ECONOMICS AFTER THE GLOBAL FINANCIAL CRISIS

Talk to The New Institute, Merewether
July 14, 2009

I want to deal briefly with the origins of what we’ve come to call the global financial crisis and its consequences for economies around the world before I focus on the underlying causes of the crisis and the role of economics. Then I’ll look at what needs to be done to avoid another such monumental failure of economic management. I’ll be talking mainly about the global scene - particular the scene in America, where the crisis had its origins - and much of what I say won’t apply to Australia, though I will talk about how Australia managed to escape the worst of the madness.

The origins of the crisis can be found in America’s huge housing boom, in which house prices rose greatly, many hundreds of thousands of new homes were built and the rate of home-ownership rose significantly. One factor that made the boom so big was the issuing of loans to sub-prime borrowers - people with bad credit histories who had no hope of servicing their loans. This irresponsible lending was encouraged by the securitisation of loans - that is, because the banks that made these dubious loans didn’t retain them but converted them into mortgage-backed securities, which they then sold to investment banks, hedge funds and pension funds, not just in America but in Europe and even to some Australian local councils. Inevitably, the housing bubble burst and it was suddenly realised that many of the sub-prime loans would never be repaid. House prices fell dramatically - because the Americans had built far more houses than they actually needed - and a lot of big investment banks and other institutions found themselves holding possibly worthless mortgage-backed securities. But it wasn’t clear which banks were holding large amounts these securities and were thus in trouble. This uncertainly generated a great deal of fear and reluctance among the banks to continue dealing with each other.

This wouldn’t have been so bad - it would have led just to a housing-led recession in the US - were it not for the fact that it brought unstuck a huge and long-running expansion in the financial sectors of all the developed countries. The financial markets had been inventing complicated new financial contracts known as derivatives that supposedly shifted various forms of risk on to the shoulders of people more able and willing to bear that risk. Because this trading of risk was believed to have reduced the risks financial institutions were facing, they were emboldened to borrow heavily to buy more of these derivatives that were proving so profitable. As part of the globalisation of financial markets, financial institutions in Britain and Europe - and Australia to some extent - participated fully in this decade or two of frenzied trading and expansion.

The sub-prime problem acted as the bump that caused this whole house of cards to collapse. The crisis reached its culmination in mid-September last year, when the US authorities decided to allow one of America’s five big investment banks, Lehman Brothers, to collapse under the weight of its debts. This caused a wave of panic among financial institutions on both sides of the Atlantic. They refused to deal with each other, financial markets temporarily stopped functioning, and banks and insurance companies started falling over. For a period of several weeks governments had to step in to prop up these institutions, all of them granting government guarantees of their banks’ deposits and wholesale borrowings. The global financial system came perilously close to collapse. The whole world watched these frightening events unfolding on television every night, resulting in a synchronised blow to the confidence of consumers and business people in almost all the developed economies. The considerable losses faced by banks in the US and Europe greatly reduced their ability and willingness to continue lending to ordinary businesses. From that point it became clear that the world had entered its most severe recession since the Great Depression. Deep recessions in the US, Britain, Europe and Japan, plus sharp slowdowns in China and the other major developing economies, have seen a marked decline in world trade. Despite optimistic talk of ‘green shoots’, the likelihood is that unemployment in these economies will continue rising for some time before it begins a very slow fall.

Who’s to blame for all this? Well, you can blame it on the greed of bankers and other participants in the financial markets, but that doesn’t get us far. I’d prefer to say that the crisis was caused by the failures of human nature, compounded by the economic managers’ reliance on a model of human behaviour that fails to take account of many aspects of that human nature.

Human beings aren’t rational as the economists’ basic, neo-classical model assumes, but are highly emotional. Even economists themselves are more driven by their emotions than many of them realise. Particularly because people are so influenced by the behaviour of those around them, the people who make up an economy are prone to an alternating cycle of optimism and pessimism. So much so that this is now - and probably always has been - the main factor driving the business cycle of boom and bust. During the optimistic phase people happily take on ever-increasing risks and obligations. They spend rather than save, expanding their possessions and activities, pursuing status symbols, piling into the markets for property and shares, forcing prices up, then piling in some more just because prices are rising.

They do all this confident in the belief that the good times will roll on forever and prices will only go higher. But, of course, as we all know but keep forgetting, some event inevitably causes the boom to end and, when it does, the prevailing mood flicks from optimism to pessimism. People become afraid, they worry about all the commitments they’ve taken on, they abandon their plans for expansion and tighten their belts. In many asset markets (but probably not our housing market) prices go from being unrealistically high to being unrealistically low. The result is business failures, lay-offs and rapidly rising unemployment. This causes the fear to deepen into a pessimism which assumes the world will stay bad forever.

My first point is that, though economists know full well that the economy moves in cycles of optimism and pessimism, boom and bust, and a large branch of economics is devoted to studying the management of the business cycle - macro-economics - economists don’t have much of a handle on the factors that drive the cycle, especially those that derive from human psychology. They accept that ‘confidence’ is a major influence on the cycle, but they can’t get confidence into their mathematical equations, so they end up underrating its importance. A big part of the problem is that conventional micro-economics has no place for psychology or the business cycle, assuming the economy is always at full employment because it is self-equilibrating, self-correcting. Alan Greenspan admitted he’d made a mistake in believing the banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions. He had too much faith in the economy’s self-correcting powers because he assumed we’d behave rationally, not emotionally.

My second point is that this chronic underestimation of human failings tempted economists and regulators to run a partially deregulated financial system and not to worry about weaknesses in the remaining regulatory system, such as the US’s multiple regulatory agencies sharing responsibility for the system, and the operation of the hedge funds completely outside the regulatory regime. Here we have a fatal combination of model-blinded thinking on the part of the economics profession and blatant self-interest on the part of powerful vested interests in the financial markets. When they’re in optimism mode, business people always want to be completely free to do as they please in their push for profits.

But because the big banks and other players in the financial markets aren’t rational and are capable of getting carried away in a boom and doing stupid things they later come to regret, they do need fairly close supervision to protect them from themselves and to protect us from them. In the absence of that supervision it was inevitable the episode would end in disaster.

In Australia, our econocrats - particularly those at the Reserve Bank - have been an honourable exception to this naivety. They’ve been a lot more worldly wise, always being very conscious of the problem of asset bubbles. The former governor, Ian Macfarlane, was highly conscious of the risks involved in our long housing boom. He devoted much effort to studying and trying to talk down the boom, with some success. So we avoided making the same errors with our banking system, partly also because of two accidents: first, the four-pillars policy banned mergers between the big four banks because politicians fear the displeasure of the electorate more than the displeasure of the banks and, second, our Australian Prudential Regulation Authority was riding herd on the banks because it was still smarting from the caning it got over its inadequate supervision of the HIH insurance company.

In their drive for profits, people in the financial markets invented these ever more sophisticated and artificial - weird and wonderful - financial contracts known as derivatives. In theory, these synthetic contracts were about ‘risk management’ - spreading and shifting risk to those most able to bear it. In practice, the risk was spread to those least able to understand it. Even the inventors of these derivatives didn’t fully understand how they worked and the circumstances under which they could come unstuck. Individual financial institutions didn’t understand the extent of the risks they were taking on and no one - neither other institutions nor the regulators - knew where the risk was accumulating. So my third point is that derivatives were a case of the market being too smart by half and not nearly as smart as it imagined itself to be.

The story of the origins of the global financial crisis is littered with references to excessive gearing or leverage or plain old excessive borrowing. The reason booms go on for so long and get so big is that they’re fed by excessive borrowing. While everything is on the up and up, borrowing is a very easy way to magnify your gains from investment. Trouble is, once prices start falling, being highly geared is a way to magnify your losses and risk your own survival.

The thing about debt - or ‘credit’ as economists prefer to call it - is that it’s like fire: a wonderfully useful and beneficial thing, but also something that, if not understood and carefully controlled, can do immense harm. Yet economic theory focuses almost solely on the benefits of credit, hardly acknowledging how dangerous it can be if allowed to get out of hand. Why such a cavalier attitude towards debt? Because of the assumption that we’re all rational; because of the economic model’s unrealistic assumptions about human nature.

So my fourth point is that a primary cause of the crisis was the failure of regulators to understand the need to impose constraints against excessive gearing. The sudden discovery of all the trouble derivatives had got us into wouldn’t have caused nearly so much devastation had not the institutions that found themselves holding the parcel when the music stopped been so precariously geared. Indeed, some of the derivatives were themselves aimed at helping people gear up.

In the past 15 or 20 years, central banks have become proficient at controlling the former scourge of inflation by means of inflation targeting. What they have not managed is to find a way to prevent the build-up of speculative asset price bubbles. That’s because the instrument they use to fight inflation - the manipulation of interest rates - can’t simultaneously be used to fight asset bubbles. But all this means is that, as part of the move back to a more carefully regulated financial system, we need to revert to direct controls over borrowing levels.

It’s overly dramatic to imagine we’re facing the death of capitalism. We’re not because there is simply no practical alternative to the use of markets to coordinate the production and consumption of goods and services. Similarly, it’s a crude caricature to imagine that in the past 20 or 30 years we moved to ‘free markets’. No market has remotely approached the position of being entirely free of government intervention and regulation. What’s true is that - particularly in the case of the financial markets, and particularly in the US - we greatly reduced the degree of regulation and allowed much of the regulation that remained to be ineffective.

