The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Monday, September 5, 2011

A Dr Grenville and tonic, sir?

Former RBA Deputy Governor and current Lowy Institute fellow, Dr Stephen Grenville, is a fine, cynically 'centrist' contributor to the public debate, even if he probably does not like me giving his alma mater a hard time. I am catching up on some of his recent writings. Here's a summary...

In this piece he criticises Ben Bernanke for not pulling a Volcker and putting politicians in their place over the current approach to fiscal policy in the US:

"While fiscal policy shouldn't be tightened with unemployment still so high, what is urgently needed is a credible detailed commitment to get the budget on a sustainable track. This is clearly in the hands of the politicians. Considering the very real danger of emulating Japan's lost decades, this is a major political failure. Bernanke included a muted version of this criticism in his Jackson Hole talk. He no doubt feels constrained by the unsympathetic, even patently hostile, Republicans like Ron Paul and Rick Perry, but it may be time for him to use his position to put the responsibility squarely on the politicians who control fiscal policy. Former Fed Chairman Paul Volker would have been bolder."

He goes on to critique the economics community more broadly here:

Some called the recovery wrongly, and are reluctant to admit they made a mistake. For example, in June the Bank for International Settlements assessed the recovery to be firmly on track, and urged countries to tighten both monetary and fiscal policy. Bad call, even with the data available at the time. Other economists have not yet noticed the poor fit between the real world, and their view of how it works, which assumes that the self–equilibrating forces in the economy are very strong and efficient markets will allocate resources optimally.

Grenville also takes issue with Steve Keen's argument about the consequences associated with the once-off increase in household leverage during the 1990s, which is something I have similarly assaulted in recent times (see my Business Spectator column here):

Certainly, the recession started with sub–prime over–borrowing. In the decades since financial deregulation, households have geared up, taking their debt to around 150% of income. But is this oft–quoted figure all that alarming? A more relevant comparison is the asset/liability ratio. This has also grown since financial deregulation (this type of balance sheet expansion was, after all, the principal motivation for deregulation). But household assets have also increased and are now four times larger than liabilities. Restating this, the household debt/equity ratio is 1:3, which any company would regard as astonishingly conservative.

Grenville makes a valuable point about solutions to the US's economic problems when he says that economists generally are not focussing on what can be specifically done to put the US fiscal house in order (note, also, that he appears to find fault with the McKibbin-critique of Australia's fiscal settings during the GFC):

"The economics is simple. Rather than urge Bernanke to undertake QE3 (which will have little effect), mainstream economists should be calling for Congress to come up with a credible plan for a sustainable fiscal position, to be implemented when the economy recovers. As well, to hasten this recovery, economists should identify specific stimulus actions (some directed at speeding resolution of the mortgage mess, some aimed at encouraging employment). The 2009 stimulus, hamstrung by a fractious Congress, was so timid as to be inadequate. Successful stimulus programs (eg Australia and China) are characteristically too big, and the measure of their success is that afterwards they are criticised as being unnecessary."

In this 22 August article for the Lowy Interpreter (the best multi-author Australian blog going around, which I read all too infrequently), Grenville makes the technical argument, based on some fragile assumptions, that quantitative easing is not money printing (while I do not completely agree with this, at least Grenville recognises that the "E" in QE denotes policy easing--although he very much doubts its impact--which is more than can be said for a member of Australia's House of Representatives' Economics Committee):

"When the Fed buys bonds, it increases the supply of 'base money'. The public doesn't want to hold any more of this base money in the form of currency, but nor does it need to get rid of the excess by buying more goods. Instead, the money is deposited in the commercial banks. The banks don't use this extra money to fund additional credit expansion: the banks have already lent to all the bankable borrowers [CJ: for the time being, SG]. The extra base money accumulates in the balance sheets of the banks, with little effect."

In the same post, Grenville also touches on the ascendant issue of central bank independence, which has been a favoured meme for this blog. I hope that when we next have a change of government, the Libs can undertake some reform on this front:

"If Bernanke can be faulted in principle, it is not because he has 'printed money', but because he has been supporting the government bond market. One of the key elements of central bank independence is that central banks should not be forced to fund fiscal deficits. They may choose to do so in special circumstances, but they know that they are opening a chink in their independence armour. Thus Bernanke will hope to avoid another QE operation."

Finally, in this post Grenville is outstanding. As I argued on this blog a few days prior to his article, too little is made of the fact that (a) this sovereign debt crisis is really a private debt crisis that has been socialised (reinforcing the original moral hazards), and (b) if we were once worried about private moral hazard, we should be more concerned about public moral hazard, especially if this Eurobond idea gets legs. Grenville makes a point I have not raised here before: that the Euro currency itself incentivized public moral hazard. He also notes that neither the financial markets', nor the rating agencies, anticipated these public sector risks:

"The evolving Greek debt tragedy illustrates the subtle nature of the financial sector's risk management process. On the surface, its risk analysis seems to have been a dismal failure, apparently unable to anticipate obvious problems. But in practice the financial sector seems to have largely succeeded in transferring its potential losses to taxpayers.

Greece's creditors have had a nasty scare, but they seem to be coming through more-or-less unscathed. Risk management turns out to have little to do with the intrinsic riskiness of the underlying investment, but rather is a political assessment of the feasibility of socialising the losses.

When Greece joined the Euro, there was no good economic reason why it should have been able to borrow at essentially the same interest rate as Germany. The Euro was a currency union, but each country was still responsible for its own debts, and Greece was always much more likely to get into trouble than the staid and disciplined Germans.

Nevertheless, Greece borrowed at close to the German rate until a little over a year ago. Being a member of the Euro took away the discipline that a country with its own exchange rate has, where profligate fiscal policies would depreciate its exchange rate and raise its borrowing interest rate...

