Defending Australia from the Financial Crisis?

• Fortress Australia?
• Preventing Economic Disaster?
• Managing Australia's  Economic Crisis

Introduction

A financial crisis originated in 2007 in the US and was first revealed when, following a 2006 downturn in property prices, banks incurred major losses initially on (so called) sub-prime mortgage loans.  The background to, and development of, that crisis is considered in  Financial Market Instability: A Many Sided Story.

Stage 1: The Fortress Scenario

After it was elected in late 2007, the Rudd Government's response to the global financial financial crisis as it has developed initially involved:

• public assertions for several months that the major economic challenge Australia faced was inflation - said to be a legacy of the previous government rather than of international influences - which required tight fiscal and monetary policy (ie limited public spending and high interest rates);
• some precautionary and behind the scenes development of contingency plans in collaboration with financial regulators and the Reserve Bank (Tingle L., 'The Treasurer who looked into the void', Financial Review, 18-19/10/08);
• a slightly lower emphasis on increasing the 2008-09 budget surplus than might otherwise have been appropriate if inflation was the only concern (op cit);
• repeated assurances about the strength of Australia's banking and financial regulatory institutions;
• reference to the strength of resources' demand from emerging economies (especially China) that would ensure Australia's continued economic growth.

As the crisis visibly worsened in September 2008 it was first suggested that authorities would be able to defend Australia's position in the face of a serious recession in the US and a likely economic slowdown in China because: (a) the Reserve Bank had a lot of scope to reduce interest rates; and (b) the federal government would be able to increase spending by running down its large budget surplus as revenues slow (eg see Hartcher P. 'Fortress Australia', Sydney Morning Herald, 1/10/08).

Problems with the initial 'fortress' scenario are considered below, with reference to: (a) an ongoing need for capital inflow; (b) underlying global macroeconomic problems; and (c) practical constraints on proposed defences.

Stage 2: Pre-empting the Crisis

Then in early October 2008 the crisis was described as a nation security issue [1] and announcements were made about:

• government guarantees on some $1,200bn of deposits with, and $200 bn of investments in, Australia's banks, building societies and credit unions; and
• a fiscal stimulus through almost immediate payments to pensioners and others of $10.4 bn - about 1% of GDP and half the expected 2008-09 budget surplus that had been set aside for future investment mainly in health, education and 'nation building' infrastructure.

These initiatives were apparently taken because of: the extreme pessimism of other national leaders; advice from others about the problem becoming unmanageable unless one 'kept ahead of the curve'; and the difficulties Australian banks were having in accessing funding (Tingle L., op cit). Business leaders reportedly expressed general support for these initiatives (Lee T. 'Rescue package hits right note with CEOs', Financial Review, 18/10/08) - while maintaining pressure for further economic reforms (eg of tax / innovation systems) (Dodson L. etal op cit).

Unfortunately, while the nominated 'causes of the fire' appear to accord with Mr Rudd's theories about political economy, they are none-the-less likely to be inadequate for reasons suggested below (see Preventing Economic Disaster?). Issues that seem to be being ignored include: (a) limitations of Australia's financial regulation and monetary policy that have increased the risk of domestic 'fires' just as they have elsewhere; (b) obstacles to effective global regulation; and (c) global macroeconomic deficiencies which are likely to amplify the coming economic crash and damage East Asia's prospects in particular.

Australia's economic prospects could be seriously worsened over the next few years as a result of (a) the repercussions of the financial crisis; (b) ineffectual federal and state governance; (c) governmental control over key economic institutions (eg banks); and (d) idealized but unrealistic economic strategies.

Stage 3: Managing the Crisis

By early November 2008 indications were emerging that the global financial crisis would lead to an economic crisis in Australia in 2009, which would be anything but easy to manage given chronic defects in Australia's machinery of government and assumptions about economic strategy. 

In January 2009 the Prime Minister raised the prospect that the federal government might arrange loans for Australian companies denied finance for property by overseas lenders [1].

In February 2009 the Prime Minister published an essay which blamed advocates of 'neo-liberalism' for the GFC, and suggested social democrats would have to find a solution by reshaping financial systems and re-establishing a strong role for government. This essay seemed to mention problems that had long required attention, but to make little progress in identifying practical solutions (see A Social Democratic Alternative to Neo-Liberalism?).

At about the same time the federal government announced a $42bn stimulus package (leading to $22bn deficit in 2008-09) including $28.8bn for infrastructure (school building $14.7bn, community housing $6.6bn); subsidies on reducing GHG emissions; tax breaks on new business investment; and $12.7bn cash payments to workers, students and farmers [1] - which the Opposition opposed on the grounds that it was too costly and poorly targeted [1].

This package seemed to be merely a response to symptoms of the GFC (see below). It was likely to exacerbate the real cause for economic concern (ie government borrowing to fund the stimulus spending would further increase the shortage of credit facing business and state governments). Moreover it did not seem to recognise the GFC's probably long term structural impacts on Australia's economic environment and government revenues which made boosting the supply side of the economy (which the package had done nothing to promote) very important.

In late February, the Federal Government proposed a round-table to check on small business concerns that they were being constrained by a lack of credit from major banks - while banks suggested that the problem arose from the failure of non-major-bank institutions which business had previously relied on [1]. As a result the federal government promised support for small firms that were not being properly funded by banks.

In March 2009, fearing the GFC's indirect effect on Australia, the Prime Minister also outlined seven point global plan for dealing with the toxic assets that he suggested were the cause of the global financial crisis. This proposal also seemed grossly inadequate.

Further developments are outlined in Managing Australia's  Economic Crisis below.

• Maintaining Capital Inflow (+ Property slump?)
• Global Macroeconomic Issues
• Practical Issues

Stage 1: Is 'Fortress Australia' a Viable Strategy?

The initial assumption that Australia could be isolated from the effects of a global financial / economic crisis was untenable because:

• Australia has an ongoing need for capital inflow which could be at risk - especially if property values slump;
• protection against a financial crisis would be futile in the absence of serious international efforts to solve underlying global macroeconomic problems; and
• there were practical constraints on actually mounting envisaged defences.

• More Practical Issues (+ Immigration impact)
• Blaming 'Extreme Capitalism'
• Policy / Regulatory Defects (+ Derivatives)
• Obstacles to Effective Global Regulation
• Inadequate Global Demand

Putting Out the Financial 'Fire' Before an Economic Disaster Strikes?

More Practical Issues

The Federal Government's initiatives to 'put out the financial fire' (ie bank guarantees and a large fiscal stimulus) are not without practical problems (eg potentially stifling ongoing economic activity and log-jamming governance as the federal government seeks to take on too many responsibilities).

However what may be even more serious is that:

• the policy direction being advocated to 'prevent future financial fires' (ie blaming 'extreme capitalism' and proposing more effective regulation) seem inadequate;
• a deficit in global demand seems likely to impede and slow recovery from the coming global economic crash; and
• machinery of government and past approaches to economic strategy appear inadequate to cope with the economic crisis that seems likely in Australia in 2009.

Blaming 'Extreme Capitalism'

Blaming 'extreme capitalism' apparently accords with Mr Rudd's world-view.  For example it parallels his writings about:

• problems in (so called) 'market fundamentalism' - for which Mr Rudd endorsed (European-style?) social democracy as an antidote (see An Alternative to Market Fundamentalism?); and
• the potential to solve problems simply by more moral leadership (see Restoring 'Faith in Politics').

But Mr Rudd's political economy theories seemed superficial  (see above-mentioned commentaries). For example, Hayek's social theories  were seen as the main cause of defects he perceived in past economic reforms  (though it is unlikely Hayek's social theories have had any material impact as almost no one has heard of them, and one apparently informed observer suggested that Mr Rudd had not understood them anyway)

Unfortunately similar superficiality apparently applies to official interpretation of the financial crisis - and this does not encourage optimism about the adequacy of solutions based on that understanding.  Factors that are being overlooked apparently include:

• how the policies of Australia's regulators have increased current risks in ways identical to their international counterparts (eg by failing to regulate derivatives, and by using monetary policy for macroeconomic management which is now recognised to cause unstable asset inflation);
• the effect of sophisticated new techniques intended to manage risk on undermining the ability of firms to act in their own self interest [1] - ie banks apparently outsmarted themselves with well-intended but inappropriate innovation;
• obstacles to effective global regulation;
• global macroeconomic deficiencies that  are likely to amplify the real-economy impact of the financial crisis for several years and have very serious adverse impacts on East Asia in particular.

There is absolutely nothing unusual about Australia's political system evaluating strategic national issues in terms of superficial / populist policy understanding (eg see Debating Iraq: A Nil All Draw). Often the 'Lucky Country' gets away with this, but stronger institutional support to the political system (eg as suggested in Restoring 'Faith in Politics') would make this less a matter of luck.

Some analysts have suggested that radical public policy actions (which can be expected to contain unforseen side effects) have been the major factor contributing to past depressions (severe and sustained economic downturns) - see Another Great Depression?

Defects in Financial Regulation and Monetary Policy

There appear to be unmentioned defects in the supposedly champion past performances by Australia's financial regulators and monetary authorities.

Australia's banks are said to be optimally regulated and well capitalised. However regulation has traditionally only applied to their investments and capital reserves - not to their exposure to 'derivative' products. Any institutions that have engaged in extensive derivatives' trade could potentially lose their entire capital reserves overnight (eg $20-100bn) - as recently happened unexpectedly to various banks in Europe (see below). Guarantees that the federal government has offered for deposits in Australia's financial institutions could prove expensive for taxpayers.

A Speculation about Derivatives: Derivatives were designed to spread risk, but seem to be doing so too effectively. One key example (but by no means the only form of derivative) involves credit default swaps (CDSs) - essentially a form of insurance sold by banks along with bundles of suspect (eg sub-prime mortgage) securities. When losses emerged in sub-prime and similar securities, it was the CDSs which brought those losses straight back to banks. However CDS markets involve some $US50tr in transactions, compared with expected US banking system losses of $US1-2tr from sub-prime and similar securities. It is understood that:

• the total derivates exposure of banks worldwide is about 100 times their capital base (and about 10 times deposits). However, as many of these cancel out, the total risk exposure of banks was only just equal to their capital base. The problem is that, in the event of failure by a major global institution (ie one which was counterparty to say 2% of all such transactions), an unlucky bank could incur losses overnight roughly equal to its capital base and an equal amount of depositors' funds. The impact has been very serious:
  • when losses started to be incurred, CDSs made it impossible for others to assess any bank's credit position, so interbank lending tended to freeze;
  • the financial crisis in Europe recently escalated and required huge government rescue operations. Though some observers ascribe this to the poor quality of their investments (eg see Financial Crisis: Who is going to bail out the euro?), Europe's banking losses exploded just after Lehman Brothers (one of the biggest derivates counterparties) was allowed to fail because the US could no longer afford to continue preventing such events.
  • it has been suggested (though this is by no means certain) that the severe problems affecting AIG insurance (which required a $US123bn government bailout) resulted from Lehman Brothers' collapse (Lehman CDS Payout On October 21: $360bn or $6bn?)
• Australia's banks have $13tr in off-balance-sheet derivatives exposure. A 1% loss in these would eliminate shareholder wealth. Total bank assets are $2.3 tr. Australia's GDP is $1.3tr and total stock market capitalization is $1tr. At least a decade will be required before these risks will be gone. ANZ and NAB are the banks with greatest exposure.  (Ferguson A., 'Counting the cost of derivatives', Australian, 18-19/10/08);
• derivates markets may not only be a mechanism for the rapid and unpredictable transmission of risks, but also a means for amplifying those risks. Because of the complexity of CDOs and the absence of any clearing-house, it is understood that: (a) CDS obligations related to the Lehman Brothers failure had to be settled in cash and some $400bn was required; and (b) the need to acquire this cash may account for the forced sales that led to recent sharemarket plunges. The result was a $2.7tr loss in the value of US shares in a short time - vastly more that the (say) $US200bn losses that had led to Lehman Brothers' failure (see Lehman's Loss: More Than $200 Billion);
• other CDO settlements are scheduled (eg Washington Mutual, another large US financial institution, on 23/10/08) and, as with Lehman Brothers, there seems to be no clarity about the likely consequences (eg see Several Auctions in October: How Does A CDS Settlement Work?);
• while rescue operations related to financial institutions should limit future derivates-related losses linked to banks, the crash in real-economy activity that is now likely could see major corporate failures which could give rise to unpredictable transmission and amplification of derivatives losses as CDSs were applied to many different types of debt instruments (see Gardiner N., 'Road from bubble to crunch', Courier Mail,  18/8/08).

Such problems are not being mentioned by governments in proposing 'solutions' to the global financial crisis - presumably because the problem is too complex. However these risks seem very real, and to have been 'under the radar' of Australia's 'champion' financial regulators. The resulting potential for unpredictable losses by Australia's banks is presumably one of of the reasons that government found it necessary to guarantee deposits with and loans to banks - and Australia's banks were willing to tolerate the resulting government oversight..

Moreover, the asset bubble which has now burst in US (and elsewhere) can't be solely blamed on 'extreme capitalism' because monetary policy settings by Reserve Banks (including Australia's) have also played a role.

Credit globally was made so cheap that property values escalated (and housing affordability became a problem) because of: (a) global fiscal imbalances associated with export-driven economic development strategies especially in East Asia which were only viable with very high levels of demand in countries such as US and Australia to sustain global growth; (b) cheap imports which constrained the inflation that would normally prevent extremely loose monetary policies; and (c) Japan's practice of creating virtually zero-interest credit that was 'exported' through carry trades (see Relationship with the Global Fiscal Imbalances and Professor Martin Wolf's more economically-conventional account, Asia’s Revenge).

Monetary policy has become the primary mechanism for macroeconomic management over the past two decades. However, as its impact has been to contribute to asset inflation which has now been shown to be dangerous, there is an apparent need to develop new techniques for macroeconomic management - which will be anything but easy (eg see Booms and Busts: Unsatisfactory Tools for Macroeconomic Management?).

In Australia the issue remains unmentioned in public debates. Moreover, in Australia's case, deficiencies in monetary policy may not have involved the setting of unrealistically low interest rates so much as failure to consider the way in which 'imported' cheap credit could contribute to asset inflation. 

Finally, it seems to have been below of radar of Australia's regulators that:

• a form of 'sub-prime crisis could arise from the use of widely-promoted deposit bonds (whereby investors can apparently purchase expensive properties with minimal (eg $1000) deposits by using bonds to cover the balance) could expose many to very large losses (ie those using such bonds are responsible for paying their full value even if property values have fallen). In the US, the sub-prime mortgage crisis apparently mainly arose when investors (not occupiers) encountered falling (rather than the expected rising) housing prices;
• the way in which structured financial packages for infrastructure have been engineered (hoping to solve public policy problems at no cost to taxpayers) may well have created an asset class part of which has unrecognised risks similar to those associated with US sub-prime mortgages;
• the Howard Government's reduction in budget deficits, meant that there was no supply of government bonds. This allowed / forced the private sector to fund Australia's substantial current account deficits by borrowing for investment in property [1]
• eliminating the need for independent trustees (and leaving just one 'responsible entity') could create chaos when managed investment schemes fail (because the management function becomes insolvent) [1].

Obstacles to Effective Global Regulation

'Better regulation' can't be a sufficient long term solution. The financial system is now globalized so any regulatory regime would need to operate globally as well as domestically. However developing an effective global regime must be hard (perhaps impossible), because of the large culturally-based differences in understandings in various parts of the world about:

• the nature of desirable systems of socio-political economy (see Fragmentation of the Global Order). For example the 'European' approach (ie in societies using various forms of Roman Law which gives society priority over individuals) is not the same as under Anglo-American traditions where individual liberty is given high precedence;
• the role of financial systems in the economy. For Western societies, the financial system is the economy's 'nervous system' (ie the main means of coordinating economic activity). For East Asia, economic activities are coordinated by relationships amongst social elites, and less importance is attached to financial outcomes in doing so (see Structural Incompatibility Puts Global Growth at Risk);
• the best means of regulating social and economic activities - as (for example) a 'rule of man' tradition applies in East Asia as the alternative to Western societies' ideal of a 'rule of law' (eg see East Asia). The role of law. selectively applied, is not to define the rules guiding individual behaviour, but rather to provide a means for disciplne of to ensure conformity with the social elite;
• the relevance of a 'global' system of regulation. The idea of a universal system is a Western concept, which is not shared in East Asia. In other words there would be a preference for many different 'world orders' existing in parallel, rather than just one. Indicators of efforts to create a 'Confucian world order' in which social relationships would dominate over money in organising economic affairs are outlined in Creating a New International 'Confucian' Economic Order?
• the way in which money is created. For example, proposals by the American Monetary Institute for  rethinking the nature of money, which appear to have some prominent supporters in the US Congress  involve creating money through governments spending it into circulation and agreeing to accept it back when payments need to be made to government (rather than continuing to create money mainly through for-profit lending by private banks supervised by politically-independent reserve banks). The latter would involve a shift in directions already taken under 'Asian' economic models - but cultural factors mean that this would have quite different implications. 'Asian' models tend to involve creation of money through banks which are tightly state-controlled in various ways (eg consider Japan's 'descent from heaven' tradition whereby such institutions are controlled by former MOF officials) and little interested in profit - and this is part of arrangements by which democratically-unchallengeable social elites maintain power. However, in Western societies state control over the creation of money would not only remove some risks associated with control of money supplies by private for-profit interests. It would also increase the risk of abuse of money supplies for unwise populist political gain;
• the methods where change is achieved. The Western tradition involves debate and decision making, while the East Asian tradition involves a preference for 'behind the scenes doing' without debate, so that outsiders are simply and unexpectedly presented with a fait accompli.

