Saturday, January 16, 2010

Intolerance of small crises led to this big one

This is my critique of a recent op-ed written by Poland's finance minister. While the minister makes some eloquent and logical arguments, he misses on some key points. Below you will find his full-length article, along with my bold-faced commentary interjected throughout.


The financial crisis was not a crisis of capitalism or globalisation. Instead it is a crisis of the "deep Keynesian project", according to which the aim of economic policy should be the maximum smoothing out of fluctuations in the real economy (as long as consumer price inflation is kept under reasonable control). While the tools of this policy approach were very different in the boom years preceding the crisis from traditional Keynesian ones, relying more on monetary than on fiscal policy, the fundamental aim was quintessentially Keynesian. The crisis is the logical outcome of the success of this policy for almost 20 years.

Absolutely. To add more granularity to Mr. Rostowski’s statements, central banks and foreign governments went on a spending spree. That is, the former printed money out of thin air while the latter consumed (i.e. their citizen’s wealth) what they did not have. What alleviated the price inflation push was the unparallel liberalization of the Chinese economy and the influx of cheap labor force once communism fell in Europe. In fact, this crisis has been in the making ever since the independent monetary restraint in the form of the gold standard was loosened (in 1914) and absolutely done away with it (in 1971).

What drives the market is the balance between fear and greed. If economic policy eliminates fear, only greed remains, and there is no mechanism to limit "irrational exuberance". This was the fundamental cause of the crisis. Moral hazard and herd behaviour are natural consequences.

This is one way to look at it. Indeed, fear and greed can be seen as the opposite ends of a spectrum. The large majority would concede that greed is never good; and the same can be said of fear. The market, which is ultimately made up of people willing to bid and offer what is deemed in their best interest, is not an absolutely impersonal and autonomous force. Society, through its moral attributes, undergirds the function of the market. Having said that, the only limitation placed on the market must come from society itself, not from any outside agent (e.g. government), whose ultimate actions must invariably be exerted through force. Therefore, there is already an innate mechanism to limit irrational exuberance (i.e. society): contrary to popular belief, the consumer determines prices, not business. Interfering with this mechanism inevitably leads to moral hazard and perverse incentives that manifest themselves in herd behavior.

The essence of global monetary policy before the crisis was the "Greenspan put" - the attempt of the then Federal Reserve chairman to prop up the securities markets by lowering interest rates, so as to avoid even mild recessions. The danger is that this policy will be continued after the crisis. The natural state of capital markets from which fear has been removed is the generation of asset bubbles. If global policymakers do not understand this, bubbles are likely to proliferate through carry trade from the US and other countries with minimal interest rates and weak currencies.

Agree. The “fear” Mr. Rostowski refers to here is actually the fear by the large corporations of going bankrupt because either the Central Bank or the government will not bail them out. Anyone with any business sense will realize that income losses frighten owners because consistent red marks will ultimately put an end to their endeavors. Remove that fear through implicit guarantees (moral hazard) and what you have is a recipe for disaster. The magnitude of the disaster will be in proportion to the level of distortion by the government. Against this backdrop, expect the next crisis to be greater in comparison to the recent one we experienced.

Weak regulation and supervision were not the fundamental problems, although they can and should be improved. Countries not in crisis - China, Poland and much of Latin America - were, above all, those with low leverage, not those with sophisticated financial supervision.

Good point. The hot shots in DC seem oblivious to this fact.

In the 1970s, ordinary Keynesianism was discredited when the Phillips curve collapsed. The alleged trade-off between inflation and unemployment turned out not to exist. Keynesian policy merely justified ever larger budget deficits and higher inflation, until policymakers understood that it led only to higher permanent unemployment. The old goal of reasonably balanced state budgets was rehabilitated.

And yet politicians, policymakers, and the majority of the economic profession call for the same failed policies to be enacted. We are witnessing the incarnation of the Biblical proverb that says, “as a dog returns to its vomit, so a fool repeats his folly.”

Moral hazard must be reduced. Fear should be greater on Wall Street and in the City of London to reduce the fear of ordinary citizens. Very loose monetary policy is rebuilding financial institutions' capital, which is good, but it must not be allowed to go on for so long that new bubbles arise.

