WORLD ECONOMY : by Colin TeeseNews Weekly
The market is unpredictable
, July 12, 2003
In the Review section of the Australian Financial Review (June 6), an article appeared by John Kaye entitled "Capitalism Betrayed". Kaye is the author of a recently published book entitled The Truth about Markets: their Genius, their Limits, their Follies.
What we call economic rationalism - that is, the combination of free trade, market deregulation, privatisation and small government - Kaye calls the American Business Model, or ABM. By way of aside, Kaye tells an amusing story about a meeting in Denver in 1997 of the G8 - that is, the eight richest countries in the world - at which then President Clinton was apparently showering effusive praise on the ABM. The London Financial Times
then reported one European at the meeting as saying:
"They keep telling us how successful their system is. Then they remind us not to stray too far from the hotel at night". Inflation
Although it is not always stated, a key part of the ABM strategy to contain inflation. In pursuit of this objective central banks have been directed by their governments to concentrate their efforts on attacking inflation, which was seen as the enemy of success for the ABM.
Governments, in turn would play their part. Trade barriers would be reduced or eliminated, in the expectation that these would help contain consumer prices. And union power would be curbed as a means of holding wages down.
Without conceding the merit or otherwise of these policies, we are entitled to ask whether they have delivered what was claimed for them? And, have central banks, through their control over interest rates, kept national economies from overheating, while, at the same time, maximising growth possibilities? Proponents of the ABM would answer "yes".
But have they, and, in any case, at what cost? Australia's central bank, for example, has a statutory responsibility to maintain full employment, which it has completely ignored for the last twenty years or so.
More generally, the ABM, with its blind faith in markets and deregulation, hasn't seemed to be able to handle economies under strain.
In the US, for example, we have watched the untrammeled growth of bubble and bust markets for US stocks.
At first, the Chairman of the US central bank insisted it was for the market to correct whatever imbalance might plague US share prices; and when it became obvious that markets were not correcting, he proclaimed himself powerless to control what he judged to be the over-exuberance of buyers, other than to fiddle with interest rates. Apparently, the possibility of market failure was a prospect too terrible to contemplate.
In Australia, our central bank has presided over a similar problem in relation to housing prices: and the response has been eerily similar to what happened in the US.
On both sides there appeared to be a conviction that market structures could be held together, in any circumstance, so long as inflation was controlled.
The trouble with this approach is that it rests on an extremely shaky foundation - that the application of the ABM model, so long as inflation is controlled, will permit markets to function in such a way that economic (and social) outcomes will be maximised.Accurate measure?
Even if we allow that the basic assumption is correct, we are always left with the problem (which seems to plague all attempts to deal with inflation): do our existing consumer price indices accurately represent the presence or absence of inflation in the economy?
By way of aside, the US economist Milton Freedman - a strenuous defender of the ABM - ran into the same problem with his Monetary Theory, which was supposed to be the last word on how to deal with inflation. Freedman's idea was deceptively simple.
Obviously, prices (however measured) inflated when the supply of money grew faster than the supply of goods. Too much money chasing too few goods.
If production could not be increased, for whatever reason, regulating the supply of money (or purchasing power) would hold down prices. Fine. Except how do you contain the money supply in the face of the kind of sophisticated loan arrangements offered by deregulated financial markets. Whatever may be the pace of production growth, funds available for loan will always be able to grow faster.
Thus, any correction policy would require direct government restrictions on lending by financial institutions - which the institutions themselves would contest - and which Freedman himself would oppose.
Interestingly, it is obvious that in the case of the escalation of share prices in the US and, to some extent, housing prices in Australia, too much money chasing too few goods is precisely the problem. A Freedman monetarist solution would work perfectly. Curtail the flow of money to purchasers by raising interests rates, and the problem is solved.
Sensible enough, surely; and, moreover, it follows the kind of orthodox economic prescription of a staunch supporter of ABM policies. So why was it not done? Because to have done so would have required central banks to take their eye off the 'control inflation' ball.
The Chairman of the US central bank, Dr Greenspan, made this abundantly clear in relation to the out-of-control US share prices. Because inflation was held low (if you excluded share prices) Greenspan held on to low interest rates. Deflation
In fact, he kept pushing them down. Whatever that may have done for the rest of the economy in the short term, longer term it caused a market correction in inflated share prices which fed serious deflation into the US economy, which threatens now to infect the entire world economy.
When he wasn't watching, the kind of inflation Greenspan didn't think he could or even needed to control, turned on the rest of the US economy and on the wider economic community.
In effect, Greenspan's ideological bent guided him into serious miscalculation. He believed he could not control inflation affecting the financial sector by increasing interest rates - without risking the possibility of driving the rest of the economy into a downturn. And yet, by not raising interest rates, the unchecked bubble and ultimate bust of US share prices did precisely the same thing.
The deflationary consequences that Greenspan hoped to avoid happened anyway .
He is most recently reported as having confessed despairingly to a colleague, that we don't yet understand how world financial markets work. Perhaps so. But, more likely, they cannot be understood on the basis of the Greenspan starting point - that is that market imperfections are best left to correct themselves.
Much the same problems are currently affecting the management of our Australian economy; except that the driver is not rapidly escalating share prices, but an overheated housing market. And while - unlike US share prices - our housing prices find their way into our consumer price index, it seems unlikely that their weightings fully reflect the way inflated house prices impact on general inflation.
In any case, one thing is certain, we may be unable to avoid repeating the mistakes Greenspan made. Our reserve bank is keeping interest rates down to keep the economy afloat, in the clear knowledge lower interest rates can only further inflate house prices.
Yet - as with the US bust and boom in share prices - allowing house prices to rise unchecked, must ultimately lead to a bust which will feed back into our general economy. Local response
Our Reserve Bank Governor's response is interesting. Previously, the bank had boasted that its sound policies insulated Australia against the Asian meltdown.
However, the Governor no longer seems to have the same confidence. Now he is saying he does not want to move on interest rates, until he is clear about how the US situation impacts upon Australia.
Perhaps, also, he might reflect upon the possibility that his ideological persuasion limits the range of economic tools at his disposal. In this case, his dilemma is, how to prick the housing boom without pushing the economy into downturn?
His role model, Greenspan, wasn't able to do manage it with shares; should we have confidence that our Reserve Bank, with the same tools at its disposal, will be more successful?
Perhaps, we may soon see the time when our Reserve Bank leader is forced to follow the Greenspan example, and admit he doesn't know how to tame delinquent market behaviour.
Of course, it would be better for all of us if both men finally came to recognise that markets will not and cannot act in the way those central banks' addicted to the American Business Model believe they should.
But don't count on that happening.
- Colin Teese was Deputy Secretary of the Department of Trade