Are the economic rationalists in Canberra losing their marbles?

When Jim asked me whether I was an economic rationalist I thought he was just stirring. The term “economic rationalist” has been used mainly in Australia and doesn’t seem to be used much anywhere these days. I don’t think there were ever many people in Canberra who called themselves economic rationalists. Those of us advocating economically rational policies just thought of ourselves as economists doing what economists should be doing. We knew that when people referred to us as economic rationalists they were probably intending to be offensive, just as most of those who refer to classical liberals as neo-liberals are intending to be offensive. But I don’t think the label worried us much. When people referred to me as an economic rationalist I knew that I was among good company.

I admitted to Jim that people had sometimes referred to me as an economic rationalist. Jim then asked me if I thought John Smith (name changed to protect Jim) would be an economic rationalist. I don’t know that I have ever met Smith but he has the reputation of being a good economist, having held senior positions in the Treasury as well as other government departments at a time when major economic reforms were being undertaken. I told Jim that I thought that Smith could be relied on to provide good public policy advice.

Jim then seemed to change the topic of conversation. He asked: “Do you think economic considerations should be taken into account in quarantine policy?” I replied that economic considerations were obviously relevant. For example, it doesn’t make economic sense to implement policies that will raise consumer prices by a huge amount in order to protect a tiny domestic industry, even if scientific evidence suggests a high probability that diseased imports will damage this industry.

Jim said: “So, are you suggesting that quarantine decisions should all be subject to a full blown 100-page cost benefit analysis?” I acknowledged that a full-blown analysis would be too expensive to do every time and is not necessary in most cases because the answer that such a study would come up with was usually obvious. I suggested that the legislation should incorporate a national interest test and require that the economic advice used to apply that test should be made public when decisions are made.

Jim replied: “But wouldn’t that make it difficult for politicians to take account of things like impacts that are concentrated in particular electorates, their concerns that voters might attribute damage to industries from highly improbable events to their mismanagement - and other irrationality that people exhibit on risk.” I said: “So what! If you are designing public policy rules in the interests of the whole community then you want the rules to make life difficult for populist politicians who pander to such concerns”.

Jim said: “I thought you might say that. But John Smith tried to sell me a very different line when I spoke to him in Canberra recently. He said that it would be important for the analysis of quarantine matters by the advisory economist to place higher weights on extreme events and on things with concentrated impacts and to make other adjustments to account for the irrationality that people exhibit on risk.”

I was stunned. All I could say at the time was that I could now understand why Jim had asked me whether John Smith was an economic rationalist.

Jim’s story makes me wonder how many other Canberra people who once advocated economically rational policies have lost their marbles by getting too close to politicians.

Postscript:
A friend and former work colleague has responded by suggesting that it is normal for people providing economic advice within the bureaucracy to advise Ministers on the distributional effects of policy initiatives. I think my friend has missed the point.
As I understand it, John Smith is considering what rules should apply in assessing future quarantine cases. The issues involved take this outside of normal bureaucratic policy advice. There are interest groups who will see quarantine as a way to obtain protection from import competition by the back door i.e. through a non-transparent process. Ideally, the issues involved should be subject to some kind of public inquiry to assess national economic benefits and costs through a transparent process. The fact that this is not practicable in every case doesn't mean that we have to resort to normal processes for bureacratic advice to Ministers. As I understand it what is proposed is legislation that would require an assessment to be made of the relative economic costs and benefits of proposed quarantine action. John Smith seems to be proposing to muddy the waters.

What can the G20 do about protectionism?

“We have got to be absolutely clear that protectionism offers no solution. It’s the road to ruin. It protects no-one in the long run at all and we are for a free trade world where we remove barriers rather than create barriers, no matter what the temptation is at this particular point in time for individual countries.” Gordon Brown, U.K. Prime Minister, talking about his hopes for the G20 summit.

I have no doubt that the G20 will make a strong statement in opposition to protectionism. After the G20 leaders have agreed that protectionism is the road to ruin and have lined up for the group photo, they will then go home and continue to increase assistance to domestic industries at the expense of imports. The most we can hope for is that the threat of retaliation will prevent the most overt kinds of protectionism that could result in escalation of retaliatory protectionism. If we are lucky the world economy will begin to pick up before protectionism gets out of control.