There is a conceptual problem here. Loose monetary policy, which is basically printing money out of thin air, is not creating capital. It is digits, paper with ink which has no intrinsic value. Sure, it fetches some price, but it has no value. This is why we say that our current monetary system is fiat-based—that is, money created by decree. Capital, on the other hand, is not so easily created. It is the excess of what is consumed by the private economy. Simply printing money and calling it capital is disingenuous at best and the lack of understanding the nature of money at worst.

It is impossible to accept, unless we are blind by cognitive dissonance, the same institutional policy and framework (promoted and endorse by central banks) that generate the boom/bust cycle. Bubbles will inevitably arise any time loose monetary policy is executed, just as Mr. Rostowski previously commented.

The easy institutional change that is needed is to limit the size of financial groups. To judge from the current economic policy debate, especially in the US, banks that are too big to fail continue to prevail. Such banks capture their governments and are subject to loose budget constraints of an almost Soviet-era type, because they know the government will bail them out. Strong implicit state guarantees mean that greed untempered by fear will be their rational behaviour.

What is the right size of a financial group? Why just financial groups and not other industries? Who determines the size of these firms? Who will be responsible to ensure that firm size is not determined by political means? These are just a few questions that Mr. Rostowski avoids. There is nothing inheritably wrong with the size of a financial group (or any company for that matter), so long as it is achieved in a competitive environment, within the framework of the law, and without special treatment. In other words, if a firm has a competitive advantage because it provides a low-cost service that people want, then there is nothing immoral with having a large market share. However, if the firm has a government-sponsored monopoly (e.g. only domestic airlines can provide service within the U.S.), then the market share is not the result of competitive forces but rather manipulated ones. However, putting Mr. Rostowski consideration into practice will create bureaucracy, the very same system that generates the policies he is gently excoriating.

There should never be a policy of “too-big-to-fail.” Failure to comply will only breed in the future more of the behavior that such policy is purported to be curtailing. This fact cannot be circumvented.

The harder institutional change is to induce policymakers to give up the "deep Keynesian project". This is very hard, because policymakers probably will never be rewarded for allowing small crises or small recessions. Yet, this is the only way to avoid herd behaviour and so to prevent big financial crises and "Great Recessions".

Politicians will almost never give up power they have attained. The objective of the politician once he/she is in power is to perpetuate that power, if not for him or her, then for the party or interests they represent. Politicians will never let a small (or big) crisis go to waste. It will be used for their chief end.

As for current policy, the present, very loose, monetary policy should be enough - we do not need a very loose fiscal policy also. The fiscal stimulus measures in 2008 and 2009 were hardly necessary. The recession is over and very little of the stimulus has yet arrived. It will do so in 2010 and 2011 when no longer needed. Automatic stabilisers - less tax collection and larger social transfers - were probably sufficient and certainly timely. Any additional discretionary public expenditures should have been avoided and should now be withdrawn.

The fiscal stimulus measures simply distort capital allocation within an economy. For instance, the tax credit for first time homebuyers in the U.S. caused a spur in demand for houses. Similarly, the “cash-for-clunkers” scheme caused an in increase in demand for new cars. Had these measures not been in place such purchases would not have occurred (or at least at the pace that they did). Therefore, it is of no surprise that once these palliative measures subsided, demand went with it [note: the home-buying credit has been extended, so demand has not fully equilibrated]. Always and everywhere discretionary public expenditures must be avoided not only for the reasons just mentioned but also because it must be funded by taking resources from an individual who could have put it to better use.

Instead, our major challenge is to contain public expenditure and restore fiscal balance. The big concern for the west is elevated public debt. It is doubtful whether debt levels above 100 per cent of gross domestic product are fiscally sustainable, but more and more countries are heading that way. The world needs smaller and more rational entitlement systems, not more discretionary spending, which has a tendency to become permanent. There should be no new mandatory expenditures for years to come.

Agree. Yet, making this a reality will take political courage (read: resign to overarching federal power). While I remain hopeful that this will happen, I am not sanguine it will occur in an orderly fashion. That is, I perceive a major fiscal crisis ultimately emanating from the exorbitant debt load.

The one big success in the current global crisis has been that no protectionist spiral has developed, but one success and many failures does not amount to an impressive scorecard.

Taking an objective look at the politicians’ scorecards, this is hardly ever the case

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