ECONOMICS AFTER THE GLOBAL FINANCIAL CRISIS

Talk to The New Institute, Merewether
July 14, 2009

I want to deal briefly with the origins of what we’ve come to call the global financial crisis and its consequences for economies around the world before I focus on the underlying causes of the crisis and the role of economics. Then I’ll look at what needs to be done to avoid another such monumental failure of economic management. I’ll be talking mainly about the global scene - particular the scene in America, where the crisis had its origins - and much of what I say won’t apply to Australia, though I will talk about how Australia managed to escape the worst of the madness.

The origins of the crisis can be found in America’s huge housing boom, in which house prices rose greatly, many hundreds of thousands of new homes were built and the rate of home-ownership rose significantly. One factor that made the boom so big was the issuing of loans to sub-prime borrowers - people with bad credit histories who had no hope of servicing their loans. This irresponsible lending was encouraged by the securitisation of loans - that is, because the banks that made these dubious loans didn’t retain them but converted them into mortgage-backed securities, which they then sold to investment banks, hedge funds and pension funds, not just in America but in Europe and even to some Australian local councils. Inevitably, the housing bubble burst and it was suddenly realised that many of the sub-prime loans would never be repaid. House prices fell dramatically - because the Americans had built far more houses than they actually needed - and a lot of big investment banks and other institutions found themselves holding possibly worthless mortgage-backed securities. But it wasn’t clear which banks were holding large amounts these securities and were thus in trouble. This uncertainly generated a great deal of fear and reluctance among the banks to continue dealing with each other.

This wouldn’t have been so bad - it would have led just to a housing-led recession in the US - were it not for the fact that it brought unstuck a huge and long-running expansion in the financial sectors of all the developed countries. The financial markets had been inventing complicated new financial contracts known as derivatives that supposedly shifted various forms of risk on to the shoulders of people more able and willing to bear that risk. Because this trading of risk was believed to have reduced the risks financial institutions were facing, they were emboldened to borrow heavily to buy more of these derivatives that were proving so profitable. As part of the globalisation of financial markets, financial institutions in Britain and Europe - and Australia to some extent - participated fully in this decade or two of frenzied trading and expansion.

The sub-prime problem acted as the bump that caused this whole house of cards to collapse. The crisis reached its culmination in mid-September last year, when the US authorities decided to allow one of America’s five big investment banks, Lehman Brothers, to collapse under the weight of its debts. This caused a wave of panic among financial institutions on both sides of the Atlantic. They refused to deal with each other, financial markets temporarily stopped functioning, and banks and insurance companies started falling over. For a period of several weeks governments had to step in to prop up these institutions, all of them granting government guarantees of their banks’ deposits and wholesale borrowings. The global financial system came perilously close to collapse. The whole world watched these frightening events unfolding on television every night, resulting in a synchronised blow to the confidence of consumers and business people in almost all the developed economies. The considerable losses faced by banks in the US and Europe greatly reduced their ability and willingness to continue lending to ordinary businesses. From that point it became clear that the world had entered its most severe recession since the Great Depression. Deep recessions in the US, Britain, Europe and Japan, plus sharp slowdowns in China and the other major developing economies, have seen a marked decline in world trade. Despite optimistic talk of ‘green shoots’, the likelihood is that unemployment in these economies will continue rising for some time before it begins a very slow fall.

Who’s to blame for all this? Well, you can blame it on the greed of bankers and other participants in the financial markets, but that doesn’t get us far. I’d prefer to say that the crisis was caused by the failures of human nature, compounded by the economic managers’ reliance on a model of human behaviour that fails to take account of many aspects of that human nature.

Human beings aren’t rational as the economists’ basic, neo-classical model assumes, but are highly emotional. Even economists themselves are more driven by their emotions than many of them realise. Particularly because people are so influenced by the behaviour of those around them, the people who make up an economy are prone to an alternating cycle of optimism and pessimism. So much so that this is now - and probably always has been - the main factor driving the business cycle of boom and bust. During the optimistic phase people happily take on ever-increasing risks and obligations. They spend rather than save, expanding their possessions and activities, pursuing status symbols, piling into the markets for property and shares, forcing prices up, then piling in some more just because prices are rising.

They do all this confident in the belief that the good times will roll on forever and prices will only go higher. But, of course, as we all know but keep forgetting, some event inevitably causes the boom to end and, when it does, the prevailing mood flicks from optimism to pessimism. People become afraid, they worry about all the commitments they’ve taken on, they abandon their plans for expansion and tighten their belts. In many asset markets (but probably not our housing market) prices go from being unrealistically high to being unrealistically low. The result is business failures, lay-offs and rapidly rising unemployment. This causes the fear to deepen into a pessimism which assumes the world will stay bad forever.

