In the annals of economic history the key change in the past two decades has been the return of depression economics worldwide. What does this mean?
Through the post-WWII period to around the end of the 1980s, Keynesian economists had concluded that contemporary economics had licked the business cycle to such an extent that depression scenarios in which enduring economic slumps with high and intractable unemployment was no longer an issue.
As the millennium drew to a close, the best of global economists realised that this was no longer the case as rolling crises took hold in emerging markets. Paul Krugman was out front, at Foreign Affairs:
In the spring of 1931 Austria’s largest bank, the Credit Anstalt, was on the verge of collapse. The Austrian government could not simply stand by and let it fail, but when it came to the bank’s rescue with large sums of freshly printed domestic currency, the resulting capital flight rapidly depleted Austria’s gold and foreign exchange reserves. The obvious answer would have been to abandon the gold standard and let the currency float. But this solution was unacceptable — not just because a drop in the schilling’s value would magnify the burden of foreign-currency-denominated debt, but because a currency devaluation would deal a devastating blow to the confidence of a country whose memories of post-World War I hyperinflation were still fresh. Austria pleaded for help from its neighbors and the then-new Bank for International Settlements, but the offered assistance was too little, too late. In the end, the desperate government resorted to capital controls.
It is a familiar story to economic historians. It is also astonishingly modern-sounding: if the plot does not exactly fit any one of today’s crisis-ridden economies around the world, it does sound very much like a pastiche of recent events in Indonesia, Malaysia, and Brazil. The main difference now is that financial rescue attempts from the international community have become routine. When a country gets in trouble today a swat team from the International Monetary Fund and the U.S. Treasury quickly arrives on the scene. Suppose, however, that the IMF could use a time machine to send its best money doctors back to that Vienna spring of 1931, but without the ability to offer a huge, no-questions-asked credit line on the spot. What would today’s experts say? What could they tell the Austrians that they did not already know?1
Most modern economists — to the extent that they think about it at all — regard the Great Depression as a gratuitous, unnecessary tragedy. They believe that what might have been an ordinary, forgettable recession became a nightmarish slump thanks to the stupidity (or at least the ignorance) of policymakers. If only the Federal Reserve had not been preoccupied with defending the gold standard instead of the real economy; if only Herbert Hoover had followed an expansionary fiscal policy instead of trying to balance the budget; if only policy in general had not been governed by a “liquidationist” philosophy that saw short-run economic pain as a necessary purgative for previous excesses — then the catastrophe could easily have been avoided. And since we know better now, it cannot happen again.
Or can it? As little as two years ago I and most of my colleagues were quite confident that although the world would continue to suffer economic difficulties, those problems would not bear much resemblance to the crisis of the 1930s — because economists and policymakers had learned the lessons of that decade and would never again perversely tighten monetary and fiscal policy in the face of recession. True, Mexico suffered a severe slump in 1995 and Japan’s economy had stagnated since 1991, but these appeared to be special cases, easily rationalized as the result of exceptionally misguided policy.
Perhaps we should have known better and realized, for example, that the dilemma Austria faced in 1931 could just as easily arise in the modern world, and that now as then there are no good answers. In any case, there is no mistaking the lesson of the terrifying economic and financial events of the last two years: the economic crisis in Asia, its spread to Latin America, the deepening slump in Japan, and the brief but ominous panic that swept bond markets last autumn. The truth is that the world economy poses more dangers than we had imagined. Problems we thought we knew how to cure have once again become intractable, like temporarily suppressed bacteria that eventually evolve a resistance to antibiotics. More specifically, the problem of aggregate demand — of getting people to spend enough to employ the economy’s productive capacity — is not, as we might have thought, always a problem with an easy solution. While it may often be possible for countries, especially large, stable, self-sufficient economies like the United States, to handle recessions simply by printing more money, we are finding an increasing number of cases in which countries find either that they cannot apply that same medicine or that the medicine is ineffectual. There is, in short, a definite whiff of the 1930s in the air.
This was written 1999. We know that since both developed and emerging markets have seen accelerating and deepening shocks including the world’s first global financial crisis since the 1930s. So what’s gone wrong? And how is it fixed?
There are three fundamental drivers to the demand deficit now experienced in developed economies:
- a diminishing demographic tailwind as Baby Boomers die off;
- de-industrialisation and the failure of productivity growth;
- financial deregulation leading to enormous debt stocks and rising economic inequality.
All of these forces sap demand and sustain supply leading global inflation into a permanent funk.
Not all developed economies have suffered the same three curses at once. Some have managed them much better than others. But the trends are roughly the same everywhere.
In Europe, northern economies have not de-industrialised, have remained competitive and prevented or contained debt explosions as interest rates fell globally. Inequality has spread but less so than elsewhere. But southern economies have all been devoured by the depressionary forces, not least because the policy responses of the dominant north has been to refuse the south fiscal relief even as their private sectors deleveraged. Combined with the straight jacket of a common currency with no separate budgets or interest rates, their adjustment has been forced inwards onto labour markets with huge unemployment and wage deflation.
Within the Anglosphere countries the same depressionary processes transpired basically uninterrupted by corrective policy-making until reaching the point of financial crisis in 2008. Since then, they have used strong cyclical fiscal pulses and unconventional monetary policy to support aggregate demand while private sectors deleveraged which, crucially, also sank their currencies boosting tradable sectors. These economies have thus largely forced the adjustment external, a much better idea for their respective polities. Where this policy prescription has come undone is in the failure of governments to correct inequality, which the remedy of external adjustment can make worse via rising asset prices at home.
