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Finance system inquiry, again

July 20th, 2009

My column in Thursday’s Fin was about the case for an inquiry into the Financial system. I quoted well-known free market economist Ian Harper who observed that the breakdown of the efficient markets hypothesis undermined the basis of our existing system of financial regulation, a point reinforced in today’s Fin by former Reserve Bank Deputy Governor, Steven Grenville. This elicited a letter from Sinclair Davidson, offering a faith-based defence of the efficient markets hypothesis as tautologically true, combined with a rather more interesting argument – since the EMH was only developed in the 1960s, it can’t have been responsible for earlier financial crises and therefore can’t be blamed for the current crisis.

This seems to me like an all-purpose Get Out of Jail Free card for economic theories. For example, since inflation occurred on many occasions before Keynes wrote the General Theory, it must be wrong to blame Keynesian macro theories for the inflation of the 1970s.

The problem here is that, even assuming that there is a 1-1 relationship between policies and outcomes, there are many different theoretical rationales for any given policy. EMH justified weak financial regulation and a laissez-faire attitude to financial innovation, but the same policies were justified in different ways long before EMH, and produced the same outcomes on a regular basis.

The recent letter by six economists, of whom I was one, calling for a new inquiry into the financial system, produced some revealing reactions.

First, there were reactions that revealed a widespread failure to learn the lessons of Australia’s last big financial crisis in the early 1990s. These reactions mainly focused on the suggestion (a minor point in the letter) that an inquiry ought to consider whether there was a role for a publicly owned and guaranteed bank like the New Zealand Kiwibank.

As commentators rushed to point out, a number of state-owned banks failed after the 1990s crisis. But the problem with these banks was that they were regulated by state governments. Private state-regulated financial institutions, such as Pyramid Building Society, also failed. At the national level, Westpac nearly went broke. But Westpac could rely on the effectively bottomless pockets of the Reserve Bank, and ultimately, those of the Australian taxpayer.

The failure of so many commentators to learn anything from the current crisis is even more striking. In a snide dismissal of the economists’ letter, Terry McCrann suggested that reform of the financial system is unnecessary because the global financial crisis hasn’t affected us. In his words, ‘Not many dead or even injured in Australia. From any systemic fault, that’s to say.’

It’s true that Australia has come through the crisis without major financial disasters. But no credible commentator has suggested that this fortunate outcome implies that our existing system has worked as planned.

The most fundamental criticism has come from Ian Harper, the former Reserve Bank economist who played the dominant intellectual role on the Wallis Committee. Harper is a strong supporter of free markets, and an economist of unquestioned intellectual integrity, not prone to blow with the wind of fashion. Harper has observed that the entire intellectual framework of the 1997 inquiry had been rendered redundant by the financial crisis.

“Our framework was essentially the efficient markets theory,” he said. “We thought we had found the ultimate fixed point in the universe, namely the market price, and so we built on top of that the regulatory framework. But then there was no market price.

“The evolution we expected has stopped, reversed and gone the other way.”

The views of former Reserve Bank Governor Ian MacFarlane offer similarly cold comfort to the Pollyannas. MacFarlane told an ASIC Summer School in March that the four pillars policy, long derided by supporters of financial deregulation, prevented the banks from adopting risky strategies in the pursuit of competitive advantage.

Even more strikingly, our status as a net international borrower, meant that our banks showed less interest in toxic US assets. As MacFarlane said “I have no doubt that if Australian banks had a surplus of domestic funds, they also would have acquired a lot of dubious assets, just as many of our counterparts did.”

The current account deficit may have saved our banks from themselves, but it remains a major vulnerability if the global crisis worsens. And the prosperity of our financial system depends, in large measure, on the fact that governments have managed to prop up housing prices, in sharp contrast to the rest of the world. This strategy was probably necessary, but it remains high-risk.

Most importantly, the central tenet of our prudential system failed in the crisis. This was the idea that governments could assure both the general public and wholesale lenders that our major banks are completely safe, while simultaneously denying that their liabilities were guaranteed. As was both predictable and predicted (Savings need a safety net, AFR, 29 August 2002) the contradictions in this stance were exposed the first time the system faced a serious crisis.

