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October 28, 2008



Hi Michael, I'm sorry I can't say that I agree with the goal to "reflate the economy, put money back in, create more activity." After the misdirections of a credit and consumption boom, an economy needs to be rebalanced as people must start to save again and resources must be directed away from the previously inflated sectors. In the short term this necessitates a painful recession. It's appropriate that there be a slowdown as the market adjusts to the new realities. The supply of credit should at the least stop rising quickly, and might even need to fall. Employment should exit the inflated sectors and re-enter the neglected sectors of the economy. Asset prices should fall dramatically and consumer spending should also collapse as people build up their real savings.

The only types of things a government can do in this environment is to redistribute the losses and prolong the misdirection of resources which characterised the boom. Many governments in recession choose to do the worst the possible things (e.g. impose price controls or attempt to print enough money to bring back the boom) and thus cause massive destruction. But the problems were caused by huge economic misallocations, and only dramatic and painful market reallocations can fix them. Governments can't possibly perform this function of reallocation, yet their political incentives are almost certainly going to be in favour of preventing it.

Michael Taft

Graham, thanks for your comment; as always, clear and cogent. But, of course, you won't be surprised that I, in turn, don't go along with your analysis. Let's take one aspect of the current recession: the financial crisis. This arose largely as a result of the deregulation of financial markets - by governments who went along with the neo-liberal tide in the 1980s/90s. This allowed a relatively handful of players to recklessly gamble unbelievable sums on 'financial products' that were flawed. Under a regulated regime, this could have been stopped. Government policy allowed this to happen, government policy can prevent this from happening in the future.

In the meantime, why should competent and profitable enterprises suffer from the resulting credit squeeze? They are, as we all are, collateral damage inflicted by an unaccountable few. This raises not only questions of economy but of democracy as well.

It also raises the issue of whether one allows the 'market' to rectify the financial mess. Would one really propose letting banks sink? The fall-out would be incredible and people who have acted in an economically responsible manner would be hit. This suggests a role for the state to protect the innocent from the economically guilty (just as in the neighbourhood).

We could apply this same analysis to the Government's ill-conceived stoking of the property market. Had a more rational policy been in place, we might be in a better position to 'weather' the current storm. Again, the debate is over the kind of Government action we need, not whether we need one at all.

We all need a better understanding of how markets and market forces operate - and in this respect many of the points you raise should be taken on board by all of us. As you know, I have constantly exhorted the Left and trade unionists to take markets seriously. After all, the one group of people who most want companies to be successful are the emloyees - because this will enhance wages, working conditions and job security. Just as in life, there are certain 'laws', a certain logic in the way markets work. We ignore and defy them at our risk. To first learn the processes, helps us minimise the risk and increase the chance for success.

However, I suppose where we might diverge, Graham, is not so much over the particulars of an expansionist approach; rather I suspect it might be that I see markets as something socially constructed. The rules, the parameters, the goals, and the bottom lines of market activity are defined by society - using the state as a tool to democratically determine how markets can serve the larger social need. But no matter how much we all diverge, it is important that we maintain a debate that can instruct us all. And in the process, who knows, we can from time to time steal good ideas from each other.


Thanks for the most civilised reply, Michael.

I guess that from my perspective there is no causal relationship that makes sense to me which could link "deregulation" with the business cycle. Empirically, I'm not even sure how much deregulation actually occurred (for example, Sarbanes-Oxley was passed in the US in 2002 which involved far greater regulation of accounting and other business practices).

If the idea that regulation can cause a business cycle is explained to me in some kind of a logical economic framework then I will certainly accept it and see if it can be applied to what has happened recently but I am yet to be able to do that.

It makes infinitely more sense to me that what really causes the business cycle are artificially low interest rates and booming credit supplies being injected into an economy. This can be exacerbated by other manifestations of government power, e.g. observe that FNME & FRE were sponsored by the US government and enjoyed implicit guarantees of being bailed out in a crisis, thus creating huge moral hazards.

I notice that many people apparently believe that the existence of complex financial products is at fault here, e.g. the much-maligned mortgage-backed securities and other derivatives. But these products are designed expressly to manage risk, not to increase it. And it's inevitable that sometimes people will miscalculate the value of these things and suffer losses as a result. The problem with the MBS was not really their complexity - the problem was that the underlying assets gradually became worthless, and also that favourable credit conditions had enticed large numbers of institutional investors to leverage up on them. If the mortgage-backed securities had been less complex the only difference would have been in the distribution of losses. As it happened, the losses were distributed such that those who had accepted greater risks in to their investments did indeed get crushed sooner. Everybody else got crushed too, but they would have done so even without the complexity of the products.

While I would accept that government regulation could indeed shut down these markets to some extent and thus prevent the malinvestments from occurring, it doesn't follow that we'd be any better off as a result. I don't see how a government could possibly distinguish between malinvestments and genuinely strong investments. And shutting down a market would clearly result in even less economic calculation than takes place in a partially free, inflated market.

As for rescuing banks and other firms from going out of business, I think that is going to cause far more terrible moral hazard than had occurred previously. Any sort of economic intuition would imply that allowing firms to play with taxpayers' money is going to cause even more wasteful activity than had previously occurred. And whlie it's true that the State could appoint its agents to the boards of those firms it props up from collapse, then we are clearly on the road to even more corporatism or socialism.

Letting banks fail would be painful in the short run, but pain is inevitable after the destruction of a credit boom. A booming economy like we had in Ireland is simply unsustainable and there's nothing anybody can do to keep it going. The unfortunate truth is that many firms probably should go out of business in this environment, at least temporarily. The painful adjustment to new conditions is what the economy needs to get back on the right road. It's possible that many of the more extravagant business enterprises which sprung up during the boom years would not prosper in a productive economy. It's important that the market figures out which ones should fail.

The deflation of a credit crunch is unfortunate for some, but falling prices also benefits some. And those businesses which really are sound and can prosper in a sound economy will suffer with everyone else for the time being but that's just another inevitable backlash of our phony economy.

Anyway, thanks for letting me comment and I'll talk to you again soon.

Michael Taft

Graham, will get back to these points soon. I would have thought that deregulation was now accepted as a contributing factor to the current crisis but I'll try to find a more detailed summary of this argument for you.

Just a quick point - I certainly do agree with you on the issue of moral hazard. If this is not handled correctly, then the spectre of irresponsible behaviour being bailed out by the state could find an unwelcomed precedenct. That's not an argument against bank bail-outs; but it is an argument for extreme caution. On the other points, as I said, I'll get back to you.

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