Such differences are almost universally put in the 'too hard' basket by governments (while post-modern theory 'excuses' students of the humanities from research into practical issues). However the consequent lack of any effective system for global governance (eg through UN and the Bretton Woods triplets - IMF, World Bank and WTO - which are built on Western governance traditions) are arguably the main reason that:

• the US has increasingly chosen unilateral, rather than multilateral, options in addressing global challenges - such as the risks of terrorists using weapons of mass destruction (see The Second Failure of Globalization?); and
• effective global regulation of financial systems does not already exist (see Ungovernable Financial Markets).

Presuming that an effective regulatory regime for a global financial system can now be created involves 'begging the question'. For example:

• a proposal to link capital adequacy requirements for banks to executive remuneration so as to prevent unrestrained greed (Rudd K., op cit). This makes no sense in relation to East Asian financial systems, because low executive remuneration can be associated with poor balance sheets not because of 'executive greed' but because balance sheets are not the most important way in which economic activities are assessed;
• it has been suggested that the global financial crisis proves the inadequacy of the 'Anglo-Saxon' concept of 'self-regulation' (the model which is the basis of the Basel I and II regimes) because it results in no regulation in the face of market euphoria [1]. However:
  • while, at a very deep level 'self regulation' (ie individual liberty) is foundational to the way in which Anglo-Saxon societies are organised (see Cultural Foundations of Western Dominance), it is over-simplistic to suggest that 'self-regulation' is the 'Anglo-Saxon' economic model. Within such countries complex systems of state economic regulation exist;
  • the global 'self-regulation' approach which was the basis of Basel II in particular arguably reflects an inability to agree on anything else; and
  • the global 'self-regulation' approach contributed to the GFC mainly because of its failure / inability to take account of the macroeconomically-unsustainable alternative models that emerged in East Asia (see  Causes of the global financial crisis);

Others have also apparently concluded that a unified regulatory system across the entire world is impossible and undesirable, given the quite different governance regimes that exist. [1]

In early 2009, a meeting of the Reinventing Bretton Woods Committee [1]:

•  suggested that the international financial system was broken;
• meaningfully discussed various aspects of its failure and options for reform. Though undoubtedly constructive in facilitating an eventual solution, these discussions showed how far the world is from implementing a solution (eg 5-10 years);
• conducted those discussions entirely in the context of a continuation of the Western-style Bretton Woods regime (ie a boosted role for the IMF was envisaged) and showed no awareness of the radically differences in approach embodied in, for example, Japan's proposals for an Asian Monetary Fund.

Speculations about the emergence of a modernised version of the China-centred trade-tribute system which had prevailed prior to the expansion of West influence are presented in Creating a New 'Confucian' Economic World?. This could be an attempt to create a 'world' within the world which did not operate according to 'global' principles - but kept the latter at arms length.

Inadequate Global Demand

The economic impact of the financial crisis, which already seems likely to be severe, may be impossible to contain because of weak final demand.

Frozen credit markets have been inhibiting normal business activities (eg making deals, paying employees arranging letters of credit that are vital for trade) and the real-economy effects of this must be significant (eg see What the Pros Say: Global GDP Could Fall 10%).

Measures are now being put in place by governments (eg bank bailouts and guarantees of funds) in an effort to stabilize the banking system and thaw credit markets to allow business to proceed more normally. Though more may still be needed to achieve stability (see below),  even stability will not be enough.

What else might be needed? It has been reasonably argued that initial actions by governments have not been sufficient to stabilize the global financial system, and that there is a requirement also for coordinated action amongst all advanced and emerging market economies to: (a) further reduce interest rates by 1.5% worldwide; (b) guarantee bank deposits, while shutting down insolvent institutions; (c) provide unlimited liquidity to solvent institutions; (d) provide public credit to companies to prevent short term financing problems; (e) a massive fiscal stimulus by governments; and (f) agreement amongst creditor countries with current account surpluses and debtors with current account deficits to maintain orderly financing of deficits (Roubini N. 'Finish the rescue job to avert disaster', Financial Review, 16/10/08).

Problems: Unfortunately there are problems with this proposal in that (a) there is no way to tell which institutions are actually solvent unless derivatives counterparty risks can be contained (see above); (b) many governments are poorly positioned to provide the fiscal stimulus which is needed (as argued below); and (c) the position of creditor countries with current account surpluses is by no means as simple as the above proposition suggests. Those in East Asia:

• have financial and economic regimes whose viability depends on a strong US financial system to generate levels of consumer demand sufficient to provide them (Asia) with the current account surpluses needed to prevent crises in their weak financial systems;
• will probably not be able to maintain those current account surpluses (and thus capital flows to debtor nations) - in the face of a likely lack of global final demand (see below).  :

The most serious problem will involve a deflationary deficit in global final demand, because no one is equipped to provide it.  The asset bubble which is now bursting has been critical to sustaining global growth - by providing consumers (especially in the US) with an ability to provide the demand which has counter-acted the demand deficiencies implicit in export-led economic strategies such as those which have allowed rapid economic development in East Asia (see Global Macroeconomic Problems above)

Though reserve banks (such as the US Federal Reserve) can increase liquidity - this may not lead to similar strong US demand in future because:

• households are suffering financial stress because of the bursting of the asset bubble;
• macroeconomic policies in future will have to guard against asset inflation. This ultimately requires reducing household debt levels - but it is only when people borrow that monetary policies can increase money supply and demand;
• banks face a major problem in reducing their 'leverage'. De-leveraging will be their main emphasis in 2008 and 2009. Banks worldwide need to de-leverage 25% (ie increase capital or reduce the amount loaned), while a 10% de-leveraging is needed in Australia (Ferguson A., 'Counting the cost of derivatives', Australian, 18-19/10/08); and
• the US Government has long run large fiscal deficits; faces a requirement for large increases in public spending; and will have incurred large losses in rescue operations to save the banking system.  In fact there may be a risk that US Government bonds could crash in value - and thus impose another class of loss on financial systems (Guy R., 'News will turn bad for US bond-holders', Financial Review,  15/10/08). Following the financial crash in 1929, it is understood that recovery was not only limited by poor policy choices (eg balancing ever-weakening budgets and inhibiting trade). When attempts were made to increase public spending through issuing bonds, the effect apparently was to collapse bond values and thus to decrease (rather than increase) money supplies.

Many other governments (though not Australia's) have incurred high levels of debts and will not be in any position to provide the massive fiscal stimulus that is now needed. And it is by no means certain that Australia and other countries that are positioned to provide a fiscal stimulus can do enough.

Expectations that 'Asia' (especially China) might now take responsibility for providing the demand to now allow global economic recovery are unrealistic (see China: Victor of Victim?). In fact, Asia's lack of effective financial institutions will make its problems much greater than currently being assumed. As the US's ability to continue large current account deficits evaporates: (a) 'Asia' will be forced in the short term into a recession matching that in the US to avoid a financial crisis - and in China's case this could easily lead to social unrest; and (b) make the Asian economic models unsustainable in the long term.

Reform of East Asian financial systems are essential (and thus radical changes to the Asian economic models so that it becomes possible to borrow to finance growth) if a global demand deficit is not to stifle the prospects of economic recovery.  In the absence of such reforms, countries (especially the US) whose excess demand is required to sustain export-driven economic strategies may find it attractive to try to reduce the drag of sustaining others' growth (eg by restricting trade) - even though past experience shows this to be damaging.

The probability that such reforms may be culturally impractical is suggested in Are East Asia's economic Models Sustainable?

• Crisis Indicators (Financial + Economic Activity + Economic Environment + Recovery? + False Dawn? + Coming Crises?)
• Global Constraints
• Australia's Position (Positives + Structural Change + Current Account)
• Domestic Constraints
• Practical Problems
• Wider Understanding of the Problem
• Suggestions

Managing Australia's Economic Crisis

The global financial crisis (GFC) seems likely to translate into an economic crisis for Australia.

The present writer's November 2008 guess, based on anecdotes concerning severe GFC-induced economic dislocation which were not at the time reflected in the data series econometricians use for forecasting, was that 2009 could see a global economic contraction of 2-3% (eg US GDP down 8-10% verging on an 'official' depression; Europe, Australia and most emerging market economies down 4-5%; and China stagnant) as the start of a 10-20% global GDP contraction (depression?) in 2-3 years with correspondingly large increases in unemployment everywhere.

By April 2009, mainstream analysts had short term expectations similar to the above, though their medium term forecasts were for much less severe outcomes arguably because:

• all out-efforts by governments and reserve banks had created both: (a) expectations of late-2009 economy recovery: and (b) long-term problems in unwinding and paying for those emergency measures; and
• the structural character of the economic problem exposed by the GFC was not yet widely understood.

In May 2009, the UN forecast a global contraction of 2.9% in 2009 [1].

In June 2009 both the OECD [1] and the IMF [1] forecast a relatively brief and shallow recession. However in doing so they reflected the implications of econometric data (ie data about movements in the real economy). At about the same time, the BIS (whose emphasis tends to be on conditions within financial systems) warned of the risk of a long period of stagnation.

In July 2009, widespread expectations of real-economy recovery from late-2008 financial shocks seemed like a false dawn, because underlying problems in global financial systems and economic structures were being papered over rather than resolved.

In September 2009, as those focused on the real economy saw ever-stronger signs of recovery, those concerned about financial systems perceived serious risks of a renewed crisis. This difference in expectation remained in March 2010, when there were signs of both: (a) strong recovery because of conditions in the 'real' economy; and (b) a renewed financial crisis

In Australia there were initially many reasons  to expect a fairly severe recession in the short term (ie 2009 and 2010) and that extensive economic change would be vital in the medium term. By late 2009 it seemed likely that the long term risks remained, but that the first phase of the GFC had had limited impact in Australia.

Crisis Indicators

Financial systems that  play a vital role in all economic activity were disrupted, and there were numerous international and domestic indicators of massive dislocation of economic activities as a result and of deterioration in the economic environment generally. Despite extensive government and business efforts to reduce economic spin-offs from the financial crisis, offsetting positive indicators remained limited globally especially in relation to the financial systems themselves.

