The harsh truths discovered in 2009

2009-12-29 12:55


THE best that can be said for 2009 is that it could have been

worse; that we pulled back from the precipice on which we seemed to be perched

late last year and that 2010 will almost surely be better for most countries

around the world.

The world has also learnt some valuable lessons, though at great

cost to both current and future prosperity – costs that were unnecessarily high

given that we should already have learnt them.

The first lesson is that markets are not self-correcting. Indeed,

without adequate regulation they are prone to excess.

In 2009 we again see why Adam Smith’s invisible hand often appears

invisible: it is not there. The bankers’ pursuit of self-interest (greed) did

not lead to the wellbeing of society; it did not even serve their shareholders

and bondholders well.

It certainly did not serve homeowners who are losing their homes,

workers who have lost their jobs, ­retirees who have seen their retirement funds

vanish or taxpayers who paid hundreds of billions to bail out the banks.

Under the threat of a collapse of the entire system the safety net–

intended to help unfortunate individuals meet the exigencies of life – was

generously extended to commercial banks, then to investment banks, insurance

firms, auto companies and even car-loan companies.

Never has so much money been

transferred from so many to so few.

We are accustomed to thinking of government transferring money from

the well off to the poor. Here it was the poor and average transferring money to

the rich.

Already heavily burdened taxpayers saw their money – intended to help

banks lend so that the economy could be revived – go to pay outsized bonuses and


Dividends are supposed to be a share of profits; here it was simply a

share of government largesse.

The justification was that bailing out the banks, however messily,

would enable a resumption of lending. That has not happened.

All that happened

was that average taxpayers gave money to the very institutions that had been

gouging them for years through predatory lending, usurious credit card interest

rates and non-transparent fees.

The bailout exposed deep hypocrisy all around. Those who had

preached fiscal restraint when it came to small welfare programmes for the poor

now clamoured for the world’s largest welfare programme.

Those who had argued

for the free market’s virtue of “transparency” ended up creating financial

systems so opaque that banks could not make sense of their own balance sheets.

And then the government too was induced to engage in decreasingly transparent

forms of bailout to cover up its largesse to the banks. Those who had argued for

“accountability” and “responsibility” now sought debt forgiveness for the

financial sector.

The second important lesson involves understanding why markets

often do not work the way they are meant to work.

There are many reasons for

market failures. In this case too-big-to-fail financial institutions had

perverse incentives: if they gambled and succeeded they walked off with the

profits; if they lost the taxpayer would pay.

Moreover, when information is

imperfect markets often do not work well – and information imperfections are

central in finance. Externalities are pervasive: the failure of one bank imposed

costs on others and failures in the financial system imposed costs on taxpayers

and workers all over the world.

The third lesson is that Keynesian policies do work. Those

countries like Australia that implemented large, well designed stimulus

programmes early emerged from the crisis faster. Other countries succumbed to

the old orthodoxy pushed by the financial wizards who got us into this mess in

the first place.

Whenever an economy goes into recession deficits appear as tax

revenues fall faster than expenditures. The old orthodoxy held that one had to

cut the deficit – raise taxes or cut expenditures – to “restore confidence”.


those policies almost ­always reduced aggregate demand, pushed the economy into

a deeper slump and further undermined confidence – most recently when the

International Monetary Fund insisted on them in East Asia in the 1990s.

The fourth lesson is that there is more to monetary policy than

just fighting inflation. Excessive focus on inflation meant that some central

banks ignored what was happening to their financial markets.

The costs of mild

inflation are ­miniscule compared to the costs imposed on economies when central

banks allow asset bubbles to grow unchecked.

The fifth lesson is that not all innovation leads to a more

efficient and productive economy, let alone a better society.

Private incentives matter. And if they are not well aligned with

social returns the result can be excessive risk-taking, excessively

short-sighted behaviour and distorted innovation.

For example, while the

benefits of many of the financial engineering innovations of recent years are

hard to prove, let alone quantify, the costs associated with them, both economic

and social, are apparent and enormous.

Indeed, financial engineering did not create products that could

help ordinary citizens manage the simple risk of home ownership – with the

consequence that millions have lost their homes and millions more are likely to

do so.

Instead, innovation was directed at perfecting the exploitation of those

who are less educated and at circumventing the regulations and accounting

standards that were designed to make markets more efficient and stable.

As a

result, financial markets, which are supposed to manage risk and allocate

capital efficiently, created risk and misallocated wildly.

We will soon find out whether we have learnt the lessons of this

crisis any better than we should have learnt the same lessons from previous


Regrettably, unless the US and other advanced industrial countries

make much greater progress on financial sector reforms in 2010 we may find

ourselves faced with another opportunity to learn them.

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