Financial markets had become ungovernable (ie no one was in a position to prevent the emergence of systemic risks) because of globalisation, and the inadequacy of the multilateral institutions established by the 1944 Bretton Woods agreement (eg the IMF) to adequately regulate the global financial system as it has now developed. For example, global financial imbalances (referred to below) arguably reflect 'clash of civilization' issues that were simply inconceivable in 1944 - yet the result is that developing nations now prefer to run current account surpluses and the core function of the IMF (ie providing emergency capital to such countries) is thus largely superfluous.

Globalization may also have made management of monetary policy by reserve banks unreliable, because interest rates are set to achieve inflationary targets - though inflation has been artificially low because of cheap (mainly Asian) imports. Thus interest rates have perhaps been set unrealistically low, leading to excessive borrowing for property investment. [1]. On the other hand it is argued that reducing interest rates would not encourage more risky use of funds - as this is usually said to occur when interest rates rise  [1].

Banks can otherwise create a virtually unlimited amount of credit (and thus expand money supply) because whenever they make an advance this tends to result in a deposit somewhere else in the banking system. And creating credit can, in turn, have macroeconomic effects (eg on the rate of economic growth and inflation) and also affect financial and property markets (eg by providing credit for leveraged purchase of shares or real estate).

Banks created 'special investment vehicles' (SIVs) for CDOs which matched investors with bundled assets - for which the banks gained management fees without theoretically having any ongoing direct financial involvement in the SIVs.

For many years CDOs provided a mechanism, outside any authority's control, to create large amounts of credit - and this has been part of the driver of real estate / business investment and household consumption (by drawing upon escalating asset values) which has underpinned strong economic growth in recent years - and created the potential for systemic failure.

An aside: It has also, probably, been a factor in the housing affordability problem which has become politically significant in Australia (and elsewhere). Cheap credit has been available for two decade (through CDOs, through loose monetary policy by Japan's and US reserve banks, and through recycling of Asian current account surpluses). $A assets have been seen as attractive for investment because the $A is viewed as a proxy for investment in commodities (because about 70% of its exports are of minerals and energy) and commodity prices have been booming. Banks drew on this available credit mainly for lending on property - and property prices have boomed

The former chairman of the US Fed, Alan Greenspan, argued in December 2007 that a housing bubble emerged because when reserve banks started to tighten short term interest rates in 2004 this had no effect on longer term rates (ie these stayed low) because financial markets had become too strong for reserve banks to control [1]

• the problems banks are experiencing in lending may be the result of being forced to bring large quantities of off-balance sheet assets onto their books [1].
• though the assets had theoretically been off balance sheets, banks chose to assume responsibility (rather than simply allowing SIV investors to carry the losses) because of concerns about the effects on their reputations and fear that legal costs could compound their losses. One observer argued that that the whole SIV phenomenon had been an Enron-like 'scam' [1];
• banks worldwide made $545bn in leveraged loans in first half of 2007. They got around capital adequacy rules by getting loans off their books. The 'shadow' banking system bundled home loans, credit card or even corporate debt, into off-balance sheet 'conduits' which raised money by issuing short term commercial paper - at higher interest rates for those who took higher level of risk. When doubts started about credit quality, investors lost interest and the problems engulfed banks - who had warehoused loans and guaranteed that they would fund conduits if they could not sell commercial paper [1];
• these problems won't be resolved until all sub-prime mortgage losses have been exposed; and structured credit assets have been exposed as highly dubious, and may not exist in 5 years [1];
• this has been an historic crisis for bankers because it has disproven the assumption that mathematical models of past behaviour can be a reliable way to manage hundreds of billions of dollars in financial assets (and create AAA rating assets out of those of poorer quality) and the assumption that old-fashioned local banking in unnecessary; [1]
• what is happening has been described as the breakdown of the modern-day banking system - which has the potential to dramatically reduce overall lending and generate a nasty recession. Financial innovations that were supposed to spread risk and make investment safer, encouraged investors to take on more risk than they recognised [1];
• a report for the World Economic Forum suggested that the scale / nature of financial crisis has raised fundamental questions about the current models of financial markets [1];
• there is now a modern version of the 'extreme liquidity preference' which contributed to the depression of the 1930s [1];
• problem arose from greed and remuneration systems of investment banks, and failure by regulators. CDOs were around long before the subprime crisis - and are a good product if well priced and transparent. The fact that only subprime (not prime) mortgages were securitized suggests that marketers knew they were dodgy and something to flick to the biggest fool. If there had been no off balance sheets deals and proper policing of derivatives the game would have been simpler. Lack of transparency on pricing and on creditworthiness were  also factors. If subprime mortgages had been securitised in the ordinary way, the damage would have been minor. Standard derivatives (like exchange traded options) still function well presumably because they are well understood, and priced / traded in a standard way (personal communication).
• a potential re-rating of $534bn of sub-prime mortgage securities in January 2008 will require many banks to write down their holdings - and perhaps seek new capital, which some may be unable to obtain  [1]

An aside: One observer speculated about whether the whole economic system may now be at risk because finance has become a major component of economies of US and others - yet contains fundamental flaws which have been revealed by (but won't be limited to) sub-prime mortgages. Debts have to be repaid, yet the value of underlying assets is unclear. They have been valued on the basis of models, and could be worth much less if 'marked to market'. Much financial enterprise has been built on the assumption of capital gains which can only continue as long as there is a constant stream of new money. Australia's property market seems to be an example, which is exposed to potential for reversal of the 'carry trade'. Reserve banks have recognised the risks, but have not yet been able to deal with the problem. It might be well beyond their ability to absorb the losses. Their acceptance of low quality assets as security for further advances to banks may be necessary, but puts $US and other currencies (and thus global financial system) at risk. Adjustment will take time, and there is a real risk of a very severe economic impact (brief outline of a personal communication)

The implications for Queensland's state financial position (and taxation) need consideration - especially given the high levels of debt-based infrastructure investment now under way.