So the choice we face is the degree to which we regulate markets and the activities of businesses. And there’s little reason to doubt that the pendulum will now swing back in favour of more regulation of markets, particularly the financial markets. We’ll need to do more to limit excessive borrowing, more to regulate the use of derivatives, more to make their use more transparent to regulators and to other players in the financial markets, more to include hedge funds within the regulated framework. We need tax reform to eliminate the tax advantages of debt funding over equity funding, including the tax advantages of negatively geared property investments.

It’s important to remember, however, that regulation offers no easy answers. The very reason we dismantled regulation and gave up public ownership of businesses in the 1980s and 90s was that they weren’t working well, partly because they were being widely circumvented. It’s now clear we went too far in that direction, but the answer isn’t to go to the opposite extreme. Rather, it’s to find a mid-way position where carefully judged regulation can keep things under better control. And here, in the example of Australia, the world does have proof that sensible, less-than-onerous regulation can keep the banks out of trouble, to their own benefit as well as ours.

I think it’s a mistake, however, to see the curbing of excessive executive salaries as central to the need for reform. To some extent it’s true that these salary packages were structured in a way that encouraged executives to take excessive risks with other people’s money. Something needs to be done about that. But the fact that these obscene salaries were grossly unfair - that they greatly overestimated the value of those executives’ contribution to their company’s success; that they were the product of market failure rather than market forces - shouldn’t cause us to overestimate their importance in the scheme of things. Say we were able to magically reduce all executive salaries to quite modest levels. When that saving was distributed between all the company’s many customers, the reduction in the prices they were paying would be fairly minor.

I believe we’ve been living through an era of heightened materialism where a revival of faith in the near infallibility of markets - the benefits of deregulation - has contributed to a breakdown in the norms of acceptable business behaviour. Business leaders now feel free to behave in self-aggrandising ways - the ruthless treatment of employees, customers and shareholders - that formerly were regarded as beyond the pale.

I believe it’s possible for us to return to a period of less self-seeking, more principled, ethical behaviour by our business leaders. This not an area that economists know much about - it requires an understanding of the drivers of human behaviour that’s outside their field of study. But social attitudes aren’t fixed; if they can change for the worse they can also change for the better. The economic and social devastation wrought by the global financial crisis - of which we’ve so far seen only the start - may be sufficient to motivate such a change of direction. And carefully judged reregulation may have a valuable part to play in that change.

Economists’ faith in rationality leads them to believe that to change people’s behaviour you must first change their attitudes. But psychology teaches that, in reality, the process works the other way: if by changing regulation you can oblige business people to change their behaviour, they will adjust their attitudes to fit their behaviour.

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CAUSES OF THE GLOBAL FINANCIAL CRISIS

Talk to Whitlam Institute public forum, Parramatta
Tuesday, May 26, 2009

David Gruen has given us a highly competent and comprehensive economists’ exposition of the causes and consequences of the global financial crisis and the global recession it has precipitated, both for the globe and for Australia. I disagree with very little of it. So using David’s exposition as a base, I want to give you my take on the causes of the crisis and, in doing so, step back from all the detail and try to identify the more general patterns of behaviour involved.

In a nutshell, my take is that the crisis was caused by the failures of human nature, compounded by the economic managers’ reliance on a model of human behaviour that fails to take account of many aspects of that human nature. If that sounds so general as to be saying very little, let me try to give it some substance.

Human beings aren’t rational as the economists’ basic, neo-classical model assumes, but are highly emotional. Even economists themselves are more driven by their emotions than many of them realise. Particularly because people are so influenced by the behaviour of those around them, the people who make up an economy are prone to an alternating cycle of optimism and pessimism. So much so that this is now - and probably always has been - the main factor driving the business cycle of boom and bust. During the optimistic phase people happily take on ever-increasing risks and obligations. They spend rather than save, expanding their possessions and activities, pursuing status symbols, piling into the markets for property and shares, forcing prices up, then piling in some more just because prices are rising.

They do all this confident in the belief that the good times will role on forever and prices will only go higher. We now see more clearly than we did at the time just how much this mentality drove the Howard Government’s response to the way its coffers overflowed during the resources boom. But, of course, as we all know but keep forgetting, some event inevitably causes the boom to end and, when it does, the prevailing mood flicks from optimism to pessimism. People become afraid, they worry about all the commitments they’ve taken on, they abandon their plans for expansion and tighten their belts. On many asset markets (but probably not our housing market) prices go from being unrealistically high to being unrealistically low. The result is business failures, lay-offs and rapidly rising unemployment. This causes the fear to deepen into a pessimism which assumes the world will stay bad forever.

My first point is that, though economists know full well that the economy moves in cycles of optimism and pessimism, boom and bust, and a large branch of economics is devoted to studying the management of the business cycle - macro-economics - economists don’t have much of a handle on the factors that drive the cycle, especially those that derive from human psychology. They accept that ‘confidence’ is a major influence on the cycle, but they can’t get confidence into their mathematical equations, so they end up underrating its importance. A big part of the problem is that conventional micro-economics has no place for psychology or the business cycle, assuming the economy is always at full employment because it is self-equilibrating, self-correcting. Alan Greenspan admitted he’d made a mistake in believing the banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions. He had too much faith in the economy’s self-correcting powers because he assumed we’d behave rationally, not emotionally.

My second point is that this chronic underestimation of human failings tempted economists and regulators to run a partially deregulated financial system and not to worry about weaknesses in the remaining regulatory system, such as the US’s multiple regulatory agencies sharing responsibility for the system, and the operation of the hedge funds completely outside the regulatory regime. Here we have a fatal combination of model-blinded thinking on the part of the economics profession and blatant self-interest on the part of powerful vested interests in the financial markets. When they’re in optimism mode, business people always want to be completely free to do as they please in their push for profits.

But because the big banks and other players in the financial markets aren’t rational and are capable of getting carried away in a boom and doing stupid things they later come to regret, they do need fairly close supervision to protect them from themselves and to protect us from them. In the absence of that supervision it was inevitable the episode would end in disaster.

In Australia, your econocrats - particularly those at the Reserve Bank - have been an honourable exception to this naivety. They’ve been a lot more worldly wise, always being very conscious of the problem of asset bubbles. The former governor, Ian Macfarlane was highly conscious of the risks involved in the long housing boom. He devoted much effort to studying and trying to talk down the boom, with some success. So we avoided making the same errors with our banking system, partly also because of two accidents: first, the four-pillars policy banned mergers between the big four banks because politicians fear the displeasure of the electorate more than the displeasure of the banks and, second, our Australian Prudential Regulation Authority was riding herd on the banks because it was still smarting from the caning it got over its inadequate supervision of the HIH insurance company.

In their drive for profits, people in the financial markets invented ever more sophisticated and artificial - weird and wonderful - financial contracts known as derivatives. In theory, these synthetic contracts were about ‘risk management’ - spreading and shifting risk to those most able to bear it. In practice, as David said, the risk was spread to those least able to understand it. Even the inventors of these derivatives didn’t fully understand how they worked and the circumstances under which they could come unstuck. Individual financial institutions didn’t understand the size of the risks they were taking on and no one - neither other institutions nor the regulators - knew where the risk was accumulating. So my third point is that derivatives were a case of the market being too smart by half and not nearly as smart as it imagined itself to be.

I don’t know whether you noticed, but at many points in David’s exposition of what went wrong he alluded to the consequences of excessive gearing or leverage or plain old excessive borrowing. His story was littered with references to debt. The reason booms go on for so long and get so big is that they’re fed by excessive borrowing. While everything is on the up and up, borrowing is a very easy way to magnify your gains from investment. Trouble is, once prices start falling, being highly geared is a way to magnify your losses and risk your own survival.

The thing about debt - or ‘credit’ as economists prefer to call it - is that it’s like fire: a wonderfully useful and beneficial thing, but also something that, if not understood and carefully controlled, can do immense harm. Yet economic theory focuses almost solely on the benefits of credit, hardly acknowledging how dangerous it can be if allowed to get out of hand. Why such a cavalier attitude towards debt? Because of the assumption that we’re all rational; because of the economic model’s unrealistic assumptions about human nature.

So my fourth point is that a primary cause of the crisis was the failure of regulators to understand the need to impose constraints against excessive gearing. The sudden discovery of all the trouble derivatives had got us into wouldn’t have caused nearly so much devastation had not the institutions that found themselves holding the parcel when the music stopped been so precariously geared. Indeed, some of the derivatives were themselves aimed at helping people gear up.

In the past 15 or 20 years, central banks have become proficient at controlling the former scourge of inflation by means of inflation targeting. What they have not managed is to find a way to prevent the build-up of speculative asset price bubbles. That’s because the instrument they use to fight inflation - the manipulation of interest rates - can’t simultaneously be used to fight asset bubbles, a point Guy Debelle of the Reserve Bank reiterated recently.

But all this means is that, as part of the move back to a more carefully regulated financial system, we need to revert to direct controls over borrowing levels.

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PUBLIC HEALTH CONSEQUENCES OF THE GLOBAL FINANCIAL CRISIS

Talk to AFPHM Congress, Sydney
May 20, 2009

Because I’m no expert on public health, I’m going to focus on the nature, size and duration of the crisis, and say something about the likely impact of the crisis on the developing countries and on Australia, leaving Steven Jan to focus on what the crisis will do to the social determinants of health.

