The crisis and beyond

Bookmark and Share Economics & Deregulation, Ideas & Liberty and The Global Financial Crisis | Henry Ergas
26th February, 2009

Henry Ergas is a Canberra based economist.

What do we owe a Prime Minister? At the very least, to take what he says seriously. Mr Rudd, in his recently published essay on "The Global Financial Crisis" (The Monthly, February 2009), does not make that easy. His method consists of caricaturing his opponents, assaulting straw men, ignoring all contrary evidence, and then failing to explain his own philosophy with any clarity or detail. Nonetheless, the claims he makes, however unsatisfactory their expression, are important, all the more so as they represent his strongly-held views. They deserve to be treated as if the best case, rather than his case, had been made in their favour.  

Those claims boil down to this: that "neo-liberalism" got us into this mess; that "social democracy" will get us out of it; and that we are at the cusp between neo-liberalism's false prophecy and the hard work of social democratic redemption.

Mr Rudd never defines his terms. But by "neo-liberalism" he seems to mean the belief in the primary role of market forces as the means of stimulating and guiding economic activity. It is this belief, he says, that induced governments to allow markets to operate free of regulatory constraint, permitting greed to flourish and sowing the seeds of our current crisis.

These claims are made with characteristic over-statement. But there can be little doubt that in both developed and developing economies, the period from the mid-1970s on did see a remarkable move to a greater role for markets.

David Henderson, former head of the OECD's Economics and Statistics Department, has documented this trend using measures of liberalisation and deregulation derived from the "Economic Freedom of the World" studies that are produced each year by the Fraser Institute in Canada.1 Comparing the early 1970s to 2004, he finds that 56 of the 57 countries for which data are available appear to have become less regulated (the exception being Venezuela). Moreover, while government intervention (ranging from distorting tariffs to exchange controls) was pervasive in the developing world at the period's start, the difference in openness to market forces between developed and developing countries had shrunk markedly by the early years of this century.

Paralleling these moves, world trade became substantially freer. As Razeen Sally, from the London School of Economics, has shown, average applied tariffs in developing countries (which have generally had the highest obstacles to trade) declined from 30 per cent in 1985 to 11 per cent in 2005, and the major non-tariff barriers these countries imposed declined correspondingly.2 In the developed economies, which were already relatively open, trade barriers declined less. But even there, Australia and New Zealand ended a century of protectionism, with a decisive opening to world trade, the US and the EU made some moves to reform their barriers to agricultural trade, and the quotas that restricted imports into the developed economies of textiles and clothing were relaxed and in some instances entirely removed. 

In that sense, Mr Rudd is right: over the period from the late 1970s, the world economy became far more market-oriented. But from there, he goes badly wrong.

It is, to begin with, absurd to characterise the trend as a triumph of right-wing ideology.

There are many accusations one could level at Deng Shiao-Ping, but being a closet admirer of Ayn Rand is not among them. As for the developed economies, six finance and treasury ministers led the move to deregulation and acted as its international champions: Nigel Lawson (UK), Miguel Boyer (Spain), Kjell-Olof Feldt (Sweden), Jacques Delors (France), Paul Keating (Australia) and Roger Douglas (New Zealand). Of the six, only Nigel Lawson was in a right-wing government; all the others were in governments of the left, including one (Delors) in a government that at least initially, included the Communist Party.

To believe that these men liberalised their economies out of blind faith in free markets defies both fact and logic; and it is even more absurd to think they were merely puppets of a vast theatre in which the shadowy (and oh so foreign-sounding) Hayek and von Mises pulled the strings. Rather, their's was a pragmatic response to the problems they faced: the drama of stagflation, in which spiralling inflation combined with high and persistent unemployment in a cocktail that repeated applications of the Keynesian recipe seemed only to worsen; the erosion of work incentives, as welfare spending spiralled out of control and tax burdens became unsustainable; inflexibility in labour markets, which allowed unions to impose inefficient work practices and pursue unreasonable wage demands, while locking the young and less skilled out of work opportunities; and the manifest failures of public enterprises, which all too often were poorly managed, drowning in losses and unresponsive to consumer needs. Combined, these ills crippled economic growth; for left wing and right wing governments alike, liberalisation was a key element in removing (or at least relaxing) those constraints, creating the conditions for a return to prosperity.

Liberalisation was, in other words, a remedy, not a religion; and while the move may have been informed by economic analysis and political philosophy, ideas were a helping hand, rather than its guiding hand.