The implications for Australia's housing market also require consideration - as banks exposed to heavily indebted households who in turn are susceptible to increased interest rates or unemployment. The IMF has suggested that household efforts to reduce debts could hurt consumption. The Reserve Bank argues that risks are low (eg mortgage arrears are low; Sub-prime lending is only small part of market; household assets have risen faster than debts). However those with the assets may not be the ones with the mortgages, and a large segment of the population has never experienced rising unemployment - and may have taken on too much debt [1]. The Economist Intelligence Unit has warned that Australia is one of three countries at most risk of following the US into a housing slump [1].

Higher interest rates will also have possible implications for Australia's current account position (and exchange rate). Australia has (something like) $700bn in foreign debts most of which apparently represent borrowings for investment in real estate - which need to be rolled over from time to time. This will be at higher interest rates in future - which will increase the current account deficit. It will also inevitably affect mortgage interest rates - and perhaps trigger a downturn in property values. As the latter are a major part of the collateral for the borrowings which balance Australia's current account deficit, funding that deficit could become difficult. The Bank of International Settlements (BIS) has warned that Australia is at risk of capital flight [1] if anything disrupted the 'carry trades' (see below) - and the consequences of this would be devaluation of the $A and high inflation. The real value of accumulated national wealth would be at risk, as would be Australians' ability to control their own future. The fact that the value of the $A has been volatile (and fallen sharply several times) recently can be noted. In December 2007, indicators emerged of the potential for a current account crisis because banks had for some months not gained international commercial funding (see below).

Financial institutions together with resource companies have been the strongest components of Australia's share market. The financial sector has also been a major contributor to income taxes, and the the ability of the federal government to reduce tax rates.

The European Central Bank started making credit available overnight, when it became apparent that there would be large spill-over effects on European institutions from systemic dislocations triggered by US subprime mortgage losses.

The US Fed has backed the conventional banks with a lot of credit - so firms who might have sought funding through now-suspect financial instruments have somewhere to go. But, as noted above, banks may not pass this on as they have their own problems. One report suggested that such funds tended to be simply invested in government bonds.

In any event, there will be huge numbers of potential borrowers lined up outside a few narrow gates, and interest rates will escalate to reflect risk more realistically.

The US Fed and Australia's reserve bank have also extended credit to non-banking entities that would be outside its normal range of responsibility - an indicated a willingness to accept CDOs as collateral - a step which one observer suggested to be probably unavoidable under the circumstances but potentially puts the value of their national currencies on the line (personal communication).

The US Fed also aggressively reduced the interest rate it charges banks (ie by 0.5% in September 2007) hopefully to stimulate the economy - and thus prevent a recession. However one observer suggested that this would only deal with the problem of liquidity - not with the problem of bank solvency [1]. Another suggested that keeping interest rates low through central bank action would boost house prices, and keeps consumers on 'retail therapy' which could make the financial crisis worse [1]

In December 2007 reserve banks in many countries agreed to collaborate in providing loans to banks in order lower interest rates and ease the availability of credit [1]. Observers suggested that this move would:

• be beneficial, but address only part of the problem (ie that related to liquidity, and not that related to potential insolvency). [1]
• not deal with problems other than liquidity (eg potential insolvency, risk aversion due to lack of information, and problems affecting non-bank institutions) [1] ;
• provide some systemic protection - at the expense of boosting moral hazard [1];
• probably not prevent the onset of recession, because interest rates primarily affect the economy by encouraging / discouraging housing investment - and no matter how low rates are cut this would not now boost housing investment [1]

Presumably financial intermediaries and rating companies are working to boost the credibility / transparency of their claims about complex financial instruments - so that those complex instruments will start to regain respectability in (say) 12 months.  It has been suggested, for example, that problems in CDOs can be ended by proper disclosure [1].

Proposals have been advanced for tighter regulation of mortgage lending practices.

US president Bush is expected to bail out households who are over-extended on their mortgages (eg with government sponsored credit or tax relief). Something like 2m families seemed likely to lose their homes in the US as interest rates rise, and the adverse effect on consumer confidence has been seen to require action. Government, rather than reserve bank, action was preferred because the latter (ie reducing interest rates generally) would have simply allowed unrealistically cheap lending to continue. Government bail-outs will reduce immediate losses (and cuts in consumer demand) but a potential for longer term losses is being created.

US government-backed mortgage giants Fannie Mae and Freddie Mac have been given authority to purchase mortgage-backed securities - thus perhaps allowing some private losses to be socialized.

Some investors are apparently moving to acquire sub-prime mortgage assets on the assumption that prices are currently very low.

Major banks (encouraged by US Treasury) proposed pooling together to establish a $100bn fund to purchase shaky mortgage backed securities in order to prevent any need for a 'fire sale' of assets. The theory was that there would be value in those assets which current market conditions do not reveal. However some believe that this would merely protect those with the largest losses at others' expense [1], while others have suggested that the proposal could be counter-productive by delaying the introduction of transparency into the mortgage backed security market, and thus delaying the re-emergence of investor confidence [1]. In practice this action did not eventuate.

Another plan has been developed (through US Treasury) to freeze mortgage rate resets for 5 years for owner-occupiers whose repayment history has been good but can't afford higher rates [1]. This would reduce companies' risk of defaulting on their debt [1]

• do nothing about the very large losses incurred before 2008 or the loss of confidence in structured finance mechanisms - which were already suggested to be large enough to have serious economic impacts;
• impose unexpected losses on other investors;
• apply to only a fraction of borrowers;
• provide only a temporary solution for those whose rates would be frozen; and
• not apply to property investors (who have apparently been the main source of defaults to date [1]).

Others suggested that the plan would (a) encourage fraud and create a bureaucratic nightmare and (b) probably fail because mortgage securities are owned by many groups some of whom have no incentive to support such changes as they bear no loss in a default [1] or (c) set a dangerous precedent [1]

Communities affected by large numbers of home repossessions seem to be experiencing severe social stresses - and confidence in the ethics of the financial system is threatened. Legal action to recover individual losses may be directed against the banks whose associated firms were responsible for sub-prime lending. This could increase the risk of bank insolvencies.