Sure enough, the low interest rate encouraged the Greeks to over-extend and live beyond their means, resulting in government debt exceeding 150% of GDP. Financial markets were ready to oblige them. For their part, the credit rating agencies failed to anticipate any problems: one major agency kept Greece at investment grade until early this year.

As the debt built up, financial markets did not progressively come to a realisation of unsustainability, with graduated price signals to reflect increasing risk perceptions. Rather, they swung quickly from uncomprehending insouciance to total panic."

Ahhh, now I really enjoyed this: Grenville picks up a quote from Larry Summers that I myself took issue with the day it was published. In a Business Spectator article entitled Cannibalising capitalism, I argued:

"An economist buddy brought to my attention former US Treasury Secretary Lawrence Summers' latest views. Summers declares that, "There must be a clear and unambiguous commitment that whatever else happens, the failure of major financial institutions in any country will not be permitted."

You must be kidding, right? Have we learned nothing from the global financial crisis (GFC)? Offering open-ended taxpayer guarantees of private companies is precisely what regulators should be seeking to avoid. It is 'too-big-to-fail' writ large.

The turmoil our world endures today very much derives from the gullible ‘socialisation’ of private problems via the insidious nexus between the Western financial 'oligarchy' and senior bureaucrats, who tend to be former financiers, or wannabe financiers.

One genuinely attractive feature of Australia's system of governance is that there tends not to be so much cross-over between the two cohorts. That is, we have a professional class of life-time bureaucrats who are not constantly on the make for big payouts by shifting into private practice.

The socialisation of non-public risks involved bailing out many bad US, UK and European banks that should arguably have been allowed to fail (or been fully nationalised until they were cleaned-up with equity and credit holders completely wiped out), and imprudently pouring tonnes of financial fertiliser over economies reeling from credit rationing.

Don't get me wrong. It does make sense to ensure that 'systematically important financial institutions' (jargon for big banks) are not allowed to fail in a manner that disrupts the vital, economically oxygenating bank-intermediated function that entails the transformation of short-term household and business savings into long-term investment. This is, after all, the lifeblood of all economies.

Yet when faced with an important private institution that has made parlous decisions, such as taking on business risks that it should not have borne, or seeking higher returns through excessive leverage, nation states should not subsidise the executives, shareholders and creditors to that entity: they should nationalise the institution, cauterise and then eviscerate the problems, and ultimately set it free to flourish as a newborn in the market wilderness.

Following the first 2007-08 private credit crisis, we now confront an even more perverse 'sovereign debt' crisis as politicians and policymakers learn that insuring private sector mistakes with public money merely transfers the problems from one party to another. More worryingly, it fundamentally thwarts the private market's Darwinian process of natural selection whereby good businesses profit, and bad business disappear.

My contention, which I have yet to read elsewhere, is that the policy reactions to the GFC, which was in part caused by the ‘heads we win, tails taxpayers lose' attitude known as ‘moral hazard’, have actually started to embed those same moral hazards into the public sphere.

If other foreign taxpayers bail sovereign states out of their financial obligations, as most European and US authorities believe is such a sensible idea today, future public debtors will rightly assume that they can behave irresponsibly and default on their repayments the next time the global game of pass-the-risk-parcel emerges.

What makes this public sector moral hazard all the more galling is that it is actually being driven by the original private sector moral hazard, which the Summers' quote above highlights. That is, we (taxpayers) can never, ever allow major private institutions to fail. Nor should we even speak of the possibility! Meanwhile the executives running these companies are allowed to make out like bandits with the benefit of their explicit and implicit guarantees.

In the current context, policymakers at the European Central Bank and IMF have been convinced by bankers that if they allow smaller European states to default on their debts, which are mostly held by private banks, the write-downs the banks take will compel them to stop lending and trigger a second GFC. So, the argument goes, we need to bail-out governments to protect private creditors.

Surely somebody can see that this cycle of perpetually deferring responsibility for risk-taking has to eventually stop. At some juncture, we have to allow both businesses and sovereign states to suffer the conditioning consequences of default and financial neglect. If we don't allow competitive markets to discipline poor decision-making, we will undermine the very basis of capitalism.

Indeed, thinking forward, as the world's centre of economic gravity inexorably migrates towards China, we must do everything possible to safeguard democracy and its private market equivalent, capitalism, as the dominant social model of our time. The risk is that moral hazard, and corruption wrought from dysfunctional public-private relations, result in capitalism cannibalising itself..."

A few days later, Grenville echoes these observations:

"There is, unfortunately, no operational method by which this debt crisis can be treated for what it really is: foolish lending to a small, globally-unimportant country. If Greece's creditors can make things sound sufficiently disastrous, they will be saved.

They seem to have succeeded. The head of the European Central Bank opposes asking creditors to take a haircut on their debt. Larry Summers, former head of President Obama's National Economic Council, argues that 'there must be a clear commitment that, whatever else happens, no big financial institution in any country will be allowed to fail'. Perhaps more surprising, left-of-centre economists such as Joe Stiglitz and Jeff Sachs are making much the same argument.

It used to be said that capitalism without bankruptcy was like Christianity without hell: there is no incentive to do the right thing. It is never a good time to remove this sort of moral hazard and restore longer-term principles by allowing Greece to declare default. If this opportunity ever existed, it was early last year when the problems in Greece first emerged. Now the financial sectorparticular the bankers' lobby group, the Institute for International Finance) has had more than a year to promote the idea that Greek default would be disastrous for the whole world.

In a curious way, the financial sector has been able to justify its original assessment that Greek debt was only marginally more risky, ultimately, than German. But how much longer can the financial sector hold governments and taxpayers to ransom in this way?"