All bubbles burst: laws of economics for the new millennium

The global economy is worth about $100 trillion a year.  To put aid and philanthropy into perspective – the total is 0.025% of the global economy.  If spent on Copenhagen Consensus smart development goals such expenditure can generate a benefit to cost ratio of more than 15.  If spent on the UN Sustainable Development Goals you may as well piss it up against a wall.  Either way – it is nowhere near the major path to universal prosperity.  Some 3.5 billion people make less than $2 a day.  Changing that can only be done by doubling and tripling global production – and doing it as quickly as possible.  Optimal economic growth is essential and that requires an understanding and implementation of explicit principles for effective economic governance of free markets.   So what are these laws of capitalism?

Markets exist – ideally – in a democratic context.  Politics provides a legislative framework for consumer protection, worker and public safety, environmental conservation and a host of other things.  Including for regulation of markets – banking capital requirements, anti-monopoly laws, prohibition of insider trading, laws on corporate transparency and probity, tax laws, etc.  A key to stable markets – and therefore growth – is fair and transparent regulation, minimal corruption and effective democratic oversight.  Markets do best where government is large enough to be an important player and small enough not to squeeze the vitality out of capitalism – government revenue of some 25% of gross domestic product.  Markets can’t exist without laws – just as civil society can’t exist without police, courts and armies.  Much is made of a laissez faire concept of capitalism – but this has never ever been a model of practical economics.

A short time ago I read an article in an economics magazine on ‘rock star economists’ post the 2008 toxic debt meltdown.  The usual suspects from the past were invoked. John Maynard Keynes still provides the rationale for deficit spending to increase economic activity.  He and Milton Freidman were mentioned in passing setting the scene for more recent practitioners – Thomas Piketty and a few others.  The modern “economic rock stars” focused on – alternatively – the inequality of wealth and the inadequacy of banking margins.  In the historical context I’d suggest that Hayek and the Austrian school – and more recently Didier Sornette – are demonstrably more important in terms of managing for economic stability.

The third great idea in 20^th century physics – along with relativity and quantum mechanics – is dynamical complexity.  Dynamical complexity has many applications in ecology, population, epidemiology, physiology, weather and climate, planetary orbits, earthquakes and economics to name a few.  We tend to accept relativity and quantum mechanics as great ideas without understanding much about them.  Dynamical complexity is more widely known as chaos theory – and is as little understood.  The broad class of dynamical systems is known by certain behaviours.  This is shown in economics by the potential for small initial shocks – a few hundred billions in toxic debt for instance – to cause a global economic meltdown as a result of collective emergent behaviour.  Fear and greed ran rampant putting an end to decades of economic stability and growth.  Didier Sornette calls these events dragon-kings.

There are a few warning signals of crashes that make them potentially controllable – primarily hyper growth with positive feedbacks.  Long before dragon-kings Friedrich Hayek and the Austrian school of economics developed principles of management of interest rates that are used to maintain price stability (low inflation) and stable economic growth.  In monetary policy the Australian government instituted a consumer price inflation target of 2–3 per cent in 1993.  This is managed primarily through the overnight cash rate.  When the economy is at risk of overheating – the overnight cash rate is increased putting a damper of demand.  Conversely – rates are decreased during downturns.  Over the period of the target Australia has had uninterrupted economic growth.  At the same time we had low government debt, conservative banking practices, a strong democracy, an effective legal system and low levels of official corruption.  Growth and stability are as much psychological as technical and flourish during periods of moderate change.

The 2008 financial crisis was predicted.  It started in America after the dotcom boom and 911.  In a looming recession the government lowered interest rates – and continued to lower them further over the next several years.  With low interest rates the housing market boomed. At the same the government funded subsidies for low income earners that further fueled the asset bubble in a self-sustaining cycle possible due to rising house prices.  The emerging problem was compounded with hundreds of billions of dollars of high risk and outright fraudulent loans.  The banks channeled funds to politicians to keep the subsidies rolling.  Neither the banks nor governments insisted on normal prudential practices of making loans to people who had the ability – and an incentive with skin in the game – to repay without continuing price rises.  These high risk loans were then packaged and on sold with AAA ratings supplied by companies paid by the banks.  When interest rates ultimately were raised again – the house of cards collapsed.

The international Basel III Convention has since raised minimum capital reserve requirements to cater for bad debt.  A fairly safe recommendation from ‘rock star economists’ – but not nearly sufficient.  Following the crash of 2008 governments embarked on bailout and stimulus programs that were vaguely Keynesian but were poorly targeted and created an immense debt overhang that persists. The question now is who will bailout governments?  This is a very real bubble and all bubbles burst.  Cutting interest rates, deficit spending and quantitative easing – printing money – all result in an increase in money supply which cause price bubbles in economies.

There are suggestions that capitalism has intrinsic flaws that make the complete dismantling of markets necessary.  It always begs the question of what it is to be replaced with.  The usual suspect is that capitalism requires growth and perpetual growth is impossible in a finite world.  This is an idea based on a mathematical abstraction that lacks essential real world parameters.  We may recycle, substitute for finite resources or innovate in products and services.  We may expand the resource base beyond the planet.  We are at any rate at a point where development is sorely needed in the world – and economic growth is still self-evidently possible.  Thomas Piketty suggests that wealth tends to concentrate in capitalist markets if the rate of return on capital exceeds economic growth.  Although we should include interest rates, inflation and redistribution in the Piketty inequality.  Inflation and interest rates should be managed to vary within a tight range as discussed.  We should perhaps tinker with redistribution – as Piketty suggests – before advocating the overthrow of capitalism.

We should also distinguish between income and expenditure as individuals and profits accruing to corporations.  Income as individuals translates to boats, cars and mansions – or perhaps just the next meal.  Company profits are inevitably distributed in part of fully to owners as income.  The majority of taxation should come from individuals in a progressive taxation system.  Profits retained in corporations go to investment in plant and jobs that build economies.  There is a case to be made for no corporate taxation – removing the incentive for corporations to channel profits through low corporate tax countries.  Something that is ridiculously easy for multi-nationals to do – just set up corporate headquarters in Ireland or Singapore – and so hard to counter.  An objection is that corporations are intrinsically amoral.  They may indeed be run by sociopaths but that’s why there are laws and penalties.

Economics is a networked system – a map would look something like this only vastly more complex and multi-layered.  It is made up of individual players who can interact with each other, with corporations and with government.  It is fueled by sweat and tears and is vulnerable to fear and greed.  The key to managing fear and greed is to avoid bubbles and the inevitable bust.

Stability brings with it economic growth and reduced scope for fear and greed.  Economic growth is faster in well managed markets in low income regions.  This leads to a broadening of economic activity and strong nodes of regional economic activity.  North and South Americas, Oceania, Asia, Africa and Europe all have scope to be influential partners in the global economy.  Multiple regions of economic strength provide buffers against instability in one region or other.  It is no longer the case that the global economy is dominated by one region or another.  A mutual interest in trade and growth provides as well a path to peace as countries recognize that co-operation is more fruitful than conflict.

In robust democracies we may argue for laws and tax regimes as we see fit – but not everything is up for grabs if we are holding out for economic stability and growth.  Economic stability is best served with government at about 25% of GDP, price stability through management of interest rates and money supply, balanced government budgets, effective prudential oversight, effective and uncorrupted enforcement of fair law and a commitment to free and open trade.