Financial Systems

• the GFC : (a) disrupted the operation of financial institutions which play a vital role in everyday economic activity; and (b) was associated with / caused an erosion of household wealth which has undermined the potential for household spending - and in the US (whose demand has been a key factor in global growth):
  • households had accounted for 70% of final demand, but now have much less easy access to credit [1], and a rapid shift in their behaviour (from high consumption to high saving) was observed, and posed risks to major companies dependent on consumer spending [1] - and also to countries with export-based economic strategies reliant on high levels of US consumer demand. This shift to emphasise savings was suggested to be being driven not only by lack of credit and losses from retirement savings, but also by the heavy debts facing the government which has led to a loss of confidence in pensions for retirement income [1];
  • a further $2tr pull-back by credit-card companies was possible [1]; and
  • government efforts to ensure that financial institutions could operate (eg through boosting liquidity / recapitalizing) will seriously constrain their commercial flexibility and thus their ability to contribute to economic recovery;
• the GFC was described (in a  summary of a meeting of the Reinventing Bretton Woods Committee) as a crisis of the financial system - rather than a crisis in that system  (ie the international financial framework was seen to be broken);
• while there are signs that banks were resuming lending after government efforts to restore balance sheets, there was still a major shortage of credit because, prior to the crisis, non-bank institutions had come to play a roughly equal role in providing credit than banks by selling securitized assets to financial markets. Normal credit arrangements require fixing securitization markets as well [1];
• banks in UK were resuming normal lending operations despite government support. UK economy could contract 5-10% in 2009 [1]
• rather than being lenders of last resort, reserve banks were becoming lenders of first (and sometimes only) resort [1];
• financial market indicators implied a long and difficult process for economic recovery - especially the yield curve (which measures gap between yields of 2 and 10 year government securities) and the Libor / OIS rate (which reflects the cost financial intermediaries face in borrowing and remains high). The yield gap was unusually wide, reflecting economic weakness. This should allow banks to repair their balance sheets (by borrowing cheaply and profiting from lending at higher rates). But this wasn't happening because concerns about counterparty risks prevent them accessing funds [1],
• in Australia:
  • structured financial packaging of infrastructure may well have created an asset class some of which has unrecognised risks like those associated with US sub-prime mortgages;
  • GDP declined (by 0.5%) in the fourth quarter of 2008 because of a significant increase in household savings. Savings were $15.1bn (8.5% of GDP - the highest level in 18 years) - much of which had been handed out by federal government. Overall savings in 2008 exceed the total of preceding 11 years combined. The combined effect in 2009 of rising savings and falling terms of trade would create difficult conditions [1];
  • Australia's banks may have severely damaged the commercial and industrial property market (and thus exposed themselves to large losses on mortgages and credit downgrades) by their aggressive approach to mortgage covenants. Small declines in property values were escalated rapidly by bank actions [1]
  • banks were squeezing home owners with higher interest rates [at the same time that unemployment was rapidly rising] to protect their profitability in the face of rising losses and higher costs of international capital [1];
  • difficulties in corporate funding were being reported from June 2009 (see above);
  • the OECD warned that the high percentage of household wealth held in the form of housing was a potential risk [1]
  • a rapid rise in interest rates was being forecast in July 2009, as government stimulus spending was continued to reduce the impact of recession [1];
  • $200bn in corporate debt financing over coming years was perceived as a potential source of business failures (especially in areas such as infrastructure where asset values have declined) [1]
  • 1/3 of Australia was regarded as entering danger zone for financial distress (ie being at risk of loan defaults) despite economic improvement. Rising interest rates or increasing unemployment were likely to cause problems because debts have risen to 160% of income [1];
  • while Australia was slow to import banking innovations that caused problems in US, the advent of currency and interest rate derivatives (totally $14tr) allowed banks to accumulate $400bn in foreign liabilities over 10 years. This funded great Australian housing / consumption boom and would have caused catastrophic bust if federal government had not guaranteed it in October 2008. The same problem applied in securitization market which was over 50% funded by foreign capital - and market would have failed without direct fiscal intervention (via AOFM purchases). Also funding of Australia is proxy for China - and would have serious troubles if China fails [1];
  • the October 2009 decision by RBA to increase interest rates is based on the assumption that recession is over so 'normal' (eg 3% pa) growth will resume. However this will only happen if debt / GDP ratio continues rising - but if de-leveraging sets in (as it did following financial crisis in late 1980s) then interest rate rises will compound the effect of a serious slowdown (as in early 1990s) [1];
  • companies wishing to expand are being constrained by their inability to get credit (and the high cost of credit) from banks [1]
• the IMF warned in early 2009 that the international financial system lacks sufficient capital to weather a deepening economic downturn [1];
• capital flows to developing markets were in danger of collapsing [1] - partly because stimulus programs in developed world are diverting capital [1];
• US Federal Reserve chairman argued that: credit markets were more dysfunctional than in the 1930s and Japan in the 1990s; and fiscal stimulus plans (eg by new Obama administration) would achieve little unless financial systems was restored - which requires further efforts to socialize banks' losses that governments have not yet adequately addressed [1];
• the crisis in US was one of insolvency for both financial institutions and households. Losses have been around $US3tr leaving all major banks essentially insolvent. Improving liquidity by reserve bank can't deal with this. Those debts need to be written off before recovery will be possible [1];
• the pace of clean-up and writing-off of bad debts in US was very slow - and this raised the risk of a protracted near-depression like Japan experienced. The US responded faster that Japan in some respects, but was also in a more difficult initial position. Monetary policy can achieve little where there is a glut of capacity, and insolvency rather than illiquidity problems. Fiscal policy is limited with high existing debts [1];
• methods for bank bailouts in US and UK may be leaving 'zombie' banks like those in Japan in 1990s (ie those that are not properly restructured) which perpetuate the credit crunch and credit freeze [1]; [CPDS Comment: This phenomenon does not seem to be limited to the UK and US]
• the collapse in confidence on the banking system is at the core of the crisis - which has undermined the supply of credit to business. Even 18 months after start of crisis, governments seemed powerless to do anything - and there was little sign (apart from stabilization of confidence measures at very low levels) that the crisis will not continue to get worse [1];
• the yield on US Treasury 10 year bonds had risen from 2 to 3% since Christmas despite efforts to restrain it. The US is already in deflation - with falling wages and core prices. Thus the real cost of capital is increasing as slump deepens - the classic debt deflation scenario. US Fed had hoped to be able to prevent this by cutting interest rates to zero and printing money to buy Treasuries. Bond markets fear being caught if US tries to monetise its debts. US Treasury wants to borrow $2tr in 2009 - but there was no one who can now lend it. China had become a net seller. [1];
• the third set of US Treasury proposals for bank bailouts would apparently involve (a) guaranteeing 'toxic' assets rather than buying either them or banks; (b) a possible role for an aggregator bank (in partnership with private sector) to buy some assets; and (c) expansion of Fed financing to securitised financial markets. This amounted to no more than keeping alive the 'Ponzi scheme' that the US financial system had become. All versions of government bailouts suffer from the fact that the assets being valued and bought by government don't have any real value. Under Bush lies were told about doing this. In UK and Europe governments have nationalized insolvent banks [1];
• US used to attract 80% of global savings (and run corresponding current account deficits). Now it needs to attract (perhaps 4-5 times) more, while world is losing thousands of $bns in assets. This must result in much higher interest rates [1];
• the Obama administration's February 2009 proposals for recapitalizing the US banking system were based on the optimistic assumption that the problem was a lack of liquidity, whereas it was likely that the problem was that most institutions are insolvent. Unless the latter problem was addressed, the US financial system would not recover. US advised others (eg Japan in the 1990s) about the need to wind up insolvent institutions, but hasn't been willing to take this advice itself [1];
• there was concern about whether governments in Europe can afford to fix problems affecting their banking system [1, 2]; EC report suggested that European banks were exposed to 16 tr pounds of 'toxic debt' - 44% of their assets [1]
• there was concern that major central banks would simply print money to deal with financial system problems and support economic stimulus [1];
• there was concern amongst G7 finance ministers about how governments will finance the increased public spending that is seen to be needed. As high debt levels were the source of the crisis, they are thus unlikely to be the solution [1];
• bad debts in the former Soviet Union (Russia, Ukraine and EU states in Eastern Europe) could destroy Europe's fragile banking system and lead to a second round of the GFC. Bad debts were estimated at 10-20% - and Austria (whose banks have loaned 230bn euros to the region and face losses that could destroy them) tried unsuccessfully to organise a rescue package [1]
• there was concern that some countries in Europe could default on their debts - eg Spain, Ireland, Greece, Portugal and Italy [1];
• the cost (especially to Germany) of covering the losses incurred throughout the EMU could result in breakdown of that union, and the end of the euro as a second global reserve currency [1];
• nationalization of banks in US and Europe appeared likely because there was now recognition that the $1tr recapitalization of banks to cover US sub-prime losses was not enough. Two additional equivalent recapitalizations are needed. Nationalized banks would be inward looking and completely change the global financial environment [1]
• European banks took a $2tr gamble on $US - which nearly brought down the global financial system. Banks (especially UBS, Credit Suisse, Deutsche Bank, RBS, ABN Amro and Bank of Scotland) expanded $US positions based on domestic borrowing. Domestic savings was recycled into longer-term US assets. When short term funding dried up they could not fund their $US positions. Despite off-balance sheet hedging, they had large balance sheet $US exposure. Given a lack of domestic funds, banks then had to produce foreign - and were forced to sell assets at distressed market prices. There is now an acute shortage of $USs - and this remains a barrier to restoring order in global financial system [1]
• China's banking system is opaque and defective. In 2003 20.4% of loans were non-performing. This was reduced by transferring such loans to SIVs - though there could be many others that have not been classified. Liberalization of controls recently is likely to increase the extent of this problem again [1];
• a large increase in foreign sales of long term US securities in early 2009 raised concerns that the US may be unable to fund its current account deficit [1]. China appeared to be seeking to diversify its foreign exchange holdings away from $US because of concern about a $US collapse [1]. Japan has threatened to buy no more US bonds unless they were dominated in Yen [1]
• US economy is in for lasting slowdown because its banks are basically insolvent. Government rescue packages are likely to be effective, but banks' need to restore their position will cause them to act as a drain on economy's future profits [1] ;
• China appears to seeking to end its exposure to $US$s by running down its foreign exchange holdings of US Treasuries to buy huge quantities of strategic inputs to its production system [1, 2].
  • Comment: If correct (and other reports mention China's rush to build up coal stockpiles at almost any price) this is very significant, because it means that either (a) China has made a serious mistake or (b) it expects, and is moving to try to ensure, that the global financial crisis will result in a general breakdown in the global market economy. China may be ensuring access to the resources needed to manufacture (say) hybrid cars as Evan's Prichard suggested - but, if a run on US Treasuries prevents the US government from funding its stimulus / bank rescue packages and budget deficits, then there is going to be no adequate market demand for whatever China intends to manufacture.
• IMF warned in April 2009 that crisis would be deep and long lasting. Massive government budget deficits were making it impossible for banks and companies to raise money. A rapid disorderly de-leveraging could result [1] [Comment: while this observation was probably correct, it needs to be recognised that this view (ie that fiscal stimulus is less beneficial than preserving credit rating) reflects the French / German attitude, and IMF now has French chief executive];
• while the majority of the $US4,100bn bad bank assets identified by IMF were held by European (not US) banks, only 14% of the $740bn written off so far had been by European banks [1];
• the world is running out of capital. Global bond markets may prove unable to fund the $6 trillion or so needed for the US fiscal package, US-European bank bail-outs, and ballooning deficits almost everywhere [1];
• large losses incurred by banks in Europe had (in May 2009) only just started to be dealt with - threatening a renewed global financial crisis in late 2009 [1];
• the asset quality of China's banks was deteriorating because of new lending to help fund government stimulus projects [1]
• there was concern that banks in many European countries could require support because of heavy losses incurred in Eastern Europe [1];
• concern was expressed that probable balance of payments crisis facing Baltic state of Latvia could spark contagion effect through Eastern Europe and Sweden producing effect like Asian crisis [1]
• German Chancellor was highly critical of loose monetary policies of Fed, Bank of England and ECB. Fed's policy of purchasing government bonds initially reduced interest rates, but this may now be increasing them because of inflationary concerns [1]
• banks in China were becoming increasingly exposed through risky lending - because China's economy can't absorb the funds that are being made available so money was leaking into stock-market speculation and keeping bankrupt builders afloat [1];
• economic recovery will be difficult because of lack of credit for business. Money sources that drove US shadow-banking system have dried up, and major banks carry huge quantities of toxic assets which will have to be written off before they will lend aggressively. Those bad debts have not been dealt with under program US government mounted because prices others would have paid would have left banks to account for losses that were not willing to admit [1]
• the IMF estimated that banks will need to write off $US4tr - yet by February 2009 only $US1.12tr had been written off . In the US write off's already exceed 50% of the balance sheet of national banking system - with UK and Germany close behind. The problem was not a temporary shortage of liquidity - but insolvency for the banking system [1]
• tough monetary policies being adopted by ECB could force all governments in Europe into severe economic downturn (projected at 4.8% contraction this year compared with 2.4% contraction in US) and into budgetary crises [1]
• though the worst of the financial and economic crisis seemed to be past, financial systems remained weighed down by an unknown burden of doubtful assets and subject to very high levels of government support / control  [1]
• Japan's opposition party (Democratic Party of Japan, which led in opinion polls) advocated shifting Japan's foreign exchange reserves from $US to IMF bonds [1]
• despite huge amounts of government support, the toxic asset problem on bank balance sheets (one original cause of the GFC) had not been resolved - arguably because those assets are too complex. Greater transparency was needed [1];
• efforts by governments and regulators to shore up banking systems and financial markets risked a shift towards financial protectionism like that which occurred between 1914 and 1945 - according to Institute of International Finance [1];
• the risk of a drag on economic growth from de-leveraging was suggested [1] because economies like Australia's, which have grown rapidly in recent decades on the basis of huge increases in asset values and debt levels, were likely to be in for a long period of debt reduction - implying:
  • something like a 4% pa ongoing decline in total debt levels until they reach (say) 50% of GDP (based on experience during earlier periods of de-leveraging). This would require de-leveraging for many years, as total debt levels had reached an historically-unprecedented 165% of GDP in Australia;
  • a resulting long-term drag on growth of (say) 5% pa [presumably because income would be devoted to debt reduction, rather than boosting economic demand]; [Demand can be seen to reflect the total of income and net increases in debt. While the latter should have little effect, in recent years increasing debt had been a major component of demand and had been critical to reducing unemployment [1] ]
  • limited scope for effective responses. Governments can only temporarily counter de-leveraging by borrowing (as Australia did over the past year to counter a 4% decline in debt levels). Moreover, reserve banks have limited scope to affect the rate at which credit is created or eroded [1].
• China was suggested to be experiencing a huge stock and property market bubble - fuelled by bank lending in an attempt to counteract the effect of economic downturn [1]
• IMF estimated in April 2009 that of $4tr losses associated with GFC only $1.5tr had been written off - so there was a risk of a second wave of the GFC [1];
• loan losses by banks on US commercial property were reaching record levels [1]
• US banking system continued to deteriorate (despite emerging economic recovery) with hundreds of banks expected to fail - and uncertainty about how quickly economy could recover [1];
• 'Prime' borrowers in US were increasingly falling behind on mortgage / credit card payments as a result of long recession and rising unemployment [1]
• it was suggested that 10 additional banks (not just Lehman Brothers) should have been allowed to fail to clean up the financial system [1]
• bank credit and M3 money supply were contracting at a rate comparable with the Great Depression - raising fears of a double-dip recession in 2010 and a slide into debt-deflation. Pressure to force banks to clean up their balance sheets may be the cause of the problem [1]. Money supplies are also contracting in Europe [1]
• BIS has warned that financial system recovery may be being presumed prematurely [1];
• low interest rates in US have created a situation in which China / India / emerging Asia can no longer afford to hold currency values down to promote exports - because doing so is causing asset bubbles in their economies. Furthermore $US is likely (because of need for long term low interest rates in US) to become next 'carry trade' currency - stimulating demand elsewhere [1]
• a new financial crisis has been suggested to be possible in Germany in 2010 because the bad debts facing banks are increasing [1];
• Europe is facing serious economic problems because Euro has risen to $US1.50. China has boosted its exports by linking currency to declining $US - and invested its surpluses increasingly in Europe (thus forcing up currency) [1]
• cheap US interest rates are funding a 'carry trade' whereby investors borrowing $USs are boosting asset values worldwide - and a crash in global asset values is possible when $US strengthens [1]. Officials in Asia are increasingly concerned that the flood of $USs is having adverse effects in terms of booming asset prices [1]
• Japan is headed for a major fiscal crisis - because government has borrowed heavily and pushed public debts beyond sustainable limit [1];
• China's stimulus programs have directed a great deal of money as policy loans to state enterprises and to property investments by those with close connections to the regime. Little thought seems to be given to repayment of loans. One consequence is further increases in the imbalance of wealth. There is official concern about the creation of a bubble [1]  ;
• the huge 'carry trade' in $USs that has been generated by exceptionally low US interest rates being set by Fed, will be unwound overnight at the first sign of strengthening of $US - thus bursting asset bubbles that are being created elsewhere by those flows [1]. However it was also suggested that the notion of such a 'carry trade' was suspect, because US banks have been stockpiling the low interest credit made available to them to boost cash reserves, rather than investing it offshore. The possibility that offshore investment might be resulting from investors who sold Treasury bonds was however raised [1]
• it is argued that the bubbles being created by easy monetary policy and resulting carry-trades (eg by Japan and US Fed) are not dangerous - however this claim might be wrong [1]
• the continuing contraction in bank lending and M3 money supply in US and Europe has been suggested to risk return to recession. At the same time the rapid growth of money supply in China (30%pa) will need to be ended soon - and probably show widespread non-performing loans [1];
• there has recently been a collapse in the value of US government bonds (and a rise in long term interest rates), apparently a result of increased investor confidence in recovery and an end of the 2007 'flight to safety' in government bonds - [1]. [This is noteworthy as in 1931 a collapse in the value of US government bonds in expectation of recovery following the 1929 'flight to safety' apparently triggered a renewed economic downturn - by (a) making government less able to borrow and spend and (b) setting expectations of return on equities much higher (because 'safe' investment returns increased) and thus causing a new collapse in share prices.
• the GFC has not led to an unravelling of global financial imbalances - and the IMF has warned that the recovery is at serious risk as a result [1]
• European business depends very heavily on debt capital, and inadequate capitalization by banks is causing concern about shortages of funds for investment in 2010 [1]
• The US government was not expected to be able to easily borrow the $2tr needed to finance stimulus spending in 2009 - yet it seemed to do so. The source of 1/4 of these purchases (households) can't be clearly identified - and (being many times more than in earlier years - appears suspicious [1]
• many emerging countries are increasingly holding foreign reserves in gold because of concern about $US [1]
• the existence of the Euro prevented currency crises in peripheral European countries as a result of GFC - but has instead caused competitive disinflation in those regions. GFC caused 3.9% fall in US GDP - but 5.1% in Eurozone. Before crisis, peripheral countries had excess demand over supply, with reverse in core (eg Germany). The effect of crisis was to cut demand - which severely damaged fiscal position in peripheral nations - and they are now trapped in structural recession. The Eurozone has no spender of last resort, as Germany is a lender instead [1]
• there is concern across Asia that US's very easy money policies are contributing to asset bubbles in Asia [1]
• US bond markets are increasingly raising interest rates on government bonds - because of concerns about inflation and government debt [1]
• Japan has been able to run large budget deficits without seeing its borrowing costs rise because Japanese people are savers. However its aging population is now likely to reverse this trend and make it difficult to fund Japan's huge budget deficits. Japan may need to sell down its holding of US Treasuries which would send international bond yields much higher [1]
• Greece is experiencing difficulties (high interest rates) in issuing government bonds and there is potential contagion effects throughout eurozone and uncertainty about whether others (eg Germany / France) might mount rescue [1]
• EU rescue measures for Greece (which involve support for its debts if budget savings are achieved [1]) have raised concerns about (a) the EU generally and (b) further 'moral hazards' being created - whereby the profligate do not suffer consequences of their actions [1]
• investors are selling out of 'junk' bonds generally, as fears about sovereign debts spread to other markets [1]
• the EU agreed to bail out Greece without first gaining agreement from parliaments of creditor nations - and some are objecting to such action [1];
• there is potential for a cascading effect from guarantees by other countries to solve sovereign debt problems in countries like Greece. Sovereign debt concerns arose in some cases because bank losses were transferred to governments [1]
• economists believe that sovereign debt problems (such as those in Greece) are unlikely to derail global growth - because such problems have been arising for several years and been progressively healed [1];
• investment banks earned huge fees from transactions that allowed Greece to hide $bns in debts. Government free-spending could continue because transactions were treated as currency trades such as loans [1];
• US budget difficulties are a major economic threat - as indicated by IMF proposal that inflationary targets should be lifted presumably as a means to rationalize the US inflating away it debts [1]
• US Federal reserve is raising interest rates to a time when US bank lending is falling at the fastest rate in history (ie at annual rate of 16% pa since January 2010) and M3 fell at 5.6 pa over past 3 month - which signals a deflation risk [1]
• there is concern that higher inflation will be needed to allow US to write down debts ('debtflation'). GFC resulted in major losses being transferred to governments, and Greek potential default has raised concerns about heavily indebted governments. US debt / GDP ratio is 60% - below the 70% at end of WWII, which was eventually brought down to 36% - but mainly because of inflation rather than economic growth. Also budget deficits are now 9% of GDP [1];
• firms with debt maturing in 2010 and 2011 assume that refinancing will be easy - but new banking regulations are likely to make refinancing much harder and sustain the downturn for 2-3 years [1];
• devaluation of Euro because of Greek financial problems will constrain recovery prospects in US / Japan [1]
• emerging markets have become much more attractive to investor - with large falls in sovereign borrowing rates relative to developed economies [1];
• governments in America, Europe and Japan are now being forced to retrench (ie cut spending) and unless quantitative monetary easing continues debt deflation is likely [1]'
• investors are increasingly concerned about risks in emerging market economies which have driven global recovery - and sharp rate rises in emerging economies could undermine global prospects [1]
• China, under increasing US pressure to revalue its currency, is resisting this on the grounds that it already is headed towards a current account deficit [1]

Anecdotal evidence of serious economic dislocation appeared worldwide and in Australia as a consequence of the  GFC. For example:

• a collapse in international trade and in some companies' order books was initially indicated by shipping data (eg see The Shipping News Suggests World Economy Is Toast). IMF data subsequently revealed a 45% decline in global trade in the final 3 months of 2008 [1]. IATA identified a 22.6% decline in air cargo traffic in the year to December 2008 - describing it as unprecedented and shocking [1]. Moreover:
• China (which has benefited most in recent years from trade) imposed bans on the purchase of foreign equipment in investment projects - a more restrictive version of the US's 'Buy America' clause - which threatened to generate reactions elsewhere [1]
• major corporate failures seemed likely to give rise to another round in the financial crisis (especially of firms with collapsing order books recently subject to debt-based private equity buyouts). Major firms (such as GM and Citigroup) also appeared to be at risk - thus raising the prospect that credit default swap (ie derivate) losses linked to large corporate failures would: again spread the pain worldwide overnight as in the case of Lehman Brothers' failure; presumably trigger failures by entities with large CDS exposure; and thus lead to further financial losses elsewhere through counter-party failures (see above). On the other hand the creation of a clearinghouse for credit default swaps in US should, when established, limit the escalation of losses;
• countries with current account deficits (eg US / Australia / UK) would have trouble with attempts at stimulating recovery by public spending, because international private capital transfers had frozen [1];
• IMF expressed concern about a global deflationary spiral - as interest rate cuts and fiscal stimulus packages failed to halt the collapse in demand. Reducing interest rates to about zero increased the deflation risk - because investment is then not worthwhile; savings are held as short term cash - and this gets a 'return' because prices are declining [1]
• there has been concern that government bond markets could collapse once the flight to safety eases because of the huge quantities that have been issued [1]. In the Great Depression a bond market crash from 1931 to 1933 occurred after an earlier flight to safety [1], and the high interest rates then paid on bonds then triggered a further contraction in other markets [1]. The bond market crash in US was due to a run on the $US by central banks in Europe after their currencies had been subjected to attack - as a result of their exposure to financial problems facing Austria because of losses incurred by Creditanstalt, a major Austrian bank [1];
  • An aside: a subsequent phase in the Great Depression involved 'liquidation' policies that ignored the danger of debt-deflation. These arose because economic stimulation by the US government eroded its gold holdings - and forced the Fed to raise interest rates [1]. This constraint is no longer an issue though other constraints on stimulatory spending could arise;
• Japan (Australia's largest export market):
  • was experiencing an economic contraction at an annual rate of 3.7% [1]

