Defending the Faith

P.D. Jonson, Great Crises of Capitalism (Connor Court, 2011), 322 pages, $29.95. 

Many readers of Quadrant will already be familiar with Dr P.D. Jonson. A former Chief Economist of the Reserve Bank of Australia, now a corporate director, Jonson is also the eponymous founder of the Henry Thornton website, which hosts commentary on economics, politics and current events from a broad spectrum of liberal opinion. Perhaps Jonson’s principal claim to significance was his role in persuading Paul Keating to float the dollar, a defining moment in the history of Australia.

In his current book, Great Crises of Capitalism, Jonson offers a rapid-paced summary of many of the major economic crises of modern capitalism, using these as a point of departure for a review of monetary theory and policy from the perspective of a former insider now ensconced in the private sector. All the expected crises are here: the South Sea and Mississippi bubbles, the Dutch tulip mania, the land booms in Melbourne in the nineteenth century, the Roaring Twenties in the USA. Carefully teasing out the lessons from the past, Jonson demonstrates that there are many possible responses available whenever a speculative bubble bursts. According to Jonson, one of the best was that of the Dutch authorities in the 1630s: they stalled for time and the courts dismissed claims for damages on the grounds that the plaintiffs had simply been gambling. The English and French governments, by contrast, applied coercive, sometimes savage and unjust, treatment to the supposed villains of their financial excesses.

Jonson’s chief concern is how to retain the successful, lightly managed, capitalism of recent years, complete with the booms and busts which reward innovation and enterprise and help bed down the newly developed industries upon which future prosperity depends. He is anxious to ensure the stability of the financial system, maintain a healthy currency and retain the trust between strangers and in institutions that is a prerequisite for any sustainable capitalist economy. Jonson is also haunted by the possibility that the crashes that follow bubbles will discredit Western capitalism, while lending prestige and plausibility to the emerging and apparently stable capitalism of China.

Jonson begins with a brief description of the crash of 2007 and 2008. The proximate origin of the crash was a collapse in the sub-prime lending market in the USA, which brought about the bankruptcy of Lehman Brothers and a consequent fall in bank share prices, which in turn dragged down share prices across Wall Street. Quoting from several economists published on the Henry Thornton website, Jonson demonstrates that the crisis was anticipated well in advance by critics with serious concerns about the considerable inflation in asset prices that had taken place, an inflation that according to Milton Friedman’s thinking would have been caused by monetary factors. Jonson sums up the big picture as follows:

In the long boom of the 1980s, 1990s and the 2000s smart people recognised that they could borrow cheaply to buy assets, not-so-smart bankers accommodated them and the credit boom was born. As the world headed inevitably to the great crash of 2007-08, the dramatic growth of China and India as major providers of cheap goods and services constrained the goods and services inflation that was the focus both of Friedman’s analysis and central banking practice.

The crash rocked financial markets, with banks starting to get shy of lending to other banks and asset prices falling at least as fast as they did in the beginning of the Great Depression. The possibility of catastrophic effects on the financial sector, as well as on employment and output, was averted by the intervention of governments ready to spend big and central bankers ready to expand the money supply. The authorities spent their way out of a costly series of market corrections by borrowing vast sums made available by central bankers printing money. The wisdom of this is still being debated, but Jonson believes that the cure may already have planted the seeds of further, greatly aggravated, turbulence. In his words:

The bottom line is that serious policy instability has been added to an inherently fragile global economy. Large discretionary lurches in policy settings confuse households and businesses and disrupt planning by private individuals and institutions. The world needs substantially less policy discretion and more stable, well understood policy rules. Failure to implement such rule-based policy regimes is perhaps the greatest risk to capitalism.

According to Jonson the lessons for governments are simple. Regulation needs to be robust, with banks and other financial institutions being required to retain sufficient capital reserves for conceivable emergencies. Automatic stabilisers for macroeconomic policy, such as a comprehensive system of welfare payments and progressive taxation, need to be retained provided that they do not weaken incentives for employment or damage a government’s credit rating. The firewall that was once mandated by the old Glass–Steagall Act in the USA, which separated carefully-regulated deposit-taking institutions (which may then be eligible for government-backed deposit insurance) from less regulated investment banks, which were free to fail, needs to be carefully rebuilt. In times of crisis, governments need to be prepared to stop banks failing, though they need to be mindful of the obvious moral hazards involved in doing so.

Jonson’s advice to bank regulators is straightforward. They need to stick with inflation targeting, but ensure that this also addresses asset inflation. Monetary policy and banking regulation alike should “lean into” asset inflation, so as to test if the underlying forces are substantial or not.

Jonson is also keen to recover neglected aspects of J.M. Keynes’s thinking, namely Keynes’s proposal for a supranational currency based on commodities, which would function as a superior, more flexible, version of the old gold standard. Jonson suggests a global monetary authority to supervise this currency. The authority would be charged with tackling inflation in goods and services, as well as assets, and participating nations would be free to maintain their national currencies. Provided that the authority ensured that the volume of currency grew at a constant rate they would be able to ensure a stable, non-inflationary foundation for global markets. Nations would be free to decide whether or not to link their national currencies to the global standard, thereby ensuring healthy competition between monetary regimes—and profits for those interested in trading in competitive currencies. A modified version of this proposal is already winning adherents amongst Chinese central bankers. A more practical compromise between the competing alternatives is difficult to imagine.

