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.