ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Has financial deregulation finally been discredited?
, June 7, 2008
Hands-off financial policies, far from stabilising markets, have so disrupted them that governments have had to intervene to prop them up.The financial crisis in the United States may have been contained, Princeton University economist Paul Krugman has suggested — cautiously — in a recent article.
If that turns out to be true, Krugman, rightly, gives credit to the chairman of the US Federal Reserve bank, Dr Ben Bernanke.
Bernanke can be shown to have acted decisively and aggressively. In particular, he cut interest rates in order to keep the economy moving — which was undoubtedly the correct focus rather than the lesser problem (in the circumstances) of tackling inflation. Incidentally, we here in Australia might also have much for which to thank him.
The governor of the Reserve Bank of Australia (RBA), Glenn Stevens, was initially tempted to follow the more orthodox path of economic management and raise interest rates to deal with what was, obviously in our case, an economy at risk of overheating. Had he done so, he might well have plunged our economy into recession. Recognising this, Mr Stevens followed the example of what was being done in the US and held his hand on interest rates.Ideological straitjacket
Of course, Dr Bernanke's reaction to the US financial crisis has not stopped at just fiddling with interest rates. He has acted in such a way as to facilitate the takeover of an important US bank whose imprudent lending practices had driven it to the edge of bankruptcy. In that act he has demonstrated an ability to think outside the ideological straitjacket which had so tightly constrained his predecessor.
No less importantly, he seems to have convinced the rest of his colleagues in the Western economies that they should act in concert in pumping money into the system to help ensure the maintenance of a reasonable credit flow.
If our recent Budget is any guide, the new Rudd Labor Government too has been impressed by the Bernanke example. To this writer at least, the Labor Government's action was a bit of a surprise. All the pre-budget rhetoric was about a "tough" budget — one devoted to cutting spending in order to slow an overheating economy. In fact, it is, in careful measure, an expansionary budget — as the federal Opposition has lost no time in pointing out.
Dr Bernanke is a respectable example to follow. He knows about economic downturns — and their causes. He is an authority on the 1930s Great Depression. As such, he is well aware of the policy failings associated with that financial crisis which ultimately devastated the world economy. He wasn't about to risk repeating those mistakes. Guided by institutional memory and objectivity, rather than ideological commitment, Dr Bernanke sensed what was needed, and did it.
We can't yet be certain that he will succeed in overcoming the financial crisis, but he is giving the US every possible chance to pull out of it with a minimum of harm. Much depends on him. If he fails, the real economy might lurch into a dangerously deep recession.
Krugman's recent article was, however, aimed at more than merely giving due credit to the US Federal Reserve chairman. He was sounding a warning about regulation of the financial sector. Swift and decisive action has, quite possibly, saved the day this time. But what emerges as the important lesson of this crisis is that the absence of regulatory restraint on the operation of the financial sector has been the root cause of the problem.
The regulatory arrangements applying to orthodox banks haven't worked. Ordinary commercial banks have found it easy to circumvent loose regulation by setting up parallel financial institutions outside the bounds of the regulations. These arrangements have promoted the widespread adoption of imprudent lending policies and the consequent losses — notable in house-lending, but going far beyond that.
The US experience makes clear that the Americans, and probably the rest of us, need to revisit the matter of regulatory constraints on financial institutions. This time we need to go further than restricting the operation of commercial banks; we need restrictions covering all financial institutions operating in a bank-like fashion.
Krugman is, presumably, not alone in his belief that an unrestrained finance sector will inevitably lead the US into another and more severe financial crisis: one from which recovery will be more prolonged and difficult. Notwithstanding this, powerful interests and financial institutions are pushing in the other direction. Wall Street (their natural fellow-traveller), with both vested and ideological interests at stake, will be right behind them.
However, while still powerful, these interests may be losing some of their influence. Indeed, the entire ideological underpinning of the deregulationist philosophy — unrestrained free markets — has never looked more vulnerable.
Until the present crisis, it was still possible, with some stretch of credibility, to defend the free market position — even to the extent of financial markets. That defence remained plausible while the illusion persisted that financial market deregulation was delivering what had previously seemed to be impossible: an apparently endless supply of cheap credit to anyone who asked for it.
