by Andrew Clark
The global financial crisis, like the big bad wolf, blew away 70 years of economic certainty. Now all that remains is turbulence and doubt.
British economist, John Maynard Keynes, the first of the "global" economists who dominated the management of international economies. Later Milton Friedman came to dominate. Now the world lacks a single leading economic theory.
"We're crossing the river one stone at a time. There's no overarching paradigm of thought or analysis that can help us understand how to navigate," Ken Courtis, a former managing director of Goldman Sachs in Asia, says.
His "one stone at a time" view alludes to the current lack of a sense of coherent economic policymaking at a global level. "The blind leading the blind", "If all the economists were laid end to end, they'd never reach a conclusion", "the dismal science", "age of anxiety", "bonfire of the certainties", "future shock" – you name it. The world is struggling and feels bad about it.
"For seven years and counting we've lived in a global economy that lurches from crisis to crisis" is the way Nobel-prize-winning economist Paul Krugman put it in The New York Times. "Every time one part of the world finally seems to get back on its feet, another part stumbles."
The Global Financial Crisis, which started with a collapse in the mortgage financing market, undermined faith in any single model of the economy. And it challenged ideas about the invincibility of the "invisible hand" generates equilibrium in the demand - supply equation of the unregulated market.
The reputation-erosion problem is ecumenical. It has been particularly hard on economists who construct sophisticated, mathematically bamboozling models to forecast the future, only to find human nature and the growing complexity of a fast-changing world have blown their house in, rather like the big bad wolf in The Three Little Pigs.
Westpac economist, Huw McKay expresses this problem in a technical, but graphic, manner: "Any school that is silent on balance sheets while abstracting away from the pro-cyclical interaction between macro-finance, confidence and the real economy has been rendered trouser-less by the events of the last decade."
A range of what the Japanese call shocku – the Global Finance Crisis, threatened Eurozone collapse, tepid growth, rising debt, uncertainty about China, retrenchment in other emerging economies, collapse of the commodities boom, concern about climate change, digital disruption – have derailed a sense of progress prevalent since the end of World War II.
However, the world is operating in an era of "secular stagnation"; in effect, a period of negligible economic growth. In April, the IMF forecast 3.5 per cent global growth over the next year. At first blush, this may seem relatively healthy. But once projected Chinese growth of 7 per cent, and Indian growth of roughly the same rate, are allowed for, and after a relatively buoyant US, it leaves a secularly stagnant Europe, a deep recession in Russia and some Mediterranean economies such as Greece, and growing problems in formerly robust emerging economies like Brazil.
The oil shocks of the 1970s - when supply dried up and prices soared fed runaway inflation. This undermined the thinking of the Keynesians and made room for the Chicago school to offer a different view of economic management.
Then this week the IMF warned commodity and energy exporters could expect a further cut in growth rates.
Locally, the emerging post GFC understanding is that our children will be worse off. They will live in a world of growing pressure and insecurity. They will work more for less – a fact that is disturbing for many. The cumulative weight of this and other shocku, and concerns about what will happen after quantitative easing (QE) tapers off, further undermine any sense of a prevailing economic orthodoxy. "No one went through this before," Ken Courtis points out. "There is no theoretical framework to help guide us."
Desperate central banks have tried extreme measures to stimulate economies. QE, an unconventional form of monetary policy whereby a central bank creates new money to buy financial assets, in the hope of stimulating economic activity, has mitigated some of the economic problems since the crisis began.
"I just look at the world and see that we are in a period of deleveraging," Courtis says, referring to the painful process of cutting back on borrowings. "Debt is going up everywhere. In many countries the big debt problem is in the private sector." He cites Portugal, which "has had no trade surplus for 51 years", as just one example. "In the US, overall debt is 430 per cent of GDP". (Total private and public debt) Moreover, the QE program and other government interventions mean that "since the GFC we haven't had markets, we have had intervention".
Nouriel Roubini, a professor of economics at New York University's Stern School of Business, and one of the few prominent economists credited with predicting the 2008 financial crisis, is worried that more trouble could be just around the corner. He has warned that "not enough money is moving in markets at any one time". This means "small corrections" in the markets "become big corrections, and big corrections can become crashes".