Australia has faced exactly the same set of depressionary forces but has been fortunate to have a Chinese tailwind to aid its struggle. This delayed the full reckoning by one business cycle, with high terms of trade and booming mining investment supporting higher interest rates and less finaincialisation up to 2011. But that ended with China’s slowdown and, stupidly, rather than learn the lessons of the rest of the world we mistook ourselves for different and exhausted our advantage by allowing one final giant asset bubble to blow off in housing. Even so, we’ve been unable to fix a weak labour market with persistently high underemployment. Now we too face the great private sector deleveraging and the choice of what to do about it, internal or external deflation.
That is where we come to the main point of this post. There is so little acknowledgement of this broader context in the wider Australian economic debate that if we don’t wake up to it soon then we are almost certain to again repeat the mistakes of other nations. To wit, John Kehoe at the AFR last week, a recently appointed guardian of contemporary economic thinking:
When Reserve Bank of Australia governor Philip Lowe hosts an annual lunch with his predecessors at the central bank’s Sydney headquarters, he is met with bemused looks from former RBA heads when he talks of his determination to lift wages and inflation higher.
…Warren Hogan, economics professor at UTS Business School…argues the RBA’s 2 to 3 per cent inflation target, set up in the higher-inflation 1990s, is too high and outdated in the modern global economy.
…Former RBA board member Warwick McKibbin has called for the RBA to adopt nominal-GDP targeting, instead of inflation.
But he too has said the RBA erred in cutting rates twice in 2016 but has since missed the boat on moving rates higher.
…Economist John Edwards, who left the RBA board in mid-2016, says his view is the RBA will “not cut interest rates”, betting on the US-China trade war ending and the US economic expansion continuing.
“I still think the next move is up, but I would have to concede it probably won’t be in 2019,” Edwards says.
…Grant Samuel Fund Management adviser Stephen Miller says monetary policy is “pushing on a string”.
“We’ve probably done all we can with monetary policy, so if we think a stimulus is needed in the future, it should fall to a well-designed fiscal response targeting consumers through income tax cuts or cash payments,” Miller says.
Seriously? After a thirty year debt boom, why are we arguing over whether or not the RBA cut rates too many times at the finish line? This cyclical chest-thumping has been cheered on by the Shadow RBA and the RBA itself, both of which have totally misjudged the structural nature of the depressionary forces in favour of cyclical tools and remedies. This has largely been made possible by their fixation with the Pitchford Thesis, which says that debt accumulation by private individuals is always a good idea, Australia’s version of the spectacularly discredited rational market hypothesis.
The implications of this total failure of imagination in the Australian economic community is now about to become very much more painful. As the housing bust gets worse, unemployment takes off and inflation crashes, their response will determine how Australia’s first real confrontation with the return of depression economics is addressed.
So far the signs are not good. As house prices and inflation crash, the choices before us are very simple. We can go the European route being recommended by all and sundry of preserving the Budget, holding interest rates and currency too high and the adjustment will be foisted entirely onto local labour via higher unemployment and deflating wages. Or, we can go the more sensible American rout of slashing interest rates, printing money and supporting aggregate demand with fiscal spending that crashes the currency, forcing as much of the adjustment as possible externally.
Obviously we should go the American rout but do so with much more remediation policy to lean against the risk of greater economic inequality.
Australia does have one other tool that is an advantage that other nations lack in immigration policy. But that is only an advantage if it is used properly. Overly high mass immigration has already played the key role in crushing wages and productivity growth (via resource misallocation and crush-loading) in this cycle. As unemployment rises ahead, overly high immigration will do great harm by making both much worse again. Indeed, if it is run too strongly, mass immigration could force the growing deflationary adjustment nearly all onto labour. My best guess is that the rate of immigration should be roughly halved to prevent this, which will still offer support to aggregate demand but limit the labour supply shock to much more targeted, high value and specialised vocations, as well cure the crush-loading of cities. Both will lift private sector incomes more quickly than otherwise, as well as help lower interest rates and the currency.
One final word must be added on the forthcoming election. The Coalition Government has shown zero awareness of this economic context. It appears wedded to tight federal budgets and surpluses even as the private sector aims to do the same, running full bore against the basic accounting identities of GDP. Plus it wants to run mass immigration at out-of-control levels. It appears to have no interest in equity and wants to sustain and grow the very debt bubble that is the number one symptom of depressionary economics in the first place. In short, it has learned absolutely nothing from the last decade of economic strife globally and, as it turns pear-shaped here, the Coalition may end up being what the Great Depression described as a “liquidationist”, ensuring that as much of the adjustment as possible is forced internally.
Labor has a much better mix of policies to deliver an externally led adjustment. It is offering huge tax reforms that will re-distribute asset inflation tax rorts to lower income household via income tax cuts. This is a direct support to greater equity, productivity and aggregate demand while allowing the asset price adjustment and enabling a lower currency. It is more likely to let go of any federal surplus with other fiscal spending supports. It’s major drawback is that it is a mass immigration extremist which will work against everything else that it is trying to achieve. As this failure becomes apparent it may be forced to re-regulate labour pricing to generate pay rises but given profits will still be weak this will only result in less jobs and lower wages anyway.
It is not clear that any Australian authority has a grasp of the magnitude of the depressionary monster stalking the nation.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.