Avoiding Ongoing Global Crashes (2009)

• Outline
• The Need to do More

In a ground-breaking article, The Global Crash we could have avoided (Australian Literary Review, 6/5/09), Dr John Edwards  suggested that the global financial crisis (GFC) could have been prevented because it was simply due to the large sub-prime losses that heavily-indebted US banks incurred as the result of commercial irresponsibility and defective regulation.

Outline of The Global Crash we could have avoided (Edwards J., Australian Literary Review, 6/5/09: The financial crisis is an abrupt denial of Australia's expectations. A surplus of $20bn last year will turn into a $50bn deficit in the next federal budget. However though more dramatic, this crisis is likely to have less effect in Australia than recessions in the 1980s and 1990s. PM suggested that this was the end of an epoch, while others (eg Soros) suggest that there is a need for major changes in US, China and Japan. The development of CMOs (collateralized mortgage obligations) in US had led to a similar crisis, eg in 1994 raised interest rates made CMOs untradable - and foretold the 2008 failure of Bear Sterns and Lehman Bros (though in the latter case mortgages had been extended to people with poor credit ratings which were bundled into collateralized debt obligations - CDOs). Banks had set up subsidiaries to hold CDOs, but were ultimately responsible for losses, and were soon in serious trouble. In 2008 this did not portend severe economic problems, as central banks provided large loans and banks found new capital. The failure of Lehman Bros suddenly made the problem much worse. Banks, not knowing who might be next, ceased lending to one another. At the end of 2008 financial markets / trade / household spending froze. 2008-09 is likely to be the worst year economically since WWII and it is only now that signs of slowing in downturn are emerging. A key question is whether there were wider causes than widespread sub-prime delinquencies in securities held by indebted banks? Some relate the crisis to broader US / global problems (eg high debt / dependence on imported oil / credit boom / low interest rates - which made cheap money available for lending / a resulting asset bubble / everything being too good leading people to take silly risks so that the whole thing blew up). China's relationship with US is also blamed (ie 'vendor financing' of cheap manufactures exported to US). Australia's PM believes that addressing these imbalances is needed - as these have destabilized the global economy. This has big implications for Australia, given its large current account deficits. But there are problems in these views, because: (a) Australia (like US) experienced a 50% rise in housing prices in the 5 years to 2007 but without serious problems; (b) US share price rises were no greater to 2007 than in Australia / Japan, and slower than in 1990s; (c) there is a view that US had a consumption boom this decade - but its GDP increased only 14% to 2007 with consumption rising at same rate, compared with 24% GDP rise (and increased consumption / GDP ratio) in second half of 1990s; (d) while debt increased in US financial institutions, it was not abnormally high in non-financial institutions, and increased in households only because of a housing boom; (e) low interest rates in 2003 may have contributed to rising house prices, but it was rising interest rates in 2005 and 2006 that triggered sub-prime delinquencies; (f) bankers were not driven to reckless lending by low official interest rates - as this did not affect longer term yields or returns on equity. Moreover there had been increasing, not falling, profitability; (g) low interest rates in themselves could never be enough to have crashed the global economy; and (h) excess savings (by China / Japan / OPEC) could not have been the problem (by forcing interest rates low) or else long term rates would have fallen (as they did to 2003 before rising to 2007) and the $US would have appreciated (though it was actually in long term decline). None of this explains: (a) why US lenders rushed to offer credit to those with poor histories, or (b) why banks bought large quantities of securities financed with overnight borrowings; or (c) why global financial system was affected and an economic catastrophe followed financial crisis. Necessary and sufficient explanation is that economic crisis resulted from financial crisis due to reckless lending and under-estimation of risk by foolish bankers and US regulatory neglect. Excessive US consumption / paying too much for houses / global imbalances / China, were not causes. Sustained growth led to under-estimation of risk. Crisis could have been avoided if the US had decent financial regulation. The US and Canada had many features of the US economy - but did not experience crises - because they had sounder regulation. Australia's PM argues that crisis reflects the failure of neo-liberalism (which covers most major recent trends in economics). However he recognises the major problem as poor regulation and political attitudes in US - as neo-liberals unrealistically believe in inherent superiority of free markets. The US Fed (unlike other reserve banks) never issued a financial stability report. The regulatory failures that occurred were not international - but national. Australia and others followed BIS rules and had no problems while US had problems (ie with sub-prime lending / leveraged investment banks / off-balance-sheet vehicles). US won't accept international regulation of its financial system (eg by IMF), but until its regulation reaches world standard, financial crises will continue to emerge from US. In mid April 2009, the global financial crisis was fading and economic downturn was slowing - though problems remained. In a year or two the world may come to rights - but it will be a different world. Australia, one of the least affected economies, will suffer large budget deficits. Elsewhere deficits will be larger. Unemployment will take years to come down. Asset prices may recover - but the crisis will be long remembered. The US will perhaps save more. China will encourage domestic consumption and investment, and discourage vast savings in state-owned industries. The US may get decent financial market regulation. Globalization (featuring the rise of China, India and Brazil) will again be the main feature of economic comment. China's resilience and support for Asia during the crisis will have established its status as the world's second greatest economic power. The US will recover. Though Australia will struggle with deficits, it will be concluded that the strength of its financial system, its well balanced prosperity and the readiness of its central bank and government to intervene when needed allowed it to pick up quickly and with limited damage.