I must start by warning you that economists are hopeless at forecasting what will happen in the economy. All they - or I - can do is offer you educated guesses, which will probably be wrong for reasons we haven’t thought of. But humans are incurably curious animals, with an insatiable desire to know what the future holds, so they go on asking economists for their predictions, and economists go on pretending to know what will happen. Now I have your informed consent, I’ll get down to it.

I’m going to skip explaining the origins of the financial crisis and take up the story at the point where the crisis reached its climax in mid-September last year with the collapse of the US investment bank Lehman Brothers. This prompted panic in global financial markets, which froze. The global banking system rocked on its foundations as governments in the US, Britain and continental Europe struggled to avert the collapse of various banks. The whole world watched these frightening events on television every night and the effect was a sudden loss of confidence among businesses and consumers in many countries. Around the world, fearful consumers tightened their belts and abandoned plans for big purchases, while businesses postponed expansion plans and wondered about laying off staff. In consequence, the global economy hit a wall at that moment. It dropped off a cliff. Just about every developed country contracted - went backwards - in the last quarter of 2008, and the contraction continued in the first quarter of this year. Over that six month period, the US economy contracted by more than 3 per cent, Europe by more than 4 per cent and Japan by maybe 6 per cent.

Those are huge figures. Australia would also have contracted over that six months, but by a lot less (we’ll get the figures for March quarter a fortnight today). Most developed economies had been slowing (as we had) or were in already in recession before the crisis reached that climax in September, but from that point it became indisputable that the global financial crisis had become a global recession, that the problem had spread from Wall Street to Main Street, from the financial markets to the ‘real’ economy of production and consumption that you and I inhabit.

As the immensity of the global contraction slowly dawned on officials, the IMF - the International Monetary Fund - revised down its forecast for growth in the world economy in 2009 five times in seven months. Its latest prediction is that the world economy will contract by. 1.3 percent in calendar 2009. This would be the first annual contraction in 60 years. It compares with record world growth of more than 5 per cent just two years earlier (2007). Virtually every advanced economy is in recession and the advanced countries as a whole are expected to contract by 3.8 per cent. The developing countries should grow, but by just 1.6 per cent. Normally, any rate of global growth below 2 per cent is regarded as a world recession, because recessions usually roll around the world, hitting different countries at different times, because the developing countries always grow a lot faster than the advanced countries (because they’re coming off a low base) and because they aren’t as closely connected to the advanced countries as the advanced countries are to each other.

The IMF is predicting that the world economy will grow by 1.9 per cent the following year, 2010, with the developing countries recovering to 4 per cent (still weak by their standards), but the advanced economies just breaking even. This, of course, would still be in recession territory.

The IMF is uncharacteristically gloomy about this recession. It’s worried by two unusual features of the present episode: first, unlike most recessions, this one has been caused by a crisis in the financial system, and second, it’s highly synchronised - everyone’s going down together, partly because of shared trauma of the events in September-October. History tell us that recessions brought on by financial crises are deeper and longer, with a weaker recovery. History says the same about synchronised recessions. Put those two negatives together and you’ve got a particularly bad prospect.

The IMF has legitimised the comparison of this recession with the Great Depression, suggesting that this episode be known as the Great Recession. However, economists are confident we won’t see anything as bad as the Depression because we’ve learnt from the gross mistakes we made then. In particular, we have four factors going for us. First, we haven’t stood around watching banks collapse, but have done everything necessary to prop them up. Second, we’re well aware of the risk of deflation (widespread and continuous falls in prices) and will resist it, understanding that, in such circumstances, printing money helps rather than harms. Third, we don’t see any virtue in balanced budgets at such a time, and are applying large amounts of timely fiscal stimulus. Fourth, no one imagines a resort to competitive currency devaluations or higher trade barriers offers a viable solution to a global problem, even if domestic political pressures make them tempting.

How bad and how protracted will the Great Recession end up being? I don’t know. Even if it’s not as bad as some people fear, it will be plenty bad enough. The main risks are, first, a new crisis somewhere in the global financial system, and second, inadequate efforts to fix the balance sheets of ailing banks, so that businesses and households fail to receive the flows of credit necessary to allow them to resume normal activity.

On the positive side, world financial markets are a lot more settled than they were, there are reasonably convincing signs that the US, which has already been in recession for a record 17 months, is stabilising and could start recovering later this year - although it could still be a year or more before there was any improvement in unemployment - and there are convincing signs that China is recovery, just as the recovery from the Asian crisis of 1998 was much stronger than (more V-shaped) than we expected. Developing economies are more resilient than advanced economies; they have a greater ability to bounce back.

Last week’s budget argued that Australia’s recession - which has hardly got started yet - will be much less severe than those of the major developed economies and much less severe than we experienced in the recessions of the early 1980s and early 1990s, even though the recession itself will last longer: three years, rather than one year in the 80s and two years in the 90s. But whereas the rate of unemployment peaked at 10 per cent in the 80s and almost 11 per cent in the 90s, this time it will peak at only 8.5 per cent, in the second half of next year. Treasury is certainly right in arguing that, when recovery finally arrives, the usual pattern is for the economy to bounce, achieving surprisingly high rates of growth as it comes up off the floor. There are three good arguments for Treasury’s relative optimism. First, thanks to the four-pillars policy and strong regulation, our banking system is in very good shape. Second, the alacrity with which we slashed interest rates and applied budgetary stimulus to the economy after September last year will prevent the economy from descending too far into the depths. Third, the recovery in China, as it switches its engines of growth from export demand to domestic demand will limit the fall in our export income. The counter argument is that we haven’t yet felt anything like the full effect of our loss of income arising from the collapse of coal and iron ore prices, nor from the rise in unemployment and the debilitating and hence compounding effect this will have on business and consumer confidence.

Edging closer to our goal of assessing the consequences of all this for public health, let me just make the obvious point that the burden of recessions is shared most unequally, with the increase in unemployment concentrated heavily on the unskilled, early school-leavers and the disadvantaged, including Aborigines and the mentally ill. Considering what we know about the social determinants of health, this does not bode well. However, though an increase in health problems as a result of the recession may lead to the overstraining of unchanged levels of provision, I don’t believe that explicit cutbacks in government health spending will represent a significant addition to the problem.

Finally, let me turn to the problem in the developing countries. On the face of it, their economies will grow faster than those of the advanced countries, but this is misleading. The developing countries’ rapid population growth means they need to grow at faster rates just to stop going backwards. In these countries I think we will see both an increase in the demand for medical assistance and a decrease in its supply. The reduction in supply will come from increased pressure on government budgets (less revenue but more spending demands), reduced official and unofficial aid, and less ability on the part of patients to bear out-of-pocket costs. In 23 developing countries more than 30 per cent of their total health spending is funded by donors. I am hopeful, however, that, where countries are obliged to apply to the IMF for financial assistance, the criticism the fund received for its mishandling of the Asian crisis will make it less inclined to provide assistance conditional on ultra-harsh cutbacks in government social spending.

According to the World Bank, each 1 per cent decline in growth causes 20 million people to be pushed into poverty. After for once enjoying a period of decent growth - a half-decade above 5 per cent a year - Africa is forecast to manage growth of just 2.8 per cent this year. So I don’t doubt that the Great Recession will lead to great suffering among the world’s poor. In developing countries as in Australia, the burden of economic downturn will be distributed unequally and unfairly, with the poor bearing most of the brunt. Similarly, in any competition for inadequate public health resources, you’d expect to see the better-off elbowing out the poor.

Even before the onset of the global recession, only a handful of African countries were on track to meet the Millennium target of halving the share of the population living on less than a dollar a day by 2015. But the gloom and doom is not total, however. One small mercy is that, at a time of global recession, you’d at least expect to see food and energy prices coming down. Another is that the African economies’ generally improved economic management in recent years leaves them better positioned to weather the crisis than they were a decade ago. It’s also fortunate that so many of the world’s poor live in China and India, which are likely to recover fastest.

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THE GLOBAL FINANCIAL CRISIS AND ITS EFFECT ON AUSTRALIA

Sydney Secondary College
March 19, 2009


The Global Financial Crisis

What we now call the global financial crisis had its origins in a bubble in the housing market of the United States economy. The bubble had been caused partly by the issue of housing loans to ‘sub-prime’ borrowers with doubtful ability to repay. Most of these sub-prime loans had been turned into mortgage-backed securities that were sold to many banks in America and Europe (and some Australian local government councils). From July 2007 it became clear that many of these securities were now worth much less than they had been bought for, but for a long time it was unclear just what these securities were now worth and how much of them particular banks were holding. So the sub-prime debt crisis touched off a sudden lost of confidence in US financial markets which led to the unravelling of a two-decade long boom in US financial markets, a boom that had been built on the invention of highly complex derivative contracts and high levels of ‘leverage’ (borrowed capital relative to equity [share] capital) by commercial banks, investment banks and hedge funds.

US Banks became reluctant to lend to each other on the short-term money market, and various financial markets seized up so that, for example, Australia’s non-bank mortgage lenders, such as RAMS, could not renew the short-term loans they had borrowed in the US market and so their businesses collapsed. Thus financial globalisation meant that problems in the US loan markets - and falls in Wall Street’s sharemarket - were quickly transmitted to other countries’ financial markets, particularly in Britain and Europe, where banks had bought large quantities of sub-prime debt, had engaged in derivatives transactions they didn’t understand and had borrowed excessively.

