29 October 2008

We can't live on moonbeams and air ~ Feil

Or the orthodoxy of Equilibrium theory.

WE OFTEN believe that proverbs are true. "We learn from our mistakes" is an obvious example of a proverb that is demonstrably untrue in the rarified atmosphere of modelling for market economic policy development.

The depression of 1930, the credit squeeze of the early 1960s, the recessions of 1987 and 1991 and the current world economic meltdown all have one thing in common. They happened after a boom that people thought would never end. They resulted from market excesses and levels of consumer spending that ignored fundamental concepts such as living within your means.

The world economy in 2008 is a direct consequence of the view that markets should not be influenced by governments. The market and the consumer had to be free to make their own product development choices and consumer decisions.

Free-market economics has been the cornerstone of the Productivity Commission's philosophy for the past 30 years. At the same time Reserve Bank economists were also captured by free-market ideology. This led to their conclusion that the RBA should not intervene in the market except to manage the level of inflation.

Since then the RBA has had no role in managing Australia's foreign debt, which now stands at $650 billion.

This view followed the assumption that the debt was a consequence of transactions freely entered into by parties behaving rationally. Accordingly, the debt outcome was an efficient transaction decision.

For more than 20 years the RBA has focused its attention on inflation. This has been regarded by the past three governors of the Reserve as its fundamental task because inflation would result in higher prices, reduced consumer demand and a downturn in economic activity.

This is not really a large enough role for it. The Reserve's record of correctly guessing the right time to increase or decrease interest rates is not impressive.

In any case this is not a large enough role for the bank's high-powered staff.

The Reserve employs hundreds of clever economists and econometricians who have written a large number of erudite and well-researched papers on several issues relevant in the Australian economy. The papers are freely available in the publications section of the Reserve's website.

The Productivity Commission also employs hundreds of economists in what has become an almost inquisitorial commitment to free-market economics. They have burnt rent-seeking heretics for 30 years. They will not tolerate backsliders in their own ranks.

Many readers cannot follow the gist of the RBA and commission's research papers because they include substantial econometric analysis to model the outcomes from the data collected by the author.

Econometric modelling is a fundamental analytical tool of all professional economists. It operates on the basis that some assumptions are necessary to permit the modelling to proceed in an ordered and controlled manner.

The assumptions and conclusions should be tested empirically against outcomes and market behaviour.

Rational market behaviour is a key assumption in free-market theory. The theory is that if consumers act rationally then they will determine, through an unfettered price mechanism, the optimal way of allocating scarce resources in the market.

This theoretical assumption is wrong.

In his second edition of The Age of Turbulence, Alan Greenspan includes a new chapter on the current credit crisis. His discussion begins by patronising the reader.

"I feel sufficiently strongly about such modelling that I will pause here to address the issue. If you are not that interested in econometrics you are still welcome to read along or to meet me on the other side when the main discussion resumes on page 522."

The essence of what Greenspan says is on pages 520-521. "The essential problem is that our models - both risk models and economic models - are still too simple to capture the full array of critical variables that govern global economic reality. A model is an abstraction from the real world.

"Business cycle and financial models still do not adequately address the innate human responses that result in swings between euphoria and fear and repeat themselves generation after generation with little evidence of a learning curve.

"But forecasters' concerns should not be whether human response has been rational or irrational, only that it is observable and systematic. This to me is the large missing explanatory variable in both risk management and macroeconomic models."

The level of empirical research into Australian industry and markets by the Reserve and the commission has diminished in the past 30 years. This is because management has decided that they have arrived at some sort of eternal truth regarding the operation of the market and appropriate government policy for the Australian economy.

They justify their position by econometric models that are generally unintelligible to the rest of the population.

The models assume markets should be free of government intervention except in the case of market failure.

They have not measured the costs of such failure and they have not examined the types and levels of consumer irrationality that have persisted for decades in Australia.

For example, is it rational to have a credit card debt that requires an interest payment of 20.74%? Is it rational to waste the amount of money on alcohol, cigarettes, gambling and excessive imported consumer goods that we do?

Has it been rational to rack up deficits created by the excess of imports over exports for the past 20 years? We owe $700 billion and much of that is in US dollars.

Even more frightening is the other debt that banks, financial institutions, multinational subsidiaries and others owe overseas. These debts relate to loans not reflected in our current account data, which only covers merchandise trade and payments of interest, income and net imported services and intellectual property.

The reaction to this from the free-market economists may be to say that Greenspan is wrong. Not so long ago he had an aura of economic infallibility that was close to the papal level for religious encyclicals.

The only alternative to dismissing Greenspan's conclusion is not very palatable but is appropriate. Economists, like those in other professions, have to continue to inquire, learn and change.

They have to get out and test their hypotheses. It is too easy to sit back in the office or university and join the tribe of like-minded people. The free thinkers should not be marginalised and eliminated.

We are in a big hole but we will get out of it. We need to learn the lessons of the world meltdown. Lesson one is that we cannot make moonbeams and fresh air and live on them. The financial sector should confine its activities to storing, counting and helping us invest our money. It is not an engine of growth by itself. We have to make tangible things.

Lesson two is that we must resuscitate honest, intellectual scientific inquiry. It is absolutely necessary to develop a thesis about economic behaviour. It is then absolutely necessary to test empirically the thesis and to retest it as time passes.

Economists stopped that process of fundamental intellectual inquiry. It was much easier to recite the jargon and use the modelling that others had developed. Now is the time for some new thinking. Our best and brightest economists need to get their hands dirty.

Martin Feil is a tax and industry policy consultant and a former director of the Industries Assistance Commission.

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