WHILE it is obvious that financial markets and the markets for goods and non-financial services are linked, stock exchange bubbles and crashes have not always spread misery to the wider economy. Until the 1930s, recessions tended to be short and sharp, and financial ruin was largely confined to the speculators whose exuberance had diverted capital into ventures where it was less than productive. Such sectorally confined downturns have also occurred in recent times, as with the dotcom collapse in 2000-01.
However, this time it is different. The reason is the boom that peaked in 2007 was fed by easy money. Unlike in the run-up to the dotcom boom, over the past few years central banks in the US and most other economies were expanding credit. The financial engineering of collateralised mortgages and pressures on US lenders to extend mortgages to low-income people caused this to be siphoned into housing.
In places where regulations were constraining supply, prices escalated. But the inflationary symptoms were largely disguised, as house price increases do not feed fully and rapidly into the normal measures of inflation. Having claimed the success for a long period of prosperity, governments now feel obliged to follow measures they are told will rescue that prosperity. But they are no more able to do this than they were able to foster the previous affluence.
Governmental roles in creating the affluence we have seen were passive. There were deregulations, outsourcings and privatisations, all of which from the 1980s allowed higher levels of capital and labour productivity. There was even a reduction in the size of governments within many national economies, including Australia, bringing additional productivity bonuses.
By contrast, current government measures are activist. They include subsidies to failing firms, regulations favouring unproductive investments such as renewable energy, gifts to pensioners and vast expansions in the supply of credit. Australia even has a new set of labour arrangements that threaten to increase real wages and reduce firms' hiring and firing flexibilities, further adding to the risk firms face in expanding production.
These government interventions will exacerbate the downturn. New spending by government inevitably fails market efficiency tests and often directly generates inefficiency in pursuit of ideological targets or in responding to political donations.
What is needed is a reallocation of income to savings, with this used to finance productive investments. We have seen inadequate levels of savings in countries such as the US, Britain and Australia, where inflated house prices led people to believe they had masses of equity in their homes. Falling house prices add to the realisation that wealth in terms of superannuation investment is much less than people had anticipated.
But the actions being taken by governments are preventing this rebalance towards savings; handouts to foster increased consumption cannibalise the savings that arerequired.
Other policy measures will further aggravate recovery prospects. These include propping up failing businesses, which prevents the reallocation of capital and labour to more promising ventures, and regulations that add to the cost of energy and employment.
As a result, the volcanic eruptions that have destroyed nearly half the value of the world's share markets will be followed by a tsunami that wipes out jobs and businesses.
The rebuilding of domestic savings levels and the drying up of foreign capital infusions has brought reductions of about one-third in bank lending and sales of homes, cars and holiday packages. Firms supplying these goods and services have to reduce their production by a third, and that means eliminating a similar share of jobs. Firms that resist such actions are saddled with excessive costs and will go bankrupt. The downturn thereby contaminates all of the private sector.
So far the public sector has been immune from such cost cutting. Indeed, increased numbers and inflated gradings are likely to follow from the present crop of measures. Yet the need to make savings is even more urgent in the public sector, much of which does not add to productivity. California, facing a desperate fiscal crisis, has reduced real wages of public servants (by cutting leave).
Lowering the remuneration of the public sector is one necessary measure. Not only does this allow lower levels of taxation, it restores some parity between the public and private sectors. With private sector employment vulnerable to market forces, the higher degree of job security in the public sector is worth far more than it was previously.
Moreover, the senior levels of the public sector have shown themselves to be of little worth. The advice of thousands of Treasury and Reserve Bank personnel has done nothing to prevent the economic debacle that will hit hard this year.
Unfortunately, salary and job pressures on the public sector will not happen. Instead we will face more pain as a result of the interventionary policies public sector advisers are promoting to governments eager to increase the power they have over the economy. This means the recession will need to be more prolonged and deeper, with 10 per cent plus unemployment levels, budget crises and perhaps stagflation, before market forces are able to revitalise the economy.
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