What began as a ‘sub-prime crisis’ and became a ‘credit crunch’ (where even sound businesses had great difficulty borrowing the money necessary to continue in business) turned into a fully blown ‘global financial crisis’ from mid-September 2008 after the failure of a large American investment bank, Lehman Brothers. In the panic that followed, credit markets seized up, many banks, mortgage lenders and big insurance companies in the US and Europe had to be prevented from collapsing by government intervention. Governments around the world had to guarantee their banks’ deposits and other borrowings. While all this was happening the world’s sharemarkets were plunging. And with the whole world watching the financial crisis unfold every night on television, the result was sharp blow to business and consumer confidence in almost all countries at the same time.

The US economy has been in recession for more than a year. A severe recession in the US has an adverse effect on most other economies because the US is the world’s biggest economy. But there is a lot more to this episode than just a severe recession in the world’s biggest economy. What makes it much worse is the crippled state of so many major banks in the US and Europe, which has largely prevented those banks from continuing to lend to viable businesses. Until businesses (and households) can get the credit they need to continue trading and start expanding, no amount of fiscal stimulus will get an economy back on its feet. Because the financial shock has hit all major economies - developed and developing - at the same time, this is the most highly synchronised world recession we have experienced for many years, thus making it more severe. The latest forecast is that gross world product will actually contract in 2009, the first time this has happened since World War II.

Channels through which the global crisis affects the Australian economy

It’s all very well to talk about the global financial crisis and assert that it will adversely affect our economy. A good student of economics has to be able to explain exactly how developments in the global economy affect us. In what ways? What are the mechanisms - or channels - by which the downturn is transmitted to Australia? You can’t just wave your arms in the air, you have to be specific.

We can identify three main channels through which the global crisis and recession has been - and is being - transmitted to our economy:

1) the financial channel has two aspects:

a) debt markets. Developments in US and other debt markets (markets for the borrowing and lending of money) have raised the interest rates our banks must pay to continue borrowing from overseas and made it much harder for non-bank borrowers to raise any more funds from overseas. Remember that almost all of Australia’s considerable net foreign debt has been borrowed by our banks. Our banks have passed their higher borrowing costs on to their business and household customers. This problem has been eased by the Government’s guarantee of inter-bank lending between our banks and their foreign counterparts.

b) equity markets. Developments in US and other equity markets have led to sharp falls in share prices on the Australian stock exchange. This has had two adverse effects: i) it has reduced the capacity of Australian businesses to raise new share capital, and ii) it has had a ‘negative wealth effect’, particularly on people with superannuation and other share investments who are in or approaching retirement. They now feel poorer than they were, which encourages them to consume less and save a higher proportion of their incomes.

2) the trade channel has two aspects:

a) reduced export volumes. Reduced consumption and investment in our trading partners’ economies reduces their imports from the rest of the world and thus the volume (quantity) of our exports.
b) reduced export prices. Reduced demand for mineral and energy commodities in the developed world and China and India is sharply reducing the prices we receive for our commodity exports, particularly coal and iron ore. Whereas until the second half of last year commodity prices were rising strongly and producing a large improvement in our terms of trade, which represented a big increase in the nation’s real income, now commodity prices are falling rapidly, which is worsening our terms of trade and reducing the nation’s real income.

3) the confidence channel: news of the global financial crisis, the global fall in sharemarkets and now the global recession has struck a blow to the confidence of our business people and consumers (and it has in almost every other economy). They are uncertain and fearful about the future, making them reluctant to take on new commitments (even though interest rates are so much lower) and anxious to reduce their exposure by cutting their spending and paying down their debts. Treasury says ‘the effects of the crisis on confidence are the hardest to quantify but arguably the most important’.

The policy response to the global crisis and recession

From the time the credit crunch worsened into the global financial crisis in mid-September last year, both the Reserve Bank and the Rudd Government have responded with speed and vigour.

Monetary policy: In the early part of last year the Reserve Bank was worried about growing inflation pressure and was still raising interest rates. By early September, the official cash rate had reached a peak of 7.25 per cent and the stance of monetary policy was quite restrictive. But the economy was slowing rapidly and the global environment was threatening, so the Reserve began easing policy, cutting the cash rate by just 0.25 percentage points. By early October, however, the financial crisis was at its height and it was evident that both financial markets and confidence had suffered a major blow. The Reserve was the first central bank to respond decisively, cutting the cash rate by a full percentage point. Further big cuts followed in November, December and February. The combined effect was to cut the cash rate by 4 percentage points in just five months. In that short time the stance of policy was switched from ‘quite restrictive’ to ‘highly expansionary’. At 3.25 per cent the cash rate is the lowest it has been for 45 years.

Although the Reserve paused to take stock in March, it is clear it will cut the rate somewhat further - perhaps by as much as another 1.25 percentage points - in the coming months.

Fiscal policy: In mid-October the Rudd Government announced its first fiscal stimulus package, worth $10.4 billion, or 1 per cent of GDP. Most of the cost went on cash bonus payments to pensioners, carers and parents. The other main measure was temporary increases in the first home owners grant, particularly for those buying newly built homes. Treasury estimated that spending of 1 per cent of GDP would cause GDP to be between 0.5 and 1 per cent higher than otherwise. This lower multiplier is explained by leakages into imports and saving.

Next the Government announced various small increases in spending on capital works, but then in February it announced a second stimulus package worth $42 billion over three years, but with most of the money to be spent in calendar 2009. This will be equivalent to 2 per cent of GDP. Less than a third of the money will go on another round of cash bonuses - this time to taxpayers, parents, farmers and some students - with more than two-thirds going on small, ‘shovel-ready’ capital works, including at every school in Australia. This package is expected to cause GDP to be higher than otherwise by about 0.5 per cent in 2008-09 and 0.75 to 1 per cent in 2009-10.

Two things are clear. First, the stance of fiscal policy is now clearly expansionary. Second, as could long have been predicted, the turn in the business cycle has prompted the Government to shift to an overtly Keynesian approach to fiscal policy. It has stated that it will ‘allow the automatic stabilisers to support economic stability’ - that is, to operate unhindered - and it has acted to add discretionary fiscal stimulus on the top. Both points are, of course, consistent with the medium-term fiscal strategy, which represents a policy of what I call ‘symmetrical Keynesianism’.

Both stimulus packages were carefully designed and represent state-of-the-art Keynesian policy in that they comply with the Three-Ts rule of fiscal stimulus: measures should be timely, targeted and temporary. The timely principle says governments should apply their stimulus as early in the downturn as possible to prevent the economy unravelling. A stitch in time . . . . The targeted principle says the stimulus should go to those people or on those purposes most likely to get the money spent quickly. The temporary principle says measures should be of a once-only nature so they do nothing to slow the budget’s return to surplus when the economy recovers.

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USES AND ABUSES OF CRIME STATISTICS

NSW Bureau of Crime Statistics and Research annual symposium
February 18, 2009

When I was at university many years ago I read a fascinating little Pelican by Darrell Huff called, How to Lie with Statistics. It’s proved invaluable in my career as a journalist. In talking about the uses and abuses of crime statistics I could focus on the misdemeanours of the politicians, but instead I’m going to concentrate on something I know a little about, the failings of journalists.

In June last year the bureau put out a report showing no link between the heroin shortage and the rise in the use of amphetamines such as ice. The study was reported on the front page of the MX newspaper with the banner headline ‘Users switch to ice - heroin blitz forces drug change’. MX is Murdoch’s afternoon giveaway paper - I guess you get what you pay for.

On another occasion the bureau gave a newspaper figures showing that the number of eight and nine-year olds coming to the attention of police had fallen from 130 a month to 94 a month over the two years to 2007. The bureau also told the journalist that less than 1 per cent of the population aged eight or nine had some contact with the police. The headline on the journo’s story was ‘Kid Crime Rampage’.

On a third occasion the bureau gave the media figures showing there was no upward or downward trend in knife attacks in Sydney or the rest of NSW. One newspaper’s report of this study attracted headline ‘Stabbings skyrocket as knives plague city’.

A fourth example involves a paper called the Herald. The bureau put out a report showing that the percentage of convicted offenders receiving prison sentences had risen substantially since 1993. The study also showed that prison terms for most offences had increased, as had the proportion of defendants refused bail. The headline on the Herald’s report of the study said, ‘Prison population rises despite lower jailing rates’.

I could quote more examples, but that’s enough. What I want to focus on is how this misuse of crime statistics is brought about and then why it occurs. We’ll start with the how.

I quoted headlines to you and the truth is that the headline on a story heavily influences a reader’s perception of what the story is saying. But headlines are written by sub-editors, not reporters, and sometimes there’s a gap between what the story actually says and what the headline says it says. If there is, most readers won’t notice it. Such gaps can occur for three reasons: because the hard-pressed sub doesn’t accurately comprehend what the story’s actually saying, because the reporter has left some ambiguity in his copy and the sub, who generally knows far less about the topic than the reporter, has jumped the wrong way, or because the sub knowingly writes a headline that makes the story sound more exciting than it actually is. The first two explanations - misunderstandings - are more likely to be the case on broadsheet newspapers; the third - misrepresentation - is more likely to be found in tabloid newspapers. In the case of the Herald story I quoted, the reporter focused on all those offences where the rate of imprisonment had fallen. Since he noted but didn’t highlight that, overall, rates of imprisonment had risen, this left the opportunity for the sub-editor who didn’t read the story as carefully as he should have to conclude from the early paragraphs that the overall rate of imprisonment had fallen.

The interesting question is why the reporter wrote his story in a way that encouraged that error to be made - why he’d focus on the unrepresentative falls rather than the representative rises. I’ll try to answer that when we get to the question of motive - why the media behave the way they do. Perhaps here I should remind you that journalists have to draw the essence from sometimes long and complex reports or events in just an hour or two - under pressure from bosses to make it quick and make it sexy - so it’s not surprising errors and misinterpretations occur.

