Wednesday, February 04, 2009

The intellectual fascinations flowing from the global economic crisis

For someone like me - I accept that I am strange - the current global economic crisis is full of fascinations.

Some of the ideologues of the right argue that the crisis is due in large part to low savings and loose monetary policy in certain countries. They are probably correct.

They then argue against budget deficits and borrowings. The sooner we take our medicine, the better things will be. Here I think that they are at at best partially right.

The ideologues of the left argue a very different line.

They suggest that a key element in the crisis lay in over-obsession with the role of the market and the consequent failure to regulate properly. I think that this is partially true, although those on the right argue that that the problem would not have occurred with the right monetary policy settings.

They welcome the return of what they see as Keynesian economics and of a more active role for Government. They suggest that a key response to the crisis should be greater Government regulation, even nationalisation of the banks.

I find myself partially in sympathy with the left.

I, too, have objected to the mindless obsession for budget surpluses and against any form of Government borrowing. I, too, have complained about the run-down in the country's physical and social infrastructure.

Beyond this point, some of the arguments that I have seen from the left have very little to do with economics, everything to do with past battles.

The world changes, and as it does our approach needs to change.

In an interview, Mr Rudd attacked Opposition leader Turnbull for citing a US economist called John Taylor, sneeringly suggesting that Professor Taylor was influenced by the US economist Milton Friedman. I thought that Professor Taylor must be some fringe academic, so had to look him up. He appears to be a very distinguished economist indeed.

Mr Rudd's attack said little about the validity of Mr Turbull's arguments, much about Mr Rudd.

Keynesian economics went out of fashion because it had no answers to the problems of the 1970s, a world dominated by stagflation (high inflation combined with low economic growth). Professor Friedman's arguments became influential because he seemed to be offering insights in a way that Keynesian economics was failing to do.

Today, stagflation is not an issue, although it could become one in the future. This removes one of the major impediments to the application of Keynesian economics. However, this of itself does not destroy the value of the insights offered by Professor Friedman.

In responding in the way he did, Mr Rudd offered nothing to the discussion. It was just a political shot.

By the way, just so my own views on Mr Turnbull's approach to economic policy are clear, I disagree with him.

Beyond the politics, there are some fascinating market and economic dynamics playing out.

Prior to the emergence of the bill and inter-company money market in Australia, the banks were the source of business loan finance. This made equity issues very important.

Shareholders looked to those issues as a way of increasing stakes and of realising money from rights' sales. As share prices rose, companies made bonus issues in part to keep the price of their shares down because this aided capital raising from shareholders. Shareholders liked this because they had more shares. They could then sell some if they need to raise capital while retaining a shareholding.

While international capital markets have begun to stabilise, they are still fragile. Further, the nature of various Government bail-out packages means that banks are lending to their domestic companies first. Consequently, international banks are withdrawing from the Australian market.

This puts the Australian banks with their control over large deposit bases in a very good position. Ignoring bad debt issues, the spread between borrowing and lending interest has widened. The banks have also tightened up on their lending criteria - credit rationing is in force. In some senses, we have gone back to the 1950s.

With domestic credit tight and international borrowings difficult, Australian companies have turned back to share issues in way not seen for many years. Over $A8 billion has been raised through new share issues since 1 January.

The scale of share issues has really soaked up funds available for equity issues. Australia's compulsory superannuation deduction stream means that a constant stream of new investment money does become available. Even so, firms are likely to turn back to ordinary shareholders in as a source of funds. I, for one, will welcome this.

I have suggested before that this downturn will accelerate the shifts in the global economic tectonic plates that were already underway. We can see this happening.

Forget China's problems. The country has cash. There are already signs of this flowing to investment in Australian resource firms to take advantage of the current downturn. So we are going to end up with closer linkages with China.

One thing that also interests me is what all this might mean for Australia.

I have argued before that Australia faces an inevitable decline in its relative economic ranking. If, as I expect, the country comes through this crisis with an intact banking system, financial markets and industrial structures, then we are going to be in a remarkably good position to take advantage of the next upturn.

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