Sunday, 26 July 2009

Clash of Economics Philosophies

26th July 2009
The Malta Independent on Sunday

The financial crisis and ensuing recession has brought to the fore a clash of economic philosophies that always existed but never in such overt and often unceremonious ways where Nobel Prize economists ridicule and accuse each other of ignorance or bad faith. The two camps are split by a basic divide of views about how the economy works.`

The conservatives, The Ricardians, base their economic thinking on the efficient market theory i.e. that the market is always right and it is best to left alone to choose the winners and losers in allocating economic resources. Their models take the view that the economic agents are superbly informed and understand the deep complexities of the world leading to `rational expectations` and correct market pricing. Their argument goes that if the market ever gets out of line from reality there are inbuilt forces in the market to force it to correct without the need of external interventions and that this in the most efficient way to avoid waste of resources and the most effective way to maintain correct market prices.

On the other side of the divide there is the interventionists, the Keynesians, who flatly refute the efficient market theory and maintain that the markets can become dysfunctional and that without external intervention will take a long time and cause great economic dislocation and outright human hardship to correct. They argue that economic agents have severe cognitive limitations and do not understand much about the complexities of the world.` This causes euphoria when economic agents underestimate risks (irrational exuberance) which is then followed by collective depression when risks are over-estimated ( irrational gloom). This is` what the founder of this economic thinking school, JM Keynes, referred to as `animal spirits` which turn uncorrelated risks into highly correlated ones and cause a great impact on fundamental forces driving macro-economic fluctuations.

I am not unbiased in this debate.` My thinking flatly falls in the Keynesian camp. I find, from experience, that the perfect market theory fails too often and that many believers in such theory do so because they are unable to capture the `animal spirits` in their macro-economic models and accordingly deny them so that they can live in the comfort of what they understand ` the behaviour of rational and superbly informed individuals. Unfortunately the world is much more complex than that and reality shows that rational decisions taken at individual level, if adopted collectively can easily turn into the madness of the crowd.

An individual could be right in selling an investment position to take a profit. But if collectively everyone sells that would cause a market crash. An individual could be right in addressing future uncertainty by spending less and saving more. But if adopted collectively that could cause a depression.

The interventionist economic theory was prevalent in the post-war period when major economic activities were nationalised and governments were the principle players in the national economy which was largely `protected from external competition.` However as the world was rebuilt from the war havoc and as countries started to trade internationally on a growing scale the inefficiency of state intervention started to show in high inflation which was exasperated by the two oil price shocks of the 1970`s. Also the` Keynes theories were abused and rendered ineffective by politicians who continued to intervene when it was not necessary and thus leading to excessive budget deficits and inflation.

The failure of interventionist school gave birth to the market-knows-best school of Hayek and Friedman that was politically given space by Thatcher in UK and Reagan in US.` `Government intervention in the economy was reigned back through privatisations, through reduced taxation and trimmed transfer payments, and the economy was liberalised through free international trade leading to globalisation, floating exchange rates and strict monetarism leading to fluctuating interest rates with the main aim of squeezing inflationary expectations out of the system.

The adjustment process was turbulent. Currencies, formerly fixed through the Bretton Woods agreement, started to fluctuate widely.` Interest rates hitherto largely regulated and kept steady started to shoot to unimaginable levels with a 20% overnight rate in the US in the early 1980`s and a 15% in UK in early 1990`s. But after the initial turbulence we have had some fifteen ` twenty of macro-economic convergence between these two schools of economic thinking.

The compromise was found in putting monetary policy at the centre stage of macro-economic management and delegating such monetary policy to independent central banks which were not under the democratic pressure of the electorate and could thus be trusted to do what was right and not what was popular.` Strict monetary targeting which led to unduly wide fluctuations in interest rates was abandoned in favour of formal or informal inflation targeting.` As `international trade brought untold wealth spread around the globe bringing the graduation of formerly backward economies of China, India, Russia and Brazil, most countries ejected or diluted their collective ownership models and adopted capitalist solutions for their economic development programmes.

So what has brought the sharp eruption in economic thinking again We are seeing one camp urging government to adopt more fiscal stimulus, whilst the other camp warning government that existing fiscal stimulus are already excessive and will delay the market adjustment needed.` One camp argues that the excessive loosening of monetary policy is needed to cushion the economy from falling into a depression and the other camp warning that the ultra loose monetary policy will unavoidably lead to an explosion of inflation in the near future.

The answer seems to be that whilst it was wise to roll back government intervention from the economy it was unwise to weaken regulation of the financial markets thinking that markets could self regulate and avoid the greed and excesses that have brought the crisis.

If we learn nothing from the crisis we have to learn that self regulation in financial markets is dead. Any bank or financial institution that is just too big to fail must be scaled back as otherwise it could become too big to save. The financial system should be rendered modular with no single component too big to fail.

The two economic schools should agree on a new system of financial regulation as this could lead to a fresh period of convergence rather than shouting on how to solve our way out of the present crisis.

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