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Central Banks to blame for creation of excessive debt
Article published in The Age's Business Day, 21 May 09.
[Square bracketed sections deleted by Ed]

It is wrong to blame free-market economics for the crisis, writes Des Moore

In an article published on 25 April ("Economists bear blame for bringing planet to brink of abyss", Business Day) Keynesian biographer Robert Skidelsky attributed much of the blame for the financial crisis to free market economics, such as that expounded by Milton Friedman. Their reasoning, he said, has been that as markets are perfectly efficient they will make the necessary adjustments to prevent crises. But if that is the case, he claimed, markets should adjust by taking account of bad policies rather than letting those policies have adverse effects.

Thus, according to Skidelsky, it was markets that failed recently because they did not take account of the adverse effects of the large increase in credit in the US as a result of the external surpluses of East Asia, particularly China, that were invested in the US and that added to the money supply.

However, Skidelsky is wrong in his interpretation of Friedman and wrong in blaming free market economics for the crisis in the US. Nor does Skidelsky explain why the Federal Reserve did not act to offset the effect of East Asian additions to the US money supply.

When questioned in a recent interview about possible mistakes by monetary authorities, US Treasury Secretary, Timothy Geithner, acknowledged that “there were three types of broad errors of policy both here and around the world. One was that monetary policy around the world was too loose, too long. And that created this just huge boom in asset prices, money chasing risk. …That was just overwhelmingly powerful … It was too easy, yes.”

Geithner, who was head of the Federal Reserve Bank of New York and right at the centre of crisis management, went on to cite a lack of supervision over bank risk taking and the slow pace of government response to the problem. But his concession that monetary policy was “too loose, too long” is of major importance in two respects.

First, contrary to popular interpretations, the blame for the panic cannot primarily be placed on irresponsible bankers: they responded rationally to the subsidy for credit created by central bankers.

Secondly, Prime Minister Kevin Rudd is clearly wrong in attributing the crisis to policies that reflect the neo-liberal views of free marketeers. Few if any supporters of free market policies believe there should be no regulation of monetary conditions.  [Even Adam Smith saw that need back in 1776. Further, although Rudd has argued that Australian banks were well-regulated and are in much better shape than overseas counterparts, he does not seem to be aware of the fact that our central bank allowed credit to grow at rates well above the growth in nominal GDP. Increasing  bad debts amongst Australian banks are not simply a result of the recession overseas]. 

It is also pertinent to recall that Friedman's advocacy of a monetary policy based on having a fixed rate of increase in the quantity of money reflected his deep mistrust of the ability of humans, particularly those running central banks [(he blamed the Federal Reserve for the 1930s depression)], to judge the effect on economic activity and prices of making short term adjustments to the money supply. In short, Friedman believed that it was necessary to have an efficient mechanism to regulate the supply of credit. [That his advocacy of a quantitative monetary rule was eventually shown to be impractical does not take away from this regulatory approach].

While the various possible causes of the present financial crisis are still being debated, it seems clear that an excessive growth in credit occurred in many countries and that this created much unserviceable debt. Central banks must bear the main blame for allowing the creation of excessive debt levels; it is stretching an extremely long bow to blame the belief of economists in free markets.

Des Moore is director of the Institute for Private Enterprise and a former deputy secretary, Treasury.

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