The failure was illustrated by the short-lived attempt to proceed with a ‘compromise’ deposit guarantee, limited to $20 000. If implemented as suggested in October 2008, this proposal could have produced a catastrophic bank run. Fortunately, it was floated on a Friday. Wiser counsels prevailed over the weekend, producing the unlimited guarantee we have now.

As the “six economists” letter points out, if the guarantee is removed, we need to consider how public confidence can be sustained. In this context, the idea of a publicly-owned option, offering guaranteed deposits, needs to be considered.

If the guarantee is retained, government needs to exercise closer control over financial institutions. Much as the Big Four would love it, a return to the days when they could parade their independence, while quietly reassuring customers that they were fully backed by the Australian government, must not be allowed.

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  1. Uncle Milton
    July 20th, 2009 at 14:37 | #1

    While the EMH wasn’t formalised until the 1960s, the hand-waiving version, which simply asserted the efficiency of markets including financial markets, and accordingly argued against intervention in those markets, was around long before that. Hayek argued this against Keynes in the 1930s, and no doubt the same arguments were made against the creation of the Fed early in the twentieth century.

    No doubt crude proto-types of the EMH were made by 19th century economists, (falsely) citing Adam Smith as an authority.

    So Sinclair’s argument doesn’t even hold up on its own grounds.

  2. Sinclair Davidson
    July 20th, 2009 at 15:27 | #2

    Nice try, Uncle Milton. but you’re factually challenged. The earliest derivation of the EMH that I am aware of is by Louis Bachelier. His story is told in Peter Bernstein’s Capital Ideas: The improbable origins of modern Wall Street.

    John – I don’t believe your argument either. Inflation can exist irrespective of what economists might believe. The EMH causing bank crises can only exist if regulators believe the EMH to be true. So until the theory is developed it cannot influence thinking. The counter-arguments to Keynes were well-known before the 1930s. My colleague Steve Kates has documented how what we know as Keynesianism is a classical fallacy.

  3. Uncle Milton
    July 20th, 2009 at 15:38 | #3

    Sinclair, as I recall, Bachelier was the first person to apply Brownian motion to financial markets, but it’s a stretch to then infer that such markets are everywhere and always efficient in the EMH sense.

    What’s more, you seem to be saying that banking crises are always caused by poor regulation, and by implication, if there was no regulation, there’s be no crises. Since there has always been regulation of some sort or another, how would you test that hypothesis?

  4. Sinclair Davidson
    July 20th, 2009 at 16:01 | #4

    I agree – but the idea of the EMH is traced back to him, with a long interlude until the 1960s (although I seem to recall that Cowles did some stuff too).

    The arguments are set out very nicely in two papers (no link – that I can find anyway) in Lawrence White, 1993, The crisis in American banking, New York University Press. The first paper is by Thomas Havrilesky ‘An empirical analysis of public choice aspects of the Savings and Loan disaster’ and the second by Richard Salsman, ‘Bankers as scapegoats for government-created crises in US history’. Both very good. Although the book long pre-dtaes the current banking crisis, it seems the arguments don’t (blaming it on the EMH is new).

  5. S.Haines
    July 20th, 2009 at 16:37 | #5


    Don’t you think it is more than a little ironic that the “free market” expert you most rely on has spent much of his career working for institutions that are the most anti-free market in Australia, namely the Reserve Bank and Fair Pay Commission?

  6. ABOM
    July 20th, 2009 at 16:59 | #6

    And as a tenured professor at a public-financed university…

  7. Ernestine Gross
    July 20th, 2009 at 18:01 | #7

    Yes, Louis Bachelier wrote a theory on speculation which had a testable hypothesis about the behaviour of share prices.

    My question to Sinclair Davidson is:

    Suppose L. Bachelier’s hypothesis has sufficient empirical support such that it cannot be rejected. Further, suppose we set aside any difficulties in empirically distinguishing between a stochastic and a deterministic process.