  • has an economic system incorporating a distorted financial system (ie one which inhibits consumption and exports cheap credit) - that may have contributed to the GFC;

  • suffered a 27% decline in exports and went into trade deficit in late 2008 (though it remained in current account surplus due to investment income) [1] - which prompted suggestions that Japan needed to do much more to finance US demand to protect Japan's export-dependent economy  [1];

  • suffered an annualized decline of 12.7% over December 2008 quarter which fits the profile of a depression [1]

  • was suffering an accelerating rate of economic decline in early 2009 - when other major economies had a slowing rate of decline. This indicates what happens when property and equity bubbles collapse, and the painful structural reforms and clean-up of the financial system is put off [1]

• industrial production in many countries around the world had fallen between 10% and 43% over a year - about 5-10 times the rate of contraction in the Great Depression [1];
• OECD forecast a 4.3% contraction in developed world's economies in 2009 [1]
• an economic 'crash landing' by both the US and China - which have been key drivers of global growth in terms of demand and production capacity respectively - was suggested [1];
• US GDP could be contracting 5% (or more) in the final quarter of 2008 because of a collapse in consumer spending (20 Reasons Why the U.S. Consumer is Capitulating, thus Triggering the Worst U.S. Recession in Decades). US GDP contracted 0.5% in the third quarter of 2008 and at an annual rate of 6.2% in the fourth quarter [1]. Moreover it was suggested that:
  • US authorities have been forced to try desperate unconventional measures as the economy crashes and stagflation threatens [1]
  • there is no guarantee that the massive financial obligations that the US government is taking on in rescuing financial institutions and stimulatory spending will be able to be financed. Commitments reportedly amount to $US7.7tr (about 50% of US GDP) [1], and considerably more than the inflation adjusted cost of WWII.. Likewise there was concern that the UK might be unable to fund its government's deficits [1];
  • UN economists have suggested that strength of $US in the face of crisis reflects a flight to safety, and this is likely to be reversed in 2009 and force the US (and world) economy into deeper recession [1];
  • a reverse 'wealth effect' emerged - as a collapse in household wealth forces households to constrain spending and emphasise saving. Assuming that stockmarket fell 50%; real-estate fell 35% and  commercial property 35-40%, the peak household wealth in US ($50tr) has fallen by $20tr - compared with US GDP ($13tr). Total debts were $25tr (which remain unchanged) while total assets were now $30tr. To restore asset / debt ratio requires write down of over $10tr - and this would painful [1]
  • "Lacking confidence that the demand for what Americans make and sell will recover significantly, anytime soon, businesses are girding for a long siege—slashing employment and dividends and hunkering down. ....  the slowdown looks more like a depression than a recession. ..  interest rate cuts and stimulus spending and tax rebates shorten recessions .... However, those policies will not end the current slump, because it is grounded in fundamental structural dysfunctions ...." [personal communication from experienced observer of US industry, April 2009]
  • in March quarter of 2009, US federal budget deficit expanded rapidly as outlays rose 40% while receipts fell 28% [1];
  • to March 2009, the US economy had contracted 6.1% yoy. The Federal Reserve (having cut interest rates and printed money as much as it reasonably could) could do no more than point to a slowdown in the rate of contraction and express hope that recovery would occur eventually [1];
  • US government was seen to be at risk of losing its AAA credit ratio because of the need for comprehensive health care reform and structural imbalances. Rating agencies had indicated concerns about this even before GFC [1]
  • US Fed has warned legislators of the need to reduce government deficits quickly - because Fed would not continue to fund them by bond purchases [1]
  • the failure of US banks to properly write down assets was likely to delay recovery. Strategy has been to try to get back to 2006 by propping up asset values and reflating popped credit bubble - while hoping for economic recovery [1]
• US economy was contracting in late 2008 at annual rate of 6% - which was better than in Germany (-7%), Japan (-12%) and Korea (-22%) [1]
• Asia was in the midst of an extraordinary economic storm, and talk of depression was common.[1] . Moreover:
  • Singapore, a bellwether for export-oriented Asia, experienced a GDP contraction at an annual rate of 16.9% in the final quarter of 2008, and the overall contraction in 2009 is expected to be 2-5% [1]; and
• In China all indicators were worsening and the government's November 2008 $6tr stimulus package may merely fill gaping holes in the property market [1]. Also:
  • while the World Bank downgraded its estimates of China's growth to 7.5% pa, this may be officially driven over-optimism, as unofficial estimates can be as low as 2% growth  [1];
  • China's exports fell 2% in November 2008 while imports fell 18% - outcomes that indicated the probably permanent end of the commodity 'super-cycle' [1];
  • Officials were starting to talk of 5% growth in 2009 [1];
  • while only 10% of China's GDP had depended on exports (where growth has turned negative), 60% of its GDP depended on investments a great deal of which relied on foreign capital that may no longer be available;
  • Asia experienced an unprecedented slump with a loss of exports, industrial production and confidence. Policy responses started but whether they will work is uncertain because of complexity of situation and the possibility that financial systems come under renewed pressure. China started to slow rapidly before exports fell because of decline in domestic demand from investment and consumption [1];
  • China's imports, on which much of East Asia depends, fell dramatically. China's growth in the final quarter of 2008 was estimated as below 7% [1]
  • unemployment in China (with potential social unrest) would be worse outcome of GFC in any major economy [1];
  • freight rates for containers from Asia to Europe fell to zero, as exports from Asia crashed and many ships lie at anchor [1];
  • China (which like Japan has had large current account surpluses and has transferred capital offshore to to prevent appreciation of its currency) was to restrict foreign investment - because of the large losses incurrent through such investment by state-owned companies and government agencies [1];
  • China's GDP annual growth to final quarter fell to 6.8% in 2008, with essentially zero growth in the final quarter. China won't return to past levels of consumption of resources (which benefited Australia) because investment in facilities to produce output for which there is no longer a demand can't be justified [1]
  • profits by Chinese companies had fallen rapidly - which would constrain corporate investment (40% of China's GDP) [1]
  • China was experiencing 1.5% pa deflation [1];
  • China's recover was seen as uncertain in May 2009 - as the government stimulus was not a sustainable basis for recovery (eg private sector is struggling, as all support is being given to SOEs; exports are continuing to fall) [1]
  • in June 2009 over-capacity and inventory accumulation was seen to be a risk to sustained growth and to commodity markets [1]
  • In July 2009, concern was expressed about 'local government investment platforms' in China which (on the basis of an asset they were give) had borrowed heavily to stimulate economy (often unprofitably) and whose sponsors (ie the local authority) lacked the revenue to cover the interest costs) [1]
  • In August concern was expressed that property speculation has played a large role in China's economic growth and in efforts to prevent head off the effects of GFC - and that this seemed to be creating a bubble similar to that which existed in US prior to GFC [1]
• OECD 'leading indicators' suggested in early 2009 that China, Germany and Russia were experiencing the fastest rate of contraction amongst major economies. An abrupt decline was indicated in Asia and amongst commodity exporters. Countries dependent on goods exports were suffering worst. China aimed to be the first to recover from GFC - but its stimulus package would have little effect for a year. China had spent 40% of GDP on building factories for exports - but can no longer afford to do so and will have trouble arranging alternative activities fast enough [1].
• the world was suggested to be experiencing a depression rather than a recession. The latter are characterised by inventory cycles; typically last 18 months and always respond to stimulus measures which increase demand. Depressions however, of which there have been four in history, are marked by balance sheet losses and de-leveraging and last 3-7 years. The fact that US interest rates had fallen to zero (and that the situation was getting worse despite extensive government efforts) indicated that we have gone beyond classic recession - and that the problems are structural not cyclical [1]
• IMF warned in April 2009 about parallels with Great Depression - suggesting that downturn was likely to be "unusually long and severe, and the recovery sluggish," and there was a risk that it could spiral down into a full-blown slump unless further action was taken to stop "feedback effects" gathering force [1].
• Germany's GDP appeared to have contracted 2% in final quarter of 2008 [1], and had been predicted to contract 9% in 2009 [1]. Economic contraction of 6% in 2009 would be worst outcome since 1931 and could potentially give rise to civil unrest [1];
• Europe (especially Germany) was experiencing more severe economic contraction than US / UK. This reflects (a) Germany's dependence on exports (b) German government's refusal to stimulate domestic demand (c) reckless lending to Eastern Europe by banks in Austria, Sweden, Greece and Italy (which have been large borrowers from German banks) and (d) euro - which allowed Europe's economy to grow by supporting large current account deficits and mortgage booms (more extreme than in US) in Spain, Greece, Ireland, Portugal and Denmark). The euro also makes it impossible for governments to borrow in their own currency, and thus exposes them to huge currency risk. This now creates serious risk of defaults in Europe [1]
• there was a run on the British pound - as the UK emerged as a possible bigger version of Iceland where the government allowed banks to default because it could not afford to bail them out. UK banks owe $US4,400bn in foreign debts, which is 73 times UK foreign reserves [1]. Iceland had no choice to allow its banks to default because it didn't have the fiscal capacity to bail them out (ie their balance sheets were 600-700% of GDP). The UK's position was not quite so bad (ie bank balance sheets are 440% of GDP), so it is likely to offer guarantees. This however will raising interest rates on UK debt and put pound under pressure [1];
• Bank of England forecast in May 2009 that UK would suffer GDP slump over 4% (biggest since 1931) [1]
• it has been suggested that Europe's industrial base may never recover from the crisis. It has been hollowed out over several years by a strong euro, damaged by the collapse in demand and faced the fact that governments can't afford to bail firms out [1];
• German chancellor expressed concern in October 2009 about the risk of collapse into depression if austerity measures were introduced at the first sign of small upturn. German public debt was however over 90% of GDP [1]
• companies in US and Middle East are planning to cut capital spending by 1/3 [1];
• the commodity 'super cycle' abruptly turned into a bust. Rising commodity prices had been driven by debt driven growth in major developed countries which stimulated strong (domestic and export) growth in emerging markets (eg China and India). This fuelled demand for resources - and expansion in resource supplier countries further fuelled global growth. The effect on prices was exacerbated by significant past under-investment in commodity related infrastructure [1];
• in Australia, reports suggest:
  • an 80% fall in inquiries about new houses [1]; 
  • consumer confidence was being damped by negative wealth effects of a declining share-market and fear of unemployment [1];
  • a decline in house prices [1] - which is potentially very significant for reasons outlined above. On the other hand it waspointed out that this affects only very small segments of the housing market (eg $1m+ properties) and that for the bulk of the housing market median prices have been stable - though no longer rapidly rising [1];
  • significant levels of arrears in mortgage payments facing lenders who have specialized in dealings with 'sub-prime' borrowers - though this practice was much less common than in the US [1];
  • a collapse in spending on resource projects with $50bn of planned spending delayed [1];
  • unions seeking a job protection package for the timber industry (like that given to car industry) because orders placed with timber millers were plummeting [1];
  • pressure on the federal government to arrange guarantees for car finance (at a price) because key firms that used to provide finance had ceased doing so [1];
  • a cash crisis for small business owners - who were not getting support from banks [1];
  • big write-downs on corporate loans by Australia's banks in 2009 [1];
  • a rapid decrease in business orders, investments and confidence - which points to more-serious-than-expected downturn in 2009 [1];
  • doubts by independent analysts about official government forecasts eg rather than its 5.75% estimates of 2010 unemployment, this might actually be around 9% [1]; and 2009 growth might be only 1% instead of the forecast 2% because of large falls in business investment [1];
  • concern that companies could face funding difficulties if banks with $54bn in current lending retreat to their home markets because of impaired assets [1];
  • concern that (with about $1200bn of private debt owed to overseas institutions which needs to be periodically rolled over) banks in many other countries have been virtually nationalised and instructed to withdraw from lending to anything but their domestic priorities [1];
  • restricted availability of credit from banks despite their apparently sound balance sheets [1];
  • severe difficulties facing property trusts (because of inability to refinance debt); job losses of 6.5% of 1m employed in property sector are expected; and asset deflation (because of much tighter lending standards by banks) [1];
  • the potential for corporate fire sales of shopping centres, hotels and tourism developments because of an inability to obtain refinancing [1];
  • forecasts of 25-35% declines in the value of commercial property [1];
  • concerns that property projects were financed during the boom on the assumption of permanent 'blue skies' [1];
  • contraction in state spending as revenues declined, and AAA credit ratings were at risk if borrowing was increased [1];
  • significant scaling back of business investment because companies were unable to obtain credit [1];
  • a collapse of business confidence in October 2008 to a record low [1]
  • difficulties facing state governments in borrowing to fund infrastructure investment [1];
  • Australia's better than global performance that can't last. One of largest ever falls in income was likely with rising unemployment from mid 2009. Recession was delayed because China was slow to turn down and falls in commodity prices won't bite til April (when they will cut 2.5% off national income). Severe financial crises tend to be followed by 9% GDP fall; 35% fall in house prices and 55% fall in shares. The latter happened - but the others were delayed. Most countries, but not Australia, will benefit from lower commodity prices. Real per-capita income could decline 7%.  Rising unemployment would exacerbate home price declines [1];
  • though Australia has suffered a 50% fall in sharemarkets, its banks were in fairly good shape. Australia's problem was going to arise from a collapse in the terms of trade and in finance for business. Proposals for fiscal stimulus packages were merely focused on symptoms, not on causes [1].
  • exposure to the risks associated with developing economies (ie collapsing commodity prices; shortages of capital; and the retreat from globalization) [1];
  • failures by firms because of high debt levels - which reflecteds a credit crunch which federal government efforts to boost demand will do nothing to counteract [1];
  • pressure on the federal government to support state major project investment with $100bn - through buying bonds or funding the Building Australia Fund [1]
  • a likely decline in national income of about 3% starting in about April 2009 as a result of renegotiation of contracts for mineral commodities (Shann E., 'Step on the gas, that's a runaway train behind us', AFR, 6/3/09);
  • the corporate credit risk blowing out to an all time high as the domestic financial market remained fractured and at the mercy of international fluctuations. Only banks (who have government guarantees) were able to issue bonds in 2009 [1]

  • economic performance in December 2008 quarter being worse than 0.5% decline in GDP, as this does not take account of falling income due to deterioration in terms of trade. More relevant wa gross domestic income (GDI) which fell 1.2% [1]

  • an inability by private sector to contribute capital to support major infrastructure projects [1];

  • significant worsening of household finances, resulting in a commitment to increase savings and reduce debts [1]

  • a very large ($90-100bn) reversal in government revenues despite a very mild recession because expected revenues were highly dependent on profits - a risk which the federal government had not appreciated when it committed to large stimulus initiatives [1];

  • significant further damage to the economy and government budgets if commodity prices (and terms of trade) are not maintained. Falls associated with economic downturn have been moderated as traders have sought alternatives to $US and expected rapid Chinese recovery [1];

  • Australia's federal budget moved into structural deficit in 2006-07 - as recorded surpluses were due to effect of boom in terms of trade. Swings in the price of commodities have a large impact on national income and tax revenues - and the effect of this was under-estimated by Treasury in advising about past budgets [1]

  • in December 2009, the effect of GFC was far from over as 50% of Australia's listed companies in a precarious financial position [1]