Second, it is no less absurd to claim that the liberalisation we observed involved a reversion to a minimalist, "night watchman" state. Rather, as David Henderson has put it, "everywhere, and predictably, the process of liberalisation has been partial, uneven, disputed, and subject to qualifications, reservations and exceptions".

Thus, in no country did government substantially withdraw from, or even materially reduce its commitment to, providing public goods and to sustaining high levels of income redistribution. Indeed, in almost all countries, developed and developing alike, public spending continued to rise rapidly, as did aggregate tax revenues, often by more than seems justified.3 Moreover, in many areas - including the environment, utility regulation, corporate law, discrimination in the labour market - the government presence became more pronounced, imposing high compliance costs and an ever-larger burden of ‘red tape'.

What is true is that from the late 1970s on, there was a search, that continues today, to achieve policy objectives in ways that are less costly and more effective: for example, by delegating monetary policy to an independent central bank, by using market-like mechanisms to deliver vital social services, and by relying on the power of price signals and incentives (rather than on the blunt stick of command and control regulation) to reduce pollution and deliver environmental benefits. But to suggest that governments thereby withdrew from the field is to confuse form and content.    

Third and perhaps most important, it is difficult to believe any sensible observer, least of all the Prime Minister of Australia, concluding that the move towards greater openness was a bad thing.

In effect, that move helped create the conditions for the extraordinary economic growth the world experienced from the early 1990s on, and from which Australians benefited so greatly. Labour market reform, along with the competitive disciplines exercised by a more open and integrated world economy, led to a falling off of union militancy, resulting in what is now widely referred to as the "great moderation".  That, in turn, allowed economies to grow, and employment levels to rise, without growth being throttled by inflationary pressures. Lower barriers to trade, both in developed and developing economies, encouraged the search for entrepreneurial opportunities and for gains from trade, fuelling the spectacular entry of China, India and a host of smaller countries into the world economy. And the integration of world financial markets greatly reduced the costs of financial intermediation to businesses and households alike, while accommodating the differences between countries in savings/investment balances that have been a feature of economic growth since the dawn of capitalism.

It was that period of sustained economic growth, and the liberalisation on which it was based, that reduced extreme poverty, doing so far more effectively than could any foreign aid or "Millennium Development Challenge" (on which Mr Rudd places great stress). The percentage of the developing world's population living on $1 a day or less was nearly cut in half between 1980 and 2004 (from 32 to 17 per cent). Moreover, the levels of extreme poverty were lowest, and the reductions in poverty most enduing, in those developing countries which did the most to open their economies to market forces. And those countries were also far more likely to have low levels of infant mortality, rising levels of life expectancy at age 1, and credible moves to reduce corruption and official arbitrariness, than the countries where governments continued to dominate economic life.4

If human dignity and happiness are our goal, outcomes such as these should lead us to wholeheartedly endorse liberalization, rather than to condemn it.

But even were all of this conceded, is it not true that governments went too far, regulating too little and too late in the face of speculative bubbles that ultimately, were certain to collapse?

That question will be debated for years to come. But even now, it is clear that there is at least as strong a case that governments intervened too much as there is that they intervened too little. They intervened too much because, like Mr Rudd,  they wanted to sustain the real economy, and hence loosened fiscal and monetary policy whenever trouble brewed. The result of their activism, most visible in the United States and the UK, was sustained credit growth, which only fed the asset price bubbles, making the eventual correction all the more painful. Government induced distortions in credit markets, notably the use of Fannie Mae and Freddie Mac to extend mortgage credit to low income households, then made things worse, deteriorating the quality of financial assets just as securitization and the growth of financial derivatives were rendering asset values more opaque. And in a striking instance of the law of unintended consequences, the 1992 decision by the Democrats in the US Congress to restrain "excessive" executive compensation by eliminating the tax deductibility of cash payments to executives of more than $1 million induced financial services firms to load up on bonuses and other performance-based payments, encouraging the "short-termism" that the Obama administration now bemoans.

That all of this created risks was hardly unknown; but as Mr Rudd rightly observes, "investors increasingly came to believe that when things went bad, they would be protected by monetary policy". That complacency, with all the costs it brought, did not come from a belief that governments would stand back; on the contrary, it came from the very activism Mr Rudd so fiercely champions.

Nor is there any evidence that corporate regulation generally, and financial regulation specifically, became any laxer.