    My question to Sinclair Davidson is: What has the persistence of L. Bachelier’s hypothesis (and therefore empirical work following Fama et al of the 1960s) got to do with any notion of ‘efficiency’ that is of interest to Economics?

  8. Sinclair Davidson
    July 20th, 2009 at 18:05 | #8

    Ernstine – I don’t know. I’m not the person making the allegations. Yet it seems to me that there are different definitions of efficiency. Operational efficiency and productive efficiency are terms economists are mostly familiar with. Then there is informational efficiency (the Fama stuff). These different forms of efficiency are nicely linked up in a 2000 paper in the Journal of Financial Economics by Jeffery Wurgler.

  9. Alice
    July 20th, 2009 at 19:32 | #9

    It seems to me we have de-regulated reasonable job creating whole industries to the lure of emh, only to find a large foreign company moves in to take over existing firms, create an unhealthy powerful oligopoly, remove profits to off shore tax mavens and indulge in fraud on a massive scale.

    If EMH is responsible for these ideas – just look up the fraud that is Parmalat in the Australian diary industry. Oh and they just got awarded Coles Qld contracts…(two bullies on the poor farmer’s back better than one).. especially when Parmalat already knows how to do big international style fraud


    So is this what EMH delivered to us? Efficient markets or efficient fraud?

    Hmmm – it didnt take long did it? Dairy was only de regulated in 98. By 2003 Parmalat is in and ripping off shareholders (and likely suppliers as well). That will add to growth (sure it will..whatever Fama says do the exact opposite).

  10. jquiggin
    July 20th, 2009 at 19:46 | #10

    Sinclair, your response to Uncle M misses the point completely. The EMH is one in a long line of rationalizations for the view that governments shouldn’t interfere with financial markets. As Uncle M says, handwaving versions of this view were around long before Bachelier.

  11. jquiggin
    July 20th, 2009 at 20:03 | #11

    S. Haines @ #5. The same comment was made under the name of John Greenfield at Catallaxy. Please confirm that you are not a sock puppet of Greenfield, and that you did not copy the comment from him.

  12. Alice
    July 20th, 2009 at 20:31 | #12

    Groannnn…shoulda known……If I ever get a one track one policy one cure mind could someone let me know…its does more damage to the economy than if the entire population had dementia.
    Prof…I cant help noticing it but you sure do attract more than your fair share of them.

  13. Sinclair Davidson
    July 20th, 2009 at 20:33 | #13

    ‘a long line of rationalizations for the view that governments shouldn’t interfere with financial markets’ – don’t know that’s true. My impression that the early financial markets mostly traded government debt.

  14. SeanG
    July 20th, 2009 at 22:04 | #14

    I completely agree with ProfQ on a new financial inquiry. The fact is that the Australian system survived, out of design and luck, but that it might not be ready for the next crisis. An inquiry will help prevent future crises by reviewing how people acted during this crunch, what worked and what didn’t and implementing the “lessons learnt” as well as deciding what to do with the deposit guarantee.

  15. Michael of Summer Hill
    July 20th, 2009 at 22:18 | #15

    John, one only needs to read up on the ‘January effect’ to realise it is best to have a holiday rather than lose your shirt.

  16. Freelander
    July 20th, 2009 at 23:16 | #16

    Following the EMH not responsible logic…. There were terrorist acts before Osama bin Laden, therefore, bin Laden has not been responsible for any terrorist acts. (He can’t be blamed for earlier terrorist acts, therefore, he can’t be blamed for some recent ones.) QED

  17. been there
    July 21st, 2009 at 07:16 | #17

    hmm, the crisis might have invalidated what Harper was thinking at the time of the Wallis Inquiry, but so did the failure of HIH (remember that?). The system has already reformed itself from what the Wallis commission and Harper thought, because APRA got beaten up post-HIH and decided to be a heavier-handed regulator after that. You could argue that the HIH Royal Commission served the purpose of an inquiry, so we’ve already had two in fifteen years, which is two more than the UK or US have.