Whatever shocks the world economy has in store, there's confusion about what is really going on. Picking on just one part of the economic policy Rubik's Cube, Professor Adrian Pagan, an Australian economist with an impressive reputation for his studies of economic modelling, says: "I doubt most of the public really know what QE was about."
Further confusing the current economic policy debate, it turns out that while QE is expansionary, and therefore somewhat Keynesian in flavour, it is in fact a monetarist tool. Milton Friedman, an economics professor at the University of Chicago and the founder of monetarism wrote, a decade before the GFC, "the surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money. That would make much-needed financial and economic reforms far easier to achieve."
Westpac's McKay, who is also a visiting scholar at the US Studies Centre at Sydney University, blames the media for much of this confusion. Media commentary on the economy has become "progressively less sophisticated, accommodating commentators and eschewing intellectuals", he says. "That elevates reportage in place of analysis and builds celebrity in the place of rigor, but does not really engender a lively mainstream public debate."
Two schools of thought
That public debate about economic policy traces its origins to the Industrial Revolution, which launched two and a half centuries of stop-start growth. There have been many economists dating back to Adam Smith (1723-1790), and they have – as George Bernard Shaw so memorably pointed out with his quip about laying economists end to end without reaching a conclusion – shown a remarkable capacity for disagreement. But the 70 years before the onset of the September 2008 GFC can, at least from an economic policy perspective, be broadly bisected.
The first period, lasting roughly 35 years from mid-way through World War II to the first oil crisis in 1973, the Vietnam War-fueled inflation and arrival of the word "stagflation", was generally "Keynesian". The following 35 years, which ended with the GFC in 2008, was broadly under the economic policy thrall of the Chicago school. A crude political labelling of these schools would say Keynesians tend to be more left-wing and monetarists, or adherents of the Chicago school, more to the right.
Comparing governments of the 1970s and '80s, when this switch from one to the other occurred, adds ballast to the bisecting thesis. In the US, in the mid- to late '70s, Democrat Jimmy Carter was president, but then Republican Ronald Reagan took over. In Germany it was the era of Social Democrats – Willy Brandt and Helmut Schmidt. But then Helmut Kohl from the more conservative Christian Democrats (CDU) took over. In Britain, the mid- to late '70s belonged to Labor governments led by Harold Wilson and James Callaghan, but then along came "cold shower" economics of Tory Margaret Thatcher, who proudly proclaimed "the lady's not for turning".
Even communist China sort of adheres to this historical pattern. In the '70s there was the Cultural Revolution and Mao Zedong's Little Red Book. But by the '80s, pragmatic strongman Deng Xiaoping was in charge, and unleashing the extraordinary latent energy that came with marrying market reforms to the Chinese work ethic.
At first blush, Australia seems the odd man out, with Liberal prime minister Malcolm Fraser presiding from the mid '70s to the early '80s, then Labor prime minister Bob Hawke taking over. But the frequent predilection for Keynesians and monetarists to engage in economic policy cross-dressing helps explain this local historical mismatch.
Keynesianism v monetarism
Keynesians were followers of – and often widely varied interpreters of – British economist John Maynard Keynes (whose surname rhymes with "brains"), who wielded enormous influence in the years after the Great Depression to the Bretton Woods Agreement on fixed exchange rates in 1944, and beyond. Keynes was an Eton old boy, Cambridge graduate, academic, government official, successful private investor, commentator and a demi-monde figure attracted to the Bloomsbury Group of writers and artists in London.
The essence of the Keynesian approach was the belief that governments could offset insufficient aggregate demand through counter-cyclical fiscal policy. In effect, tweaking spending and taxing to stimulate the economy. Keynesians advocated a mixed economy where the private sector remained the principal actor, but there was a "counter-cyclical" role for government through tax and spend decisions and interventions by central banks.
But this Keynesian approach failed to stabilize economies in the wake of the oil price shocks and rising inflation of the '70s. Like adding accelerant to a fire, the economies flamed up, but the result was inflation or, worse still, stagflation. The latter means growth spluttered, but unemployment and inflation worsened at the same time. The causes of this stagflation varied and are still being argued over. Globally, a giant spending hangover from the costs of the Vietnam War, and the impact of the dramatic quadrupling of crude oil prices on the prices of consumer goods ranging from cars to caviar, played a significant part.
