Bill Rosenberg is the Economist and Policy Director for the NZ Council of Trade Unions (CTU). This is the Commentary from his CTU Monthly Economic Bulletin, No 150, September 2013. Reproduced with permission. Ed

September 2013 is the fifth anniversary of the collapse of US investment bank, Lehman Brothers. By allowing it to collapse the US government was attempting to signal that investors could not count on Government bailouts and that the Government would rely on the market to fix the problem itself. Instead, it signalled the seriousness of the growing financial crisis and the start of some of the largest bailouts in history. One estimate is that as a result of the crisis, by the beginning of 2013 the US economy had lost over $US7 trillion in output or $US20,000 per US resident and will probably lose another $US4 trillion before even approaching full employment (1). While there are some signs of improvement in its economy, it is still operating at well below capacity with unemployment at 7.6%, held back by punishing cuts in Government spending forced by the mad-as-a-hatter Tea Party thinking which dominates the Republican Party. The IMF (International Monetary Fund) Chief Economist Olivier Blanchard stated in April 2013 that without this “fiscal contraction”, “growth (in the US) would probably be between 1.5 and 2% higher than it is this year”(2). Instead it was at 1.6% in the year to June 2013 according to the Organisation for Economic Cooperation and Development (OECD).

Don’t Mention the Depression

Through tightly linked international financial markets the US collapse rapidly infected Europe, triggering banking collapses in the UK and other countries and severe economic downturns almost everywhere. Leading economist Joseph Stiglitz wrote in March 2013: “While Europe's leaders shy away from the word, the reality is that much of the European Union is in depression. The loss of output in Italy since the beginning of the crisis is as great as it was in the 1930s. The youth unemployment rate in Greece now exceeds 60%, and the figure for Spain is above 50%.”(3)

Financial Times economics columnist Martin Wolf wrote in September 2013 (4) about the Eurozone (the bloc of countries using the Euro currency): “Its unemployment is 12%. Its gross domestic product (GDP) in the second quarter was 3% below its pre-crisis peak and 13% below its pre-crisis trend. In the most recent quarter, Spain’s GDP was 7.5% below its pre-crisis peak; Portugal’s, 7.6%; Ireland’s, 8.4%; Italy’s, 8.8%; and Greece’s, 23.4%. None of these countries is enjoying a strong recovery. The latest unemployment rate is 12% in Italy; 13.8% in Ireland; 16.5% in Portugal; 26.3% in Spain; and 27.9% in Greece. These would be higher, without emigration. Ireland’s plight is a warning: it has long since restored its competitiveness and is running a large current account surplus. Yet its GDP has stagnated for four years”. Neither is the UK a model, with stuttering economic growth, 7.7% unemployment and its financial sector still deeply damaged from bank collapses and numerous scandals.

An analysis of austerity measures in developing countries (5) – often overlooked in the coverage of this broad and deep crisis – found that “fiscal contraction is most severe in the developing world. Overall, 68 developing countries are projected to cut public spending by 3.7% of GDP, on average, in the third phase of the crisis (2013-15) compared to 26 high-income countries, which are expected to contract by 2.2% of GDP, on average… In terms of population, austerity will be affecting 5.8 billion people or 80% of the global population in 2013; this is expected to increase to 6.3 billion or 90% of persons worldwide by 2015”.

While Australia was one of the few countries in the OECD not to go into recession as a result of well-designed Government stimulus policies, New Zealand’s GDP per capita has only just got back to where it was in 2008, and unemployment at 6.4% has been higher than Australia for the longest stretch since it began being surveyed in 1986. If GDP per capita had continued to grow at its historical rate, it would be 11% higher than it is now, a total loss of almost six months output per person since the beginning of 2008.

These are huge economic losses and enormous social consequences. Have economists, and politicians who, in Keynes’* words, “believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist”, learned anything from this disaster? Below I list some of the ideas that have ruled conventional economics which have been severely shaken by these events – and the response to them, or lack of it, in New Zealand and internationally. For each one I must be brief because the list is long though still incomplete. The Global Financial Crisis should have been a life-changing event for economics. With some notable exceptions, we have yet to see it.*John Maynard Keynes (1863 –1946) advocated Government spending on public works to stimulate the economy and provide employment. He was the most influential Western economist for several decades after World War 2, until he was supplanted by the neo-liberal monetarists. Ed.

Finance

The crisis was triggered by a financial meltdown with cascading company collapses. In its theories and models of the economy (“macro-economics”) the workings of the finance sector were treated as largely irrelevant by conventional economics: finance would flow, interest rates get set, risks would be managed by “the market”. Only at the “micro” level – the effect on individual firms, households or sectors – was finance seen as warranting attention. We have been reminded (to put it mildly) that the finance sector can have a major effect on the real economy.

