Time for more reflections on the financial crisis, starting with seeing whether my predictions of two months ago have come true, followed by observations on a new set of unexpected twists, and rounded off by a set of policy recommendations for how to reduce the severity of the recession.
Lets start with reviewing my October predictions and their outcome, to see whether my crystal ball is worth anything and hence whether you should read the policy recommendations:
- I predicted that mortgage holders would be the grand winners of the crisis. This is obviously true. We are currently talking a drop of about one-third in mortgage payments which can be expected to become a drop of at least half. As a result, the media has stopped all talk of mortgage-stress. Mortgage-belt Australians no longer need fear eviction. Renters, on the other hand, are losing. Renters for years have enjoyed extraordinarily low prices due to the expectation amongst the owners of their house that the value would keep rising (making them willing to charge less than the full price), but are now being asked to start paying the full price of the house they stay in. Over time, this means low-income families will be pushed outside the city centres, away from where their jobs are. Expect more ghetto-like suburbs on the outskirts.
- I predicted mass-unemployment in the financial sector with good times for economists. The former is clearly the case: the major banks have started to reduce their investment groups and hedge funds are on their way out. Only 6 months ago it was hard to find financially trained people, now they pester you with their cvs. Economists on the other hand are, as predicted, in great demand. Economists are like the undertakers at a funeral: quite busy. Not only are we popular with every member of the family wanting to know about the recession, but the preliminary enrolment numbers for our courses also look up, particularly from Asia (see the various articles listed here). Its a known fact that people tent to stay in education longer during recessions and this one seems no exception.
- I said Keynesianism is back. The Australian had a decent piece recently on the return to the fold of Keyenesianism within economics (though it never was quite absent) and I confidently predict a surge of papers on Keynesian themes like contagion and information cascades.
- My assessment was that the US plan to take over toxic debt was too hard to implement and that it should follow the UK plan of buying shares in banks. This has now been universally recognised (not because of me, of course: whole hordes of economists said much the same) and the Americans have abandoned this part of their scheme and decided to adopt the plan of the Brits to simply buy equity in banks. I find it amazing, by the way, that the US congress has allowed this to happen without any further fight. Just reflect on what has effectively happened here: 700 billion dollars, or roughly 5% of US GDP, was earmarked to be spent on toxic debt, and is now suddenly spent on something else without going back to congress for extensive approval rounds. This is equivalent to deciding overnight not to spend anything this year on education and instead spend it on something else! Would you get away with that in this country?
- I denounced political talk about restrictions on CEO pay to be mainly hot air because the underlying issues were too complex and it would be really tough to legislate against it. Indeed, talk of interfering with CEO pay have now been reduced to a few token protestations that bail-out money cannot be paid to CEOs, but no general moves have been undertaken to counter-act the self-enrichment of managers in the economy. No doubt libertarians rejoice over this.
- Political talk on concerted international action to regulate the financial markets was said to be hot air. This was an easy prediction to make and has so far proven spot-on. The moment that Sarkozy stood up at the G8 and said any plan would have to make sure the worlds poor would have to be catered for, is the moment any sane observer would have known there wasnt going to be a plan. Different countries have different interests, with the countries that have something to gain by lax financial regulation frustrating any efforts by the others to get an effective global system. I still think a Tobin tax would be a great policy to enact, but cannot see it happen.
- The bank deposit guarantee was deemed an ill-thought out plan that would hopefully quietly disappear. This is the one prediction that has not quite materialised. The fact that the plan was made up after it passed through parliament is now well and truly understood (the details only became known at the end of November), but the deposit guarantee is still with us and is having distortionary effects (see below). I did hedge my bets in my predictions by allowing for the proposition that politicians have such a wish to avoid losing face that they might go ahead with the guarantee despite its failings. This is indeed unfortunately what happened.
Let us consider the surprising new winners and losers of the last 2 months:
- Funnily enough, the worlds poorest seem to have been provisional winners of the crisis. This is mainly because the price of food and fuel, staple items in every country, has dropped significantly (food has dropped about 35%) in the last few months due to the drop in world demand. Great news for Africa and the poorer parts of Asia!
- Government debts have become much cheaper to roll-over. The main reason for this is that real interest rates have gone down to roughly 0% in many parts of the world, allowing governments to roll over their high-interest rate debts into low-interest rate debts. This is particularly true for the US government which has seen a flood of loose money looking for a secure haven. It has been a real surprise that investors have chosen to hang on to their US dollars in stead of selling them and investing in industries in other countries.
- Private investments might start to suffer from the bank guarantees (commercial finance has dropped about 30% so far this year, see here): banks and individuals have become exceptionally risk-averse, putting all their money into bank and government assets. Its a classic case of the crowding out of private investment by government borrowing. The bank guarantee can strongly aggravate this tendency because it favours the holding of deposits over other investments, hence draining money out of investment funds. In this way, the coming recession might well be created by the reaction of the governments, i.e. by distorting the relative returns on various investments.
