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Failed classical economics - Martin Wolf (FT.COM)

The failure to forecast the Global Financial Crisis, has been widely seen as a major failure of mainstream (Classical) economics. Martin Wolf examines the issues around this:

  • The tests of this discipline are whether its adepts understand what might go wrong in the economy and how to put it right. When the financial crisis that hit in 2007 caught the profession almost completely unawares, it failed the first of these tests. It did better on the second. Nevertheless, it needs rebuilding.

  • As David Vines and Samuel Wills explain in their excellent overview, the core macroeconomic model rested on two critical assumptions: the efficient markets hypothesis and rational expectations. Neither looks convincing today. It is questionable whether it is even possible to have "rational expectations" of a profoundly uncertain future. Such uncertainty helps explain the existence of institutions — money, debt and banks — whose effects are so significant and yet were largely ignored in standard models. It is better to be roughly right than precisely wrong.

  • It is not good enough to argue that the canonical model works in normal times. We need also to understand the risks of crises and what to do about them. This is partly because crises are, as the Nobel-laureate Joseph Stiglitz notes, the most costly events. A macroeconomics that does not include the possibility of crises misses the essential, just as would a medicine that assumes away the possibility of heart attacks. Moreover, crises are endogenous: that is to say, they come from within the economy. They are a result of the interaction between tendencies towards excessive optimism and the fragility of any system of highly leveraged financial intermediaries.

  • Economies would be more resilient if they were less highly leveraged and, in particular, if they depended less on holdings of money backed by risky assets owned by the highly leveraged financial intermediaries known as banks. Obvious solutions include eliminating the incentives towards leverage in our tax systems, encouraging greater use by the economy of equity finance and debt that can be readily converted into equity, raising the reserve and capital requirements of banks and moving swiftly towards the issuance of digital central bank cash.

There is a very important message here for Australia:

  • Australia has far too much private debt - very similar to USA and much of Europe before the Global Financial Crisis.

  • We have far too much debt in our very highly geared banks (Chris Joye has pointed to this over recent years), and the Australian economy depends for financial stability, too heavily on those banks (particular the big 4 banks).

  • And Australian private households hold far too much debt ( ) and 90% of this is mortgage debt. Australia has a 100 year+ historic record in terms of mortgage debt to GDP, more private debt/GDP than Ireland had before their massive house price crash in 2009. Already something like 20% of mortgagee households are in mortgage stress - even though cash rates are at historic lows for Australia - and globally, interest rates are now rising again.

  • This historic record private debt in Australia severely put Australia's future financial stability at risk. If either:

  • If interest rates rise sufficiently (making many mortgages unsustainable) - even just back to "normal levels" by historic averages OR

  • if we have a recession (where unemployment rises, resulting already financially stressed households being unable to keep up repayments on mortgages),

  • the the financial fragility of the Australian economy will become very apparent and Australia will have a financial crisis. This seems almost a certainty with only the timing in questions because:

  • if is only a matter of time before Australian interest rates (and Australian bond rates are ultimately outside Australia's control .... and if western economies have significant more inflation [again outside Australia's control] Australian cash rates must rise) return to more normal levels like historic averages AND

  • it is only a matter of time before Australia has its recessions, which are ultimately an unpreventable normal part of the economic cycle.

  • THEREFORE: If does seem to be just a matter of time, before Australia has a severe economic crisis, because of economic fragility in the Australian economy - that we have allowed to occur, by allowing growth in the level of debt in the Australian economy - to current levels.

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