The responses of financial markets to these development (as always) reflect a balance between greed and fear.

An aside: Such markets are 'efficient' in integrating the diverse information available to thousands of entities in an economy.  However they are not efficient in dealing with systemic changes (ie situations that no one had expected), and it is then that the 'wisdom of a crowd' can become the 'panic of a herd'.

A member of the RBA board suggested that the US economy could go into recession without seriously adversely affecting the global economy, and that US sub-prime problems would be brief [1] - a perception that seems typical of many professional observers but which this document suggests may be overly optimistic (see further below).

In early 2008 it was reported that the US government was alarmed about the situation and had re-assembled its 'plunge protection team' which has power to support markets by buying futures contracts on stock indices. Because of its budget surplus the US government has some (but not unlimited) ability to counter the expected economic downturn. [1]

The US Fed introduced large (0.75% and 0.5%) sudden cuts in interest rates to forestall what appeared likely to be a stock market collapse. This has some effect on the market but observers suggest that it may be inadequate because:

• such actions were the cause of the current problem [1];
  • An aside: an observer in Europe noted that while rapid reduction in interest rates might encourage US consumers to spend, the effect could be quite the reverse elsewhere (eg in Europe - and presumably also Asia) where perceptions of economic crisis would simply encourage households to further increase their savings. This would not aid in resolving the global financial imbalances which (as outlined below) are part of the background to current problems.
• cutting interest rates will be inadequate because the problem is a lack of confidence in institutions rather than a lack of liquidity; long term interest rates may not come down; and nothing is going to stop housing price crash which will have huge effect on consumption [1]  ;
• the intensifying credit crunch is so severe that lower interest rates alone won't compensate for likely downturn. Thus in IMF view fiscal stimuli by governments is also vital [1]. Others however suggest that such fiscal stimuli often do more harm than good by creating unsustainable budgetary positions that generate long term problems [1];
• reducing interest rates won't encourage investment in housing because banks are limited to prime mortgages (and to existing mortgages) and bond markets won't invest in structured mortgage products until these are reformed. Reforms have not been made because sovereign wealth funds have been willing to purchase these products without reforms [personal communication].

US regulators are reportedly trying to spur a bailout of bond insurers (monoliners) [1]

In late January 2008, major banks expressed some confidence that the problems were being brought under control - because of the above initiatives [1].

Others have more apocalyptic interpretations, For example:

• George Soros developed a case that current instabilities are more than a normal boom-bust cycle - and reflect a 60 year boom in consumer borrowing and credit growth - which has produced excesses in banking, asset values and financial innovation. Ending this, he argues, will end the dominance of $US and shift balance of power in world economy to creditor nations in Asia / Middle East - though this may not occur just yet [1]
• in March 2008, it was suggested that Fed's actions had failed. There is a flight to safety by investors - and debt markets remain frozen. Failures in 'term auction' market have forced public authorities to pay high rates for borrowing. Corporate borrowing rates and default risks are high. US house prices are in free fall. There are still many mortgage resets due. Overall losses from credit crunch in US could be $600-1000bn. Losses have extended to prime mortgages, commercial property, home equity loans, car loans, credit cards and student loans. Housing busts in UK, Mediterranean, East Europe and Australia are still coming [1];
• in late 2008 there will be a new tipping point in the unfolding global economic crisis. This will translate into collapse of US real economy - as part of unprecedented global transition which supposed 'experts' seem unable to see. The global order which has developed around the US since WWII will dissolve - given the US's negative savings, free-falling housing markets and currency values, public and trade deficits, and economic recession and costly wars. others won't suffer as much - as decoupling is taking place [1],

In March 2008 the US Fed:

• asked banks to forgive part of the principal of mortgages to distressed home buyers to stem the explosion in foreclosures - as so many are involve negative equity [1];
• buoyed hopes that a broader credit crunch might be averted by offering to lend $200bn in US Treasuries to banks in exchange for debt including mortgage backed securities [1]

The US Government unveiled plans for regulatory reform which observers suggested might prevent a repeat of the crisis, but do little to resolve it [1]

It was also pointed out that the success or failure of efforts to stem problems in the financial system depended a great deal on inter-relationships with the 'real economy'. If the latter responded to stimulatory measures, the economic impacts will be limited - but if it doesn't the impact could be long and severe [1]

• US Treasury data show that Japan (followed by China) led a large net withdrawal of capital from the US in August 2007 (including a $US52bn net sale of Treasuries), which unless reversed is likely to force up interest rates on US Treasuries [1]; and
• the Bank of Japan has indicated an intention to raise interest rates - arguing that low interest rates can spark investment bubbles [1];
• Japan, the world's largest creditor, seems to be bringing the money home. The 'carry trade' is reversing. [1]. The reversal of the carry trade has led to large increases in Yen value, declining competitiveness of Japanese industry and severe stock market falls [1];
• policy mistakes and official inaction are seen as major contributory factors to Japan's economic downturn in late 2007 [1];
• Japan seems to be reversing the trend towards liberalization of its financial system - and this is resulting in withdrawal of foreign capital and rapid falls in share market despite reasonable profit levels [1].

The consequence of reversing the flow of capital (apart from strengthening the Yen and reducing Japan's industrial competitiveness) could be financial crises which had massive global economic impact (eg by making it impossible for US demand to drive global growth - while no other country is positioned to fill the gap) and lead to depression, political extremism and (possibly) major wars. However, as what could be at stake in the longer term could be the character of the global financial system and thus of the whole global order (see An Invisible Clash of Financial Systems), some pain might be seen to be justified.   The goal which ultranationalist factions in Japan have apparently maintained of casting off Japan's 'merchant soul' (and replacing it with the 'soul of a samurai') should not be forgotten.

Proposals have long been developing (led by Japan) for the creation of an Asian Monetary Fund (AMF) as an alternative to the profitability-oriented IMF which would operate under 'Asian values' (ie presumably a neo-Confucian preference for coordinating economic activity through relationships amongst a hierarchy of social elites, rather than by the financial profitability of independent enterprises).