Though it is possible to quibble about details of his case, the path out of the GFC that Dr Edwards has suggested as a consequence of that simplifying conclusion (ie addressing one part of the global problem at a time and starting with reform of US institutions) is plausible and attractive.

 Some inconsequential quibbles with the above article include:

• banks around the world had apparently curtailed lending to one another (because no one knew where losses might be concealed) before the failure of Lehman Bros - though the latter exacerbated the problem;
• the major early losses in US banking system did not mainly arise from sub-prime loans (though such losses were serious), but rather from loans to investors who had been hoping to turn properties over before settlement at a profit. Subsequently losses have been incurred on many different types of loans (eg prime mortgages / commercial property / credit cards / student loans / car loans);
• US banks loaned to those with poor credit status partly because new equity-oriented laws and the US government forced them to do so;
• banks (and others) disregarded risk partly because new techniques of macroeconomic management (through boosting liquidity to prevent financial dislocations affecting the real economy) had been developed by the US Federal Reserve as a response to the 1987 sharemarket crash, and this made risk seem negligible. Thus it was not entirely unreasonable (if imprudent) to believe that asset price rises would never be seriously disrupted.

For references see Causes in Global Financial Crisis: The Second Test of Globalization?:

Outline

None-the-less it will be suggested below that more than reform of US institutions is required to reduce the risk of ongoing global crises because:

• the possible broader causes of the GFC that have been raised (ie beyond blaming US financial regulation and political attitudes) do need attention. The US-focused article has not addressed all relevant aspects of the problem because: (a) Europe appears likely to suffer even worse financial / economic outcomes than the US; and (b) East Asia's economic models involve financial regimes which are much less compliant with world 'best practice' than the US's;
• potential GFC causes can't be discounted because they were benign elsewhere, as local conditions affect the outcomes from similar causes;
• the US was heavily exposed to risks. As a Cold War legacy, it unilaterally tried to promote global development on the basis of democratic capitalist principles;
• East Asia's economic models make demand deficits essential, and are thus unsustainable without support from a strong external source of demand;
• the US strategically supported East Asia's development despite its unbalanced economic models, on the basis of the US's perceived financial / economic strength and at some risk - presumably in the hope that market forces would ultimately force changes to reduce the financial imbalances this policy generated;
• though there is some value in doing one thing at a time, without parallel reform in East Asia, the US-focused reforms suggested will merely expose East Asia to the hazards implicit in the economic models that were copied from Japan.

The Need to Do More than Reform US Institutions

The article, The Global Crash We Could have Avoided, did not only suggest a simple explanation of, and remedy for, the GFC (related to better banking practices and regulation in the US). It also outlined and argued against many broader theories about GFC causes (eg high debt levels / a credit boom / low interest rates / an asset bubble / international financial imbalances).

For example, the article commented on many of the views expressed about causes of the GFC by Australia's Prime Minister (Mr Rudd) in a paper ('The Global Financial Crisis, The Monthly, February 2009). It endorsed his view that "the main problem in the US was [poor] financial regulation and political attitudes towards it", but rejected his suggestions (and similar claims by many other observers) that broader issues are also at stake.

Can Other Factors Be Ignored?

However, while Mr Rudd's main conclusion seems overstated (ie that a heavily interventionist system of political economy is now needed because the 'neo-liberal' paradigm of the last few decades failed - see A Social Democratic Alternative to 'Neo-Liberalism'?), there is a need to consider the other possibly-significant causes that he (and others) suggested. Unless these are addressed, as well as the relatively-easily-corrected defects that Dr Edward's article nominated, the GFC is likely to have more severe and longer-lasting consequences than he implied.

Two particular facts suggest that his article has not addressed all aspects of the problem:

• Europe has apparently experienced a worse financial crisis than the US (and may have worse economic outcomes) - yet European countries had no domestic sub-prime mortgages or any lack of compliance with international regulatory regimes (ie the defects that were suggested to be the only cause of the US crisis);
• for complex cultural reasons financial systems in East Asia bear little relationship to the 'world standard' financial regulation were advocated. Economic production seems to be coordinated mainly in terms of neo-Confucian social relationships, rather than by a search for the profitable use of capital. It appears that such practices, though effective in organising production: (a) inhibited Japan's economic recovery after its financial crisis in 1990; (b) played a part in the Asian financial crisis of 1997; (c) were responsible for the subsequent accumulation of large foreign exchange reserves to guard against future financial crises despite the lack of serious financial system reform; and thus; (d) contributed to the GFC (eg see Financial Imbalances in Global Financial Instability: A Many Sided Story).