It is true that, as Mr Rudd notes, the United States repealed the Glass-Steagall Act, which had previously limited the range of activities US banks could undertake. But what Mr Rudd fails to mention is that that Act was repealed by the Clinton Administration, not by George W. Bush; and that the restrictions it imposed were an anachronism, unparalleled in other advanced economies. If allowing deposit banks to engage in investment banking is a mistake, it is hardly one that originates in the US, much less in neo-liberalism. Moreover, the repeal of Glass-Steagall was followed by other changes in the US, not least the Sarbanes-Oxley Act, which greatly strengthened corporate disclosure and increased penalties for corporate malfeasance. In fact, Berkeley Professor Robert Kagan's careful study find US regulation to be significantly more intrusive, far more frequent in its use of large fines and incarceration as penalties and deterrents, and generally much less open to compromise and negotiation than regulation in the other advanced economies.5 That does not mean US regulation was effective: its intrusive, adversarial character may well have compromised its success. But to say that the regulatory hand was too heavy to be effective is very different from claiming, as does Mr Rudd, that it had been removed.

It is also true, as Mr Rudd again notes, that throughout the advanced economies, new prudential regulations were brought in for banks, based on the so-called Basel II guidelines. But those regulations were devised by the Bank for International Settlements, which Mr Rudd later lauds as the institution most skeptical of liberalized financial markets and most alert to the need for effective regulation. If the guidelines were flawed, it was certainly not by design.

As for "marking to market" (the regulations requiring financial institutions to restate their balance sheets to reflect current market values), which Mr Rudd criticizes, surely the problem is not that it was carried to excess, but that it was not done rigorously enough. As a result, when the crisis broke, balance sheets were too exposed to further falls in asset values, since earlier falls had not been adequately reflected in asset revaluations disclosed to investors and regulators. To claim that the regulation itself was at fault is to misunderstand the nature of the problem.

Where financial regulation was seriously at fault, and plainly unduly lax, is the UK. Partly out of cronyism, partly out of the hope that the financial sector would underpin British prosperity, the Blair-Brown Labour government turned a blind eye to every warning sign. "New Labour's" crony capitalism culminated in Gordon Brown's appointment of James Crosby, who bore a heavy responsibility for the collapse of HBOS, to a senior position in the British financial regulator. Deplorable? Undoubtedly. The fault of Hayek, von Mises and the free-marketers? Surely not.

None of this is to say that no mistakes were made or (more importantly) that there are no lessons to be learnt. The opposite is true. But the mistakes were hardly owned by the right, any more than the lessons are likely to be owned by the left. Indeed, the solutions that are being applied today to the banking crisis, both in Australia and overseas, were not developed by Mr Rudd's social democracy; rather, they were devised by a conservative Swedish government as it struggled, in 1992-1993, with the financial crisis it inherited from its social democratic predecessors. The point is not to disparage the one side or praise the other; rather, it is to note that all responsible governments, regardless of their underlying philosophy, have a commitment to financial stability, however difficult it may prove to achieve.  

In short, Mr Rudd's claim that "the great neo-liberal experiment of the past 30 years has failed" is very far from the mark. If anything, liberalisation brought unmatched prosperity, just as markets have historically. Of course, markets can be harsh and volatile, as they are at the moment. Of course, there is a crucial role for government. And of course, that role must evolve as problems come to light and new solutions are devised. But none of that is inconsistent with the course of public policy over the last 30 years. Mr Rudd needs better arguments, and far more solid evidence, if his criticisms of that course are to convince.  

What about Mr Rudd's social democratic alternative? The difficulty lies in knowing its content. He excoriates Mr Howard for saying that "competitive capitalism within free markets remains the most effective economic paradigm"; but if Mr Howard is wrong, what is the "most effective economic paradigm" and where is the evidence that points to its success?

Is it Mr Rudd's claim that the answer lies in the social philosophy of John Maynard Keynes, who he repeatedly cites and seems to take as a mentor? Although Keynes was a complex man, of wide interests and extraordinary capabilities, his views as to the nature of the good society were a jumble of aestheticism, 19th century liberalism and at times, unabashed collectivism. As Mr Rudd says, Keynes wanted to save capitalism from itself. But key to this, he thought, was to drive down the return on savings to the point that would cause the "euthanasia of the rentier",  so that an individualist society could flourish shorn of its "Jewish" features, "the exaction of usury .. and the love of money", vices he saw as the central flaws of capitalism and as inextricably linked with "the race that has done the most for the principle of compound interest and particularly loves this most purposive of human institutions."6 Whatever Mr Rudd's social democracy may be, it is difficult to believe that this is what he has in mind.