• deterioration in the US economy and reducing future bank losses from sub-prime exposure was seen to require ongoing cuts in official interest rates by the Federal Reserve [personal communications from US economic analyst] - though inflationary risk and market responses (eg $US weakness) imply a limit to such cuts. Inflation risk and $US weakness have also led to some withdrawal of capital from US Treasuries. Such a withdrawal on a large scale seemed to result in higher interest rates and contribute to the 1987 share market crash;
• the large cut in interest rates by the Fed in January 2008  to head off possible recession was seen as like the aggressive rate reductions that led to the speculative bubble in housing in the first place. It now won't stimulate a housing boom, but could lead to higher inflation [1]
• long term private capital inflows to US have ceased, so that despite a reduction in in the US current account deficit, there is now total dependence of foreign reserve banks and sovereign wealth funds to finance the deficit (which had been fully funded by private capital inflows in 2000) [1] - see Funding Financial Imbalances;
• private investors are increasingly unwilling to fund US current account deficit. As a result, at some point, lowering official interest rates will cease to have a stimulatory effect, as long term rates will start to go up [1]
• there has been a run on one (quasi) bank in the US - which was forced to suspend withdrawals - and this could be the first of many [1];
• defaults in US housing markets are extending beyond sub-prime threatening even bigger bank losses. Default rates on home loans have reached 7.3% (with 4% rate for prime mortgages). Prime mortgages are valued at $8tr, while sub-prime are only $2tr. Financial damage could be huge. Crisis is extending to credit card debt, auto debt and student loans. Corporate defaults could rise from 1% to 5-9% in 12 months [1]
• 10-15m US families may walk away from their homes because of negative equity in the face of a 20-30% decline in property values (which now seems increasingly likely). This would impose $1-2 tr losses on banks (compared with $200-400 bn losses associated with sub-prime mortgages) - and exceed their available capital probably requiring that they be nationalised [1]
• signs of stress like that in sub-prime lending are emerging in US auto loans [1];
• Merrill Lynch forecast that subprime turmoil will spread to credit cards and consumer loans [1];
• cash management accounts of some state governments have suffered unexpected losses [1];
• efforts by major US banks to defer the impacts of sub-prime losses were suggested to be counterproductive by prolonging uncertainty [1]; 
• proposals by US Treasury to enable those who can't afford mortgage resets to renegotiate their loans seem to have limitations (see above)
• lax standards in lending, that are now likely to result in losses, do not seem to have been confined to sub-prime mortgages. For example:
• reckless lending was not confined to sub-prime mortgages. 50-60% of mortgage lending recently has been reckless. There are also sub-prime auto loans and sub-prime credit cards. The problem extends into companies because easy credit has been made available to firms that might otherwise have failed (resulting in recent years in very low rates of corporate defaults). As credit tightens this will reverse [1];
• there may be a risk to corporate debt also - because of heavy past borrowings (for acquisitions etc) and the likely deterioration in economic growth [1];
• securitization has meant that the same disregard for credit quality that affected sub-prime lending has emerged in other packages that financial institutions originated but did not then hold [1] ;
• investors' concerns are shifting from residential real estate to potential losses associated with commercial real estate and the related securitized products - as (a) these suffered the same poor underwriting standards and loose lending to marginal projects as sub-prime and (b) commercial real estate tends to follow trends in residential real estate after a few months [1]
• US banks have been loading assets into the (so called) Level 3 category where valuations are based on models rather than on markets. Some $100bn in losses (in addition to those associated with sub-prime) are likely to be exposed by new accounting regulations which prevent this practice [1];
• even borrowers with good credit ratings may default in US if housing prices keep falling. What seemed like a credit quality problem could be a general problem for home loans. Many just walk away if they have no equity. As close to 100% of property values was loaned, many never gained much equity [1]
• the 'guns and butter' era in the US in recent years has been associated with significantly increasing government borrowing, while at the same time public spending backlogs have developed [1]. This implies future tax increases that would compound the constraints on consumer demand and business investment implicit in higher credit costs; 
• US government could lose its AAA credit rating in a few years unless there is urgent action to curb soaring healthcare and social security spending [1] - which seems to be a consequence of population aging;
• funding of local authorities has been severely affected by sub-prime mortgage crisis - leading to calls for urgent federal aid [1];
• US is headed for potential bankruptcy because of  (a) huge 'defence' spending (>50% of world's spending) that does nothing to improve national security (b) loss of manufacturing base and (c) failure to invest in social infrastructure [1]
• sub-prime losses are now widely expected to be $500bn and result in $2tr reduction in lending. Problems are also possible in home equity loans - which have been pushed to the limit of home values. Problems also affect loan insurers, who are incurring sub-prime losses which downgrades their AAA status, and forces sales by pension funds etc of assets that they had guaranteed  [1]
• there has been an increase in the funding of mortgages in the US, but this has been supported only by funds from official sources [1]
• US has entered severe recession due to: housing recession; liquidity / credit crunch; high oil prices; falling corporate spending; low job creation; and consumer exhaustion. There is also a risk of systemic financial crisis, as losses spread from subprime to prime mortgages / consumer debts / commercial real estate loans / leveraged loans - and soon rising defaults on corporate bonds. Total losses could be over $US1tr. [1]
• US is sliding towards a 1930s' style liquidity trap that can't be stopped by interest rate cuts, while proposed fiscal stimulus won't compensate for loss of consumer spending associated with drawing down home equity [1]
• US recession in 2008 will be much worse than after dotcom crash because the industries now shuddering to a halt (homebuilding and housing dependent consumption) are 6 times greater than IT spending [1]
• home equity lending - to allow home-owners to increase spending - is proving to be a big source of losses for US banks in the face of declining house prices [1]
• there seems to be a shift in sentiment in US households towards thrift and away from credit-based consumption - as a consequence of falling jobs and house prices and growing debts. This could have major implications for an economy based on consumption [1]
• there has been a long term problem affecting US households - that their incomes had not risen as fast as their need to spend. Easy credit had bridged the gap - and this is no longer available. Also households are concerned that retirement savings may not be adequate because of declining house prices and share prices [1]
• financial market problems are extending beyond mortgage backed securities - and now affect low rated corporate loans; securities backed by student loans and municipal bonds and commercial real-estate [1];
• there is a potential for defaults on municipal bonds (as well as on the structured credit that the 'monoliners' had offered insurance on). These are traditionally assumed to be very safe because governments can just raise taxes. This assumption may no longer be valid because so much revenue depends on property taxes - and this is declining [1]
• US economy is not responding to interest rate cuts and Fed is running out of options. A sharp repricing of assets is possible, as is a prolonged recession [1];
• getting US out of recession will be difficult, as debt-laden households won't spend, banks are in no position to provide credit and federal government is heavily indebted. This implies a long period of 'de-leveraging' (ie reducing debt) and poor economic growth [1];
• US consumer confidence has fallen sharply because of falls in asset values, and as consumers spending accounts for 2/3 of GDP this must deepen recession [1];
• US house price index fell 10.7% in January 2008 after a 9% fall over previous year [1];
• subprime losses were less than some estimates suggest. Some banks have had better than expected results, and Fed and US government have made major contributions to boosting liquidity and spending. A turnaround is possible [1]

