Is financial deregulation any longer a credible strategy for maintaining economic stability, asks Colin Teese.
Only a few weeks before the current financial crisis burst upon us, Martin Wolf, associate editor and chief economics commentator of the London Financial Times, warned:
“Much of the institutional scenery of two decades ago – distinct national business elites, stable managerial control over companies and long-term relationships with financial institutions – is disappearing into economic history.
“We have, instead, the triumph of the global over the local, of the speculator over the manager and of the financier over the producer….
“Above all, the financial sector, which was placed in chains after the Depression of the 1930s, is once again unbound.” (Martin Wolf, “Unfettered finance is fast reshaping the global economy”, Financial Times, June 18, 2007).
Wolf was announcing all this only two months before at least part of what he characterised as the new “institutional scenery” took a turn for the worse. At this stage it seems that the durability of the present financial system is being sorely tested. We don’t yet know in what precise form it might continue.
Before the world market for money began to unravel two weeks ago, financial assets had, in Wolf’s words, “exploded”. Speculation in financial markets – concomitant of deregulation – is at the heart of the explosion: first, in the form of “junk bonds”; later, in the birth of speculative trading based on the future movements in capital value and interest rates; and, most recently, the emergence of “hedge funds” and “private equity capital”.
Under that impetus, the ratio of global financial assets to global output of goods and services has jumped from 109 per cent in 1980 to 316 per cent in 2005. Global assets are now valued at $US140,000 billion – an almost unimaginable sum.
Is it any wonder the richest in rich countries have become wondrously rich – and becoming ever more so?
Like the rest of us, back in June Martin Wolf could not anticipate what would happen, but he was alert to the possibilities.
Optimists, he reminded us, held to the view that a speculative system coped with the year 2000 stock market crash and has generally helped stabilise the system. There is some truth in this assertion, providing you are prepared to ignore the role of speculative capital movements in the Asian financial crisis of 1997-99.
Pessimists point to the risks associated with speculative lending. Deregulated markets allow problems to accumulate unnoticed and uncontrolled: the operation of the market tends to ignore problems it is ill-equipped to deal with. The pessimists’ warnings went unheeded, but it now seems they might be proved right.
Moreover, informed opinion seemed to agree with them. The US’s watchdog on financial markets, the US Securities and Exchange Commission (SEC), was certainly worried. Back in 2004 it tried to make hedge-fund managers register with the SEC and submit to some oversight. Its efforts were struck down in the US Court of Appeal. Nevertheless, the SEC Chairman chose not to ask Congress to legislate for change; perhaps he remembered President Bill Clinton’s 1998 public statement that he saw no need to regulate hedge funds.
Right now, presumably, the US wishes its then President had argued differently.
At first it was being said that what we were seeing was nothing more than a timely correction to some bad lending decisions. Instead, what the SEC had already identified as a ticking, speculative time-bomb did in fact explode, setting off a chain reaction around the world. The question now is, when the dust finally settles, how much will remain the same?
We are seeing corrections in asset prices in international stock markets. It seem unlikely that the property market will escape unscathed. As with shares, the greater hardship will certainly be borne by those carrying the most precariously balanced debt burdens.
Nothing like the full picture is yet clear, but a few truths are beginning to emerge. Some of these truths contradict current economic orthodoxy. The editorial columns of the Australian Financial Review routinely extol (and overstate) the role of managing goods-inflation in creating economic stability. They further insist that managing cost-inflation generates the low interest rates we now enjoy.
It is now time to re-examine those assumptions. What most recent developments tell us is that interest rates are a function of the availability of money. In a deregulated market awash with money, interest rates are forced down by the sheer availability of credit.
No matter what the risk, investment funds must find a home at whatever interest rate they can find. And they do – until the high-risk borrowers default in sufficient numbers to cause panic among lenders who then withdraw their funds. This sequence of events is precisely what we are now witnessing.
Panic has caused the cheap money tap to be turned off. But there is a second factor, apart from interest rates, which has helped hold down prices (other than asset prices, of course), and that has been the willingness and ability of China to flood the markets of the spending economies – for example, the US, Australia and Britain – with cheap imports. In effect, China has been exporting deflation to the rest of us.
Those are the real reasons behind our ability to contain inflation.
But it has come with a price tag. While China has been exporting deflation to us, we have been exporting cheap borrowed money to them in order to pay for the cheap imports. China has become rich. Thus far it has been prepared to invest its accumulated export surpluses in US Treasury bills. This mechanism has allowed the US to fund its import bill.
The delicate balance of all this could easily be disturbed. Indeed, some kind of imbalance is quite likely to be generated, either by the conscious or unconscious acts or China or the US – or by both in some kind of reaction.
How? Well, the Chinese export surpluses are maintained by China artificially holding down its exchange rate against the dollar. Worried about its mounting debt problems, the US is pressuring China to allow its exchange rate to rise against the dollar. If it does not, then the US may well act to curtail Chinese imports into the US.
If this were to happen, then Chinese growth, which is currently being maintained at unrealistically high levels, would fall significantly. The impact of this would reverberate throughout world markets – because, at the moment, Chinese growth, based as it is on cheap money and cheap goods, is driving world economic growth.
This is an absolutely crucial point. China is not yet the largest economy in the world (though it is heading in that direction), but it is the world’s powerhouse. If the US takes any action which noticeably slows Chinese growth, the entire world will be affected – and most notably affected in the deregulated financial markets of spending economies of the English-speaking world. For the last quarter of a century, most of their economic growth has been generated by financial activities.
That’s one side of the equation based upon possible corrective action by the US. Suppose the US curtails Chinese imports – which is quite likely, given current US sentiments. Certainly, there are concerns in the US about the growing power of China, quite apart from trade and payments considerations. What would be the likely Chinese response? It’s hard to guess, but it is unlikely to be helpful to the world economy.
The Chinese could, for example, sell off its massive holdings of US Treasury paper. The implications of any such action, in itself, would certainly be profound. But that would not be the end of it. Presumably, China would also seek to emulate every other emerging economic power and seek to invest its surpluses in productive assets around the world.
The extent to which it was frustrated in these efforts would certainly generate new global political tensions. Such frustrations almost always have. No less important is that keeping China out of that loop would undermine the credibility of the Western economies as defenders of open borders. What would flow from that can only be guessed at for the moment.
It is, of course, perfectly possible that all of these problems can, and will, be resolved by international cooperation – though, in the present climate, quite how that might be arranged is not immediately obvious.
What does seem clear, however, is that the issues which have led to, and appear to underwrite, the present crisis will not be addressed, let alone solved, by continuing to insist that the fundamentals of our domestic economies (and, indeed, the world economy) are all correct. Yet this is being insisted upon by Western leaders backed up by the heads of their central banks.
The fact is the fundamentals are not okay. For a start, financial deregulation – with nothing more behind it than intervention by central banks to manage interest rates – seems no longer a credible strategy for maintaining stable economic conditions. Even John Hewson, former Liberal Party leader, said as much in a recent article in the Australian Financial Review.
The situation is no better when we look at international economic management. The reasons are beyond the scope of this article (but will form the subject of a separate article at a later time). It is sufficient to say now that neither the World Trade Organization nor the International Monetary Fund is any longer able to generate international economic cooperation in the way it was intended when the Bretton Woods Agreement was concluded at the end World War II.
The fundamentals cannot be said to be okay until these issues, among others, have been satisfactorily addressed. Right now, we are a long way from doing any of that.
– Colin Teese is a former deputy secretary of the Department of Trade.