Peter Lyons: Free market doctrine's bubble about to burst

Lower interest rates during downturns have also led to numerous asset bubbles in property and shares over the past 30 years. Photo / AP

We may be witnessing the death of a doctrine that has shaped our economy. I first encountered the subject of economics as a spotty teenager at high school in the 1970s. It was a traditional boys' school, my economics class was taught by an attractive young female teacher. The other option available was Latin. I chose Economics.

We were taught Keynesian economics, a product of the Great Depression of the 1930s. John Maynard Keynes had crucial insights into how an economy functioned in its entirety. He believed a free market economy did not automatically tend to full employment. An economy could get stuck in a situation where substantial unemployment could be a permanent reality.

New Zealand has had an unemployment rate above 5 per cent since 2007. This is more than 130,000 Kiwis willing and able to work yet unable to find jobs.

Keynes also pointed to a concept called the fallacy of composition. What holds true in the parts may not hold true in the whole. If I decide to drive to work at 7.30am each morning I will get to work quicker than walking. If everyone else decides to drive to work at the same time it may be quicker to walk. Keynes pointed out that during a severe recession if all households decide to cut their spending and save or repay debt then this is likely to make the recession even worse.

Keynes' prescription for ending the Great Depression was for governments to pump up demand in their economies by borrowing and spending. After World War II most Western economies followed the Keynesian prescription. Full employment was the main goal of economic management. If an economy experienced a downturn the government would pump up demand by borrowing and spending.

But just as I was learning this Keynesian economic doctrine in the mid-1970s it was already falling apart. Government borrow and spend policies had led to massive public sector debts and rampant inflation.

From the early 1980s Keynesian economics was being replaced by an alternative doctrine called monetarism in many countries. New Zealand's economy has been run on staunch monetarist principles since 1989 when the Reserve Bank Act was passed. A key aspect of monetarism is that during an economic downturn a central bank should cut interest rates to encourage the private sector to borrow and spend. Another key tenet of monetarism is that free markets are the best means to organise an economy. Governments should step back and let markets and free enterprise weave their magic.

I can remember as a callow teenager in the 1970s thinking that Keynesian economics made good sense. Now as a fuller-figured middle-aged Adonis I have learned to be wary of any doctrine that appears to have all the answers. An economic system is hugely complex. It is also unique for each country. There is no "one size fits all" recipe to economic management for each country.

Keynesian doctrine required governments to borrow and spend during downturns. By the 1970s it had become ineffective. Governments were saddled with huge debts. Monetarist doctrine requires central banks to slash interest rates during downturns to encourage the private sector to borrow and spend. The private sector in many Western economies are now saddled with huge debts. Monetarism has become impotent.

Lower interest rates during downturns have also led to numerous asset bubbles in property and shares over the past 30 years. They have also led to a significant growth in wealth inequality in many countries including New Zealand. Those who own financial assets such as property and shares are pulling away rapidly from those who don't. This process has been facilitated by record low interest rates in recent years as central banks attempt to reflate their economies.

Meanwhile, the large income and wealth inequalities mean many economies resemble an unbalanced Dynamo that is not functioning properly. For an economy to operate near or at full employment the demand side of the economy cannot be too skewed. The trickle-down effect is largely a myth. The rich often use their excess funds to bid up the prices of existing assets such as property, shares and art works. There are few new jobs created in this process.

A starting point to rebalancing our economy may be significant tax reform. The bulk of the tax burden in New Zealand is borne by workers. Yet the rewards of our current economic system are largely skewed towards the owners of capital. This is not only unfair, it is also very inefficient because it distorts demand. The economic Dynamo is not functioning properly. The problem is figuring out how to fix it.

Peter Lyons teaches Economics at St Peter's College in Epsom and has written several economics texts.

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