My first point is that, though economists know full well that the economy moves in cycles of optimism and pessimism, boom and bust, and a large branch of economics is devoted to studying the management of the business cycle - macro-economics - economists don’t have much of a handle on the factors that drive the cycle, especially those that derive from human psychology. They accept that ‘confidence’ is a major influence on the cycle, but they can’t get confidence into their mathematical equations, so they end up underrating its importance. A big part of the problem is that conventional micro-economics has no place for psychology or the business cycle, assuming the economy is always at full employment because it is self-equilibrating, self-correcting. Alan Greenspan admitted he’d made a mistake in believing the banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions. He had too much faith in the economy’s self-correcting powers because he assumed we’d behave rationally, not emotionally.

My second point is that this chronic underestimation of human failings tempted economists and regulators to run a partially deregulated financial system and not to worry about weaknesses in the remaining regulatory system, such as the US’s multiple regulatory agencies sharing responsibility for the system, and the operation of the hedge funds completely outside the regulatory regime. Here we have a fatal combination of model-blinded thinking on the part of the economics profession and blatant self-interest on the part of powerful vested interests in the financial markets. When they’re in optimism mode, business people always want to be completely free to do as they please in their push for profits.

But because the big banks and other players in the financial markets aren’t rational and are capable of getting carried away in a boom and doing stupid things they later come to regret, they do need fairly close supervision to protect them from themselves and to protect us from them. In the absence of that supervision it was inevitable the episode would end in disaster.

In Australia, our econocrats - particularly those at the Reserve Bank - have been an honourable exception to this naivety. They’ve been a lot more worldly wise, always being very conscious of the problem of asset bubbles. The former governor, Ian Macfarlane, was highly conscious of the risks involved in our long housing boom. He devoted much effort to studying and trying to talk down the boom, with some success. So we avoided making the same errors with our banking system, partly also because of two accidents: first, the four-pillars policy banned mergers between the big four banks because politicians fear the displeasure of the electorate more than the displeasure of the banks and, second, our Australian Prudential Regulation Authority was riding herd on the banks because it was still smarting from the caning it got over its inadequate supervision of the HIH insurance company.

In their drive for profits, people in the financial markets invented these ever more sophisticated and artificial - weird and wonderful - financial contracts known as derivatives. In theory, these synthetic contracts were about ‘risk management’ - spreading and shifting risk to those most able to bear it. In practice, the risk was spread to those least able to understand it. Even the inventors of these derivatives didn’t fully understand how they worked and the circumstances under which they could come unstuck. Individual financial institutions didn’t understand the extent of the risks they were taking on and no one - neither other institutions nor the regulators - knew where the risk was accumulating. So my third point is that derivatives were a case of the market being too smart by half and not nearly as smart as it imagined itself to be.

The story of the origins of the global financial crisis is littered with references to excessive gearing or leverage or plain old excessive borrowing. The reason booms go on for so long and get so big is that they’re fed by excessive borrowing. While everything is on the up and up, borrowing is a very easy way to magnify your gains from investment. Trouble is, once prices start falling, being highly geared is a way to magnify your losses and risk your own survival.

The thing about debt - or ‘credit’ as economists prefer to call it - is that it’s like fire: a wonderfully useful and beneficial thing, but also something that, if not understood and carefully controlled, can do immense harm. Yet economic theory focuses almost solely on the benefits of credit, hardly acknowledging how dangerous it can be if allowed to get out of hand. Why such a cavalier attitude towards debt? Because of the assumption that we’re all rational; because of the economic model’s unrealistic assumptions about human nature.

So my fourth point is that a primary cause of the crisis was the failure of regulators to understand the need to impose constraints against excessive gearing. The sudden discovery of all the trouble derivatives had got us into wouldn’t have caused nearly so much devastation had not the institutions that found themselves holding the parcel when the music stopped been so precariously geared. Indeed, some of the derivatives were themselves aimed at helping people gear up.

In the past 15 or 20 years, central banks have become proficient at controlling the former scourge of inflation by means of inflation targeting. What they have not managed is to find a way to prevent the build-up of speculative asset price bubbles. That’s because the instrument they use to fight inflation - the manipulation of interest rates - can’t simultaneously be used to fight asset bubbles. But all this means is that, as part of the move back to a more carefully regulated financial system, we need to revert to direct controls over borrowing levels.