From a position that assumed rather simplistically that more finance was good, no matter what its form, some researchers have suggested (as most people suspected) that countries can have “too much finance” (6), and that different types of finance have important implications for stability (7). This has led to international and national moves back to tighter regulation of the finance sector. Tighter capital requirements, preventing commercial banks from speculating with their customers’ funds (separating financial dealing from conventional banking), taking action to prevent banks becoming “too big to fail” or “too intertwined to fail”, and financial transaction taxes have been extensively debated.

Unfortunately the finance sector has proved far too powerful and reform so far has barely touched the fundamental weaknesses that need addressing. Banks in the US, for example, are back to most of their old ways; the crisis has led to banks getting bigger rather than smaller; the tight international integration and rapid financial flows which enabled the crisis to spread faster than any disease has not been touched and indeed attempts are being made to ‘liberalise’ it further in the World Trade Organisation and through agreements like the Trans Pacific Partnership Agreement (TPPA).

The finance sector internationally is resisting greater supervision, further regulation, and more control of the often frenetic domestic and international financial markets. Yet their disconnection from the real needs of society and the economy and potential for damaging them has not lessened. When the US average share holding lasts just 22 seconds (8), and the New Zealand dollar is the tenth most traded currency in the world, the disconnection seems clear (9). We would be foolish to believe that risk has now been properly controlled, or that another of these hugely damaging catastrophes could not occur again.

Nothing “Rational” About Economics

Here in New Zealand, the Reserve Bank has tightened its control of bank borrowing and lending in the interests of financial stability, but there are still many areas of vulnerability. There is a comfortable myth that regulatory standards here and in Australia saved us. But former Reserve Bank of Australia Governor, Ian Macfarlane (and other Australian observers), didn’t agree, speculating that the reason for the situation might be the lack of competition between the four big Australian banks which own the big four here, and paradoxically the lack of savings in Australia to invest in the high risk US markets. But, he said: “they would have if they could have” (10). The same circumstances apply here, and when we look at how close the banks here came to being unable to renew their international borrowing during the crisis due to their heavy reliance on foreign-sourced short term money, their large-scale tax evasion, their control by their Australian parents, and the lack of regulatory restraint on dealing, it’s hard to escape his conclusion. Much more must be done here and internationally to prevent another such crash.

Underlying the belief of conventional economics in the ability of financial markets to stabilise themselves was their belief that humans behave rationally, maximising their individual returns, looking far ahead and using all information available. I studied psychology for my doctorate – a science which spends a large part of its effort in explaining why humans do not apparently behave rationally – so always found this absurd. The application of psychology to economics (“behavioural economics”) is making some impression on these beliefs but has a long way to go. Information will always be scarce and unequally distributed, and humans make mistakes and follow herds or “rules of thumb” when information is scarce or too complicated. The crisis made this crystal clear. Regulation will always be needed in these circumstances – but is resisted by the finance sector and old thinking at every step.

Monetary Policy

The conventional place of monetary policy is for one purpose: controlling inflation. One instrument – setting short term interest rates – is supposed to be all that is needed to do this. The expansion of money supply beyond what the real economy’s output justifies would always be inflationary and could have no effect on the real economy in any case because our rational humans would anticipate the need to tighten the supply in future. Therefore monetary policy is best left to a technocratic authority (the Reserve Bank) to act independently from the political authorities (Government) who control taxation and Government spending.

Yet all that unravelled in the crisis and on looking back at what led to it. IMF research, for example, showed that the high interest rates resulting from this kind of monetary policy in small open economies like New Zealand led to capital flowing in (potentially destabilising in itself) and an over-valued exchange rate which harmed exporters (11). Rapidly rising house prices were a crucial ingredient in the crisis in several countries but, using a single short term interest rate to control them, risks damage to the rest of the economy. So we need policies in addition to the interest rate, such as the rediscovered “macro-prudential tools” like loan-to-value ratios for mortgages, which are useful for both financial stability and anti-inflationary purposes. 

But, most spectacularly, the use of “quantitative easing” (a huge increase in the money supply) to keep banks afloat has been used in the US as the main anti-recessionary policy with some success – and little inflation. Both macro-prudential policies and quantitative easing are designed to impact on the real economy, so the need for the monetary authorities (the Reserve Bank) to work much more closely with the fiscal authorities (Treasury and Government) becomes obvious. The autonomy of the Reserve Bank will increasingly be called into question. Quantitative easing – like the bank bailouts – is being used primarily to “save Wall Street, not the economy” in the words of economist Dean Baker. It is helping the US economy along the way, but it could have been more effective if used in other ways. Whatever the case, it is hard now to take quantitative easing off the agenda for other much more worthy purposes. 