• estimates for global economy suggested 4% contraction in last 3 months of 2008 - with further steep declines to come. Global industrial production fell 19% [1];
• Capital expenditures were falling rapidly everywhere because of overcapacity [1]
• world trade was expected to decline 9% in 2009 [1]
• a second round of de-leveraging and negative growth seemed in April 2009 to be just over the horizon - given declining international trade, rising unemployment, rising defaults on corporate debt and big problems in commercial real estate [1];
• global economy was in severe recession. Government efforts to restore confidence had not yet been successful. Recovery from recession would be slow and painful - because of the large losses incurred by financial institutions and the debts incurred by government trying to repair damage. IMF expected total losses of $US4tr. World's major economies will be in debt for a long time. Recessions following financial crises are usually severe. Australia will face severe problems because of its low savings rate and dependence on foreign capital - which will not be available [1];
• Barry Eichengreen (author of 'Golden Fetters') suggested that global contraction had been worse than in 1930s - as debt leverage had been much greater. Industrial output fell faster in many countries. World trade fell faster. The global equity crash was twice as bad. However policy responses had been different - and the question wais whether they worked. World Bank pointed out that capacity utilization was 50-60% - so companies may fire many workers. Trade data in Asia continued to be poor, as did US freight data. Firms had not cut inventories fast enough to keep up with falling demand. Bulk shipping increased because China bought commodities while they were cheap. However Asia's recovery depended on the West - and this can't work this time because US has exhausted its credit and desire to borrow. US will probably increase savings (eg to 15% of income). This could shatter surplus economies (ie China, Japan, Germany). ECB will contract til mid 2010. Deflation is emerging in more countries every month. Increased bond prices could bring any recovery to a halt [1]
• while there were signs of improvement (and some recovery must follow from massive stimulus and evolution in inventory cycle), long term problem remained noting (a) rising unemployment (b) failure to deal with solvency problems facing banks (c) consumers in deficit countries must stop spending (d) financial system remains badly damaged (e) weak profitability (etc) constrains business expansion (f) government debts must force up interest rates (h) while slack product / labour markets are deflationary in short term, in longer term expansion of monetary base by reserve banks could be inflationary (I) domestic demand may not grow fast enough in surplus countries to compensate for decline in demand in deficit countries [1]
• in June 2009 trade data continued to decline worldwide, and at a rate far greater than during Great Depression. This reflected to some extent the greater international financial / trade integration. Trade had been a means for transmission of the crisis. Declines reflect partly inventory reduction - and an inventory rebuilding would improve the situation at some time [1]
• huge increases in unemployment was likely as a lagged effect of declines in GDP in various countries - and this was likely to depress any recovery [1]
• according to World Bank chief economist (Justin Lin) excess industrial capacity existed in many economies (like that in the 1920s which some see, rather than problems in credit markets, as the primary driver of the Great Depression). Moreover there are signs of deflation in many economies [1]
• Spain is sliding into full economic depression with unemployment levels like those in 1930s - arguably because its economy was not equipped to cope with constraints imposed by entering the EMU [1];
• IMF has warned that Asia's rapid recovery can't be maintained - because it has not actually decoupled from US [1]
• weak $US could result in a bubble in oil market which derails US recovery [1] [It can be noted that some observers have argued that oil prices had a significant role in generating the GFC]
• China's growth was said to be unsustainable because of: asset bubbles; overcapacity; inflation - which is likely to be followed by overheating; a breakdown in its rapid growth and deflation. Concern was also expressed about loses in China's large (mainly $US) foreign exchange holdings [1] ;
• China's apartment market was seen as a potential bubble - with 50-7) price rises in a year; the world's highest cost / income ratio; and huge numbers of vacant properties - bought as investments to hold value in the absence of alternatives [1] China's leaders are good at reviving an economy - but have no way to fine tune it when it becomes too hot. In 2004 and 2009 central bank and bank regulators (both politically directed) let inflation get away and then hit real estate with severe credit controls. Many think this is again likely soon [1]
• much of US was still in downturn in November 2009. Small business sentiment and output is poor. Unemployment, nominally 10.2% is actually 17.5% when discouraged workers / under-employed are considered. Many job losses (construction, finance, outsourced manufacturing) are permanently lost, and a further 25% of US jobs could be outsourced. No one but prime borrowers can get credit. Bottom 1/3 of households have none. Huge numbers of small businesses and households are becoming bankrupt. Data showing improved retail spending only captures larger firms, and misses the others who are going out of business Household savings has risen from zero to 4% and must rise to 8% to reduce household debts. Income and wealth inequality is rising. While US may near end of recession, most of US is in near depression [1]
• US has worst unemployment month since recession started with workforce decline of 661,000 in December 2009 - mainly because so many dropped out of labour force. Home foreclosures continue at 300,000 / month - and judges are now blocking evictions as in 1932-34 (because of social crisis). US grew at 2.2% pa in final quarter - due to heavy stimulus but much down on 7.3% pa usual at and of recessions. Money supply is collapsing. The stock market is now a lagging indicator [1]
• US consumers have been de-leveraging (reducing debts) for 10 months, and in November 2009 were doing so at an accelerating pace [1]
• China's economy might grow at 16%pa under current stimulus measures - and seriously overheat [1];
• strains are appearing in the Chinese economy, linked to asset speculation and the fact that China’s bank lending has been expanding at a much faster rate than its economy [1];
• China has a massive over-capacity problem - noting to investment constitutes over 50% of GDP. In 2001 it was 25% of GDP - but has to be steadily increased because domestic demand has not risen sufficiently, Over-capacity was concealed after 2005 by increasing net exports, but this wass interrupted by financial crisis - which led to increasingly government-driven stimulus-investment binge which has been used irresponsibly. This (which benefited Australia's resources industries in short term) can't continue much longer (eg for more than 5 years) [1]
• China (like Dubai) has reached the peak of a bubble. Its export led economic model yielded strong growth - but trade is now stagnant. Consumption has not been increased - in fact fell from 60% of GDP to 30% last year - the world's lowest, To compensate for slumping demand China launched stimulus directly and through state banks of $1.1tr. Now 95% of growth is attributable to state investment. Power data show growth only 2/3 announced figure. Claims of roaring retail sales are belied by flat consumer prices, and declining import demand. Groth is constrained by growing budget deficits and bad loans by state banks. Also economy is being re-nationalised - whereas past growth was due to shift towards private sector. Floods of state money also (a) divert China's businesses from requirements for competitiveness and (b) spill over into 'casino' economy. [1]
• Europe's economic recovery seems to be stalling [1];
• China is facing labour shortages as its export industries recover [1]

Deterioration in the Economic Environment

• the way in which Lehman Brothers failed was suggested to have transformed the crisis from one of orderly adjustment and routine transactions to one in which all organisations were simply concerned with precautions to protect themselves [1];
• the financial crisis increased the risk of global political instability [1];
• radical actions that governments were taking to recapitalize financial systems and prevent recessions could themselves trigger further crises;
• 'East Asian' economic models are likely to impose a deflationary demand deficit on the global economy - which may make global recovery from the economic impact of the GFC very slow given the necessity for de-leveraging in many major economies (see above);
• Germany was seen to be engaging in 'beggar my neighbour' policies like those which led to the Great Depression when countries having large current account surpluses (US and France at that time) refused to stimulate economic growth and left deficit countries to try unsuccessfully to do so. Germany's trade surplus ($US283bn) exceeds China's ($279bn) [1].
• the Bank of England suggested that global deflation is a real risk - which would be very serious as incomes fall while debts remain unchanged. Also people tend not to spend because prices are expected to be lower later [1]
• in the longer term the 'East Asian' economic models (whose application has generated the resources demand that has been the major driver of Australia's recent economic boom) are unlikely to remain viable (see  Are East Asia's economic Models Sustainable?). China's prospects for ongoing market-driven economic growth appeared to be at risk as the GFC unfolded (see China: After the Bubble);
• a long (eg 15-20 years) period of debt deflation was seen to be possible - because debt to GDP ratios exceeded historical levels, and the assets related to those debts were falling in value and producing declining returns. The response to this problem in the past (1870-880s, 1930s) has been for households to live within their means and increase savings to reduce debts. This takes a very long time. Government actions to stimulate the economy make little difference. Though there are upturns in business, and there is a negative risk premium (ie returns on government bonds have exceeded returns on shares for many years). [1]
• concerns have arisen about obstacles to international investment - as China authorised its companies to make international acquisitions while prohibiting a multinational firm from acquiring a Chinese company [1];
• signs of deflation and competitive devaluations were emerging. Swiss CPI was contracting causing great concern to its National Bank - who was seeking to devalue the Swiss Franc as a response. If other countries seek to export deflation, the economic crisis would enter a new phase. Taiwan was devaluing. Korea, Singapore and Sweden were tempted. Japan suffered a catastrophic collapse because other currencies have devalued against the Yen - and Japan was likely to have to devalue in response [1];
• in June 2009, BIS warned that governments might be forced by bond investors to abandon stimulus packages - and instead slash spending and lift interest rates - if economies seemed likely to stagnate for years with chronic budget deficits. BIS's annual reports have warned of depression risk - and its latest warns of risk of run on currencies (such as Australia's) which force tighter monetary policies than domestic conditions warranted. Stimulus programs may only lead to (a) temporary growth followed by protracted stagnation and (b) difficulties for authorities to take unpopular actions needed to restore financial system. Major problems exist in both financial systems and real economies.  Problem assets have not been removed from bank balance sheets, while government guarantees have exposed taxpayers to large risks. Governments may exhaust fiscal capacity before financial systems are repaired - and drive up interest rate / inflationary expectations. Financial sectors have to shrink - because it has grown too large on the basis of assets of doubtful quality. Debt needs to be reduced, and household savings increased. Nations dependent on exports (eg Japan and Germany) and those dependent  on capital inflow (eg US) need more balanced models - which can't be done quickly. BIS criticised US bank rescue package and European unwillingness to subject banks to stress tests [1];
• OECD warned that financial crisis would result in major problems facing public and private pension schemes that will last decades [1];
• US budget position was becoming unsustainable - with prospects of ever increasing debt levels unless political system increases taxes or reduces spending. Current national debt was nominally $11tr - but this becomes $56tr when account is taken of unfunded future liabilities [1]
• Ireland has been forced to slash public spending as deficits approach 15% of GDP and has been paying penalty interest rates on borrowings. Similar problems affect Britain, Spain, France, Germany, Italy, US and Japan because of large debts (eg 100% of GDP or more) and demographic decline. Current state structures wee becoming unaffordable.  Japan suffered from years of stimulus spending - and had debts 240% of GDP (thus facing a bond market meltdown). Governments should cut spending every year, and compensate with quantitative easing for resulting deflationary trend [1];
• the potential conflict with Iran over its nuclear weapons program could have global consequences. Israel can't tolerate that threat, yet is too weak to deal with it alone. Any Israeli action would result in blockage of Persian Gulf - which would force US action, probably resulting in loss of access to Iranian oil which could tip global economy into crisis [1] ;
• Latvia is on the point of political collapse because of failure to meet conditions on financial rescue package [1]
• Social / political unrest has been suggested to be possible in several countries which face fast-rising government debts as a consequence of the GFC [1]
• Worst financial crisis since WWII is ending. It was much more significant that Japan's real-estate bubble (from which it has not recovered) and Great Depression.. Unlike the latter, this time financial system was put on life-support rather than being allowed to collapse. Total credit in 1929 was 160% of GDP (and rose to 250% in 1932). This time starting point was 365% (not including derivatives0. Life support worked - but recovery is likely to run out of steam. Most people don't understand the extent of problem. Initial efforts to deal with the problem were conventional (rescuing institutions and fiscal stimulus). But when Lehman Bros failed, governments had to guarantee that no others would - and problem spread to emerging economies (especially Eastern Europe) where such guarantees could not be given. Now many hope that the problem is solved, but this is invalid. Globalization made finance hard to regulate / tax. This created instability because it was assumed that financial markets could be left to own devices. Global markets need global regulators - which is not currently possible, and governments are domestically focused. This risks financial protectionism which could destroy global markets. It will be hard to get agreement on global regulations. In the 1930s trade protectionism made situation worse - as financial protectionism could do now [1].
• the EMU has been seen to be similar to the pre-1930s 'gold standard' in terms of trapping states in debt-deflation environment (noting the position of Greece). Ideally surplus states should loosen policy in a downturn, while those with deficits tighten. The gold standard forced those with deficits to tighten - creating debt deflation. The EMU's current effect is similar [1]

Recovery?

Despite extensive efforts being taken by governments and businesses to counter and adapt to the effects of the crisis, there were for a long time only limited indications of progress emerge, such as for example:

• in February 2009, there were signs that economic decline was slowing. Freight rates had increased. Some commodity prices had risen. Debt funding is more available. Housing sales are increasing. The shut-down following Lehman Brothers failure seemed to have eased. China's manufacturing was stabilizing. [1];
• in Australia firms were responding to the downturn by diversifying into new markets and services, as well as by traditional cost cutting [1];
• in April 2009 consumer confidence was significantly improving and buyers were returning to housing market in Australia [1] - presumably in response to massive fiscal effort by government to achieve those outcomes;
• in March 2009, CitiBank showed a surprise trading profit - however this was achieved by taking on derivatives risk (perhaps from AIG) which could be valued at above its cost, but may simply create future problems [1];
• in May 2009 improvements were perceived involving (a) more normal inter-bank and corporate lending (b) improvements in China, some commodity markets, US housing and (c) the need to rebuild inventories [1];
• in May 2009 the results of government 'stress tests' on US banks (ie their ability to cope with possible further economic downturn) suggested achievable further capital raisings needed from 19 major banks of $US75bn (and possible future write-downs of $US600bn). This was seen to invalidate IMF estimates of $US1-2tr in likely future losses [1]. However the tests were criticised [1, 2] on the basis that:
  • the projected economic downturn for late 2010 which was the basis of the test seemed likely in the near future;
  • estimated were not fully objective, and banks lobbied hard for favourable assessments;
  • the capital adequacy ratio used in the tests (4%) was inadequate for systemically important institutions;
• the US Federal reserve was seen to have saved both US and global economy through making credit available (about $620bn of which went to meet $ demands of banks outside US, including Australia). The Fed committed to lending an additional $2tr - beyond what monetarists would have endorsed [1]
• rescue in US financial system was nearing success - though some institutions required large capital injections (presumably by conversion of preference shares). Corporate debt markets had strengthened. Share issues weree being absorbed. However there was still a huge de-leveraging underway and losses in CDSs. Also governments wanted to borrow $US3tr in 2009 (2 in US alone) - which is four times normal. Interest rates would be high. Banks and companies would struggle for capital [1] ;
• a large surge was recorded in US consumer sentiment in May 2009 [1]

In March 2009, the ECB suggested that there were signs of recovery associated with: massive stimulus packages; commitment to prevent failure by systemically important institutions; lower interest rates; reduced oil prices - and signs of stabilization in some markets [1].

In April 2009, various economic 'green shoots' were seen to be emerging in the context of the G20 summit. 

In May 2009 it was noted that the decline in the rate of economic contraction that was apparent did not indicate imminent recovery because (a) though governments responded to the near financial meltdown with 'overwhelming force' which was having an effect, this would will have negative long term effects on taxes and interest rates (b) the 'green shoots' that have been perceived (in terms of US unemployment claims, retail sales, industrial production and housing) were dubious; (c) the crisis was caused by excessive borrowing and debt - yet recovery has been based on increasing this further - ie the real process of de-leveraging had not yet started - and when this happens growth will falter; (d) the financial system was seriously damaged and can't recovery quickly; (e) real interest rates must rise because of cost of servicing large government deficits (f) monetisation of debts raised risks of inflation (as there is no easy way to cut liquidity) (g) countries with current account deficits would now need to boost rapidly domestic demand (h) in any recovery there would be risks associated with high oil prices / rising taxes / inflation [1]

Share-markets were seen to be rebounding in May 2009 because (a) global financial system had not completely failed (b) rate of real-economy decline had slowed - so recovery must eventually occur and (c) interest rates were very low.  However (a) excess liquidity will need to be withdrawn as recovery occurs - and it will be hard to get timing right to avoid further downturn or inflation and (b) high levels of government debts will force interest rates up for years and thus dampen recovery [1]

In June 2009, many positive indicators could be identified (eg rising UK house prices; increased industrial production in Japan; improved business and consumer sentiment in US - as well as reduced unemployment, increased orders / property sales, stabilized housing prices; rising share-markets). Moreover bond yields can rise in recoveries without renewed recession; the availability of money was improving; most increases in US savings had already occurred; government deficits will be no real problem as debts would be below 100% of GDP - the latter being common during 20th century; reserve bank credit creation won't expand inflation unless it is lent to private sector. None-the-less it was not clear how financial imbalances will be resolved, while inflation / protectionism remain long term risks [1]

In June 2009 various observers suggested that growth in emerging economies had remained strong and that this was likely to (a) drive future global growth and (b) indicate the emergence of a new world order. However their apparent success might have been little more than a temporary consequence of earlier financial imbalances (see A New World Order Built on Emerging Economies?)

In July 2009 new 'green shoots' were identified (eg the US Fed forecast a slower rate of economic contraction in 2009 than its previous estimates, and there were no signs of the deflation that had been feared [1]; Singapore's huge GDP contraction was almost reversed, US consumption rose, Goldman recorded large profits [1]. China's achievement of 8% growth yoy in June quarter through economic stimulus was suggested to be able to save global economy [1]. The end of the GFC was proclaimed on the basis of: (a) unbridled optimism; increasing share indices; corporate earning is bad economic environment; better US bond issues; and slight reduction in jobless claims [1].

Constraints on recovery were seen (for example) in terms of the need to deal with: (a) eventually ending stimulus measures (ie public spending and low interest rates); (b) new-found consumer frugalism; (c) problem assets remaining on the balance sheets of financial institution despite injection of fresh equity; (d) higher interest rates on bonds - because of large government borrowings - that would erode the value of other assets; and (e) risk-avoidance by investors [1]. Moreover recovery in Europe was expected to be slower than elsewhere, because of: (a) permanent decline in potential output; (b) large internal imbalances - and consequent deflationary pressures; (c) restricted policy responses to crisis; (d) leveraged financial institutions which were both too big to fail and too big to save; and (e) strong industry reliance on bank funding - which suffers a bigger financing gap than in US [1].