• EU has created the most dangerous credit bubble. Germany entered euro with over-valued currency - and suffered competitiveness problems. The ECB set low interest rates to compensate, and this created booms in other EMU countries. Firms and families became massively over-borrowed, and banks over-lent, on inflated house prices. Some of these countries have large current account deficits, which can't be addressed by devaluation because they are trapped in EMU [1]
• the Bank of England warned about the effects of the credit crunch [1] - specifically about the fact that equity markets do not seem to have taken account of repricing of risk, and are probably poised for major falls [1]. The UK economy is exposed because it has depended on a housing boom - and housing prices are now starting to decline. The Pound could weaken significantly setting off rapid inflation [1];
• the biggest casualties of falling $US and the debt crisis will be European companies. The credit crunch and US housing crisis have been less significant than a likely shift in global growth to favour US at the expense of Europe and UK. Declining $US will see exports boom, while falling house prices in US will see imports decline. This boost should offset losses from sub-prime crisis - but be at the expense of Europe, Asia and others.  European countries could emerge with large current account deficits because of the revaluation of their currencies [1]
• $US devaluation has improved US export competitiveness, reduced the US current account deficit and led France to warn about 'economic war' [1];
• Banks in UK have sharply reduced their willingness to lend to both households and business  [1]
• fallout from credit crunch is likely to affect consumer spending in Europe. Interest rates are up because of scramble for increasingly scarce credit. A 50% housing price crash in UK (and other housing boom countries in Europe) is possible. The shrinking availability of credit is also affecting business - especially in Europe where banks are more dependent on inter-bank credit markets. Germany's economy is susceptible to both strong euro and problems in small banks [1];
• as $US falls to $1.50 to euro, Europe is in political / economic crisis - and EU may not survive in its present form [1];
• the continued strengthening of euro (due in part to falling interest rates in US and high rates in Europe) is leading to concerns about competitiveness and the need to shift production off-shore and also to a sell-off in sovereign bonds from some countries (eg Spain / Italy) seen as least able to cope with very strong currency [1]
• hot housing markets in Europe and some emerging economies will cool dramatically. No junk bonds have been issued in Europe for months.  Lenders are refusing to roll over asset backed loans. [1]
• Swiss banks, who for centuries have presented themselves as safe havens for money in times of trouble, have been badly hurt by sub-prime crisis [1];
• economic setbacks in UK and Europe can't be blamed just on US sub-prime crisis.  Housing and mortgage markets have been main source of US problem - but the situation in UK / Europe is much worse (in terms of recent escalation of house prices and housing oversupply) [1]
• Europe hopes to be sheltered but it will be affected because (a) US is still 25% of global economy and will be in severe difficulties (b) the ECB is still worried about inflationary risks which will soon disappear (c) Europe has already been affected by financial contagion - and this will have bad effect on business because of high dependence on banks (d) housing booms / bubbles occurred in Spain, UK, Ireland, France, Portugal, Italy, Greece - and some are starting to deflate (e) rise of euro to 1.50 relative to $US is eroding competitiveness - even in Germany and France (f) consumer purchasing power is eroding due to high oil / commodity / food prices; investor / consumer sentiment is weak. Many countries are verging on recession.  There is little room for fiscal stimulus [1]
• British banks are taking significant losses - which would not have been a problem if they had been well capitalized, but investors have for years insisted on return of capital so they are very thinly capitalised, and may require additional capital from investors [1]
• 10m people in UK may be unable to meet their commitments established through easy (mortgage, credit card and personal loan) credit [1]
• UK is facing the possibility of a financial crisis - because of possible inability to continue gaining international investment to fund government deficits. Spending is up and tax receipts are down - and deficit seems out of control. Economic is heavily dependent on financial services - which are being hurt by credit crunch [1];
• UK faces severe economic challenge related to: high current account deficit; basing growth on unsustainable asset bubble; fiscal deficit and likely need to raise taxes in a downturn; and increased state share of economy [1]
• Bank of England is uncertain about what to do is the face of the world's biggest ever peacetime liquidity crisis [1]
• Irish banks are in severe difficulties because of property price crashes - yet normal measures of support can't be used because Ireland is in eurozone. Nationalization may be the only option [1]
• UK could experience similar development in property market to those in US. The phenomenon of negative equity is real. There are however fewer loans with low 'teaser' rates. Despite high real demand for housing in UK - prices could fall 20%. Because loans were being made much more readily available to people with limited ability to repay, house prices had been forced up to record levels [1]
• Eastern Europe faces the risk of a very hard economic landing (according to IMF) because its banking system has built up a large negative net foreign position which relies on continued capital inflow from Western Europe, and the latter can no longer provide the funds to continue this [1]