So the second phase, called monetarism, came into vogue. Popularized by Friedman, monetarism argues that excessive expansion of the money supply is inherently inflationary, and monetary authorities should focus solely on maintaining price stability, i.e. tackling inflation. Friedman, a Nobel-prize-winning economist, was a diminutive, courtly figure, but one who argued his corner in a sharp, pointed manner. Anticipating significant changes in economic policymaking, he also advocated the dismantling of large parts of the Keynesian – or mixed economy – heritage, through deregulation and privatization.
Friedman's views, and those of his imitators and embellishers, became known as the Chicago school – named after Friedman's academic alma mater. Six years after the first oil shock, monetarism took center stage, although what happened next remains hotly contested between both schools.
In 1979, then US Federal Reserve head Paul Volcker decided to shrink inflation out of the system. The elections of Conservative Party leader Margaret Thatcher as British prime Minister in the same year and Republican Ronald Reagan to the US presidency a year later, was followed by Friedman-style tax cuts, deregulation and privatizations – a policy later emulated in Europe, Latin America and Australasia. At this point, the political-economic policy mix between Keynesianism and the Chicago school becomes muddied. Many of the governments involved, particularly in later years, were, like the Hawke Labor government in Australia, center-left.
The contraction and drop in demand then led to a fall in interest rates. Working with a much lower cost of money than had been the case for years meant firms could afford to borrow more. The resulting pent-up activity, combined with freed-up foreign exchange markets and productivity gains from the first wave of digitization, ushered in a global assets boom. "So Volcker achieved a Keynesian result through a monetarist guise," Edwards maintains.
The subsequent onset of floating currencies, globalization, collapse of the communist Eastern Bloc, explosive growth in China and India, and digitization of finance markets, ushered in a massive boom and with it affirmation of the economic policy suzerainty of the Chicago school.
A 'failure of imagination'
But the Chicago school's reckoning came with a sudden thud in September 2008, with the collapse of the New York-based Lehman Brothers investment bank, and the financial equivalent of open heart surgery performed on banks in America and Europe. The Chicago school's "efficient markets hypothesis", growing out of Adam Smith's original "invisible hand', was, according to monetarists, an unobservable force that generates equilibrium in the demand-supply equation. But it was blown up, along with trillions of dollars invested in derivatives, by the GFC.
The failure of all but a few in the economics profession to anticipate the crisis, and a tepid recovery since then as the world wallows in a sea of debt, helped usher in this new age of uncertainty.
Now seven years old, the GFC has, according to Mark Mazower, professor of history at Columbia University in New York, discredited "the more mythical idealisations of the market" and "encouraged the restoration of state power as a goal in itself".
Whether this proves to be true or not, Westpac's McKay, sees the inability of economists, to foresee, the onrush of the GFC as "more a failure of imagination than anything". In this case, McKay believes "imagination is derived from historical knowledge. Those with a deeper storehouse of historical knowledge can envisage a wider range of possible outcomes; those with a training in neoclassical equilibrium theory, not so much. In its quest for mathematical elegance, economics no longer has the time or inclination to teach history and the profession is suffering."
RBA board member Edwards says the GFC "undermined the view that financial markets are rational and well informed and price risk well" – a view that had been "important to the Chicago school's thinking about financial markets". Further, "Chicago school monetarists would have expected higher inflation as a result of the vast volume of money creation incidental to quantitative easing, and it hasn't happened – or not yet. So that is at least two strikes against Chicago in the last seven years."
Different times, different policies
However, Pagan, also a onetime Reserve Bank Board member, asks whether it is necessary to have a prevailing economic policymaking view. Put more simply, does the media have to try to construct a God Economist to suit our troubled times? "I have never felt that we either need some dominant view of the world or that the GFC has meant we needed New Economic Thinking institutions. I have always felt that there are many views and our task is to synthesize them in some useful way."
Pagan, who has held academic positions as an economist at the ANU, Sydney University, Oxford, Yale, Princeton, Johns Hopkins and the University of California, Los Angeles, says Keynes had a "world view that was appropriate for the Great Depression". A generation later "the emphasis on 'rational expectations' was very much a consequence of the inflation seen in the 1960s, where one had to allow for the fact that the inflation partly came from wage negotiations that reflected expectations about possible future inflation rather than just the past."