Why am I pessimistic about the effectiveness of the anti-protectionist pronouncements that seem likely to come out of the G20? It is because decisions by governments about industry assistance are made primarily in response to domestic political pressures and because prevailing perceptions about domestic economic impacts will cause governments to take most notice of the narrow interests that stand to gain from protectionism.

The prevailing perceptions I am writing about include the belief that during a recession it is possible to protect jobs in one industry without any adverse effects elsewhere in the economy, unless there is foreign retaliation. It is easy to see why this is economic nonsense. Import restrictions cause consumers to buy higher-priced domestic production rather than imports – they work in the same way as a tax on consumption of a good that is used to finance a subsidy to producers. The result is that consumers have less income to spend on other goods. Jobs are saved in one industry at the expense of jobs elsewhere in the economy.

Some readers might be thinking that this reasoning doesn’t apply to industry assistance that is funded from government spending because the increased spending just goes to increase the fiscal deficit and government debt. Some government leaders who increase budgetary assistance to industry might even think they have reason to expect to be patted on the head by leaders of other governments for doing something to stimulate the world economy. The truth is, however, that such covert protectionism is unlikely to even stimulate the domestic economy since private investors are likely to be forced to pay higher interest rates in order to fund their investments, and domestic taxpayers are likely to increase precautionary savings in anticipation of having to pay higher taxes in the years ahead.

Is there anything that the G20 countries could do that would help governments to deal with the domestic political pressures that result in increased protection during recessions? The least they could do is to compare notes about how they cope with such pressures in their own countries. Australia’s prime minister, Kevin Rudd, is probably too modest to trumpet the success of the Hawke government in dealing with protectionism in the 1980s with the help of domestic transparency arrangements. It might be possible, however, for leaders of other governments who have an interest in this matter to prevail upon our Kevin to provide them with some helpful information on this topic.

Postscript:
Readers who wonder what I am talking about might be interested in this.

Does fractional reserve banking have to be a scam?

“To some extent, commercial bankers lend out their own capital and money acquired by CDs (certificates of deposit). But most commercial banking is "deposit banking" based on a gigantic scam: the idea, which most depositors believe, that their money is down at the bank, ready to be redeemed in cash at any time. If Jim has a checking account of $1,000 at a local bank, Jim knows that this is a "demand deposit," that is, that the bank pledges to pay him $1,000 in cash, on demand, anytime he wishes to "get his money out." Naturally, the Jims of this world are convinced that their money is safely there, in the bank, for them to take out at any time.” Murray N Rothbard, ‘Fractional Reserve Banking’.

When my friend Jim asked my reaction to this quote, I said that I didn’t know that he knew Murray Rothbard. Jim replied: “I didn’t know that he knew me, but I think he is making a good point.”

I asked Jim whether he thought most people really believed that banks were like warehouses that kept the money deposited with them until people wanted to withdraw it. Jim said: “Most people know that banks lend the funds deposited with them to other people, but the point is that banks do promise to repay deposits on demand. They know that they can’t keep this promise if everyone wants their money back at the same time. Banks shouldn’t be allowed to make promises they can’t keep.”

I tried to argue that the financial system generally works well even though exceptional circumstances can arise where financial intermediaries make promises that they cannot keep. I suggested that it is very rare for situations to arise when a high proportion of borrowers do not meet their commitments and the value of the security held by banks falls below the value of loans outstanding.

Jim said: “Look, you can’t pretend that these situations where banks can’t keep their promises occur so infrequently that they should be ignored. Democratic governments don’t just look the other way when banks go bust. Do you think that the best solution for this problem is for governments to get involved by offering deposit insurance, guarantees that banks will not be allowed to fail and close supervision and regulation to ensure that such guarantee do not result in irresponsible behaviour? Don’t you see that this government intervention has arisen because banks are allowed to make promises that they can’t keep.”

I asked Jim whether he was suggesting that instead of promising to repay deposits on demand, banks should convert themselves into unit trusts. That would mean that the amount that investors could get back on demand would vary according to the market value of the financial institution’s loan portfolio.

Jim replied: “I don’t think many people would view that system as a good substitute for conventional bank deposits that are repayable on demand. What I have in mind is that a bank would specify in its agreement with depositors that in the event that it could not meet its promise to repay deposits in full within, say, a month of the request being made, then equity holdings in the bank would immediately be cancelled and re-issued to depositors in proportion to the nominal value of their deposits. The former depositors could decide whether they wanted to liquidate these equity holdings immediately by selling them on the stock market, or to hold on in the hope that the bank’s financial situation would improve.”