• Japan has gone into recession and suffered a big fall in housing starts because of new laws;
• policy mistakes and official inaction have been major factors in the slowdown in Japan - and to an extent has slowed growth potential across Asia [1];
• there has been a significant decline in US imports of Asian manufactures - as well as a rise in US exports in November [1]
• Singapore's export-dependent economy contracted in late 2007 and Japan's share-market experienced major downturn - suggesting that China's efforts to tighten credit are starting to bite [1];
• there has been a massive flight to safety by investors across Asia who had initially ignored the sub-prime crisis [1];
• Japan's share market has suffered large losses, because the Yen has appreciated as the 'carry trade' (which had exported funds to high yield economies including Australia) has been reversed. This has damaged the export competitiveness of Japanese industry [1] - see also below;
• Japan's financial institutions could have invested in a large part of sub-prime assets which have lost value in US, and still be hiding losses. US and European institutions have acknowledged only $130bn of the estimated $400-500bn in total estimated losses. Japan's institutions have tightened lending very aggressively. The economy is headed for recession. Steel and semi-conductor sales to China have slowed. The Yen-carry trade reversed in August [1];

• China's manufacturers are under pressure from falling US housing market, a new labour law that increases costs, rapidly rising input costs and loss of preferential treatment for exporters. [1];

• Asia is experiencing rapid inflation - and this has the potential to end the trend towards increasing prosperity (because basic commodities such as food are increasing fastest, and are people's main purchases). Inflation results both from low interest rate policies (eg in US / Japan), and from skilled labour shortages. High growth with low inflation is no longer possible. Rises have been coming for a decade, but have been masked by subsidies which are now becoming too expensive. Reserve banks will be forced to increase interest rates which will stifle economic growth [1]

Australia

• Australia is potentially headed for economic trouble, noting rapid growth in economy, credit and consumer spending (despite Reserve Bank efforts to slow these down) and declining export competitiveness [1];
• some Australian companies (with large debts) are being exposed to cash shortfall as a result of global credit crunch [1];
• in December 2007 it was suggested that funding Australia's current account deficit through bank borrowing for property investment had effectively ended - and that the reserve bank was bridging the gap [1], though the RBA denied that it was intervening because the $28bn it injected was merely the completion of an earlier swap [1]. Another informed observer suggested that (a) the apparent run down in Australia's foreign exchange reserves reflected the withdrawal of government funds from RBA - which reduced both reserves and equivalent negative forward commitments and (b) banks had been able to borrow [1].
• smaller Australian banks which have relied upon securitization are under some pressure [1];
• it has become harder to finance new projects. Over time this will affect private equity and infrastructure [1]
• Australia's leading infrastructure companies could face much higher funding costs [1] because of implosion of monoline insurers in US [1]
• there are potential problems in the commercial property sector - because valuations have been set aggressively and used as the basis for borrowing, resulting in high levels of debt on inflated valuations [1];
• one of Australia's economic strengths has been its unusually large contingent of banking stocks - but this is now turning to a weakness. Those banks had little direct exposure to US subprime crisis, but borrow in the same markets and have been dependent on offshore wholesale markets to finance Australia's strong credit growth. Also they are facing strong competition from HBOS-backed BankWest which is the first foreign bank to take the challenge of developing a strong local network - and this is constraining profits [1]
• Australia's big banks are facing a system-wide blow-out in bad debts. All are exposed to corporate borrowers struggling to refinance / service loans. Australia's debt-laden commercial property sector could be problem area. Business lending surged after 2002, but for geared purchases of commercial property - not for capital expenditure. Banks are exposed to struggling borrowers (eg RAMS, Centro, MFS and Tricom) [1]

• the IMF has ranked Australia highly as susceptible to a house price slump [1]

• there appear to be other signs that the property boom could be ending:
  • Australia faces a housing bust and falling commodity prices [1]
  • 750,000 homeowners in Australia are suffering mortgage stress, and 300,000 are at risk of defaulting on repayments and losing properties in 2008 (double the number of a few months ago). The full impact of credit crunch has not yet been felt. Interest rates are likely to rise further [1];
  • prestige property, which boomed 25% in value last year, could be hit by share market volatility [1]
• a company which had allowed investors to acquire shares without full financials - in a way comparable to sub-prime mortgage lending - is in trouble [1]
• companies whose directors have purchased large quantities of shares on margin are proving susceptible to short-selling raids which forces price collapse by requiring those shares to be sold into a falling market [1];
• banks are facing as increasing liquidity squeeze - because of the much higher cost of their wholesale funds, only half of the cost of which has yet been passed on to borrowers [1];
• infrastructure funds and property trusts which have large borrowings are losing investor support as cheap credit ceases to be available [1]

• banks may have to restrict lending because of credit freeze - according to RBA [1];

• in Australia banks are running out of money - not just having to pay too much for it. This is world's biggest current economic issue - as more companies come to banks to borrow. Banks' capital bases have shrunk at the same time that companies who relied on securitization for funding have approached them for loans. Banks' capital to asset ratios average 10.2 (with 10 minimum in US), so there is little more to lend [1];

• companies are finding it much harder to get funding for projects [1];

• a recession in likely in 2009 [1]

Elsewhere

• the possibility has been suggested of a repeat of something like the Asian financial crisis in Eastern Europe [1, 2]. Others are concerned about possible bubbles in Latin America and parts of Asia as well [1]
• Russia is suffering from the effects of high oil prices - erosion of competitive foundation of other industries. Inflation is high, property prices are high, there is a critical lack of infrastructure [1]
• emerging economies are experiencing rapid inflation because, by tying their currency values to $US, they are importing a highly expansionary monetary policy as Fed seeks to stimulate US economy in the face of credit crisis [1]
• Iceland's banking system is close to collapse, and it may be beyond its government's power to prevent this [1]. The asset base of its banking system is 8 times GDP - drawn from global markets to finance offshore investment. Credit has no been turned off, and currency has fallen in the face of capital flight [1];
• investor flight could trigger problems for many countries with current account deficits (eg Turkey 8% of GDP; Iceland 16%; Latvia 25%; Bulgaria 19%; Georgia 18%; Estonia 16%; Lithuania 14%; Romania 14%; Serbia 13%) [1]