It’s overly dramatic to imagine we’re facing the death of capitalism. We’re not because there is simply no practical alternative to the use of markets to coordinate the production and consumption of goods and services. Similarly, it’s a crude caricature to imagine that in the past 20 or 30 years we moved to ‘free markets’. No market has remotely approached the position of being entirely free of government intervention and regulation. What’s true is that - particularly in the case of the financial markets, and particularly in the US - we greatly reduced the degree of regulation and allowed much of the regulation that remained to be ineffective.

So the choice we face is the degree to which we regulate markets and the activities of businesses. And there’s little reason to doubt that the pendulum will now swing back in favour of more regulation of markets, particularly the financial markets. We’ll need to do more to limit excessive borrowing, more to regulate the use of derivatives, more to make their use more transparent to regulators and to other players in the financial markets, more to include hedge funds within the regulated framework. We need tax reform to eliminate the tax advantages of debt funding over equity funding, including the tax advantages of negatively geared property investments.

It’s important to remember, however, that regulation offers no easy answers. The very reason we dismantled regulation and gave up public ownership of businesses in the 1980s and 90s was that they weren’t working well, partly because they were being widely circumvented. It’s now clear we went too far in that direction, but the answer isn’t to go to the opposite extreme. Rather, it’s to find a mid-way position where carefully judged regulation can keep things under better control. And here, in the example of Australia, the world does have proof that sensible, less-than-onerous regulation can keep the banks out of trouble, to their own benefit as well as ours.

I think it’s a mistake, however, to see the curbing of excessive executive salaries as central to the need for reform. To some extent it’s true that these salary packages were structured in a way that encouraged executives to take excessive risks with other people’s money. Something needs to be done about that. But the fact that these obscene salaries were grossly unfair - that they greatly overestimated the value of those executives’ contribution to their company’s success; that they were the product of market failure rather than market forces - shouldn’t cause us to overestimate their importance in the scheme of things. Say we were able to magically reduce all executive salaries to quite modest levels. When that saving was distributed between all the company’s many customers, the reduction in the prices they were paying would be fairly minor.

I believe we’ve been living through an era of heightened materialism where a revival of faith in the near infallibility of markets - the benefits of deregulation - has contributed to a breakdown in the norms of acceptable business behaviour. Business leaders now feel free to behave in self-aggrandising ways - the ruthless treatment of employees, customers and shareholders - that formerly were regarded as beyond the pale.

I believe it’s possible for us to return to a period of less self-seeking, more principled, ethical behaviour by our business leaders. This not an area that economists know much about - it requires an understanding of the drivers of human behaviour that’s outside their field of study. But social attitudes aren’t fixed; if they can change for the worse they can also change for the better. The economic and social devastation wrought by the global financial crisis - of which we’ve so far seen only the start - may be sufficient to motivate such a change of direction. And carefully judged reregulation may have a valuable part to play in that change.

Economists’ faith in rationality leads them to believe that to change people’s behaviour you must first change their attitudes. But psychology teaches that, in reality, the process works the other way: if by changing regulation you can oblige business people to change their behaviour, they will adjust their attitudes to fit their behaviour.

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CAUSES OF THE GLOBAL FINANCIAL CRISIS

Talk to Whitlam Institute public forum, Parramatta
Tuesday, May 26, 2009

David Gruen has given us a highly competent and comprehensive economists’ exposition of the causes and consequences of the global financial crisis and the global recession it has precipitated, both for the globe and for Australia. I disagree with very little of it. So using David’s exposition as a base, I want to give you my take on the causes of the crisis and, in doing so, step back from all the detail and try to identify the more general patterns of behaviour involved.

In a nutshell, my take is that the crisis was caused by the failures of human nature, compounded by the economic managers’ reliance on a model of human behaviour that fails to take account of many aspects of that human nature. If that sounds so general as to be saying very little, let me try to give it some substance.

Human beings aren’t rational as the economists’ basic, neo-classical model assumes, but are highly emotional. Even economists themselves are more driven by their emotions than many of them realise. Particularly because people are so influenced by the behaviour of those around them, the people who make up an economy are prone to an alternating cycle of optimism and pessimism. So much so that this is now - and probably always has been - the main factor driving the business cycle of boom and bust. During the optimistic phase people happily take on ever-increasing risks and obligations. They spend rather than save, expanding their possessions and activities, pursuing status symbols, piling into the markets for property and shares, forcing prices up, then piling in some more just because prices are rising.

