ECONOMIC AFFAIRS: by Peter D. Jonson News Weekly
Lessons from the global financial crisis
, August 6, 2011
Boom and bust are inherent features of capitalism. The tendency to episodes of over-confidence, even mania, is present in many people, maybe especially the most creative.
The message of history is that occasionally, perhaps under modern conditions more frequently, there is a tendency to episodes of collective optimism or even mania.
These episodes always end in a crisis in which great damage is done to whole economies, and to many individuals and families.
In this article we focus on what should and can be done to cope with the general tendency to financial boom and bust, leading in extreme cases to bubbles followed by depression.
Current policy is piling an Everest of new government debt on existing mountains of private debt. U.S. Federal Reserve chairman Ben Bernanke has repeated his predecessor Alan Greenspan’s mistake in taking U.S. cash rates to record lows, and “quantitative easing” (= printing money) adds massive monetary policy ease.
If, as I expect, this leads to massive inflation in due course, this will pose a great challenge to capitalism. Inflation did great damage to the capitalist economies in the Age of Aquarius, and the damage will be greater if there is another similar episode.
Building economic activity on mountains of debt is also fraught with risk. Debt needs to be serviced, and government debt has produced many problems in the history of capitalism.
Excessive government debt is always “cured” by inflation, outright default or a vast squeeze on services, including spending on defence leading to the decline of a debt-laden nation’s ability to defend itself or protect its other interests.
Excessive private debt makes companies fragile and at risk of bankruptcy, and puts individuals and families at risk of needing to embrace a greatly straitened way of life. Private debt is a tangible sign of people or corporations spending in excess of earnings, and reducing debt reverses this process.
All governments need to devise and implement robust systems of overall financial regulation. “Robust” encompasses stability policy that insists on financial institutions with capital adequate for conceivable emergencies. Required capital ratios should flex with the economy in predictable ways.
Stable and well-understood macroeconomics policies are required and should include fiscal arrangements that also provide some degree of “automatic stabilisation”. Welfare policy should help protect the poorest people from absolute destitution in the inevitable overall economic downturns or in the case of personal financial catastrophe.
“Progressive” tax systems and comprehensive welfare arrangements add up to “automatic stabilisers”, at least as long as a government’s credit rating remains good and until incentives are blunted. But too much “progressivity” in income or wealth taxes will damage incentives to work and to save, so care needs to be taken in the choice of the tax scales.
Modern capitalist nations, it seems to me, have gone much too far along a consumerist road. The prevailing ideology of economists is “maximisation of lifetime consumption”, so the consumerist bias has some powerful backing.
This capitalist bias is creating vast differences in saving patterns between “developed” and “developing” nations, and this is the source of great opportunity for swings in currency values (if exchange rates are flexible) or in ownership of assets in the high-saving nations and growth of international debt owed by the low-saving nations.
Current imbalances among the family of nations are unsustainable and it would be useful to develop a more coherent economic policy framework. To this writer, a modified ideology for developed nations with explicit weight on “acquisition of knowledge” and away from simple consumerism would be a good start.
One specific change to present general tax arrangements would be for developed nations in particular to place greater weight on consumption taxes and less weight on income or wealth taxes. This would tend to limit consumption in the developed nations, and thus help to harmonise the fiscal imbalances already discussed.
It would also provide a tax that would help to even out the ebbs and flows of economic activity, as a semi-automatic increase in consumption taxes in booms and decreases in downturns would provide a more efficient economic moderating mechanism than current income and wealth taxes.
Governments also have a legitimate role in devising and maintaining sensible rules about various features of the financial system. The first such feature should be doing whatever can be done to encourage prudent and ethical behaviour by financial institutions and financial salespeople.
Rules should require financial institutions to hold sufficient capital to provide real discouragement to practices that too easily allow, indeed encourage, funding of asset booms. Some form of dynamic capital ratio regime is desirable, with required reserves as a ratio to assets rising as a boom gathers strength. Here the aim is not to stop an asset boom, but to make sure it has been properly tested and is not being engorged by a diet of easy money.
