End the jihad on neo-liberalism

WITH the world economy showing signs of recovery, attention is shifting to the lessons of the crisis.

Understandably, much of the focus is on financial regulation, with proposals that range from the probably sensible (such as revising capital adequacy requirements) to the undoubtedly foolish (such as British Prime Minister Gordon Brown's idea of taxing international financial transactions). It is important, however, to stand back and ask why the crisis, painful though it has been, is likely to prove shallower than many expected.

In part, the answer is simply that the doomsday scenarios were greatly oversold.

Today's global economy is vastly different from that of the 1930s: sectors that are relatively recession-proof, such as government services and health care, are far larger, capital markets are deeper and more diversified, and international trade is far freer.

As a result, it was never likely that output would shrink by 40 per cent, as occurred in the US in the period from 1929 to 1933. That said, the initial contraction was severe and there were real risks of a lengthy global recession.

Historically, global financial crises have resulted in prolonged declines in housing prices, deep falls in equity markets and steeply rising, widespread and persistent unemployment. Why didn't this shock repeat the pattern?

No matter how loud the claims made on its behalf, the fiscal stimulus co-ordinated by the G20 is not well placed to take the credit.

There is simply too little relation between what was committed and what was spent for stimulus packages to explain the turnaround.

This is not to deny the significant stimulus in some economies, notably China.

There the government retains control over the levers of a command economy, while distortions in product and financial markets reduce the relative efficacy of monetary policy, forcing counter-cyclical policy to rely heavily on government spending. For the world as a whole, however, it is likely that by far the greatest policy contribution was made through sustained monetary easing and the restoration of confidence in the banking system.

But if these measures proved relatively effective, it is in large part because of the reforms of the late 80s and 90s.

However incomplete they may have been, country after country worked hard to remove distortions in markets, improve fiscal positions and increase public sector efficiency.

All of these changes contributed to the great moderation of the previous decade, with its trifecta of low inflation, low unemployment and rapid increases in world trade and output.

When the subprime crisis hit, low inflation created scope for the sustained monetary policy response, quite unlike the situation in the period following the oil shocks of the 70s. At the same time, more flexible product, capital and labour markets made it easier for economies to absorb some of the impact through relative price changes, rather than through reductions in the use of resources.

Flexible exchange rates have been an important part of this story, especially now that the devaluation of the US dollar has begun to shift resources in the US towards the export and import-competing sectors.

There is a marked contrast here with what happened in the 30s when pervasive distortions greatly hindered recovery from the Depression.

A widely cited study by professors Harold Cole and Lee Ohanian found that the New Deal's interventions caused 60 per cent of the losses associated with the Depression's persistence.

In short, neo-liberalism, the purported villain of the crisis, may well prove to be its hero.

As for the policies adopted during the downturn, such as the salvage plans for the US, European and Australian auto industries, the distortions they introduce will only make it more difficult for the world economy to weather the next crisis as well as it weathered this one. And come it will.

As professors Carmen Reinhart and Kenneth Rogoff stress in their recent book dissecting eight centuries of financial follies, banking crises are an equal opportunity menace that no country has eliminated. While regulators fight the last war, financial innovators are inevitably stirring up the next one, advancing prosperity at the cost of periodic turbulence.

Perhaps one could obtain eternal financial tranquillity by stifling innovation, but it would be an insurance policy that cost far more to buy than it could ever pay out.

The best insurance is the old-time religion of fiscal and monetary prudence, which provides the room to respond when needed; low inflation, which makes macro-economic policy more effective; and flexible product and labour markets, which help cushion the shock to economic activity.

Unfortunately, though that is the most important lesson of the crisis, it is the lesson governments are most reluctant to learn.

Renewed optimism about Australia's economic prospects makes it more vital that this lesson be understood, not merely to be prepared for the next downturn but also to draw the full benefit of the coming upswing.

The risk is that of being lured into complacency by high export prices, as if this guaranteed higher living standards. In the mid-50s, our export prices were falling relative to our import prices.

Nonetheless, Australia was extremely prosperous because rapid gains in agricultural productivity were more than sufficient to offset the price fall.

In the same way, even if China's economic growth continues to hold up export prices, even slight reductions in the efficiency with which we produce our exports could blow the income gain away.

This is why the wave of policies that hang over the Australian economy, from industrial relations changes to the Carbon Pollution Reduction Scheme, are so worrying. The government seems to believe that these are mere inefficiencies that we are rich enough to afford. But even on the road to recovery, our future prosperity is all too easy to lose. And in the process of losing it, we can make the next crisis far more severe than it needs to be.

Turning our backs on the neo-liberalism that helped save our bacon is the best way of doing that. Yet this government has elevated its attacks on neo-liberalism into a jihad. Does it have either the courage or the wisdom to think again? Not so far. But until it does, Australia's economic prospects will remain far more risky and uncertain than they need to be.