In August 2009:

• one observer suggested there were so many bullish indicators that it was just like being back in 2007, and that 2008 and 2009 had never happened [1] - an unfortunate position to be in as 2007 must be followed by 2008.
• it would soon be necessary to raise interest rates in Australia to prevent economic over-heating [1]
• China was starting to experience a recovery in export demand [1]

In early October 2009, IMF forecasts of total losses associated with GFC was reduced from $4tr to $US3.4tr {1]

In October a former RBA governor (Ian Macfarlane) suggested that the GFC had been misunderstood - and that both financial markets and global economy would continue to recover. The GFC came sooner, was more intense and (when governments showed they would not allow systemically important institutions to fail - so risk premiums collapsed) ended sooner than expected. The GFC was brief failure of part of market, but mainly reflected political failure to adapt to China's rise. GFC was needed to end unbalanced global growth. US won't be able to rely on China's excess savings. China will have to allow currency to rise, promote domestic demand and liberalize its economy. Instead of looking to US world economy will in future need to lead to emerging markets (mainly China). US growth will be slow. Australia's problem is not a collapse in demand (such as occurred in US / UK) for which stimulus spending was needed, but rather coping with new China export boom [1]

Head of US Council of Economic Advisors argues that world narrowly escaped a depression because, as a result of government action demonstrating that important financial institutions to fail, general panic (a self reinforcing path to depression) did not set in [1]

In October: it was suggested simultaneously that:

• Australia was likely to experience a new mining boom based on exports to China, so it was inappropriate for the government to be still maintaining policies appropriate to a global crisis that was fast disappearing [1];
• Australia was likely to suffer slow growth because of the GFC - because (a) households can't maintain spending (b) the effects of stimulus spending is wearing off and (c) China's rapid recovery is likely to be followed by a slowdown [1];
• Australia's economy has been over-stimulated (through massive interest rate cuts, spraying money at consumers, boosting home-buyers grants; accelerate infrastructure / government spending programs) which could see growth of 6% in early 2010. Stimulus was to cope with impact of global recession which never really happened because of stimulus efforts by China (Australia's key export customer) [1]

In early 2010, it was noted that commodity demand was expected to rise rapidly due to increased demand from China and a rapidly improving global outlook [1]

In March 2010 the US was seen to be poised for a robust recovery - as the private sector took over from fiscally-challenged government, because of: (a) V-shaped recoveries are common - eg in the early 1990s under similar conditions; (b) recovery will occur when profits rise - and cost cutting has facilitated this; (c) companies can finance expansion internally despite bank weaknesses; and (d) signs exist of business investment renewing  [1] [Note: at the same time, observers focussed on other indicators believed that renewed economic downturn was more likely]

False Dawn?.

In mid-2009 'green shoots' were widely perceived mainly in the form of slowing of the real-economy contractions that had started in late 2008, when the near-failure of global financial systems was triggered by Lehman Brother's bankruptcy.

The 'green shoots' arguably reflected the effect of: (a) large government and reserve bank efforts to stimulate growth especially in the US and China; (b) adjustments, and the search for new opportunities, by businesses;  and (c) some papering over of financial system losses that had given rise to the GFC.

However the perception that 'green shoots' reflect imminent economic recovery may result from a tendency by economists (who typically did not anticipate the GFC) to consider stimulus-driven 'real' economy variables and assume that financial markets will be stable - an assumption that the GFC proved incorrect because the character of those markets was changing and rendering them unstable for many reasons (eg regulatory changes; financing innovations; escalating levels of private debts (and asset values) relative to GDP; and the emergence of radically different East Asian economic models). Observers who focus on financial system considerations (eg the Bank of International Settlements) have a less optimistic outlook [1]. For example in August 2009, it was simultaneously suggested by respected observers that:

• the global recession was essentially over, and those who had expected worse outcomes now looked silly [1]; and
• there was a massive contrast between the euphoria of markets and the stern warnings of central banks and financial watchdogs. But lasting damage has been done and the expected recovery was impossible [1]

Also in the UK, which suffered similar problems to the US and took a lead role in developing international responses, authorities were far less optimistic about recovery than those in the US - perhaps because the US relied on the $US's status as the global reserve currency, which others can't do [1], However the US's reliance on the $US's status (ie allowing its authorities to drive global growth by boosting domestic spending and assuming that the resulting current account deficits could be funded by borrowing) was a significant factor in the emergence of the GFC, and would need to be reversed before recovery could be assumed to be sustainable.

Large losses were incurred during the GFC by financial institutions especially in Europe (where banks have traditionally been the key source of business funding) and in the US. 

In the US: (a) governments couldn't afford to absorb those losses; (b) writing them off would have led to further insolvencies like Lehman Brothers which had a devastating global impact because of the (credit default swap) derivatives repercussions; (c) buyers for toxic assets could not be found at prices that would have allowed banks to remain solvent; and (d) losses were papered over eg by easing mark-to-market valuation rules and modest government 'stress tests'. It seems that the initial assumption by US authorities, that fixing financial institutions would lead to economic recovery, was reversed in the hope that economic recovery would allow banks' balance sheets to be restored. Perhaps 10 additional banks (not just Lehman Brothers) needed to be allowed to fail to clean up the financial system [1]. Western banks generally have been suggested (by the Economist) to be now so dependent on short term borrowing supported by government guarantees that they would be unable to operate independently [1]. In addition the securitization model (which had accounted for about half of the credit created in US before the GFC - and had expanded the overall capacity to create credit as it did not depend on bank's capital reserves) had been discredited and not restarted.

In Europe (which incurred the greatest banking losses related to international rather than domestic lending) little systematic effort seemed to have been taken to even address the problem (see also above).

The net effect was that toxic assets remained unresolved (perhaps $2.5tr remained unresolved out of total $4tr according to IMF estimate [1]) to potentially trigger further economic setbacks - eg because of:

• the possibility of a second phase of the GFC; or
• the inability of affected financial institutions to play an effective role in US / European economic recovery as future earnings will long need to be directed to rectifying old debts (much as occurred in Japan in the 1990s).  It is for the latter reason that recessions triggered by financial crises traditionally take much longer to resolve than those that arise from normal business cycles.

Withdrawing from the large fiscal and monetary stimulus that governments / reserve banks have engaged in has been suggested to be very difficult (because if such supports are withdrawn too late inflation will set in, but if withdrawn too early a relapse into recession is likely, as in Great Depression and in Japan in 1990s) [1]. Restoration of more normal interest rates (which the RBA conspicuously started doing in October 2009) might, for example, lead to a crash in government bond markets like that which occurred in 1931 and resulted in expectations of higher yields on all assets and thus a second-round stock market crash.

In early 2010, there were warnings of the huge refinancing task which will emerge when government guarantees are removed, and the likelihood of much higher interest rates in 2012 [1]

There is also a risk (though no certainty) that long term de-leveraging could act as a drag on economic growth  for many years (see above). A process of household de-leveraging (ie a large increase in savings) seems well established in US (where private debt is reportedly around 300% of GDP (150% in Australia) [1], historically an extremely high level). In Australia de-leveraging seems established - but more associated with business than households. Based on experience in earlier periods of de-leveraging it is possible that a (say) 5% pa drag on growth could set in as income is diverted from economic demand to reducing debt levels from the historically extreme debt / GDP ratios that were created on the basis of asset inflation in the pre-GFC environment.

Difficulties have been compounded by heavy spending by some governments (especially the US) on measures to protect financial institutions and stimulate economic activity. This has created severe fiscal pressures (especially in the US where long term budget deficit difficulties were already arising due to deficit spending and unfunded liabilities) and this will constrain future growth by requiring higher taxes, reduced public spending and higher interest rates.

There is also doubt about the benefits of loose monetary policy in counter-acting the effects of GFC. The world experienced two decades of sustained strong growth partly because of a virtuous circle between easy monetary policy and economic growth. The US Fed showed, after the 1987 stock market crash, that a financial crisis could be prevented from seriously impacting on the 'real' economy by boosting the availability of credit to financial institutions. This (the so-called 'Greenspan put')  reduced the perceived risk of investing, and the real rates of return investors expected. The latter in turn contributed to rising asset values - and strong consumer spending based on a 'wealth' effect (even though incomes were not rising strongly). Ultimately asset inflation proved unsustainable, and this gave rise to the GFC. While loose monetary policy is again being expected to prevent a financial crisis from impacting the real economy, past experience shows that it can only do this by reinflating asset values  - and thus create reasonable expectations of a further financial crisis. There is a fairly clear need to invent new methods for macroeconomic management - yet little sign of practical progress in doing so.

By October 2009 the US Fed's easy money policy was seen to be resulting in asset inflation through a dollar carry trade flooding money into everything [1]. And the rapid recovery in equity markets that had occurred by October appeared to largely reflect that 'flood'. In November 2009, despite strong indicators of economic recovery job shedding in the US continued strongly though in a normal recovery it would have slowed (personal communication).

Furthermore, the structural adjustments to the 'real economy' required to end global financial imbalances (ie the world economy's dependence on US consumer demand, because of the export-driven development strategies and undeveloped financial institutions in Japan and many emerging economies) have not been made, yet US consumers (who accounted for 70% of US demand) are not positioned to resume their role as drivers of global growth (because of the severe setbacks they suffered). One respected observer suggested that because of this no one knows what the recovery will be like [1].

The US and Europe raised the need for systematic efforts to reduce imbalances in the context of a September 2009 G20 meeting - a proposal to which China objected [1].

However the methods by which the US is taking to limiting financial imbalances seem crude (eg applying tariffs to tyre imports [1]). Constructive methods, compatible with the G20 aspiration to prevent protectionism limiting trade, would include boosting the supply side of its economy (eg by methods like those suggested for Australia in A Case for Innovative Economic Leadership) while constraining the availability of credit for consumption.

Moreover, while China (for example) seems to have made some adjustments in the direction of basing growth more on domestic demand, in the development of a solar cell industry China seems to be applying traditional techniques (ie subsiding production in order to gain huge global market share) [1] a tactic which implies an expectation of large scale ongoing financial imbalances.

Finally, China's growth is most unlikely to be sustainable as an independent source of regional / global growth, because East Asian economic models lack the profit-focused financial / business systems needed to:

• effectively balance supply and demand; and
• attract the capital inflow needed to balance the current account deficits that world-leading growth would generate (see Another 'Tiananmen Square' moment for China's regime?). 

In August 2009 there were moreover warnings of constraints on China's ability to maintain strong growth in the face of a weak global economy. For example:

• China was said to have created a bubble economy like that in US before GFC, and the surge in demand for commodities [that, incidentally, has so far prevented GFC affecting Australia severely] resulted from state controlled banks throwing money at economy which could not be used productively - so that  it was used to stockpile future commodity inputs.[1] (as well as boosting property speculation [1)];
• the stock market results and economic claims out of China imply that it has been transformed in a matter of months from an export-oriented economy to one based on domestic growth. However the reality may be only propaganda driven bubble - based on flooding the economy with cheap credit for everyone to do anything. If so this is a bubble that must burst [1];
• China was suggested to have merely repeated the tactics used at the time of of the Asian financial crisis - ie a large short term stimulus on the expectation that export-driven growth will soon resume [1].

By November 2009, there were loudly-expressed concerns from many sources that economic stimulus efforts in China was creating asset bubbles [eg 1]

In the 1990s Japan experienced a financial crisis followed by prolonged economic stagnation, because in the 1980s its state-controlled banking system had indulged in run-away credit creation leading to property bubbles and excess capacity, just as may be the case in China now. 

On the other hand the Economist suggested that China's huge economic stimulus through expansion of credit might not be generating a financial bubble - though continuing this in the longer term would only be possible if the link between Yuan and $US was broken [1]. Moreover it was suggested in October 2009 that China's recovery was no longer dependent on government stimulus [1]

The World Bank, it can be noted, has issued warnings about the potential deflationary effect of the unprecedented levels of 'excess industrial capacity' which seems now to exist in worldwide - because investments were made in anticipation of continued rapid growth and there are now far too few real customers [1]

Unresolved Problems and Coming Crises?

It was the the present writer's expectation in mid-late 2009 that further stages of financial and economic crisis were likely which had been overlooked in coordinated efforts by governments through the G20 to deal with the GFC (see Structural Indicators of Ongoing Recession / Depression). In brief:

• serious financial problems remain in banking institutions, which will (a) potentially result in further failures with consequences spread by derivative products; and (b) constrain banks' role in any recovery;
• fiscal stimulus efforts by governments may exhaust their credit and be reversed into a fiscal drag (as taxes and interest rates rise) that is potentially amplified by private de-leveraging;
• structural problems in the global economy  that contributed to the the first phase of the GFC (ie dependence on US demand resulting in financial imbalances that could only be sustained by asset inflation) have not been resolved, and may actually be irresolvable (because of the economic models that have been the basis of East Asia's rise) without a global economic and political breakdown.

Furthermore as the obvious crisis abated, many other analysts raised concerns about ongoing risks:

