Tuesday, December 22, 2009

Lessons From the Economics of the Naughties

See part 1: Economics of the Naughties

Financial Markets need regulating.

Financial deregulation has been a disaster. Unchecked, the credit crisis shows that financial institutions can make basic mistakes in the pursuit of risky profit. Supporters of the free market have vainly tried to show the irresponsible loans of the naughties was actually due to government pressure. But, this is misleading, it was unregulated financial companies who made the vast majority of loans that had no chance of being repaid. There was a complete failure to adequately measure the level of risk involved in the buying of subprime loans. Somehow many of the NINJA mortgages (no income, no job) were rebundled, repacked and bundled as triple AAA credit rating. Western banks took these mortgages on, and it was the taxpayer who had to bailout their mistakes. Many banks pursued risky strategies of reducing liquidity ratios. There was a temptation to achieve short term profits by borrowing short to lend long. Northern Rock was once proud of it 125% mortgages. But, when the credit crisis hit, they were left unable to finance its positions. It was only when credit markets froze that they realised their business structure was flawed.

The Problem of Moral Hazard

A real problem we have is that banks acted on a premise of invulnerability. As we mentioned in this post, bankers often have an incentive to pursue risk. (problem of bank bonuses) Heads they win - tail the taxpayers lose. This is still a pressing issue - how to balance the need to ensure banking stability and prevent bank runs, without giving bankers a green light to pursue the most irresponsible strategy - knowing if they mess up someone else will clean it up.

One Tool Does Not fit

In the middle of the 2000s, it seemed that interest rates were the magic wand of the central bank to achieve any economic goal they wanted. Alas, this is not the case. Managing the economy is much more difficult that just changing interest rates. An interest rate cannot maintain strong growth, target inflation, and target asset bubbles all at the same time.

Keynesian economics

At the start of the recession, interest rates were slashed from 5% to 0%, without effect. We were in a liquidity trap where rate cuts may have no effect. In a liquidity trap, there is need for more - expansionary fiscal policy, quantitative easing. Faced with the failure of markets and the prospect of another Great Depression. The analysis of Keynes from the 1930s became very important.

Government Borrowing is necessary in a recession

One of the difficult things has been to explain, though government borrowing is bad, it would be even worse to try and reduce borrowing in the middle of a recession.

A boom is a time to reduce deficits.

Hindsight is a wonderful thing. But, at the height of the boom the decision to increase government borrowing was a painful mistake. America cut taxes and increased military spending. The UK increased spending on social security and health care. This meant both had large deficits before the recession started. This reduced room for maneouvre when the recession came.

Inflation Target can be Misleading

The central policy target of both UK and US was low inflation. With low inflation, neither governments could believe they were in the middle of an unsustainable boom. The low inflation rate, masked a boom in asset prices caused by unsustainable lending. A stable economy doesn't just need low inflation it needs stable asset prices, and sustainable bank lending.


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