The case for a supranational currency has problems, and any hint of a global monetary authority won’t impress anyone who has ever noticed the conduct of the many global agencies already devoted to world improvement. Yet the decision of the US Federal Reserve to finance the colossal federal debt via quantitative easing raises pressing, inescapable questions about the future viability of fiat currency, which the French correctly call cours forcé or forced currency. Given this context, Jonson’s proposal for a currency backed by commodities is a great and timely idea that should not alarm Australian readers. The value of the Aussie dollar is already determined in large part by the price of our two key commodity exports (iron ore and coal) and a shift to a commodity-based regime would simply formalise this situation for good. The principal attraction of a commodity-based currency is that its value would in no way depend on the perceived reliability of the authorities, but on transparent market forces alone. In any future global financial crisis a currency that owes its value to a bundle of commodities with an intrinsic value will have advantages over currencies based solely on the demonstrated willingness of a given state to operate its printing presses. Australia is almost uniquely well-placed to reform its monetary policy in this sensible way should any of the major fiat currencies ever end up in free-fall. 

Jonson goes on to discuss various future scenarios. He expects that technology-based innovation will be essential for nations to remain globally competitive. China and other key developing nations are making rapid progress, while the developed nations remain mired in a consumption-focused lifestyle made possible by debt and asset sales to nations that have retained their capacity for deferred gratification and high rates of saving. The implications for Australia are obvious. Jonson also identifies Australia as a classic “two-speed” economy in which:

interest rates are in effect waging war against small businesses, or at least those with no direct connection to what is happening in the great mining provinces in the Pilbara or in the NSW and Queensland coalfields or the Northern Australian gas fields … Without far wiser economic management than currently on offer, Australia’s two-speed economy is likely to experience a standard boom-and-bust disaster that will lead to widespread job losses and business failures as interest rates and the Australian dollar rise.

It is hard to see how he could be wrong about this. In any case we shall know soon enough. Though Jonson does not speculate when the two-speed economy will end, the historic pattern of our terms of trade suggests that a steep drop following the current advantageous spike is inevitable. At the very best, Australia’s prosperity can only last as long as the minerals-intensive stage of China’s current wave of urbanisation, after which we will face the consequences of our collective failures of judgment and spirit throughout the good years. 

Great Crises of Capitalism is not without faults. While Jonson glosses over the policy drivers behind the sub-prime crisis in the USA, I would have preferred a more detailed account of the precise origins of the crisis, which is a classic case of regulatory good intentions carving paving stones for the road to hell. Those who go into print to make the case for yet more regulation should be obliged to account in detail for the failures of judgment by recent or current regulators. Readers would greatly profit from finding out about the murky thinking, political opportunism and weakness for social engineering that led the governors of the Federal Reserve Board to sign off on Regulation C pursuant to the Home Mortgage Disclosure Act, which, amongst other things, aimed (in its own words) to “help determine whether financial institutions are serving the housing needs of their communities”. As the sub-prime fiasco illustrated, such failures do not necessarily derive from the wicked impulses of America’s spivs, but from the cutting edge of its respected utopians and activists.

As befits the work of a former reserve banker, Great Crises of Capitalism has a reserved, almost cautious, quality. Thus some pressing matters of current concern are left insufficiently explored. Jonson notes in passing the possibility of America defaulting indirectly by way of hyperinflation, but does not discuss it at any length. Yet credit is by definition an act of faith—one party lends to another in the expectation of being repaid. Government debt involves the expectation that the debt of the current generation will in fact be repaid by the next and that the next generation has both the inclination and productivity to make the requisite repayments with currency that has retained its value over time. The sheer volume of public debt owed by governments at all levels in the USA is now so enormous that repayment is starting to inspire doubt. It is precisely from uncertainties such as this that great crises emerge.

Furthermore, governments of almost all stripes (and their debt-hungry constituents) in the advanced economies have long been happy with inflation high enough to quietly expedite the repayment of loans in modestly devalued currency. Over time inflation works like compound interest in reverse, turning today’s self-funded retirees into tomorrow’s pensioners. It is the inability of the currencies on offer to retain value over time that feeds much of the demand of speculators anxious to find assets whose value will inflate at a higher rate than that of money itself. Jonson’s understandable enthusiasm for targeting asset inflation, however attractive an idea per se, risks exposing the long-term implications of everyone pretending that 3 or 4 per cent annual inflation in goods and services is necessarily a great result for everyone.

Luckily for the reader, flaws such as these are pretty minor. Great Crises of Capitalism has a great many more very attractive features, not least being the author’s good-natured, often dry humour which peppers the text with observations about human behaviour, markets and policy-making. Jonson also has that most welcome of gifts in any author on politics or economics—the ability to explain without ranting and to make a case without imposing a partisan straitjacket for the reader.

Few readers will fail to find food for thought in Jonson’s intervention in the debate about what needs to be done to secure our future freedom and prosperity. Great Crises of Capitalism provides a nuanced analysis of the choices that we must make either now or in the rapidly approaching future.

Phillip Hilton works in Canberra. His book Bitter Honey: Recuperating the Medical and Scientific Context of Bernard Mandeville was published by Peter Lang last year.