‘No growth, easy money’

(By Dolapo Ajala)

A similar scenario played out in Nigeria under the leadership of Prof. Charles Soludo, the former governor of the Central Bank. Soludo had opened an Expanded Discount Window, a vehicle through which banks that couldn’t get inter-bank loans easily borrowed from the CBN. Soludo also left interest rates at very low levels.   The CBN did not as well scrutinise the balance sheets of the banks properly neither did it enforce the existing financial regulation. The result was that many Nigerian banks recklessly lent money without following proper risk assessment and management procedures.

Pre great depression

BEFORE the 1930s, Smithsonian Economics held sway – an economic theory, which followed the classical laissez faire approach as propounded by Adam Smith. The summary of this approach is that markets are inherently self-correcting. In essence, if there were ever any disequilibrium in the market, the ‘invisible hand’ would simply adjust the markets and restore it to a state of equilibrium; therefore, there was no need for government intervention or interference in the market. At the outset of the Great Depression in 1929, classical economists assured the world that the invisible hand would come to the rescue. However, the depression persisted into the 1930s. The ‘invisible hand’ did not to show up to help, neither could the classical economic theorists get it to do so.  Misery thus persisted. A Nobel Prize winning economist would later tell us that “the reason that the invisible hand often seems invisible is that it is often not there.” How true!

In any case, the pangs of depression gnawed deeply across the world and there was nothing the classical economic midwives could do. Their only face saving explanation was that since the “invisible hand” was probably on a journey in the short run it was bound to return in the long run to correct the market.

The rise of Keynesian economics

In the midst of the crises, one of the best thinkers in economic history emerged— John Maynard Keynes whose famous quote “Long run is a misleading guide to current affairs, In the long run we are all dead,” set the pace for revolutionary ideas that challenged classical orthodoxy.

Contrary to Say’s law which is based on supply, Keynesian economics stresses the importance of effective demand. Effective demand is derived from the actual household disposable income and not from disposable income that would be gained from full employment, as classical theories state. To stimulate effective demand Keynes recommended a mix of expansionary fiscal policy – more public spending/investment and lower taxes, and monetary policies. His new ideas worked! Keynes had saved the world from a debilitating depression and thus Keynesian Economics held sway from the 40s through the early 70s.

The rise of the Chicago school of thought

The Chicago School of Economics was founded in 1892 with the appointment of J. Laurence Laughlin as head professor. An uncompromising advocate of laissez faire and free trade, Laughlin may be said to have set the tone for much of the department for the next hundred years. Thus while most Schools of Economics/Economic Departments (with exception of the Austrian School) around the world switched to the teaching and developing Keynesian Economics, University of Chicago’s Economic department kept teaching classical/laissez faire economics. Milton Friedman, one of the most influential economists of the 20th century, joined the department in 1946, the year Keynes died. He later re-invented classical economics by using elaborate mathematical models and technical analyses, tools that were described by Harvard professor John Kenneth Galbraith as “Divorced from Reality.” Milton later led a new movement (The Monetarist School) in economic thought that transcended economics to law and psychology. The Monetarist school laid emphasis on the importance of money supply in the economy.

Friedman and his followers denounced Keynesianism and any form of governmental intervention. Friedman himself said “Chicago stands for a belief in the efficacy of the market as a means of organising resources, for skepticism about government intervention into economic affair.” And as such from the mid 70s Chicago School scholars began a neo free market movement, receiving world wide acclaim by winning the highest number of Nobel prize in Economics than any other University in the world. Friedman himself won the Nobel Prize in 1976. The Chicago School developed financial models and instruments, thereby creating a new field of financial engineering.

The making of a financial crisis

Friedman reviewed the early research of Professors Fischer Black and Myron Scholes who gave Chicago theories a bigger and more direct role in the financial markets. The pair provided a foundation for trading call options on stocks by creating a formula to link the value of options to share price and volatility, time remaining on the option and interest rates. The Black-Scholes model helped spark the global derivatives market.

At the time Eugene Fama, another Chicago School scholar, posited that securities’ prices reflect the collective wisdom of all participants. This “efficient market” theory helped make him the No.1 scholarly business writer. Fama’s theory helped pave the way for the recent economic crises by sanctioning limited government.

Notre Dame’s Mirowski says, “Fama taught that no human being knows enough to understand how resources should be allocated.” He says, “All you can do is let the market have greater and greater ability to repackage information and risk. The result is, people bought mortgage-backed securities with no idea whether borrowers could repay.”

