Sunday, 11 March 2007

My Economic Philosophy - 4 (Liquidism as "Extreme Economics")

(This is the fourth of n pieces on my emerging economic philosophy called Liquidism.)

In spite of its seemingly revolutionary approach, Liquidism isn't really a radical departure from current "best practice" in economics. The three schools of macroeconomic thought I referred to in my third post on this topic do not really contradict each other, either.

Those who assert that governments must not run deficit budgets are in fact agreeing with those who claim that inflation needs to be kept in the vicinity of 2-3%. Government budget deficits are known to be inflationary, so balanced or surplus budgets greatly assist central banks in their task of controlling inflation through the manipulation of interest rates.

Similarly, those who believe that the most important parameter is low unemployment, and therefore clamour for growth-oriented economic policies are not disagreeing with the other two schools of thought. Growth occurs best in an environment of stable and low inflation. Witness the example of Australia, the clever country (not the lucky country, by the way, because Australia's prosperity is the result of smart management, not undeserved good luck). Australia has enjoyed an unprecedented 15 years of nonstop growth, while the rest of the world has seen periods of both growth and recession. Unsurprisingly, during this period, the Australian federal government budget has been largely balanced or in surplus, and inflation has been vigilantly maintained in the 2-3% range by an alert and active central bank.

So we seem to have stumbled upon the magic formula that reconciles seemingly different schools of macroeconomic thought. Keep inflation low by constantly tweaking interest rates, avoid contributing to inflation by running budget deficits, and you will achieve steady growth that will keep unemployment low.

Liquidism only carries this argument one step further, because all the above techniques, impressive though their results may be, do not succeed in driving inefficiency out of the system. Inefficiency, in the terminology of modern software development, is a "smell" that suggests that something is wrong somewhere.

Lest anyone think that I'm a blind devotee of The Australian Way, take a look at the Australian banking sector. It's an oligopoly, with only four major banks. I have a unique inside view into the functioning of these organisations, having worked in two of them. I will not jeopardise my current employment by going into specifics, but most activities in these organisations are highly wasteful, compared to similar activities in organisations in more competitive industries. And yet the big four banks remain highly profitable! If organisations can show huge profits year after year while being extremely inefficient and wasteful (as is obvious to an insider), it's a "smell". Something is rotten in the system, and it's not a problem with the banks themselves. Their inefficiency is a symptom, not the problem. The problem is with the competitive environment. Less competition, less efficiency. Wealth is vanishing from the system, being eaten by the friction of inefficiency between its wheels. In the case of the banks, customers are picking up the tab and paying more than they should, while shareholders are earning less than they should.

What do we do? Let's take a leaf from the software development industry, specifically, a recent methodology called "Extreme Programming", called XP for short. The father of XP, Kent Beck, explains the technique in these words:

"When I first articulated XP, I had the mental image of knobs on a control board. Each was a practice that from experience I knew worked well. I would turn all the knobs up to 10 and see what happened. I was a little surprised to find that the whole package of practices was stable, predictable, and flexible."

We now know that certain economic practices work well. Keeping inflation low is one of them. We also know that competitive (liquid) markets are efficient, while oligopolistic or monopolistic (illiquid) markets are inefficient. How do we, in Kent Beck's words, turn all the knobs representing good macroeconomic practice up to 10?

1. Turn the fiscal knob up to 10 (manage spending and income to avoid a deficit budget at all costs)
2. Turn the monetary knob up to 10 (actively manage money supply through the interest rate vehicle and keep inflation within 2-3%)
3. Turn the market efficiency knob up to 10 (aggressively enforce antitrust and keep markets liquid)

I believe that Liquidism represents the "complete" macroeconomic philosophy, with its inclusion of the final leg in the triad of macroeconomic policy.

It's not a rejection of current economic thought, but merely the next necessary step in our thinking.

It's "Extreme Economics", if you will. And if the vaunted results of Extreme Programming are anything to go by, it could be wildly successful.
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