- Skilled migration might lose, though it is early days yet. Unions are calling for the Australian government to prevent the inflow of newcomers, but business is resisting this. In the past, governments usually reduce immigration in bad economic times so I guess it is still on the cards. I predict it to be a serious mistake to reduce migration at this time, mainly because migrants spend a lot of resources when they are new into a country: they have to buy cars, homes, furniture, clothes, etc. Skilled migrants are not poor and hence have quite a bit to spend at the start. Just as important, skilled migrants are in essence direct transfers of resources from other countries to Australia: for nothing, we are getting a huge slab of human capital paid for by another country. This human capital boosts production at times when other investments in capital go down. Wed be nuts to reduce the inflow of large spending power and human capital at this moment, particularly given the incentives for Australian universities to have low-quality degrees (see here).
- The environment has been seen to be a loser, but this is a mirage. One might think that the reduced attention to the carbon trading scheme, and the inability of the international community to unite on a common approach, is proof that the crisis has hurt the environment. Indeed, one might argue that the obscene amount of stress caused by the mere prospect of the population being only as wealthy next year as it already is this year, is proof of the re-assertion of the growth fetish and the loss of the environment. However, this would overstate the chance that carbon reduction schemes stood in the first place. As I have argued before, the world is not going to seriously do something about carbon emissions as long as the decisions are made by competing nation states that each have an incentive to free-ride on the others. The crisis merely provides a convenient excuse, but in reality true change was never on the cards and its derailment has been an on-going process long before the crisis.
So, what should our government do if it would want to make the coming recession a short and shallow one? The most important drivers of the recession are out of its hands, but there is a whole raft of things it then can and should do in my opinion:
- Maintain high levels of skilled migration. Skilled migrants need to buy a lot of stuff to get going, implying a quick demand boost. Also, their skills are useful to get productivity increases going, as Bruce Chapman argued before: they are the front-line troops of business investments. They represent free gifts from other countries and to increase barriers to skilled migration is to invite a longer and deeper recession. Also, they usually do not have access to welfare benefits for the first 2 years, meaning they can only become a drag on the state after the recession has ended.
- No more bail-outs of failing industries. A common political mistake is to think that one can bail-out one industry without any other industry loosing. However, you can only subsidise one area of the economy by taxing other areas, hence the bail-out to a failing industry comes at the expense of making other industries less competitive. One should not expect the recovery to come from the bailed-out industries either, but rather from the other ones. Hence, the more you tax the succesful industries to bail-out the failing industries, the longer you will be in recession.
- No stringent restrictions on the ratio of childcare nurses per baby in childcare facilities. There are now hints by the likes of Maxine McKew in the corridors of power that we should have have a maximum of 3 babies per childcare provider. This will increase the cost of childcare, thereby driving many mothers out of employment and directly reducing employment for low-skilled workers in the childcare industry.
- An expansion of generic skills education to avoid long-run welfare dependency. This recession will lead to a whole glut of new entrants into the unemployment pool. Under the current system, they have strong incentives never to return to work but, rather, to become a lone carer or be absorbed into the disability pension pool. At present, there is no real barrier to doing this and one should hence expect a large boost to the number virtually permanently on the various welfare schemes. Under a welfare-as-usual scenario, the government will try to pester those on unemployment benefits (New Start) into a job but will not tinker with disability or welfare payments for lone parents or other carers. I predict widespread use of these escape valves by the new glut of unemployed unless these escape valves are seriously tightened. Even then, it should simply be noted that the unemployed-to-be are unemployable with their current skills and health problems. There is no easy short-run solution, because this is an issue of life-long learning and of learning generic skills rather than specific skills. The only short-run solution that is remotely possible is to reduce minimum wages and make welfare time-limited. This essentially forces a lot of low-employability people onto low-wage jobs, but this might be politically difficult and is not a long-term solution.
- Private investment should be encouraged, if need be via a government investment bank. The danger is that private investment will be crowded out by government borrowing to fund second-rate infrastructure projects. Governments will prime the pump anyway via the tax and welfare system and the level of additional spending it has engaged in so far seems roughly appropriate at the level it is now. Any more will probably lead to crowding out. It is from the private sector that we expect the recovery to come and, given the slump in minerals, this will be mainly the service sector and the agricultural sector, perhaps even the eco-sector. To allow this to happen, the government should take the usual steps to get banks to lend to private investors: allow the RBA to reduce interest rates further, and allow skilled migration to fuel business investments.
- We should take this opportunity to remove the inefficiencies in the agricultural sector (i.e. the various forms of cross-subsidisation via water allocations and distortionary drought subsidies) in order to allow more rational investment in this long-term growth sector of our economy.
- Minimise the additional red tape inflicted upon the economy. Canberra is working overtime at the moment to pump out legislation on a whole raft of issues (additional labour laws, childcare laws, additional financial and accounting regulation, tax reviews, etc). This activity is also a form of government employment creation, but not a form that is very useful for other sectors if done at a frantic pace during a recession. A tongue-in-cheek suggestion would be to send a box full of sedatives to Canberra.