    We could have an inquiry, but surely it should be an international one, comparing which countries did better than others and why. This “we must have an inquiry” reaction is a peculiarly Australian behavioural tic.

  18. Ernestine Gross
    July 21st, 2009 at 09:16 | #18

    Sinclair @8,

    you don’t know – fair enough.

    I don’t think my question can be answered in the applied area of financial economics where inferences are drawn from statistical work that is conditional on the premise that there is no market failure. May I suggest the literature on ‘fully revealing rational expectations equilibria’, which goes back about 20 years, to look for the conditions for the existence of a market (price). This literature treats informational and allocative efficiency (which in turn includes productive efficiency) simultaneously.

    Ian Harper’s statement, “We thought we had found the ultimate fixed point in the universe, namely the market price, and so we built on top of that the regulatory framework. But then there was no market price.” quoted in JQ’s head post, says that the conditions are not fulfilled.

  19. Sinclair Davidson
    July 21st, 2009 at 10:21 | #19

    I’m not comfortable relying on Harper’s comment – I haven’t seen what else he had to say and the context he said it in. That quote by itself is nonsensical. Why a price a particular point represents ‘the ultimate fixed point in the universe’ is a strange thing to say. Especially when we know that market prices are not fixed.

    “May I suggest the literature on ‘fully revealing rational expectations equilibria’” – are you refering to the Stiglitz paper on the impossibility of efficient markets? If so, I have read it.

    In the meantime, I’m going to continue to be guided by Israel Kirzner’s comment

    It is one thing to postulate rapid equilibrating processes as imposing systematic order upon markets; it is quite another thing … to treat the world as at all times already in the attained state of equilibrium.

  20. July 21st, 2009 at 13:55 | #20

    Even if the EMH is “a long line of rationalizations for the view that governments shouldn’t interfere with financial markets” in order that you could then take that as a case for government interference would it not be necessary to prove that the government is likely to be more efficient than even a putatively inefficient market?

  21. ABOM
    July 21st, 2009 at 15:05 | #21

    Agreed. And if I might add: If economists believe in free market competition and believe in marginal utility and that innovation works best in a decentralised, price driven market, why is there such appalling treatment of those Austrian economists who advocate a free market in money production?

    I was hated for even mentioning it. I still am.

  22. Ubiquity
    July 21st, 2009 at 15:26 | #22

    EMH faith caused the GFC. Anthropogenic CO2 causes global warmimg.
    Eat to much and get fat. Smoke and you will die etc.

    Life seems so simple when every cause has an effect.

    “If you prove the cause, you at once prove the effect; and conversely nothing can exist without its cause.” (Aristotle)

    Aristotle wasn’t aware of randomn quantum events, Einstein lost sleep over it. It seems to me better to consider the cause and effect of “random government initiated regulated events’ that tend to generate outcomes with the certainty of a roulette game.

    I can agree that EMH thinking is BS but I can’t see how it is implicated as a primary cause of the GFC.

    As an aside. Your brief conjures up images of six economist with ray guns zapping EMH possesed, zombie like bankers, chanting EMH, wondering aimlessly through the ruins of the GFC landscape.

  23. derrida derider
    July 21st, 2009 at 15:57 | #23

    EMH justified weak financial regulation and a laissez-faire attitude to financial innovation, but the same policies were justified in different ways long before EMH, and produced the same outcomes on a regular basis.

    An old-fashioned Marxist would seize on this point. If the same sequence of events is happening but each time with a diferent ideological justification, doesn’t this mean that the ideology is just a superstructure over the top of a definite and recurring class interest?

    As I’ve said elsewhere, the classical and neoclassical economic frameworks in no way lead inevitably to right-wing nostrums. But the way many in the economics profession use that framework to further the interests of the “haves” indicates there is an underlying sociology at work.

  24. July 21st, 2009 at 18:35 | #24

    DD – you mean the ideology gets poluted by the politics? Who would have thought!

  25. SeanG
    July 25th, 2009 at 01:27 | #25


    EMH did not cause the GFC. Global imbalances with western nations being overleveraged did.

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