Here’s my article from yesterday’s Fin

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The speed with which bank nationalisation has risen to the top of the policy agenda has found the economics profession largely unprepared. The literature on property rights that developed in the 1970s produced a range of arguments in favour of private as opposed to public ownership which had at least some influence on the widespread adoption of privatisation policies in the 1980s and 1990s. Although subsequent theoretical and empirical developments, such as the discovery of the equity premium puzzle and developments in agency theory cast doubt on the claims of the original literature, the profession had moved on, and showed little interest in revisiting the issues. As Joshua Gans observes,

the main contributions have come from Australian economists who did this research a decade ago only to be told by international journals that as privatisation had occurred everywhere by then, no one was interested in the conditions under which government ownership would be preferable.

and notes “I guess that view is wrong.” Unsurprisingly, I was among those who tried, with limited success, to interest the international profession in this question.

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The news that, on average, superannuation investments lost nearly 20 per cent of their value last year Johnny Got His Gun movie download comes as no surprise, and its likely that there are plenty of unrealised losses still on the books. Still, while the losses on the stockmarket have been as bad here as anywhere, we can take some comfort in the fact that Australian superannuation funds, like Australian banks, don’t seem to be in the same trouble as some of their overseas counterparts. As the government scrambles to keep the financial system operational, it’s natural to ask what, if anything can be done about this.

In the short term, the answer appears to be, nothing, or very little. Fortunately, for most people the losses are, in a sense, notional, wiping out the spurious gains of previous years. It’s only for those at or near retirement that the crash presents an immediate economic problem. Given that the demand for labour is plummeting, the government could perhaps consider an ex gratia payment to people who choose to retire now. There are all sorts of problems with this, and in normal times, such a proposal would never pass muster, but plainly, these aren’t normal times.

Looking to the longer view, this is more than a bad year for superannuation funds. The crash and the way it came about undermines the fundamental premise that has driven Australian retirement income policy for the past decade: that allowing individuals, with good financial advice, to make their own investment decisions on the basis of defined contributions from employers to personal accounts, is the best way of financing retirement. The old age pension, in this view, serves as a residual for those who don’t manage to save enough.

This privatised approach (also represented in Bush’s failed attempt to reform Social Security in the US) is has been largely discredited by the crash. Financial advisers, even the honest ones, have proved to be useless. Lots of investments that were marketed as low-risk have turned out to be little more than junk. Morover, the idea that stocks will always perform better than bonds over the medium term (say a decade) has been proved false. This is a central premise of long-term investment advice.

We need to look again at the alternatives: either a return to employer-based defined benefit schemes, with portability of service, or some kind of national superannation schemes. In the short term, the call for an increase in the aged pension will also gain strength.

Update 27/1/09 The New York Times agrees. And today’s Fin has a piece from Robert Shiller denouncing the efficient markets hypothesis. I’d better get cracking with more refutations, while there are still plenty of doctrines left to refute.

Back in November, I observed that Australia’s economic situation felt something the opening of Nevil Shute’s 1957 novel, On the Beach, where a nuclear war has devastated the Northern Hemisphere. Australia has not been hit, but a lethal cloud of fallout is gradually drifting southwards.

The fallout has certainly hit now. Huge job losses are being announced across the board, but particularly in the mining sector, which was booming only a few months ago. The government is already contemplating radical action to respond to the likely withdrawal of most foreign banks from our financial markets, and it needs to be similarly radical in its response to the imminent collapse of the labour market. For now, I’ll restate what I wrote in November, hopefully with more to come on this topic

Job creation gets a bad name from silly projects exemplified by the (apparently apocryphal) case of ‘painting rocks white’, so they tend to be a last resort. But the alternative of wage subsidies is least effective during the initial contraction phase of a recession, when employers are cutting back or freezing their staff numbers.

It’s precisely at this time when some well-timed projects could do a lot of good. In this respect the recently-announced assistance to local governments looks like a good idea.