Moving into the '80s and right up to the 2000s, "there is no doubt that the interaction between the financial and real economies got downplayed in what were pretty benign years".
In previous decades, economists had done a lot of work examining credit crises, such as the one that later triggered the GFC, Pagan says. Now "people have started thinking about this all over again, although there is no figure, you could point to as producing the key insight."
This leads Pagan to question whether, in economic policy leadership terms, "we will ever find a single person", such as Keynes and Friedman, again. Referring to their perceived dominance of economic policymaking over consecutive eras, he says this "ignores the fact that there were a lot of other people around with the same ideas. I think the difference was that the other people were either not as well connected or as articulate as Friedman and Keynes, but their ideas did have influence.
"Anyway, the point is that there are many ideas and they are expressed by a lot of people. I have always rejected the idea that there is one true way of doing things. However, I think that the media is always keen on the idea that there is such a view and spend a lot of time looking for the representative of it."
Professor Edward Nelson, who has just left a senior position with the US Federal Reserve in Washington to become an economics professor at Sydney University, and whose training as an economist largely followed the Chicago school, also acknowledges it is "probably" true that "there is no single leading economist" at present. He puts this down to an increasing convergence in the teaching of economics at a tertiary level.
"In the 1960s and 1970s, for example, the courses taught to graduate students in economics at MIT [the Massachusetts Institute of Technology] and the University of Chicago differed greatly from one another. Over the years, however, these courses and those in many other universities around the world have converged."
According to Nelson, who earned his PhD in economics at the Carnegie Mellon University in the US and has written extensively about Friedman, the "upshot" of this convergence process in the teaching of economics is "that economists with different educational backgrounds tend to talk on the same wavelength".
He concedes the GFC "has underlined the imperative" to pay more attention to financial markets, affording them "a more central role in macroeconomic modelling" and giving "greater weight to scenarios in which credit market instability spills over into macroeconomic instability".
However, "I do not regard QE or the Eurozone crisis as factors that were inherently contrary to pre-existing economic schools of thought. The Eurozone's problems have brought into sharp focus the difficulty of sacrificing floating exchange rates (a key element in the Chicago school approach) as a mechanism of adjustment to economic shocks. Viewed in that light, the Eurozone problems can be regarded as validating the arguments for floating exchange rates that economists have made over the years, including Milton Friedman."
Nelson maintains that because the financial crisis was largely confined to the financial sector, the Chicago school's support for the price system "has not been undermined". Further, Chicago school followers have, he says, "never been united" on the issue of finance market regulation. This means "one cannot make a categorical statement about the implications of recent years' events for the Chicago school's position on financial matters". He points out that even Milton Friedman expressed support "for such measures as capital requirements on commercial banks."
But Nelson acknowledges that the financial crisis has "cast into doubt" the Chicago school's core view "that financial markets can be counted upon to make the prices of financial assets – and real estate – closely related to fundamentals". However, this efficient markets hypothesis was "not universally adhered to by Chicago school economists", although "that hypothesis remains a useful baseline against which other theories of asset pricing can be judged".
Learning the hard way
In Australia the febrile nature of the efficient market hypothesis generated a political storm in the early 2000s, following the collapse of insurance giant, HIH. The Howard government learned the hard way that faith in the efficient market hypothesis should not take precedence over prudence.
The HIH collapse ushered in more regulation in Australia. But this is a pinprick compared with the global reaction to the GFC, made all the more dramatic because of the almost total lack of preparation for such an event among governments. However, Nelson maintains there were "several prominent economists", apart from Nouriel Roubini, "who were concerned about the precariousness of the financial system in the years leading up to 2007".
These included a former governor of the US Federal Reserve, the late Edward (Ned) Gramlich; the former president of the Federal Reserve Bank of St Louis, William Poole; and William White, formerly of the Swiss-based Bank for International Settlements.
Westpac's McKay nominates Raghuram Rajan, governor of the Reserve Bank of India as a GFC oracle and "of the best".
Rajan – a former chief economic adviser to India's Ministry of Finance, former IMF chief economist and on leave as finance professor at the Graduate Business School of the University of Chicago – works "at the intersection of finance, policy and academia", McKay says. He has a macro-finance background, understands markets and is an independent thinker "who can bend theory to meet the demands of policy" and has "a deep knowledge of history as well as other social science disciplines. It is the ability to blend financial market dynamics with historical and other social science insights – psychology in particular – that makes a good forecaster in today's economy," McKay maintains.