Simple Causes in Complex Systems?

An even more fundamental question involves the adequacy of simple causes (such as irresponsible bankers and defective regulation) in explaining outcomes in complex systems. A lightening-strike does not necessarily cause a bush-fire. What happens depends on the environment in which it occurs (ie a bushfire may result in a in a tinder-dry environment, but seldom during a thunderstorm). The assassination of Archduke Franz Ferdinand of Austria has often been identified as the 'cause' of World War I. But there have been many assassinations that did not lead to world wars. Other environmental circumstances (eg international political stresses) also had to be right for that particular assassination to have such severe consequences.

Thus one can't conclude (as the article suggested) that factors that did not lead to a financial crisis elsewhere could not have contributed to one in the US. Moreover:

• to understand a crisis there is a need to consider environmental factors, as well as the event that triggered it (whether a lightening strike, an assassination or unexpected losses by heavily geared banks);
• if circumstances favour a crisis, then there is likely to be a crisis no matter what triggers it. If a forest is tinder dry / or there is a tense political situation, then there a bush-fire or a war is likely - and it is naive to solely blame a particular spark or assassin for igniting it.

Dr Edward's article was probably premature to conclude that, because booms in sharemarket and property values did not lead to financial crises in (say) Australia, they could not have done so in the US - a quite different environment.

Context to the GFC

The US, unlike Australia, was apparently engaged in very risky unilateral endeavours to promote global economic development in the basis of democratic capitalist practices - presumably as a legacy of the Cold War against Communism.

The US clearly based its monetary policy (which had been the main tool for macroeconomic management since the 1970s) on maintaining global growth in the face of the demand deficits implicit in East Asia's export-led industrialization strategies (see Structural Incompatibility Puts Global Growth at Risk, 2003). For example Alan Greenspan (as Federal Reserve Chairnan) often noted the need to guard against deflation as the reason for the low interest rates that inadvertently encouraged asset inflation in the US - yet deflation was a risk that Japan faced because of features of its economic model (but the US itself didn't). Mr Greenspan, at the same time, expressed hope that market forces would eventually force a reduction in the global financial imbalances that resulted from this.

The East Asian export led industrialization strategies that Japan pioneered were macroeconomically unbalanced (ie they had to contain a large demand deficit, because of the way production was organised). They were thus unsustainable within themselves (ie they depended critically on other's willingness and ability to run large and perpetual current account deficits) - see Are East Asian Economic Models Sustainable?, The US was able to take this responsibility for counter-balancing these demand deficits for many years because: (a) the $US was the global reserve currency; (b) it had a strong financial system; (c) the development of macroeconomic management methods (ie boosting liquidity to counter financial reversals) appeared to allow long term sustained growth; and (d) rapid escalation in asset values in recent years allowed high rates of household spending and government tax collections. However because of the scale that economies operating on East Asian economic models acquired, they ultimately had the effect of making global growth unsustainable, long before US sub-prime mortgages emerged to trigger a crisis in 2007 (op cit).

A financial crisis of some sort could probably not have been avoided just by smarter bankers and better regulation just in the US. A tinder-dry economic environment had been created, and was likely to be ignited by something. If the US had not had the aggressive banks and loose regulatory / monetary arrangements needed to sustain large financial imbalances, a different sort of crisis would have occurred at another time.

The Problem with a Narrow Focus

Dr Edward's hopeful vision of the future had much appeal. However it may not be achieved without practical action to address more of the diverse factors that have led to the current situation, Structural Indicators of Ongoing Recession / Depression speculates about what else could go wrong, for example, that:

• governments (especially the US) may be unable to fund the deficits incurred in seeking to counter the financial crisis and stimulate economic growth; and
• East Asia's economic models may prove unsustainable in an environment in which growth has to be driven by domestic demand. It will not be possible in future for the US (and other trade deficit countries) to support large demand deficiencies in East Asian economies because (a) they must constrain demand to repay past debts, and (b) only modest asset inflation can result in the unavoidably more conservative banking and monetary environment that your article prescribed.

US adherence to 'world standards' for financial regulation on its own would merely expose East Asia (which is now economically significant to Australia) to the financial crises that have always been implicit in the region's economic models. The adjustment to market forces that would occur in a few years would probably be catastrophic rather than incremental.

Getting Australia's House in Order

On the assumption that the problem may be quite complex and thus not quickly resolved, some suggestions about Australia's response are in Managing Australia's Economic Crisis. This refers (for example) to: developing more realistic machinery of government; and boosting the supply capacity of the economy.