Now let me give you some relevant background information. Much of the news the media publish comes to them in the form of press releases. All of the bureau’s reports, for instance, are accompanied by a summarising press release. It’s often alleged that the media are so lazy they largely publish uncritically the press releases sent to them by powerful government, business and other interests. In my experience that’s usually not the case; quite the reverse. These days most interest groups seek to use the media to advance their own interests. They employ PR people to put their own spin on the information they release to the media. Most journalists aren’t lazy and they see it as their job to get past the spin, finding the news their audience would like to know about but which the powerful interest would like to conceal. When they receive a report or a press release they think: there’s probably an interesting story in here somewhere, but I’ll have to dig for it; certainly, it won’t be the one the people who put out the press release put at the top of the release. There’s so much spin in the world that many journalists come to the conclusion that everyone’s trying to pull the wool over their eyes. You may regard the bureau as a beacon of independent truth-seeking, but I guess many journalists would suspect it’s just another government agency pumping out bromide about the receding crime wave at the behest of its political masters. There’s a saying in journalism that news is anything somebody somewhere doesn’t want you to know. My guess is that the Herald journalist in question waded through the bureau’s report until he found the bit he thought the NSW Government wouldn’t want people to know: that in the case of five significant offences, rates of imprisonment are going down not up.

Much of the misrepresentation of crime stats arises from statistical misinterpretation. You can misrepresent a time series in a host of obvious ways: by choosing a convenient time period for your comparison, by ignoring random variation (ie failing to ignore outliers), by ignoring seasonal variation (eg the number of assaults peaks in January each year and troughs in May or June), by ignoring base effects (eg saying some crime rate has doubled when it’s gone from 2 a year to 4 a year) and by ignoring the effect of police activity. For instance, when the number of arrests goes up because we’ve got more police on the job arresting people, you call it a crime wave; when the number of arrests goes down you say police aren’t out there on the job countering the crime wave.

The question is whether the journos who commit these statistical crimes are knaves or fools. I couldn’t deny there’s a lot of knavery - journos who know they’re distorting the statistics’ message, but don’t care - but there are more fools than you may imagine. Most journalists are arts-degree types with a very weak grasp on maths and little clue about how to interpret statistical information. If they did understand those things they’d be an economics editor by now. But the question goes deeper: many journalists wouldn’t be sure the diligent performance of their job required them to take account of those statistical niceties. The rules of statistical interpretation aim to ensure the user draws from the stats an accurate or representative picture of the aspect of the world the stats relate to. But that’s simply not the objective of journalism. Journalism pays no heed to the scientific method.

So let’s turn to the question of why the media misuse crime statistics and misrepresent the extent of crime. As the coppers would say, let’s look at motive. Much of the criticism of the media rests on the unspoken assumption that the media’s role is to give us an accurate picture of the world around us. We don’t have first hand experience of much of what’s happening around us and we need the media to inform us.

If that’s the role you think the media play - or should play - I have shocking news. The news media are on about news. What is news worthy? Anything happening out there that our audience will find interesting or important, although the interesting will always trump the important. Paris Hilton is interesting but of no importance; the latest change in the superannuation rules is important but deadly dull - guess which one gets more media overage?

Maybe 99 per cent of what happens in the world is of little interest: 99 per cent of the motorists who crossed the Bridge today made it without incident; someone you’ve never heard of went to work as usual and sold a new ring to someone you don’t know; Australia didn’t declare war on New Zealand . . . the list of uninteresting things that happen is endless. Journalists sort through all the things that happen looking for things they believe their audience will find interesting: the 10-car pile-up on the Bridge, Brad Pitt bought a ring for Angelina Jolie to make up after a fight, the Dutch withdrew their troops from Afghanistan.

When social scientists take a random sample they may examine the sample and discard any outliers that could distort their survey, throwing them on the floor. A journalist is someone who comes along, finds them on the floor and says, ‘these would make a great story’. I happened to be in the Herald’s daily news conference a fortnight ago on the day Kevin Rudd’s $42 billion stimulus package was announced, with all its (then) $950 cash handouts. We discussed searching for a farmer who’d get $950 because he was in exceptional circumstances, $950 because he paid tax last year, $950 because his wife also works, $4750 because he has five school-age kids, and maybe another $950 because one of the kids is doing a training course. And, of course, he’d have a big mortgage, meaning he’d also save $250 a month because of the 1 per cent cut in interest rates announced the same day. Had we found such a person and taken a good photo of him he’d have been all over our front page. The point is that we were search for the most unrepresentative person we could find. Why? Because our readers would have been fascinated to read about him. It’s reasonable to expect the media to be accurate in the facts they report but, even if they are, it’s idle to expect them to give us a representative picture of the world. And that takes me to an even more shocking thought: if the media aren’t on about giving us a representative picture of the world around us, why would journalists bother adhering to the rules of statistical interpretation? Why not highlight a quite unrepresentative statistical comparison if it happens to be the most interesting comparison?

It’s often claimed that the media focus heavily on bad news, often ignoring good news. Guilty as charged. But we do so for a simple reason: we know our audience finds bad news a lot more interesting than good news. So I’m not particularly apologetic for this state of affairs: our failings are the failings of our audience, which are the failings of human nature. Why do people find bad news more interesting than good news? As I’ve written elsewhere (SMH 12.4.2006), I believe the explanation can be found in our evolutionary history. Our brains are hardwired to perpetually scan our environment for threats, and now the chances of our being eaten by a lion have diminished we’re left with a strong appetite for bad news about, for instance, the threat of crime.

Communications research tells us we read much more for reinforcement than enlightenment. While there’s a niche market for columns that challenge the conventional wisdom, and news about some new and unexpected twist in a standard story will be found interesting, journalists know the news that goes down best is the news that confirms people prejudices. Perhaps thanks to the efforts of the media themselves, most people know as a self-evident truth that crime is increasing. Most stories about crime are intended to reinforce that belief.

Let me conclude. The media’s defence against criticism is that their failings are those of their audience; they do what they do because their audience demands it of them. But shouldn’t we hold the media to a higher standard than we hold ourselves? Yes we should. We can expect less crass commercialism and more professionalism. Doctors, for instance, don’t ask patients what disease they want to be told they have and don’t let patients pick the medicine they want prescribed.

And there’s a limit of inaccuracy and sensationalism below which market punishment sets in. Mediums that play too lightly with the truth eventually lose their credibility and their audience’s respect. This means there are checks and balances. Mediums that value their credibility - in commercial as well as ethical terms - often employ commentators who set a high store on making sure their audience isn’t misled, even when those commentators spend a fair bit of time highlighting the media’s own failings and trying to beat down some of the things that get beaten up on the front page. My guess is that, as information overload and infotainment continue to grow, at least the better-educated audience will gravitate to those journalists and journals they perceive to be committed to the search for truth. What’s more, it is possible to be truthful and interesting at the same time. So don’t slit you throat yet.

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AUSTRALIA’S OUTLOOK FOR POLITICS AND GOVERNMENT IN 2009

Talk Australian Business Economists Annual Forecasting Conference, Sydney, December 9, 2008

According to the conventional wisdom, in his first year of office Kevin Rudd has had the huge misfortune of being hit by a global recession that’s likely to drag our economy down, disrupt his many plans and possibly see him thrown out of office after just one term. But that’s not the way I see it. I think he’s had the great good fortune of having the world economy let him off the hook and greatly improve his chances of being re-elected. He and his ministers must be privately delighted.

Don’t blame me, it’s the GFC

As I observed in my talk a year ago, this was not a good election to win. Federal governments usually lose office only after they’ve presided over a recession, but John Howard got tossed out before any recession. As he left office, however, the economy was in its 17th year of expansion and close to full capacity, with the headline inflation rate heading for 5 per cent and the Reserve Bank stepping ever heavier on the interest-rate brakes so as to engineer a period of below-trend growth and rising unemployment. So the chances of a recession during the Rudd Government’s first term were high. It would then have had to convince the electorate this was due to the negligence of its predecessors, not any mismanagement of its own. Coming after Peter Costello had spent 11 years reinforcing the public’s natural suspicion that Labor isn’t good at running economies, this would have been a tall order. Post-war history says no federal government has ever been turfed out after one term, but this time last year I thought Mr Rudd’s chance of being the first was quite high.

All this Labor understood full well even before it won the election. That’s why it set about from the very start criticising its predecessor’s economic management and dramatising the extent to which inflation was blowing out. As we know from the national accounts, tight monetary policy caused the economy to slow to stalling speed in the September quarter without much help from the rest of the world. But that’s not the way the public sees it, nor is it the way the Government is encouraging us to see it. The global financial crisis that followed the collapse of Lehman Brothers on September 15 was so scary it’s now burnt into the public’s brain and the obvious cause of all the nastiness that’s to follow. So, as long as the Rudd Government keeps reinforcing that rewriting of history, it’s off the hook. Don’t blame me, it’s the GFC.

All past Australian recessions have occurred as a result of a combination of domestic imbalances and world recession. This one will be no exception. But politicians from the Whitlam government on have always had trouble shifting the blame to overseas factors beyond their control. The punters almost always think local. But that’s what different this time. If Mr Rudd can portray himself as just the guy cleaning up the mess after an international conflagration, and doing so with reasonable competence, his chances of re-election are, paradoxically, much enhanced.