Lone voice at Jackson Hole
Pagan also turns the question of the lack of prescience about the GFC on its head. The reputation of economists "may have diminished", but this "raises the issue of whether [the GFC] was foreseeable."
"There have been endless crises in economic history," and "there is always someone who has said that there would be one. If you go back to the 1890s, there are people who said before it that there would be a problem then. The problem is that, even if you worry about the level of debt etc, then predicting when a crisis will occur is pretty much impossible since you need to know the future shocks. All those who predict it say for a long time there will be one. Often they keep saying this and it never happens, but sometimes it does."
However, Pagan also praises Rajan's anticipation of the GFC tsunami, referring to a speech he made at the Jackson Hole symposium – a colloquium of heavy-hitters in US finance, business, government and academe – in the US, on August 27, 2005, or almost exactly three years before the GFC. This "pointed out that financial innovation was making the world a lot riskier, and that this raised serious problems".
In his Jackson Hole paper, titled "Has Financial Development Made the World Riskier?", Rajan argued that "disaster might loom". He pointed out that finance market executives were encouraged to "take risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks. But perhaps the most important concern is whether banks will be able to provide liquidity to financial markets so that if the tail risk does materialize, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimized."
Former US treasury secretary and Harvard president Lawrence Summers lambasted the warnings as "misguided". Rajan "was ignored", Pagan says, "although as you might have expected, there were many staff in the IMF who agreed with his viewpoint."
Search for consensus
Many also agree that the secular stagnation hypothesis has gained traction in the aftermath of the GFC. Demography has also played a role. Ken Courtis says that Japan, with its rapidly ageing population, "is facing a demographic undertow. I wonder if monetary policy works in the same way when a large part of the population has retired."
Another factor is the internet, or iPhone, economy. The extraordinary changes taking place in the media, retailing, manufacturing, transport and medicine through new technology are so far not that susceptible to measurement by traditional statistical analysis. But their impact on employment, and therefore demand, are huge.
Amid this wrenching change, fear and apprehension, the outlines of a more consensual approach – one cherry-pick from the main schools of economic thought – are emerging at home. This is reflected in Thursday's summit held in Canberra by Prime Minister Malcolm Turnbull, where he met representatives of the principal players in the Australian economy – business, unions, welfare groups and NGOs – to try to thrash out a consensus on a new tax-change-for-growth program. (The meeting, incidentally, follows an earlier summit initiative by The Australian Financial Review, The Australian and KPMG.)
According to John Edwards, there is "much more consensus now" about economic policy. He contrasts this emerging consensus with the earlier period when "crude Keynesianism was undone by stagflation in early 1970s" and when "monetarism was undermined by the GFC".
Edwards says "a broad and recognizable mainstream of economic thinking has emerged over the last couple of decades. The emphasis is often different but the language is usually similar, the analytic methods and concepts similar [and] the statistical evidence adduced usually involves the same variables analyzed by the same methods." There remain "plenty of interesting controversies among economists, but usually within a common conceptual framework.
"Australia is a pretty good example of the way we have moved to a public consensus on major economic issues over the last few decades," he says. "It is widely agreed, for example, that good policies and practices include a floating exchange rate, an inflation-targeting central bank, the ambition of a balanced budget (on average), low tariffs and an open economy, negotiated wages, skilled migration, targeted welfare, and so forth. These were all big controversies in economics as well as in more public debate, and there is now broad agreement in all of them."
The renaissance economist
The lesson seems to be that the best economist these days is someone who is broadly educated, has a vivid imagination, is moved by the great writers and the great composers, understands history, has an insight into human behavior, and has been exposed to the 'animal spirits' in finance markets. He or she understands economic modelling but knows its limitations, is intellectually adaptable and politically nimble. Above all, he or she has the knowledge, confidence and wisdom to cherry-pick from the best of all the schools of economic thought, but is beholden to none.
Well, the literature and music part was my idea. But the question arises: have you ever met anyone like that?
*Andrew Clark is a senior writer on The Australian Financial Review.