain uncertainties as to the impact of fiscal policy.
One reason is that the patterns of spending in the fiscal response are driven in part by political criteria, not necessarily effectiveness which runs the risk of longer term problems. More importantly, the responsiveness of the economies of the world to these various actions in this current environment is difficult for economists to predict. This is a topic for further work and part of a new research agenda which is emerging from this crisis.
We conclude with a point about the long run. Joseph Schumpeter calls the process of growth in a capitalist market economy one of ‘creative destruction.’ New ideas, new technologies, new businesses, new forms of human capital, new networks of traders, new financial instruments, emerge from the creative process. But the old must make room for the new. A recession is a time most favourable to the new. It is no surprise the many of the world’s biggest and most successful firms were born in recession or even depression.
The 6th edition of the authors’ textbook Economics, published by Pearson Education Australia, will be published in June this year.
As an amateur economist, I sort of agree with the author’s points’, but only to a certain degree. The second dot point at the beginning was like a bottle half empty versus a bottle half full. While it sounds obvious right, but one can’t help have a sense of tautology in the argument. Nevertheless, it may inject some fine-tuning to the hot debate on strengthening financial regulations with some cold reasoning.
The third dot point appears to be too much of a defence of the indefensible. The authors provided some examples to show their point. To quote from them:
[Evidence of a problem had started to accumulate from early 2007 and economists were already working on scenarios associated with sub-prime problems in the US. In early 2008, the body of academic economists in the US had sessions in their annual conference on exactly that topic. Nouriel Roubini and Paul Krugman were then making their warnings.
The focus at that time was on the sub-prime assets associated with housing loans and it was expected that any shock there would be a relatively small and manageable. That expectation was not met, because of the interconnectedness of the financial markets in different countries, the extent to which banks in other countries were exposed to these assets and the extent of leveraging that had taken place.]
It seems that the very examples they used actually disproved their point at the same time when they tried to argue it and shot their own feet. The root of the current crisis had its origine much earlier than 2007. As the authors said, in as early as 2002 the Fed began its overly loose monetary policy and persisted with that unwise monetary stimulus policy until 2006. The sub-prime would have started also well before early 2007 when the author said economist were working on that. As the author said, only until early 2008 “economists Nouriel Roubini and Paul Krugman were then making their warnings”.
Was that strong enough to say that economists didn’t fail to anticipate and avoid the crisis? As an amateur economist, I don’t feel that way, to be frank. To say otherwise is too defensive, if not being interpreted as offensive.
The fourth dot point is obvious correct, but is incomplete in the sense that it does not say there have been significant failures in economics, both at the microeconomics and the macroeconomics levels. From microeconomics point of view, there are the issues of correct valuation of securities, derivatives and etc, as well as information failure. Economics needs to contribute to the resolution of those issues.
At the macroeconomics, the conventional macroeconomic tools or policies provided few ready policy prescriptions for the authorities to use to combat the financial and economic crisis, so that the Fed had to resort to the so-called non-conventional methods in its attempt to find a way out. Conventional monetary policy has long become ineffective when interest rates are very low, as have been the cases in a number of countries.
The effectiveness of conventional fiscal policy has also been in doubt. This is because the levels of government debts in quite a number of advanced economies were high and further rises in government debts run into political difficulties and also undermine confidences. More to the point, if the private sector stops, it is too much to expect that the government can fill the entire void left. There are also the longer run consequences of too much government spending and debts. Long run efficiency is at risk with government playing the private sector role. More importantly, fiscal policy does not appear to be the right approach to solve the current financial and economic crisis, a balance sheet recession as some economists calls it similar to the Japanese case following the bubble burst in the early 1990s.
Economists’ two arms of macroeconomic tools or policies have been ineffective. Like it or not, that has been the fact and economists should have the courage to admit it. Only by truthfully realising the failures of economics, can economists create new theories to remedy those failures, to provide new and more effective prescriptions for authorities to deal with similar future challenges.
The Keynesian theory was born following the great depression. Although having been criticised and ridiculed by many, it including both the conventional fiscal and monetary tools, has contributed in preventing another great depression until this great recession. New theories will arise from the experience of this great recession. They will further enrich the body of economics and provide theoretic guidance to policy makers when they face another one. But hopefully, if advances in microeconomic theories can effectively address the correct valuation of securities and risks, we may not experience another great recession.
While it is too early or premature to say what is needed of macroeconomics, it appears that it might need to keep the stability and correctness of “asset market values”. They can’t be allowed to grow too fast to balloon to bubbles. Nor can they be allowed to fall too much when bubbles burst to such a degree that severely affects both the supply (firms don’t produce) and demand (consumers don’t consume) as a result of battered balance sheet due to falling assets values.
What the authorities in many countries have done so far have an effect to lift the values of both the housing markets and the equity markets or at least to prevent them to fall further, intentionally or not. But the efforts so far have appeared to lack of potence. But they are trying without the guidance from economists, or maybe ignoring theirs.
It is in this sense of advancing both microeconomics and macroeconomics that I totally agree with the authors’ fourth dot point, that is more economic research is the best hope.
“The current crisis is a failure of regulation that calls for not more regulation, but the right regulation.”
The Great Depression led to many reforms in banking and finance that were gradually removed during the past twenty years. Some of the “right” regulation was eliminated at the same time that Congress was urging government agencies to guarantee 100% of value home mortgages. This subsidization of housing and the provision of federal guarantees on risky loans represent not “regulation,” but governmental interference in the market place. Then there was the backdrop of rewarding bad behavior by bankers over the past twenty years–Remember the loans to Underdeveloped nations on the major NYC banks’ books–and the Mexican bail-out; and the S&L bail-out?
Faced with the mounting level of risky loans, the Fed tightened interest rates, bringing on the total collapse. First the excesses of Fannie-Mae, etc, fanned by the opportunities from loosened regulations, then higher interest– Could the government have possibly done more harm? Such ill-advised government actions should not be cloaked in a fog of macro and micro finance theory. If ever there was a case study in the harm done by central planning under big government programs, this was the most obvious.
Bill, what is your point? Forgiving me being slow, but I really have difficulties in making sure what you were talking about. You started with a quoted semtemce, did you support that or arguing against it?
You talked about “some of the “right” regulation was eliminated. Does it mean we got more or less regulation, albeit the “right” one?
You talked about “the harm done by central planning under big government programs”, I have also heared the US government outsourcing to reduce government size. I am not living in the US and don’t have first hand experience of the size of government programs and the “right” or wrong government regulation, or wether too much or too little regulation. Can you enlighten me on those, please?
I am eagerly waiting.