Rudd as an economic manager and reformer

Last year I speculated on what Mr Rudd would be like as an economic manager, but this year we’ve got a lot more evidence to work with. I think the key to understanding him is his boast that he’s not ideological. It’s true, he’s not - which means he doesn’t have deeply held convictions about how the world works and how it should work. The closest he comes is that he’s a great believer in ‘process’. By training and by instinct he’s a bureaucrat. Governments’ job is to run the country and to do so in an orderly, considered, usually consultative way. That makes him a bureaucratic fixer. A leader’s job is to work his way through a list of all the things that are going wrong and need to be put right. Lacking strong views about how the world should work he doesn’t have priorities in any genuine sense, he has a to-do list. The fact that he’s a control freak also militates against him having genuine priorities.

Mr Rudd keeps saying he’s an economic conservative. I think that’s true. It’s mainly something you say to protect yourself in a Costello-created world obsessed by budget surpluses, but I doubt it will inhibit him all that much in allowing the automatic stabilisers to work and in applying an appropriate degree of fiscal stimulus on the top. When even the most respectable economists are calling on you to spend money, few politicians resist. On a deeper level, I think Mr Rudd is pretty conservative - in all things. He has no great desire to change the world in radical ways. He has no ideology driving him in such a direction and, in any case, radical change would annoy a lot of people and possibly cost him votes. You might think his resolve to do something about climate change doesn’t fit with this but, in fact, the great promise of an emissions trading scheme is that it’s the way to tackle the problem with least disruption to the status quo.

What being an economic conservative definitely doesn’t equate to is being an economic rationalist. Rationalists are ideological and want radical change. Mr Rudd is pro-business, not pro-market. He knows Labor can’t occupy government without the at least tacit support of big business and people otherwise inclined to vote Liberal. Having no strong commitment to smaller government or means-tested welfare, he has no burning desire reduce middle-class welfare. Being of bureaucratic inclination he is, almost by definition, an interventionist. If you want a label for him, Michelle Grattan has found the best: he’s a pragmatic interventionist.

I don’t want to shock you, but Mr Rudd is so lacking in ideology he sees economic rationalists not as people arguing propositions that are either right or wrong, but as just another interest group needing to be squared away somehow. You can see that perfectly in his car plan: the rationalists got continued falls in tariffs; the industry policy advocates got massive government spending. What’s your problem? Similarly, with climate change the rationalists get emissions trading and the environmentalists get renewable energy targets.

One of the most disappointing things about the Rudd Government is its obsession with dominating the 24-hour news cycle and its insatiable need for ‘announceables’. Utterly contrary to Mr Rudd’s commitment to good process, this is a preoccupation that wastes the time of its bureaucratic advisers, perpetually distracts the attention of ministers and gives spin doctors primacy over policy wonks. It makes me think we’re getting an antipodean version of Tony Blair and New Labour - superficially intelligent and committed to sensible, middle-of-the-road policy but, actually, preoccupied with re-election and, ultimately, disappointing and disillusioning.

Mr Rudd is a timid leader, one anxious to avoid offending many voters and lacking the courage of his convictions - manly because he doesn’t have many. The Government seems far more worried by what the Opposition will say about things than it needs to be. So Malcolm Turnbull will carry on about a budget deficit - so what? Labor is so obsessed by its unjustified reputation as a bad economic manager that it fails to see all the advantages of incumbency it possesses. Governments monopolise the microphone. When it comes to budgets, what the Treasurer says drowns out what anyone else says (including yours truly).

Rudd Government’s first year

Mr Rudd’s first year had some high spots - the ratification of Kyoto, the apology to the Stolen Generation - and quite a few low ones, such as all the nonsense about petrol and grocery price watches. The $6.2 billion car plan and Mr Rudd’s statements about not wanting to be the leader of a country that doesn’t make things was disappointing. It’s noteworthy that the global financial crisis was used to help justify the car plan, a sign that we can expect more exercises in the New Protectionism, all in the name of protecting jobs. How can protecting jobs be bad?

Labor’s first budget purported to involve a significant tightening of fiscal policy so as to reduce the pressure on monetary policy and interest rates, but didn’t. We were told to expect tough spending cuts but they were few and far between, with their place taken by increases in the taxes on alcopops, luxury cars and petrol condensate. With storm clouds gathering internationally, the Government took a punt that a tightening of fiscal policy wouldn’t be needed and its bet paid off. Even so, a once-in-a-government chance to spring clean government spending with political impunity was lost. We were told the Government hadn’t had enough time to properly review spending programs and that a proper review would be implemented in next year’s budget, but I’ll believe that when I see it.

Despite the lone campaign being conducted by an Australian newspaper, Labor’s replacement of Work Choices with its own Fair Work was almost completely consistent with its election commitment. It was a reasonably even-handed exercise, to which the main employer groups took little exception, unless you believe that fairness is an irrelevant consideration in industrial relations and that efforts to stamp out collective bargaining are in the best interests of all sides. Remember that Work Choices had already been heavily modified by John Howard with his late insertion of a ‘fairness test’. As an example of Labor’s moderation, note that the guidelines devised for the Fair Pay Commission’s setting of minimum wages were little changed when handed over to Fair Work Australia.

Mr Rudd and his ministers have put much effort into achieving productivity improvement through co-operative federalism and revitalisation of the COAG process. About 90 special purpose payments have been reduced to five broad categories and ‘national partnership payments’ introduced as an incentive for the states to achieve certain targets. But progress has been slow and how much actual improvement is achieved remains to be seen.

Generally speaking the Government did well with its ‘decisive’ response to the global financial crisis in late September and October. Its one significant error was that, when it finally produced details of its guarantee of bank deposits, it didn’t pull back sufficiently so as to reduce flow-on problems for other institutions.

Policy prospects for 2009

Next week the Government will publish its white paper on its Carbon Pollution Reduction Scheme, including its target for reduction in emissions by 2020. I fear we’ll see a demonstration of Mr Rudd’s lack of courage and lack of conviction. We’ll be off to a very slow start - with a reduction of maybe only 10 per cent by 2020 and a fixed or tightly capped carbon price - plus a lot more concessions to polluters than are warranted.

Next year’s budget will be an important one, no doubt with a lot more fiscal stimulus. We know it will contain increased payments to single pensioners combined with, we must hope, reform of the interface between tax and transfers. We know Ken Henry’s root and branch tax review has also been called on for advice about superannuation arrangements - though not about the tax-free status of payments to the over-60s. The budget will incorporate already-announced spending on infrastructure projects. Note that spending from the nation-building funds will add to the budget deficit but not to the borrowing requirement. The budget will contain the second round of tax cuts promised in the election campaign - which, though already included in the forward estimates, will add to the fiscal stimulus. The thing to note here, however, is that as they stand, those cuts deliver little to low and middle income-earners, and so will have to be supplemented by additional cuts that aren’t in the forward estimates.

Speaking of the tax review, it’s supposed to report late next year, but I have a feeling it won’t figure largely in the government’s pre-election figuring, except to the extent that, as with transfer payments and with super, it’s called on for special advice on a specific issue. Next year will be some sort of moment of truth for the Rudd Government as the many inquiries it has commissioned report and recommend action. The Government has been running a line that says: terribly sorry, we assumed we’d have a big budget surplus to play with, but now the GFC has robbed us of that we’ll have to be much more selective in what we can agree to. I find this a curious argument. If we were still running big surpluses that would mean we were still close to full capacity and so the Government shouldn’t be spending big. On the other hand, in my experience periods of recession and deficit are times when governments spend freely and become less discriminating, not more. So perhaps this line is the Government’s way of belatedly admitting that, in commissioning so many inquiries, it bit off a lot more than it could chew.

My summary judgement on the Rudd Government’s performance to date: good but far from great.

Observations on monetary policy

Towards the end of the monetary policy tightening cycle that ran for six years, the Reserve Bank developed a clear and simple modus operandi in which it waited for the quarterly CPI release, revised its inflation forecast on the basis of the new information and then adjusted the stance of policy if necessary at the board meeting about two weeks later. It aligned its quarterly statements on monetary policy so they followed the board meeting after the CPI release and they preceded its six monthly appearances before the parliamentary committee. This simple MO had many advantages for the Reserve, but also for the markets. Particularly because the Reserve moved in steps of 25 basis points, predicting the size and timing of rate rises became child’s play.

But in these comments last year I observed that this MO would not be suitable in times when you needed to move fast, nor during an easing cycle. I noted that this MO would last only as long as it suited the Reserve. Well, that’s one thing I got right. As soon as the Reserve began its easing cycle in September the old, predictable way of doing things disappeared. When you’re cutting interest rates there’s never any political resistance - from the government or the lobby groups - so you don’t have to worry about carrying the public with you. And, just as the old saying says the dollar goes up by the stairs and down by the lift, so you need to ease a lot faster than you tightened. I think this is because the effect of rate rises isn’t linear. When business and consumers are in an optimistic mood, you can keep tightening time after time and not have much effect on demand. But then one day you give it one more turn and suddenly the mood switches to pessimism and caution. The economy begins slowing rapidly and you need to cut quickly to avoid a hard landing.

When the world is hit by a global financial crisis of almost unprecedented scariness, and when it becomes clear that almost all the major economies are already in recession, then the need to achieve a rapid change in the stance of policy is clear. When interest rates are a long way from neutral - in either direction - you probably shouldn’t stay there for long, and you need to act quickly if you discover the stance is no longer appropriate. On this occasion, the Reserve moved the stance from quite restrictive to clearly expansionary in just three moves spread over two months. In that time it cut the cash rate by a remarkable 40 per cent.