• the banking system in the US / UK / Europe appears to be in serious difficulties which do not simply relate to sub-prime losses (see above);
• 'dumping' the $US has the potential to undermine the whole global financial system because of the status of $US as world's reserve currency. There is also a risk of a new bout of competitive devaluations [1]. A decision by China to diversify its foreign exchange holdings contributed to significant weakening of $US [1]. Many other (mainly small) nations have indicated an intention to do likewise;
• declining value of $US has left central banks everywhere with large losses - and this will give rise to political / military tensions [1]
• some commodity prices fell sharply and investors retreated from perceived high-risk markets [1]; 
• while some argue that commodities are now in perpetual boom because the world is running out of resources (eg consider the peak oil concept), most resource markets are driven by the industrial cycle - and booms can turn to busts. As the US is in the grip of a credit crisis, capital is fleeing to Asia and the Middle East - and driving investment booms which not only boost commodity demand but also put their currency pegs at risk. When they impose controls, more realistic commodity prices will emerge [1];
• the rapid increase in money supply that reserve banks are providing in order to maintain liquidity in the face of banking's failure is beginning to spark inflation - which could turn into stagflation [1]
• while the crisis emerged from sub-prime market, its origins run deeper (ie very low interest rates since 2000 and excessive risk), and it could have unexpected global impacts.  It is leading to repricing of risk, reduced appetite for borrowing, slower growth / reduced profits, lower interest rates, weaker $US, and pressure on countries like China to change exchange rates [1];
• the initial expectation was that crisis would only affect financial markets and not spill over to the real economy. Then it emerged that real economy (lax lending standards, slowing economy and rising interest rates) was driving the defaults, foreclosures, falling house prices and more defaults [1];
• though the sub-prime crisis was a limited problem in one market, it has had wide global impacts. The rules under which central banks operate are set by the Basel Committee, and have proven inadequate [1]. To avoid a worse crisis that 1929, one observer suggested a requirement to liberalize the Basel rules that apply to banks' capital base to allow them to cope with being forced to bring large quantities of off-balance-sheet assets onto their books [1].
• the new Basel II capital adequacy framework for banks is intended to overcome problems in the older systems by allowing banks with sophisticated risk management systems to use their own models for determining the amount of capital they need. However current turmoil in financial markets shows that those methods (which are the foundation of Basel II) simply don't work [1]
• the financial crisis has been exacerbated by current banking rules. Regulators relied on Basel Rules - and allowed banks to approach their capital limits before issuing warnings. Moreover Basel II Rules (involving marking assets to market) accelerated the downward spiral once problems started  [1]
• the modern global financial system was supposed to manage risk with greater efficiency through deregulation. But the reverse happened - as the effect of many changes has been to shift risk to those least able to understand it - especially households [1];
• the a global slowdown which results from financial instability will be deflationary (not inflationary) because it will be the result of a negative demand shock. Stagflation (which some worry about) can only occur when growth slows as a result of a supply shock.  [1]
• the liberal conditions under which financial markets have operated have been perfect for making money. But problems have emerged. The latest to be revealed involves the derivatives operations by bond insurers - which put at risk the value of bonds they insure. Government intervention in, and control over, financial markets is likely to be much more extensive in future [1]
• authorities will now impose regulation on financial systems which, while necessary in some ways, will also put grit into the engine of the economy [1]
• the monetary loosening and fiscal stimulation that the US will at best create the conditions which have led to the current crisis. The priority should be worldwide adoption of policies that allow a big fall in US current account deficit without weakening global activity. The US can't do this alone  [1]
• $US could become the basis of a new 'carry trade' (rather than Yen) because relative interest rates in US are now low [1]
• heavily indebted companies (especially those involved in property) are in increasing risk of default because of continued closure of credit markets in Europe and US - which prevents debt refinancing [1]
• commercial and investment banks in NY are operating on a flawed business model - because executive compensation is large and based on the volumes of securities transactions. This suits a business model which involves the development of complex securities products - but may be inconsistent with what is required for those banks to prosper in future. These problems seem to be being overlooked by Fed [1]
• large failures in private equity can be expected in 2008 as a result of earlier excesses (in debt funded takeovers of companies) and banks will be hurt [1]. Companies had been bought with high levels of debt with inadequate due diligence standards and false earnings estimates [1] ;
• 'auction rate securities' are another structured finance product in which failing leaving investors with large losses. This involved regular re-auctioning of long term bonds - which (because interest rate curve normally rises) allowed issuers to get lower rates than normal and investors to get  higher rates on short term investments. Demand for these has evaporated, and banks have withdrawn guarantee to buy (ie to absorb interest rate risk) leaving short term investors holding long term assets at a loss and forcing borrowers to pay penalty interest rates [1];
• a crash in commodity prices is possible, because these have been driven up speculatively by investors seeking diversification - and assuming that China etc can ensure rapid growth in commodities demand in the face of slowdowns in 60% of global economy [1]
• de-leveraging is necessary as the credit crunch has shown that financial institutions have too much debt. Hedge funds have started this, but banks haven't. The best way to do this would be through reducing assets - but cutting lending would hurt the real economy [1]
• the IMF has warned that costs of financial crisis could be nearly $1tr. It referred to (a) collective failure to appreciate the extent of leverage taken on by financial institutions and the associate risks (b) regulators inability to keep up with the speed of changes and (c) the use of off balance sheet vehicles [1]

