Learning the lessons

Anna Schwartz co-authored with Milton Friedman the signature piece of work on money and economic stability. Now 92 and still working, she recalls that in 2002, US Federal Reserve Chairman, Mr Bernanke, said in a speech in honour of Friedman's 90th birthday, "I would like to say to Milton and Anna: regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

In fact the hubris of those in charge of policy intervention is never having to say sorry - at least for their own actions. Federal Reserve Chairman Bernanke and before him Alan Greenspan, as well as Australia’s Reserve Bank chiefs Glenn Stevens and Ian MacFarlane, thought they knew the solutions to avoiding a re-run of the Great Depression.

And yet, and yet!

The prologue to the current crisis was the same effervescent money supply expansion we saw in the 1920s. Easy and cheap money caused the same asset price inflation. Uncertainty over how long this could last and belated attempts by the authorities to rein it in led to the Great Depression. Central bankers then and now, wanting to be nice guys, oversaw a shoveling out of money into the economy. In doing so they were sowing the seeds of disaster.

The recent period of debt accumulation fuelling asset inflation is instructive. For Australian households, debt to disposable income increased from under 40 per cent in the period to the mid 1980s to over 150 per cent by the mid 2000s. Although asset values also increased, this still left a massive rise in debt net of assets. And the value of assets (especially houses and shares) that underpinned most of that debt is now heading south.

Interest rates were held too low for too long and a level of housing stock that zoning regulations have kept in tight supply was the obvious outlet for the Reserve Bank’s monetary excesses. Households’ interest payments on homes, historically at less than 4 per cent of disposable income, ballooned out to double this by 2004 and, with the interest rate increases since then, in June of this year approached 12 per cent.

As with the Great Depression, governments are now “reflating”. In doing so, they are taking the advice of the very Reserve Banks and Treasury Departments that pulled the levers which caused the problem. Governments and Reserve Banks are lowering interest rates, handing out cash and supporting financial businesses with suspect assets.

This time last year, the Reserve Bank was forecasting growth a tad lower than the previous year’s 4 per cent. It now sees growth in June 2009 at only 1 per cent.

Notwithstanding last week’s forecasts by the OECD of positive growth for Australia, even this looks optimistic. Worldwide, reductions of 20 per cent are now being built into many firms’ production schedules.

For Australia, the world financial collapse has shown we were over-reliant on foreign capital that was indirectly financing consumers’ spending. We now need to save more.

But the government’s knee-jerk reaction to the economic downturn, in addition to slashing interest rates has been to give consumers money to increase their spending.

Canberra has already handed out $10.4 billion to promote more consumer spending. As ever, the problem is not a shortage of demand. It is that people have become over-extended and with assets overvalued they have to repair their real levels of savings. Disposing of the budget surplus in a spending spree means releasing funds that previously were locked up in forced savings by taxpayers. But those forced savings were, serendipitously, partly compensating for the savings diverted into speculative activity.

If pushing $10.4 billion money into the economy to promote consumer spending were capable of doing the trick why not increase the largesse tenfold? There is no documented case of hand outs averting a recession. As is testified to by many inflation prone third world countries, unless the productive potential is there, more money will not bring increased output. And Australia’s productive potential has been diminished in recent years by wasteful investments and by regulatory impediments to development, in assets like wind farms, as well as in inflated housing.

Other measures being undertaken are similarly doomed to failure.

A host of infrastructure projects are queuing up for Commonwealth support. Some of these may be useful. But you can bet your government-guaranteed-bank-savings that those getting the tick will include lots of wasteful investment into public transport, desalination plants and other uneconomical projects.

The government has given $22 million to ABC Learning which had gone bankrupt. But ABC Learning’s failure was not due to lack of demand. ABC Learning was actually underpricing its services, and had been accused of pricing low to force out competitors.

The overwhelming number of ABC Learning’s 1,040 centres clearly generate sufficient cash to stay open. Most of those identified by the firm’s receiver as unprofitable can probably take pricing or other management action to remain viable. But the Minister, Julia Gillard, preferred $22 million of taxpayers’ insurance rather than watching any centre close down amidst heart wrenching appeals by parents.

ABC Learning getting $22 million of taxpayers’ funds was chicken feed compared to Canberra gifting $6.4 billion to the car industry, which the government sees as strategic for all industry. But granting firms blood transfusions of taxpayer money will only defer their collapse or, at best, their downsizing.

The coming recession will mean a string of businesses looking for similar government support and marshalling a case that they are “strategic”.

Part of the car industry subsidy was to pursue the mirage of the Australian green car. Linking the environment and job support is becoming increasingly fashionable.

In-coming US President Barack Obama has said he will create five million green jobs in alternative power resources based on wind, and solar. Maybe instead we could replace conventional power stations with people generating electricity by push-bike! This would create jobs but, like those created producing alternative energy, the accompanying subsidies and high costs would destroy far more jobs.

When emerging from Communism, Eastern Europe faced far worse dilemmas than those currently confronting the Australian government. In 1992, Hanna Gronkiewicz-Waltz found herself Chairman of the dominant Polish bank. Her frequent response was to reject claims for bail-outs and financial infusions arguing to the applicants, “you say these are valued assets but all I see is debts and losses”.

Forcing overweight businesses to slim down and divest their poorly performing parts proved to be necessary surgery. In post-Communist Poland, as in present day Australia, those businesses that can show an ability to profitably supply goods and services that people want will always find backers.

If we are to avoid a lengthy and costly recession, Australian governments need to absorb these lessons.

Simply reducing interest rates does not solve the problem, which is that assets are overvalued - and some financial businesses which have highly leveraged loans are holding some assets that are worthless.

While we should release funds that have been taken from the community in over-taxation we must simultaneously remove many other inflexibilities that have diverted savings from productive venues, as well as having reduced the real level of savings. Above all, we must recognise that many assets, especially houses, are not worth as much as we thought they were. Having done so, we have to allow asset prices to fall to their underlying market value.