Credit Code Red

by Peter Brain

  The best example of a country where the government adopted an appropriate framework for high, sustainable growth is China, which refined the old Soviet comprehensive and rigid planning framework to concentrate its policy focus and resources on the 15 to 20 per cent of the economy that is essential for sustainable growth — namely the high-technology sectors, the sectors where large-scale capital resources are important for competitive success, the infrastructure-service sectors, and those sectors whose world trade share is going to grow relatively rapidly. The rest could be left to market responses. The Chinese learned from the Japanese, the Germans, and the Taiwanese that targeted control of market forces can be a highly efficient way of achieving national economic objectives.

  The efficiency of the Chinese economy and of other countries that have learned the same lessons, and the ability of these countries to take advantage of growth opportunities, means that the Anglosphere economies cannot compete. The neo-liberal countries have a simple choice: they can either get with the strength by providing themselves with active, competent governments, or they can retain their current ideological commitments and retreat behind trade barriers.

  Faced with this dilemma, the anti-Keynesians will argue that active government is incompatible with economic freedoms. They are wrong. Europe and East Asia both include countries that have combined democracy with active government. A particularly apposite exemplar for Australia is Norway, which over the past decade and more has shown that a democratic version of the Chinese model can manage a resources boom to permanently enrich its citizens — in complete contrast to the Australian case, where the recent mining boom resulted in excessive debt and rising prospects of economic catastrophe. Norway astutely retained ownership of its minerals until their final sale on world markets, employing multinational companies as contractors for the production process; by contrast, the Australian states sold their minerals in situ, in the ground, so that the multinational mining companies cornered nearly all of the final sales value of the minerals.

  In this book, we draw on our Keynesian background and on recent developments in practical economics to critique Australian economic policies implemented over the past thirty years, and to present an admittedly gloomy view of the immediate future if current policies continue. Our gloom arises not from a lack of alternatives, but from the cramped mindset of the present political, academic, and media elite. It arises because this cramped mindset is so wilfully unaware of its limitations. We have been trying to point these out for decades.

  How do we challenge the neo-liberal mindset? Not by denying the basics of demand and supply; traditional market analysis provides a very useful account of the interaction between highly motivated buyers and sellers.4 However, we insist that economic analysis cannot be abstracted from the march of time. Economies lurch through time; they are often the prisoners of their past, the playthings of technological change, the pawns of international circumstance. This contrasts with the ideal of timeless optimality embedded deeply in the neo-liberal account of market activity. We deny that this basic calculus adequately describes market behaviour; we eschew the concept of equilibrium. The particular resource endowments of regions and nations matter, as do the processes by which these endowments change and are managed and governed.

  We try to constantly remind ourselves that economies are infinitely complex; that relationships which are important in some times and places are unimportant in others, and that this changes over time. No matter how many variables and relationships are programmed into the computer, economic analysis inevitably simplifies reality. The challenge is to extract from all the complexity a relevant, comprehensive, yet comprehensible account of each economic question: an account that gives due weight to the uncertainties which arise as we look into the future. The best that can be done is to try to learn from history, from other places, and from developments in all the fields of study that affect economic outcomes — which, in turn, become the inputs for the next round of history. Let the reader judge whether we succeed.

  1

  Economic breakdown as a threat to prosperity

  Australia has long been a country of high incomes, one in which it is easy to take prosperity for granted. However, neither God nor nature guarantees the Australian standard of living.

  It is now certain that Australians who are currently children will face the challenge of responding to climate change, which will involve modifying the way of life to which they have been born. Whether this can be done without permanent sacrifice of their standard of living is unknown and at present unknowable.

  Australia has had little experience of environmental limitations to prosperity, though it has had some: right across the country at a latitude of 30 to 35 degrees there stand the ruins of farmhouses abandoned due to drought, often in combination with a sheen of salt on once-fertile paddocks. In the course of their long occupation of the island-continent, the Aboriginal peoples survived an Ice Age and a major rise in sea levels, while today, across wide swathes of the country, the former Aboriginal hunter-gatherer lifestyle is no longer possible due to loss of the plants that Aboriginal people gathered and the animals that they hunted. The threat of climate change is real, but this is not a book about it — not, that is, until we discuss policy responses in the last chapter.

  A second threat is easier to imagine, because there are instances of it in the historic record, though no longer within living memory. This is the threat of war. During both the First and Second World Wars, the Australian standard of living fell appreciably. Consumption fell by 24 per cent between 1913 and 1918, and by 30 per cent between 1938 and 1944.1 During wars, resources are diverted from consumption to defence, so the decline in the value of Gross Domestic Product (GDP) was less, though still significant — 12 per cent during the First World War, and 15 per cent during the Second. As with climate change, the threat of war is real, but this is not a book about it, either.