Or is Mr Rudd referring to Keynesian economics, stripped of those unsavoury (yet important) wider connotations, which set Keynes so far apart from Hayek and the Chicago economists? If so, that is hardly a political philosophy. Rather, Keynesian economics, as developed by John Hicks, Paul Samuelson and Don Patinkin, is a technical tool for aggregate demand management, and one of arguable efficiency at that, all the more so in small, open economies. It makes no more sense to have an a priori attachment to such a tool, independently of the circumstances which determine its effectiveness, than it does to say that one's political philosophy is a commitment to the use of a hammer.

Or perhaps Mr Rudd's alternative is the Blairite Third Way, which Mr Rudd praises in his essay, but of which Vernon Bogdanor, the distinguished Professor of Government at Oxford and no friend of the conservatives, has said that all it had of new was the sheer scale of its public expenditure?7

Or lastly, is it simply the belief that governments should correct market failures, when they can do so in a way that is less costly than the market failures themselves? If so, then it is no more than neoclassical welfare economics, enshrined in the despised Howard government's better regulation guidelines. This may well be firm ground, but it is hardly ground social democracy can sensibly claim as its own.

None of this is clear from Mr Rudd's article. Rather, what we are told is that Mr Rudd believes in an "activist" state that "intervenes to reduce the greater inequalities that competitive markets will inevitably generate". "Greater inequalities" than what? Greater than those generated by non-competitive markets or by central planning? That would be difficult to believe. And "reduce" those "greater inequalities" how, to what extent and at what cost? It is those that are the difficult questions, but they are questions to which Mr Rudd gives no answers.

That Mr Rudd's efforts to give content to social democracy should yield so little result is unsurprising, for the fault lies not in his formulation but in the underlying doctrine. As the great British social democrat, Anthony Crosland, author of the vastly influential tract, "The Future of Socialism", clearly recognised, social democracy is not a fixed set of policies or prescriptions, but at best a set of values - a sentiment in favour of equality and fairness. But even Crosland was never able to sensibly define either "equality" or "fairness", much less articulate the limiting principles that would guide their pursuit. And his translation of those values into strategies that could steer action relied on premises that time has eroded to the point of disappearance: that government could "exert any influence it likes on income distribution", making the distribution of income as readily controllable as the price of postage stamps; and that the machinery of government was an inherently beneficent way of taking decisions, implementing policies and providing socially desirable goods.

Ignored by Crosland were the risks of moral hazard: that subsidising unemployment would create entrenched welfare dependency; the efficiency costs of high taxation: that the tax rates needed to achieve far-reaching redistribution would reduce incomes overall, and shrink opportunities even for the worse off; and the incentive problems inherent in government provision, problems so manifest in government's vulnerability to rent-seeking and in the difficulties of securing high-quality, cost-effective supply of public services.

The complete unrealism of this view of the world became obvious in the 1980's. Together with the repeated failure of Keynesian demand management, the result was to knock the legs off the Crosland stool, leaving social democracy without a solid intellectual basis. Their way lost, and the forward march of labour halted, the former Croslandites responded by burning their map.

Nowhere was the resulting vacuum clearer than in the moral collapse of "New Labour". Roy Hattersley (now Baron Hattersley PC), Deputy Leader of the Labour Party from 1983 to 1992, captured this well when he said that until Blair, Labour, if only rarely a party of ideas, had been one of principles; but with Blair, it abandoned even those.8 The result, ably analysed by Sir Christopher Foster (eminent economist and close collaborator of that formidable figure of British Labour, Barbara Castle) in his recent book on "British Government in Crisis", was an assault on all the features that had long made British government not only generally competent but also exceptionally free of corruption.9 Mired in questionable deals with the private sector, unable to control public expenditure, surrounded by a society in an ever more advanced state of decay, British social democracy no longer seemed any better than its long-derided French or Italian counterparts.

Nor did a more glorious fate await the Scandinavian and German social democrats. These are, of course, formidable political machines, but they are barren as an intellectual force. By and large, the Swedish social democrats have sensibly embraced privatisation, including of education, and the shrinking of the public sector: the far-reaching ambitions of the Swedish Crosland, Gunnar Myrdal (economist, keen taxidermist, enthusiastic eugenicist and ardent promoter of compulsory sterilization), are as long forgotten as his manifesto, "Beyond the Welfare State". The Norwegians, the world's fourth largest oil exporter, should have been uniquely well-placed to achieve the social democratic utopia; but a comprehensive audit of Norwegian democracy, carried out by a prestigious official committee, has found "a democratic infrastructure in collapse", in which workers (other than the large middle class dependent on cushy jobs in the public sector) are increasingly alienated from the Social Democratic machine, and in which racism, xenophobia and every form of intolerance have been on the rise.10 Finally, having buried the dreams of Bad Godesberg (where in 1959, the SPD sought to recast itself as a modernising force), the German Social Democrats are in practice little more than defenders of the status quo, for whom the only real issue is how much of the past they can entrench and for how long.

