Ross Gittins had a great rant in the Sydney Morning Herald yesterday. Libertarians and their evil theories, especially the efficient markets hypothesis (EMH), are to blame for the global financial crisis. Luckily, Australian politicians, econocrats and the public are immune to such silliness and our economy is now much admired around the world. A fine story to be sure; such a pity he makes a factual error in the first sentence and it all deteriorates from there. What Gittins gets right seems to be accidental.
Much of the Australian media have made the argument that Australia is the first country to raise interest rates and Gittins repeats this line. While Israel is not a G20 member or OECD economy, it also has had to raise rates. Australia is, at best, the second country to raise rates. The remainder of the article comprises one smelly orthodoxy after another.
The so-called efficient markets hypothesis is a theory that posits that new information is quickly incorporated into stock prices. Traders are not going to outperform the market by trading on information that everybody already knows. It is not at all the theory that markets are efficient. Economists have be working on that idea and refining their understanding of markets since Adam Smith’s time. The EMH, by contrast, is a relatively new theory and is popularly associated with Chicago University’s Eugene Fama.
The EMH does not suggest that there is no role for regulators. Nor, in contrast to Gittins’ claim, do free-market economists suggest there is no role for regulation. Markets do not develop or prosper in the absence of a legal framework. Friedrich von Hayek makes much of the importance of the rule of law. Ludwig von Mises described the market system as being co-operation under the division of labour. Humans co-operate in order to compete — the latest economics Nobel winners Elinor Ostrom and Oliver Williamson have shown how co-operation takes on many diverse forms in building up those institutions that facilitate exchange.
Contracts, tort law, prohibitions on various types of fraud, and courts of law are all important mechanisms to ensure that markets work well. Andrei Shleifer, of Harvard University, and several co-authors have very carefully documented the positive role that regulation and legal structures play in ensuring markets are deep and liquid. Of course, this is not the argument that any and every regulation adds value, but it does suggest the “free market economists are anarchists” meme is seriously misleading, if not dishonest. In particular, Shleifer argues that security regulation that enhances market discipline through private contracting and private dispute resolution is superior to regulation that emphasises public enforcement.
What Gittins and his ilk never explain is which regulations are important. He seems to think that more regulation is the answer. But what does he have in mind? Should the US adopt our four pillars policy or, perhaps, re-introduce the Glass-Steagall Act? What regulation is it exactly that will crisis-proof the economy?
Gittins is correct in arguing that conservative banking practices lead to Australian banks being somewhat immune from the crisis. Mind you, it is those very same conservative banking practices that have led to substantial criticism of our banks. The most conservative practice is to not lend money to people who can’t pay you back. That seems fairly sensible and Australian regulators never adopted any policy along those lines. Unlike our American friends who did adopt such policies and then encouraged banks to securitise and onsell very complex instruments. To be blunt, people who trade in complex securities they don’t understand deserve to go broke.
Australian policy makers have been deregulating and liberalising the economy since the early 1980s. It is that process that has to weather the storm. As Gittins says, the important Howard-era reforms to monetary policy independence combined with negative net debt and a budget surplus have served us well. It is far more sensible to distil the positive lessons of the Australian experience than to grind ideological axes.
Sinclair Davidson is a professor in the School of Economics, Finance and Marketing at RMIT University and a senior fellow at the Institute of Public Affairs.