  And then there is the threat of economic breakdown, which is the subject of this book.

  The concept of economic breakdown

  Economic breakdowns come in a great variety. The closure of a single factory can be enough to break the economy of a country town; the closure of an industry can break the economic prospects of a generation of skilled workers. A breakdown may be regional — a dust bowl, a rust belt — but it may equally be nationwide, or indeed part of a worldwide slump. Apart from the two World Wars, Australia has twice experienced national economic breakdown. Between 1891 and 1897, GDP fell by 27 per cent, and between 1928 and 1933 it fell by 22 per cent.2

  There are two sources of economic breakdown widespread enough to affect whole countries, rather than merely particular regions or industries. One source is overseas, in the form of depressed export sales for a wide range of industries and regions (as, for Australia, in the Depression of the 1930s); the other source is domestic, lying in the mismanagement of the two sectors that have dealings right across the national economy. These two sectors are government and finance (which, in Australia, were jointly responsible for the Depression of the 1890s).

  Needless to say, a breakdown can have mixed causes — an adverse external shock is much more likely to tip a country into economic breakdown if its public or finance sectors have been mismanaged, and when a breakdown originates overseas, the government and finance sectors quickly find themselves at the centre of events. The reason why the government and finance sectors are so central is that economic breakdown arises from bad debts. Borrowing and lending are central to the capitalist system, and, thanks to the uncertainty of economic affairs, carry an unavoidable risk that debts will go bad. Economic crises arise when so many debts threaten to go bad that the system breaks down.

  Though economic breakdown always involves defaults and threats of default that are generalised to the whole economy via the public sector, the financial sector, or both, they vary in their origin. They may be generated primarily overseas, or in the domestic gov
ernment or financial sectors; they may generate different flow-on combinations of economic woes, including unemployment and inflation; they may be mild or severe. In their book on the international history of financial crises, This Time is Different, C M Reinhart and K S Rogoff distinguish several main types of crisis. The first type is an inflation crisis, for which they set a threshold of general prices rising by 40 per cent a year or more, usually as a result of mismanagement of the public finances. (Inflation is a time-honoured way of defaulting on public debt.) Closely related are currency crashes, where a country’s currency depreciates against the currency of its trading partners by 25 per cent a year or more.

  Mismanagement in the private sector more often results in a banking crisis, a crisis in which banks and other financial institutions encounter difficulty in meeting their obligations. The primary source of such difficulties generally lies on the asset side of bank balance sheets, in the form of bad debts to the banks (sometimes glossed over as ‘non-performing loans’), but a bank can also run into trouble on the liability side of its balance sheet when the cost of one particular liability (typically ‘loans raised overseas’) rises so much that the bank is unable to meet its obligations for other liabilities (say, ‘domestic deposits’). Banking crises do not always reach the stage of outright default, since this is often averted by the reconstruction of major parts of the financial system, usually with government involvement.

  The public-sector counterpart of a banking crisis is a government debt crisis. It has been claimed that governments do not default on debts contracted in their own currency, since they can always print money and so relieve themselves of debt by causing inflation, but Reinhart and Rogoff instance episodes in which governments have preferred default to printing. More commonly, governments in financial crisis may default on debts incurred in external currencies. These might be debts incurred through government overseas borrowing, but may have been originally incurred through private borrowing and transferred to the government in its capacity as manager of a country’s foreign-exchange reserves.

  Armed with these definitions, Reinhart and Rogoff find that, over the long haul since the early nineteenth century, Australia has been reasonably free of inflation (only during the 1850s gold rush did the rate breach their 40 per cent threshold), and Australian governments have honoured their debts, both external and domestic. (When New South Wales attempted to default in the early 1930s, it was brought to heel by the Commonwealth.) However, Australia (or at least its eastern states) underwent a major banking crisis in 1893, involving bank closures, the severe curtailment of credit, and a Depression with soaring unemployment. Like many of his fellow Victorians, one of our grandfathers weathered the Depression on the goldfields at Kalgoorlie in Western Australia.

  It is notable that Australia survived the Great Depression of the 1930s without a banking crisis. The economic breakdown of those years was transmitted from abroad — a major contrast to the Depression of the 1890s, which occurred despite reasonably buoyant world trading conditions.

  Thus summarised, Australia’s largely forgotten history of economic breakdown has much in common with that of other countries: severe costs during the World Wars and the Great Depression, plus a home-made Depression in the late nineteenth century. The Second World War was followed by six decades during which Australia shared in the post-war economic recovery and then in the general prosperity and economic growth of the wealthy countries.