I have been thinking about Jim’s proposal. I do not imagine that the conversion of deposits in a troubled bank into equity holdings would be as quick and simple as Jim envisages. Nevertheless his proposal seems to me to be preferable to the current shambles that has arisen as government regulators have sought to substitute their assurances for dodgy promises that financial institutions are not able to keep.

What is the best analogy to help us understand the financial crisis?

In attempting to understand the current financial crisis I don’t have the benefit of a great deal of knowledge of macroeconomics. Nevertheless, I can understand only too well what many macroeconomists are saying about fiscal stimulus and multipliers because they are using Keynesian language that I learned in my first year at university 45 years ago.

During the 1970s nearly all macroeconomists seemed to abandon the crude Keynesianism that I learned about at university. Why have so many reverted to it at this time? The answer might have more to do with the desire for a comfort blanket in times of uncertainty than with the merits of Keynes’ approach. The Keynesian remedy does not seem to me to be much more relevant to the current situation than it was to the stagflation of the 1970s. It suggests that when you wake up with a debt-induced hangover, then you will soon feel better if you get the government to take on some more debt on your behalf. That doesn’t sound to me like a recipe for a more healthy world economy.

So I have been looking for articles which will help me to understand why the world is in recession and what can be done about it. The best aid to understanding that I have found so far is John Cochrane’s refinery analogy:

“Imagine by analogy that several major refineries had blown up. There would be tankers full of oil sitting in the harbor, and oil prices would be low, yet little gasoline would be available and gas prices would be high. Stimulating people to drive around would not revive gas sales. Borrowing gasoline and using it on infrastructure projects would be worse. The right policy action would obviously be to run whatever government or military refineries could be cobbled together on short notice at full speed, and focus on rebuilding the private ones.” John H Cochrane, ‘Fiscal Stimulus, Fiscal Inflation or Fiscal Fallacies’.

The “major refineries” correspond to the banks that have loaded themselves with toxic assets. The oil tankers sitting in the harbour correspond to the savings that are going to government securities paying low interest rates and the high gas prices correspond to the high price of credit to businesses and consumers (in many countries). The running of government and military refineries at full speed corresponds to the government raising funds by issuing debt and lending it to businesses and consumers.

Cochrane recognizes that this analogy does not give a complete picture of the current situation. He explains that if we just had a shock to the supply of credit (blown up refineries) we would expect to see stagflation – lower quantities of goods and services sold, but upward pressure on prices. Instead we are seeing lower quantities sold and lower inflation. So, we are also seeing a demand shock as a result of people becoming much more averse to holding risks. (The refinery analogy could possibly be stretched to accommodate this. If several major refineries were blown up then investors could be expected to seek to reduce the exposure of their portfolios to other firms that might also be at risk of “blowing up”.)

Would the situation be resolved if the central banks were to target a specific rate of growth in nominal GDP (as I discussed in an earlier post)? The answer might depend on what assets the central banks purchase from the public in pursuit of this objective. If they buy government bonds this will help satisfy the increased demand for money, but not address the supply shock in the credit market. It is possible that the market could take care of this problem e.g. major firms may be able to by-pass the damaged banks by raising funds directly from the public. However, when central banks buy newly-issued commercial paper and securitized debt they are acting directly in place of the injured banks.

As a stop-gap measure this kind of by-pass intervention has the important merit of being a lot easier to unwind than alternative approaches. If central banks confine their purchases to quality assets they will not have any difficulty selling them when inflation begins to rise and people get tired of holding so much money. The effects of fiscal stimulus involving cash splashes by governments are likely to be much more difficult to unwind without a decade or more of high-tax and low-growth stagflation.

It seems to me that current debates about the effectiveness of stimulus packages in lifting aggregate demand tend to miss a more important point about consequences beyond the immediate short term (i.e. long before Keynes’ long run when we will all be dead). John Cochrane makes the point as follows in relation to the U.S. economy:

“If the resources are not there to unwind our current operations, to quickly retire ... newly created debt, a large inflation will result as people dump government debt. If history is any guide, this outcome will unleash economic dislocations on a scale to make our current troubles look like a pleasant memory.”