Thursday, March 19, 2009


Sydney Secondary College
March 19, 2009

The Global Financial Crisis

What we now call the global financial crisis had its origins in a bubble in the housing market of the United States economy. The bubble had been caused partly by the issue of housing loans to ‘sub-prime’ borrowers with doubtful ability to repay. Most of these sub-prime loans had been turned into mortgage-backed securities that were sold to many banks in America and Europe (and some Australian local government councils). From July 2007 it became clear that many of these securities were now worth much less than they had been bought for, but for a long time it was unclear just what these securities were now worth and how much of them particular banks were holding. So the sub-prime debt crisis touched off a sudden lost of confidence in US financial markets which led to the unravelling of a two-decade long boom in US financial markets, a boom that had been built on the invention of highly complex derivative contracts and high levels of ‘leverage’ (borrowed capital relative to equity [share] capital) by commercial banks, investment banks and hedge funds.

US Banks became reluctant to lend to each other on the short-term money market, and various financial markets seized up so that, for example, Australia’s non-bank mortgage lenders, such as RAMS, could not renew the short-term loans they had borrowed in the US market and so their businesses collapsed. Thus financial globalisation meant that problems in the US loan markets - and falls in Wall Street’s sharemarket - were quickly transmitted to other countries’ financial markets, particularly in Britain and Europe, where banks had bought large quantities of sub-prime debt, had engaged in derivatives transactions they didn’t understand and had borrowed excessively.

What began as a ‘sub-prime crisis’ and became a ‘credit crunch’ (where even sound businesses had great difficulty borrowing the money necessary to continue in business) turned into a fully blown ‘global financial crisis’ from mid-September 2008 after the failure of a large American investment bank, Lehman Brothers. In the panic that followed, credit markets seized up, many banks, mortgage lenders and big insurance companies in the US and Europe had to be prevented from collapsing by government intervention. Governments around the world had to guarantee their banks’ deposits and other borrowings. While all this was happening the world’s sharemarkets were plunging. And with the whole world watching the financial crisis unfold every night on television, the result was sharp blow to business and consumer confidence in almost all countries at the same time.

The US economy has been in recession for more than a year. A severe recession in the US has an adverse effect on most other economies because the US is the world’s biggest economy. But there is a lot more to this episode than just a severe recession in the world’s biggest economy. What makes it much worse is the crippled state of so many major banks in the US and Europe, which has largely prevented those banks from continuing to lend to viable businesses. Until businesses (and households) can get the credit they need to continue trading and start expanding, no amount of fiscal stimulus will get an economy back on its feet. Because the financial shock has hit all major economies - developed and developing - at the same time, this is the most highly synchronised world recession we have experienced for many years, thus making it more severe. The latest forecast is that gross world product will actually contract in 2009, the first time this has happened since World War II.

Channels through which the global crisis affects the Australian economy

It’s all very well to talk about the global financial crisis and assert that it will adversely affect our economy. A good student of economics has to be able to explain exactly how developments in the global economy affect us. In what ways? What are the mechanisms - or channels - by which the downturn is transmitted to Australia? You can’t just wave your arms in the air, you have to be specific.

We can identify three main channels through which the global crisis and recession has been - and is being - transmitted to our economy:

1) the financial channel has two aspects:

a) debt markets. Developments in US and other debt markets (markets for the borrowing and lending of money) have raised the interest rates our banks must pay to continue borrowing from overseas and made it much harder for non-bank borrowers to raise any more funds from overseas. Remember that almost all of Australia’s considerable net foreign debt has been borrowed by our banks. Our banks have passed their higher borrowing costs on to their business and household customers. This problem has been eased by the Government’s guarantee of inter-bank lending between our banks and their foreign counterparts.

b) equity markets. Developments in US and other equity markets have led to sharp falls in share prices on the Australian stock exchange. This has had two adverse effects: i) it has reduced the capacity of Australian businesses to raise new share capital, and ii) it has had a ‘negative wealth effect’, particularly on people with superannuation and other share investments who are in or approaching retirement. They now feel poorer than they were, which encourages them to consume less and save a higher proportion of their incomes.

