INTOLERANCE OF SMALL CRISES LED TO BIG ONE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

Intolerance of small crises led to big one

By Jacek Rostowski

Published: January 13 2010 20:42

The financial crisis was not a crisis of capitalism or globalisation. Instead it is a crisis of the “deep Keynesian project”, according to which the aim of economic policy should be the maximum smoothing out of fluctuations in the real economy (as long as consumer price inflation is kept under reasonable control). While the tools of this policy approach were very different in the boom years preceding the crisis from traditional Keynesian ones, relying more on monetary than on fiscal policy, the fundamental aim was quintessentially Keynesian. The crisis is the logical outcome of the success of this policy for almost 20 years.

What drives the market is the balance between fear and greed. If economic policy eliminates fear, only greed remains, and there is no mechanism to limit “irrational exuberance”. This was the fundamental cause of the crisis. Moral hazard and herd behaviour are natural consequences.

The essence of global monetary policy before the crisis was the “Greenspan put” – the attempt of the then Federal Reserve chairman to prop up the securities markets by lowering interest  rates, so as to avoid even mild recessions. The danger is that this policy will be continued after the crisis. The natural state of capital markets from which fear has been removed is the generation of asset bubbles. If global policymakers do not understand this, bubbles are likely to proliferate through carry trade from the US and other countries with minimal interest rates and weak currencies.

Weak regulation and supervision were not the fundamental problems, although they can and should be improved. Countries not in crisis – China, Poland and much of Latin America – were, above all, those with low leverage, not those with sophisticated financial supervision.

In the 1970s, ordinary Keynesianism was discredited when the Phillips curve collapsed. The alleged trade-off between inflation and unemployment turned out not to exist. Keynesian policy merely justified ever larger budget deficits and higher inflation, until policymakers understood that it led only to higher permanent unemployment. The old goal of reasonably balanced state budgets was rehabilitated.

Moral hazard must be reduced. Fear should be greater on Wall Street and in the City of London to reduce the fear of ordinary citizens. Very loose monetary policy is rebuilding financial institutions’ capital, which is good, but it must not be allowed to go on for so long that new bubbles arise.

The easy institutional change that is needed is to limit the size of financial groups. To judge from the current economic policy debate, especially in the US, banks that are too big to fail continue to prevail. Such banks capture their governments and are subject to loose budget constraints of an almost Soviet-era type, because they know the government will bail them out. Strong implicit state guarantees mean that greed untempered by fear will be their rational behaviour.

The harder institutional change is to induce policymakers to give up the “deep Keynesian project”. This is very hard, because policymakers probably will never be rewarded for allowing small crises or small recessions. Yet, this is the only way to avoid herd behaviour and so to prevent big financial crises and “Great Recessions”.

As for current policy, the present, very loose, monetary policy should be enough – we do not need a very loose fiscal policy also. The fiscal stimulus measures in 2008 and 2009 were hardly necessary. The recession is over and very little of the stimulus has yet arrived. It will do so in 2010 and 2011 when no longer needed. Automatic stabilisers – less tax collection and larger social transfers – were probably sufficient and certainly timely. Any additional discretionary public expenditures should have been avoided and should now be withdrawn.

Instead, our major challenge is to contain public expenditure and restore fiscal balance. The big concern for the west is elevated public debt. It is doubtful whether debt levels above 100 per cent of gross domestic product are fiscally sustainable, but more and more countries are heading that way. The world needs smaller and more rational entitlement systems, not more discretionary spending, which has a tendency to become permanent. There should be no new mandatory expenditures for years to come.

The one big success in the current global crisis has been that no protectionist spiral has developed, but one success and many failures does not amount to an impressive scorecard.

The writer is Poland’s finance minister

Copyright The Financial Times Limited 2010.