Finally, while there are good reasons for governments to pick up the private sector slack as regards infrastructure investment, it’s important to remember that the days of large gangs of workers swinging picks and shovels are long gone. Physical infrastructure projects have many potential merits, but large-scale job creation is not among them.

The biggest employment gains nowadays come from expanding the services sector, and particularly human services such as health and education. The financial services sector has also been an important source of growth since the 1970s, but the jobs being cut there now are unlikely to return for some years, if they ever do.

As James Surowiecki points out here, my views on what’s entailed in bank nationalisation differ significantly from those of Paul Krugman[1]. Krugman, like quite a few other advocates of nationalisation, has in mind models like the Resolution Trust Corporation and the Swedish nationalizations of the 1990s, where the government took insolvent institutions into temporary public ownership, liquidated the bad assets and returned them to the private sector. These solutions worked well because the global financial system as a whole was solvent and liquid, even though some sectors (US S&Ls, Swedish banks) were not.

What’s needed in the present case is not only to fix the problems of individual banks, problems on a much bigger scale than have been seen before (even in the leadup to the Great Depression, the financial sector played a smaller role in the economy than in the recent bubble), but to reconstruct a failed global financial system. It’s kind of like rewiring an electrical system in near-meltdown, while keeping the power on (this is possible, but tricky and dangerous). The job is likely to be much slower than the rescues mentioned above, and the institutions that emerge from it will be very different from those that went in.

But, contra Surowiecki this time, this only strengthens the argument for nationalisation. Financial restructuring is going to be a huge challenge, involving both a radical redesign of national regulations and the construction of an almost completely new global financial architecture. To attempt this task while leaving the banks under the control of discredited managers nominally responsible to shareholders whose equity has, in the absence of massive transfers from taxpayers, been wiped out by bad debts, seems like doing live electrical work while wearing a blindfold and standing in a pool of water.

fn1. Krugman is well-known for being right when lots of others have been wrong, so take this into account in assessing the arguments.

All reasonable^TM commentators now agree that nationalisation of big banks like Citigroup, Bank of America and Royal Bank of Scotland must take place soon, explicitly or otherwise. As I said at just before the second (failed) Citigroup bailout) banks like Citi are not only too big to fail, they’re too big to rescue with any of the half-measures that have been tried so far.

It’s obvious that “If it were done when ’tis done, then ’twere well It were done quickly” and cleanly, without any dodges designed to hide the reality of nationalisation. The longer these zombie institutions are allowed to run on public money, but under the existing discredited managers, legally answerable to the private shareholders, the bigger the costs the public will ultimately face.

Nationalisation would resolve a lot of the difficult questions around ideas such as the creation of a “bad bank” to hold all the toxic assets accumulated during the boom. That’s critical as long as policy is aimed at turning the troubled banks around while keeping them private, but it’s unimportant once all the debts and assets have been taken on to the public balance sheet. Once the big banks are nationalized, the government can take its time salvaging whatever assets are still worthwhile and preparing for the reconstruction of a private banking system under a completely new system of regulation, a task that is likely to take several years.

The big question is, what should governments do with the banks once they own them? Clearly, there’s an imperative for banks to start lending again, but there is no benefit in making yet more bad loans. And, right at the moment, credit-worthy borrowers are hard to find. The immediate concern must be to ensure that commercially sound loans aren’t being constrained by the need to bolster bank balance sheets. Then, governments need to consider whether some form of support for loans, such as interest rate subsidies or guarantees (secured against assets seen as having a long-term value that exceeds their current market value) should be part of the policy response to the recession. Such policies have plenty of risk associated with them, but the risks are mitigated a bit if the guarantor and the bank owner are ultimately the same (in this case, the public).

Obviously, this is not the kind of question economists have spent a lot of time thinking about until fairly recently. I don’t imagine many of us would have expected, a year ago, to be reading the Wall Street Journal castigating Henry Paulson and the Bush Administration for the (partial) nationalisation of the Bank of America. No doubt plenty of mistakes will be made. But there is no time for leisurely reflection here. As in 1933, the next hundred days will make a big difference, one way or another.

