James Galbraith, son of the late American economist John K Galbraith and noted economist in his own right, was asked by New York Times reporter in October if he found it odd that so few economists foresaw the credit disaster. Some did, Galbraith replied – he credited Washington economist, Dean Baker, with having the most serious claim for seeing it coming. He himself saw it coming “in general terms”.
Skip to next paragraph. But the US had at least 15,000 professional economists, the interviewer pointed out, “and you’re saying only two or three of them foresaw the mortgage crisis?” Ten or 12 would be closer than two or three, Galbraith rejoined. But even that was small minority, so what did it say about the field of economics, which claims to be science? “It’s an enormous blot on the reputation of the profession,” Galbraith acknowledged. “There are thousands of economists. Most of them teach. And most of them teach theoretical framework that has been shown to be fundamentally useless.”
While President Reagan’s economists had worshipped “the market”, he went on, George W Bush’s didn’t. He simply turned over regulatory authority to his friends. “It enabled all the shady operators and card sharks in the system to come to dominate how we finance.”
Then there was the role of Alan Greenspan, long-serving chairman of the Federal Reserve (the American central bank). Galbraith added his voice to the many economists who were blaming him for the financial crisis that was nudging the world’s biggest economy towards recession. The critics accuse Greenspan of encouraging the bubble in housing prices by keeping interest rates too low for too long and for failing to rein in burgeoning of risky mortgage lending.
“His belief was you can’t really regulate and discipline the market and you shouldn’t try,” Galbraith complained. “I think Greenspan bears high, high degree of responsibility for what has happened.”
It’s fair cop, at least partially, chastened Greenspan remarkably conceded. Almost three years after stepping down from his powerful post at The Fed, he admitted putting too much faith in the self-correcting power of free markets and failing to anticipate the self-destructive power of wanton mortgage lending. “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in state of shocked disbelief,” he told the House Committee on Oversight and Government Reform in Washington.
He had been “partially wrong” in his hands-off approach towards the banking industry and the credit crunch had left him alarmed. “I have found flaw,” Greenspan said of his economic philosophy. “I don’t know how significant or permanent it is. But I have been very distressed by that fact.”
In this country, many economists can lay claim to predicting the bursting of the housing bubble. They weren’t so hot at predicting when it would burst. They included Reserve Bank governor Alan Bollard, who for the past few years persistently warned investors about what would happen. The difference between him and the others is that he could huff and puff and burst the bubble by blowing up the official cash rate. But often he would stop huffing and let interest rates fall again.
Three years ago, he was worrying about whether he had enough tools to do the job, and announced the Reserve Bank would be exploring other options to quell the housing market (apart from the seemingly impotent official cash rate). Critics said this smacked of desperation and Muldoonism.
Without securing extra powers, Bollard did burst the bubble. Median house prices peaked in May last year at around $349,000. By August this year they had eased to $330,000 and continued to deflate, wiping hundreds of billions of dollars off the value of the country’s housing stock. Household debt, around 100 percent of net household disposable incomes in 1999, had ballooned to 160 percent at the peak, helping to worsen the country’s chronic balance of payments deficit.
Has enough been done? As recently as August Bollard was complaining about the continuing distortion of the housing market through tax incentives which provide the potential for another boom. Trouble is, his using the OCR to slow the demand for housing has had distortionary effect too, most notably – until recent months – in raising the exchange rate and hampering export growth. After nearly 20 years of targeting nothing but inflation, policy managers had slowed the economy. But they also hobbled the tradeable sector with their attempts to slow excessive housing growth.
Alas, there has been negligible political response to few calls for review of our economic framework, to make it more balanced and appropriate for small, open economy dependent on the fortunes of its export sector.
Bob Edlin is leading economic commentator and NZ Management’s regular economics columnist.
