The Australian Financial Review Saturday, November 14, 1998The Deputy Governor of the RBA, Stephen Grenville: faith in greater transparency of capital markets is 'naive'.
Confessions of a market heretic
By Brian Toohey
Stephen Grenville is living proof that British policy adviser Sir Alfred Sherman was wrong when he warned in 1992: "Bishops who used to believe in God, they can go in for socialism or sodomy, but an economist who's agnostic about economics is unemployable." While Grenville may not be strictly agnostic, he has certainly committed heresy so far as mainstream economics is concerned by focusing on the irrational mood swings of capital markets. Yet he still has a job as Deputy Governor of the Reserve Bank of Australia.
Perhaps it helps that the Governor, Ian Macfarlane, appears to have undergone an even greater crisis of faith and managed to survive.
In the wake of the financial crisis that erupted in Asia last year, Grenville has emerged as one of the most forceful exponents of a view that sees problems endemic to international capital markets as being at least as important as the sins of individual countries.
In a speech in March, he focused on the scant regard paid to market fundamentals as a wild panic engulfed a number of Asian countries, leading to a devastating $US112 billion turnaround in capital flows. He followed up with a provocative speech to a conference in Sydney yesterday where he shared the platform with two other heretics, Paul Krugman and Al Wojnilower.
Grenville has essentially abandoned two of the central tenets of the belief system that gives mainstream economists such immense confidence that they know what is best for the nation and the individual.
In his speech yesterday, he rejected the Efficient Market Hypothesis which is holy writ to many economists. For good measure, he also rejected the underlying premise that markets follow an equilibrium path with any deviations being corrected in a smooth and relatively painless fashion.
The Efficient Market Hypotheses holds that traders act as a stabilising force in international financial markets. Promoted by Milton Friedman and other University of Chicago economists, the Hypotheses assume that traders make rational use of all available information. Any errors about future price movements will fairly quickly cancel each other out, thus helping to restore equilibrium.
Grenville did not mince words yesterday. "Despite the most diligent, strenuous efforts on the part of those who have built models and academic reputations on the Efficient Markets Hypotheses, the data consistently but inconveniently refute it." He said vested interests had used "the efficient markets paradigm as an intellectual battering ram to open new commercial opportunities". But the intellectual climate was shifting.
"When the doyen of the hedge finds, George Soros, describes capital flows as a 'wrecker's ball', you know the debate has changed".
In Grenville's harsh assessment of what happened in the recent crisis, the theory of how exchange rates would behave, "with its implication of a continuous, enduring, finely balanced calculus, did not fit reality, even remotely".
Nor did he spare Leon Walras's general equilibrium theory which lies at the core of the dominant neo-classical school of economics. "We have to accept that markets, even under as favourable conditions as are likely to be found in the real world, have not -- and will not -- consistently act as a smooth, well-informed, far-sighted Walrasian auction process to maximise benefits and minimise the costs of capital flows."
The theorists were not the only ones to take some stick. According to Grenville, the degree of ignorance displayed by some fund managers "is so great as to border on the comic". But he does not accept claims that the problems of the capital markets can be fixed with more information.
Instead, he describes faith in greater transparency as "naive", adding that he has to be careful in pointing this out since questioning the benefits of greater transparency is "like arguing against peace, freedom and motherhood".
Nor does he see good domestic policies as a sufficient defence against the erratic behaviour of the capital markets. In any event, he says: "We need a framework which can cope with the inevitable imperfections of the policy process."
Such a framework will have to involve some degree of market intervention because "the idea that private sector burrowers and lenders (consenting adults) will work things out satisfactorily has proved naive: the collateral damage is too great. Private sector debt was (and remains) a festering sore which inhibits the return to health of some Asian economies."
Grenville does not deny the benefits of capital flows, especially in the form of direct foreign investment. His concern is extreme volatility, which he says is clearly harmful. He quotes approvingly US economist Darni Rodrik, who wrote this year: "Boom and bust cycles are hardly a sideshow or minor blemish on international capital flows: they are the main story". He also quotes one of the foremost supporters of free trade, Jagdish Bhagwati, who says that "the panics, manias and crashes that characterise capital flows have no counterpart in trade flows".