• while economic growth may resume in late 2009, risks were perceived (by Nouriel Roubini) of a 'double dip' recession in 2010 because of ending of fiscal and monetary stimulus; risks arising in managing stimulus exit strategies; and possible speculative rises in oil / commodity prices.[1];
• risks of a double dip were seen as likely when stimulus is reduced because: fundamental issues (too much borrowing, corruption in financial system, and excessive government debt) were not addressed; bank balance sheets were not genuinely cleaned up; banks are dependent on government guarantees which will eventually be withdrawn; unemployment is much greater than official statistics [1];
• the US needs to show how it is going to deal with its debt burden - and no matter how this is done the consequences will be nasty [1];
• deflation seems increasingly widespread, yet governments have reached their limits in maintaining economic stimulus. The best that might be hoped for now is a slow and painful process of de-leveraging [1]
• complications associated with current economic situation include: failure to tackle need for sound banking systems in US and Europe (without which recovery can't be sustained); massive government debts (especially in US); trade imbalances; difficulties in managing exchange rates as monetary stimulus is wound down; [1]
• the financial crisis is slowly changing into a government debt crisis. Investors feel confident in economy only because governments have cast a vast safety net over it, and spent taxpayers money heavily. However their debt levels make this unsustainable.  [1]
• by bailing out financial players in latest crisis, governments have entrenched the problem of moral hazard. Structural flaws in global financial system still remain to be addressed [1];
• bank credit and M3 money supply have been contracting in US at a rate comparable with the Great Depression - raising fears of a double-dip recession in 2010 and a slide into debt-deflation. [1]. Money supplies are also contracting in Europe [1];
• the G20, which sought to coordinate international responses to GFC, was seen as a complete waste of time because all that happened was that unsustainable increases in US private debts have been replaced as key driver of global economy by unsustainable increases in US government debts [1]. The weaknesses that created crisis (eg low interest rates that discouraged savings and encouraged speculation) have not been addressed, and regulations proposed by G20 are likely to be worse than those existing before - so a future crisis is inevitable [1]. G20 is able to get agreement on financial regulation (an issue on which there is wide agreement) but is having difficulty getting agreement on trade, financial imbalances and reform of Bretton Woods institutions [1];
• there can't be a serious recovery because of high debt levels. Commercial real estate crash is still coming. People have to pay so much for debts that they have little to spend - so economy shrinks. Shares have gone up because US government gave $13tr to banks - but this doesn't help real economy. The US 'recovery' is jobless - and thus not real. Debt deflation is happening - especially in Baltic and post Soviet economies. Debts can't be repaid - and defaults are inevitable. US real economy is being sacrificed to support financial sector. Australia has major problem with debt creation linked to real estate. Raising interest rates will attract capital from abroad (eg from US where can now borrow at zero interest rates). Australia is setting itself up for financial problems that will increase taxes. [1]
• risks of a double dip recession include: (a) financial crisis is far from over with only 50% of expected losses yet identified; (b) global recession was massive - involving 75% of economies (c) ongoing demand will be weak and 9D) supply side is unbalanced with large financial imbalances [1];
• contraction of money supply in US and Europe will puncture recovery in 2010. Recovery of 2009 will run into excess Chinese capacity - surpklus countries have not increased demand enough to compensate for decline in deficit countries. Debt problems have been shifted to governments, and while reserve bank bond purchases will hold rates down for a time, this must end. Japan is most at risk with public debt 225% of GDP. China must also end QE process - because boosting mercantilist export model generates asset bubble. [1]. However it was noted that Japan's position (while serious) is less likely to generate immediate crisis because net debt is only just over 100% of GDP, and little public debt is held by institutions government can't control [1];
• economic difficulties could arise in 2010 because of (a) the costs of government efforts in 2009 are coming due (eg in Japan, whose ratings are being downgraded - but is not alone) (b) demand remains elusive - and growth may falter as stimulus fades (c) trade tensions could explode (noting failure to get international cooperating in Copenhagen , and concerns about China's $US peg; (d) reserve banks face many problems in exiting easy money policies without inflation or exploding asset bubbles; (e) many improbably-but-very-damaging ('black swan') possibilities exist [1]
• the World Economic Forum warned of future potential crises related to sovereign debts and growth slowdown in China [1];
• a new global credit crunch has been suggested to be likely to be more violent than the GFC, and arrive in 4-5 years because countries had failed to impose serious banking / accounting reforms. Since 1982 there have been three financial crises, and the period between each is always shorter [1] ;
• during the GFC many countries turned to IMF (or EU) for external support = and this prevented a fully fledged payments crisis. Now political developments in several countries (eg Iceland, Latvia, Romania and Ukraine) face political obstacles to gaining further funding - and this threatens (a) attention to many other countries in a similar position and (b) a possible renewed crisis [1];
• unprecedented monetary and fiscal stimulus is all that is prodding developed and major emerging economies along. The private sector is now spending less than its income (ie de-leveraging) at various rates (eg 5-10% of GDP) despite monetary loosening. World economy had developed a credit super-bubble over 3 decades - that burst in 2008. Some see this as simply the result of monetary policy errors (ie interest rates were kept too low because inflation was constrained by supply shocks)  - as had occurred in the US in 1920s and Japan in 1980s. There are now two possible outcomes (a) private spending again surges, fiscal deficits shrink and 'normality' seems to return (b) private de-leveraging continues and fiscal deficits continue growing. Both will result in disaster through sovereign debt crisis. Avoiding this requires either investment surge in deficit countries (which increases income to cover fiscal deficits), or a demand surge in emerging countries (which would allow deleveraging in deficit countries to flow into investment in emerging economies). This would require radical rethinking (ie of sustained deficits in UK / US, and international agreements to reform financial systems so that capital can flow to emerging economies. A credit fuelled consumption binge is not the solution [1] ;
• a note of resignation has crept into economic debate - because of collective recognition that fiscal and monetary policy has reached its limit in countering downturn. This is illustrated by austerity measures adopted in Greece despite deepening economic contraction, and determination by ECB to 'normalize' monetary conditions even though eurozone economy is stagnant [1]
• the risks of a double-dip recession in US are rising (noting poor consumer confidence / home sales / construction / employment / durable goods orders / disposable incomes / manufacturing index; declining fiscal stimulus) though many are more optimistic. The eurozone faces a rising double-dip risk - because of fiscal austerity on periphery. UK faces fiscal-sustainability concerns and a possible currency crisis. [1]
• China has warned of the risk of renewed global recession while (a) refusing to consider reducing its stimulus or revaluing its currency; (b) calling for change in world financial system (c) seeking to constrain inflation and increase domestic demand; (d) expressing concern about surging commodity prices; (e) expressing concern about high US unemployment and widespread sovereign debt problems; and (f) mentioning (while not explaining) the effect of the GFC on China's development model. Any trouble in China, it was also noted would quickly affect Australia [1].
• problems of debt facing many countries will have economic effects - as lower consumption and growth in such economies will affect others exports. Reducing debt usually affects growth - and can be achieved by either: (a) belt tightening - which usually involves 7 years of deleveraging (b) high inflation; (c)  default; or (d) growth - though this is rare [1]
• the rapid reduction in bank credit in US (and associated private sector de-leveraging) has been suggested as possibly leading to several years of deflation (especially as Federal reserve starts to unwind its monetary easing) followed by rapid inflation in order to assist in reducing government debts [1];
• there may be risks of a disruption of international trade (noting rising tensions between US and China) because of an apparent inability to resolve concerns about financial imbalances (ie the accumulation of large foreign exchange reserves in some countries and huge debts in others) [1, 2].
  • Furthermore: the US Treasury may find it hard to rule that China is not a currency manipulator. China is inturn attacking the US - apparently in denial about its role in the global imbalances behind the GFC. China is over-estimating its power. Every time large foreign exchange reserves have been accumulated, depression has resulted. reserves can't be used internally to support China's economy. US could impose capital controls to prevent a bond crisis, and block markets to destroy China's export machine. Free trade may not be desirable in dealing with mercantilist powers, and protectionism does not have symmetrical effects (ie it mainly devastates surplus countries [1];
  • a special 25% punitive duty on Chinese goods would have the same effect as revaluation of its currency; would be quickly copied by Europe; and would probably force China to revalue [1];
• China has been suggested to be in the late stages of a major speculative bubble. Bubbles require compelling growth story to get started (and in China's case this is its massive population). China's ability to continue 8% pa growth while migrating rural workers to cities is accepted uncritically. Many people in China already live in large cities. China's population will start to fall in 2015, while workforce participation peaks in 2010. Wages are now likely to rise - putting China's competitiveness at risk. Faith in China's authorities may also be excessive. Obsession with growth has led this to be the objective of policy rather than rather than outcome of economic processes. China, like Asian tigers, is boosting growth through ever more investment inputs - a strategy that was shown to fail in 1997 [1];
• there are risks that post WWII international order could collapse (noting breakdown in international collaboration in Copenhagen; worsening of US relations with China / Europe; monetary volatility; sovereign risk worries; social conflict in Europe; social fragmentation in US due to increased poverty of middle classes, and lack of social compact; dismantling of public services; social / political stresses in China; increasing revolutions in Africa) [1]
• BIS has argued that sovereign debt crisis risks forcing government borrowing rates much higher [1]
• Greece's problems are not being resolved by provision of emergency funds by EU. The bailout of 30bn euros is small compared with needed 110bn to prevent default and devaluation. Greek situation was like Argentina before 2001 default. After that IMF concluded that it should not prop up an unworkable structure with over-valued exchange rate. Greece needs default with 65% losses for creditors, then exiting euro. But Greece is just tip of iceberg with others in Club Med trapped in debt deflation / permanent slump. Greek situation is like failure of Credit Anstalt which in 1931 led to contagion in central Europe and ultimately caused Great Depression to start in earnest. Proposed bail-out is not of Greece, but of European lenders to Greece (like the bail-out of US banks after the failure of Lehman Bros. The EU rescue will load losses onto taxpayers. German Landesbanken with thin capital ratios may not stand a second crisis [1]
• Greece's debts are just the first of a series of 'debt bombs' that are likely to explode in Europe (eg Iceland and in Eastern Europe). These countries are mainly not in eurozone, but have euro-denominated debts. These are unrepayable as those economies are sinking into depression - because past growth had been funded by capital inflows that have now ceased. Banks in EU will discover that this is there problem - because they will wear the costs of loan write-offs [1]
• IMF has expressed concern that default by Greece could have contagion effect elsewhere - with serious impact given that financial system remains fragile [1]
• holdings of mortgage backed securities by US Federal Reserve (acquired to protect financial institutions) could be the basis of major future problems - because huge losses could be incurred if (as expected) interest rates are increased as recovery occurs. This would compound problems associated with US fiscal deficits (Guy R. 'Timebomb on the US Fed books', AFR, 21/4/10);
• ECB may need to turn to quantitative easing (ie printing money) to deal with investor flight from southern European bond markets [1]
• There is concern about a new credit crunch emerging in Europe as a result of Greek debt crisis and its potential contagion, and a risk that this could derail global recovery (Rich S 'Debt fears slam markets', Australian, 29/4/10)
• CBA has warned that Greek debt crisis will affect the pricing and availability of wholesale funding for Australia's banks (Rich S., 'The end of cheap money: Norris', Australian, 29/4/10);
• China's economy is likely to slow - and perhaps crash over next year. Property bubble will expand as long as government keeps interest rates low - and government doesn't want to lift rates as this would expose problems in China's economy. China has industrial over-capacity based on expected US / European imports - but this demand has slowed due to GFC. Stimulus spending and easing of credit resulted in mis-spending - particularly in property. Raising rates to slow this could cause large scale failures in manufacturing / property development - with adverse impacts on banks [1] ;
• a second economic dip is possible in 2010-11 due to: slowdown in China; end of US inventory build-up; European debt crisis; and ending of stimulus spending [1]
• Europe's banks have 2.3tr Euro exposure to peripheral countries with sovereign debt concerns - forcing either a rescue of those countries or bailing out the banks [1] ;
• Europe's banking system is under strain, as banks are reluctant to lend to each other because of uncertainty about how much each might have lent to the PIIGS [1]
• the 'flash crash' in US sharemarket on 6/5/10 has been explained as due to a trader error or problems associated with computer trading, but it may actually have been the consequence of announcement by ECB that it would not support Greek government debts. (Baker P 'Spooked by what ECB's Tricket did not say', AFR, 8-9/5/10)
• 1930s-style wage cuts have been demanded to slash budget deficits in Europe as condition of rescue package [1]
• the proposals to issue bonds to support Greece and other European nations with debt problems constitutes the creation of a European Treasury and the formation of a real European Government - though it is possible that German people may not be willing to pay the cost of bailing out other countries [1]
• Governor of Bank of England suggests that the US faces many of the fiscal problems that are affecting Greece, and that a united Europe won't survive unless it becomes a federalised fiscal union, ie has a central power to tax and spend [1]
• instability in Europe (eg potential withdrawals from EMU) threatens Australia's prospects; China's growth; and 'Japanese' syndrome emerging in Europe. China's economy is highly export-dependent and can't cope with weaknesses in both US and Europe. Also Europe's mountains of debts seem likely to lead to a Japan-style 'lost decade' [1]
• Roubini, who predicted the GFC, argues that measures taken to respond to this crisis (socializing losses) has left private institutions with excessive debts and governments with little ability to cope with the next, inevitable crisis [1]
• markets are not only concerned that losses like those revealed by Lehman Bros failure in 2008 are now affecting countries as a whole (eg Greece) and that there is a consequent risk that the European Union could splinter. There is also concern that China has provided $2.3tr in new lending since later 2008 and created both industrial over-capacity and a real estate bubble. Though US economy seems to be recovering, there is concern about unexpected rise in US jobless, and that over 10% of US home borrowers are in mortgage default. In Europe there is concern that banks may be carrying large amounts of risky debt. Capital is fleeing to perceived safe havens. Harsh austerity budgets in countries with sovereign debt worries, are being resisted and may generate both social instability as well as retarding economic growth. The developed world is carrying high debt levels - and many countries are expected to take a long time (eg decades) to reduce this to sustainable levels (eg about 60% of GDP) [1] ;
• Germany is pushing other Eurozone countries to slash their budget deficit, and this is likely to lead to deflation - which could spill over to US [1]
• hidden losses from the previous credit crisis have caught up with Germany - and its government's attempted to prevent short selling of its banks / insurers / bonds has backfired by encouraging capital to shift to perceived safer havens [1]
• Rising trade tensions between US and China are adding to investors nervousness (Korporaal G 'US-China talks mean more global market jitters', Australian, 21/5/10);
• there is concern that European Economic Crisis could trigger something like a Great Depression II [1];
• the simultaneous impact of faltering recovery in US, Chinese credit restrictions in the face of a property bubble and Europe's intractable debt crisis have dislocated financial markets [1]
• because of concern about European situation, interbank spreads are rising as they did before credit markets froze at start of GFC [1]
• trouble in Europe could nip US recovery in the bud (ie contagion could spread across the Atlantic).  problems include (a) jobless recovery in US - which impedes consumer spending; (b) declining in value of euro disrupts expectation that export-based growth will support US recovery - and also seriously limits prospects for Chinese exports to Europe; (c) this has made China less inclined to increase Yuan value - and increases Chinese imports into US; (d) sovreign debt crisis in Greece has focused attention on all government balance sheets - and here US has a problem. Thus there is a possibility of a credit downgrade, and pressure to cut spending and / or increase taxes. (e) US banks are at increased risk because of their exposure to European institutions (eg this accounts for 80% of funds set aside to absorb losses by major US banks); (f) interbank lending is again at risk (Stelzer I 'Why Obama can't ignore the euro debacle', Australian, 25/5/10)
• IMF now estimates that bank losses in advanced economies from for last crisis was $2.8tr of which $2.3tr has been recognised - but this does not include new losses [1]
• failure to understand the lessons of Lehman Bros increases the risk of another financial disaster. Following the failure of that bank, there was a major contagion effect which put the entire financial system at risk. Many observers are now suggesting that it will be necessary for Greece to default on its debts - though this would trigger a global financial catastrophe. If Greece were to defaiult banks would immediately move to dump any Spanish / Portuguese - and perhaps even Italian debt. If Greece were suspended from euro, then citizens of affected countries would shift funds from banks in Greece [1]
• concerns about another financial crisis are exaggerated - because recovery is firmly entrenched. Europe's economy will respond to normal responses to downturn (lower interest rates and currency) while emerging economy growth remains strong. Asia's currency rises will solve most of problem of inflation which had been looming. Bond rate falls in Europe will make capital cheaper. World is now awash with liquidity, unlike situation in 2008 [1]
• M3 money supply in US is falling at accelerating rate (now similar to that between 1929 and 19933) despite near zero interest rates and massive fiscal stimulus. This decline is fastest since Depression. It is probably occurring because regulators are requiring banks to raise capital asset ratios [1];
• the deepest fear in financial markets is that the US, like Greece, will have to pull back on government spending and raise taxes to reduce its burgeoning debt [1];
• the European crisis is likely to benefit the US economy - which is on the point of a strong economic recovery - because it will delay to introduction of measures designed to strengthen the global financial system [1] [Comment: whether events that inhibit the introduction of presumably-desirable reforms should be considered to improve the economic outlook is uncertain]
• governments need to cut spending without adversely affecting economic activity -according to IMF. The risk is that otherwise they (including US) will be forced to cut spending anyway because of excessive debts [1]
• a possible debt crisis in Hungary has added to worries [1]
• European countries with sovereign debt problems are likely to restructure by issuing new bonds with the same face value but much longer maturities and interest rates - and thus lower real values. Banks holding these will be able to maintain the fiction that they have not incurred losses, but (as occurred when Japan did this) those banks will be turned into 'zombies' for many years - unable to contribute to growth. Also liquidization (slashing government spending while economies are still in recession) is gaining traction elsewhere - eg through G20. Debt deflation is a likely outcome of a world awash with money and nothing to invest it in - and this can only be combated by monetization (printing money) which would debase the value of currencies [1]
• Australia is being hurt by unwinding of carry trades. Investors had borrowed at low interest rates (eg in euro) to invest in secure sovereign debt (eg in Australia) while shorting the $A to protect against currency changes. When euro weakened because of its sovereign debt problems, this turned into a losing strategy - and a flight from Australian market [1]
• the economic situation in 2010 is seen as worse than in 2008 because (a) quantity of debt has dramatically increased; (b) tax base has shrunk; and (c) banks balance sheets have not improved. Austerity is seen as the only solution [1]
• Institute of International Finance estimates that regulatory reforms proposed by Basel Committee could reduce real GDP in developed economies by 3.1% [1]
• BIS has suggested that the loss of investor confidence associated with sovereign debts in Europe is similar to the subprime crisis that led to GFC [1]
• a second round of problems in US housing markets could again shatter investor confidence [1]
• IMF argues that risks to recovery are escalating because European crisis may undermine commodity prices and world trade. Investor concerns about European governments could quickly spill over into a banking crisis [1]
• US Fed chairman is battling to control monetary policy to be able to substantially expand monetary easing to prevent a feared deflationary spiral as US economy falters [1]
• there are four great sources of global economic uncertainty (a) the US recovery from GFC is occurring but fragile; (b) while China seems to have strong growth prospects, it faces complex challenges (eg a speculative property bubble, pressure for higher worker wages); (c) weaknesses in global banking system - which have been exacerbated by losses in Europe and (d) Europe's aging population, rigid regulation, unsustainably generous public sector work conditions in some countries and a monetary union that is not supported by political and fiscal union [1]
• ECB data indicated the risk of failure by two large and complex banking groups in May 2010. There are indications of a surge in interest in gold for holding reserves - because of concerns about the values of other assets, rather than because of concerns about inflation [1]
• BIS has warned of the side effects of unprecedented monetary and fiscal stimulus measures (eg such as large amounts of direct support to the financial system, low interest rates, vastly expanded central bank balance sheets and massive fiscal stimulus) - and the consequent need to unwind these. Side effects include: delaying post-crisis adjustment; creating zombie financial institutions; discouraging de-leveraging by continued low interest rates; distorting pricing because central banks acquired large quantities of troubled assets; and leading to unsustainable debts in many countries [1]
• there is a view that financial crisis only affected North Atlantic countries (and thus has no lessons for Australia). However growing fears of a US double-dip recession, suggest that the problem is not that simple. Post 1970 recoveries all involved rising private-debt / GDP ratios. And US is now suffering much more from private sector de-leveraging than in did in 1930s. In 1928 rising debt had added 8% to aggregate demand and at height of Great Depression falling debt was taking 25% from demand. Situation now is more extreme as at end of 2007 increasing debt added 22% to aggregate demand, and falling private debt now takes 15% from demand (which is worse than in 1931). Rising government debt  has offset that this time (by 13% of GDP), which it did not start to do in the 1930s until somewhat later. Private debt only increased demand by 18.75% before the GFC in Australia, and de-leveraging has not yet really started. Australia's private sector debt to GDP ratio was much lower than in US before GFC (ie 156% as compared with 300% - though in Australia it was 90% greater than in Great Depression). This seems to be why de-leveraging has no yet emerged strongly in Australia - though the fact that households are even more debt constrained than those in the US suggests that recovery in Australia will be weak. [1]
• US economy is contracting severely despite strong government stimulus measures [1];
• there is concern that eurozone could break up - because of differences in the levels of economic development of various countries which is incompatible with a single currency - and that this would have devastating consequences for global economy [1]. There is also concern that legal challenges to German support for weaker members of eurozone could result in such a breakup almost immediately [1]
• IMF anticipates strengthening global growth - mainly in emerging economies - but cautions about very serious residual risks [1]
• US FED has suggested that US economy may not recover for years [1]
• global economy, artificially boosted since 2008, is headed for sharp slowdown as stimulus wanes while excesses (ie too much debt in many advanced economies and excess savings in China, emerging Asia, Germany and Japan) have not been addressed. Global aggregate demand will be weak because spending is not being increased in countries that saved too much as spending falls in countries that now need to de-leverage. At best the world will experience a long U-shaped recovery, but there are many potential sources of a shock that could make the situation much worse [1]
• the Great recession has dramatically shrunk the time left for the big AAA states to prevent a sovereign debt crisis associated with their aging populations [1]
• deflation (rather than inflation) is inevitable in advanced economies despite food and oil price spike because money supplies and economic stimulus are contracting [1]

In September 2009 it was noted that financial pressures (a result of economic weakness and very low interest rates in US) are making it impossible for India / China / emerging Asia to maintain export oriented growth strategies - so their demand will have to drive the global economy. As noted above, this shift must lead underdeveloped financial systems in East Asia into crises (perhaps even more serious than those already experienced in US / Europe)

Constraints on Global Solutions

Developing an effective globally-coordinated response is likely to be difficult or impossible. 