In short, the social democratic cat vanished long ago. All that now remains is the grin: the warm glow of pretending to be nicer, fairer and kinder than one's opponents, but with no guiding principles that are not a pale imitation of those better articulated by the other side.

Mr Rudd's alternative is therefore no alternative at all. Considered as an analysis of the world and as a guide to action, it is at best, mostly vacuous and at worst, largely false. That lack of intellectual scaffolding may well suit Mr Rudd, for at heart, his philosophy is to be all things to all people. He wants to be pro-market, when the audience is the business community; pro-unions, when it is the ACTU; pro-public sector provision, when it is the teacher's unions or the nurses; pro-contracting out, when it is the proponents of "private public partnerships". Far more regulation is needed, he tells The Monthly; far less, the Financial Review. The mock slogan devised by the late Martin Hollis (a leading political philosopher) comes to mind, "liberalism for the liberals, cannibalism for the cannibals!": which is fine, until it is you that is to be put in the pot. For then a choice must be made between the liberals and the cannibals, and principled choice requires more than a warm glow.

Ecclesiastes pointed out that there is a time for planting and one for uprooting: all things cannot be done at once. This time may be Mr Rudd's. He is fortunate to have come to his season inheriting an economy sufficiently strong, and a fiscal position so solid, as to reduce the need to make painful decisions. But even in the lucky country ("run by second-rate people who share its luck"), scarcity has not been abolished and resource constraints must ultimately be confronted. So too do we need to draw the lessons of the current crisis, and ensure that those lessons make us better, rather than worse, placed for a return to sustained economic growth.

None of that will happen without serious attention to ideas. But "serious attention" is very different from emotional sloganeering; it requires hard work - in Max Weber's phrase, "like boring through hard wood".11 For that work to be done, ideas must be treated with respect: not as mere excuses for denigrating one's opponents, nor as flimsy rationalisations adopted and discarded, like a party frock, to please the immediate audience. Set against that standard, Mr Rudd's article does him little credit. As Prime Minister, Mr Rudd must and does command our considered attention; it is a pity that attention has not been repaid with the seriousness it both merits and can legitimately expect.




1. David Henderson, "The Uneasy Trend to Greater Economic Freedom", originally in Political Competition and Economic Regulation, edited by Peter Bernholz and Roland Vaubel, Routledge, 2007 and updated in a mimeo dated 13 October 2007.

2. Razeen Sally, New Frontiers in Free Trade: Globalization's Future and Asia's Rising Role, The Cato Institute, 2008.

3. See for example the trend in more recent years for the OECD countries, as set out at

4. See The Fraser Institute, Economic Freedom of the World: 2008 Annual Report.

5. See Robert A. Kagan and Lee Axelrad "Adversarial Legalism" in Pietro S. Nivola, Comparative Disadvantages?: Social Regulations and the Global Economy, Brookings Institution Press, 1997 and Robert A. Kagan, Adversarial Legalism: The American Way of Law, Harvard University Press, 2003.

6. See Robert Skidelsky, John Maynard Keynes, volume 2, London, 1992, especially pages 237-239.

7. See Anthony Seldon, Blair's Britain, 1997-2007, Cambridge University Press, 2007.

8. See Raymond Plant, Matt Beech, Kevin Hickson, The Struggle for Labour's Soul: Understanding Labour's Political Thought Since 1945, Routledge, 2004

9. Christopher D. Foster, British Government in Crisis, Hart Publishing, 2005

10. See Selle, Per, and Øyvind Østerud. 2006. "The eroding of representative democracy in Norway." Journal of European Public Policy 13:551-56; Østerud, Øyivind., and Per Selle, 2006. "Power and democracy in Norway: The transformation of Norwegian politics." Scandinavian Political Studies 29:25-46; and generally, Stein Ringen, "Wealth and decay", The Times Literary Supplement, February 13, 2004.

11. Max Weber, The Vocation Lectures: Science As a Vocation, Politics As a Vocation; edited by  David S. Owen, Tracy B. Strong, Rodney Livingstone and translated by Rodney Livingstone; Hackett Publishing, 2004. The phrase appears in the essay on the vocation of politics.