Grenville's solution is to support "stand-fast and work-out" arrangements for private debt. Although he did not go into detail in Friday's speech, this basically entails a temporary freeze to stop capital rushing out the door as soon as a crisis emerges.
He accepts, however, that there is little enthusiasm for a solution along these lines. While acknowledging that intervention may be required in certain circumstances, he says the international consensus has a rather disparaging tone: "Just as 'real men don't eat quiche', real countries don't resort to capital controls."
But Grenville says refusing to act -- either in the hope the problems will go away or because of an "ideological defence of market purity" -- will put at risk the benefits of capital flows. Accordingly, he ended his speech by comparing support for intervention in global financial markets with Lord Keynes's justification of active fiscal intervention in the 1930s as being necessary to save capitalism.
To cynics, Grenville's support for intervention in international capital markets can be explained by his natural predilections as a central banker. Central bankers owe their existence to their role of intervening in domestic money markets in order to set official interest rates in an effort to control inflation. Grenville's career background, however, may provide a better clue to his personal dismay at the way the massive outflow of capital from several Asian countries last year has plunged tens of millions of people into abject poverty.
After graduating in economics from Sydney University in 1965, he joined the Department of Foreign Affairs where he served in the Australian Embassy in Jakarta in 1969-70 and in Saigon in 1970-71. Along the way he completed a PhD on the Indonesian economy at the Australian National University. He returned to Indonesia -- a country for which he has great affection -- in 1977 as deputy head of the International Monetary Fund office.
After a stint at the OECD in Paris, he joined the Reserve Bank in 1982 where he has gained a reputation for a lack of intellectual rigidity. He is a critic, for example, of the Reserve's earlier adherence to the failed monetarist dogma which held that inflation could be controlled by controlling the money supply.
According to those who know him, he is now sympathetic to those who regard the IMF as a sclerotic organisation which has badly misunderstood the nature of the crisis in Asia and Russia.
Born in 1994, Grenville is married to a Vietnamese woman, Ly. His sister, Kate, is an accomplished novelist. Her husband, Bruce Petty, is a cartoonist and animator perhaps best known for drawing the economy as an immensely complicated and perverse machine.
While stopping well short of Petty's critique, Grenville is clearly sceptical of mechanistic approaches to understanding how economies work. Instead, he is fond of quoting the Harvard economist Jeffrey Sachs, who has written: "There was a touch of the absurd to the unfolding drama (in Asia), as international money managers harshly castigated the very governments they were praising just months before . . . Euphoria turned to panic without missing a beat".
Grenville also enjoys referring to the US Federal Reserve chairman Alan Greenspan's description of the ensuing capital flight as stemming from a "visceral, engulfing fear" in which currency falls had "no tie to reality".
Greenspan's use of such language might suggest that economists have always spoken this way about capital markets. An earlier generation certainly contained some powerful critics, perhaps the most notable US example being Hyman Minsky, while Keynes famously remarked: "When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill done." But these views have been brusquely shunted aside for well over two decades as economic leaders -- with Greenspan in the vanguard -- backed the IMF's relentless push for the greater liberalisation of capital markets.
Macfarlane was also a diligent keeper of the faith until recently. As former government policy adviser Fred Argy has pointed out, Macfarlane gave a speech in 1995 expressing his fervent belief that deregulated financial markets exerted a benign discipline on governments around the globe. In a wrenching about-turn in a speech in Singapore last month, Macfarlane concluded that the international financial system was "basically unstable".
Macfarlane's 1995 approach has been reflected in bodies such as the Asia Pacific Economic Cooperation forum which are formally committed to the free movement of capital. But this could be about to change as the Prime Minister, John Howard, has also undergone a crisis of faith.
Howard now says he will be supporting intervention to protect member countries against the "destructive stampedes" of global capital when he attends the latest APEC meeting in Malaysia in the coming week. Although Grenville would deny any influence, sometimes heretics can find their ideas are eminently employable.