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November 21st 2011 print

Peter Smith

Unholy alliance of errors

The danger is that someone in government, particularly on the Left/Greens side, might actually think there is some sense to Robert Leeson’s arguments, when, of course, there is none at all.


Economics gets curiouser and curiouser


Waiting for some books at the State Library to be retrieved from its research collection, I perused last Friday’s AFR and read an article (“Unholy Alliance”) by Robert Leeson, who has professorial (economics and business) appointments at Stanford, Trento, and Notre Dame in Australia. I didn’t bargain for the experience. Professor Leeson is no lightweight. He has many economics publications to his name. I am not sure where he sits on the political spectrum but that is neither here nor there.

In his article he blames Keynes and Hayek for our current economic malaise. Keynes for being radicalised by fixed exchange rates into underestimating the dangers of fiscal deficits and Hayek for the way he “legitimised the tyranny of the markets”.

I don’t have much to say about his Keynesian theory. Flexible exchange rates do allow economies to adjust more readily to worsening economic circumstances than do fixed exchange rates and may, therefore, have produced a more sanguine Keynes than the one who despaired about the ability of free market economies to maintain full employment. It is a theory.

His Hayekian theory is much more problematic. It leads him into two most curious recommendations about the way Australia should engineer its financial affairs “to avoid serious misfortune”. The danger in this is that someone in government, particularly on the Left/Greens side, might actually think there is some sense to his arguments, with his credentials; when, of course, there is none at all.

 The tyranny of markets he suggests has liberated the financial sector “from its traditional role of assessing and bearing the risk of turning savings into capital expenditure”. He sees virtue in new capital investment and in the financing of such investment and, against this, notes that the “circulation of second hand investment toxins has proved to be disastrous”. As we are all nodding our heads in agreement he makes a giant disconcerting leap. I quote fairly fully because I didn’t quite believe it when I read it.

First, some proportion of compulsory superannuation contributions should be channelled into new capital expenditure: buying and selling second hand assets (toxic or otherwise) adds little or nothing to our capital stock.”

Second, banks must be rechartered as “lending banks”. When a deposit is made, it should be swept up into a bank’s account with the Reserve Bank and accessed only when a withdrawal is demanded or a loan about to be made. If a bank is unable or unwilling to undertake the arduous task of assessing and bearing the risk of making a business loan, then these deposits should be used to fund infrastructure projects or buy newly-issued government bonds. Banks must be stripped of their discretion to hoard excess reserves or buy second hand bonds”.

Where does this all go wrong? In many ways is the answer. I will concentrate on three.

First, and perhaps most fundamentally, there seems to be no understanding of the role of prices in a market economy – a fatal flaw for any economic argument. The purchase of second-hand financial assets has a price effect on those assets which improves the ability of the issuer to issue new financial assets. So it is simply not true to say that the purchase of second-hand assets adds nothing to the capital stock. More generally, without a vibrant and liquid second-hand market, it would be much more difficult for companies to raise new capital.

Second, exactly who is going to decide where superannuation funds should be channelled? Perhaps we should allow Christine Milne to channel super funds into solar panel companies. Ridiculous you think? So should we all. Again, the role of prices in allocating resources is made to play second fiddle to the role of some wise authority directing people as to where they must put their own savings. I think it is called socialism.

Third, we have banks so hamstrung that they are likely to disappear altogether, which rather undermines the point of controlling them in the national interest. The raw material of banking is deposits. Banks attract deposits by paying interest. If banks are seriously disadvantaged in the assets they can purchase, they will become uncompetitive and lose deposits. Economics 101 is sufficient to understand that, or it used to be. Moreover, banking, in large part, is about controlling risk. A second-hand security might be regarded by a bank as safer than a new issue, or it might have a maturity profile which better fits the other side of a bank’s book. This has to be left to individual banks.

A lot of the current concentration on banks is misconceived and ill-directed. Banking is an intrinsically risky business. Banks borrow funds which they must repay and lend, quite often, to individuals and businesses that go broke. Banks take account of this in their interest rate margins, by putting aside reserves, and by taking security over real property and other assets. Usually this all works. But if the economy goes into a tailspin many loans go bad and property values decline. Banks can do little in the end result to counter this and so we have banking crises over and over again. It is a price worth paying; and par for the course in dynamic capitalist economies, which give us so much prosperity.

However, when we look at the current banking malaise we see the offending hand of governments making things so much worse. In the subprime crisis; legislation in the United States enacted by Carter, and strengthened by Clinton, cajoled banks into making poor quality loans, while the government-sponsored Fannie Mae and Freddie Mac bought them up. In the current global debt crisis banks are in trouble because they hold government debt. Usually, prudential authorities insist that banks hold government securities as a risk aversion measure. We shouldn’t miss the irony.

The problem is not banking; it is not the market; and it can’t be laid at the door of Hayek. The problem is too much government; whether it is interfering with market processes, bailing out failed companies, or grossly overspending. Australia will not become better off by forcing super funds to invest in new capital and/or by onerously regulating banking. We will become much worse off. If you doubt that, remember that these kinds of schemes constraining capitalism would likely appeal to the Greens, to the OWS rabbles, and to those internally-conflicted creatures: socialist economists. Is it likely that any of these groups are ever right about anything?

Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics