Defending Australia from the Financial Crisis?  (2008+)

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Introduction + Addenda:


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).

At about the same time, the Federal Government:
  • suggested that a recession could be avoided, and that the budget would remain in surplus despite the need for a large fiscal stimulus [1];
  • endorsed the need to deal with the 'cause of the fire', as well as 'fire-fighting' (Dodson l., op cit);
  • suggested that 'extreme capitalism' and 'free market ideologues' were the problem (Rudd K., 'Realism and true grit will get us through this', Financial Review, 16/10/08; Madigan M., 'Rudd blasts money-men', Courier Mail,  6/10/08);
  • nominated better regulation as the key to preventing future 'fires' (Tingle L., op cit) - with particular reference to global regulatory regimes (Rudd K., op cit);
  • suggested linking capital adequacy requirements for banks to executive remuneration to inhibit unrestrained greed (op cit);
  • indicated that it was planning for further 'new, big and different' initiatives (Dodson L. et al 'Business calls for reform despite crisis', Financial Review, 18-19/10/08);
  • suggested that tax cuts due for 2009 could be brought forward (Milne G., etal 'Fallback plan for rescue package', Sunday Mail, 19/10/08;
  • indicated that immigration levels would be reduced if unemployment increased [1, 2];
  • referred to a $76bn infrastructure fund which could be financed from surpluses - a claim that the opposition disputed [1].

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.

Fortress Australia? +

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:

Maintaining Capital Inflow

Australia's supposed 'economic fortress' might prove to have an indefensible front door because of its current account deficit and consequent need to continue attracting capital inflows (which had long been around $60bn pa until reduced somewhat by strong export demand for minerals and energy) to fund investment.

This is not simply an academic issue as withdrawal of foreign capital after the near collapse of Barings bank was a major factor in the collapse of many Australian banks in the 1890s. As land was the main security held by Australia's banks, withdrawal of capital forced large scale sale of land and a price collapse which further undermined banks' balance sheets [1]

The Bank of International Settlements (BIS) reportedly warned in 2007 that the A$ was more at risk of capital flight than any other (apart from the Turkish Lira) because of the growth of Australia's foreign debts and dependence on the 'carry trade' to provide capital inflow (Uren D., 'Ignoring foreign debt puts dollar in peril', Australian, 26/3/07). When the commodity boom was seen to be unstoppable, $A investments were attractive and the $A was strong (as the $A is viewed by investors as a substitute for commodity investment). But the commodity boom, and thus the $A as a currency for investment, are now much less secure.

Furthermore Australia's current account deficit has apparently been covered mainly by banks borrowing in international markets to make property investments. Australia, like many other countries, has experienced a huge increase in property values over the past decade at least partly as a by-product of easy credit. Deflation of what proved to be a property bubble has been the initial source of the financial crisis in the US. Domestic property bubbles have apparently also deflated in UK, France, Ireland, Spain, emerging Europe, China and elsewhere. The IMF has reportedly ranked Australia as highly susceptible to a similar house price slump (see Rollins A., Financial Review, 4/4/08). Other observers have argued that Australia has borrowed and spent too much money on real estate and now has to devote 4% of GDP to repayments, double that of the US (Why real estate spending could make Australia the new Iceland) . In December 2008 an 11% decline in business credit was viewed by the RBA as a fall in foreign currency dominated lending [1]

If a property slump emerges (and there are signs that one is possible - eg see Harley R., 'Property the experts are divided', Financial review, 18-19/10/08, and Uren D. 'RBA to cut as housing prices crash', Australian, 4/11/08), then:

  • those who have invested in property in the hope of short term capital gain but with inadequate financial capacity will be in difficulties. Investors who confronted unexpected declines in property values (not home occupiers) were apparently the primary trigger for the sub-prime crisis in the US - and concern has been expressed [1] that aggressive marketing of property investment in recent years has led significant numbers of buyers to falsify applications for deposit bonds (which create an obligation to pay but does not require up-front cash) in securing properties they can't now afford to buy;
  • Australia's banks (and other financial institutions) will:
    • be less able to justify international borrowing for property investment to balance Australia's current account deficit;
    • be exposed to losses which, though probably less severe than those experienced in US because of very limited US-style 'sub-prime' adventurism, will none-the-less erode their reserves and potentially require 'rescue' operations. Most of the losses incurred from falling property values elsewhere have involved supposedly 'prime' mortgages where large falls in values left owners with negative equity;
    • potentially disrupt normal activity with a credit freeze (like that in US / UK / parts of Europe) because non-transparent derivates contracts will make it impossible to know who actually carries the resulting losses;
  • government guarantees on deposits with regulated financial institutions could result on large costs to taxpayers.

There has been debate about whether a serious property price slump is likely in Australia (Harley R., op cit). Protection against such a slump is seen to be offered by the fact that (contrary to situation in US) Australia does not have a supply of homes well in excess of the need for them [1]. Moreover it is only in a few regions that aggressive mortgage lending practices have been applied - thus perhaps only in those regions have property bubbles become inflated.


  • a property slump occurred in UK despite the absence of US-style excess supply;
  • banks have significantly tightened their property lending criteria - making households unable to afford houses that they previously might have aspired to buy;
  • many households are facing financial stresses that require property sales;
  • if decades of importing cheap capital created through easy monetary policies (eg in Japan and US) have been significant in inflating a property bubble, then the latter will not be a narrow regional phenomenon;
  • a 5% fall in Victorian property values was reported by January 2009 [1];
  • forecasts of 25-35% declines in the value of commercial property emerged in January 2009 [1];.
  • banks may have created a form of sub-prime crisis by lending to those with limited capacity to repay because of the expanded first home owners grant [1]

Other indicators of the potential for a house price slump are [1] that:

  • Australian house prices have increased 175% since the mid 1990s (compared with 80% in the US);
  • such increases have been seen to be justified by the high level of demand for housing, and a very high rate of immigration;
  • very low yields on property investment have been accepted because capital gains were high;
  • Australian household debts are 40% higher than in US - because this has been offset by higher house prices;
  • in future rent increases will be constrained by pressure on household finances, so in the absence of capital gains, yields will increase mainly through reducing property values (eg by 20%);
  • demand for property will be further reduced because the government says that immigration will be reduced if unemployment increases.

Despite this, there are reasonable grounds for expecting that moderate devaluation of the $A should provide a buffer against any current account problems because:

  • devaluation will discourage imports and promote exports ;
  • Australia's economy is fairly diversified; and
  • though there is scope for improvement, the financial system is reasonably well regulated compared with some others and thus fairly transparent - so investors would be able to assess their risks.

Moreover government guarantees for bank deposits allows them to borrow fairly readily in international markets - and to make significant profits [1].

However if difficulties did emerge in funding Australia's current account deficit, then the conventional response (ie that favoured by the IMF as a condition for providing access to its funding) would involve:

  • slashing spending - particularly public spending - which would clearly clash with the expectation of increasing such spending to counter the effects of recession;
  • institutional reform - eg to make financing arrangements more transparent, and make it less likely that investors will flee because of fears about what they don't know.

Australia's 'recession we had to have' (around 1980) reflected a self-imposed version of these responses.

Non-conventional responses to potential current account risks have emerged in Asia - particularly as an outcome of the 1997 Asian financial crisis - involving high rates of national savings and current account surpluses so that there is no need for foreign capital. This would require significant changes in community expectations, and would probably no longer be viable for reasons outlined below.

In June 2009 it was reported that:

  •  Australia had funded its current account deficit with equity rather than with debt as had long been the practice - because offshore equity investments were repatriated home (and there was some reduction in the current account deficit because of large commodity revenues and a fall in domestic investment) [1]
  • big companies are increasingly looking to Asian debt markets to meet their funding needs [1];
  • bank chiefs have warned that Australia's heavy reliance on off-shore funding and low rate of deposits to loans is making banking system vulnerable and threatening economic recovery [1]

In late 2009:

  •  the need for huge government fiscal intervention in 2008 to protect Australia's financial system was identified, as was the ongoing financial dependence on China growth.
  • it was reported that a year earlier all major Australian banks found difficulty rolling over their foreign loans and would have (a) had to withdraw credit from domestic borrowers (b) eventually gone bankrupt. Government guarantees of bank deposits were vital to prevent this happening [1];
  • it was noted that the number of housing starts was falling - indicating perhaps that property investors are starting to expect a price crash [1]

In 2010, it was suggested that:

  •  first home buyers (enticed into the housing markets by government grants) were frequently (ie in 45% of cases) struggling to maintain their mortgage payments in the face of rising interest rates and various price increases [1].
  • Australia had avoided the boom and bust in house prices the US experienced, and the factors that gave housing market strength continued to the point that a bubble mentality is developing and affordability is again of concern.  US hose prices were driven up by low interest rates, abundant credit and sub-prime loans - and then fell 30% after 2006. In Australia prices were flat for years 2002, as interest rates were raised. They fell only modestly during financial crisis, and have since risen again (starting with first home buyers). A crisis was avoided because of: limited low-doc loans; constraints on building; stronger bank balance sheets; recession was only shallow; immigration was strong; full recourse loans are made; government grants were generous. Housing construction has been low by historical standards, while population growth has been high. Supply side difficulties are likely to push prices higher - so planning guidelines and infrastructure constraints need attention. Investors are now looking for price gains. Rises will be constrained by increased interest rates in a couple of years - especially given affordability concerns. But this is likely to involve slowdown, not bust [1]
  • Australia is in an unsustainable housing bubble (according to Edward Chancellor, GMO). House prices need to fall by 1/3 (some of which could be made up by rising incomes). Australia's banking system (seen as a cartel) was said to have avoided problems because of lack of competition that forced extreme risk-taking in US. Problems face first home buyers given rising interest rates - and housing market is likely to fall due to problems of affordability. Australia's other risk is a collapse in commodities demand from China. Australia is not yet out of the woods - and in fact has not yet entered the woods [1]
  • Steven Keen (UWS) has long been convinced that Australia's house prices are dangerously high - and has now been joined by the influential Jeremy Grantham. He suggested that Australian and UK housing markets are the two outstanding bubbles - on the basis that house prices in long run average 3.5 times household incomes, yet are now 7.5 times in Australia. Keen relies rather on long term graph of real house prices that seems to skyrocket in recent years. RBA argues that house prices have increased relative to incomes because of: structural decline in inflation / interest rates; financial deregulation ended the need for banks to ration housing credit - which made affordability into the rationing device; lack of adequate supply of new housing (which made price the means of rationing); Australia is highly urbanised and faces development constraints on denser housing. Unlike US bubble there seemed to be no glut of new homes - with rental vacancy rates at lows. Australia's rapid population growth also keeps spurring demand. Mortgage stress affects relatively few households. HIA data suggests that average house price has been $498,000 compared with average household income of $125,000 - a ratio of 4:1.  Average mortgage repayments are likely to be about 30% of income - which suggests limits to further increases. Keen's chart needs to be given a logarithmic scale to show that real price growth is only slightly greater than real GDP. Australia's house prices are likely to remain uncomfortably high unless there is a sudden increase in interest rates or a sudden rise in interest rates  (Bassanese D 'Disputing the doomsayers' view of housing', AFR, 19-20/6/10) (Comment: ABS's publication (Household Income and Income Distribution 2007-08, 6523.0) suggested that mean household income in Australia was $1649 per week (ie $85,750 pa) and this implies that households on average income (which is well in excess of the income of the average household) would have to pay 52% of their after-tax income on their mortgage assuming: property cost of $498,000; 6.75% interest rate; a 30 year term; a 20% deposit; and a 30% average tax rate).
  • foreign investors frequently express concern about Australia's housing market when expected to provide the funds required to balance Australia's current account deficits [1]
  • large increases in global wholesale funding of Australia's banks would be needed to achieve the economic growth rates forecast by the federal government. As this may well not be available, banks will need to fill the funding gap by increasing interest rates, and when this is passed on to mortgages the effect on housing could be significant [1]
  • construction industry claims that Australia has 190,000 families desperately seeking housing who are unable to find it. But no one is able to find them - and they may be a fiction.  HIA claims average first home buyer spending $535,000 whereas ABS suggests that they borow $292,000 . HIA suggests that there will be 466,000 shortfall of houses in 2020 - but there are large areas of zoned land waiting for houses to be built. Vacancy rates would be low if there were a housing shortfall - but this is above 3% in all cites but Canberra and Adelaide. Rental growth has also been subdued. One observer suggests that we are now going into housing over-supply because much population increase has involved family reunions which simply increased home occupancy rates [1]

In May 2011 it was argued that: (a) deregulation of mortgage lending and a structural decline in interest rates is mainly responsible for the escalation of housing prices in Australia. Prior to financial deregulation prices had been very low because credit was limited and provided by banks to customers with the best credit rating. Deregulation resulted in large inflows of capital, which made affordability the basis of credit rationing - so that many more people were able to afford to buy; and (b) it is none-the-less unlikely that prices will crash [1]. [CPDS comment: Affordability was not the sole basis on which credit was sought for property purchases, so was the once off super-fast surge in property prices which encouraged the view that this was the best path to wealth for investors]


Global Macroeconomic Problems

There is no point relying on domestic economic strength in an unsustainable economic global environment. Australia can't succeed by simply trying to protect its status-quo from symptoms of broader problems. The need for more is illustrated by China: Victor of Victim?. In brief this argued that:

  • global financial imbalances are central to the current financial crisis - a view apparently accepted by the BIS. Those imbalances (characterised by a 'savings glut' in East Asia and large current account deficits by the US, Australia and a few other countries) have required the US in particular to provide levels of demand well in excess of its income. Funding this high level of demand depended on the development of an asset bubble - whose bursting has resulted in the current crisis;
  • China (and others with variations of the macroeconomically-unsustainable Asian economic model) are likely to be victims of the financial crisis. Financial system reforms in the US must stifle the financial imbalances that have protected East-Asia against defects in their economic / financial / monetary systems. And foreign exchange holdings that have been built up in the past will not go very far.

In view of what has happened in the US, other countries will be unwise to try to step into its shoes and provide the excess demand required to drive global growth in the face of Asian demand-deficits. This applies particularly to Australia, in view of its probable exposure to current account problems (as mentioned above).

Unfortunately current international proposals for reform, such as the work of the Financial Stability Forum which Australia's Prime Minister Mr Rudd, endorsed in his address to the UN General Assembly, have focused narrowly on financial regulation and do not seem to deal with the broader (financial imbalances) issue.

The confidence that Mr Rudd expressed in China's strong growth continuing to stabilize the global economy in the face of weakness elsewhere (Chalmers E., 'PM puts his faith in China', Courier Mail,  4-5/10/08) is probably misplaced. China was little affected by the 1997 Asian crisis and could provide strong growth to stabilize Asia generally because it was backstopped by strong US demand which provided it (and Japan) with current account surpluses - and thus no need for foreign capital. Others in Asia learned from this experience, and the ever-larger fiscal imbalances that are a major factor in the current global crisis resulted. But strong cash flow without worrying about its banks' balance sheets can't continue to be available to China as the US's financial system reforms must drastically reduce credit-based consumption.

Practical Issues

Defending 'Fortress Australia' would require a lot of resources, and be subject to practical constraints. For example:

  • reducing RBA interest rates may not affect the interest rates that banks charge in an environment in which most of their funding sources are constrained;
  • revenue falls and increases in spending to compensate for reduced investment and consumption by business and households could be very significant;
  • spin-offs from the global financial crisis must now escalate - and these have already been stressing Australia's financial / business institutions and households (eg see Escalating Concerns which refers, for example, to: problems in corporate cash flow / investment financing / aggressive valuations of commercial property; blow out in bad debts affecting financial institutions; and evidence of ending of property boom);
  • defending the integrity of financial institutions in the face of a large (eg 10-20%) decline in property values could require many times the $4bn that the federal Treasurer recently committed for investment in home mortgages;
  • there is no effective machinery for determining what to increase public spending on. Presumably infrastructure would be a priority. The federal government set up Infrastructure Australia (IA) to suggest projects, but this can't be realistic (see Infrastructure Magic?) because: (a) central planning can't take account of all the local considerations that are critical to such decisions; and (b) the environment is changing rapidly and the resource industry emphasis built into IA's terms of reference must now be uncertain. To oversimplify, those who could have the information to make sensible decisions don't have the financial capacity to make them, and those with the finance can't access the information - which is precisely the reason that central planning of any economic function must fail. Moreover at present state infrastructure machinery is likely to be no more realistic (eg see Brisbane's Transportation Monster) as a result of systemic weaknesses in Australia's system of government that have now become chronic (see Infrastructure Constraints on Australia's Economy).
Preventing Economic Disaster?



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).

For example:
  • the guarantees provided to deposits with, and loans to, Australia's banks, building societies and credit unions:
    • could well result in large costs to taxpayers (eg $50-100bn) - if financial  institutions (like their counterparts elsewhere) are adversely affected by losses through derivatives trades which have been 'below the radar' of Australia's financial regulators (see below);
    • appear to be difficult to implement because of the complexities involved with many different types of institution and financial instrument (eg see Tingle L., op cit);
    • put benefited institutions in a significantly stronger competitive position relative to other financial institutions, and thus enable them to pay lower interest rates to investors while their competitors lose the ability to do business and have grounds for complaint about sovereign risk. This issue seems to concern the RBA (RBA warned against bank guarantee: report);
    • have made it difficult and more expensive for state governments to fund infrastructure investment [1];
  • despite Australia's initially relatively strong government fiscal position, maintaining a strong fiscal stimulus in the long term (which seems likely to be needed because of macroeconomic obstacles to early recovery) may prove challenging. The federal government's view that the budget would remain in surplus after the proposed spending increases seems implausible. If the budget is likely to be in surplus. as a result of increased public spending, then the latter was probably not required. Australia's Future Fund reportedly suggested that it is unrealistic to expect that budget surpluses will fund the $41bn that the Federal Government wants to commit for infrastructure, education and health in the short term [1];
  • a large fiscal stimulus in Australia which leads to a level of growth out of balance with that achieved elsewhere would exacerbate any potential current account problems Australia may face (see above, and note the adverse balance of payments effect of the commodities crash [1]). As noted below many countries do not have the ability to mount a strong fiscal stimulus;
  • it has been suggested that proposals to increase first home-owners grants could be counter-productive. For example these might:
    • result in many buyers with negative equity (Milne etal 'Fallback plan for rescue package', Sunday Mail, 19/10/08);
    • simply encourage an expansion of a major cause of the financial crisis - through encouraging households to take on more debt. Booms and busts are regular events. in the past these were dependent on business balance sheets - but they now depend on household balance sheets. Debt financing has been made available to households on an unprecedented scale, creating a new source of potential instability [1] ;
    • have put bank's AA credit rating at risk by encouraging the emergence of a form of sub-prime lending to those with limited capacity to repay [1]
  • reducing immigration levels to counteract increases in unemployment could: (a) take away a significant source of demand for housing and thus make a slump in housing prices (which could adversely affect bank balance sheets) more likely; and (b) perhaps increase unemployment for reasons outlined below;
  • the federal government was already virtually logged-jammed with issues that it has been seeking to micro-manage - noting: (a) the large number of inquiries commissioned into diverse subjects about which reports are almost due; and (b) the tendency to announce initiatives which are more symbolic than substantial (eg see Productivity Magic?; Fixing Australia's Health and Hospital Systems? ; Apology Magic?; Infrastructure Magic?; Australia's New 'Cooperative' Federalism). Significant decentralization of functional responsibility (and financial capacity) seems likely to be required to avoid gridlocked governance in the face of now-prevailing complexity;
  • guarantees of bank deposits in Australia - which were intended to stabilize them - led to a crisis for other institutions (eg cash management trusts and mortgage funds) which had no such guarantee and subsequently experienced a run on their funds. Moreover:
    • those guarantees did not provide benefited institutions with the AAA rating that was intended because that rating apparently requires payments to be made within 24 hours, while action under the guarantee would require legislation;
    • the OECD has warned that such guarantees could encourage reckless lending that makes the financial crisis worse [1];
    • Australia's banks have remained successful in international borrowing [perhaps due to these guarantees] and this will reduce pressure on SMEs [1];
  • arrangements by Australia's federal government to provide credit for commercial real estate in partnership with Australian banks where foreign banks withdraw from the Australian market and thus don't roll-over the debts of major companies have been suggested to:
    • perhaps actually accelerate such institutions' withdrawal from the Australian market - by making this painless for them [1];
    • be needed to guard against large falls in the value of assets - which would discourage further investment - though the Reserve Bank is concerned that the arrangement would interfere with normal workings of the market [1];
    • be intended to forestall a rout in property values that could spill over to affect the housing market [1];
    • to be likely to protect construction employment in the government's opinion - though this view is disputed [1];
    • need very careful design to ensure that all losses are not born by the Commonwealth - because Treasury officials will not tend to have the same level of commercial skill as banks[1];
    • be used very carefully so as not to prop up dubious projects [1];
    • be likely to conceal sloppy lending practices by banks during the property boom [1]. Increasing numbers of observers are suggesting that projects were financed during the boom on a continuing 'blue skies' basis [1];
    • be heavily weighed in favour of banks at the expense of taxpayers [1];
    • possible be illegal through contravention of trade practices legislation [1].
  • political pressure in Australia on banks to lower home loan lending rates forces them to change very high interest rates to small and medium enterprises (the largest sector providing jobs) with the result that job prospects are more limited than they otherwise would be [1]
  • a proposed $42bn  fiscal stimulus by Australia's federal government in early 2009 was criticised on the basis that:
    • large government budge deficits pose problems for Australia because of its dependence on foreign capital [1];
    • 'pump priming' will only retard recovery and leave a painful legacy of debt. The problem arises because of lax monetary policy for over a decade. Unwinding the misallocation of resources that results from this will be painful, but 'pump priming' will prevent this. The focus should be on increasing savings [1]
    • Australia's fiscal position had already deteriorated more than most as a result of crisis - though its economic situation was not as bad. Fiscal expansion (in small open economy) may merely raise interest rates, induce capital inflow, inflate the $A and reduce exports. Monetary policy would be better. Proposed spending is too much too soon - because unemployment is not yet rising significantly. There is thus a risk of crowding out other activities. Unproductive spending creates long term problems - because it doesn't contribute to tax revenues. The stimulus proposal contains no details of how to return to budget balance [1]
    • any large payments to households are more likely to be saved than spent [1];
    • the stimulus is solely focussed on increasing the demand side of the economy - not on boosting supply. Australia has a deficiency on the supply side - as indicated by its current account deficits - and its households (who ultimately have to pay for government spending) carry heavy debt burdens [1];
    • this will increase the capital shortage in Australia and force the sale of assets at the bottom of the cycle. Australian business and households took on too much debt during the boom [1];
    • Australia's fiscal position is deteriorating faster than comparable countries. Fiscal policy may not be effective in a small open economy (ie it may simply raise interest rates, induce capital inflow, cause currency appreciation and reduce exports).  Higher budget deficits can significantly increase interest rates in Australia. The fiscal stimulus is too much - and before symptoms are apparent. There will be little room for future manoeuvring. employment is more likely to be relocated than created. There is no credible strategy for returning to budget balance [1]
    • households chose to save any extra income they received because their debt levels had increased significantly since 2000 [1];
    • economic growth depends ultimately on the productive use of savings - and much of the stimulus involved unproductive spending which must undermine Australia's economic prospects [1];
    • a large stimulus in an open economy has perverse effects - eg increasing demand for capital, forcing up interest rates, attracting foreign capital, increasing exchange rates, depressing exports and thereby increasing current account deficits. The impact of stimulatory spending has been over-estimated because these consequences have been assumed away [1]
  • a state government in Australia was suggested to be at risk of causing panic by referring to the need to go on a 'war footing' because of the potential impact of the crisis, while not revealing to the public the reasons for this conclusion [1]
  • legislation proposed by the federal government that would apparently require lenders to take responsibility for the ability of borrowers to repay loans could seriously impede the provision of credit - and thus make it impossible for the community to achieve the levels of spending required to avoid recession [1]

Similar concerns about the unintended consequences of policy action have emerged elsewhere (see details in Global Financial Crisis: The Second Test)

What is the net effect of immigration on labour supply and employment? In May 2008 the federal government proposed increasing migration as a way to meet labour shortages and gear Australia for what was seen as the new global competition for workers. (Kelly P. 'Rudd taps global labour pool', Australian, 17/5/08), and in October reduced immigration was seen as a way to respond to feared rises in unemployment [1].

These proposed changes seems to be based on assumptions about the effect of immigration on labour supply which may or may not not be correct - given the impact that migration has in itself creating a demand for (and thus absorbing labour in supplying) housing, services and infrastructure.

SE Queensland's economy (for example) has been affected by high rates of interstate migration for 30 years and a very simple calculation by the present writer 10 years ago suggested that this process was internally self-sustaining (ie that the provision of capital goods (eg houses) and ongoing services for ever-increasing numbers of migrants employed a workforce in that region roughly equal to the labour available from the pool of workers available from migration over the previous 20 years, as well as generating a somewhat greater demand for labour in other regions). In other words migration has been a (perhaps the) major driver of economic and employment growth in SE Queensland - and was thus anything but source of potential unemployment for existing residents in that region.

Though migration to SE Queensland apparently generated a roughly equal demand for labour elsewhere, the net effect of interstate migration to SE Queensland on national labour demand is not equal to the sum of jobs generated inside and outside the region, because some of the jobs generated by rising population in SE Queensland were offset by falls in other regions. However in the case of international migration, it seems likely that the demand for labour associated with migration could well be much greater than that provided by the migrant population (as declining labour demand in countries that are the source of migrants would not offset increasing demand in Australia). 

Moreover, for most those years state governments failed to respond to the infrastructure demands associated with accelerating migration and massive catch-up investment has recently been commissioned. It is possible that the recent effect of 30 years of interstate migration was to dramatically reduce the net availability of labour for other functions (eg export industries).

If this applies to Australia also, then rapid migration could itself be a significant factor in Australia's past labour shortages, and reducing immigration in future might actually increase unemployment.

Whilst the latter speculation is only based on back-of-an-envelop estimates, before committing to large changes in international migration for economic reasons there is a need to consider whether this will actually deliver a solution to (or compound) Australia's past labour shortages and anticipated future labour surplus.

Clearly immigration will result in a net increase in the available workforce if only workers migrate and they are housed in something like a tent city. But if they are accompanied by families, and fully integrated into the general community (which requires the development of new houses, shops, schools, sporting facilities, hospitals, roads, power stations etc) then it is not immediately obvious what the effect on net availability of labour for functions other than supporting immigrants is.

However what may be even more serious is that:

Blaming 'Extreme Capitalism'

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

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:

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?

Managing Australia's  Economic Crisis +


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:

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. One observer suggested that this moderate impact was the result of both: (a) interrupting the de-leveraging process, which had contributed to the major downturn in US but had been limited in Australia partly because of government incentives to continue private borrowing; and (b) impact of China's commodity demands [1],

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]


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:

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 - surplus 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) sovereign 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 default 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]
  • while buoyant corporate earnings could prop up the market for a while, it has been argued that lack of aggregate demand in US is a fundamental problem. Government has increased spending but this hasn't overcome basic structural problem - declining share of income going to workers (because of technological advances and free trade). Workers share fell from 58% in 2001 to 53% in 2010. This had no effect for a while because of increased borrowing (from 2.5-5% of GDP in 1990s to 7.5-10% in 2002-2006). Creating asset bubbles with easy credit merely deferred this problem. US workers can't be relied on to drive economic recovery [1]
  • China, under Hayman declaration, has revealed an intention not to buy further US Treasuries. This will have major implications. For past decade China funded US deficits, and US bought products from China.  China's shift into other investments has included Japanese Yen - which caused Japan to react (out of concern about effect on competitiveness) by buying US Treasuries. Similarly Europeans concerned about domestic losses have been heavy purchasers of US Treasuries. Eventually when fear subsides US will need to increase interest rates dramatically to attract capital, but now everyone seens Treasuries as best way to protect wealth. Australia's currency has been appreciating - and the economic effects will turn nasty soon [1]
  • global economy will suffer future crises (according to Nouriel Roubini) because financial reforms are inadequate. Further quantitative easing won't help as economy is already flush with liquidity (eg US banks have $1tr in excess reserves). The economy's problems are solvency, credit, housing, corporates and banks [1]
  • there are increasing signs of a currency war as various countries (eg Japan, China, US, UK) seek to cheapen their currencies for competitive advantage - and other (eg Brazil) might seek to join in [1];
  • many countries are considering intervening in currency markets to prevent their currencies rising too far, as liquidity created through quantitative easing in US floods into other countries [1]
  • Ireland has fully recognised the losses facing its banks. However this has not been done in US. Government is hoping that real estate recovery will allow banks to avoid recognising losses. It is estimated that US banks have only restructured 25% of their delinquent loans. 1/3 of US households have negative equity in their homes (ie mortgages greater than home values) [1]
  • IMF's World Economic Outlook suggests that southern Europe will suffer slow suffocation, and implies that fiscal tightening will trap North America, Britain and US in a long slump. Fiscal consolidation can work for countries that can export their way out of trouble through reducing exchange rates - but this won't work if everyone tries to do it simultaneously [1]
  • Brazil's finance minister declared that there is an international currency war. Many governments and central banks are intervening to force currencies down. China intervenes directly by pegging Yuan to dollar. US authorities intervene by holding interest rates at zero - and talking about printing money. Everyone but Australia is worried about currency value. World is now finding out that without rampant credit growth (which borrows demand from future) it is hard to create enough work for people supplying domestic markets (or in China's case exports supported by US credit growth). Now credit crisis of 2007 is entering a new phase - in which countries try to steal demand and employment from each other rather than from future as before. Martin Wolf wrote about demand deficits (of something like 10%) in US, Japan, Germany, France, UK, Italy. These countries are now trying to use other countries demand to make up the gap through exports - eg by debasing currencies and so forcing money to flow into emerging economies, thus forcing their currencies higher. China's peg against $US means that this doesn't work - so tariffs / embargoes against China (ie a trade war not a currency war) is likely instead [1]
  • new regulations that push US banks towards safer investments will dramatically reduce the availability of credit made available to middle class consumers [1]
  • US banking system (and to a small extent that in Australia) faces increased risks from bad mortgage loans. Collapse in prices of homes caused losses - but banks were able to limit losses by foreclosing on mortgages and selling properties. Now it seems that this may become impossible, because the documentation of mortgages was often inadequate to allow foreclosures to be legally enforced, and a ban on foreclosures is possible to allow legal mess to be resolved - and this would put many smaller banks at risk [1]
  • US is likely to win the 'currency war' with China (and others) as US attempts to inflate other economies through quantitative easing (the proceeds of which will tend to flow offshore), while other seek to achieve a rebalancing of global growth by deflation in US. The US will win, because there is no limit to the Fed's ability to print $USs [1]
  • capital inflow to Australia from Asia has taken a hit because pressure from US is being recognised as likely to force revaluation of China's currency - so investment in property in Australia now seems less attractive [1]
  • China's decision to raise bank interest rates suggests that it failed to curb property bubble in other ways (eg higher deposits) - and is having economic repercussions externally. Because rates on savings were below inflation people preferred investment in real estate, and because rentals available were very low many of these properties were left empty. This also created risk to China's banks because so much capital was secured against property. With increased interest rates, there is concern about effect on SOE who are depended on artificially low interest rates to remain profitable. Also property slow down will damage revenue base of local authorities [1]
  • the Fed proposal for QE in order to stimulate economic growth is dangerous, because the velocity of money is now recovering, and QE thus risks igniting inflation [1]
  • a second credit crunch may be looming because of difficulties that banks are facing in refinancing lending [1]
  • Unless ECB acts quickly it will destroy euro, and allow political catastrophe in Europe. Europe faces risk of contagion linked to potential Irish default. This could have similar effect to failure of Austrian Bank (Credit Anstaldt) in 1931 which brought down central European financial system, and affected global system to the extent of setting off second and deeper phase of Great Depression [1]

  • China may be facing severe problems due to loose credit feeding stagflation. It boosted money supplies when GFC limited its ability to grow through mercantilist export strategies. China sought to keep game going as if nothing had changed, and is now trapped because it can't raise interest rates fast enough to slow inflation without exposing bad debts in its banking system [1];
  • US government's apparent inability to get budget deficits under control, led to sell off of US Treasuries - and rising yields on bonds which threatens to counter the benefits of stimulus measures [1]. Western governments face increasing borrowing costs - and this contributed to sell-off of US Treasuries [1]
  • Problems remain regarding EU currency. Modest decisions made are inadequate - and could lead to costly transfer mechanism from richer to weaker nations permanently. With risks now to Spain and Portugal, Europe is world's biggest economic threat. Concerns about national solvency could cause euro to implode anytime. National defaults are not uncommon.- and Europe's situation is only different because of common currency. European countries are too different to be bound together by common currency. This worsens effect of any county's default and prevents relief mechanism (devaluation) usually open to countries in trouble. Also any default would result in large losses throughout Europe's financial system. Huge political capital has been invested in Europe project - and reversing this is unthinkable. There is a need for over-indebted countries to default - not struggle on with ever greater debt. A traditional IMF style restructuring is needed, as is options to leave eurozone. Productivity differences in Europe are too great to retain single currency. But sensible options are not yet even being considered.  [1]

  • US housing market is in danger of 'double dipping' because of (a) expiration of government incentives to support buying; and (b) chaos in mortgage documentation - which leads to suspension of foreclosure process [1]

  •  Political leaders speak of end of financial crisis - as bank bailouts and massive stimulus spending has encouraged people to borrow, spend and speculate again. But this is like 2003 when Fed was advised to create housing bubble to replace dot-com bubble which had burst. Financial crisis was partly due to lo interest rates, huge deficits and credit financed consumption - which is again seen as solution to economic slowdown. Despite talk of austerity, governments continue to borrow like crazy - with 50% increase in rich countries debts in past 3 years. Governments hope to continue borrowing at low rates, but markets may prevent this. Crash happened when consumers consumed too much - sending debts to banks and then to governments. Greece and Ireland are insolvent (not illiquid). Markets are lending to Spain (Italy / Belgium / France) because it is assumed that someone will bail them out - but this is not assured. 2011 poses risks for indebted nations in Europe and banks which also need to continue to borrow. US now needs to pay higher interest rates after Obama's stimulus borrowing, and quantitative easing poses risks to $US. Economies in East Asia, India and Brazil are not as sound as they seem. India and Brazil are growing because of short term foreign capital - as a result of easy money policies. China's wealth and prospects seem dazzling. Property prices in wealthy cities have doubled over 2 years. But this reflects money shock - with huge fiscal and monetary stimulus in addition to foreign capital inflows. Millions of the properties that have been developed are empty. Who is providing protection. China lends to others, yet who lends to China. Governments are saving banks, yet who is saving governments. The EU offers a safety net, yet who will bail out EU. Current reliance on debt to maintain growth is dangerous  [1]

  • Europe's debt markets could be hit by new credit crisis soon because of huge volumes of bonds that governments / banks need to sell in 2011 [1]

  • Analysts have suggested that China has lost control of its economy - as a result of its version of quantitative easing - and will need to slam on the brakes in 2011 or 2012, with major adverse effects on the rest of the world [1]

  • Urbanisation in China is driving strong demand for Australia's iron and coal. However there are increasing risks of a hard landing over the next year or two - because of inflation and excess liquidity that authorities have been unable to drain from the system [1];

  • IMF warned that imbalances threaten to derail global recovery, and may set off wars in deeply unequal countries. Many rich nations face slumps, while emerging economies such as China / India / Brazil face overheating. Global unemployment is at record highs, and inequality is rising. IMF suggests that global imbalances caused the GFC, and that China and Germany are the main sources of the problem - through reliance on export-driven growth. If there ase imbalances are not resolved, global clashes and trade protectionism are likely. China's efforts to hold down the value its currency were seen as serious cause. This aligns IMF with US views. IMF also warned about risk of overheating, inflation and hard landing in Asia [1]
  • effect of Japan's earthquake / tsunami could be economically disruptive. Its economy was shrinking beforehand, government is shaky and nuclear power is under a cloud. A severe crisis of confidence could tip it into depression - which would affect others because Japan is the biggest lender to other countries (especially to the US because of its current account surpluses) and its government is also the biggest debtor. Repatriation of Japanese capital could trigger bond price collapse in US and higher interest rates which lead to another phase of GFC [1]
  • some see US Fed's quantitative easing as reckless - as flooding world with $US has pumped up commodity prices and overheated emerging market economies. Yet monetarists agree with Bernanke - because Fed has merely substituted for credit no longer available from damaged US banking system. Before crisis US banks' cash reserves were $2bn, but are over $1tr now. Lending has been restricted because of feared losses. Monetary financial institutions credit contracted in 2009. and is now growing much more slowly than before GFC. QE can't increase inflation unless it increases overall money supply. In 1930s Fed allowed depression by allowing money supply to fall by 1/3 - and Bernanke indicated this would not happen again. But this could still cause problems - because China and Brazil don't allow exchange rates to vary against $US - so they are importing monetary policy suited to US - and thus risk inflation bubbles. This in turn feeds into the effect on commodity prices on US inflation. Fed might be forced to reverse QE - but this could be hard to do [1];
  • there is increasing concern in May 2011, that market instabilities could signal a major downturn. Some are concerned about what happens when US Fed ends its quantitative easing - but the larger problem could be that emerging economies that wanted to stop currencies rising against the $US have been printing money and using this to buy US Treasuries. This has led them to significant inflation - and they could now be forced to tighten liquidity, and this would set US bond rates much higher. The associated deflationary shock could set global markets much lower [1]
  • Australia's resource companies are benefiting enormously from high commodity prices. However the world economy is operating under most unusual conditions - with malaise in the developed world and an unprecedented boom in China. This has to be unsustainable. Cheap money is a major factor in feeding the commodity boom [1]
  • Speculation in derivatives has been suggested to be likely to cause another financial crisis [1];
  • there are signs that China property bubble is starting to deflate. China's economic growth could slow rapidly and adversely affect global economy. Real estate is foundation of China's rapid growth for two decades, and is crucial to construction / steel / cement industries. It is also favoured investment in China, because of poor bank interest rates, and critical to local authority budgets (as property sales fund infrastructure spending). Property construction in China was 13% of GDP in 2010, twice the level of 1990s. Many other countries have come to depend on this. Some cities have 20 months inventory of unsold properties, and suffer declining prices. Ordinary citizens can no longer afford to buy properties. In 2006 average apartment cost 32 years average salaries, but this is now 57 years [1]
  • Geek debt crisis could have implications well beyond Europe because UK and US banks have underwritten insurance against sovereign defaults [1]
  • the problem is not a potential default by Greece but the interlink ages within the international banking system that are the problem, as these could cause such a default to lead to failure by many institutions worldwide [1];
  • Europe is in crisis because the PIGS (Portugal, Ireland, Greece and Spain) require external capital in 2011-2013 of 50% of GDP. Finance won't be available on terms they can afford (for Greece and Portugal particularly). They are thus headed for default - which would impose large costs on eurozone banks, If default is avoided, economies will stagnate. Greece has often been in default. Problems with debts reflect social conflicts in southern Europe, as fascist regimes made transition to democracy. This makes it hard to levy taxes, and requires spending to cover social cracks. PIGS joined euro at time of low inflation, when interest rates were low which suited northern Europe, but in PIGS real interest rates were negative because of high inflation. In Spain banks used this for property investment. In Greece and Portugal (without solid banks) cheap loans were used by government. While PIGS were on borrowing binge, northern Europe was in fiscal consolidation. Given low inflation, savings rates in northern Europe were high. Also competitiveness increased in northern Europe due to restrained costs. Trade within eurozone increased. But savers in northern Europe lent to borrowers in the PIGS, By 2010 the PIGS were exposed to $1.2 tr from lenders in Germany, Britain and France - and like Asian economies in 1990s had to service large loans in currency they could not control, and were in trouble when inflows stopped. European regulators encouraged these dealings as all eurozone public debts equally. Thus banks sought high yielding PIGS' debt rather than low yielding German debt. While the PIGS will be bailed out, their problems won't be solved. The real problem is that the euro was imposed as an 'elite' solution without public debate [1]
  • There is a risk of a double dip recession without shock absorbers. Interest rates are near zero in much of OECD. US is likely to tighten fiscal policy as will Europe as economies slow. China has pushed debts to 200% of GDP. Printing money increases the assets of rich, at cost of higher prices for the poor. Everything was thrown at financial crisis after Lehman Bros failure [1]
  • reserve banks in emerging economies are facing an unattractive choice between easing monetary policy (because of weaknesses in developed economies) which is increasing inflationary risks, and tightening policy to contain inflation - which would also slow growth [1]
  • China is facing a hard landing (because of excessive credit growth and attempts to control the consequences) and as Europe and US experience economic problems China will not be able to again boost spending to boost global economy [1]
  • the European debt crisis was described in late 2011 as creating conditions similar to the GFC - noting the freezing of credit markets [1]
  • the banking crisis in Europe is having global effects, as Europe's banks (being bailed out by their governments) will give preference to maintaining credit for domestic business activity and withdraw capital / sell assets elsewhere. This is making it harder for banks in US to access capital [1]
  • Europe is headed towards severe deflation because of contraction in its money supply because of the discounting of sovereign debts held in the banking system. Such bonds previously were able to be treated by banks as equivalent to euros (ie there was no need to hold reserves against them). Now substantial reserves have to be held, and the effect is to contract the money supply [1, 2]
  • quantitative easing may be reaching the limits of its effectiveness in maintaing growth because: (a) it impedes necessary de-leveraging; and (b) discourages risk taking. It is becoming a case of 'pushing on a string' [1]
  • the World Bank has warned of new and more severe financial crisis than in 2008 because of downturn in Europe / Emerging markets; broad freezing of capital markets; and inability of developed economies to launch strong countercyclical policy responses [1];
  • monetary easing by reserve banks was seen in March 2012 as risking the emergence of an inflationary breakout [1];
  • M1 money supply growth in major world economies has peaked, and is falling rapidly as it did in the months before Great recession in 2008. The credit cycle in mature economies is deflating just as emerging economies start to struggle [1]
  • the possibility that Portugal might need bailouts similar to Greece has been suggested [1]
  • There has been a significant (eg 50%) slump in demand for loans from households and firms in Europe - which is similar to the post-bubble situation in Japan [1]
  • The next phase of the GFC may arise in Japan which suffers: (a) a need to import most energy because of nuclear accident; (b) fiscal deficit of 10% of GDP; (c) government debt of 230% of GDP; (d) emerging trade deficits; and (e) increasing interest rates and interest costs [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)


  • 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)


  • 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:
    • 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]

Constraints on Domestic Responses

Effective domestic management of Australia's 2009 economic crisis will be difficult. For example, defects have been allowed to accumulate in government machinery (see Australia's Governance Crisis) and this will be serious given the much greater role that the public sector is likely to have to play because of the GFC [1]. Moreover, an unbalanced approach to economic strategy has prevailed (as noted above), which will make the development of viable new economic capabilities much harder. 

Other constraints include:
  • economic modelling is likely to be an unreliable method for developing policy - because it depends on economic relationships and data which are changing rapidly and thus tend not to be reflected in models. Reliance on hard data necessarily involves 'looking in the rear view mirror', which is not an effective way to steer through approaching curves. It was not until December 2008 that analysts had sufficient hard data to know that the US had been in recession since December 2007 [1]. Unreliable economic statistics can potentially turn attempts at counter cyclical macroeconomic management into policy induced booms and busts - a problem that appeared in 2010 to exist in relation to estimates of house prices, which by then had become a major focus of RBA attention in determining official interest rates (because of fear about generating a housing price bubble, whose bursting could damage the financial system

Suspect house price statistics: A formula for policy-induced booms and busts? (email sent 29/12/10)

Barry Fitzgerald,
The Age

Re: Australia leads world in house price rises, Dec 29, 2010

Your article quoted international comparisons of changes in house prices by Canada’s Scotiabank which suggests that Australia was “the 'clear front-runner' for house price increases, with a gain of 9.4 per cent year-on-year for the September quarter on an inflation adjusted basis”.

However there seems to be an incompatibility between such claims and what is happening on the ground, and (as elaborated below) this implies that government and reserve bank policies could be the source of economic instability because they will tend to be heavily influenced by apparently suspect house price statistics.

Disconnect between reality and the official statistics economic analysts rely upon? The figures used in your article appear to be ultimately based on a Scotiabank analysis (Global Real Estate Trends, Dec 23, 2010, p10) by Adrienne Warren (see also Scotiabank’s press release about this). That analysis cited the Australian Bureau of Statistics (ABS) as the source of data about Australia’s inflation adjusted, year-on-year changes in house prices.

The ABS presents price estimates in House Price Indexes: Eight Capital Cities (6416.0) and the September 2010 data shows a weighted national average year-on-year change in house prices of 11.5% - with a corresponding figure for Brisbane (with which I have some familiarity) of 3%. There are reasons why Brisbane’s house price changes are likely well below the national average, namely a dramatic decline in the rate of population growth (see Speculations about Queensland's Economic Predicament).

However the 3% year-on-year growth data for Brisbane appears inconsistent with advice from those with an involvement in real estate. For example:

  • Various media reports (eg Coast loses its golden hue and House of horrors) have commented on substantial falls in the value of some properties in major coastal regions adjacent to Brisbane;
  • A real estate agent operating on Brisbane’s north side suggested in October that properties across-the-board have fallen 5-10% over the past year, and that mortgagee sales by banks are now accelerating the decline (personal communication);
  • Another ex-agent with ongoing connections and interest in the industry suggested recently that: average-value properties have fallen by up to 20%, and only the cheapest and the most expensive properties are holding their value (personal communication).

If this apparent ‘disconnect’ is real, it could arise because economic analysts rely ultimately on ‘median’ price estimates and these can be distorted by changes in the composition of property sales resulting from government incentives and interest rate changes.

The potential problem with ‘median’ price data: The ABS’s data is ultimately based on median house prices (see Explanatory Note on 6416.0, para 20). The problem with this is that the median is very sensitive to changes in the composition of property sales. The median (ie the property value with equal numbers of higher and lower transactions) might increase (say 20%) even though the value of every property fell (say 20%) if transactions during a particular period were limited to relatively high value properties (eg because of reductions in first home buyer grants, or because rising interest rates create affordability problems for first home buyers). Similarly under other circumstances median prices might fall, even though the value of every property rose.

The ABS is clearly aware of the potential ‘compositional’ problem with median prices, and attempts to reduce difficulties associated with this by stratification of data so that comparisons are made with similar properties (see Explanatory Note on 6416.0, paras 11-12). However [,noting the possibility of significant compositional shifts within, as well as between, the zones in which data is stratified,] it seems possible that the ABS’s attempts to protect against the distorting effect of compositional changes are inadequate , because:

  • The apparent significant over-estimate in price rises in official statistics in the case of Brisbane above, occurs at a time when rising interest rates and falling home-buyer incentives will tend to discourage purchases of cheaper properties and thus bias results upwards;
  • The variations in established house prices for Australia as a whole since 2007 (see 6416.0) appear to correlate with changes in the willingness of buyers in particular (ie higher or lower) price ranges to acquire properties due to changes in interest rates and government incentives that affect the affordability of houses for first home buyers.

There seems to be a need to raise public awareness of this potential risk, because Reserve Bank and government policies are presumably set on the basis of official statistics that may be more a reflection of their policies than what is actually happening. If so, this is a formula for policy-induced booms and busts. For example, the Reserve Bank might be motivated to raise interest rates because it fears a housing bubble and official statistics show that house prices are rising rapidly, though the latter statistic may simply reflect a compositional change induced by interest rates that are already too high.

John Craig

  • fiscal policy is unlikely to provide an effective mechanism to counter-balance the economic downturn for the same reason that countercyclical public spending to balance the business cycle has tended to lose credibility since the 1970s - ie (a) responses tend to be so slow that government action tended to amplify, rather than moderate, booms and busts (eg because infrastructure projects, which the incoming US administration is reportedly intending to emphasise [1] can take years to plan and implement); and (b) the effect that political rent-seeking has on spending priorities. The apparent inability of Australia's federal Treasurer's to perceive the risk of recession / budget deficits also illustrates the the first of these risks (presumably because of: (a) a responsible desire not to undermine confidence; (b) decision making on the basis of hard data that can be months out of data; and (c) Treasury assumptions that 'committed' resource investment projects won't be scrapped) [1];
  • across-the-board tax cuts and bail-outs of troubled industries have been suggested by the IMF to be ineffective (and potentially wasteful), and great care is needed in designing stimulus packages [1];
  • if public spending is used to boost economic activity at the expense of the private sector (eg if taxes need to rise to fund spending) there may be no net effect on reducing unemployment [1];
  • problems are likely in managing federal public finance (see also Australia's Future Tax System: The Cost of The Financial Crisis and The Opportunity to Fix Government). For example:
    • the adverse trends in economic growth must increase unemployment and welfare costs and reduce tax revenues (and thus capacity for spending on infrastructure or other policy goals);
    • the federal government announced that the GFC has eliminated an estimated $40bn in revenues over the next 4 years - and that (a) this puts proposals for tax cuts, infrastructure spending, federal-state relationships in doubt; and all that the federal government might commit to is providing promised increases for pensioners [1];
    • the challenge facing Infrastructure Australia has been said to have shifted from advising the federal government on where to spend it money on infrastructure to how funds might be obtained for infrastructure given: GFC; overweighting of infrastructure by superannuation funds; guarantee of bank deposits; loss of liquidity in secondary market for state securities [1] .
    • there have been concerns that multinational companies may transfer losses to Australia [1] - presumably because Australia's company tax rates are relatively high;
    • state revenues will have suffered downturns, and states have few options to compensate other than seeking increased federal funding;
    • despite limited development of real economic capabilities, the community has profited significantly from:
      • asset inflation (mainly of property values in Australia's case) supported by inflows of cheap capital - which seem now unlikely to be so readily available;
      • large increases in federal tax revenues due to the economic boom that were returned to households in the form of reduced income taxes and increases in welfare payments. The latter have: (a) compensated for the increased inequity which would otherwise accompany market liberalization with weak capacity to compete successfully in high productivity activities; and (b) created a sense of entitlement to ongoing benefits. These expectations may be politically suicidal to unwind, and yet economically impossible to leave unchanged;
    • risk in managing retirement incomes has been transferred from government and business to households - and, if households prove unable to manage it, pressure for welfare payments from Australia's aging population will grow [1];
    • IMF suggests that Australia should lift retirement age and cut healthcare benefits because of GFC. Australia's retirees are more exposed than any others to GFC (as super funds have 80% of money in equities and mutual funds - where most have <10%) - and government could be forced to provide support. Unless governments find ways to cut costs, confidence in their ability to repay debts could be lost [1]
  • easing of monetary policy (ie lower interest rates) may have limited stimulatory effect because:
    • in a deflationary environment households / businesses may not want to borrow. Property investment has been a major destination for borrowed funds, but this would be unattractive if property values are slumping;
    • Australia has been highly dependent on international financial markets for capital;
    • changes in interest rates have limited effect on consumer spending, because when rates are (say) reduced this increases the disposable income of borrowers but reduces that of investors.
  • new methods of macroeconomic management arguably need to be developed which are less likely than primary reliance on monetary policy to allow asset inflation that puts financial systems at risk. Though the risks associated with asset inflation are now being officially recognised, it is by no means clear how they might be reduce (see Booms and Busts: Unsatisfactory Tools for Macroeconomic Management?). Attention also needs to be given to the asset inflation risk associated with inflows of foreign capital;


  • the complexity of the issues will often cause 'rational' initiatives to deal with the crisis to have counter-productive outcomes (eg consider the apparent practical defects in the initial assumption that Australia was invulnerable  and in the first round of defence measures that were then mounted). For example:
    • the potential effectiveness of financial institutions in contributing to economic recovery has been impeded; and
    • large losses could be imposed on taxpayers through guarantees offered of bank deposits;
  • the federal government may inadvertently be constraining the economy's ability to adjust by: (a) industrial relations changes that limit enterprise bargaining and flexibility; (b) introducing an emissions trading scheme; and (c) processes for deciding infrastructure priorities that could result in wasteful spending in response to rent-seekers [1

Practical Problems with Australia's Crisis Response

The major thrust of the federal government's early 2009 response to the risk that the GFC would induce a major recession in Australia was a $42bn package of spending and payments to households to boost demand. Unfortunately this merely addressed symptoms of the failure of the global financial system (ie the disruption of the real economy) while arguably increasing Australia's potential exposure to the causes of that disruption (ie the shortage of credit).

The Core Problem: Reports in early 2009 suggested that problems in the global banking system (ie insolvency) could not be solved easily or soon. Thus credit shortages would continue, and symptoms seemed already to have been emerging.

For example it was suggested that capital flows to developing markets seemed to be at risk of collapsing - partly because stimulus programs in the developed world were diverting capital. Moreover the US government may be unable to fund its activities and proposed economic stimulus. The US envisaged a $US2tr borrowing program in 2009 - in an environment in which there could be few lenders and all governments have similar needs.

Despite the strength of Australia's pre-GFC position, the global credit shortfall has been likely to affect Australia eventually because of the inflow of capital from overseas banks (about $60bn pa) that is needed to balance the current account deficit if domestic growth is strong. Government pressure to favour home loans also made credit scarcer and more expensive for business and states [1], while bank deposit guarantees created funding problems for competing non-bank institutions.

While Australia's banks (having sound credit ratings and government guarantees on deposits) could still provide loans, the conditions on lending have tightened and some businesses are unable to get credit (eg see Switzer P., 'Rudd blamed for cash problems and uncertainty, Australian, 3/11/08; and Stuchbury M., 'Numbers stacking up and the news is all bad', Australian, 18/11/08). Likewise state governments apparently found it difficult to borrow to fund infrastructure (eg see Tingle L., 'Banking on steering clear of state woes', Financial Review, 5/12/08). Federal government support in borrowing $100bn for major state infrastructure projects was suggested to be being sought (AFR, 2/3/09). And the private sector became unable to contribute capital to support major infrastructure projects [1].

In an environment in which credit was constrained large federal government borrowings to boost demand would make it harder and more costly for business to get working capital and for state governments to fund infrastructure.

Furthermore capital from international markets that covers Australia’s current account deficits had mainly been used in the past for property investment. If such capital becomes scarce (eg see Gilyas R, 'Peril if foreign banks flee', Australian, 15-16/11/08) a big fall in property values is possible – and there have been warning signs in commercial property, and in higher-priced residential property. A large fall would undermine the balance sheets of local banks, and their ability to provide credit. While the federal government and banks set up a $4bn fund (dubbed the 'Ruddbank') to meet shortfalls in the refinancing of loans on commercial property, this would be inadequate in the face of a (say) $20bn capital shortfall.

The shortfall in credit (ie the mechanism whereby the global financial crisis (GFC) has crippled the real economy elsewhere) started to be felt in Australia. This implied a lack of working capital for business as well as difficulties in funding infrastructure and property investment. The large borrowing program which the federal government committed itself to fund its stimulus package made that credit shortage worse - so that while some jobs would emerge in (say) installing ceiling insulation and building schools, this could be at the expense of more bread and butter economic activities.

There was however a counter-view that government borrowing would not squeeze out others until there is a general economic recover - because (in February 2009) there was a global contraction in non-governmental borrowing of about $5tr [1].

But IMF warned in April 2009 that massive government budget deficits were making it impossible for banks and companies to raise money. A rapid disorderly de-leveraging could result - and this could be a particular problem for countries such as Australia that depend on international capital markets to raise money [1]

Another cause for concern about the emphasis on stimulating demand was that it seemed to do nothing to boost the supply side of Australia's economy which was likely to be essential in the medium to longer because of the likely adverse effect of the GFC on Australia's economic environment and government revenue.

Why?: The economic effect of GFC seemed unlikely to be simply a cyclical economic downturn. It seemed to represent a dislocation of the past basis of economic globalization which must have long term adverse structural effects on Australia's economy and government revenue (eg see Australia's Future Tax System: The Cost of the Financial Crisis and the Opportunity to Fix Government  and Are East Asian Economic Models Sustainable?). Thus:
  • Australia needed to boost the supply side of its economy and cope with likely structural economic changes. Little was proposed to facilitate this;
  • maintaining strong domestic economic activity in the face of weak external demand would increase Australia’s need for foreign capital inflows, which (as noted above) was already likely to pose financing risks;
  • the Federal Government could find that, without tax increases, it could not continue the generous level of transfer payment that were set in place by its predecessor on the basis of revenues generated in an unsustainable economic boom.

Australia's Treasurer noted in May 2009 that large revenue shortfalls due to the GFC had caused the budget to go into deficit, and suggested that restoration of surpluses could be expected when economic growth returned to trend [1]. The problem was that, while growth will undoubtedly eventually be restored, this may take a long time and require huge economic adjustments. At about the same time, Australia's Small Business Minister suggested that further market liberalization reforms along the lines of those under the Hawke-Keating Governments would be the best path to future prosperity (even though financial regulations now require tightening because of financial excesses in US / Europe, future prosperity). Specifically he referred to the need for  investment in education, infrastructure and innovation as well as further deregulation. However more effective machinery to develop the economy would be needed if Australians were to successfully meet the competitive challenge that he highlighted.

By mid 2009, economic 'green shoots' were seen to be emerging giving rise to expectations that the economic downturn would be short and shallow. Unfortunately it is likely that those 'green shoots' merely reflect 'real economy' recovery from the effect of a severe financial shock in late 2008 and the financial system defects that gave rise to that shock have been papered over rather than resolved, and thus are likely to cause ongoing severe problems (see above).

By October 2009, it emerged that:

  • Australia's banking system had been extremely vulnerable in late 2008 (because of its dependence on foreign capital that had ceased to be available) and had to be rescued by emergency government action to guarantee bank deposits;
  • the massive efforts to stimulate Australia's economy by governments and the RBA might prove to overheat the economy, though there were alternative possible outcomes

Arguably the key cause of problems in Australia's GFC response had been the dominance within government of an unrealistically narrow 'neo-liberalism-and-greedy-bankers-dun-it' view of the cause of a problem that has much broader / global origins.

Wider Understanding of the Problem [Preliminary]

In October 2009 Professor Ross Garnaut produced an analysis ('The Great Crash of 2008') which highlighted the wide range of factors involved in the GFC and implied that its effect on Australia would probably be much greater than had been generally appreciated. 

Perspectives on Professor Garnaut's Analysis:

The GFC had its origins in: (a) a boom / bust cycle which was normal except that it started with very long / strong period of global growth and resulted in the mainstream integration of emerging economies; (b) large imbalances in current account payments - especially associated with savings in East Asia (particularly China) and in commodity exporting countries, and deficits in Anglo-sphere; (c) the development of new financial instruments on unprecedented scale and complexity; and (d) increasing greed at the expense of society. Concerns about risk had declined because of sustained growth - and this distorted regulatory systems. [Professor Ross Garnaut in a podcast on The Great Crash of 2008]

Ross Garnaut has warned that the effect of GFC on Australia is only starting to be felt and is poorly understood. In a Lowy Institute address he warned of declining living standards, reinforcing concerns expressed in a recent book The Great Crash of 2008 (which had warned of the need for declining living standards to restore full employment and the risk of poor policy responses if the problem is not understood). He implies also that public policy in Western democracies will deteriorate in post-crisis environment because of the impact of interest groups on political intervention (which he argued recently was illustrated by ETS debate as an example of bad policy making). He suggests that government won't be able to deliver on community expectations for increasing defence / health / climate change expenditure. Garnaut's book suggests that a nation's recovery from the GFC will depend on: (a) whether banks failed; (b) current account deficit; and (c) deterioration in terms of trade - and that Australia will suffer because of the latter two. He is critical of RBA, Treasury and past Coalition government. Treasury, he suggests, was too complacent about current account deficits - as that originating in private debt (which can instantly become public liabilities in a crisis) should not be seen as irrelevant to macro-economic policy. Given the role of payments imbalances in GFC, a more prudent approach seems likely in future. Howard Government was said to have spent too much of pre-crash national income on the basis of unsustainable commodity prices - and Australians will need to accept that they were living beyond their means. Garnaut advocates pulling back on stimulus because of the severe adjustment Australia faces. Garnaut sees global financial system - whose benchmarks were set in US - as having failed comprehensively; and fears that necessary reforms may not be made while governments merely intervene un-necessarily in other areas. [1]

This is a very useful contribution to broadening understanding of the issues involved in the GFC, and many of Professor Garnaut's suggestions about the GFC's more complex implications for Australia seem appropriate (such as reconsidering the affordability of some political priorities; being less complacent about current account deficits; reviewing stimulus programs; and avoiding damaging economic interventions by governments).  

However, there remains a great deal more to be done (eg in terms of recognising the cultural dimensions of the problem; adopting more effective methods for economic development; and strengthening of Australia's system of government).

Wby: Based on the present writers attempt to identify causes of the GFC (in The Second Failure of Globalization), it appears that Professor Garnaut's book (The Great Crash of 2008) is correct in suggesting that those causes included:
  • the declining perception of investment risk associated with an unusually long period of sustained global growth - a period also associated with the integration of many (especially Asian) emerging economies into the global economy; and
  • the growth of financial imbalances, associated with (a) high savings levels in Asia; (b) current account surpluses both in Asia and in many commodity-exporting emerging economies; and (c) offsetting deficits mainly in the Anglo-sphere.

However there is an 'elephant in the room'. The economic models adopted in East Asia (in emulation of the methods Japan used to achieve its pre-1990 economic miracles) are based on cultural traditions significantly different to those in Western societies (see Understanding East Asian Economic Models). Those cultural features are moreover central to:

  • the uniquely rapid economic development achieved in East Asia, which allowed such economies to become globally significant; 
  • the current account surpluses that were essential in countries such as Japan and China to protect financial institutions that deploy capital at the initiative of nationalistic elites rather than through a capitalistic search for profit;
  • the consequent need for high-market-share-oriented export-led development, which then provided cheap imports that allowed extremely loose monetary policies to be pursed for years in the US without being derailed by the inflation that would otherwise be expected (see Outline of Current Situation, 2003).

Moreover those cultural / civilizational dimensions are central to real concerns that East Asian economic models (on whose success Australia's economy has become highly dependent) may not be sustainable in the post-GFC environment in which a more prudent approach to international imbalances will necessarily prevail. Japan, which pioneered those economic models, has been unable to adapt to a profitability-driven economic model and has recently indicated an intention to cease trying (see Which Identity Does Japan want Back?). And there is no reason to believe that China would be any more successful in creating financial institutions that would be secure in the absence of significant current account surpluses (see China: After the GFC).

Professor Garnaut is undoubtedly correct in suggesting that Australia needs to make major adjustments as a consequence of the GFC. However:

  • appropriate adjustments won't be made if the cultural / civilizational 'elephant in the room' continues to be ignored;
  • Australia will not necessarily have to adapt to past debt-fuelled over-spending by accepting declining living standards in future. Methods to further increase productivity (through accelerating economic development) may be available that would allow both: (a) high living standards; and (b) high savings to reduce net debts (eg see A Case for Innovative Economic Leadership);
  • while (as Professor Garnaut suggested) policy development in Western democracies is deteriorating and the ETS debate is a particularly bad example, the problem may be less the result of interest group pressure than of increasing complexity (which makes it hard to find realistic policies) and a trend towards political 'populism' ie political endorsement of superficially plausible but unrealistic policies based on oversimplifying issues (see Challenges to Australia's Democratic Institutions - which suggests institutional remedies for this problem). In particular the ETS debate seems to reflect a very poor policy process largely because of the populist pursuit of a simplistic 'answer' to a problem whose complexity is much greater than is being politically acknowledged (see Climate Change; 'No time to lose' in doing exactly what?, 2006)


An effective response must cover a wide range of areas including: more realistic government machinery; short term counter-cyclical policy; recognition of the need for structural adjustment and adoption of methods to facilitate change; ensuring effective community awareness and involvement; and participation in global initiatives.

 Success probably requires:
  • recognising the need for realistic (rather than idealistic) institutional reform to Australia's system of government in the medium term (eg along the lines suggested in Australia's Governance Crisis). The core goals of such reforms might involve:
    • enabling the community generally to better understand policy debates about complex issues;
    • competent apolitical Public Services to support the community's elected representatives;
    • reducing the complexity that governments have to deal with by (a) decentralization of responsibility and revenue sources; and (b) creation of apolitical community-based capabilities operating under democratically-endorsed protocols to stimulate action on opportunities and solutions to problems through enterprising or community initiatives without direct political engagement;
  • greater emphasis on fiscal policy (probably involving increased government borrowing) in stimulating economic recovery, than on monetary policy (because of constraints on the latter outlined above), while recognising the constraints that also apply to fiscal policy (see above). The IMF has suggested that governments go in hard and fast on efforts to minimize the effect of the financial crisis on the real economy - to prevent feedbacks emerging which cause the situation to get out of hand [1]. However the probability of a long term structural impact from the crisis makes this a difficult judgment (see above and Australia's Future Tax System: The Cost of the Financial Crisis and the Opportunity to Fix Government);
  • maintaining the integrity of the financial and monetary systems as far as possible, as these are equivalent to the 'nervous' system of the economy. The relationship between this and maintaining the value of property was demonstrated by the 1890s crash (see above);
  • recognition that the problem is structural rather than cyclical - ie that the past framework of economic globalization and sustained economic growth has probably 'broken', so that measures to protect economic activities from the changed situation are likely to be counter productive and the supply side of the economy requires at least as much support as the demand side (see Global Financial Crisis: The Second Test);
  • developing an industrial relations system that builds on past 'best practice' examples of enterprise based bargaining which promoting both flexibility and the equitable sharing of business income between investors and employees;
  • market-oriented approaches to accelerate economic learning within industry clusters to build the systemic capacity needed for all to prosper in a competitive environment (eg see Defects in Economic Tactics, Strategy and Outcomes and A Case for Innovative Economic Leadership). This should also improve productivity and international competitiveness - thus allowing a fiscal stimulus to be applied with lesser adverse current account implications;
  • providing financial incentives to state governments (who are the front line in government efforts to encourage economic development) to value real success in promoting high value-added activities (see Providing Incentives for Effective Economic Development);
  • caution in taking radical / 'quick fix' policy initiatives to stabilize the financial system, stimulate the economy and deal with the social consequences of the economic crisis. There are indications that efforts to do so have had unforeseen negative impacts (see above);
  • establishment of machinery which (a) enables information about the crisis to be assessed by grass-roots community leaders and also made publicly available; and (b) encourages those with current operational responsibilities to develop responses (including potential government initiatives) that would be assessed through their normal processes for accountability. This should mobilize initiative and also reduce the risk of: (a) ill-informed 'populist' policies; and (b) the counter-productive outcomes which can result from unintended consequences;
  • participation in global forums concerning the GFC which go beyond merely considering financial regulation and techniques for coordinated 'economic management' (see Obstacles to Effective Global Regulation).

Some suggestions about the implications of the GFC for reform of Australia's tax / transfer system are outlined in Australia's Future Tax System: The Cost of the Financial Crisis and the Opportunity to Fix Government.

Of particular significance is the fact that the high levels of transfer payments which have grown in recent years have been socially and economically significant by helping to maintain a reasonable level of income equality in Australia. They should not be assumed to be easily dispensed with unless arrangements are put in place to allow rapid economic change with less risk that individuals / regions will suffer long term disadvantage.

Overlooked Issues Affecting Australia's Banking System +


Overlooked Issues Affecting Australia's Banking System (email sent 23/10/10)

Hon Joe Hockey, MP,
Member for North Sydney,
Shadow Treasurer

Re: 'New-era finance sector must be held accountable', The Australian, 22/10/10

Your article suggested the need to review the way Australia's banking system operates.

My interpretation of your article: A socially responsible compact with banks is needed, as is a major debate about banking and financial services in Australia. The industry is changing worldwide as a result of Basel 3 rules. Government intensive-care of major banks is ending. Asia will be the most important source of future finance - though most major banks are in US and Europe. Some Australian banks are looking for growth in Asia. Two have indicated that they want to be growth based, rather than yield-based investments. However governments underwrite bank risks, and taxpayers have recently guaranteed bank deposits and spent billions to re-inflate residential mortgage backed securities. While recovery of international markets from GFC will take many years, recently funding costs have been flat. There must be a debate about the role of banks and their relationship with community, as they are not only custodians of deposits but also of superannuation. Treasurer has often asked banks not to increase interest rates above Reserve Bank changes - but this achieved nothing. There is a need for a social compact with banks, and a mature debate on where financial services are headed. This might result in: more liquidity in mortgage-backed securities; simplification of legislation; better prudential standards; less price signalling. Banking systems' direction must be acceptable to the taxpayers, shareholders and depositors, because taxpayers ultimately foot the bill in the event of bank failures.

While there are valid domestic reasons for such a review (eg the prospective shift to risky strategies by traditionally-conservative taxpayer-underwritten institutions), it is submitted that there is also a need for deeper consideration of the international issues affecting Australia's banking system than those mentioned in your article.

My reasons for suggesting this are outlined below. In brief it is suggested that: (a) Australia's banking system and its economy generally are dependent on the international financial system; (b) there are continuing instabilities in that system that have not been resolved through the G20; (c) Australia's banking system has been, and remains, exposed to this instability - and this poses risks to the economy generally; and (d) the future reliance on 'Asian' finance that your article suggested would tend to limit scope for 'free' enterprise, because the region's major financial systems don't operate on a Western-style capitalistic basis.

In any review of Australia's banking system such considerations should not be overlooked. It is noted that, in the various positive and negative reactions to your proposal (some of which are outlined below), the international issues that I have suggested seem to be generally overlooked.

John Craig

Detailed Comments

Domestic Banking Issues

There is no doubt that there are important domestic questions about Australia's banking system.

For example: shifting from yield-based to growth-based investment status implies shifting from deposit-taking / conservative investment activities towards more commercially-risky 'investment banking' activities. Keeping a separation between deposit-taking banks (which justify government underwriting of losses) and riskier investment banking was one of the key lessons of the Great Depression. This resulted in the Glass-Seagall Act in the US, and progressive repeal of that Act (in 1980 and 1999) is seen by many observers as facilitating the financial excesses in the US that contributed to the global financial crisis (GFC)

Australia's Dependency on International Financial Systems

However the international environment in which Australia's banks operate, and on which they (and through them Australia's economy) are dependent, is much more hazardous than your article indicated.

Australia's banks (and non-bank financial institutions) have strong linkages with the international financial system. One reason for this is that Australia's economy has traditionally run current account deficits (eg $50-60bn pa) which have had to be covered by capital inflow - and it is understood that this inflow has mainly been achieved by banks (and the originators of residential mortgage backed securities, RMBS) borrowing in international financial markets, for real estate lending. Thus Australia's economy is also macroeconomically dependent on offshore borrowing by banks (and RMBS originators).

Instability in International Financial Systems

Unfortunately the international financial system remains unstable and potentially crisis prone despite reform proposals such as Basel 3, and the efforts of the G20.

In brief the problem seems to be that: (a) some financial systems have been organised so as to gain mercantilist advantages in international trade; and (b) unsustainable financial imbalances have developed as a consequence, and have contributed to financial crises (especially to the GFC that emerged in 2007). In particular, it is noted that:

  • East Asian economic models appear to use financial systems as a form of protectionism (ie as a means for transferring income from the economy generally to subsidise state-backed export-oriented production), though the whole-of-society arrangements through which this is achieved have not been appreciated by most Western analysts - see Resist Protectionism: A Call That is Decades Too Late;
  • that form of protectionism has made global growth macroeconomically unsustainable, as it requires large domestic 'demand deficits' in countries with such financial systems and thus a willingness and ability by their trading partners to provide demand in excess of their income and thus to increase their debts indefinitely (see Structural Incompatibility Puts Global Growth at Risk, 2003). This probably played a significant role in the the emergence of the asset bubbles that led to the GFC (see Financial Imbalances in Global Financial Instability, 2007 and GFC Causes);
  • increasing concern has been expressed about the possibility of 'currency wars' in response to the associated trade imbalances. For example the US Federal Reserve apparently intends to use quantitative easing (QE, ie printing money) to stimulate the economy by purchasing US Treasury bonds. Given the de-leveraging by US households (who provide 70% of US demand) there is no chance that QE by the Federal Reserve is going to stimulate the US economy directly (ie few now want to borrow). Rather QE will presumably create a $US 'carry trade' which stimulates asset inflation and spending in countries whose economies are currently stronger (mainly the emerging economies) and thereby (hopefully) boost US exports and incomes (without further increasing US debts). This is the same as Japan has been doing since the 1990s through its monetary policies (ie creating cheap credit for which there was no local demand, and thus feeding into asset inflation and spending elsewhere through a Yen carry trade), and equivalent to what emerging economies (especially those in East Asia) have been doing by organising financial systems to ensure current account surpluses, and thus a flood of liquidity into other economies (especially the US).

Such problems have simply not yet been addressed by the G20 in its efforts to create the framework for a stable future global financial system (see Too Hard for the G20?). The most recent development in G20 deliberations involves an attempt by the US Government to head of 'currency wars' by seeking the adoption of rules to govern trade imbalances. However little progress is likely until the origin of major components of those imbalances in the way some systems of socio-political-economy are organised is recognised.

Australia's Exposure to Risks

Australia's banking system has been, and remains, exposed to this instability, and this has broader policy implications. For example:

  • the 'carry trades' (eg especially Yen in the past, and possibly $US in the future) that result from the creation of virtually zero-interest credit by Reserve Banks facing deflation risks have provided a source of cheap credit which has presumably boosted asset inflation (especially of real estate) in Australia, and thus contributed to problems in housing affordability when rates increase;
  • Australia's economy generally has been at risk because of the complex (virtuous or vicious feedback) relationship between: (a) the need for substantial international borrowing to cover Australia's current account deficits; (b) the balance sheets of Australia's banks and non-bank financial institutions; (c) the value of real estate; and (d) potential disruptions to the availability of capital through international financial markets (see, for example, Maintaining Capital Inflow). This vulnerability is indicated by:
    • the disruption of international capital inflow to Australia in the 1890s that led to: a withdrawal from property lending by banks; a collapse in property values; failures by banks when the biggest item on their balance sheets devalued; and a depression;
    • numerous warnings by the Bank of International Settlements (and others) in recent years about Australia's vulnerability to a currency crisis;
    • the federal government's blanket guarantees of bank deposits at the height of the credit crunch associated with GFC, (presumably) to prevent a recurrence of something like the events of the 1890s, and the need to provide capital injections to support RMBS originators;
    • Treasury Red Book advice to the incoming Gillard Government.

Though the issues involved in creating the potential for instability in the international financial system are hard, there are scenarios under which:

  • the present trend towards a 'currency war' could result in a severe disruption of the international financial system, and / or a dislocation of the 'China boom' on which Australia's economy has become dependent;
  • Australia comes to depend on finance from 'Asia' provided through neo-Confucian systems of socio-political-economy with which most Australians are unfamiliar (see Some Thoughts on the 'China Era').

Thus, though Australia traditionally relies on others to deal with such 'hard' issues, on this occasion there seems to be no safe alternative to doing so.

Reliance on Finance from 'Asia' Implies Constraints on 'Free' Enterprise

It is noted that some objections to your proposal for a social compact with Australia's banks have been based on this being a restriction on 'free enterprise'. However if, as your article suggested, Australia depends increasingly in future on finance from 'Asia' then this in itself implies constraints on 'free' enterprise, because financial systems in the region tend to provide finance selectively on the basis of connections with ethnic social elites (in the expectation of increasing the latter's economic power and thus the economic power of their ethnic communities) rather than to enterprises that simply have capitalistic prospects of profitability for investors (see Understanding East Asia's Economic Models).

Outline of Some Reactions

Joe Hockey may have blundered into issue of bank regulation, but he is right about the need for a fundamental debate about bank regulation. RBA showed that banks' claims about facing higher interest rates are rubbish. In debate he is seeking Hockey should look for: (a) greater competition for big banks - eg by government guarantee of RMBS; and ideas put forward by Six Economists about a people's bank. ACCC should also look closely at price signaling. He also raised fundamental issue of whether banks should be yield or growth stocks - an issue some economists have drawn attention to for some time. Banks' core activities (taking deposits and household / business lending) will never grow rapidly, but bank executives want faster growing share prices. Banks will only become growth stocks by involvement in riskier operations. It was their non-exposure to these that allowed Australia to survive the GFC. Now that want to grow faster - and to expand into riskier Asian markets with implicit government guarantee. This creates moral hazard. Banks want to be private companies while being regulated like utilities. These are issues that Hockey has now put on the table (Keane B. Hockey gets it right on banks Crikey, 21/10/10)

Since GFC, Coalition economic spokesmen have sought to keep bank interest rate increases to increases in RBA's cash rate. Over the past year this would have led banks to losses - and caused credit to disappear. Outcomes in UK and US illustrate what happens when banks make losses. There is no need for a new social compact, as banks already recognise obligations to community. ABA rejects suggestions that taxpayers had to bail out the banks, as government support was for the stability of the banking system and the economy (Federal Opposition's Interest Rate Policy is Dangerous, Australian Bankers Association, 21/10/10)

Joe hockey is taking a risk by entering debate about bank margins and profits, and threatening regulation. Bank profits appear large, but this is mainly because of the size of their capitalisation. Hockey referred to RBA notes on relatively flat bank funding costs in recent months. But the banks still face the problem of rolling over wholesale debt that was raised in the pre-GFC environment (Bartholemeuz S. 'Hockey's flawed rates reasoning', Business Spectator 21/10/10)

John Howard had a major role in opening up Australia's financial system (eg in setting up Campbell Committee). Once can only imagine his reaction to opposition Treasury spokesman, Joe Hockey, that government needs to stop banks raising interest rates above Reserve Bank cash rate. Even the Australian Bankers Association criticised Hockey's proposal. Leading bankers had gone to great lengths to explain to increasing costs of funds in post GFC world. But would-be-treasurer suggested that Treasurer should do more to stand up to banks. And would a social compact with community include requirements not to expand off-shore - eg into Asia. Such restrictions have been tried, and failed. As uproar grew Hockey said that he was not talking about regulating banks. Treasurer described Hockey's comments as incomprehensible and reckless. The real question is whether Hockey believes there is a need for more heavy handed economic regulation from Canberra. If so why stop at banks? (Korporaal G., Howard wrote book on RBA independence, 22/10/10)

Joe Hockey suggested government should constrain interest rate increases by banks. But this is not practical or good policy. Banks are businesses - and must be run for profit. Certainly banks received government support during GFC, and should not impose unreasonable harshness of mortgages - but market-oriented Liberal Party should not advocate direct interference and re-regulation. Bank bashing is good politics, but not good economics (Let the banks get on with their business', editorial, Adelaide Advertiser, 22/10/10)

Opposition Treasury spokesman demanded that Treasurer ensure that banks don't increase interest rates - but was not specific about how. There is nothing Canberra can do except reduced its own debts. Mr Hockey's subsequent article was sensible, but had nothing to do with constraining bank interest rates. One Liberal backbencher, Don Randall, though that this was a 'fringe lunatic idea' from the Greens. (Hockey should stop investing in junk policies, The Australian, 22/10/10)

Joe Hockey has won Greens support for his call for more government action to stop banks lifting interest rates above official increases (Kelly J. Greens swing behind Joe Hockey on bid for more control over bank interest rates', The Australian, 22/10/10)

Treasury boss Ken Henry said that opposition proposal for government to regulate interest rates would rob the poor of the chance of home ownership (Madigan M., 'Interest rate regulation would hit the poor's access to loans', Courier Mail, 22/10/10)

Joe Hockey's threat to punish banks that lift interest rates by more than RBA moves fuels doubts about coalition commitment to market reform. He expressed reservations about ANZ and NAB plans to expand into Asia, and said that new global banking regulations could be used to prevent mortgage rate increases above RBA moves. This caused confusion in Coalition - and the proposal was said to be not Coalition policy. The Treasurer described this as an attack on the basis of Australia's prosperity. DR Henry said that government could not control interest rates while RBA independently managed monetary policy. Malcolm Turnbull suggested that he was unaware of federal government regulation of interest rates in recent years. Mr Hockey said government could use implementation of new global banking rules to keep banks in line, and also called for a national debate on banks' roles (Uren D., 'Joe Hockey's bank stance worries Coalition', The Australian, 22/10/10)

Shadow Treasurer was criticised for most sensible suggestion about banks since GFC - ie by calling for debate about banking. He argues that banks have no reason for further unofficial interest rate rises. Banks are in privileged position - as mediators of savings and credit they have licence to print money, and are vital to smooth running of economy. After Wallis inquiry there was a split between regulation of banks, and RMBS securities that were left unregulated. Both types of institutions than conflicted, borrowing huge amounts offshore for investment in housing mortgages. When GFC arrived, both sides of regulatory structure failed. Non-banks relied on cheap short-term funding to fund long term loans - and this dried up. Banks also has similar problems. Since GFC markets have recovered enough to provide finance at reasonable rates - though these are higher than before GFC. So banks borrowing costs have risen. Banks can pass these on because there is no competition - ie because all banks borrowed monstrously off-shore. Suggestions about extending government guarantees to RMBSs is problematic. Better option would be more banks. Australia needs a new inquiry to determine nature of banking system in 10 years - especially given the new environment Australia is in (Llewyn-Smith D. 'Lay off Joe, he makes total sense on banks', Houses and Holes, 22/10/10)

ACCC sees a need for greater regulation of banks to prevent collusion - via price signalling. (ACCC adds voice to criticism of banks', 22/10/10)

Joe Hockey suggested using punitive measures if banks don't keep interest rates in line with Reserve bank cash rates. But can Parliament do this? Powers are already available, but are only used under exceptional circumstances. The problems with banks is their excessive market power - and this was increased by government during GFC. However small businesses have not been helped, and families now pay higher interest rates on mortgages - though interest rates on deposits have not risen, Banks lead the world in shareholder return. Banks need to be subject to community oversight - eg by a community representative on boards. An act is not the appropriate way to achieve oversight (Sathye M. Banks need reining in, but an act is not the way, 22/10/10)

Opposition has demanded that banks be punished for increasing interest rates above RBA increases, but then found itself being accused of re-regulation of rates. Hockey had referred to many levers being available, and to the possibility that the Opposition might itself take action, He eventually ruled out re-regulation and referred to a ;social compact' . Hockey's speech came two days after he tried to kill perceptions created by shadow finance spokesman, Andrew Robb, that government should try to influence the value of $A. Both Hockey and Robb have been accused of being out of date, and at risk of fracturing consensus that has been so important domestically and confidence in international economy (Coorey P. 'Hockey rate comments lift tensions in Coalition', Brisbane Times, 22/10/10)

ASX Merger with Singapore Exchange (email sent 25/10/10)

Tim Boreham

Re: Fund managers welcome Asian tie-up through Singapore Exchange , The Australian, 25/10/10

Your article noted:

"..... National interest sensitivities on both sides of the deal could also frustrate the path to regulatory and shareholder approval. ..... (and)

Arnhem Investment Management portfolio manager Mark Nathan said "sovereignty issues" made a true cross-border arrangements difficult to structure."

In this respect, it is worth considering the sensitivities that were exposed to Singaporean investment some years ago (see Competing and Collaborating Economically in South and East Asia) and also the comments that tend to be made about Singapore's system of socio-political-economy (see various articles in East Asia). The latter referred, for example: to (a) Singapore's emergence as a centre allowing secret banking - as Switzerland is forced to more openness; (b) Singapore's original success arising from money laundering for corrupt Indonesian officials; (c) China's probable shift towards something like a Singaporean model - which would not involve true democracy; (d) Singapore's society being highly patriarchal and based on Confucianism - with reforms not leading to democracy; (e) the prevalence of old-style authoritarian capitalism - and hypocritical Asian values which suppress political opposition and dissent; (f) Singapore's competitiveness constraints due to heavy state intervention; (g) Singapore's 'soft' authoritarianism; and (h) 50% of Singapore's people reportedly wanting to leave.

For Australia, reliance on 'Asian' finance generally poses difficult issues which are only now starting to be seriously considered (see Overlooked Issues Affecting Australia's Banking System) and, though Singapore is a 'soft' version of 'Asia', it raises much the same issues. Moreover, as the latter document also implies, the financial systems emerging under 'Asian' models of socio-political-economy arguably contain macroeconomic distortions that make global economic growth unsustainable - a fact which seems likely to trigger an international crisis fairly soon because it is colliding with the economic welfare of the world's only superpower (see Instability in International Financial Systems). In this environment the assured access by 'Asia' to Australia's coal and iron ore resources (and thus influence over institutions through which mineral and energy projects in Australia are organised) will be increasingly strategically significant.

John Craig

Proposed ASX Takeover: Lifting the Level of Debate (email sent 1/11/10)

Rowan Callick,
The Australian 

Re ‘Merger talk shows our ugly side’, The Australian, 29/10/10

 Your article correctly suggested that the proposed merger between the Australian and Singaporean Stock Exchanges could show Australia’s ugly side.  

My interpretation of your article: Australian politicians have reacted shamefully to the ASX takeover. Goh Eng Yeow (Straits Times) described this as a ‘vitriolic outpouring’. The details of the deal are not yet known, and debate is needed because regulatory changes are being sought. But the tone of the debate is that Australia is superior to Asia – with an instinctive resistance to engagement. All that is needed is for Pauline Hanson, the queen of such posturing to get involved. The PM has spoken out against the Hansonist anti-reformists in the Coalition – but won’t take on the Greens over this. It sounds in Asia as if the Ugly Australia is back. Goh Eng Yeow wrote that independent politicians had too much power in Australia, and that parochialism could scupper the deal. Swedish SXG CEO (Magnus Bocker) has experience in merging exchanges, and has made an effort to achieve this. Greens mentioned Lee Kuan Yew’s warning about Australia as ‘poor white trash of Asia’, and this would have been true if Australia had not opened in ways Greens would oppose. Greens’ leader said that Australians are not regarded as equals. There seems to be an assumption that because the process through which shares are bought and sold involved an overseas exchange, the way in which business raises funds would become tainted.   The Coalition did not wait for more information, or welcome engagement with Australia’s Asian neighbourhood. Opposition Treasury spokesman (Joe Hockey) suggested that Singapore was Australia’s competitor for financial services jobs. When Hansonism was surging, many expressed concerns about the long term consequences, but none have gone in to bat for closer engagement. Australia is happy to celebrate its good fortune due to resource demand, but does not want to have much to do with it after shipping them out. Australia depends increasingly on Asian capital to keep businesses going, and Singapore has invited Australians onto boards – a step that has not been reciprocated. Australians are not white trash, but sometimes they talk as if they are.

One of the uglier sides of Australian politics is that attempts are made from time to time to sway debate about issues by alleging that opposing arguments must be based on racism (see examples at the end of this email).

It would be a pity to see this happen in relation to the proposed Singaporean takeover of the ASX, because there are real and difficult issues to consider in potentially changing the way such an institution is controlled (as the ASX can potentially influence, or facilitate access to strategic information about, the way businesses are being financed). Issues that may need to be considered in relation to that proposal are suggested below. They include:

  • differences between East-Asian systems of socio-political-economy, such as that in Singapore, and Australia’s individualistic, democratic, capitalistic practices, and consequent differences in the goals of ‘business’ (ie seeking economic power for elites on behalf of their ethnic communities, as compared with seeking profits for investors);
  • the risks that Australia faces through increasing reliance on ‘Asian’ finance and economic growth, because the macroeconomic distortions that are embodied in financial systems in East Asia are unsustainable, and probably nearing their ‘use-by’ date;  
  • the sensitivities that have long arisen in Australia as a result of exposure to Singapore’s system of socio-political economy; and
  • the potential to reduce the tax revenues that Australia gains from mining investments, if investments were facilitated under ‘Asian’ business practices.

Such issues need to be understood, and taken into account, in making any decision about the proposed takeover of the ASX – though this will clearly be difficult because of the pervasive lack of Asia literacy that prevails in Australia even amongst those who purport to be experts (see Babes in the Asian Woods).

In this environment, playing the ‘racism card’ (which can do nothing but stifle serious debate about the complex issues involved) would not be helpful.

John Craig

Issues Requiring Consideration in Relation to ASX Takeover

The systems of socio-political-economy that have emerged in East Asia (and in Singapore) arise from cultural traditions that are quite unlike the West’s classical Greek and Judo-Christian heritage (see East Asia in Competing Civilizations). Though those systems have strengths (eg allowing accelerated catch-up economic development) their characteristics need to be considered in relation to questions about control of the ASX (as the latter can influence, or provide access to strategic information about, the way businesses are being financed).

In brief East Asian systems of socio-political-economy involve: (a) economic activities that are coordinated by relationships amongst social elites and their subordinates, rather than on the basis of the profitability of independent enterprises; (b) seeking to maximize market-share / cash flow rather than business profitability; and (c) a consequent necessity for ‘demand deficits’ (ie a very high savings rate and thus current account surpluses) to avoid the need to borrow in international markets because institutions tend to have unsound balance sheets (see Understanding East Asian Economic Models).

Australia needs to seriously consider the risks associated with increasing economic reliance on ‘Asian’ growth or finance. This has not yet been done, though it involves difficult and increasingly important issues (see Overlooked Issues Affecting Australia's Banking System). Amongst other things the latter document noted that the financial systems emerging under 'Asian' models of socio-political-economy:

  • embody a novel form of protectionism by transferring national savings to state-supported producers at the expense of the economy generally;
  • contain macroeconomic distortions that make global economic growth unsustainable – because of the necessity they create for their trading partners to be willing and able to run current account deficits and accumulate increasing debt levels indefinitely;
  • are likely to trigger an international crisis fairly soon, because the macroeconomic distortions they embody have reached their limits. In the event of such a crisis, access by 'Asia' to Australia's coal, natural gas and iron ore resources (and thus influence over institutions through which mineral and energy projects in Australia are organised) could become strategically significant for geopolitical reasons that are not limited to economics. 

Options to reduce such risks include: (a) taking the development of Australia’s economy seriously (eg as suggested in A Case for Innovative Economic Leadership); and (b) ‘nation building’ to make governments, and other important institutions, more effective (see A Nation Building Agenda).

As implied above, business’ goals in ‘Asia’ are quite different to those that are traditional in Australia (ie the difference between seeking economic power for social elites presumably acting on behalf of their ethnic communities; and seeking ‘profitability’ for investors).  And, though Singapore is an extremely attractive version of 'Asia', the way business is done there has caused concern to diverse observers. Consider, for example:

  • Singapore has few peers for one-party rule. There are no political independents – and Singapore’s ethos involves merging mammon and political muscle. Singapore’s parliament comprises hand-picked loyalists and is mainly a rubber stamp. Real power in every institution gathers pyramidally and peaks with one of the world’s most powerful families, the Lees. Singapore has little corruption, but a great deal of intimidation by well-rewarded cronies. The Lee family has a role in the proposed ASX takeover. In the past other takeovers in which the Lees were involved have been successful through offering premium payments, by drawing upon the wealth of Singaporeans generally ….. [and more on suggestions of crony capitalism associated with Singapore] (Ellis E. ‘The money-making machine of Singapore Inc, 30/10/10)
  • the sensitivities that Singaporean investment caused some years ago (see Competing and Collaborating Economically in South and East Asia);
  • diverse comments by observers about Singapore's system of socio-political-economy (see East Asia), such as: (a) Singapore's emergence as a centre allowing secret banking - as Switzerland is forced to more openness; (b) Singapore's original success arising from money laundering for corrupt Indonesian officials; (c) China's probable shift towards something like a Singaporean model - which would not involve true democracy; (d) Singapore's society being highly patriarchal and based on Confucianism - with reforms not leading to democracy; (e) the prevalence of old-style authoritarian capitalism - and hypocritical Asian values which suppress political opposition and dissent; (f) Singapore's competitiveness constraints due to heavy state intervention; (g) Singapore's 'soft' authoritarianism; and (h) 50% of Singapore's people reportedly wanting to leave.

Similar observations added later: Treasurer accepted FIRB advice to reject ASX takeover because it would be contrary to national interest (as a result of Singapore Government control of ASX and loss of jobs). Study suggests that ASX takeover would have created no synergies and had negative economic impact. Takeover failed 5 of FIRB's 6 tests. Singapore government is main shareholder in SGX - through Temasek (Singapore's sovereign wealth fund) whose CEO is PM's wife. Temasek is supposed to have non-voting role - but this is a veil. There are many connections between SGX, its regulator (Monetary Authority of Singapore), Singapore Government and Singapore's ruling families. A director of SGX is PM's brother. Singapore media also have to do government's bidding. There is a form of crony / state capitalism where powerful can do what they like - with little evidence of a rule of law. SGX and its regulators are notorious for poor corporate governance and a lack of transparency. SGX is in partnership with Chi-X which is alternative exchange in Australia, and this would have limited competition. ASICs ability to regulate ASX under SGX control would be limited as the latter is subject to direction by Monetary Authority of Singapore.

Changing the way the ASX is controlled may also be significant in relation to proposals to address Australia’s structural budget deficits by increasing taxation on profits from mining investments, because of the scope that exists to reduce or even avoid such taxation through mining operations conducted under 'Asian-style' business practices (see RSPT Won't Hurt Miners: But Pity Help Naive Australians).

Examples of Playing the ‘Racism Card in recent years have included:

  • trying to prevent regional communities from expressing grievances that arose from unbalanced economic strategies - see Assessing the Implications of Pauline Hanson's One Nation (July 1998). Market liberalization had required Australians to become more economically competitive, yet little was done to reduce the systemic obstacles to competing successfully that faced those in economically marginal regions (see The Inadequacy of Market Liberalization). When unsophisticated disadvantaged communities expressed their frustration, they were typically not offered help (or even a sympathetic ear), but rather were criticised because of the ‘racist’ spin placed on some of the remedies they sought (eg treating all people equally);
  • discouraging expressions of concern about people smuggling, though the latter was hardly the best way to deal with the humanitarian disaster represented by the world’s umpteen million refugees (see Complexities in the Refugee Problem from November 2001).

Pollies need Asia-literate help in deciding on Asia links (email sent 9/12/10)

Bryan Frith
The Australian

Re: ‘Pollies need to decide whether we swim in Asia or sink at home’, The Australian, 9/12/10

Your article outlined the support which a study by Access Economics has given to the proposal to sell Australia’s stock exchange (the ASX) to Singapore’s exchange (the SGX). However that analysis was a grossly inadequate form of national ‘due diligence’, as it made no mention of the nature or implications of the difference between Singapore’s neo-Confucian system of socio-political-economy and Australia’s liberal-democratic-capitalist traditions.

In a parallel article another journalist, Glenda Korpooral, supported your implication that Australia needs to rely increasingly on Asian capital. However this also raised issues (such as the durability of the ‘East Asian’ economic models) that can’t be properly understood on the basis of simplistic economic hype.

Thus, for reasons that are outlined further below, I respectfully suggest that Australia’s politicians need to look beyond Asia-illiterate advisers in considering questions such as the proposed Singaporean takeover of the ASX.

John Craig

Outline of Article and Detailed Comments

My interpretation of your article: Some argue that ASX should acquire Singapore’s stock exchange, but the decision to allow other operators into Australia reduced ASX capitalization and its ability to take the leading role. Access Economics found that proposed merger would: lower capital costs for Australian companies; improve Australia’s chance of becoming a financial hub; and improve Australia’s ability to diversify savings. It rejected sovereignty concerns (noting that regulatory oversight would remain with ASIC and RBA). The 23% Singaporean Government holding in SGX was seen as irrelevant, as it involves no voting rights. Access Economics also noted that: stock exchange consolidation is a global trend; the merger would build conduits to Asian capital, and connect Australia fund managers to Asian savings pools; there are complementarities between ASX and SGX capabilities; SGX is the most logical partner for ASX; rejection of mergers has tended to be based only on public opinion. Politicians need to decide whether Australia and its funds management industry are to be connected to fast-growing Asian capital markets or stagnate in a domestic pond.

There is no doubt that Australia needs to make decisions in relation to connecting the Asian capital markets (such as by a Singaporean takeover of the ASX). However politicians needs Asia-literate help in making that decision, which Access Economics appears unable or unwilling to provide. Some speculations about the issues involved are outlined in Proposed ASX Takeover: Lifting the Level of Debate. For example, Access Economics noted the lack of voting rights which the Singaporean Government has in the SGX as a reason to ignore the substantial Singapore Government's substantial shareholding in the SGX, but this is beside the point under neo-Confucian systems of socio-political-economy where political and economic power are linked through social relationships amongst ethnic elites, rather than by legal formalities such as voting rights as they would be in Australia.

It is noted that Glenda Korpooral’s parallel article today supported your implication that Australia needs to rely increasingly on Asian capital.

My interpretation of Ms Korpooral’s article: Hong Kong has become home of the largest pool of new listings in the world. The proposed ASX- SGX deal needs to be considered in the light of Asia as an emerging capital raising power-house. New listings in Hong Kong have raised $US 50bn this year – so that, despite weaknesses in Europe and US, this year is likely to set a new record for global capital raising. Many IPO’s in Asia have been over-subscribed. Relatively modest amounts of capital have been raised through the ASX. Australian politicians are continuing to argue about dividing the pie, while Asia is focused on growth and new sources of growth. Supporters of ASX-SGX merger suggest that it would be like putting a pipe directly into Asian savings pools and create much wider range of investments for Australians’s superannuation funds. Past attempts to generate cross-border flows of funds informally have been unsuccessful. Australian institutions can have quite different perceptions to international investors. Queensland’s Treasurer, Andrew Fraser, noted this difference. There are serious questions to consider in relation to ASX-SGX merger, but this needs to be debated in terms of merits of the deal, and how Australia can tap into the Asian economic powerhouse, rather than in terms of populist reactions.( Vale's Hong Kong listing an eye-opener, The Australian, 9/12/10)

Creating a situation in which Australia relies heavily on obtaining capital in Asia raises very complex questions, and these also require Asia-literate analysis to which Australia’s politicians clearly do not yet have access. For example:

  • The very high rates of savings in ‘Asia’, which help make the region into a possible source of capital, are also the ‘savings gluts’ (and consequent domestic demand deficits) that pose serious global macroeconomic difficulties in sustaining economic growth (see Understanding East Asia's Economic Models and Impacting the Global Economy). To over-simplify, neo-Confucian models of socio-political economy involve resource allocation by ethnic social elites and their subordinates seeking to maximizing cash flow / turnover (ie to increasing the economic power of their communities), rather than independent enterprises seeking profitability. This arrangement is only viable so long as domestic demand is suppressed so that there is no need to borrow in international markets, thus requiring also that trading partners be willing and able to perpetually run current account deficits (and sustain rising debts) to counter-balance local demand deficits. Though the US is still naively struggling to support an international economy where financial imbalances have escalated, because many economies have moved away from the US’s liberal-democratic-capitalist ideal, it is likely that economic models reliant on favourable imbalances are approaching their use-by date (see G20 in Korea: Unreal Optimism?);
  • Where financial systems are rigged to provide subsidies to state-favoured producers at the expense of a community generally (see Resist Protectionism: A Call That is Decades Too Late ), the balance sheets of banks are likely to be suspect. There thus appears to be something of a ‘Ponzi’ quality to financial systems in countries such as China (see China’s Ponzi-like Economy). Certainly ‘Asia’ is seeking to promote growth and new economic activity, but this may a reflection of desperation because, if the money shuffling stops, balance sheets might be found to be unsound (just as happened to the ‘empires’ of the entrepreneurs who built financial houses-of-cards in Australia after deregulation in the 1980s). It can also be noted that: (a) Ireland’s financial disaster was seen to be linked to its shift to unsafe reliance on property after its foreign-investment and export-led growth faltered (see Arlidge J., 'Irishman walks into a bubble', The Australian, 17/11/10); and (b) about 60% of China’s GDP involves investment – a not inconsiderable component of which involves property and the creation of apparent-over-capacity in various industries;
  • Cash-flow / turnover (ie economic power) oriented investors in ‘Asia’ undoubtedly have a different perception of investment opportunities in Australia compared with profit-seeking local institutions. Where ‘Asian’ producers reliant on Australian raw materials could have the opportunity to directly control mining operations and then sell commodities on very low margins, the scope to thereby avoid paying profit-based Australian taxes is presumably appealing – but not necessarily in Australian’s interest (eg see RSPT Won't Hurt Miners: But Pity Help Naive Australians).

ASX Takeover Proposal - email sent 4/1/11

Professor Peter Swan
University of NSW

Re: Treasurer should ban ASX takeover, The Australian, 4/1/11

Your reservations concerning the ASX takeover proposal (ie the small scale and relative inefficiency of Singaporean exchange) seem appropriate.

I should like to suggest that there is also a need to take account of the character of the systems of socio-political-economy that appear to prevail in countries such as Singapore (see Pollies need Asia-literate help in deciding on Asia links).

In terms of the issues raised in your article this (probably) has relevance because, in financing the ASX takeover proposal, the Singaporean exchange is likely to be: (a) drawing on the resources of Singapore as a whole orchestrated through political connections – rather than the resources of private investors; and (b) motivated by a desire to increase economic power (ie market share and turnover) rather than profitability. This same feature tends to invalidate the argument developed in Access Economics’ report on the proposal – ie that this takeover would facilitate access to ‘Asian capital’ – because ‘Asian capital’ is not able to be provided on the basis of the balance sheets of financial institutions, but rather requires drawing upon cash flows generated by high-turnover production with limited regard to profitability and enforcing a high rate of national savings. As the demand deficits and international imbalances this strategy requires are getting close to disrupting global economic growth, ‘Asian capital’ could cease to be available to anyone (because, if the strong cash flows abate, there would be no basis for providing capital) .

Another point of relevance relates to your observation about transparency (and its effect on transactions through an exchange). East Asian economic / financial systems are arranged to boost the prospects of ‘insiders’ connected to the local regime, not of ‘outsiders’ – so transparency is not valued. The fact that South Korea seems (based on comments about this in your article, and some other indications) to have moved away from the type of system that prevails in various ways in Japan, China and Singapore is interesting.

John Craig

Blocking the ASX Takeover: The Effect on Australia's Image in Asia (email sent 6/4/11)

John Durie,
The Australian

Re: ‘Singapore sting hurts our image’, The Australian, 6/4/11

Your article suggested that there are defects in the way a decision was reached about the proposed ASX takeover. Your article was introduced by the subheading ‘Strategic leaks suggest that the decision making process was flawed’, and it then went on to state:

“Treasurer Wayne Swan has put politics ahead of due process in signalling opposition to the Singapore takeover of the Australian stock exchange without proper examination. The move -- and how it was done by way of a negative indication before a final decision -- neatly explains why foreign investors are increasingly weighing up sovereign risks when deciding on Australian investments. There is growing evidence the government's decision-making process lacks integrity.”

There is no doubt that the decision making process was not transparent. No one knows why the Foreign Investment Review Board (FIRB) concluded that the takeover would not be in Australia’s interest. The decision may have reflected the xenophobia of economic nationalists, as one observer feared (Keane B. ‘Australia’s black box of foreign investment regulation’, Crikey, 6/4/11). Or, as perceived by an international observer, the FIRB may simply have continued Australia’s well-recognised aversion to the takeover of strategic businesses by state-linked investors.

Australia's foreign-investment approval process has been criticized for decades as being opaque and unpredictable, but two clear trends have emerged: the vast majority of applications are uncontentious and approved, but problems are likely to arise when state-linked investors look to take control of a strategic business.” (Australia Defends Blocking ASX-SGX Deal, Says Open to Investment, CNBC, 5/4/11).

Alternately the FIRB may even have taken Asia-literate account of the effect on Australia’s future prospects of control of the ASX (an institution which can influence how business financing occurs) by the SGX (an institution effectively, though non-transparently, controlled by the families who also control Singapore’s Government). As was suggested in Proposed ASX Takeover: Lifting the Level of Debate (2010), it was impossible to assess the implications of the proposed takeover on the basis of economic principles relevant to Western systems of political economy, because of the radically different character of the neo-Confucian systems of socio-political-economy that appear to prevail in countries such as Singapore..

Whether or not an Asia-literate approach was taken to assessing the ASX takeover proposal, the lack of transparency associated with the decision to recommend against it should improve Australia’s image in ‘Asia’, because it conforms with traditional ‘Asian’ practices.

John Craig

Finding Australia's Place in the International Financial System (email sent 7/4/11)

The Australian – for consideration not for publication

Re: ‘Acting in the national interest’. Editorial, The Australian, 7/4/11

I should like to try to add value to your suggestion about moving on from Singapore’s ASX takeover proposal towards finding effective ways for Australia to participate in international financial markets.

My interpretation of your editorial: The SGX bid was for a takeover not a merger. But given a choice between market forces and politically expedient populism, the markets are better. Governments must keep the nation open for business. A case can be made that ASX should follow global trend towards merging with larger exchanges, though this would have left it subject to directions by Monetary Authority of Singapore. A relevant question is what would have happened if ASX had wanted to buy SGX – and Singapore Government (which has large stakes in key companies) would have rejected this. Wayne Swan has left the door open to the SGX to give reasons not to accept FIRB recommendations, but is most unlikely to do so. Having to give reasons for this could damage international relations. Now the priority must be to set policies that allow Australia to take its pick of international investments (as countries such as Singapore have been able to do) – eg by a dedicated savings fund to lock in benefits of the mining boom.

Firstly your observation about the desirability of acting in accordance with market forces rather than political considerations makes a great deal of sense. The fact that East Asian systems of socio-political-economy make no distinction between politics and market forces (ie markets are orchestrated / rigged by the social elites who also control governments) is the reason that it was impossible to realistically assess the ASX takeover proposal without understanding how those systems work (eg see Pollies need Asia-literate help in deciding on Asia links and Blocking the ASX Takeover: The Effect on Australia's Image in Asia). Unfortunately it seems that journalists writing for The Australian continue to comment on this issue without the Asia-literacy to do so competently (as illustrated by examples following this email).

Secondly the international financial system that Australia needs to participate in effectively, both as provider of financial services and as the originator and destination of foreign investment, is in crisis and likely to undergo very significant changes. Current arrangements are made unsustainable by structural macroeconomic imbalances in ‘Asia’ that translate into ‘savings gluts’, and require international financial imbalances. Serious attempts to find a solution to this problem have not yet been made (eg see G20 in Korea: Unreal Optimism) because the way in which neo-Confucian systems work and contribute to the imbalances is not easily perceived by the Asia-illiterate. The excess savings that seem to make strong links to ‘Asia’ attractive in order to finance investment in Australia at present are also the reasons that global economic growth will prove unsustainable unless those systems are transformed (see Should Fixing the International Monetary System Start in Asia?).

In order to position Australia in the international financial system that is likely to emerge over the next few years there is a need to look beyond the current environment and consider what sort of environment is likely to exist in 5-10 years’ time.

Finally, in seeking options for Australia to participate in the expected future international environment, there is a need to involve all elements of the current financial system (and their international associates) in a process of discovery about that likely environment and how complementary initiatives could be taken to benefit from it. What will be required for success is systemic change, rather than isolated initiatives (such as the savings fund suggested in your editorial) as the latter would not necessarily be compatible with, or complementary to, other initiatives. Accelerated development of the financial system as a whole might be achieved by methods similar to those suggested for developing Australia’s innovation capabilities in A Case for Innovative Economic Leadership

John Craig

Examples of Articles that Reflect Little Asia-Literacy

In today’s Australian articles concerning the ASX takeover proposal have simply referred to:

None of these writers seemed able to view the issue except in terms of the market logic that makes sense in Western economies, but does not really apply in anything like the same way in ‘Asia’ (eg see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy). Many other examples of Asia-illiterate policy analysis are outlined in Risks from Asia-illiterate Policy Making

ASX and the Free Market - email sent 14/4/11

John Roskham,

Re: ‘Free market in chains’, Australian Financial Review, 8/4/11

Your article suggested that the government’s decision to block the proposed Singaporean takeover of the ASX showed a lack of commitment to the free market principles that have boosted Australia’s economic performance since the 1980s.

However this is quite the reverse of the real situation – as there is nothing ‘free’ about markets in neo-Confucian ‘Asia’ (including Singapore). One reason given by the government for blocking the takeover was Australia’s inability to then regulate the market. What needs to be recognised is that markets (and everything else) in neo-Confucian ‘Asia’ are governed by a ‘rule of man’, rather than by a ‘rule of law’ (see East Asia in Competing Civilizations). Thus, had the takeover proceeded, a key element of Australia’s economic infrastructure would no longer have been regulated under a ‘rule of law’ (which is the basic requirement for a ‘free’ market). Rather it would have been subject to control by the social elites who control Singapore’s government and ‘market’ economy and whose anything-but-free-market reputation is outlined in Proposed ASX Takeover: Lifting the Level of Debate.

The pervasive lack of Asia-literacy in Australian institutions remains the major obstacle to the survival of the free market. Similar points were made earlier in Finding Australia's Place in the International Financial System.


John Craig


Benign Effects - So Far

Benign Effects - So Far - email sent 11/7/12

Professor Mark Wooden
University of Melbourne

Re: The benign effects of the ‘Great recession’, The Conversation, 10/7/12

Your article drew attention to the benign effects of the ‘Great Recession’ that has accompanied what has been called the Global Financial Crisis (GFC).

I should like to submit, with respect, that ‘you probably ain’t seen nothing yet’ – because there has been no serious effort to come to grips with the implications of the GFC for the sustainability of global economic growth (ie those related to the international financial imbalances that played a key role in generating the GFC).

Australia was initially expected to suffer from the effect of the Asian Financial Crisis in the late 1990s, but was little affected because commodity exports remained strong. Those commodity exports were not ultimately to ‘Asia’ (which was in recession at that time) but rather mainly involved providing inputs to exports from ‘Asia’ to the US and Europe (whose demand was not much affected by the Asian crisis).

Australia has also been relatively sheltered from the effects of the GFC (so far) because strong commodity export demand has resulted from counter-cyclical responses to the GFC in the US and China (in particular) involving fiscal and monetary policy measures which both have had the effect of escalating public debts. However, as was suggested in an initial assessment of the GFC’s challenge to Australia (Defending Australia from the Financial Crisis? , 2008) further stages of the GFC were likely to involve:

  • sovereign debt problems - which are now apparent in Europe, and on the point of gaining recognition in the USA as it approaches its ‘fiscal cliff’; and
  • economic problems in ‘Asia’ because poorly developed financial systems would be in crisis when external demand proved insufficient to provide the protection that current account surpluses provide.

As nothing has been done to address the problems associated with financial imbalances, the GFC is presumably anything but over (eg see G20 in Washington: Waiting for Hell to Freeze Over?, 2011). And further stages are very likely to adversely affect Australia’s major commodity markets (eg see Are East Asian Economic Models Sustainable? and China: Heading for a Crash?). Moreover the number of economies that are likely to experience problems when major deficit economies are eventually forced into general austerity has escalated. One effect of the Asian crisis was that many more countries with poorly developed (eg crony capitalist) financial systems discovered that (like Japan and China) they also could obtain protection from such crises by seeking current account surpluses and thus adding to the constraints on the global economy associated with financial imbalances (see Leadership by Emerging Economies?).

I would be interested in your response to my speculations.

John Craig

A Banking Royal Commission and a Potential Financial / Banking Crisis at the Same Time?

A Banking Royal Commission and a Potential Financial / Banking Crisis at the Same Time? [Working Draft]

External sources: The following draws upon a large number of external sources that are outlined in: (a) How Durable is Australia's Luck?; (b) Are Unfinished Apartments a Risk for Australia Also?; (c) An Approaching [Global] Crisis; and (d) [China] Heading for a Crash or a Meltdown?.

In April 2016 Australia's federal Labor opposition proposed a two year royal commission into Australia's banking system because of various scandals and behaviours that have adversely affected the community. The federal government responded by suggesting that the Australian Security and Investment Commission (ASIC) could be more effective than a royal commission in dealing with those issues. Independent observers have expressed various views about this matter including preference for the royal commission option (eg see Ferguson A., ASIC moves welcome but banks must feel the royal commission blowtorch, Business Day, 20/4/16)

However, while there are undoubtedly non-trivial issues that such a commission could investigate, the issue is arguably more complex than 'royal commission' advocates (and their opponents) have considered. A desk-top study to identify those complexities would be a wiser way to start than a royal commission to deal with what could be a small part of a big issue.

For reasons outlined below Australia faces a non-trivial risk of financial and banking crises.  If a royal commission applies a 'blowtorch' to Australia's banks to achieve domestic political goals in the middle of a financial / banking crisis which partly has its source in international financial instabilities, banks would be even more severely hampered in their ability to deal with that emergency. 

Australia's Risk of Financial / Banking Crises as Growth is Driven by Rapidly Rising and Often Misdirected Debt  [<]

The sources mentioned above suggest that Australia has (after China) apparently been the second most reliant country (perhaps the most reliant) on rapid increases in debt to support economic growth in recent years. This creates risks because: Australia's overall 'national' (ie household, government and corporate) debt / GDP ratio has become very high;  a significant component (eg 40%) of new debt has been off-shore funded - and thus would be at risk (or at least more expensive) if Australia's national creditworthiness worsened; undisciplined investment in the post resource-boom era has created risks of significant financial losses due to a large over-supply of apartments in major cities; and rapidly rising government debts have reduced the credibility of government guarantees of Australia's banks who traditionally borrowed offshore to cover Australia's current account deficits and are heavily (eg 60%) exposed to real estate.

Australia's national debt was 243% of GDP in mid 2016 and has not been incurred productively with $9 debt required for each $1 rise in GDP [1]. National debt ($3.5tr) was 217% of GDP ($1.5tr) in 2014. Private debt was $1.7tr [1] . Household debt (130% of GDP) is higher than than anywhere else in developed world [1].  Private debt / GDP ratio has never previously been as high as it is now - with the previous record being 60% of GDP during 1880s' property bubble [1]. Property investment has been a major factor in rising household debt. Mortgage debt rose from 15% of GDP in the late 1980s to 95% of GDP [1]. Following GFC the average private debt in developed economies fell from 170% of GDP to 160%. In Australia it rose over 20%. in 2016 private debt is likely to be $3.4bn while GDP is around $1.6bn [1].

The IMF suggested that Australia faces risks because of its high debt levels. // Australia's net foreign debt ($US1.045tr) has been rated as extreme by Standard and Poors. // Australians are deeper in debt than ever and wages are growing at the slowest pace. The RBA warned that debt / income ratio is the worst ever - weakening Australia's ability to withstand a financial shock. Households' ability to borrow further to sustain demand is constrained because the household-debt to GDP ratio is now very high (because low interest rates encouraged high debt levels to acquire real estate).

The high rate of borrowing to sustain economic growth as the resource investment boom weakened has been heavily focused on real estate. Australia's banks have traditionally imported capital to offset Australia's structural current account deficits and directed this to real estate. There has also been a boom in the development of Australian apartments (apparently driven largely by Chinese investors - though the actual extent of this is uncertain). The boom created a significant over-supply as had previously occurred in China and thus a potential for large financial losses.

Australia's very high economic dependence on increasing debt to sustain growth (eg because post resource boom growth has been driven by debt-financed apartment building rather than by competitive advantages) has been seen as a risk. // Morgan Stanley has warned about economic dangers associated with Australia's apartment market

APRA has sought to reduce these risks by tighter prudential regulation (eg to increase banks' capital base relative to their lending and tighten lending conditions). At the same time China has made increasing desperate efforts to control capital outflow / flight because of concern about its own risks of a debt crisis (see below) .

Australia's post-GFC control over government spending has been the worst of any G20 nation, and the opportunity that strong growth provided to bring the deficit under control was lost.

However others suggest that these risks are limited because: (a) Australia's institutions are quite effective and high household debts are usually incurred by those with a sound capacity to pay; and (b) the balance sheets of banks are sound after 25 years of growth .

International financial markets have come to view investment in Australia as a 'proxy' for investment in China. Investment in Australia is much less complicated than investing in China and Australia's economy has benefited from (and become highly dependent on) the commodity demand (especially coal and iron ore) that has been associated with China's industrial, property and infrastructure driven growth. The 'China boom' (which escalated after the GFC) has been suggested to have made Australia into little more than an emerging economy.

Also, as Australia's resource investment boom declined, a property investment boom sustained Australia's economic growth. Apartment development in Australia was heavily funded by Chinese investors (eg 20-40-80% - though no one was really sure as something like 50% of purchases involved only family money (so banks will have no records of loan approvals) and there was no need to register off-the-plan purchases with  Australia's Foreign Investment Review Board).   In early 2017 it was indicated that about 80% of new apartments in Sydney and Melbourne (and a lower percentage elsewhere) had been being bought by Chinese investors 2-3 years previously and that (because of difficulties gaining finance this had fallen to 50% while non-Asian investors picked up the balance because they had lost faith in the superannuation system. It was indicated a few weeks later that Chinese purchases of new apartments had fallen to 25% (and was still falling) and that enthusiasm for property purchases in Sydney seemed to be evaporating (presumably because there were not enough wealthy investors who were being forced by the $1.6m limit rule to pull money out of superannuation to compensate for rapidly-declining Chinese interest).

Thus if China suffered a serious set-back (and this increasingly seems unavoidable as indicated below) Australia could lose its ability to obtain at low interest rates the (say) $50-60bn pa capital inflows that are: (a) required to compensate for persistent current account deficits; and (b) traditionally obtained by Australia’s banks mainly for investment in real estate (see above).

Risks are already seen to be developing in Australia's property markets (see Are Unfinished Apartments a Risk in Australia Also?).

The latter refers to factors that indicate the existence of such risks including:

  • Australia’s property values represent over half of the assets that underpin the value of loans to / deposits with banks;
  • property prices have collapsed in those regions where strong demand had been driven by the resources' investment boom;
  • in major cities housing prices are almost the most unaffordable in the world (in terms of median property values relative to per capita incomes). Prices have been high because: (a) domestic investors have viewed property favourably as a source of capital gains; (b) Chinese investors' have sought ways of getting money out of China; and (c) urban population growth has been strong - as the resources' boom sustained high rates of immigration; 
  • an apartment construction boom, significantly (eg 40% or perhaps even 80%) driven by Chinese investors, has been a major factor in Australia's economic growth as the resource investment boom phased down. A large (over) supply of apartments (especially in Sydney, Melbourne and Brisbane) has resulted - suggesting that prices will fall significantly, because:
    • as price growth moderated (and reversed in some areas) the (at one time about 40% of) domestic demand from investors fell - and could potentially reverse.
    • immigration (and thus urban population growth) has moderated;
    • prudential regulation has made it harder to finance property purchases;
    • in early 2016 China made it harder for investors to get money out to complete property purchases, and domestic banks tightened conditions on foreign buyers. Despite this many Chinese families could get around the loose restrictions on foreign real estate investment (so demand remained strong). In late 2016 efforts announced made to block off those routes though phone apps and online platforms can make international transfers that do not go near China's banking system and will hard to control;
    • in late 2016 China decided that it would need to accept a slower rate of economic growth because its rapid expansion in debt was creating risks of a financial crisis. As any reduction in China's rate of increasing debt directly subtracts from demand growth, it is inevitable that China will need to crack down heavily on the capital flight that has been resulting in large scale purchases of apartments in Australia and North America (because this outflow also has a contractionary economic effect in China); 
    • With very large numbers of new apartments hitting the market over next 18 months in late 2016 a 'hard landing' in apartment prices seemed likely
  • banks carry risks from apartment developments - as they have financed developers on the basis of off-the-plan sales (which required only 10% deposits) and those who entered 'off the plan' buying commitments are finding it much harder to finance settlement (eg because resale values may be significantly below off-the-plan prices);
  • ALP proposals to change the negative gearing arrangements affecting property investment would reduce investors' motivation to buy (and increase their motivation to sell) investment properties - while the Coalition government's preference for discouraging the use of superannuation as a tax-minimization tactic would presumably have the reverse effect;

In the 1890s an international financial crisis led to: (a) severe constraints on capital inflows to Australia and thus on banks’ ability to provide funds for real estate; (b) a property market collapse; (c) banking failures; and (d) a depression.

Following financial deregulation as part of Australia's 1980s economic reform agenda, banks have become a major component of Australia's economy and share-market.

After the 2008 Global Financial Crisis (GFC) severely constrained the availability of credit worldwide, the federal government guaranteed all capital advanced to Australia’s banks to prevent any repeat of what happened in the 1890s (which was not impossible even then because of Australia's very high levels of lending for property development).

The federal government's ability to provide credible credit guarantees now is less certain as its debt / GDP level is no longer negligible (given substantial debt-financing of government spending partly as a result of committing for ongoing spending the revenues gained at the peak of a capital gains' tax boom associated with resource investment). The risk of the federal government losing its AAA credit rating is increasingly discussed - eg see here and here - though is not considered imminent.

 In late 2015 losses on banks' loans seemed likely and were already starting to cause concern (eg see 1).

Examples of areas where bank's losses were of concern:
  • industrial operations adversely affected by: (a) China's industrial overcapacity and dumping in international markets (eg steel); (b) problems besetting the dairy industry; and (c) Australia's recent lack of emphasis on boosting international competitiveness;
  • fund a resource investment boom - where the security of loans depends on the continuance of a strong commodities' demand from China (and consequent high commodity prices). The latter in turn depends heavily on China's economy: (a) remaining heavily investment driven - despite the Chinese government's attempts to shift from an investment-driven to a domestic-demand driven economy; and (b) avoiding what seems to be a potential financial crisis because of its dependence on rapidly rising debts to sustain growth (see below);
  • contribute to a China-stimulated apartment-construction boom which sustained Australia's economic growth in the post-commodity-investment-boom era - and created a significant level of exposure for Australia's banks because the total investment involved was about 60% of that in the resources boom. And the apartment investment boom seems likely to prove to be a bubble as a similar boom did in China (see below); and

In early 2016 an international credit rating agency identified Australia's rising house prices and the leverage involved as a credit negative for Australia's major banks because of the risk of a price slump. In May 2016 a 50% (?) fall in Chinese investment in Australian apartments was reported. And as property values were then declining slightly, this was seen to create major risks to Australia's economy and banking system. After a recovery  falling prices were again seen in late 2016 to be a risk due to: (a) the torrent of new apartments due to be settled in major cities; (b) tighter lending conditions by Australian banks; (c) and efforts by China to eliminate ways that its people been found to get around its restrictions on capital outflow - restrictions that seemed likely to intensify in 2017 as China finally started to confront its debt crisis.

External sources of risks to Australia's ability to obtain the capital inflow needed to counter-balance its structural current account deficits without paying higher interest rates are:(a) a likely set-back for China's economy; (b) a potential international financial crisis (see below); and (c) the apparently accelerating global trend towards higher interest rates the emerged in late 2016 as the 30 year reliance on ever-easier money policies as the basis for macro-economic management came to an end and bonds thus ceased providing 'risk free reward' and became a source of 'reward free risks' (see Risks Facing Australia's Banks). 

In early 2017 Standard and Poors suggested that Australian banks were under credit rating risk because the increased chance of a property price correction, increasing economic imbalances (related to significant role of property in economy) and weakening of sovereign support (due to higher government debt levels). Residential loans are 2/3 of banks lending assets - which is above the global average and leaves banks exposed to property pullback. The risk is likely to increase because low interest rates, benign economic outlook and imbalance between housing supply and demand [1]

Household wealth rose to $11.7tr last quarter as cash holdings exceeded $1tr. Wealth net of liabilities exceeded $9.4tr mainly because of $247 rise in house prices to $6.4tr. GDP is $1.7tr. High household wealth is the reason that RBA is not too concerned about debt-fuelled property speculation.  Debt is a problem especially as it increases faster than GDP - but asset side of balance sheet is good. Mortgage debt is $1.7tr - which is only 27% of house and land values [1

Future generations will pay the price if a sustainable future for all is not prioritized over entitlements for the few. Middle-class welfare for those who could afford to look after themselves is unsustainable. Social security ay 42% of all commonwealth payments is unsustainable. Now there are 4.7 working Australians for every person over 2.7. This will drop to 2.7 by 2055 if immigration rates are maintained . Australia is likely to collapse in same way as Japan. It did well after WWII but failed to adjusr - which led to years of negative growth and falling wages, fewer opportunities and unsustainable debts. There needs to be a healthy safety net - but with net debt of #317bn culture of entitlement must end  [1

Importing Risks from China  [<]

For reasons suggested above China's financial / economic / political system has significant economic implications for Australia.

China's Financial Risks  [<]

There have been concerns about China's financial system for many years. In 2013 China sought to reduce this perception by announcing proposals for financial liberalization and writing off bad debts and arguing that investing the 'wall of money' that rich Chinese held would benefit the whole world. However those claims seemed unrealistic (see Preparing for a Financial Con? - Late 2013).

China's financial / economic risks subsequently became increasingly severe. Though it is difficult to get data about China's non-transparent situation and debt levels are by no means the limits of China's economic risks, some notes on a range of (not always compatible) observations from 2015 about China's debt exposure outlined at the latter link are outlined below. And China's financial / economic risks are compounded by serious political risks.  In early 2017 there were indicators that these problems were coming to a head and that China faced a major debt crisis which would be extremely disruptive and difficult to resolve.

Examples of Observers' Views of China's Looming a Debt Crisis: - from sources here

GDP: China's GDP was estimated to have been $US11.4tr [1, 2] in 2016 - up from $11.2tr in 2015, $6.1tr in 2010 and $2.3tr in 2005.

Total Debts: Credit has risen 100% over 5 years - twice the rate in Japan before the Nikkei bubble burst in 1990. Total credit exceeds 250% of GDP // Budget deficits exceed 10% of GDP. China's credit growth was 20% of GDP pa in mid 2015 - a major problem because its debt growth was 2-3 times faster than GDP growth // China's private debt / GDP ratio is the world's highest at 290% - and has been increasing 28% pa. // China's fixed capital investment is $5tr pa (equal to Europe and North America combined) - and is producing massive excess capacity.// China's local government debts rose 30% over 18 months, while revenues fell. // China's overall debts ($28tr) are half the world's total [while its economy accounts for about 15% of global GDP]. // China's increase in debt since 2008 was 50% of the world total. China's corporate debts have grown at twice the rate of next highest country. // China's total debt levels are estimated at 308% of GDP ($30tr) and have risen enormously in 2016. Much of this went into property which government sees as a growth engine despite a 2-5 year glut of unsold properties. // China's debts are rising $4tr pa - ie about 25% of China's GDP. // In July 2016 it was believed that China not only had a very high debt / GDP ratio (ie over 250% of GDP) but that this was being increased by $1tr / quarter (ie about 25% of GDP) largely for speculative investment rather than, as it had been, for investment in real (if not always needed) assets - infrastructure and property.

Bad debts: China's concealed bad-debts are estimated at 70-140% of GDP - while unfunded pension liabilities could be 40% of GDP. // Much of China's increased debts has been taken by local governments and is hidden in SOEs. // China's banks have $34tr in credit - up from $3tr 10 years ago - and loans (eg for inefficient infrastructure projects) were made on the basis of political connections rather than on the basis of borrowers' ability to repay. // China's banks are using wealth management products to hide debt levels. Many firms have declining ability to repay debts. // The gross debt / earning ratio has doubled since 2010. // Median days to pay suppliers have risen to 70 - as compared with 35-45 that is normal elsewhere. // Potential loans at risk are 15% of GDP.  // Much of China's rapidly rising credit is simply being used to repay old loans. // The IMF estimates that 14% of Chinese companies' debt is 'bad' though others put this figure at 28%. Non-performing loans by China's banks are estimated at 19% - not the official 1.6% and global average of 4.5%. // China's banks face $1.7tr losses - and 60% of their capital is at risk. // SOE debt restructuring would endanger 50% of banks' capital.  SOE liabilities are 115% of GDP. // Many asset bubbles have been created by torrents of money. // China's official debts are only part of the story - as banks are disguising $2tr of loans (mainly to property developers) as investments and thus not maintaining capital reserves to guard against losses. Any slowdown in the rate of credit creation which adversely affected property markets could have serious consequences for banks;

Economic Impacts: Low cost exports have declined as a share of China's economy. // To maintain growth China's leaders have embraced monetary and fiscal stimulus which escalated outstanding debt to 250% of GDP. // In late 2016 data suggested that China is not rebalancing as growth was confined to old economy functions while services and retail weakened. It is thus wrong to believe that China is stable. // China has a property bubble - and belief that China will strengthen global commodities demand could be wrong. // Credit continues to be provided to technically bankrupt companies - mainly SOEs - at the same time as China's unemployment rises, manufacturing employment falls, there are bond defaults, foreign investment falls and property experiences declines.

Credit Assessments: Rating agencies are downgrading China - and its debts are seen to have reached crisis levels. // Shadow (ie off balance sheet) financing by banks has reached 59% of GDP. // Investment remains the main driver of growth (46% of GDP). A gigantic monetary bubble is seen to have corrupted every aspect of the country. // A large proportion of credit has been given to companies that can't account for it - and a great deal of it is believed to have been stolen.

China has created the biggest pool of domestic liquidity in history to stimulate its economy and finance a crushing debt burden. // Between 2007 and 2015 China created 63% ($16tr) of additions to the world's money supply. // China's problem is that debts are increasing almost as fast as money is generated to service them. // China will have a problem when it ceases creating money fast enough to service debts that are now 250% of GDP.

In the late 1990s China overcame problems in its financial system because options were then available for rapid economic growth when it entered the WTO. However a major new external source of growth is not available 2016. 

Even if China's banks are insolvent China is unlikely to experience a financial crisis like that which could occur in Europe or US. The government controls what is a non-commercial financial system and can move money around (including foreign exchange reserves) to deal with whatever is seen as the main current problem. China probably faces a long period of economic stagnation rather than any sudden crisis.

China has already put measures in place to reduce its risks. Major banks are well capitalized to deal with large numbers of NPLs. However as long as debts rise 2-3 times faster than GDP it will be hard to prevent the problem escalating.

Why China Has a Financial Problem: Introduction  [<]

China’s problem in late 2016 was that (a) it had run up massive national debts (about 300% of GDP); and (b) come to rely on VERY LARGE increases in those debts  to maintain sufficient economic growth to avoid political instability. China's national debts had been rising about $US4-5tr pa - which was some 50% of the total increase of debt globally though China only accounted for 15% of global GDP.

For complex reasons developed further below, the main sources of China's debt problem are that:

  • China's growth has been accompanied by a rapid rise in debt levels (and bad debts) ever since the start of its export-manufacturing 'miracle' in the late 1970s because:
    • to achieve real-economy ‘miracles’ China implemented a variation of the neo-Confucian methods that Japan had pioneered. Development of 'real economy' capabilities was catalyzed within hierarchical social networks across whole industry clusters by highly educated officials and national savings were allocated to state-linked enterprises by the consensus of state-linked social elites to achieve nationalistic / mercantilist goals. Credit was expanded with limited concern for the profitable use of capital in particular enterprises / projects;
    •  the bad balance sheets in banks and enterprises that resulted could be ignored so long as there was no external scrutiny of their financial positions. In China, as in Japan until the 1990s, scrutiny was avoided by ‘financial repression’ (ie constraining household incomes) to ensure strong current account surpluses as manufacturing production capacity increased and thus that large foreign exchange reserves accumulated. National (bad) debts could increase almost without limit to provide capital for investment;
  • From about the time of the GFC export demand weakened as a driver of China's economic growth (because of the effect of financial crises and of stronger competition in labour intensive manufacturing). The demand needed to sustain rapid growth (and avoid political instability) became dependent on high levels of credit-funded domestic over-investment (in infrastructure, property and industrial capacity). The domestic consumption that was being encouraged as an alternative from 2011 did not maintain a sufficiently-high rate of economic growth to prevent political instability

Similar financial practices were a key part of the non-capitalist neo-Confucian systems that allowed 'real economy' miracles in East Asia, and had led to financial crises elsewhere in the 1980s and 1990s:

  • After Japan's export-manufacturing economic miracle had reached its limit, it experienced a financial crisis in the late 1980s after industrial over-investment was accompanied by investment in areas subject to market forces (ie extensive property investment led to a real estate bubble which burst and offshore assets were bought at the top of the market). Japan's financial crisis saw a 70-80% fall in Japan's share and property values and ongoing economic stagnation from which Japan has not yet really recovered.
  • Financial indiscipline also led to crises in 1997 in many East Asian countries that had not taken the precaution that Japan and China did of accumulating large foreign exchange reserves through financial repression (eg suppressing household incomes to limit consumer spending and imports) to protect state-linked banks and companies with bad balance sheets from international scrutiny by giving those nations as a whole an impression of creditworthiness.

China's problem has been compounded by the apparently unrecognized effect of:

  •  its regime's plan (through its 12th Five Year Plan, 2011-2015) to emphasise growth driven by domestic demand / consumption rather than by export-oriented manufacturing in the hope of thereby avoiding the 'low income trap' that many emerging economies have encountered. That shift made it necessary to boost domestic demand and thus impossible to continue relying on 'financial repression' to build up its foreign exchange reserves with large current account surpluses;
  • encouraging foreign investment by Chinese companies and seeking IMF 'reserve currency' status for China's currency in 2016 [1]. These made falls in its foreign exchange reserves possible.

Given increasingly open capital markets, huge national debts and a chronically irresponsible state-controlled financial system, many Chinese took the opportunity to increase their financial security by shifting assets off-shore – and China’s foreign exchange reserves (and the protection they provide to banks and enterprises with bad balance sheets) started falling rapidly in 2015.

China faces structural obstacles to economic growth if large foreign exchange reserves are not available to reduce the risk of a financial crisis by protecting banks and companies with bad balance sheets from market scrutiny. Firstly there are massive cultural obstacles (in the way information is used and in traditional social organisation) in shifting to a financial system in which return on / of capital is taken seriously so bad debts would not automatically increase as a by-product of economic growth. Secondly the methods that China trialed to obtain capital without simply rapidly increasing its national debt failed (eg inflating asset values and trying to attract foreign investment). They are likely to continue to fail as long as China maintains: (a) its irresponsible financial system; and (b) its corporate state (ie an expectation that ‘private’ businesses will act as extensions of the state in pursuing nationalistic / mercantilist goals rather than as independent profit-focused undertakings).

Why China Has a Financial Problem: Elaboration  [<]

To properly appreciate China's problem it needs to be recognised that:

  • East Asia societies with an ancient Chinese cultural heritage have significant differences to Western societies (see Competing Civilizations and Babes in the Asian Woods). This results in incompatible financial systems (see A Generally Unrecognised 'Financial War'? and Structural Incompatibility Puts Global growth at Risk). Traditional ways of thinking and social organisation make it difficult to rely on 'capitalistic' calculations of profitability by independent enterprises. Power is not associated with making decisions but with having subordinates who will do so. Abstract / rational decision making works reasonably well in 'liberal' Western economic environments, but can't be reliable in a complex social environment. It is presumed that coordination of economic activities through social networks produces greater economic benefits - an assumption that can be true in relation to achieving 'real economy' miracles, but false in relation to the productive use of national savings;  
  • in major East Asian 'market' economies (eg Japan and China) significant investment tend to be determined by the consensus of hierarchical state-centered social elites, rather than by 'capitalistic' calculations of profitability by independent enterprises (see evidence); .
  • The balance sheets of major enterprises and banks (all of which are linked to the state by hierarchical social networks) are unreliable. Thus obtaining capital from profit-focused international financial systems: is never straight forward; and creates risks of financial crises because it could reveal institutions’ bad balance sheets;
  • In China (as in Japan until perhaps the 1990s) obtaining significant foreign capital was rendered unnecessary by 'financial repression' (ie suppressing domestic consumption to ensure high national savings, large current account surpluses and the accumulation of substantial foreign exchange reserves). The latter ensured that China was given a sound credit rating despite the largely-undisclosed bad balance sheets of its banks and major enterprises. The capital needed for major investment could be mobilized by its state-orchestrated banking system (despite its bad balances sheets) from national savings and by expanding national debt (see Understanding East Asia’s neo-Confucian Systems of Socio-Political Economy). The international financial imbalances created by 'financial repression' had major adverse effects on international financial stability (see Impacting the Global Economy) - ie maintaining global growth in the face of structural demand deficits in some economies required the use of neo-liberal systems of political economy and easy monetary policies that had adverse long-term side effects (ie distorting investment and ultimately creating social / political instability). Ironically this also contributed to China's capital flight risk in 2016 (see below);
  • Elsewhere in East Asia variations of the post-WWII methods that Japan had pioneered to generate 'real economy' miracles (despite financial weaknesses) were adopted from the 1960s by countries that also had historical exposure to Confucian systems of government. However only in Japan and China was the precaution of large current account surpluses put in place.  The result was that the weak balance sheets that resulted from what some called 'crony capitalism' led to a major financial crisis in many smaller countries in East Asia in 1997 (ie in the so-called Asian Financial Crisis);
  • China’s pre-2013 system (where the role of a traditional Confucian bureaucracy was not played by a real imperially-accountable bureaucracy as it was in Japan) had allowed Communist Party insiders (ie often 'China's princelings' (the descendants of the earliest prominent / influential Communist Party officials) to corruptly enrich themselves / their families by exploiting their positions in the neo-Confucian social / economic / political hierarchy by which all aspects of China had been increasingly orchestrated since the late 1970s. This seemed similar to the official corruption that plagued Russia's transfer of assets from state ownership after Communism collapsed. To counter this, China tried to ‘purify’ the Chinese regime (on Confucian principles) under its new president (Xi Jinping). A major anti-corruption drive was launched in 2013;
  • Suppressing domestic consumption to provide a tame source of capital for investment could not be continued in China if future growth was to be significantly driven by domestic demand. China officially adopted a shift from investment / export driven growth to domestic demand driven growth in 2011 - presumably because it could not avoid the low-income trap that developing countries face if they  continue to rely on export-driven growth whose competitiveness depends on low average wage rates. It was, however, anything but straight forward to achieve this.

The Challenge in Shifting to Domestic-Demand-Driven Growth

  • changing to consumer driven growth required changes on the demand side as well as on the supply side - and while China had decades of experience in orchestrating the latter, the former was new;
  • China relied on neo-Confucian methods in orchestrating economic change - rather than independent profit-focused decisions within a free-market. The former involved financially-hazardous resource allocation by consensus rather than by calculation of return on capital;
  • shifting to domestic demand driven growth implied eliminating / reducing the large current account surpluses that allowed foreign exchange reserves to accumulate and prevent external scrutiny of the balance sheets of China's banks and companies; .
  • China thus apparently tried to engineer financial booms (in property and share-markets) so as to mobilize capital for investment without increasing the bad debts that its undisciplined financial system generated.  Those state-orchestrated booms turned out to be perceived / actual bubbles.
    •  China’s property boom has produced significant over-supply (eg many Chinese cities were left as virtual ghost towns with large numbers of uncompleted and / or unoccupied apartments). In 2014 it was expected that the perceived 'bubble' would burst (as again in 2016). However, despite downturns the 'bubble' has continued growing because: (a) an apparently very conservative approach has been taken to property investment (ie few owners have mortgages and property purchases have only been allowed when buyers has large existing assets); and (b) the government-controlled financial system has reduced interest rates to re-ignite demand whenever prices fall. This process is only sustainable so long as the 'wealth' that households have to support property purchases (especially their savings in state-controlled banks) is accepted to be real.  This would no longer be so if China's extreme overall national debt levels (and dependence on rapidly rising debt to drive economic growth) encourage large capital outflows and thus cause China's foreign reserves to be seen to be inadequate as a protection for its currency value;
    • China's ham-fisted response to the 2015-16 collapse of its share-market bubble caused its government to lose a lot of credibility. The difficulties that systems reliant on consensual decision making have in dealing with rapidly changing situations was apparently seen by Sir William Slim as a factor in constraints on the effectiveness of the Japanese army during WWII.
    • China has more recently also sought to obtain capital (without simply suppressing domestic consumption) by seeking international investment in its financial system (eg buying Chinese bonds). However the value of all such assets are artificial (because of dubious accounting practices) as 'markets' in China are simply political tools;
    • In May 2016 a massive speculative boom and bust in China's commodity markets was perceived as another risk to China's financial system and economy;
  • China also seemed to hope that large quantities of foreign capital could be obtained to finance investment (eg in domestic-demand-driven industries). However, for reasons outline below, this was limited, eg: (a) successful direct investment depended on obtaining reliable connections to China's non-transparent corporate state; and (b) the Chinese companies in which portfolio investment could be made were constrained by pressure from the 'connections' in China's corporate state to pursue mercantilist rather than commercial goals; 
  • In early 2015 slow diversification to domestic demand and constrained credit led to a major downturn in China’s economy (which risked political instability). Thus escalation of credit growth resumed in early 2016. This policy reversal: (a) boosted China's investment-driven growth; (b) reversed (at least temporarily) the global commodity price crash that had created problems for economies dependent on providing inputs to China's economy; and (c) put China back on a path to a Japan-like financial crisis. There were then: (a) indications in April 2016 that this policy might be being reversed again; (b) indications in May 2016 that this may not happen; (c) indications of disputes at the highest level of the Chinese state about what to do - and who to blame; and (d) an apparent decision in December 2016 that China's high and rapidly escalating debt / GDP ratio was so dangerous that reforms were needed. In December 2016 China's central bank increased its efforts to drain cash from that county's financial system - to reduce excess borrowing and frothy markets. China's government also introduced new measures (M&As, bankruptcies, debt / equity swaps; and debt securitisation)  to try to deal with its corporate debt mountain - though observers were not convinced this would work. It also proposed taking even tougher measures to block capital flight (eg by family purchases of foreign property) - though those measures may be hard to put into practice because digital tools for capital transfer can remove transfers from the banking system;
  • Having avoided the worst of the 1997 Asian Financial Crisis, Japan and China long seemed to have believed that serious reform of their financial systems was not required (ie they could get away with bad debts if they maintained large foreign exchange reserves as a shield behind which balance sheets could be manipulated). However in China's case that expectation was undermined (despite government efforts to control it) by a significant capital outflow that put China at risk of significant currency devaluation – which could lead to uncontrollable capital flight - while also restricting money supply and thus constraining economic growth. This arguably arose because: 
    • President Xi's anti-corruption drive presumably motivated attempts to get corruptly-acquired wealth out of China - as may apply to some (much?) of what is being invested by Chinese people in apartments in North America and Australia;
    • recognition of widespread official corruption undermined many Chinese people's willingness to believe in and support claims that the regime was acting in the community interest.  It also compounded grass-roots concerns about whether China would emphasis social equality - as eliminating the social hierarchy involved in China's traditional Confucian system of government had been the main, and widely supported, goal of Mao's Cultural Revolution. Thus the case for sacrificing individual / family interests for the nation as a whole was weakened - and interest is emerging in the foundations of Western liberalism (see The Western Path to Progress);
    • China faced a general risk of a debt crisis. And its regime had lost economic credibility because of its poor responses to asset booms and busts;
    • Chinese companies had borrowed heavily at very low rates in $US after Federal Reserve had been forced to adopt extremely easy monetary policy to facilitate recovery from the effects of the 2008 financial crisis (partly because of the international financial imbalances associated with neo-Confucian systems of socio-political-economy). Rising future interest rates would make repaying those debts ever more expensive and thus required early action;
    • the Chinese yuan is believed to be over-valued on a trade-weighted basis - and increasing capital outflows are seen to be likely especially as $US strengthens because of rising US interest rates;
    • China's government encouraged the use of the yuan as an international currency;
  • There were flaws in the view that China's risk of a financial crisis was limited because: debt problems were limited to domestic institutions; China's government controlled the whole financial system; and China had large foreign exchange reserves.

China's Weakening Foreign Exchange Reserves - referring to diverse sources outlined here and here

China's foreign exchange reserves peaked (at $US4tr) in mid 2014. There was a serious loss of confidence in the economic competence of China's regime related to the stock market bubble and bust in 2015 - after which China started to experience capital outflow and has had to tighten controls on capital movement to prevent this. China has increasingly had to sell its foreign exchange reserves to defend the $US value of the yuan - and would experience an even bigger flight of capital if it failed to do so. Capital outflows were estimated at $100bn per month in late 2015 - with $57bn in foreign exchange reserves being sold each month to defend the yuan. China probably has $900bn in reserves that could be used this way without leading to a serious problem. Chinese exporters want to hold reserves in $US - and their trading partners don't want yuan. When the US started raising interest rates investment capital inflows into China were reversed.  Using foreign exchange reserves to prevent yuan devaluation has the effect of tightening the availability of domestic credit - and thus restricting economic growth just as the reverse (ie adding to foreign exchange reserved) long had an expansionary economic impact. China's FOREX reserves may be either: (a) only $2.1-2.2tr after allowing for China's sovereign wealth fund - which is below the $2.7tr needed for safety; or (b) $3.2tr not including China's sovereign wealth fund. 

Chinese companies with non-transparent financial positions are investing offshore. However such offshore investing is increasingly failing as government tries to block offshore capital movements.

Officials fear that Chinese people believe that they would be better off getting their money out of China - as capital flight would sap the liquidity needed to keep China's bubble from bursting. There has been a boom in Chinese buying of offshore real estate. As much was invested in the first half of 2016 as in 2015. Money is getting out despite government efforts to stop it. In October 2016 China's headline foreign exchange reserves fell by $100bn - five times as much as in September. In December 2016 China indicated an intent to close loopholes in measures that were in place to restrict capital outflow. 

However phone apps and online platforms can make international transfers that do not go near China's banking system and will hard to control. Companies can disguise capital flight as normal business tractions. Exerting complete control over capital flows would be incompatible with the reserve currency status for the yuan that China sought and obtained from the IMF.

  • the adoption of a more liberal economic system and a rule of law had been announced by President Xi as part of a major 2013 reform agenda. However it was probably impossible to achieve this. The methods used to achieve change in recent decades (including China's 'real economy' miracle) have been incompatible with the liberalizing changes that were now allegedly to achieve (ie they involved stimulating change through hierarchical state-centered social networks rather than through independent initiative under (say) a rule of law). China's president's attempt to suppress corruption was seen to suppress economic initiative because personal profit had often gone had in hand with official leadership of economic change. In early 2017 China's response to the situation it confronted involved an abandonment of attempts to liberalize its economy with an emphasis on maintaining control by the ruling regime by continuing to maximize growth despite its exposed financial position

Why China Faces Political Instability   [<]

Political instability has plagued China's neo-Confucian regime since its establishment in the late 1970s (see Political Constraints, 2004). For example, it was autocratic and faced a seething mass of local protests that it suppressed - eg related to official corruption. These were amplified by: growth at all costs policies; the perceived collapse of public morality; economic underdevelopment in NE China which has fought many civil wars with more-commercially-successful southern China in the past; extreme income inequality; and the emergence of Falun Gong in 1992 in the tradition of the White Lotus society which had been the source of earlier attempts to gain political power in China.

There were later signs of a loss of confidence in economic tactics for further boosting China's power and status (see Discord / Conflict, 2009+). Observers started suspecting that a military route to the expansion of China's power was being emphasised (see Comments on Australia's Strategic Edge in 2030, 2011). Also an increasingly autocratic domestic approach by China's regime was put place from 2012 under president Xi Jinping (see The Resurgence of Ancient Authoritarianism in China, 2014) - and this was the opposite of what was needed to sustain rapid market-driven economic progress.

The neo-Confucian system of government that China's 'Communist' Party adopted (initially to achieve its economic 'miracle' and later to enforce national discipline) is arguably increasingly at risk (eg another anti-Confucian cultural revolution is possible) because:

  • Neo-Confucian methods require the existence of a social hierarchy. In a 'Confucian' system progress depends (not on rational decisions by individuals in liberal institutions but rather) on educated elites guiding changes in their subordinates' behaviour and everyone valuing the (eg economic / geopolitical) interests of the ethnic nation above their own;
  • There has been strong grass-roots resentment of the late-1970s’ re-emergence of a neo-Confucian social hierarchy in China. Mao's late-1960s-early-1970s cultural revolution had sought to eliminate China's hierarchical Confucian cultural tradition - as it was seen to be oppressive - and replace it with notions of social equality. It was reintroduced in the post-Mao era (as neo-Confucianism which incorporated Daoism and officially called 'socialism with Chinese characteristics') because this had been the basis of achieving the economic 'miracles' that Japan had first demonstrated. And, as in Japan, the existence of a neo-Confucian social hierarchy has remained critical to achieving significant economic change / development in China - while the risks of financial crises escalated;
  • In late 2016 it was suggested that a significant populist movement  had developed that could challenge China's regime. It rejects official 'economy first' priorities and supports Mao's egalitarian ideas. It can also be noted that China's long term history has seen repeated civil wars between 'spiritual' factions in north China and the 'commercial' south - which have seen the latter driven out to become the Chinese diaspora in SE Asia. The latter arguably regained power through an ideological takeover of the (so-called) 'Communist' Party after Mao's death because the PLA believed that economic success would be the best way to boost China's military strength;
  •  China generated the massive wealth-imbalances mentioned above (ie many connected with the so-called ‘Communist’ Party exploited their positions to become exceedingly and corruptly rich). This led to the need for an anti-corruption crackdown in 2013;
  • the legitimacy of the so-called ‘Communist’ Party has rested mainly on its economic success – but many of China’s economic policy initiatives in recent years have been ineffectual. Disputes over who is to blame for China's debt crisis have emerged;
  • China's people have had a strong emphasis on savings (for cultural reasons and because of the lack of a social safety net). This includes deposits with China's state-controlled banking system where savings have been used for investment to achieve nationalist goals but with little regard for return on / return of capital. The credibility of deposits with those institutions depends on the regime's ability (by maintaining large foreign exchange reserves) to prevent their balance sheets being subject to scrutiny by foreign investors. China's debt crisis has the potential over the next few years to alienate China's citizens by eroding their household wealth;
  • Falun Gong (an exercise / spiritually oriented group) has been persecuted by China's regime since 1999. It has about as many members as the Communist Party, is independent of them, has its own ideology and cuts across socio-economic lines;
  • there is also resentment in the so-called ‘Communist’ Party about President Xi’s attempt to give himself absolute control of everything so he can fix all of China’s problems (which is equated with Maoism).

Various observers have expressed concern that China seems to be focused only on gaining power rather than with the changes needed to achieve ongoing economic success. Others expressed concern that China seemed to be making preparations for war.

China's Likely 2017 Financial Crisis   [<]

In early 2017 there were indications that in December 2016 China's government had finally accepted  that: (a) its extremely high debt / GDP ratio and heavy dependence on rising debt to sustain growth create unacceptable financial risks; and (b) a slower rate of economic growth was needed in the interests of 'stability'.  External observers remained very concerned about China's risk of a debt crisis (op cit). And the reforms announced in early 2017 to deal with China's problem seemed inadequate.

In relation to China's problem, the Chinese Academy of Social Sciences had reportedly indicated that 'stability' could be achieved by reducing China's growth rate by a fraction of a percent (eg from 6.5% pa to 6.4% pa), while a US observer speculated that giving up half a percentage point in growth would ensure against bond / currency market instability. 

However such modest adjustments seem unrealistic. It seemed likely that if China implements the policy shift apparently intended in late 2016 (ie stabilizing its debt / GDP ratio) it would experience a 'hard landing' while other economies dependent on China's imports or foreign investment would suffer setbacks.  However China's challenge was arguably more severe that this, because (if a liberal international economic and political order remains dominant) China's system of socio-political-economy would be incompatible with its regime's desire to avoid the 'low-income trap' that had limited the performance of many emerging economies by shifting to domestic-demand / consumer driven growth.

An Overview of China's Apparent Financial Predicament in Early 2017

Based on an undoubtedly-improvable attempt to form a 'consensus' of the diverse and not always compatible sources that are outlined above, it seemed that:

  • China’s total debt levels: (a) had been rising about 3 times faster than GDP growth (ie about 20% pa or $US1+tr / quarter) to sustain the 6-7% pa rate of economic growth that China has needed to avoid political instability; and (b) have now reached around 300% of GDP (ie about $US30tr);
  • China’s dependence on rapidly rising debt and its overall debt level were almost universally seen by external observers as posing risks of a debt crisis – though this risk has been able to be managed in ways that would have been impossible elsewhere because China's government has had extensive control over the financial system and its large foreign exchange reserves could be shifted to boost any area that was then seen to be exposed;
  • Despite determined government efforts to prevent this, China’s foreign exchange reserves were eroding quickly as a result of net capital outflows (ie falling by 25% from their $US4tr peak in early 2014 to $US3tr – ie an average of around $US30bn / month with a November 2016 fall of about $US80bn). This will have reflected the combined effect of:
    • China's current account surplus - which peaked at around $US400b pa in 2008 before declining steadily to $US200bn pa in 2016);
    • outward corporate foreign investment (which grew from around $US3bn in 2005 to $US170bn in 2016 - with a particularly large growth in 2016); 
    • inward foreign investment - which had been rising steadily (ie from (approx) $US155bn in 2009 to $US200bn in 2015) before falling about $US45bn to about $US155bn in 2016 [Note - there are many different estimates of China's foreign investment and the specific source of the latter more-or-less typical figures can no longer be located];
    • sale of China's Forex reserves by PBOC to defend the value of yuan - (say) $US300-400bn [1, 2, 3];
    • capital flight (eg related to concerns about China's overall debt position and its state-manipulated financial system). This might have grown to $US400-500bn in 2016 - a CPDS' guess-timate based on the above rough / improvable estimates of other factors affecting the approx $700bn fall in China's foreign exchange reserves in 2016;
  • Running down foreign exchange reserves to defend yuan value has the effect of tightening domestic liquidity and thus suppressing domestic economic activity - just as increasing those reserves once had an expansionary effect by increasing domestic liquidity;
  • The IMF reportedly believes that the minimum foreign exchange reserves China needs for safety (eg because of its managed exchange rate) is about $US 2.7 tr. This level would be reached before mid 2017 if late 2016 rates of decline were maintained. Other observers have suggested that: (a) there would be concern about their adequacy if reserves fall much below $3tr - given the scale of China's financial pressures and its economic structure; (b) the PBOC could continue selling FX until reserves fall to $US1.8tr (given China's export income, broad money, foreign liabilities and capital controls); (c) $US3tr is ample foreign exchange reserves for China given that its liquid external assets are greater than its external debts and its current account is in surplus [1]; and (d) China has $3tr in foreign exchange reserves of which $2tr are illiquid or needed to bail out its banking system, leaving $1tr still to be used to defend the yuan in the face of capital outflow [1]. Perhaps China's 'safe' FX reserve limit depends on how reliable financial markets think that China's state-manipulated financial system as a whole is;
  • Concerns about the adequacy of foreign exchange reserves are however merely a symptom of China's underlying problem (ie stabilizing its huge debt / GDP ratio in the face of its economy's dependence on rapidly expanding debt). The debt problem won't be solved by stabilizing FOREX reserves or showing their 'adequacy'. Moreover, for reasons suggested below, China's system of socio-political economy seems incompatible with mobilizing large quantities of capital without merely increasing its national (bad) debts;
  • Extensive bad debts have accumulated which would need to be written-off or rationalized in some other way in order to restore international credibility to China's financial system;

New debt can directly add to an economies' final demand (a fact that is being explored as part of the development of Credit Impulse theories). Thus reducing China's rate of creating new debt (which has been about $US4-5tr pa)  will tend directly and indirectly to reduce demand, and affect economic growth. It is very hard to reduce dependence on rapid debt growth as the source of economic demand and potentially very economically disruptive to do so.

Merely stabilizing China's debt / GDP ratio at its current very high level (ie about 300%) would perhaps require reducing the new debt created each year by (say) $US2.5-3.5tr pa (ie cut current $US4-5tr pa new debt creation by about 2/3) – eg by:

  • slashing the creation of new debt for (industrial, infrastructure, property) investment or for domestic consumption by (say) $US2-3tr - which would result in a (say) 10-15% cut in final demand (and a similar effect on GDP);
  • clamping down very firmly on capital outflow by Chinese companies and households (eg with a $US500bn cut). Such a cut (which, for reasons suggested above, might not happen without a financial crisis) would weaken the economies of the many countries that have come to depend on capital from China as the world's largest post-GFC credit creator. This (and the reason it was needed) would also perhaps put the reserve currency status of China's yuan with the IMF at risk;

China's Clampdown on Capital Outflows: It can be noted that in late 2016 China's commerce minister had made reference to restricting foreign investment by Chinese firms and encouraging foreign investment in China because outflows had risen rapidly while inflows were stable and there was concern about capital flight.

In January 2017 one observer suggested that Chinese companies backed out of $36bn in foreign acquisitions in 2016 (a 7 fold increase on 2015) and that many of the record $225bn in foreign acquisitions by Chinese companies that had been announced in 2016 were stalled because of regulatory constraints. [Another observer suggested that the value of deals that Chinese companies backed out of in 2016 was $75bn - and that European / US asset sellers were now hesitant about selling to Chinese buyers].

In February 2017 it was noted that: (a) China had added strict new measures to prevent capital outflow for the purchase of real estate; (b) total capital outflow from China had fallen to zero in December 2016; (c) Chinese purchases of certain apartments in Australia was 25% of total demand (down from 80% at one time and 50% in late 2016) and falling fast; and (d) the decline in Chinese buyers could affect real estate demand in Australia's major capital cities.

In March 2017 it was suggested that China had decided that clampdown on offshore property purchases by small Chinese investors would / might be relaxed after a year (ie at the end of 2017). Chinese buyers rushed back into the market - buying 50% of off-the-plan apartments which would settle in 2-3 years. Australian-born Chinese investors were buying another 25%.

In April 2017 it was:

  •  suggested that Chinese banks were lending abroad at record rates in a bid to tap new growth helped by state-backed ambitions to build infrastructure worldwide. Particular emphasis is given to OBOR projects - with loans for hundreds of projects envisaged along ancient trade routes promising profitability options in place of declining returns in China;
  • reported that measures that restrict money leaving China were being relaxed;
  • argued that China's continued rapid expansion of its debt was creating the risk of a crisis.

China's property / infrastructure booms have been locked in by government for another year. This has driven commodity price recovery that benefits Australia - but creates uncertainty because no one knows when destabilizing mountain of debt will topple over. The constant postponement of efforts to rain in debt-driven spending brings reckoning closer. Attempts to constrain property speculation with a property tax have been ineffective. GDP growth has been mainly driven by property investment - and China's economy has again become investment driven. Laying a favorable foundation for 19th 5-yearly communist party congress in November 2017 has been given priority.


The global impact of restricting debt creation by China enough to stabilize its debt / GDP ratio would be severe. China has been creating 50% (or slightly less or more) of total new global new credit. Thus a 2/3 reduction in the rate at which China creates credit would cut the amount of debt created globally by about 1/3. At the same time monetary polices are likely to be being tightened: (a) in Europe by tapering the ECB's bond buying program; and (b) in the US by likely Fed increases in interest rates during 2017.

If China wanted to do more than stabilize it high debt / GDP ratio, even greater cuts would be needed.

While there was a behind-the-scenes recognition that there is a financial problem that needs to be addressed in late 2016, taking official action (except by clamping own on outward capital flows as noted above and discrete increases in interest rates from November 2016) will apparently be delayed because it depends on a new Politbureau being appointed by the 19th National Congress of the Chinese Communist Party in late 2017. 

One observer (Charlene Chu, Autonomous) reportedly suggested that the adjustment process could be slow (because China's government has tight control over the 'financial levers') and that it might also involve: (a) attracting foreign investment (eg by raising interest rates); (b) devaluation of the yuan (presumably to reduce the incentive to get money out because devaluation is expected in future); and (c) possibly benefitting from weakening of the $US to which yuan has been more-or-less linked.

However, though there might be ways mentioned below to marginally reduce China's reliance on rapidly increasing debt to drive growth, financial adjustment might not be slow and tightly government controlled. Given that: (a) constraining capital outflow is difficult; (b) the pace of capital outflow from China was accelerating; and (c) China's foreign exchange reserves were expected to be below the safe level recommended by the IMF by mid 2017, a response delayed until late 2017 (ie until after the 19th Congress of the Communist Party) might be too late to avoid an uncontrolled market-driven crisis (as was the case for China's ham-fisted responses to its 2015 share-market crash). 

More determined efforts to constrain outward foreign investment appeared to be put in place in late 2016 - and there were indications that this would limit or perhaps stop much foreign investment. The economic stimulus that (say) $200+bn of China's foreign investment would have provided to trading partners would be lost. And the rate at which China approached what the IMF saw as its least safe level of foreign exchange reserves ($2.7tr) would be reduced - with that level not being reached until (say) September 2017 rather than (say) April 2017.

Significantly boosting demand from other sources (eg from domestic consumption) would also allow the rate of debt creation to be reduced without adversely affecting total demand.

Background on Consumer Demand in China:

  • Services are expected to be China's new economic engine [1];
  • China’s initial strategy of suppressing consumption to boost investment significantly reduced consumption as a percentage of its economy (ie from 51% of GDP in 1985, 43% 1995; 38% in 2005; 34% in 2013). However, as China's economic growth was fast (eg from 2000 to 2010, China’s GDP doubled), consumption grew strongly (ie from $650bn to $$1.4 tr)  even though it fell as a percentage of total GDP   [1];  
  • Consumer demand in China has recently been increasing about 10% pa [1], In 2015 private consumption was estimated as $4.2tr (compared with total GDP of about $11.2tr ) and by 2020 private consumption has been estimated to be $6.4tr [1]. China’s household income is now $5tr pa, and discretionary spending is increasing [1];
  • Factors driving increased consumer spending have been seen as: rise of upper middle class; a new generation of free spending sophisticated consumers; and the role of ecommerce [1] .

Despite the rapid (about 10%pa) growth in consumer demand, this is limited as a way of reducing China's dependence on rapidly increasing its national debt to drive growth, because:

  • The reduction in annual credit creation needed to stabilize China debt / GDP ratio in the absence of other changes is some $2.5-3tr. The annual increase in consumer spending is about $220bn;
  • Rising consumer spending depends on a high rate of stimulus spending to boost household incomes [1].  Consumer spending also relies to some extent on the availability of new credit;
  • China's households are conditioned to a high saving rate - for cultural reasons and because of the lack of a social safety net [1];
  • Households' increasing affluence includes their savings in China's state-owned banking system, and the value of those savings has been has been constantly eroded because of: (a) the irresponsible use of national savings in financing investment; and (b) the resulting bad debts and suspect balance sheets of China's banks and companies. If China suffers a significant financial crisis the value of savings held in China's banks (and thus consumer spending) could fall dramatically.

Attracting a lot more foreign investment would also reduce the need for an economic 'hard landing' to stabilize China's high debt / GDP ratio and eliminate dependence on very high rates of new domestic debt creation to sustain growth. However this is unlikely to be easy because:

  • as noted above, China's high and rapidly rising debt / GDP ratio (which causes financial instability) will continue to worsen unless the rate at which new credit is created is slashed (eg cut by something like $US2.5-3.5tr pa not just by the $US100-200bn that would be the most optimistic view of potential new foreign investment);
  • many now try to get money out of China or are increasingly reluctant to invest in China because the risk of losses associated with China's unreliable financial system and heavily debt-exposed economy.  China's corporatist system of socio-political-economy has been able to engineer 'real economy' miracles but has been unreliable financially because:(a) government controlled the 'financial levers'; and (b) for complex cultural reasons financial results had no priority  (see Why China Has a Financial Problem). Outright fraud has also been a non-trivial issue. Fixing the problems in China's state-manipulated financial system will probably be needed before unwanted capital outflows will ease or foreign investment can significantly increase;
  • a very large increase in inward foreign investment would be needed to make any useful difference. Reversing the approx. $US45bn pa fall in inward foreign investment in 2016 would provide only a fraction of the new credit needed to allow China's debt / GDP ratio to be stabilized without a large cut to final demand and GDP. Attracting foreign investment would be hard because:
    • the opportunities that attracted many companies to invest in China have not proven as good as expected because: (a) running retail operations is difficult and expensive; (b) China's growth rate has slowed; and (c) the expected boom in consumer spending has not happened [1]
    • direct foreign investment in China has been anything but straightforward (eg consider the OECD's index of investment restrictions and Australia's experience). Investment success has required reliable 'connections' to China's corporate state. Given the mess that Chinese government manipulation of 'financial levers' has created, direct foreign investors are likely to remain hesitant in the absence of a transparent business environment (eg one based on law rather than on 'connections' to China's corporate state). Creating an attractive environment for foreign investment (ie eliminating dependence on reliable 'connections' to China's financially-irresponsible corporate state) will take a major cultural / political shift. It can be noted however that doing so would also: (a) remedy the bad trading reputation China has had due to its non-tariff barriers; and (b) remove the main obstacle to the creation of a stable international financial system (see Donald Trump is Not Alone in Facing Dilemmas, 2017);
    • portfolio foreign investment in China has tended to provide investors with limited ability to exert any control over the enterprises they invest in. China has a corporate state (ie so-called 'private' enterprises are seen as extensions of the state). Control of enterprises (eg Alibaba) remains in the hands of Chinese principals [1, 2, 3] who will conform to the nationalistic / mercantilist pressures they are subject to through their social relationships - rather than maximizing return to investors. Creating an environment in which portfolio investment in China results in the ability to gain control and focus on return on capital would require dissolving China's corporate state;
    • selling state-owned enterprises (SOEs) could in theory attract increased foreign investment in China. However this would not be straight forward because: (a) given the large and often unknown / concealed bad debts association with such enterprises, determining a value that external investors could rely upon would not be possible without fundamental reforms of China's whole financial system; (b) the widespread incidence of corruption in China's financial and corporate systems (which government anti-corruption programs are targeting) implies that abuses of the process of selling SOEs could be as widespread as in post-Communist Russia; and (c) nationalistic, rather than commercially oriented, Chinese control of such enterprises would presumably still be sought, thus creating the same problems for ex-SOE investors that are now associated with portfolio investment. 
  • Goldman Sachs suggested in early 2017 that China could attract large quantities of capital inflow by liberalizing its bond market to the extent that its ($US1.7tr) outstanding pool of bonds  could be included in in global bond indices. The trouble is that, because of the character of the state-manipulated financial system that China has used, the value of bonds would be: (a) highly uncertain and dependent on China's ability to prevent capital outflow which could expose its banks' / companies' balance sheets to critical examination; and (b) constantly worsening because of the nature of its manipulated financial system (see Why China has a Financial Problem). In March 2017 the PBOC announced that Chinese bonds would be available to foreign investors but not included on global bond indices.

It has been suggested that a large yuan devaluation might be an option to boost China's economy (by increasing its international export competitiveness) while reducing dependence on creating new debt. Problems with that option are that:

  •  this would be a reversal to some extent of China's attempt to change its economy from dependence on exports sustained by low wages towards domestic demand - and thus confuse official efforts to set directions for China's future economic growth;
  • if devaluation (say) reversed the $200bn decline in China's trade surplus from 2008, this would make little difference to the cuts to domestic credit creation needed to stabilize China's debt / GDP ratio;
  • the credibility of China's financial system would remain in tatters unless devaluation was accompanied by structural changes to China's financial system (ie towards a system where major resource allocation depended on return on / return of capital rather than on insider connections). 

China's financial challenge was not however limited to the immediate issues it faced in early 2017. If a liberal international economic and political order remained dominant, China's neo-Confucian system of socio-political-economy seemed incompatible with its regime's desire to shift its economy to domestic-demand / consumer driven growth (for reasons outlined in Why China Has a Financial Problem).

The latter suggested that China's neo-Confucian system of socio-political-economy makes it impossible to generate capital for investment without merely increasing its national bad debt levels (eg its state-controlled financial system could not take profitability seriously and attempts to gain capital by boosting asset values / attracting foreign investment failed). China's regime thus faced a choice between:

  • radically changing / liberalizing China's system of socio-political-economy - and suffering severe economic damage and political instability in the process;
  • internal political and economic crackdowns, turning inward (as it did in 1525 perhaps because its political elite were afraid of free trade [1]) and accepting economic backwardness;
  • going all out to achieve its apparent long term goal of creating a new international order in which the constraints that liberal international political and economic institutions impose on the exercise of power through authoritarian state-centred social hierarchies might be eliminated.

China's Inadequate Reform Proposals in Early 2017 [<]

At the time of the March 2017 meeting of the National Congress, China's regime acknowledged its debt crisis and announced many steps that were to be be taken. This could deceive anyone who had not actually 'done the sums' into believing that China's debt crisis was being dealt with - presumably to maintain the impression of economic power that its political elite needs to maintain their authoritarian rule.  China's debt problems are an order of magnitude greater than the 'solutions' that were being offered in early 2017 (ie a cut of some $US2.5-3.5tr in China's rate of increasing its national debt is needed to merely stabilize its dangerously high debt / GDP ratio).  What has been announced might only achieve a $200-300bn cut. This would only result in only a small decline in China's rate of economic growth, but would not deal with China's debt crisis. This seemed like a repeat of the efforts that China made in 2013 to convince the world that its financial system was being 'fixed' and that Chinese capital could make a major difference to the world economy (Preparing for a Financial Con? - Late 2013) - assurances which had been followed by ever increasing problems in China's financial system.

Reform Proposals in Early 2017

China's president (Xi Jinping) indicated that a major change could be made to China's economy by winding down heavily indebted SOEs to make room for more private service industry companies. [CPDS Comment: While this would presumably reduce the rate at which bad debts accumulate, there would be little short-term impact and constrained long-term impact on China's need for rapidly-escalating national debts because: (a) as indicated above likely increases domestic consumption can do little to compensate for the very large cuts to new debt that are needed to stabilize its debt / GDP ratio; and (b) China's corporate state system pressures 'private' enterprises to achieve mercantilist, rather than simply commercial, goals while its banking system places little emphasis on actual return on capital].

China's premier (Li Kequiang) indicated a desire for a slight reduction in growth by reducing the availability of credit. It was noted that in 2016 Li had supported economic stimulus measures and been criticized by an 'authoritative' figure for supporting debt-driven growth. The Chinese regime was seen to be more interested in maintaining political stability than in economic reform.

China's premier also indicated a desire to increase employment while avoiding strong stimulus measures. More foreign and private Chinese investment would be encouraged while the availability of credit would be restricted. [CPDS Comment: As noted above, foreign investment is unlikely to make much difference without significant reform of China's whole system of socio-political economy. And 'private' investment within China's 'corporate state' comes with a lesser version of the same problems (ie pressure from state-linked social networks to achieve mercantilist rather than commercial goals) that afflict SOEs. Very limited reductions in debt-based stimulus measures are likely to be possible if a high rate of employment creation is to be achieved in an attempt to maintain political stability. To stabilize (quite apart from reducing) China's debt / GDP ratio arguably requires cutting annual creation of new debt by $US2.5-3tr - and reform proposals would seem unlikely to achieve more than a cut of a few $US00bn].

In February 2017 China's foreign exchange reserves reportedly increased (about $7bn) in the face of expectations that they would fall significantly (about $30bn) - a fact which indicated that the PBOC had again started buying to increase China's foreign exchange reserves. China's gold holdings also reportedly increased [CPDS Comment: Buying assets to increase FOREX reserves could be expected to: (a) weaken the value of yuan and thus boost China's international competitiveness - while increasing the risk of a trade war with US; (b) perhaps reduce the incentive for capital flight associated with reserves declining to unsafe levels; (c) increase China's national debt levels - unless increases to FOREX reserves were funded by sale of undeclared national assets - such as its gold reserves; and (d) provide a domestic economic stimulus by increasing liquidity.  The possibility that sale of gold reserves was involved in purchase of other FOREX reserves is suggested by: (a) the fact that the PBOC made a point of declaring an increase in China's gold reserves; and (b) China's actual gold reserves are often suggested to be (perhaps much) greater than officially stated].

In March 2017 a stunning reversal of China's clampdown on Australian apartment purchasers appeared likely after 12 months - resulting in restoration of Chinese buyers as the dominant force in the 'off-the-plan' apartment market  [CPDS Comment: Chinese buyers of apartments faced massive losses as an apartment boom driven by offshore buyers risked collapsing as their ability to settle on purchases disappeared.  This attempt by Chinese authorities to prevent this by 'managing' a speculative market (ie by announcing a policy reversal after a couple of months) bears some resemblance to what was done as China's domestic sharemarket boom turned into a bust in 2015. A chaotic outcome seems likely]

In March 2017 the PBOC acknowledged that China's debt levels were too high and stated that: (a) this could not be corrected in the short term; and (b) Chinese bonds would not be included in global bond indexes [CPDS Comment: Including Chinese bonds in global bond indices would have meant that index organizers would have had to be given access to the books of the institutions that issued the bonds to assess their soundness, China's regime did not allow this]

In March 2017 senior officials acknowledged that China's debt levels were too high. Finance minister (Xiao Jie) said that there was a lot of room for central government to raise more money (eg to cover bad debts of local governments). As China's economy grows bigger so will China's fiscal revenues. [CPDS Comment: China's problem is that its national debt levels are extremely high, and that its growth depends on raising them much faster than its economy (and fiscal revenues) are growing. Shifting debts from local to national government levels is not a solution to that problem]

In March 2017 China reportedly introduced new regulations to cover outbound investment to stem capital outflow and speculative investments. Emphasis would be given to strategic investments.[CPDS Comment: China has always sought to identify 'strategic' investments and has succeeded in finding those likely to achieve market demand but are relatively unprofitable and require large increases in national debts. Continuing to do this won't eliminate China's debt problem. Increased reliance on 'private' enterprise won't do so either as long as China maintains a corporate state (ie a system in which large independently-owned enterprises act as extensions of the state rather than as independent profit-driven undertakings).

In March 2017 external observers suggested that:

  • (a) severe monetary tightening seemed to have occurred which could erode the value of China's equities and property markets; and (b) inflation was rising fast perhaps requiring even tighter monetary policy and increasing the risk of capital flight. (see here)
  • China's growth (which was strong initially) could weaken because slowing consumption shows that demand is not strong enough to pick up the slack from waning stimulus policies. Economists see China as walking a fine line in trying to stimulate economy enough to prevent sharp drop in output while addressing rising debt and industrial over-capacity that resulted from years of stimulus [1]
  • Both US and China are on a path to higher interest rates - and though reasons are different they are linked. Positive economic data spurred rising rates in US. China's concern is rampant asset bubbles as post GFC cash found its way from stocks to real estate.  But China is also concerned that a stronger $US could accelerate capital flows out of China. Fed rate increases put PBOC under pressure to do the same. As bond yields rise Chinese companies find it cheaper to borrow outside China in $US.  But while leverage in China's financial markets fell, the broader economy remains highly dependent on debt - and this will take years to resolve  [1]
  • China is not overleveraged according to Prudential CEO (Mike Wells). The structure of leverage is improving. China is at the middle end of an industrial phase. There will be more structural reform and production efficiency. It has not yet really tapped consumerism [1].
  • China has hundreds of large companies with innovative / superior products who have been developing within China's domestic market and will now start 'taking on the world' in the same way that Alibaba and Huawei did - see here

CPDS Comment: China could hope that this 'secret weapon' could overcome the limitations imposed by its debt crisis (ie dangerously high debt levels; economic dependence on rapidly rising debts; and capital flight which risked eroding the ability of its large FOREX reserves to prevent external scrutiny of the poor balance sheets of its banks and companies). Establishing such companies might generate large additional current account surpluses and thus reverse the collapse of China's FOREX reserves. China's export-oriented capital intensive manufacturing (combined with suppression of domestic consumption) did this during China's initial industrialization. However:

  • the hoped-for large resurgence of current account surpluses might not happen through a new competitive challenge to what have become the world's highest valued-added industries (as capital-intensive manufacturing was in the 1960s). Large current account surpluses had been achieved by export-oriented manufacturing in Japan and China because: (a) domestic demand was suppressed; and (b) easy money policies were adopted elsewhere to compensate for those demand deficits by creating a wealth effect and making it easier to build up large debt levels. Domestic demand can't now be suppressed by China because it is increasingly being relied upon as a driver of China's economic growth. And the days in which the US (for example) was willing and able to compensate for current account deficits by building up debt levels with ultra-easy monetary policies are presumably at an end because the side effects are social inequality and political instability. And competitor nations have new options to boost their economic capabilities (eg see Getting out of the Economic Quicksand, 2011);
  • even if large increases in current account surpluses were to emerge, establishing the economic capabilities to achieve this will presumably add a great deal to China's national debts (and bad debts) - and thus merely disguise, rather than resolve, China's fundamental problem (ie the incompatability between the liberal economic / financial regime that could allow China to overcome its debt crisis and the autocratic political system through which it would have to achieve that change). 

In March 2017 China's State Research Centre suggested that the risk to China's growth had fallen - and there had been a shift from falling to steady growth. Growth was achieved through record bank loans, a speculative housing boom and massive government investment. As housing market is cooled, growth will depend more on domestic consumption and private investment. China's industrial output grew 6% in January and February 2017 - and fixed asset investment was similar to that in late 2016. China had a trade gap in February 2017 as the construction boom increased imports more than expected  [1]

Importing Global Risks   [<]

It also needs to be considered that:

  • There has been and remains a real risk of a global credit crisis. By way of background it is noted that:
    • economic growth has been driven since the late 1980s by ever accelerating increases in credit as a consequence of easy money policies and ultimately ultra-low interest rates / quantitative easing. This process started as a way of preventing financial crises (ie the 1987 stock market crash in the first instance) from impacting the real economy;
    • easy money policies then had to be maintained to create a wealth effect amongst those with significant existing assets (eg through rising asset values) to generate the demand needed to compensate for demand deficits that resulted from suppressing consumption / ‘savings gluts’ in East Asia (and elsewhere);
    • ultra-low rates boosted asset values (eg stimulated property booms such as that which burst in the US in 2008 giving rise to the Global Financial Crisis) but:
      • impeded ‘real economy’ growth in developed economies (and thus economic growth) by biasing investment towards the relatively easy gains to be made by 'playing the (financial and property) markets'; and
      • contributed to global deflation by encouraging investors to seek higher returns in emerging economies where export-oriented industrial over-capacity emerged. Ultra-low rates arguably also had a deflationary impact by forcing those in or approaching retirement (and increasing population share in developed economies) to increase savings and reduce consumption;
    • this also led to increasing social inequality in developed economies (ie the rich got richer – while others didn’t):
    • that inequality is now leading to potential political instability and incompetent governance (ie it seems to be the reason that Donald Trump emerged as a significant Presidential candidate in US – and is one of the reasons for equally irresponsible groups making political gains elsewhere);
    • overall debt levels globally are now very high by historical standards relative to global GDP - suggesting that rapid debt growth and debt driven economic growth may soon come to an end; and
    • slow overall economic growth as well as over-commitments associated with the asset booms created by US quantitative easing and China’s pre-2013 investment / debt driven economy have been putting various heavily indebted financial institutions / systems worldwide at risk of failure. This was presumably the explanation of severe falls in stock-market values in early 2016;
  • Recent attempts have been made (especially in Japan and Europe) to boost the debt-driven growth of recent years by shifting to negative official interest rates. However this is leading to economic stagnation while putting banks at increased risk of failure;
  • In the US the Federal Reserve which started the ultra-low interest rate trends seems to be confronting both slow economic growth and increasing inflation. The latter, combined with the various adverse economic / social / political consequences of ultra-low interest rates, will require lifting interest rates. When this happens servicing the massive government, corporate and household debt levels that have been encouraged by ultra-low rates will probably prove impossible – and a renewal of the global financial crisis is very likely;
  • in particular corporate debt has reportedly exploded in emerging economies to $US 25tr. Zero interest rates and QE flooded developing nations with cheap credit - and much of this was wasted. They also imported deformities of Western finance that they could not deal with. Some countries are experiencing premature de-industrialization. The middle income trap closed in on Latin America and the non-oil Middle Eastern states a long time ago - and is now starting to affect Malaysia, Thailand and China. Yet the liabilities associated with QE remain. In late 2016 it was similarly noted as the $US strengthened due to rising domestic interest rates, that the about $US20tr of US denominated debts in emerging markets could create risks. In early 2017 it was suggested that Emirates Airlines (which has become a major force in global aviation and was investing in the expectation that its future was unlimited) could be in trouble  - a situation which illustrated the exposure of emerging economies more generally because of their lack of a disciplined approach to investment;
  • Donald Trump's proposals for significant fiscal policy stimulus to US economy have boosted $US value and reduced international availably of $US, and this is expected to have more serious adverse effects for emerging economies (eg for companies that borrowed in $US) than his protectionist policies;
  • as noted above, China’s 2015 attempt wean itself from rapid growth in debt levels was a factor in the severe global share-market downturn in early 2016 – because of the adverse effect on global trade / commodity prices and recognition of the likely emergence of serious losses given high debt levels globally and weak economic growth. Then China’s shift back to rapidly increasing debt (which was unlikely to be sustainable) was probably a significant factor in the subsequent uncertain global share-market recovery. In late 2016 this seemed likely to be reversed because further escalating China's risk of a debt crisis was clearly not working as its economic growth continued falling.
  • there now seems to be fairly general acceptance by economists that: (a) low rates have pushed investors into property, stocks and bonds which drive up market prices while doing little to fuel economic growth; and (b) big shakeouts are likely in financial markets as interest rates are normalized.
  • major banks in Europe who are experiencing financial difficulties are likely to see 'bail-ins' of investors rather than 'bail-outs' by governments and this will lead to a retreat from all potentially troubled financial institutions

An Appropriate Response?

Any investigation of Australia's banking system in the near future should arguably include an emphasis on the risk of financial / banking crises and banks' ability to respond to such events.  

Moreover as China recognised in 2013, reliance on fast growing debts to ensure economic growth is a formula for a financial crisis - even though it benefits banks. Australia (which has apparently been second to China in relying on rising debt to sustain growth) also needs to moderate that trend. Even though Australia's financial systems are more reliable than (say) China's, Australians are not forced to invest in nationalistic undertakings or organised to produce goods and services through state-linked social hierarchies as they are in China. And Australia's ability to obtain credit depends on reliable accounting and sound balance sheets.

Suggestions about what might be required to sustain growth without rapidly-rising national debt are in Alternatives to Monetary Policy.

Problems in the Banking System Need a Desktop Analysis First

Problems in the Banking System Need a Desktop Analysis First - email sent 23/4/16

Sid Maher and Paul Kelly
The Australian

Re: Scott Morrison on the attack over ‘little list’ of bank problems and Federal election 2016: bank blitz goes far beyond a stunt (The Australian 22/4/16)

In the first of these two articles, Sid Maher reported that the ALP’s proposal for a royal commission into Australia banks was being ridiculed by the Treasurer (Scott Morrison) as not dealing with matters of real substance.

Why: The Opposition leader (Bill Shorten) had only expressed concern about: vertical integration; banks’ involvement in too many products; pressure to cross-sell things; remuneration structures; selling products customers don’t need; and irresponsible lending.

In the second article, Paul Kelly suggested that a royal commission could address very substantial matters and make a big difference to Australia’s banking system.

Why: Most of the scandals that have affected banks arise from their wealth management functions – ie from producing and distributing financial products. Vertical integration (which involves banks providing insurance / financial advice while also playing money markets) reduces their ability to deal with their core borrowing / lending function. The ALP does not trust the banking system as a consequence of the 2008-09 global financial crisis. It is perhaps seeking whistle-blower protections, better-defined remuneration packages, fewer conflicts of interest and definite compensation schemes.

However seeking substantial reforms of Australia’s banking system through a royal commission to promote domestic goals could be hazardous as far as Australia’s economic future is concerned. It could have the effect of applying a ‘blowtorch’ to bank managements who are simultaneously struggling to deal with a major financial crisis that is largely due to international developments (see A Royal Commission and a Potential Banking Crisis at the Same Time?).

There is undoubtedly a need to improve Australia’s banking system. But there is first a need to be clear about the full extent of the problems that affect that system – many of which are the result of international developments (eg for reasons suggested in An Approaching Crisis - From Late 2013? and Alternatives to Monetary Policy). A desktop analysis of the whole situation would be highly desirable before sponsoring a royal commission to deal with a part of it.

John Craig

Interest Rates and The Challenge of Stimulating a Deflationary Economy

Interest Rates and The Challenge of Stimulating a Deflationary Economy - email sent 8/5/16

Patrick Commins,
Australian Financial Review

Re: Why Australian interest rates are heading to zero , Australian Financial Review, 6/5/16 (also here)

Your article highlighted suggestions by a respected credit analyst (Alberto Gallo) that Australia is likely to have to move towards the ‘new normal’ of zero interest rates once it loses the protection its economy has had from strong commodity demands from China. While it is refreshing to see an analyst confronting the question of what needs to happen in Australia as China’s likely debt crisis unfolds, Mr Gallo’s suggestion (ie that even lower / zero / negative interest rates would be the best available option) is suspect.

My Interpretation of your article: Australia may be headed to zero interest rates – according to Alberto Gallo (former head of global credit research at RBS). Australian economists dismiss this – though last week’s March quarter deflation data sparked an immediate interest rate cut by the RBA. Mr Gallo forecasts a long period of low, near zero or negative rates. Quantitative easing permitted higher growth after the GFC but has led to adverse side effects (eg asset bubbles, resource misallocation, inequality, political risk and low productivity). Australia has had extreme over-investment in mining and energy which needs to be unwound. Australia’s exports to China have grown from 3% to 30% over past 25 years – and Australia now depends on housing investment which is increasingly funded by foreign (mainly Chinese) investors. Australia is the classic case of a country that has relied on the credit boom and the China boom. Commodity prices soared again in recent months as China again stimulated its ‘old economy’ (ie infrastructure and property). This is unlikely to be unsustainable as China’s total credit went from 200% to 230% of GDP - and, if China slows again, Australia will need further stimulus. Interest rates in Australia will need to hit zero in next 5 years because of China slowdown. There is a vicious circle involved as quantitative easing leads to slower growth which requires more monetary stimulus. Australia is fortunate that the RBA and regulators have restricted investment and required banks to raise more capital buffers. However it took 20 years to gear up Australia’s economy – and it won’t adjust quickly. The asset management industry is not well prepared for this environment

Mr Gallo’s observation about the strategic financial and economic environment that Australia faces seem reasonable given the necessary constraints of space in a brief article. They are a refreshing change from the official ‘no-problem-here’ view of Australia’s financial and economic position that has made it hard to develop a realistic policy response (eg see Creighton A., ‘Treasury Paints Too Rosy Picture of a Debt-laden Economy, The Australian, 7/5/16).

The present writer’s interpretation of Australia’s difficult financial / economic environment is in A Banking Royal Commission and a Potential Financial / Banking Crisis at the Same Time? This dealt with:

  • Australia’s risk of a financial / banking crisis due to: (a) a high level of ‘bubble’ investment over many years (especially in city apartments in recent years); and (b) a lack of serious attention to boosting economic competitiveness;
  • the risks that Australia is importing from China – due to continued dependence on exports to, and finance from, China as the latter’s credit bubble presumably bursts as Japan’s did in the late 1980s; and
  • the risks of a global financial crisis because of the world’s long dependence on ever-easier monetary policy (and escalating debts) to sustain growth in the face of the demand deficits / ‘savings gluts’ many economies required to reduce the risk of financial crises (eg the risks that resulted in East Asia from the non-capitalist / neo-Confucian methods they used to achieve ‘economic miracles’).

Mr Gallo’s observations about the adverse side effects of low interest rates (which include distorting investment, financial instability, social inequality and increasing political instability) also seem reasonable up to a point. However those low rates and quantitative easing (QE) have also been a major factor in generating the deflation that the RBA recently lowered Australia’s official interest rates to supposedly counteract. Ultra-low interest rates and QE arguably distorted investment globally so as to contribute to a deflationary imbalance between the growth of an export-oriented over-supply of goods in emerging economies (which attracted real-economy investment because of their higher interest rates) and weakening demand in their more developed target markets (where rational investors focused more on the speculative investments that falling interest rates boosted though they did little to boost national income or the incomes (and thus consumer spending) of all but a few segments of society) - see Alternatives to Monetary Policy.

As Mr Gallo also did, the latter suggested that ultra-low interest rates and QE have contributed to a global financial, economic, social and political crisis. Thus (even though perpetuating low rates and QE might allow unproductive speculative investments to drive economic growth for another couple of years) it would be foolish to regard this as the ‘solution’ to the crises they helped create. Rather it suggested that:

  • there is a long overdue need to raise the policy and operational competence of governments (and of the civil institutions that provide inputs to political debates);
  • there are alternatives to financial stimulation – eg accelerating growth by improving developed-economies’ access to and ability to use information (which economists have long recognised as the major factor in economic growth); and
  • low interest rates were used in the first place partly because of a neglected cultural incompatibly that has distorted the international financial system for many decades and is long overdue for attention.

Unless there is a shift from the perception that perpetuating low / zero / negative interest rates is the ‘solution’ to current economic constraints, the world is headed for catastrophe. The reported proposal by the controversial US presidential candidate, Donald Trump, to exploit ultra-low rates by increasing US government debts without concern and then defaulting if deemed necessary would undoubtedly lead to a breakdown of confidence in US Treasuries (traditionally a fall-back asset class in times of instability) and perhaps also the $US which has been the world’s major reserve currency. However even just maintaining zero / negative interest rates for much longer seems likely to have a similar effect on monetary systems - by encouraging, and ultimately forcing, investors to dump anything dependent on the value of fiat ‘money’.

John Craig

Good Question - But Decades Late

Good Question - But Decades Late - email sent 21/5/16

Mark Mulligan
Fairfax Media

Re: Understanding how interest rates got so low, Business Day, 20/5/16

Your article pointed to the extreme difficulty that ultra-low interest rates pose for those approaching, or in, retirement – and highlighted the need to understand why rates had become so low.

However the issue is vastly more complex than your article indicated:

Suggestions in your article: “ After the galloping inflation and oil shocks of 1970s, central banks determined to make price movements crucial to their policy deliberations. Deregulation of financial markets and the ever-quicker flow of information and money around the world then helped create the conditions that led to the GFC. In terms of supply-demand dynamics, it also provided a taste of what was to come. Because just as border-less, easy credit and demand facilitated the rampant overstocking of residential property markets that brought down the US, Ireland and Spain, so, too, emerging market powerhouses such as China, Russia and Brazil were able to ramp up production capacity in energy, metals, and manufactured goods. As demand from the GFC-ravaged developed world fell, so did prices. Partly as a result, Brazil is now mired in recession and China is cooling fast. Meanwhile, deflationary pressures, both imported and homegrown, have troubled most of the advanced world. Welcome to the new normal.”

An attempt to address the very complex issues involved is in Global Financial Crisis: The Second Test of Globalization (2008+).

A core problem has arguably been the neo-Confucian methods for exerting power through elite-dominated social hierarchies that (as compared with Western style profit-focused investment by independent entities) have been the basis for achieving economic ‘miracles’ in East Asia (see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, 2009).

The chronic lack of attention to the cultural issues involved in what amounts to a ‘clash of civilizations’ has had serious adverse consequences (see Competing Civilizations, 2001+). In brief those neo-Confucian methods:

  • (a) allowed rapid progress in the development of ‘real economy’ production; (b) required suppressing domestic demand to avoid financial crises because mercantilism (ie increasing national economic power) rather than capitalist profitability was the basis of major resource allocation; (c) led East Asia (Japan initially in the 1950s, then the Asian ‘tigers’ and ultimately China from the late 1970s) to ‘miracle’ gains in competitiveness in mass production manufacturing that had previously been the main basis of broadly based high incomes in developed Western economies – and thus to deindustrialization in Europe and North America in the 1960s and 1970s; and (d) required market liberalization in developed economies from the 1980s to prevent interest group pressures slowing economic change after government attempts to speed adjustment in Europe in the 1970s had been shown to be counter-productive (see China as a Dominant Power, 2014):
  • Led to increased Japan-led efforts to create an international financial system that was compatible with ‘mercantilist’ East Asian, rather than ‘capitalist’ Western, traditions (see A Generally Unrecognised 'Financial War'?, 2001+);
  • Created a global financial economic / economic environment that was intrinsically unsustainable – because: (a) the ‘savings gluts’ / demand deficits needed to avoid the risk of financial crises had to be compensated for by the willingness and ability of their trading partners (especially the US which had been the world’s ‘consumer of last resort’ to encourage the spread of a liberal political and economic systems) to tolerate current account deficits and continually rising debts (see Structural Incompatibility Puts Global Growth at Risk, 2003+). Easy money policies started to be used in 1987 to prevent a share market crash from adversely affecting the real economy – and these continued to induce a wealth effect amongst those with significant existing assets (by boosting asset prices) and thus high levels of consumer demand and public spending – as well as the risk of financial instability (see Impacting the Global Economy, 2009+);
  • Have been put in the ‘too hard’ basket by the G20 which was (theoretically) established to deal with problems in the international financial system (see Refusing to Face Up to East-West Structural Incompatabilities and Will China's Presidency in 2016 End the G20's Chronic Failure?).

As your article noted, there are indeed risks to the global economy and financial system, but suggesting that low interest rates are the ‘new normal’ that might continue indefinitely as the ‘solution’ is fanciful – for reasons suggested in Alternatives to Monetary Policy. Ultra-low rates have: (a) distorted investment and raised risks of financial instability; (b) contributed to a deflationary constraint on global economic growth; (c) contributed to serious social inequality – and thus to potentially crippling political instability (eg in US); and (d) been increasingly recognised to be economically ineffectual. And at the same time the major (ie East Asian) sources of the macro-economic imbalances that required low-rates in the first place might now be forced to adapt despite the massive cultural obstacles they face in doing so (eg see Japan's Predicament, 2009 and Continuing Concerns about China’s Financial / Economic Sustainability) – though war is another possible outcome.

It is indeed unfortunate that there has been such determined resistance to considering the practical consequences of differences in cultural assumptions / traditions (and thus of why ultra-low interest rates have come to be seen to be ‘normal’).

John Craig

Sustainable Growth Requires Ending Low Interest Rates

Sustainable Growth Requires Ending Low Interest Rates - email sent 4/6/16

Jessica Irvine
Fairfax Media

Re: Cheer up, the Reserve Bank's low interest rates are working, Business Day, 4/6/16

Irrespective of whether, as your article suggests, the RBA’s low interest rates can be seen to be ‘working’ at the moment, I submit that they seem to be leading Australia towards a crippling financial crisis. Alternative ways of boosting economic growth (eg apolitical processes that would use strategic information to build on, and build up, competitive advantages in regional industry clusters) are arguably available and need to be put in place as a matter of urgency.

My Interpretation of your article: Those who believe that Australia’s economy is in trouble are wrong. Global markets were concerned at the start of 2016 about China’s economy. However Australia’s economy expanded a solid 1.1% in the first 3 months. This was above expectations and could point to a 4% annual expansion. The 2016 March quarter expansion was driven by a large increase in net exports – due to surging mineral exports (especially gas). This occurred because rising export volumes more than offset falling commodity prices. And while iron ore exports are now near maximum, there is still scope for increased gas exports. Also services exports (eg tourism and education) are growing – because $A is weaker. Low interest rates are also helping – by stimulating the construction / renovation of houses. Business investment has however fallen sharply for mining and remained subdued in other areas. And Australians’ income has been falling for 4 years. But the latest data show that at least people still have jobs – and that the economy is growing above its trend rate. Treasury estimates potential growth at 2.75% pa. Growth depends on population, participation and productivity (the 3 ‘Ps’). Potential growth has declined because the first two have been weaker (eg because of a fall in the population growth that had been associated with the resources boom and population aging). Productivity is crucial. Above-trend growth suggests that the economy is starting to use some of spare capacity developed since the GFC.

Unfortunately as well as the 3 ‘Ps’ that your article mentioned, avoiding a financial / debt crisis is also a critical requirement for strong economic and jobs’ growth. And in this respect Australia seems to be headed for trouble (eg see outline of Alan Kohler’s The Trouble with Harry and A Banking Royal Commission and a Potential Financial / Banking Crisis at the Same Time?).

Australia’s economic growth has been driven by rapidly rising national debt – to finance relatively unproductive spending. Households have borrowed to fund consumption and speculative (property) investment while governments have borrowed to fund infrastructure, tax relief, income transfers and the provision of public services. China’s economy (on which Australia largely depends for strong commodity demand) has been facing much the same problem (because its rapid growth has depended on state-supported over-investment in industry / infrastructure / property with little regard to return on spending) and its current autocratic regime does not seem to have a solution (see Importing Risks from China).

Observers are increasingly drawing attention also to the risks that Australia’s high debt levels pose (see How Durable is Australia’s Luck? – 2016). Avoiding this risk arguably requires a significant increase in interest rates to: (a) discourage borrowing for economically unproductive spending; (b) encourage savings; and (c) force a shift from speculative (eg property) investment to that which is productive without reliance on every-falling interest rates.

The risk associated with Australia’s high national debt / GDP ratio and the dependence of growth on rapidly rising national debts does not seem to be officially recognised. The RBA apparently regards further increasing debt levels (via low interest rates to encourage more speculative investment, household consumption and government debts) as the key to stimulating growth. Political parties express various levels of concern about government deficits (and the possibility of a future downgrade in the federal government’s credit rating). But they do not seem to acknowledge the credit risk that the nation faces as a whole – especially if a similar problem leads to a crisis in China (as many observers expect).

Limits to low interest rates as a method for stimulating economic growth are now widely recognised internationally (eg see Interest Rates and The Challenge of Stimulating a Deflationary Economy). As the latter points out experience suggests that ultra-low rates have adverse long-term side effects including distorting investment, financial instability, social inequality and political instability – while also (probably) accentuating the deflation that that they are now supposedly being maintained to counteract. Those countries that are experimenting with negative rates have found no positive economic effects – though they are increasing the risks facing their banking systems. Speculations that ‘helicopter money’ (ie printing money to fund government spending) could be the solution to the world’s apparent low growth trap raise the specter of hyperinflation – because, rather than merely increasing liquidity by buying existing financial assets, reserve banks would then be increasing money supply (and the velocity of money). The US Federal Reserve now responsibly seems to be hoping for an opportunity to normalize interest rates – and thus reduce the distortions that long-term low interest rate policies have generated.

Suggestions about options to create a basis for sustainable economic growth in Australia are in Alternatives to Monetary Policy. The latter speculated that, as an alternative to low interest rates or increased government borrowing to fund infrastructure, growth might best be made sustainable by an emphasis on:

  • Restoring competence to government administration;
  • Using information (which economists recognise as the most important factor in economic growth), rather than money, as the key to boosting economic growth – eg by facilitating apolitical processes to use strategic information relevant to existing competitive advantages to stimulate the development of integrated regional industry clusters which could provide market-driven support for ongoing innovative initiatives by enterprises and individuals. Doing so would create more opportunities for the genuinely highly-productive opportunities that investors would be forced to seek by higher interest rates;
  • Encouraging international attention to the obstacles to global economic growth that distorted financial systems (especially the non-capitalist / mercantilist systems in East Asia) have by requiring: (a) domestic savings gluts; and (b) that their trading partners provide demand in excess of their national incomes and tolerate ever rising debt levels supported by very low interest rates which (as noted above) have severe adverse long term impacts.

Whatever low interest rates are currently doing, they are not creating a basis for sustainable economic and jobs growth in Australia.


John Craig

Don't Overlook Australia's Risk of a 'National' Credit Crisis

Don't Overlook Australia's Risk of a 'National' Credit Crisis - email sent 19/6/16

Adam Bandt, MP
Australian Greens

On ABC TV this morning you were advocating federal government borrowing to fund environmentally-beneficial investments (ie related to climate change and public transport). However Australia is increasing being seen by financial experts as having a potential problem due to its high ‘national’ debt – and its dependence on rapidly increasing that debt to sustain growth (see references amongst other material here – and a summary in The Risk from Rapidly Increasing Debt to Sustain Growth). ‘National’ debt has been suggested to be rising many times faster than GDP – as compared with a 1:1 ratio a few years ago.

And, though there has been little public awareness of the rapidly-escalating ‘national’ debt problem in spite of attention to questions about ‘government’ debts, it is possible that this will have changed by July 2. The following illustrates the fact that public awareness of what has so only far been recognised by experts is likely to increase.

Australia and China adopted mirror strategies deal with GFC - and both now face similar problems (which the IMF has highlighted in China's case). Both invested heavily after GFC in resource industries as well as housing and construction. IMF warns that China needs to deal with rising corporate debt or face dangers. China may have $1.3tr lent to borrowers who lack income to repay it. China has accumulated debt (now 247% of GDP) faster than any other country - but Australia is close behind. Vimal Got (BT) argues that during commodity boom Australia's banks borrowed heavily - mainly through long term bonds in foreign markets. This borrowing against future income assumed that rising commodity prices would continue forever. The money went to housing credit - which rose 20% pa - so benefits of Australia's mining boom mainly went to funding Australian house prices. The income windfall from rising commodity prices was spent as soon as earned. The balance sheets of CBA, Westpac and NAB more than doubled from 2003 to 2008 - as foreigners were happy to provide loans. Banks are now restricted from borrowing - but federal government borrowing is replacing them in allowing Australians to live beyond their means. Australia's current account deficit remains large - and more is being borrowed than earned. Australia thus needs to make adjustments like China is facing - but this does not seem to be understood politically. BT suggests that Australia's inability to tackle debt will force $A down to US40 cents. China's transition away from commodity-driven export industries will compound the problem (Gottleibsen R., China’s looming debt crisis has an Australian Echo, The Australian, 17/6/16)

It would be desirable to consider the implications of this issue in advocating borrowing for public spending. Though ‘government’ debt levels are by no means critical, ‘national’ debt levels may lead to significant constraints on further increasing overall ‘national’ (including 'government') debts (especially in the event of an anything-but-impossible Chinese and or international financial crisis).

[Note added later: It has been argued that though Australia's government debt / GDP ratio may be lower than in other developed countries, the rate at which it is being increased [a consequence of budget deficits] poses significant risks, and that political parties' claims that deficits will fall are fictitious].

A suggestion about what might help prevent this risk from translating into a ‘national’ credit crisis is in Another Approach to 'My Big Idea'.

John Craig

Are We Prepared for the End of China's 'Never-ending' Boom?

Are We Prepared for the End of China's 'Never-ending' Boom? - email sent 7/9/16

Brian Robins,
Sydney Morning Herald

Re: China's never ending boom - but are we prepared? Brisbane Times, 7/9/16

There is something strange about the analysis by the Australian Centre for Financial Studies (ACFS) that your article reviewed (ie The Long Boom: What Rebalancing Means for Australia’s Future). It seems out of sync with information and ideas that are coming from many other sources.

My Interpretation of your article: Last decade no one could have anticipated the effect of the commodity boom on Australia’s economy. Now China’s shift to greater reliance on services raises questions about Australia’s preparedness for major impacts on healthcare, education, tourism, financial services and construction – according to a recent Australia China report by the Australian Centre for Financial Services. 25% of Australia’s services could be destined for China. China now has the world’s largest middle class. Its shift from an investment-heavy economy to one driven by domestic consumption will change its links with Australia – according for John Brumby, chair of the Australia China Business Council which commissioned the study. Australia needs to study what is needed for success in this market. Edward Buckingham (Monash University) believes that China’s future growth will demand a much wider variety of goods and services. This raises strategic questions that need to be considered. Australia faces competition from other countries – and also from domestic service providers in China. Expanding services exports requires far more customisation than mining or agricultural trade. The last time a single market was as important to Australia as China was with the UK (40%) in 1952-53. China now takes 28% of Australia’s exports – though this could rise to 33% if China’s growth is faster than expected. Rebalancing may lead to gains by education and tourism – as well as construction. Much more of Australia’s exports could go to China in future. Also financial services could benefit. This is Australia’s largest industry and such services are poorly developed in China. Exports to China could rise from 11% to 16-19% of Australia’s financial services. Exports of healthcare and social assistance could rise to be equivalent to Australia’s mining exports in a decade.

Nothing in the ‘Long Boom’ report suggests that the ACFS appreciates that financial experts almost everywhere seem to expect China to soon suffer a financial crisis like that that ended Japan’s ‘long boom’ in about 1990 (see overview of typical views in Importing Risks from China). If such a crisis arises, it would invalidate claims about large economic opportunities for Australia from a new ‘long boom’ associated with China’s rebalancing.

ACFS’s attempt to produce a report on improving Australia – China relations purely in terms of specific economic opportunities seemed unwise also because:

Why is There a Problem? Economic Babes in the Asian Woods, in commenting on another report on China / Australia economic relations, noted the huge differences and incompatibilities between:

  • liberal / Western-style global financial systems - which emphasise market-oriented investment with a view to profitability by independent enterprises; and
  • those associated with East Asian ‘real economy’ miracles. The latter: (a) involve major resource allocation by state-linked-and-nationalistically-motivated financial institutions that have limited regard to return of / return on, capital; (b) have led to poor resource allocation and financial crises in East Asia; and (c) played a significant role in creating financial, economic, social and political problems elsewhere.
  • Rather than reforming its financial system (which is almost impossible because China's system of government is constrained in making any economically liberalizing change by the same excessive centralization that is leading to a financial crisis) China seems to be trying to head off the risks of a financial crisis that it now faces under prevailing Western-style international financial practices by creating a new international order like that by which Asia was administered from China prior to Western expansion. That system involved trade-tribute relationships whereby businesses with social connections with China’s autocratic regime would organise economic opportunities for those who accepted a subordinate political relationship with the Chinese state. In relation to this it is noted that:

Might it be worth writing another article which examines the ACFS’s ‘Long Boom’ report from a broader perspective?

John Craig

Risks Facing Australia's Banks

Risks Facing Australia's Banks - email sent 19/11/16

Robert Gottleibsen,
The Australian

Re: What could cause our banks to go belly up, The Australian, 17/11/16

Your article suggested that a stress test arranged by APRA is showing that the risks that Australia’s banks fear most are cyber-attacks and major commercial property losses.

My Interpretation of your article: APRA is conducting important stress tests on Australian banks. This is showing that banks are afraid of catastrophic internet / computer failure - potentially due to external attack. Banks no longer have paper back-ups. The second concern relates to substantial collapse in Australia's economy - in the commercial property market - rather than for housing. The most probable cause of a breakdown would be China pulling the plug. Trump intends to build US defence strength against China - and China might react by attacking economically

It is timely for a stress test to be conducted on Australia's banks.

However the risk factors that should arguably be considered are broader than those identified in your article (see A Banking Royal Commission and a Potential Financial / Banking Crisis at the Same Time?). This speculated about risks related to: (a) Australia’s heavy reliance on debt to finance growth and high national debt / GDP ratio; (b) a likely debt crisis in China on which Australia’s economy has become highly dependent; and (c) another major global credit crisis. Needless to say the accelerating trend towards higher interest rates (due to the economic inadequacy of easy money policies and the US’s likely shift to fiscal stimulus under president-elect Donald Trump) will exacerbate those risks.

John Craig

You ain't seen nothing yet

You ain't seen nothing yet - email sent 8/2/17

Emily Cadman and Chris Bourke

RE: With $1 trillion of Australian mortgages, the RBA might be getting worried, Brisbane Times, 8/2/17

Your article pointed to the rise of mortgage stress in Australia and to the high levels of total mortgage and household debt.

The underlying problem will probably dramatically increase because several independent factors are likely to reduce the availability of cheap credit (ie give rise to a severe credit squeeze). In particular:

  • China, whose investment in Australian property has been very significant, is struggling to deal with a massive debt crisis – and has recently started trying to contain this by clamping down severely on outbound foreign investment and capital flight. However China is likely to have to do much more than this to reduce its (and the world economy's) dependence on the rapid (ie 28% / $4-5tr pa) escalation of its national debt - given that its (300%) debt / GDP ratio is already dangerously high (see outline of what seems to be happening in The Risks from China and 'Trumponics' Both Matter);
  • The US Federal Reserve has been seeking to normalize (ie significantly increase) interest rates because: (a) while monetary policy can help boost liquidity in a financial crisis, the long term effects of ultra-low rates are highly dysfunctional (ie directly increasing the value of financial assets and property which biases investment towards speculative asset appreciation rather than ‘real economy’ investment and thus increases social inequality and political instability); (b) there is a need to normalize rates to have some ‘ammunition’ to use during the next financial crisis; and (c) President Trump’s economic agenda is believed to be likely to increase inflation in the US;
  • The European Central Bank has stated that it will soon start tapering its purchases of bonds – and warned of the constraints that this will impose on liquidity / the availability of cheap credit. The 'taper tantrum' that followed a similar change by the US Federal Reserve in 2013 provides a precedent;
  • Bond markets have experienced significant falls (and rising yields) because of expectations of rising interest rates – which would turn bonds' ‘risk-free-reward’ (when interest rates were constantly falling) into ‘reward-free-risk’;
  • ‘bail in’ rather than ‘bail out’ arrangements (ie imposing losses on investors rather than on governments) have become widely practised (and were apparently accepted by G20 countries at their 2014 Brisbane meeting in relation to any future failures by major financial institutions) – thus ensuring that investors will desert any potentially exposed financial institutions almost immediately. The latter will have to greatly increase the return on investors' funds if they want to continue trading;
  • while it might seem that global liquidity (and thus cheapish credit) might be increased by the IMF, this would not overcome the fundamental problem associated with the irresponsible use of ultra-cheap credit – a problem that has been most extreme in the major neo-Confucian non-capitalistic systems in East Asia in the absence of international regulation of lending standards.

The RBA is well aware of these international trends and thus that domestic attempts to counter-balance them by lowering Australian rates would have little effect. Doing so could in fact exacerbate a crisis by reducing Australia’s attractiveness to foreign investment in the face of: (a) the above indicators of a looming global credit squeeze; (b) the second highest national debt / GDP ratio in the world; (c) a need to maintain significant capital inflows to offset large structural current account deficits; and (d) the exposure of Australia’s banks to a financial crisis if capital inflows sufficient to maintain property values are not maintained (see Australia's Risk of Financial / Banking Crises as Growth is Driven by Rapidly Rising and Often Misdirected Debt).

John Craig

How Credible are Chinese Investment Proposals? Do the Sums!!

How Credible are Chinese Investment Proposals? Do the Sums!! - email sent 7/3/17

Rosanne Barrett and Ben Wilmott
The Australian

Re: Chinese to build $1bn city on coast, The Australian, 4/3/17

Your article suggested that a Chinese theme park entrepreneur is seeking control over a large area of sugar cane land on the northern tip of the Gold Coast in order to develop a $1bn city over the next 25 years.

Might I respectfully suggest that, rather than simply reporting such proposals, it would be desirable to critically consider their credibility. China is facing a massive debt crisis (see China's Likely 2017 Financial Crisis and Why China Has a Financial Problem). And, in response to the capital flight that has resulted from its debt problems, China is clamping down VERY severely on foreign investment (see China’s Clampdown on Capital Outflows).

It can be also noted that a predominantly Chinese company taking the lead in trying to organise a $3bn casino / hotel project on the Southport Spit was reportedly running out of money (see Klan A., Audit raises doubts about ASF, firm picked to lead $3bn resort, The Australian, 7/3/17).

‘Doing the sums’ on China debt crisis is not easy, yet doing so suggests that China faces a problem that its proposed policy responses to date (as well as the almost complete blockage of outward capital flow) will be totally inadequate to deal with.

John Craig

If There is Too Much Risky Debt, Why Not Do Something About It?

If There is Too Much Risky Debt, Why Not Do Something About It? - email sent 7/4/17

Dr Philip Lowe,
Governor, Reserve Bank of Australia

Re: Uren D., Economy at risk as debt bomb grows, The Australian, 5/4/17

You reportedly pointed to the risk Australia’s economy faces due to high household debts in the context of property booms mainly in Sydney and Melbourne. You then suggested options to limit risky lending, but did not mention: (a) the role that easy money policies have played in this; or (b) the risk of a debt crisis because of high national debt levels and the dependence of economic growth on rapidly increasing poorly-directed debt.

Themes Developed Below - The long term use of easy money policies as a means for macroeconomic management has adverse effects that need to be acknowledged. Slowly normalising interest rates would be a useful step towards: (a) easing risky debt-fuelled property booms in Australia’s largest cities; and (b) placing the economy on a path to sustainable growth. The risks with proposals to boost growth via public investments (eg in regional development or infrastructure) that would not produce short term financial returns also need to be emphasised, while new methods to encourage increased private investments likely to have shorter term financial returns should be considered. Reducing the supply-demand imbalance that is a major factor in rising house prices requires more effectively developing urban infrastructure. This in turn requires significant reforms to Australia’s machinery of government.

My Interpretation of the article in which you were quoted: RBA governor (Philip Lowe) warned that a debt-fuelled surge in Sydney / Melbourne property markets threatens the national economy. Housing debts are rising twice as fast as household incomes. Banks lend to people who can’t afford to repay. Stretched balance sheets create problems in a downturn. High debt levels with low wage growth are a bad combination. David Murray (chairman of the Financial System Inquiry, FSI) suggests that the housing boom could be followed by crisis like that of 1890 property collapse – which led to the failure of half of Australia’s banks. Capital city house prices have risen 12.9% over the past year (18.9% in Sydney and 15.9% in Melbourne). Dr Lowe’s comments are part of campaign by the Council of Financial Regulators to restrain property investment in Sydney and Melbourne. APRA and ASIC have announced steps to limit risky bank lending. RBA held the benchmark cash rate at 1.5%. RBA sees signs of improvements in the world economy but has concern about Australia. Dr Lowe does not accept that banks’ financial stability is at risk because they are soundly capitalised. However he is concerned that economic downturn could cause problems for indebted property investors / homebuyers. Housing related debt rose 6.5% over the past year while household income rose only 3%. Arrears are however low and many have built up buffers in mortgage offset accounts. Dr Lowe criticised lending to borrowers who could not afford it and interest only loans. RBA has called for negative gearing and capital gains tax incentives to be reviewed. Dr Lowe said that interest-only loans, as in Australia, were unusual. They were only allowed in other countries where borrowers already had a lot of equity. Loans are being made where borrowers have little income buffer above interest payments. Dr Lowe said that the root cause of the housing boom was governments’ failure to provide transport infrastructure to support fast growing populations. Good transport links would increase supply of well-located land. Under-investment in transport pushes housing prices up. Dr Lowe rejected claims that easy credit was the primary cause of the boom. Prices were subdued in some cities. Treasury is expected to have a housing affordability package for next month’s budget which focuses on increasing land supply. Mr Murray called for implementation of FSI inquiry recommendation about preventing superannuation funds from borrowing.

As you and others observers have noted, many factors apart from monetary policy contribute to Australia’s debt-fuelled property booms (eg supply-demand imbalances; infrastructure constraints on land supply; high immigration levels; centralized economic / population growth; foreign / Chinese investment; banks’ / non-banks' lending practices; and governments’ policies on superannuation, pensions and taxing property).

Ending the Use of Unsafe Monetary Policies

Since the late 1980s reserve banks (initially the US Federal Reserve) have found that providing emergency access to additional credit has been very useful in preventing financial crises from affecting the real economy. Doing so has limited the amplifying effect of failures by major financial institutions on the financial system and economy as a whole.

However reliance on easy money policies as the main method for countercyclical macroeconomic management (which has become a global phenomenon) has had quite negative consequences – including large increases in debt, asset bubbles and increased risk of financial crises.

Over the long term easy money policies distort investment by encouraging a bias towards assets likely to benefit from those interventions. As benchmark interest rates fall, the price earnings ratio for assets with reasonably predictable earnings rise. Thus the prices bid for such assets (eg bonds, property and share-buybacks) will rise and ownership provides a relatively ‘risk free reward’. Encouraging a preference for investment in such assets: (a) constrains increases in GDP (because value added is deferred until assets are sold); (b) shifts emphasis from investment in assets that would strengthen the ‘real economy’ on which business profits, household incomes and government taxes mainly depend; and (c) increases the risk of financial crises when asset booms are disrupted.

Another Investment Distortion (note added later): At about the same time that the use of easy money policies started encouraging investment in assets that would benefit from monetary interventions by reserve banks, the 1988 Basel Capital Accord encouraged banks to favour mortgage lending. Bank prudential rules allowed mortgages to households to be presumed to be safe. Banks had to hold only 25% of the capital for these that they did for business-loans. In the 1980s 2/3 of loans by Australia banks were for business, but this has fallen to 1/3. In the late 1980s mortgage debt was about 15% of Australia's GDP. It has since risen to 95% - and this is a major component in concerns about Australia's very high national debt / GDP ratio.

As well as distorting investment, social inequality can be increased because the major benefits will tend to accrue to those with existing assets. The prices of some of their existing assets will be driven up by easy monetary policy and the incentives given to banks to favour household mortgage lending.  And existing equity can be the foundation of further borrowing to obtain relatively ‘risk free rewards’. Rising inequality associated with boosting the wealth of the already-affluent and the limited economic prospects that many face when ‘real economy’ investment is less favoured have led to political instability, and thus disrupted government efforts to manage the situation competently.

There seems to be increasingly widespread recognition of these problems and of the need to normalize interest rates (see Do Low Rate Help?). Moreover the US Federal Reserve seems to be taking a lead in doing so even though the process is risky and needs to be slow. The European Monetary Union now seems likely to taper its bond-buying programs.

What does not yet seem to have received serious attention is the role that distortions in state-manipulated financial systems in East Asia have played in the first place in creating a need for easy money policies as a means to stimulate sufficient demand to prevent the global economy stagnating. Reasons for this (which require considering the practical implications of cultural differences – especially those related to social organisation and the way information is used) are outlined very briefly in International Regulation of Lending Standards. As the latter suggested, eliminating those distortions would seem essential to allow interest rates to be normalised and thus eliminate the economic, social and political problems associated with the long-term use of easy money policies to try to maintain growth. Changing the Basel Capital Accord's reported presumption that mortgage lending to households by banks should be treated as being low risk would also seem desirable.

Reducing National Debt Risks

As you reportedly noted, rising household debts associated with booming property markets are a potential risk to Australia’s economy.

However surely Australia’s national debt problem is broader than that associated with property markets (see Australia's Risk of Financial / Banking Crises as Growth is Driven by Rapidly Rising and Often Misdirected Debt). Australia’s debt / GDP ratio is high and economic growth has come to depend on increasing national debts through investments that contribute little to GDP. This has been seen to create the risk of a financial / banking crisis partly because of: (a) the need for extensive foreign capital to cover structural current account deficits; (b) the extent to which investment has been in a debt-driven property boom; (c) the high dependence of bank balance sheets on property assets; and (d) rapidly rising federal government debts to meet community desires for government services and transfers which undermine the credibility of any guarantees that might be offered in relation to Australia’s banks. Those domestic risks are compounded by the risk that debt crises could affect China (on whose economy Australia has become highly dependent) and / or the global economy.

The warning that David Murray reportedly offered about a crisis like that Australia suffered in the 1890s might be an overstatement if external risks do not arise – but under other circumstances it might not.

Australia’s risk of a national debt crisis makes it essential (as you reportedly suggested) to avoid problems related to high rates of household investment in urban property markets.

However there would also seem to be a need to ensure that any increases national debts should be in undertakings / projects that generate substantial increases in national income / GDP in the short term – to prevent further increases in Australia’s hazardously high national-debt / GDP ratio. The implications of this for regional development and the provision of infrastructure are suggested respectively in Reducing Congestion by Accelerating the Growth of Australia's Second-tier Cities and Alternatives to Monetary Policy. Proposals to boost economic growth by public spending on regional development and / or infrastructure projects whose financial returns were either uncertain or likely to be delayed would seem highly undesirable.

Private market-oriented investments are likely to have much greater financial returns in the relatively short term. Methods to increase the attractiveness of such investments are suggested in A Case for Innovative Economic Leadership, 2009 (in relation to theory) and Developing a Regional Industry Cluster, 2000 (in relation to methods the present writer used experimentally in the 1980s). Modern economic growth theories recognise that, though labour and capital inputs are necessary, information / knowledge is the primary driver of growth. The suggested methods involve more effectively mobilizing strategic information to speed the development of market-responsive and high productivity industry clusters. The effect would be comparable with: (a) innovation within individual enterprises; and (b) the neo-Confucian methods that have been the basis of ‘real economy’ miracles in East Asia in recent decades (though without the distorted financial systems the latter have used). Such methods could:

  • Boost economic growth, business profits, household incomes and governments’ tax revenues much more effectively than easy money policies are ever likely to;
  • Reduce Australia’s debt / GDP ratio;
  • Provide better opportunities for household investment than debt-driven property speculation; and
  • Create high income population ‘magnets’ in some major regional centres to potentially promote decentralization and thus reduce population growth and the need for unmanageably high rates of housing investment in major cities (see Reinventing the Regions, 2010 and Reducing Congestion by Accelerating the Growth of Australia's Second-tier Cities, 2017).

Urban and Infrastructure Development

You reportedly also drew attention to the need for improvements in the development of infrastructure to increase the supply of housing (and thus reduce the supply-demand imbalance). This arguably requires quite significant changes to Australia’s machinery of government – for reasons suggested in Bring Infrastructure into the 21st Century: Some Suggestions. The difficulty of making those changes could be reduced by temporary cuts to Australia’s high levels of international immigration, because such cuts would reduce the currently-intense / unmanageable ‘pressure’ that exists on urban and infrastructure development systems in major cities.

John Craig

Avoiding a Market 'Solution' To Australia's Overinvestment in Real Estate

Avoiding a Market 'Solution' To Australia's Overinvestment in Real Estate - email sent 11/4/17

Simon Benson
The Australian

Re Scott Morrison’s cradle-to-grave housing plan, The Australian, 10/4/17

Your article outlined what seems likely to be the Federal Government’s proposals for dealing with housing affordability (and briefly mentioned the federal Opposition’s critical response). Neither the government nor the opposition seem to have recognised the relationship between escalating problems in housing affordability and Australians’ unbalanced patterns of investment in recent decades.

My Interpretation of your article: The Turnbull Government will pursue a ‘cradle to grave’ housing affordability package – probably including: a mutual-obligation plan for first home buyers; tax breaks for downsizing the family home in retirement; a social housing plan to alleviate rental stress; use of federal / state land for housing to address housing supply issues. Institutional investment in social / affordable housing is planned. 1.3m Australians now negatively gear properties. The federal government will intervene in the life cycle of home ownership by addressing barriers to entry, institutional investment in social housing, rental affordability, regional relocation incentives, investment and housing in retirement. Superannuation model could allow first-home buyers to divert superannuation contributions to a home savings account to be matched $ for $ by personal contributions. Tax disincentives for retirees downsizing family home may be removed. Retirees using superannuation to pay off mortgage will be addressed. Stamp duty changes for foreign property purchases are being considered. Changes won’t be made to negative gearing – as this could lead to a rental crisis. Migrants may get incentives to settle in regional areas. Agreements on grants to states to provide public/ social housing will be rewritten. Mr Morrison said the budget package would lay the foundation to address fundamental problems – but not be a one-off panacea for the housing crisis. 2m taxpayers have an interest in residential investment, 72% own one, 90% have no more than 2. Reforms to alleviate rental stress are needed which now affects 40% of renters. Government is likely to adopt Britain’s ‘bond aggregator’ model to encourage investment in social housing through access to cheaper finance. There is a need for more housing for home owners / renters / key workers who can’t afford to rent or buy / those on low incomes / disabled / disadvantaged. Intervention in an area driven largely by interest rates and state governments will come with political risk. Opposition finance spokesman rejected Mr Morrison’s proposed changes – arguing that negative gearing and capital gains discounts need reform.

The nature of the problem and how it might be addressed is suggested in If There is Too Much Risky Debt, Why Not Do Something About It? .

In simple terms the latter suggested that since the late 1980s Australians have invested very heavily in housing. Strong incentives to do so have been implicit in the financial system (ie in the use of monetary policy for macroeconomic management and the Basel rules that allowed banks to treat household mortgages as low risk assets). Domestic investment in business undertakings has been limited by comparison. In the resources’ boom a decade ago a great deal of investment came from offshore, rather than from domestic sources. Investment in housing is relatively unproductive in contributing to GDP compared with investment in business. Much of the gains from housing investment will be locked into future capital gains. The latter will create a wealth effect for those who own houses but make limited immediate contribution to business profits, employee incomes and government’s tax bases. Over-investment in housing and under-investment in productive businesses has arguably:

  • created a national debt / GDP ratio which is so high (mainly because of a massive rise in the household mortgage / GDP ratio) that there have been repeatedly warnings of Australia’s risk of a national debt crisis; and
  • left large segments of the community with limited incomes to try to buy or rent from a housing stock which is very expensive because so much has been invested in developing it.

The pattern of investment in Australia’s economy needs to change. Government intervention would be complex and ineffectual if it merely tries to allow those whose incomes are low due to under-investment in productive businesses to meet the cost of accommodation that is high because of housing over-investment. Such intervention would not prevent the underlying problem from escalating. Unless a serious effort is made to rebalance investment in Australia, the market is likely to impose a ‘solution’ in the form of a collapse in property values. This would be economically disastrous, but would ultimately restore a balance between the value of housing and the general community’s capacity to pay.

John Craig