It is unlikely that emerging global efforts to develop coordinated fiscal, monetary and regulatory arrangements to ensure future economic growth will be effective because of large culturally-based differences in understandings of the nature of those arrangements (eg see Obstacles to Effective Global Regulation above).

Similar difficulties led to the unsatisfactory global responses to the 2001 crisis related to the risk of terrorists with weapons of mass destruction (see The Second Failure of Globalization? and Competing Civilizations). In brief, the latter suggested that:

• cultural assumptions are a primary determinant of a people's ability to be materially and politically successful - or to generate stresses that can give rise to extremism through economic and political failure. They are also central to the perceptions that different societies have about desirable means for global governance (eg compare French / EU preferences for strict regulation of financial markets by state / multilateral institutions with US resistance to this);
• the cultural issues involved in getting agreement on global arrangements to ease such problems at their source by giving all a reasonable prospect of success are beyond the capacity of those concerned with geopolitical and economic policy - so (a) 'realists' accept that many must fail, while (b) some 'idealists' conclude that coercion may be the only way to help the disadvantaged;
• specialists in the humanities, who might potentially make more substantial progress, never seem to do so because of their idealistic (post-modern) desire for cultural assumptions to have no practical consequences.

A seven point plan for easing the global crisis that was put forward by Australia Prime Minister because of the indirect impact of the GFC on Australia seemed not to recognise such difficulties, and to suffer more mundane deficiencies.

Outline: To ease global economic crisis, it is necessary to deal with causes of GFC. It is vital therefore to cleanse the financial system of the $trs of toxic assets that stop credit flowing. Private credit markets are not working because US / European bank balance sheets are weighed down by toxic assets infected by sup-prime lending. Such banks have assets of $US 3.4tr - but hold toxic assets estimated as between $US1.2- 3.6 tr. - numbers which are increasing as the economic crisis continues. Without additional capital, banks could be insolvent. The IMF values potential shortfall in US as $500bn - though others suggest $1tr. Australia's banks hold few toxic assets - but Australia is integrated with global economy - so the GFC affects Australia. If global credit flows restrict business in Australia, then the problem will compound. A 7 point strategy is being advocated to cleanse balance sheets of toxic assets (a) all strategically significant banks should be stress tested, to ensure that there are no surprises (b) non-viable banks must be closed or nationalized (c) toxic assets on bank balance sheets must be removed through a 'bad bank' or insurance arrangements (d) bad asset prices should be determined by a transparent mechanism that is uniform across all jurisdictions (e) public and private institutions and international financial institutions need to work together - and any nationalizations should be temporary (f) the stress test must identify the capital banks need to recommence lending (g) once recapitalized banks must agree to provide regulated levels of lending in return for government guarantees of deposits (Rudd K. 'Global fix for global problem', The Australian, 6/3/09)

Comments:

• the causes of the GFC are much more complex than toxic assets in banks related to sub-prime lending. For example:
  • sub-prime was only the tip of the iceberg in relation to assets on which losses have been incurred;
  • losses were also amplified by derivatives (especially credit default swaps);
  • easy money policies created conditions under which assets could become overvalued - and this was partly due to the demand deficient economic strategies that prevailed in East Asia and accumulated large quantities of foreign reserves;
  • overvalued assets in turn were the foundation for high levels of consumer spending in US which provided levels of demand which drove global growth, despite the East Asian demand deficits;
• the US government has been trying to deal with toxic assets - but has found it difficult to know how to achieve this. Some of the actions taken have made the situation worse (eg private investors may have inadvertently been discouraged from participating in efforts to rescue banks, thus leaving responsibility entirely to government which lacks the necessary capital and skills - eg [1, 2]);
• US authorities have been stress testing banks - by apparently assuming a contraction in the economy and in asset values which is very optimistic by comparison with what many private analysts expect (and thus unrealistic?);
• fixing banks can not be sufficient to restore adequate credit availability because about 50% of credit had been provided by securitization;
• there is a need not only to remove toxic assets, but to create an economic regime in which such problems are not likely to emerge - and as noted above this is almost impossible to achieve;
• the nature of banks is not uniform around the world, so suggestions about applying uniform methods for valuing toxic assets seem unreal;
• it is possible in both the US and Europe that authorities may be unable to mobilize sufficient assets to recapitalize banks

A former Australian Prime Minister put forward another suggestion that an agreement by the US and China to reverse their respective savings / consumption roles might resolve the current crisis - on the basis of his assumption that the GFC is due more to global financial imbalances than to defects in neo-liberalism. This proposal pointed towards the structural factors that are likely to lead to a long term economic crisis but seemed impractical as a potential solution.

Outline: Paul Keating expressed doubt whether the US president's $US787bn stimulus package would work. He also blamed the crisis on the Clinton administration, the IMF and Timothy Geithner (now US Treasury Secretary). Fixing the global imbalance behind the crisis requires US belt tightening - as part of grand bargain with China. Under this China would use its $US2tr reserves to stoke domestic demand, build infrastructure and construct social safety net. In stead of drawing on China's savings to finance US consumption, China would let yuan appreciate to allow US industry to narrow trade deficit. Global recovery would be driven by Chinese consumers and US exports - so correcting fundamental imbalance. However Obama has embarked on massive spending which will widen its budget and trade deficits - which seems plausible only with falling defence spending and rosy glasses. US will have trouble selling bonds. US inconsistently wants China not only to buy US bonds, but to stop manipulating its cheap currency in ways that generate the capital to buy them. Keating blames Clinton for not reshaping global economy after end of Cold War - but rather taking world's savings for consumption as the spoils. Next G20 meeting must must entrench G20 as successor to G7 and also to IMF (as official funder to distressed economies). IMF has been failing by prescribing harsh medicine rather than bridging finance for distressed economies, and Geithner wrote the policy that IMF applied at time of Asian crisis. To prevent this recurring, Asia (especially China) built a war chest of foreign reserves with money that could have otherwise improved living standards. But Chinese demand increased price of US government debt and reduced interest rates - which inflated the US housing bubble and poisoned global financial system. Obama's 'yes we can' programs (eg increased public spending such as for universal health insurance) depend on ongoing Chinese credit. The US is now being forced by the credit crisis to tighten its belt in the same way that Indonesia had to do a decade ago. The US needs to generate savings to invest in emerging economies, but Obama is instead resisting adjustment to China's ascent (Stuchbury M. 'Deadly Recession Cure;, Australian, 10/3/09)

Comments:

• while it is useful to emphasise the linkage between global financial imbalances and the GFC, it needs to be recognised that it wasn't only China's demand that built up the price of US Treasury bonds and helped make credit unreasonably cheap. Japan became the world's largest creator of credit (at virtually zero interest) because of its failure to reform its economic systems after its financial crisis in about 1990 - and much of this was exported to the US (and elsewhere) through 'carry trades'. Japan's role in this situation requires much closer attention, especially as the US appears likely to rely on continued Japanese credit to increase its pre-GFC levels of consumption. Also:
• the 'grand bargain' that Mr Keating proposes that the G20 seek to arrange is impractical. China could not keep its part of such a bargain (any more than Japan could do so), because it could not develop the type of financial system system needed if economic growth were to benefit ordinary Chinese people . The reasons for this are suggested in a speculation about China's options (After the Bubble: Internal Discord, Fundamental Reform or Aggressive Nationalism?); Similarly:
• the reason that China and many other countries in East Asia built up large foreign exchange holdings after the Asian crisis (just as Japan had done before) was that they would have been unable to develop the sort of transparent financial systems that would have made such reserves unnecessary (see The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems, 1998).

There was little prospect that last-ditch agreements sought through a G20 summit would be effective in reversing the likely economic impacts of the GFC despite claims of success by world leaders, who may have been experiencing a 'Neville Chamberlain moment', (see Announcing 'Peace for Our Time'?). The latter suggested that:

• there was obvious confusion amongst world leaders about the nature of the problem;
• nothing was done about the structural causes of the financial imbalances that make global growth unsustainable;
• correcting those imbalances was both necessary and likely to make East Asian economic models unworkable;
• establishing global institutions to address the problem of economic management and financial regulation merely 'passed the buck'; and
• there remained many serious market-level indicators of ongoing problems.

Australia's Position

Though Australia started with some useful strengths, it faces pressure for economic transformation and potentially serious current account constraints.

Positive Factors for Australia

For Australia the global negatives will be countered by positive domestic and global factors such as:

• devaluation of $A which improves the prospect of exporters (see above)  [though it will also add to the costs involved in capacity expansion as much plant and equipment tends to be imported];
• substantial capital expenditures that companies have committed, because a boom in resources investments had been under way since 2003 and this will ultimately increase export capacity     [though:
  • the costs incurred in creating that capacity will reduce their earnings significantly in the face of a collapse in commodities' demand and prices;
  • while a 5.5% pa real increase in investment spending is the basis of official forecasts that Australia will not go into recession, Australia's resource investment halved in response to a 15% decline in commodity prices in the 1990s - and companies may now choose not to proceed with 'committed' projects that are not well advanced [1]];
  • there is great uncertainty about the extent of resource price declines, because the escalation of prices over the past 5 years has been unprecedented. Treasury assumes that Australia's terms of trade will rise 10.75% this year and only moderately retrace this in the next year - though actual outcomes could be much worse [1]
• improved rainfall which will boost previously-depressed rural sector's prospects;
• reduced inflationary risk as commodity (especially oil) prices decline [though commodity price declines would also erode a strong driver of industrial investment in Australia];
• business debt levels are not generally high [1]    [though some large companies have high debt levels and will have to sell associated assets over the next 12 months [1]  ];
• fiscal and monetary policy measures to stimulate the economy    [though  fiscal stimulation by government may be subject to current account constraints (see below). Moreover, if few want to borrow, reducing interest rates can have no stimulatory effect (see below)];
• the lack of any over-supply of housing which contributed to property busts elsewhere    [though a bust occurred in the UK without any over-supply; property values are declining; and cuts to migration in the face of rising unemployment (as government has suggested) would reduce housing demand]
• the limited exposure Australia's banks had to sub-prime mortgages which triggered the GFC    [though such institutions have not been without credit risks related to: (a) potential major corporate failures; (b) derivates' counterparty risks; (c) a potential slump in property values; and (d) loans for purchase of equities which in some cases included guarantees against share-market losses];
• the risk that Australia's banks will be unable to access capital has been partly reduced by borrowing in Japan [1] - whose large domestic demand deficit provides it with scope for capital exports;
• the guarantees offered to depositors in regulated Australian financial institutions    [though this triggered severe problems for their unregulated counterparts];
• Australia did relatively well (according to RBA, because of (a) a lack of takeover competition between banks which meant that they did not have to take excessive risks and (b) a lack of domsetic savings which kept investors out of US sub-prime markets [1]

Economic Transformation?

There are none-the-less pressures for economic transformation in Australia as a result of the GFC and constraints on achieving this.

• collapses in commodity prices will reduce profits in the resources sector over the next few years - a sector which has recently been the major area of strength in corporate Australia and an important source of revenue for the federal government as well as improving the current account position;
• financial services have also become important as a knowledge-intensive post-industrial growth sector in Australia's economy and as a contributor to federal government revenues. However some of the techniques used (though they were usually conservative and well regulated) are suspect (eg highly geared private infrastructure funding packages that appear to embody conflict of interest risks equivalent to sub-prime lending in the US);
• economic flexibility has been reduced by government efforts to protect the banking system (through guarantees on investor funds - which may be hard to unwind) and through efforts to 'save' companies whose failure would have escalated the financial crisis (eg [1]);
• a new model for achieving economic prosperity is needed [1]; because:
• Australia's economy has specialized in the provision of raw material inputs to 'industrial era' models for economic growth (in UK / Japan / China in turn);
• first world living standards have been maintained through reliance on foreign capital - and, on one occasion, this dried up after a decade of reckless property speculation and a wool boom resulting in: (a) depression in the 1890s and (b) the adoption of protectionist policies that impeded growth until the 1980s;
• Australia's advantages in energy-intensive processing may now be invalidated by concerns about climate change;
• the financial crisis will ease, and global growth will resume - but credit will be scarce and commodity prices lower;
• productivity gains from 1980s reforms have been exhausted, and an aging population implies a less productive workforce;
• securitization has been viewed since the mid 1990s (eg by the Wallis Inquiry) as the basis for more effective provision of capital and management of risk for economic activities in Australia than through traditional balance-sheet banking. But it poses systemic risks that have been exposed by the GFC; 
• there has been a loss of faith in markets as the most efficient processors of available information. The ability of middle-men (eg bankers) to manage risks has been invalidated as securities have become too complex;
• though the actual regulation of Australia's banks has been more conservative than Wallis recommended and they are thus well capitalized, they can't be expected to compensate for the loss of funding through securitization;
• Australia's economic strategies over the past 15-20 years have been and remain unbalanced. In particular:
  • the focus has been on liberalizing markets and promoting competition, but:
    • (a) too little has been done to develop the system-level capacities needed for competing successfully; and (b) outcomes often reflected political aspirations rather than real market requirements (eg see Review of National Competition Policy Reforms; The Impact of Economic Liberalism in Australia, The Economic Futility of Backing Australia's Ability 2; Queensland's Economic Strategy; Commentary on Smart State);
    • financial markets may not tend towards equilibrium - because market trends can reinforce themselves and lead to boom / bust sequences [1];

  • current versions of government economic strategies also seem highly 'political' and unlikely to be economically effective (eg see Productivity Magic?); 

  • Australia's apparent success in reversing long term decline in its relative economic status has arguably been as much due to its ability to benefit from an unprecedented global boom driven by cheap credit (which is now turning into an unprecedented bust), as to domestic capabilities;
  • that cheap credit has been heavily invested in increasingly luxurious housing - an asset whose ability to produce a return depends on income earned in other activities;

Current Account Constraints

Furthermore Australia's large current account deficit limits stimulation of the economy (eg by reducing interest rates or increased public spending) - due to the risk of precipitate devaluation of $A. It can be noted that:

• domestic stimulus in the face of external contraction will increase deficits;
• moreover: (a) banks found international funding that they have relied upon to fund the deficit hard to get - and this will get even harder in the event of a property slump; (b) the RBA had to defend the $A; (c) 'carry trades' reversed - ie high interest rates no longer attracted capital inflow; and (d) global financial markets 'priced in' a 1% pa annual deflation (reversing earlier expectations of 3% inflation). Deflation is serious for countries with large foreign obligations;
• Australia is potentially exposed as a capital importer at a time when the world is severely rationing credit [1];
• giving government guarantees to banks has shifted the question foreign investors must answer in considering investment in Australia from the credit-worthiness of banks onto the status and prospects of Australia's government and economy - where there are points of possible concern [1] such as; (a) relatively high current account deficits and household debt levels; (b) continued heavy dependence on commodity exports - which are notorious for booms and busts ; (c) suspect economic strategies (see above); and (d) likely pressure on federal finances (see below).
• the IMF's traditional solution to current account crises (which some countries still face) involves cuts to public spending - which is neither economically stimulatory nor politically popular.
• the 'East Asian' alternative has been rigid government control of financial systems and inhibiting consumption spending so that a current account surplus emerges, and there is no need for external borrowing and thus no real accountability related to bank balance sheets. However, quite apart from the lack of public enthusiasm for slashing household spending, current account surpluses have depended on US willingness / ability to sustain current account deficits - which reforms to eliminate the sources of its financial crisis will presumably eliminate in future;
• forecasts are emerging of unprecedented levels of current account deficits (8.4% of GDP) which could put Australia's AAA credit rating at risk - and make it much harder to obtain capital [1]
• given that Australia's banks are currently borrowing on the basis of the federal government's AAA credit rating, the most serious threat to macroeconomic stability would arise from the loss of that rating [1]