• the losses which sub-prime crisis and property crash might lead to in US are similar to losses incurred in various other financial dislocations over the last couple of decades [1];
• there is limited evidence of widespread credit crunch. Though credit standards have tightened, bank lending is still increasing. Many US companies have reduced short term debts - and have strong cash flow [1];
• US economy can withstand the sub-prime crisis because housing is only 5% of economy - and even the worst housing outcomes can not have a broad impact [1] - though the fact that a boom in house prices has underpinned consumer spending (70% of US GDP) well in excess of household income suggests that the economic impact of falling house prices could be quite strong;
• a US export boom resulting from the weaker $US could help offset the effect of sub-prime losses [1]. The export surge has shrunk the trade deficit by 1.5% of GDP which roughly offsets the 2% of GDP lost in sub-prime assets [1];
• action by US authorities might be sufficient to reduce the effects of the sub-prime crisis to the point where a US recession is avoided [1] - though possible defects in those actions were mentioned above.
• credit crisis is almost over. Credit spreads in interbank market have returned to normal. Leading banks are reporting large write-downs which will end their troubles. If this doesn't happen governments will announce public backing for their national mortgage / banking systems, as crisis must be resolved soon because world economy can't continue without normal banking services. The US will avoid a recession because interest rates will be very low. Share prices have already been discounted. Decoupling of global growth from US, won't occur for Europe, but will occur for Asia. .[1]
• there is no sign of a credit crunch in the Eurozone - as borrowing by business has been rising at a record rate. This and the effect of a strong euro on containing inflation will make the ECB unwilling to reduce interest rates [1]
• The current credit crunch is not particularly severe. In 1982 when Mexico and Brazil defaulted - all leading US / UK and European bank become effectively insolvent [1]
• there are reasons to suspect that US financial markets will soon return to normalcy. Liquidity is readily available, and arrangements have been made to increase demand for about $1bn in problem mortgages. Asset prices reflect the view that very severe economic impacts will emerge [1]

• the IMF has argued that financial instability will have limited effect because it occurred when economic growth was strong - especially in emerging market economies [1];
• its IMF's World Economic Outlook projects continued strong global growth - led by low income economies - despite a financial crisis at the core of the world economy [1];
• take off by developing countries will set stage for the next era of global growth. They are producing major changes in global trade / capital flows. Their success will prevent a downturn in the US from affecting the global economy [1]
• Merrill Lynch argued  that decoupling is already proved - because global growth outside US accelerated in 2007as US decelerated. Though consumer demand will weaken in US (and UK) it will be strong elsewhere. What is happening is 'rebalancing' - and this creates major opportunities for US export industries [1];
• in 2007 Asia was little affected by sub-prime problems. World Bank has high expectations for Asian growth - powered by domestic demand growth in China. Exposure to global conditions has been reduced since 1990s because of: domestic demand; current account surpluses and foreign reserves; and a reduction in non-performing loan ratio from 10% in 2002 to less than 5%. There is also a lot of room to cut interest rates or expand fiscal policy to counter any slowdown [1];
• growth has been strong in Asia in 2007 - driven both by exports and by increasing domestic demand in some countries. Current account surpluses are large while reserves have grown. China's surpluses are falling as a share of GDP. Financial systems have limited exposure to US sub-prime mortgages or complex structured credit products. Growth is now likely to slow because of policy tightening in China and export demand / foreign investment weakening. Asia has reduced its vulnerability to financial crises since 1997 (eg via financial / corporate / monetary reforms). Moreover large foreign exchange reserves are available. Trade interdependence in Asia continues to increase [1];
• a continued boom in commodities (driven by China's demand) at the time of US economic downturn suggests that decoupling is real [1]

• China  is so dependent on US / EU markets that a 1% fall in external demand will lead to a 4.5% fall in exports and a .75% fall in GDP [1]
• the US can't have a recession without a fall in consumer spending (as this accounts for 70% of GDP) - and falls in consumption will hit countries that rely on exports to US. Moreover consumption has been financed by borrowing in recent years - which only makes sense if home prices are rising and this now seems likely to reverse sharply [1];
• China has developed industrial over-capacity which could be a source of problems if export-led growth fades [1];
• China's commerce ministry warned that slowing US economy could trigger a drop in exports and lead to a turning point in China's rapid growth. Exports account for 1/3 of growth and 10% of China's GDP. US takes 20% of China's exports (behind Europe). Every 1% drop in US growth will reduce China's exports 6%. Exports to US have slowed significantly in 2007 [1];
• all the big economies (ie Europe and Japan) show signs of slower growth in parallel with US, so even if emerging economies grow strongly this won't decouple overall growth from US [1];
• by keeping yuan low, China strengthens its export industries and makes it more susceptible to US slowdown [1];
• the ideas of self-sustaining Asian growth is premature. Consumption has declined as a percentage of Asian nations' GDP over the last 5 years. While the share of exports to US has fallen (from 23% in 1985 to 17%), the intra-regional trade that has replaced it correlates with US imports - a correlation that is strengthening. Dependence on US knowledge has not yet started to decline  [1]
• China's effort to steer its economy towards consumption and away from exports and investment is not working. Consumption is only 37% of GDP the lowest in 20 years. While high home prices are blamed: underdeveloped credit systems; declining wages' share of GDP because of efforts to boost profits; central bank efforts to reduce money supply to keep yuan from appreciating; lack of public services; and Confucian emphasis on thrift may be more important [1];
• decoupling arguments don't take account of shocks from G3. Increasing trade / financial links increase the risk of transmission. High level of intra-regional trade overstates the position, as 70% of this is intermediate goods for export. Only 20% of Asia's GDP comes from final demand in the region. Asia could withstand a modest US slowdown, but not a severe one. It remains heavily dependent on exports [1]
• China has appeared unaffected by US slowdown only because the latter has (so far) only affected housing rather than consumer demand. While intra- Asian trade has grown this largely depends on US demand.[1]

• other emerging market economies have done what IMF recommended (eg smaller budget deficits, independent central banks, low inflation, floating exchange rates, current account surpluses, cleaning up banks etc) and this has reduced their vulnerability . However their success also depended on sound global growth, high commodity prices and low risk aversion by international investors. This now could reverse. [1]

• no country would be immune to a US recession, both directly and because of the impact on China which relies on US exports to drive growth [1];

• China's leaders have sought to make their country more internationally engaged that it had ever been in the past - so decoupling is most unlikely [1]

• China has growing penetration of European markets [1];
• Asia benefits from both stronger European and domestic demand [1];
• China's dependence on exports has been over-estimated. While the gross value of exports is 40% of GDP, in value-added terms exports are only 10% of its economy