Tuesday, March 10, 2009

Time to borrow from Keynes

March 10, 2009

By Randall Morck

THIS recession shows signs of getting out of hand. The over-the-top rhetoric of United States officials - 'the world will end unless you do just as I say' - has bordered on economic malpractice. Terrifying people rarely makes them buy new cars or technology stocks.

The Panic of 2008 followed an old-fashioned scam: high-risk investments disguised as 'sure things'.

American banks had securitised high-risk mortgages. Had the bond holders known these mortgages were risky, all would have been well. Investors should be free to bet on clearly risky ventures.

But the mortgage-backed bonds somehow got coveted AAA ratings. Foreign banks, pension funds and small investors relied on these ratings, and bought what seemed 'safe' investments. Insurance companies, like AIG, happily insured companies holding these AAA bonds. And meanwhile, the outfits organising the securitisations frenetically lobbied for oversight so relaxed as to verge on a meditative trance.

Also governments negotiating global banking regulations somehow ended up vying for their national banks' tactical advantage, rather than building a sensible regulatory framework. Freed of meaningful oversight, banks everywhere took risky bets.

Why didn't regulators quash gambling? Why didn't they check where the risk in the risky mortgages was hiding? Why did diplomats become advocates for their countries' banks? Were all these just inexplicable lapses or the result of corruption?

When all of this hit the fan, investors were not amused and banks' share prices collapsed. Fearing for their multimillion dollar income streams, top bankers panicked. That panic, I suspect, finds its way into the utterances of top US officials.

To be fair, Federal Reserve chairman Ben Bernanke is a respected specialist on the Great Depression. Just as cardiologists suspect the heart in any inexplicable health disorder, he might see a looming Great Depression in inexplicable economic symptoms.

Unfortunately, economies are profoundly affected by people's expectations. In economics, expecting a heart attack can cause one. The panic of 2008 might have ended quickly, with a few bank nationalisations, but this is no longer possible. Consumers no longer dare consume, suppliers are unwilling to extend credit and savers have all but buried their coins in the garden. Consumers, business managers and savers now expect a crisis of 'historical dimensions' - and will therefore probably get one.

Globalisation, which generates much prosperity in normal times, allowed the disease spread. Trade and investment barriers are worse than useless now, for all are infected. Neither quarantines nor anti-American Schadenfreude will help.

Rather, governments should adjust people's catastrophically self-fulfilling expectations. Keynesian economics, long abused by left-leaning politicians, shows how. Keynes saw expectations about the future (his term was 'animal spirits') collapsing in the 1930s, and prescribed two antidepressants.

One was expansionary fiscal policy. Increased government spending creates stable business, stable incomes and a sense of security for investors. Asia needs schools, hospitals, roads and bridges, and governments should use the current downturn to get more of these. Tax cuts help counterbalance evaporating stock portfolios in people's assessments of their finances.

Of course, the danger lies in becoming addicted to perpetual deficits, as many countries did in the 1970s. That is why public works with fixed goals are best.

Keynes' second prescription was expansionary monetary policy - print money. This is because deflationary expectations can develop in severe downturns. Feeling poorer, we buy less, so businesses mark down prices, which cuts their profits, making them cut our salaries, making us poorer so we buy even less - and so on, in a downward spiral. Once prices are falling, we delay purchases in the expectation of further falls. Printing money induces inflationary pressure. We don't want the high inflation of the 1970s again, but we should err on the side of inflation a bit, rather than risk deflation.

The continuing source of the infection is America's banks. Keynes saw banks as the heart of the economy. The biggest impediment to global recovery is America's fear of a heart transplant for its banking system. When its banks were stuffed with 'toxic' assets in the 1990s, Sweden nationalised them first and sorted out the 'toxic' assets later. This cost the Swedes but it saved them from Japan's lost decade. In contrast, bank bailouts are pain killers, and no substitute for a new heart.

Critics of Keynes rightly argue that 'Keynesian economics' lost credibility in the 1970s and 1980s. It did - because self-described Keynesians abused it to justify ever bigger government. Despite occasional bloopers, Keynes is more reasonable than most Keynesians. His prescriptions can cure our present illness. Once cured, Keynes can be returned to the bookshelf, where he can wait quietly until we need him again.

The writer, the NUS Business School Dean's Visiting Professor, is also University Professor and the Jarislowsky Chair in finance at the University of Alberta, and the Schoen Visiting Professor of Finance at Yale University.

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