The present crisis has demonstrated, yet again — and decisively — that such miracles are unsustainable. More importantly still, it has exposed another economic truth — that asset-bubble inflation, the hitherto unacknowledged child of irresponsible lending policies, is quite capable of crushing the real economy.
Most orthodox analysts have studiously ignored the adverse consequences of asset-price inflation. Some, even, have championed it as a virtue — understandable perhaps, since to do otherwise would contradict the virtue of unrestrained market operation.
Financial deregulation always has marched in lockstep with other aspects of free market dogma. The question now is: how much longer can the deregulationist ideology hold sway in the face of mounting adverse evidence?
If the Western economies feel compelled to embrace tighter regulation for financial institutions, that will be a serious setback for the free market ideologues. If the unfettered market doesn't work for the financial sector, why should we believe it's appropriate for the wider economy?
This is especially so once we acknowledge that the free market experiments applied to the real economies of Latin America have failed spectacularly. Despite initial guidance from the high priest of free market orthodoxy, the late Professor Milton Friedman of the University of Chicago, these economies — most notably, in Brazil and Argentina — have subsequently had to be rescued from bankruptcy by a return to an interventionist type of capitalism.Total failure
The free market experiment was a total failure in Bolivia. Even in Chile, where General Augusto Pinochet's dictatorship (1973-1990) gave Friedman's ideas perhaps their freest rein, these deregulationist policies initially caused much hardship. Recovery proved painful and protracted. Indeed, it probably only proved possible because, in a moment of wisdom, Pinochet declined to privatise the highly profitable state-owned copper-mining enterprise.
And, of course, we should not forget the disastrous free market experiment in post-Soviet Russia.
The Latin American experiment stands as evidence that unrestrained free markets and deregulationist policies can never generate the savings necessary for growth in developing economies. Consumption-based economies, such as exist in most of the English-speaking, advanced Western democracies, have embraced this philosophy with great enthusiasm. However, even for them, its benefits, real and imagined, should be set against some quite unwelcome side-effects.
Seriously unequal distribution of economic growth outcomes is one. Another is a high level of long-term, realistically calculated unemployment. A third is an ever-mounting level of overseas borrowings. To all these we may now add another — a destabilised financial sector.
Don't forget, either, that those economies most fully succumbing to financial market deregulation pressures have suffered most in the present crisis. By contrast, the savings-oriented democracies outside the English-speaking world, which held on to some form of interventionist capitalism, seem to have fared better.
The entire deregulationist push came as a reaction to the post-war interventionist policies promoted by the English economist John Maynard Keynes. It was he who led the push against the classical economic orthodoxy which held that unrestricted markets could always be relied upon to ensure that the economy operated at maximum output and full employment, and that government intervention could never help matters.
Keynes disagreed. Markets, he maintained, did not necessarily deliver appropriate self-correcting mechanisms for the economy as a whole. Sometimes governments needed to intervene with corrective and supportive polices.
Keynesian ideas delivered economic growth and prosperity until the 1970s — when the world economy became plagued simultaneously with stagnant growth, unemployment and rising inflation — a phenomenon called "stagflation".Discredited alternative
Traditional Keynesian-type interventions didn't work. As a result, the door was opened for a re-run of the previously discredited deregulationist economic alternative.
Despite its early promise, the return to deregulation and free market economics has not succeeded. Stagflation is once again on the march. And this time, Keynes can't be blamed.
Free market ideology and hands-off financial policies in the English-speaking Western democracies, far from stabilising markets, have so disrupted them that government financial subsidies have been necessary to protect the system from collapse.
As already pointed out, it all could have been much worse but for the timely example set by the chairman of US Federal Reserve, Ben Bernanke.
But isn't it time also to spare a thought for Keynes? After all, the responses of Dr Bernanke have been classically Keynesian. When markets fail — and they sometimes do — the only alternative to economic chaos is, as Keynes used to argue, government intervention. Dr Bernanke seems to have sensed this, and acted accordingly.
No wonder a wise head like Eric Janszen has already observed that, however many of us may be free-market adherents in a booming economy, "we're all Keynesians on the way down" (Harper's Magazine
, February 2008).
Is there perhaps more to Keynesian prescriptions than economists trained over the last quarter century have been led to believe?— Colin Teese is a former deputy secretary of the Department of Trade.