2) the trade channel has two aspects:

a) reduced export volumes. Reduced consumption and investment in our trading partners’ economies reduces their imports from the rest of the world and thus the volume (quantity) of our exports.
b) reduced export prices. Reduced demand for mineral and energy commodities in the developed world and China and India is sharply reducing the prices we receive for our commodity exports, particularly coal and iron ore. Whereas until the second half of last year commodity prices were rising strongly and producing a large improvement in our terms of trade, which represented a big increase in the nation’s real income, now commodity prices are falling rapidly, which is worsening our terms of trade and reducing the nation’s real income.

3) the confidence channel: news of the global financial crisis, the global fall in sharemarkets and now the global recession has struck a blow to the confidence of our business people and consumers (and it has in almost every other economy). They are uncertain and fearful about the future, making them reluctant to take on new commitments (even though interest rates are so much lower) and anxious to reduce their exposure by cutting their spending and paying down their debts. Treasury says ‘the effects of the crisis on confidence are the hardest to quantify but arguably the most important’.

The policy response to the global crisis and recession

From the time the credit crunch worsened into the global financial crisis in mid-September last year, both the Reserve Bank and the Rudd Government have responded with speed and vigour.

Monetary policy: In the early part of last year the Reserve Bank was worried about growing inflation pressure and was still raising interest rates. By early September, the official cash rate had reached a peak of 7.25 per cent and the stance of monetary policy was quite restrictive. But the economy was slowing rapidly and the global environment was threatening, so the Reserve began easing policy, cutting the cash rate by just 0.25 percentage points. By early October, however, the financial crisis was at its height and it was evident that both financial markets and confidence had suffered a major blow. The Reserve was the first central bank to respond decisively, cutting the cash rate by a full percentage point. Further big cuts followed in November, December and February. The combined effect was to cut the cash rate by 4 percentage points in just five months. In that short time the stance of policy was switched from ‘quite restrictive’ to ‘highly expansionary’. At 3.25 per cent the cash rate is the lowest it has been for 45 years.

Although the Reserve paused to take stock in March, it is clear it will cut the rate somewhat further - perhaps by as much as another 1.25 percentage points - in the coming months.

Fiscal policy: In mid-October the Rudd Government announced its first fiscal stimulus package, worth $10.4 billion, or 1 per cent of GDP. Most of the cost went on cash bonus payments to pensioners, carers and parents. The other main measure was temporary increases in the first home owners grant, particularly for those buying newly built homes. Treasury estimated that spending of 1 per cent of GDP would cause GDP to be between 0.5 and 1 per cent higher than otherwise. This lower multiplier is explained by leakages into imports and saving.

Next the Government announced various small increases in spending on capital works, but then in February it announced a second stimulus package worth $42 billion over three years, but with most of the money to be spent in calendar 2009. This will be equivalent to 2 per cent of GDP. Less than a third of the money will go on another round of cash bonuses - this time to taxpayers, parents, farmers and some students - with more than two-thirds going on small, ‘shovel-ready’ capital works, including at every school in Australia. This package is expected to cause GDP to be higher than otherwise by about 0.5 per cent in 2008-09 and 0.75 to 1 per cent in 2009-10.

Two things are clear. First, the stance of fiscal policy is now clearly expansionary. Second, as could long have been predicted, the turn in the business cycle has prompted the Government to shift to an overtly Keynesian approach to fiscal policy. It has stated that it will ‘allow the automatic stabilisers to support economic stability’ - that is, to operate unhindered - and it has acted to add discretionary fiscal stimulus on the top. Both points are, of course, consistent with the medium-term fiscal strategy, which represents a policy of what I call ‘symmetrical Keynesianism’.

Both stimulus packages were carefully designed and represent state-of-the-art Keynesian policy in that they comply with the Three-Ts rule of fiscal stimulus: measures should be timely, targeted and temporary. The timely principle says governments should apply their stimulus as early in the downturn as possible to prevent the economy unravelling. A stitch in time . . . . The targeted principle says the stimulus should go to those people or on those purposes most likely to get the money spent quickly. The temporary principle says measures should be of a once-only nature so they do nothing to slow the budget’s return to surplus when the economy recovers.