My passing remark about the role of gold in the Panic of 1873 provoked plenty of discussion, so I thought I’d have a preliminary go at a post I’ve been thinking about for a while.

The global financial crisis has been an intellectual disaster for those supporters of free markets who rely on mainstream arguments such as the efficient capital markets hypothesis. But it’s been something of a boon for fringe free-market viewpoints such as those of the Austrian school and (an overlapping group), advocates of the gold standard. Members of this group have been predicting disaster at least as long, and (relative to their numbers) at least as loudly, as social democratic critics of financial deregulation.

So, it’s worth presenting my critique of the gold standard in several parts, which can be classed as microeconomic, macroeconomic, empirical and political, along with some miscellaneous points. I don’t claim any particular originality for it, but I’m presenting on the basis of my own analysis rather than directly citing a source (I’d welcome pointers on this)

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Writing in the Oz, Alan Moran begins a case for wage cuts as a response to recession with the claim

Until the 1930s, recessions tended to be short and sharp, and financial ruin was largely confined to the speculators whose exuberance had diverted capital into ventures where it was less than productive.

Much the same assumption appears to underlie the thinking of those who propose a return to the macroeconomic policies of the 19th century, such as the gold standard. Economic statistics for this period aren’t exactly comparable to those available today, but, such as they are, they don’t support the claim. In the US, for example, the longest-ever recession, according to the National Bureau of Economic Research was that of the 1870s (following the Panic of 1873, which in turn followed the US shift from bimetallism to a gold standard). As the NBER data shows, 19th century recessions commonly lasted for more than a year.

In Australia, the long and deep depression of the 1890s, and the substantial wage cuts imposed during that depression (with employers getting the full backing of governments) were a major factor in the formation of the Labor Party and the shift to a parliamentary, as opposed to a purely industrial strategy, for the labour movement.

It’s (past) time once again for the Monday Message Board. As usual civilised discussion and no coarse language.

The “Great Moderation” is a phrase coined by Ben Bernanke in 2004 to describe one particular interpretation of evidence showing that the volatility of output has declined over time in the US and other developed countries (though not, by then, Japan). Bernanke starts by citing the work of Blanchard and Simon, who offer both a different view of the evidence and a different explanation. Blanchard and Simon say that output volatility has been declining since the 1950s (fn: reliable national accounts don’t go back before WWII, but obviously output volatility was very high in the 1920s and 1930s), with an interruption in the 1970s and 1980s. However, they note that the data could also be interpreted as having a single structural break in the mid-1980s, and this is the view of the evidence taken by Bernanke.

A variety of explanations have been put forward for the Great Moderation. To the extent that the Moderation has been seen as more than a run of good luck, it has typically been explained either by a combination of improvements in macroeconomic management associated with central bank independence and reliance on monetary rather than fiscal policy and the benefits of economic liberalism, as in this piece by Gerard Baker

Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement. Good policy has played a part: central banks have got much better at timing interest rate moves to smoothe out the curves of economic progress. But the really important reason tells us much more about the best way to manage economies.

It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle. These changes gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods.

The Great Moderation has vanished with surprising rapidity, though in retrospect its unsustainability has been evident since the late 1990s. It is clear that the global economy is undergoing a severe recession, which will generate a substantial increase in the volatility of output. But even if the recession ends by mid-2009, as is suggested by some optimistic forecasters, crucial elements of the Great Moderation hypothesis have already been refuted. Over the period of the Great moderation, all the major components of aggregate output (consumption, investment and public spending) became more stable. By contrast, if a deep recession is avoided in 2009, this will be the result of a massive fiscal stimulus, with a huge increase in public expenditure (net of taxes) offsetting large reductions in private sector demand.

Just as the failure of the efficient markets hypothesis has destroyed much of the theoretical basis of the policy framework dominant in recent decades, the collapse of the Great Moderation has destroyed the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s delivered sustained prosperity. If anything can be salvaged from the current mess, it will be in spite of the policies of recent decades and not because of them.