  The post-war intention on both sides of the Iron Curtain was to eliminate economic crises and the associated Depressions. So long as the policy agencies in each country concentrated on this aim there was a degree of success, and few countries experienced economic crisis in the two decades following 1945. However, as the 1930s receded into history, the various national policy agencies faced new challenges, such as the change in the distribution of world wealth that followed from increased oil prices. All the wealthy countries, Australia included, shared in the 1970s combination of stagnation and inflation, which they muddled through without any of them incurring the feared hyper-inflation or serious Depression.

  However, the decade of stagflation prompted fundamental revisions to economic policy, based on the revival of neo-liberal economics. We describe this revival in more detail in Chapter 2; here, it is sufficient to note that it originated in the United States, and was adopted with some enthusiasm in other Anglophone countries, although with less enthusiasm by countries subject to the ministrations of the International Monetary Fund (IMF). Here, we stick to the background story of the international incidence of banking crises.

  Economic breakdowns from the 1970s onwards

  As the post-war period receded into history, crises involving serious falls in GDP became more common. Starting in the economically less robust countries, particularly in Latin America, in 1998 the trail of crisis moved to the ‘Tiger Economies’ of East Asia, and finally in 2008 reached the core of the global economy in the United States and Europe. Economic crises had not, after all, been consigned to history.

  An economic crisis is worse than the recessions of the kind that, from time to time, arrested economic growth during the post-war period. It is catastrophic; a conflagration that leaves no citizen unaffected, no element in the capital stock untouched, and which so devastates the foundations of the economy that a complete restructure is required.

  Across the world, the years since 1980 have seen economic catastrophes from both war and hyper-inflation, but these have been confined to low-income or, at the most, middle-income countries. The high-income countries have been affected but not thrown into crisis by the costs of war, and they have experienced inflation, but again not so badly as to suffer catastrophe. Neither war nor hyper-inflation are current threats in the high-income countries, but unfortunately this does not preclude banking crises that, uncontrolled, snowball into economic catastrophes.

  As Reinhart and Rogoff emphasise, banking crises arise out of bad debts; more specifically, from defaults on financial contracts. Banking crises arise fundamentally out of failed attempts to take the risk out of lending by the issue of supposedly risk-free debt, rather than by equity instruments in which the lender shares the risk. The genius of capitalism is that it is able to raise funds for risky investments by equity financing — this underlies its record of innovation. But let the investor beware: the investment prospectus may be shonky; the risks may be under-stated, and even if they are correctly perceived, the uncertainties of innovation are such that much of the equity invested in innovation will go bad.

  The precise purpose of equity markets is to deal with this, and because they deal in uncertainty they are inherently unstable and prone to cycles of optimism and pessimism, boom and bust. It is important that equity markets are able to rise and fall without seriously affecting the ordinary flow of production — as, for example, the dot.com bubble of 1995–2001 inflated and burst without causing serious economic breakdown. The bursting of such an equity bubble creates financial losses, but they are not likely to be unmanageable unless they have been converted into bad-debt losses by investors who are not in a position to bear uncertainty.

  In theory, the same story should apply in property markets, since property is an equity investment. However, equity in property is usually leveraged with debt, which means that property bubbles are a dangerous source of bad debts.

  The historical experience is that fixed-interest lending can deal with a certain level of bad debts. Banks have historically been major sources of finance for businesses too small to have access to equity markets. Though the risky nature of small business provides a strong argument for equity rather than debt support, banks are an established source of funds, especially to businesses that can provide collateral and accept basic management advice as a condition of the loan. However, fixed-interest lending becomes dangerous when it finances propositions more suited to equity lending — if indeed they are suited to lending at all. The old golden rule was that
a lender who finances consumption is taking on a high risk of default.

  No matter what the country, the government and finance sectors both have the potential to generate a banking crisis that ends in economic catastrophe by incurring more debts than they can handle. Governments are constantly caught between the Scylla of expenditure demands and the Charybdis of tax resistance; they are tempted to the insidious accumulation of debt that turns bad when it fails to generate additional tax revenues. Similarly, financial institutions are under constant temptation to seek high returns by accepting high levels of risk. When they succumb to this temptation they also may find themselves lumbered with unmanageable bad debts. The temptation to engage in excessive borrowing tends to be strongest in times of euphoria, when uncertainty is downplayed — hence the association of excess debt with booms, particularly consumption booms.

  As is often the case with temptations, behaviour that is desirable or at least tolerable in moderation becomes disastrous when carried to excess. Current rhetoric would have it that government deficits — government borrowing — are always and everywhere undesirable. But the truth is that, in moderation, they can help to accumulate public capital that pays for itself through increased tax revenues. Deficits can also be appropriate when they finance the utilisation of resources that would otherwise be unemployed — once again yielding revenue that would not otherwise be received. Conversely, current rhetoric would have it that bank borrowing to finance credit for home-buyers is generally desirable; but when such lending ends up financing rising urban land prices, rather than actual construction, the loans have a nasty propensity to turn bad.