Former Fed Chairman Alan Greenspan held interest rate at insanely low levels during the boom years a policy that Keynesians opposed. The result was a flooding of Wall Street with so much cash that banks could increase profits with short term borrowing to service long time liabilities. The mismatch grew more dangerous as Greenspan resisted regulation of off-balance sheet structured investment vehicles, which banks used to circumvent capital requirements.

A similar scenario played out in Nigeria under the leadership of Prof. Charles Soludo, the former governor of the Central Bank. Soludo had opened an Expanded Discount Window, a vehicle through which banks that couldn’t get inter-bank loans easily borrowed from the CBN. Soludo also left interest rates at very low levels.   The CBN did not as well scrutinise the balance sheets of the banks properly neither did it enforce the existing financial regulation. The result was that many Nigerian banks recklessly lent money without following proper risk assessment and management procedures.

Thus the global financial crisis of 2008/2009 was ushered in which led to economic turmoil that analysts described as the worst since the Great Depression. “The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self-adjusting and the best role for government is to do nothing,” says Nobel Prize winner Joseph Stieglitz.

Friedman’s view was that banks failed in the 1930s because money supply contracted encouraged Central Bankers around the world to pursue expansionary monetary policy.

In response to the global financial crises, governments had to intervene in the markets by bailing out banks and tightening financial regulations.

While governments around the world have realised the need for stricter regulations of the financial markets, most refuse to pursue expansionary fiscal policy – efforts to increase government expenditure, lower taxation and invest in long-term productive output which would boost demand, increase growth/output and employment. Instead most governments especially in the Euro-zone believe that implementing huge cuts in public spending, increasing taxes, reducing wages, which, in sum, is known as austerity measures/programmes, is vital to kick-starting the economy.

Meanwhile, expansionary monetary policy of increasing monetary supply available to lenders and businesses, with the expectation that easier access to credit is more effective in generating productive growth has been undertaken. So far, the availability of easy money hasn’t generated any growth whatsoever instead unemployment in the Euro-zone especially in countries such as Spain, Greece, Portugal and Italy have climbed to record highs of over 20 per cent. Social unrest is rife and there are even reports of soaring suicide rate due to economic hardships in some of these countries. Lenders and businesses are not hiring or investing because they are waiting for the economy to get better. It is against this background that the topic of one of the policy discussions in the just concluded World Economic Forum in Davos was “No Growth, Easy Money” unfortunately all Euro-zone policy makers still maintain that the path of austerity is the right path.

The U.S., on the other hand, during the first term of President Obama, injected a fiscal stimulus of $800 billion while the Fed simultaneously pursued Quantitative Easing QE1. The simultaneous expansion in fiscal and monetary policies saved the U.S. economy and the world from slipping into a “Great Recession.” The policies brought down unemployment levels in the U.S. from 11 per cent to 7.8 per cent, indeed now to 7.7 per cent, and boosted growth during the past few years.

However, the Republican controlled House has opposed any further fiscal stimulus. This scenario left the Fed with the sole responsibility of managing the crises. The Fed introduced QE2 with limited success and is thinking of QE3, which analysts say would have no significant impact on the economy as interest rates are already close to zero.

Last week the U.S. GDP report showed that the economy contracted for the first time since the second quarter of 2009. Gross Domestic Product dropped at a 0.1 per cent annual rate. A report from the Labour Department showed that the unemployment rate increased to 7.9 per cent from 7.8 per cent. This indicates that monetary policy alone won’t drive growth.

If there are any lessons to learn from this financial crisis, it is that:

• Markets are not efficient, they are never self-correcting and some form of government regulation is needed.

• During recessions, monetary policies alone hardly ever engender growth. It is a combination of moderate expansionary fiscal and monetary policy that works.

The world has learnt the former (as can be seen in the formulation comprehensive financial regulatory infrastructure articulated in Basel 3 which is to take off in 2015) but is yet to learn the latter maybe because the economics of balance is a tough and tricky science. In any case policy makers and regulators must begin to master the science from now on.

• Ajala is a strategist and wrote from Abuja.

“Opinion pieces of this sort published on RISE Networks are those of the original authors and do not in anyway represent the thoughts, beliefs and ideas of RISE Networks.”

RISE NETWORKS

"Nigeria's Leading Private Sector and Donor funded Social Enterprise with deliberate interest in Technology and its relevance to Youth and Education Development across Africa. Our Strategic focus is on vital human capital Development issues and their relationship to economic growth and democratic consolidation." Twitter: @risenetworks || Facebook - RISE GROUP || Google Plus - Rise Networks