This writer is happy to stand with Paul Volcker in calling for the return of the Glass-Steagall law in the United States, and equivalent rules elsewhere. Such laws separate financial institutions into “commercial banks”, which are closely regulated and may have government-backed deposit insurance, and “investment banks” that are lightly regulated but with no government guarantees.
It is also desirable to use anti-monopoly laws to attack the problem of institutions that are seen to be “too big to fail”, thought with global financial institutions this probably requires at least international coordination through one or other of the relevant international financial organisations.
Clearly, regular stress-testing of bank balance sheets is highly desirable and one expects this to be done with global outcomes in mind.
It is far harder to anticipate and to provide similar resistance to new forms of finance. But, as we have seen, new forms of finance, including the now infamous securitised sub-prime loans, are part of the landscape of boom and bust.
The trick is to find ways of preventing the generals of financial regulation from fighting the last war but one.
This writer believes that, in a sufficiently serious crisis, it is desirable for large financial institutions that are at risk of failing to be rescued by relevant governments. This is controversial. The standard objection to bailout is that it encourages what economists call “moral hazard”. If financiers develop foolish management practices leading to failure, but are rescued, they (or their successors) have little incentive to behave more sensibly in future.
Extreme free-market economists say allowing failed financial enterprises to go broke will remove this moral hazard and make for a more robust, sustainable financial system. The trouble is, if failed financial enterprises are big enough to create a serious, potentially global, depression, avoidance of this will dominate thinking in any real crisis.
The trouble with not providing bailout has been seen many times before. To take just two examples, the inability of the Victorian colonial government to bail out the financiers in Melbourne in the 1890s meant many sound banks as well as unsound financial institutions were forced to shut their doors, making the downturn far worse than it might have been.
The U.S. government’s inability or unwillingness to save the myriad of U.S. banks was also a material factor in making the Great Depression of the 1930s far worse than it might have been, as current U.S. Fed. chief Ben Bernanke’s own research shows.
In the current global financial crisis, the risks of declining to bailout a major financier were seen in the case of Lehman Brothers. This unlovely organisation no doubt deserved to fail, but its failure produced a situation of massive financial gridlock that caused the world of finance to wobble on its axis, and could well have turned a nasty downturn into another Great Depression.
There is still risk of such an outcome, focussed on the twin issues of global inflation and sovereign debt default, so we need to be crystal clear that bailout is necessary — with provisos.
Governments bailing out companies “too big to fail” should take equity in the failed enterprise so that taxpayers have a chance of recovering their investment. The rules should also provide for the dismissal with minimum or no compensation for the most senior executives and board members as soon as replacements are installed.
This requires that unequivocal failure — defined as requiring taxpayers’ funding — is like proven fraud as a case for dismissal without the usual protections of contract law. These two rules should help to overcome the so-called “moral hazard” implicit in bailout with no real sanctions.
Governments also have an interest in the design of incentive plans for executives in major financial institutions. How this should be implemented and enforced is worthy of debate, but I am confident that rules are desirable that encourage executives to take a long-term view of the profitability and viability of the financial institutions that they manage.
Similar rules may benefit other corporations also, but the mooted change is vitally important for the health of a nation’s financial system. Indeed, in the cases of major global banks and other financial institutions, it is vital for the health of the global economy.
Principles that are highly desirable include the following:
• bonuses go into a trust that is not paid out until some time, e.g., five years, after the executive retires;
• clawback allowed, indeed required, on some pro rata basis if losses are made, so that executives cannot benefit from taking large risks and being rewarded only for success, with no penalty for failure;
• bonuses earned in this way might be taxed when received at the normal capital gains rate.
This writer agrees with J.M. Keynes that excessive inequality is one of the great threats to capitalism. Hard thought needs to be given to what to do about this.
Possibly salaries that are more than some widely agreed substantial multiple of average wages in society might attract a rate of income tax — say 50 per cent — well above the normal highest rate, which I would set at 30 per cent. I do not believe that this would greatly reduce the supply of senior executives.
Dr Peter D. Jonson is a former chief economist of the Reserve Bank of Australia. He writes a regular column under the pseudonym of Henry Thornton. This article is an extract from his recent book, Great Crises of Capitalism (available from News Weekly Books).