The Role Of Government

Conventionally, economists said that governments borrowing to spend during a recession in order to stimulate the economy would be self-defeating and inflationary. That rational human would know that sometime in the future the Government would have to raise taxes to repay the rising debt and so would hold back their spending in anticipation. It was much better for governments to “get their house in order” by getting back to surplus and paying off debt as quickly as possible through expenditure cuts and (less desirably because they disincentivised investment and work) tax rises. That would let the private sector get on with the job of investing and getting the economy moving again. This philosophy is at the heart of “neo-liberalism” – the idea that Government is best as small as possible and that the private sector is always more efficient and works best when it is deregulated and left to get on with it.

In fact the countries, such as the UK and Greece, which have followed this advice, have got into much deeper recession. The power of Government spending is particularly high when an economy has high private debt levels. Households and business with high debt levels will at some point stop spending in order to pay off debt. Other firms suffer as demand for their products evaporates. People lose jobs, further depressing demand. The Government is then the only institution that can break this downward spiral into depression. It can fund its spending by borrowing – or by credit from the Reserve Bank – that only a Government has the standing to do (see Economic Bulletin 122, March 2011, for explanation of why a Government is not like a household).

The IMF has, with some honesty, revised earlier estimates of the effect on the economy of the expansion (or contraction) of Government spending. It found they were significant (12). It has also found that they are not neutral in the effects on people. Low income people are hit hardest by contractions – especially by cuts in spending and services (13). That other symbol of neo-liberalism, privatisation, has also taken a severe blow. The US and UK governments nationalised insurance companies, banks and car manufacturers to prevent a more severe crash. The picture of a sturdy, independent private sector with its willingness to take losses on the chin proved a myth as the finance sector put out its hand and accepted, ungraciously, the huge Government hand-outs and guarantees that are now threatening the stability of governments and the livelihoods of millions of blameless people. The reliance of the most powerful elements of the private sector on Government has rarely been clearer. The implication that, with reliance must come accountability; has yet to be addressed. Such firms must accept a much higher degree of public oversight including in their regulation and their governance.

Inequality

Conventionally, economics swore it had nothing useful to say about inequality. That was an “ethical” issue which had nothing to do with the efficiency or productivity of an economy. As recently as 2012, Treasury organised a series of lectures on this theme. That the policies they were recommending led to a concentration of wealth and income was not an issue for economists to worry about. The crisis led to the popular realisation that the “1%” had cornered far too much power, income and wealth, and too often was using it irresponsibly. In policy circles particularly within the OECD, IMF and International Labor Organization (ILO) this led to a re-examination of the economics of inequality. They found many links. Inequality is likely to have contributed to the financial crisis by households with stagnant or falling incomes increasing their debt to unsustainable levels; in small open economies that is likely to have led to increased current account deficits and international debt; economies with high levels of inequality had shorter periods of economic growth; the loss of demand due to lower incomes among wage and salary earners leads to lower economic and productivity growth rates. Health researchers Wilkinson and Pickett found links between inequality and a large range of social and health problems. On the other hand, inequality is exacerbated by the increased internationalisation of production, offshoring and the growth of supply chains, by financial globalisation, lower employee bargaining power and employment protection, increased part time work and changes in the taxation system. Most of these inequality-increasing policies were prescribed by the OECD, IMF and orthodox economists.

International agencies are now, at least in theory, saying policies should address growing inequality – but there is a large gap between the findings of the research departments of the IMF, OECD and European Commission and what they actually put pressure on countries to adopt. Here in New Zealand, Treasury has adopted a “Living Standards’ Framework” which includes not only economic growth but sustainability, managing risks, social infrastructure and “increasing equity” as criteria. We have yet to see its practical effects. Current privatisation, regulatory, tax, labour and welfare policies tend to increase inequality rather than reduce it.

In another significant change, the IMF’s Research Department produced a paper under the name of its Chief Economist (14) recommending more centralised collective bargaining, something it has opposed for most of existence, and inconsistently, still opposes when dealing with indebted countries. This is a major move away from the constant push to the “flexible” individual contracting model that has been the standard, inequality-heightening prescription. There are many other lessons being learned which space does not allow me to touch on. They include the need to control international financial movements, the dangers of private international debt, the great advantages of a country having its own currency and the policy failures of the Euro, the revival of interest in manufacturing in the high income economies, and a new-found aversion to tax havens.

But Some Lessons Have Not Even Begun To Be Learned