Tuesday, May 26, 2009


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.