In the process, however, the Reserve’s signalling to the market went awry and a lot of market participants and business economists were caught out. So let’s try to explain what happened. We now know that, at both the October and November board meetings, the rate cut that was recommended in the board papers was increased at the meeting itself. Some people have wondered whether surprising the market by cutting more than expected was a ploy intended to increase the favourable impact of the move. It wasn’t. The explanation was simply that, in the short period between the recommendation and the meeting, more worrying information arrived to cause the governor to decide that an even greater cut was warranted. Monetary policy has always been set in the governor’s gut.

Some people were led astray by a speech Ric Battellino gave in which he observed that the big inflation task could limit the Reserve’s room for manoeuvre on monetary policy. This hardly seemed to fit with the move less than a week later to cut by 75 points. So how was it explained? Well, Ric is an independent thinker, he has strong and non-conformist views which, as a member of the board in his own right, he’s not afraid to express. There’s no danger of group think while Ric’s around. He expressed his view but, in the end, it didn’t prevail.

It’s clear Glenn Stevens regards the threat to our economy from the global recession as very great and decided to get rates down to the right level as quickly as possible. But while the Reserve does not see it as its job to provide the markets and business economists with an everlasting one-way bet, it also knows that if it goes on surprising people it will lose some goodwill. I think we’ll find that, when the minutes of the December meeting are published, the cut of 100 points was what had been recommended in the board papers.

Remember, too, that in response to the market’s urging, the Reserve puts out a lot more material than it used to - a statement after every board meeting, even when there’s no change; minutes of board meetings, and Mr Stevens giving a lot more speeches than Ian Macfarlane did. But the more material the Reserve puts out, the greater the scope for misunderstandings.

Looking to next year, there are a few things we can say. I’m sure the board will meet in January if that proves necessary, but the normal gap until early February provides a welcome opportunity for the Reserve to sit back and take stock. It has made a very large change in a short time, taking the cash rate down to its previous low. To some extent it’s got ahead of the data, relying heavily on ‘liaison’ (regular and systematic consultations with key firms and industry groups), anecdote and intuition. It has assumed that what’s been happening abroad will have a big effect on us, but it will now need to see the hard data confirming this.

The world recession looks like being significantly more severe than we’ve experienced before. If so, there’s little doubt we’ll be pushed into recession as well. It’s already apparent that our economy is softer than was forecast as recently as the November SoMP. We now know the first quarter has made a contribution of just 0.1 per cent to the forecast of GDP growth over the year to June 09 of 1.5 per cent. Similarly, the first quarter has made a contribution of minus 0.3 per cent to a forecast for non-farm growth of 1 per cent.

So it’s clear that, even though the cash rate is already as far from normal/neutral on the downside as we’ve seen, the Reserve has further to go next year. But if you thought it likely on present indications to go no further than the low 3s, just one more cut of 100 points would see it done. This suggests the Reserve will soon have to level out, making smaller cuts of 50 points or even 25.

The Reserve will respond to developments as they occur. But there are two things to remember about next year. First, the cuts to date have had an expectation of more bad news to come factored in. So when the expected bad news actually arrives, you need to respond only to the extent that it’s worse than you originally allowed for. That is, you have to avoid double counting. Second, because the Reserve has acted with such alacrity, we’re reaching a point where things continue getting worse, but it doesn’t respond because it’s already done all it considers appropriate. This is an inevitable consequence of the pre-emptive approach to monetary policy, but that won’t make the appearance of inaction any easier to accept by the public - and maybe even some business economists.


AUSTRALIA’S OUTLOOK FOR POLITICS AND GOVERNMENT IN 2009

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THE CHANGING ECONOMIC POLICY MIX

Comview conference, Melbourne
November 24, 2008

Economic developments have come thick and fast during the Rudd Government’s first year in office and, as a result, the policy mix and the stance of policy arms have changed significantly. Since you’ve just heard from Chris Caton on the economy’s current performance and outlook, I’ll focus on describing the changing policy response to those developments.

But first, a little political context. When the Rudd Government came to power last November, two perceptions dominated its approach to matters economic. First, it believed - no doubt on the basis of its market research - it had a serious credibility problem with voters on the question of economic management, thanks to Peter Costello’s success over the previous 11 years in characterising it as the bad manager who left him to inherit a $10 billion ‘budget black hole’ and a mountain of federal government debt. In the process of scoring these political points, Mr Costello managed to roll back decades of Keynesian thinking, convincing many in the public and in political circles that budget deficits and debt were an unarguable sign of economic irresponsibility, whereas budget surpluses and the elimination of government debt were the ultimate proof of exemplary economic management. As a result of this, Labor believed it had no choice but to embrace the Howard Government’s policy mix and fiscal rhetoric without demur.

Second, well before it won the November 2007 election, Labor knew it would be taking over after the economy had been expanding for a record 16 years, but with the economy approaching full capacity, inflation pressure building and the Reserve Bank stepping ever-harder on the monetary policy brakes. Federal office usually changes hands immediately after an incumbent government has presided over a recession, but this time the change-over was occurring before any recession. So Labor knew the chances of a recession during its first term were high, and that if it was to survive such a disaster it would have to start from the very beginning implanting in the electorate’s mind the belief that every adverse economic development was the fault of its predecessors’ mismanagement.

When federal government changes hands once a decade or so, standard practice is for the incoming government to find an excuse to make its first budget a really tough one, in which spending programs are cut hard. The econocrats encourage their new masters to do this, knowing it’s their best chance of ever persuading governments to have a spring cleaning because all unpleasantness can be blamed on their predecessors. This practice is also motivated by a desire to cut out their predecessors’ pet programs to make room for their own pet programs.

As you remember, so concerned was the Reserve about the build up of inflation pressure - which was pushing the underlying inflation rate well above the 2 to 3 per cent target range - that it increased the official rate in August 2007, shortly before the start of the election campaign, and then did so again right in the middle of the campaign. From the moment it took office the Rudd Government would have realised that the Reserve was intent on raising rates further, as indeed it did in February and March 2008. Wayne Swan thus began by emphasising the severity of the inflation problem the new Government had inherited from the Liberals. We were given the clear impression Labor’s first budget would be very tough, with sweeping cuts in spending used to produce the largest budget surplus possible given Labor’s commitment to matching the three years of tax cuts the Liberals had promised in the election campaign.

The object was to change the policy mix, with fiscal policy tightened so it took more of the burden of restraining demand and thus reduce the need for ever tighter monetary policy. As it turned out, however, the budget was not a tough one. Spending was not cut hard and the main way Labor attempted to cover the cost of its election promises was with a few tax increases (on alcopops, luxury cars and oil condensate). Why the sudden change of heart? Because Mr Swan’s private discussions with American and European leaders during his trip to the IMF convinced him the problems arising from the subprime crisis were far from over and that the world economy was heading into recession. This was not the time to add a tightening in fiscal policy to already tight monetary policy. So, in the end, the policy mix wasn’t changed at that time.

The Rudd Government’s first year has thus been one in which a preoccupation with the need to reduce inflation by using policy to slow the economy has been replaced by a preoccupation with the need to prevent the economy being pulled down into the global recession by dramatic reversals in the stances of both fiscal policy and monetary policy. Let’s examine the two policy arms in turn, concluding with a summary statement of the changed mix of those policies.

Monetary policy

Objective and instruments: The Rudd Government made no change to the objective of monetary policy, which is to be the primary instrument for achieving internal balance - that is, low inflation, low unemployment and a stable rate of economic growth. It accepted the RBA’s inflation target - to hold the inflation rate between 2 and 3 per cent on average over the cycle - and affirmed that the RBA would be allowed to conduct monetary policy independently of the elected government. The new Government agreed to some minor changes to the RBA’s institutional arrangements eg decisions of the monthly meetings of the RBA’s board are now announced at 2.30 on the afternoon of the meeting, rather than at 9.30 the following morning.

The RBA has made some small changes to the way it conducts its open market operations in response to the financial crisis. Most textbooks say market operations are conducted by means of the outright purchase and sale of CGS but, for many years, the main means has been by ‘repurchase agreements’, known as ‘repos’. Under a repurchase agreement the RBA agrees to buy (or occasionally, sell) eligible securities with a simultaneous undertaking by the seller to reverse the transaction at an agreed price and date in the future. This means a repo is essentially a secured loan. A bank that wants to borrow exchange settlement funds (‘cash’) from the RBA hands over an eligible security worth more than the loan, agreeing to repay the debt by buying the security back, with interest, on an agreed date anything from a week to a year later.

Since the subprime crisis began in August 2007, the RBA (like many other central banks) has been steadily widening the range of highly rated securities it is willing to accept for repo agreements. As well as accepting all types of government securities, it is now willing to accept bank bills and certificates of deposit.

Open market operations involve the RBA using its market operations to manipulate the supply of exchange settlement funds so as to ensure the demand for funds equals the supply of funds at the target cash interest rate it has nominated. Every bank is required to end each day with a balance on its exchange settlement account with the RBA of zero or more (ie not be in overdraft). Because the interest rate the RBA pays on ES balances is a little less than the cash rate, banks usually prefer to lend any surplus ES funds to those other banks that expect to be short of funds at the end of the day, with the interest rate on the loan being the (full) cash rate.

However, because the global credit crisis has left banks in Australia and other developed economies reluctant to lend to each other (for fear that they may not be repaid, or fear that no other bank will be willing to lend to them should they need funds in future) the RBA and other central banks have had to use repos to lend much more to banks than would normally be the case. That is, the banks have been hoarding cash. The media sometimes refer to this process as ‘flooding the market with liquidity’. There are three things to note. First, the funds are lent to the banks against security for short periods at normal interest rates. So the banks aren’t receiving any subsidy. Second, the increase in ES funds does not involve any change in the stance of monetary policy. Indeed, the central banks’ willingness to lend the system all the extra funds it needs because some banks are hoarding their funds actually prevents the cash rate from shooting up way above the central bank’s target rate. Third, the process doesn’t involve adding to the money supply and isn’t inflationary. As the banks calm down and start trusting each other again, the surplus ES funds will be withdrawn from the system.

Stance of policy: When the Rudd Government was elected in November 2007 the RBA was busy resisting the build-up of inflation pressure and the cash rate stood at 6.75 per cent, which was ‘tight’ or ‘restrictive’ - that is, it should actively discourage households and firms from borrowing and spending. By March 2008, the cash rate had been raised twice more, to 7.25 per cent, which is quite restrictive.

By September 2008, however, the RBA judged that the economy was slowing rapidly - at that stage, partly because of the negative effects of the global slowdown, but mainly because domestic interest rates had been so high for so long. The RBA also judged that insufficient growth and thus higher unemployment was becoming a bigger risk than excessive inflation pressure. So the RBA began easing policy, lowering the cash rate by a cautious 0.25 percentage points. Not long after, the financial markets’ adverse reaction to the US authorities’ decision to allow the Lehman Bros investment bank to fail caused the credit crunch to worsen into the full-blown global financial crisis, in which various US and European banks and other financial institutions had to be bailed out and propped up by governments. These were frightening events for consumers and businesses around the developed world and many governments had to issue explicit guarantees of bank deposits to prevent runs. In this dramatically worsened environment - in which the risk of a local recession cast out all fears about continuing high inflation - the RBA cut the cash rate by a surprising 1 percentage point in October and a further 0.75 percentage point in early November.

This combined cut of 2 percentage points in just two months - early September to early November - reduced the cash rate to 5.25 per cent. Thus the stance of monetary policy has quickly been returned to ‘neutral’ - neither expansionary nor contractionary. Any further cuts will take the stance from neutral to ‘expansionary’ or ‘accommodating’. And the RBA has left little doubt it is prepared to cut further, either in the hope of avoiding a recession or ensuring one is as short and shallow as possible. The lowest the nominal cash rate has got in the past was 4.25 per cent in the first half of 2002. It won’t be surprising to see the rate get down to that next year, if not lower.

Credit crunch: In the aftermath of the subprime debacle many US and European banks and merchant banks became reluctant to continue lending. The market for mortgage-backed securities froze up. The very best credit risks (eg our Big Four banks) could borrow only at much higher rates, while lesser financial institutions (eg our non-bank mortgage originators) could not borrow at all. Economic theory says that in a free market banks are always willing to lend, although their degree of enthusiasm or reluctance - including their assessment of the degree of risk involved - will be reflected in the size of the prices (interest rates) they charge.

We know, however, that at times of stress, the theory doesn’t hold: banks become unwilling to lend regardless of the price they could charge. In such circumstances, banks are rationing credit on a basis other than price. This is the meaning of the term ‘credit crunch’.

Our banks borrow heavily from abroad. As you probably know, almost all of Australia’s net foreign debt has been borrowed by our banks. The banks have been able to roll over their short-term foreign loans, but only at significantly higher interest rates. The banks have passed these higher borrowing costs on to business borrowers in full, and early this year they sought to pass them on to customers with mortgages, and then to avoid passing cuts in the cash rate on in full. The politicians berated the banks for their greediness, but the RBA Governor has defended them, arguing that higher rates are preferable to the alternative: the banks refusing to lend because lending has become unprofitable.

The point to note is that the RBA has made it clear it will take full account of the banks’ ‘unofficial’ rate rises in the judgements it makes about by how much the official cash rate needs to rise or fall. In the end, what it cares about are the interest rates that affect the behaviour of households and businesses, which are the rates households and businesses actually pay. It will adjust the cash rate to whatever extent is necessary to get actual borrowing rates to where it judges they need to be.

Fiscal policy

Objective and instruments: The objective of fiscal policy has been expressed in the ‘medium-term fiscal strategy’. Under the Howard government this was ‘to maintain budget balance, on average, over the course of the economic cycle’. In other words, if you add up all the deficits in the bad years and all the surpluses in the good years they should total roughly zero. The Rudd Government’s medium-term fiscal strategy is only a little different: ‘maintaining a budget surplus, on average, over the medium-term’. The difference is more apparent than real, reflecting only Labor desire to appear more Liberal than the Liberals on economic management.

In principle, the role of fiscal policy was to act as a back-up to the main instrument used to achieve internal balance, monetary policy. In practice, and while the economy was booming, the budget surplus overflowing and monetary policy struggling to prevent an inflation breakout, the Howard government put fiscal policy into neutral. Rather than assisting monetary policy by allowing the budget’s automatic stabilisers to produce an ever-greater surplus, it chose to hold the planned budget surplus steady at 1 per cent of GDP. It increased spending and cut income tax as necessary to reduce the planned surplus to 1 per cent of GDP. Thus, contrary to the Howard government’s claims, fiscal policy did nothing to ease the burden being carried by monetary policy in restraining demand, thereby requiring interest rates to be higher than otherwise.

Stance of policy: When the Rudd Government came to power it decided to raise the budget surplus target from 1 per cent to 1.5 per cent, and also that any upward revision of tax collections would be ‘banked’ (added to the surplus) rather than used to increase the already-promised tax cuts. It thus budgeted for a surplus of 1.8 per cent of GDP in 2008-09, only a little higher than the 1.5 per cent expected in 2007-08. Judged the strict Keynesian way, the stance of policy adopted in the 2008 budget was expansionary because the cost of the increased spending and tax cuts promised in the election campaign greatly outweighed the value of the spending cuts and tax increases (on alcopops, luxury cars and petrol condensate) announced in the budget. Judged the way the RBA does, however - that is, simply comparing the expected budget balances for last year and this year - the increase was too small to register. That is, under the Rudd Government the stance of fiscal policy remained neutral.

All that changed, however, when the global financial crisis reached its height in mid-October 2008. The Rudd Government announced a discretionary fiscal stimulus - grandly titled the Economic Security Strategy - involving one-off cash payments to pensioners, families with children, and first-home buyers - worth $10.4 billion in 2008-09, with most of that money paid out in mid-December.

When the mid-year budget review was published a few weeks later, it became clear that the rapid slowing in the economy had caused the budget’s automatic stabilisers to change direction. Whereas formerly the stabilisers had been trying to use a higher budget surplus to hold the booming economy back, now they were producing a lower budget surplus to bolster a slowing economy. The originally expected budget surplus of $21.7 billion (1.8 per cent of GDP) is now expected to be only $5.4 billion (0.4 per cent), reduced by lower-than expected tax collections of $4.9 billion and the $10.4 billion stimulus package (plus $1 billion in odds and ends).

Two things are clear from this. First, no matter how you measure it, the stance of fiscal policy is now clearly expansionary. Second, as could long have been predicted, the turn in the business cycle has prompted the Government to shift to an overtly Keynesian approach to fiscal policy. It has stated that it will ‘allow the automatic stabilisers to support economic stability’ - that is, to operate unhindered - and it has acted to add discretionary fiscal stimulus on the top. Both points are, of course, consistent with the medium-term fiscal strategy, which represents a policy of what I call ‘symmetrical Keynesianism’.

The stimulus package was carefully designed and represents state-of-the-art Keynesian policy in that it follows Dr Ken Henry’s advice to ‘go early, go hard and go households’. The Government has initiated this stimulus very much earlier than was done in previous recessions. ‘Go hard’ means spend a lot, and $10.4 billion represents almost 1 per cent of GDP, which certainly qualifies. ‘Go households’ means direct the stimulus to those people who are most likely to spend it immediately, rather than spending on capital works (which take months or years to organise) or job-creation schemes. Note, too, that the one-off or temporary nature of the payments means the package will make no lasting addition to government spending.

Most macro econocrats have in their minds the rough rule of thumb that fiscal stimulus has a multiplier of 1 - that is, it adds to GDP, but that’s all. In this case, however, the mid-year review states explicitly that the stimulus of almost 1 per cent of GDP is expected to cause real GDP to be between 0.5 and 1 per cent higher than otherwise, and cause employment to be ‘up to’ 75,000 higher than otherwise. Why a multiplier of less than 1? Because of leakages to saving and imports.

The Government has made it clear it will be accelerating its capital works program funded (in part, at least) from the three nation-building funds it established in the 2008 budget. It has also expressed its willingness to apply further fiscal stimulus if necessary. Despite its reluctance to say so before it has to, there is no reason to doubt its willingness to allow the budget to drop into deficit.

The new policy mix

The rapid slowing in the economy has caused significant changes in the stances of both macro policy arms and in the mix of policies. Over the Rudd Government’s first year, the stance of monetary policy has moved from quite restrictive to neutral, with little doubt that it is on its way to expansionary. The stance of fiscal policy has moved from neutral to expansionary. The effect on the mix is that now both arms are pulling in the same direction, with fiscal policy now actively assisting monetary policy in the pursuit of internal balance.

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