They do all this confident in the belief that the good times will role on forever and prices will only go higher. We now see more clearly than we did at the time just how much this mentality drove the Howard Government’s response to the way its coffers overflowed during the resources boom. But, of course, as we all know but keep forgetting, some event inevitably causes the boom to end and, when it does, the prevailing mood flicks from optimism to pessimism. People become afraid, they worry about all the commitments they’ve taken on, they abandon their plans for expansion and tighten their belts. On many asset markets (but probably not our housing market) prices go from being unrealistically high to being unrealistically low. The result is business failures, lay-offs and rapidly rising unemployment. This causes the fear to deepen into a pessimism which assumes the world will stay bad forever.

My first point is that, though economists know full well that the economy moves in cycles of optimism and pessimism, boom and bust, and a large branch of economics is devoted to studying the management of the business cycle - macro-economics - economists don’t have much of a handle on the factors that drive the cycle, especially those that derive from human psychology. They accept that ‘confidence’ is a major influence on the cycle, but they can’t get confidence into their mathematical equations, so they end up underrating its importance. A big part of the problem is that conventional micro-economics has no place for psychology or the business cycle, assuming the economy is always at full employment because it is self-equilibrating, self-correcting. Alan Greenspan admitted he’d made a mistake in believing the banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions. He had too much faith in the economy’s self-correcting powers because he assumed we’d behave rationally, not emotionally.

My second point is that this chronic underestimation of human failings tempted economists and regulators to run a partially deregulated financial system and not to worry about weaknesses in the remaining regulatory system, such as the US’s multiple regulatory agencies sharing responsibility for the system, and the operation of the hedge funds completely outside the regulatory regime. Here we have a fatal combination of model-blinded thinking on the part of the economics profession and blatant self-interest on the part of powerful vested interests in the financial markets. When they’re in optimism mode, business people always want to be completely free to do as they please in their push for profits.

But because the big banks and other players in the financial markets aren’t rational and are capable of getting carried away in a boom and doing stupid things they later come to regret, they do need fairly close supervision to protect them from themselves and to protect us from them. In the absence of that supervision it was inevitable the episode would end in disaster.

In Australia, your econocrats - particularly those at the Reserve Bank - have been an honourable exception to this naivety. They’ve been a lot more worldly wise, always being very conscious of the problem of asset bubbles. The former governor, Ian Macfarlane was highly conscious of the risks involved in the long housing boom. He devoted much effort to studying and trying to talk down the boom, with some success. So we avoided making the same errors with our banking system, partly also because of two accidents: first, the four-pillars policy banned mergers between the big four banks because politicians fear the displeasure of the electorate more than the displeasure of the banks and, second, our Australian Prudential Regulation Authority was riding herd on the banks because it was still smarting from the caning it got over its inadequate supervision of the HIH insurance company.

In their drive for profits, people in the financial markets invented ever more sophisticated and artificial - weird and wonderful - financial contracts known as derivatives. In theory, these synthetic contracts were about ‘risk management’ - spreading and shifting risk to those most able to bear it. In practice, as David said, the risk was spread to those least able to understand it. Even the inventors of these derivatives didn’t fully understand how they worked and the circumstances under which they could come unstuck. Individual financial institutions didn’t understand the size of the risks they were taking on and no one - neither other institutions nor the regulators - knew where the risk was accumulating. So my third point is that derivatives were a case of the market being too smart by half and not nearly as smart as it imagined itself to be.

I don’t know whether you noticed, but at many points in David’s exposition of what went wrong he alluded to the consequences of excessive gearing or leverage or plain old excessive borrowing. His story was littered with references to debt. The reason booms go on for so long and get so big is that they’re fed by excessive borrowing. While everything is on the up and up, borrowing is a very easy way to magnify your gains from investment. Trouble is, once prices start falling, being highly geared is a way to magnify your losses and risk your own survival.

The thing about debt - or ‘credit’ as economists prefer to call it - is that it’s like fire: a wonderfully useful and beneficial thing, but also something that, if not understood and carefully controlled, can do immense harm. Yet economic theory focuses almost solely on the benefits of credit, hardly acknowledging how dangerous it can be if allowed to get out of hand. Why such a cavalier attitude towards debt? Because of the assumption that we’re all rational; because of the economic model’s unrealistic assumptions about human nature.

So my fourth point is that a primary cause of the crisis was the failure of regulators to understand the need to impose constraints against excessive gearing. The sudden discovery of all the trouble derivatives had got us into wouldn’t have caused nearly so much devastation had not the institutions that found themselves holding the parcel when the music stopped been so precariously geared. Indeed, some of the derivatives were themselves aimed at helping people gear up.

In the past 15 or 20 years, central banks have become proficient at controlling the former scourge of inflation by means of inflation targeting. What they have not managed is to find a way to prevent the build-up of speculative asset price bubbles. That’s because the instrument they use to fight inflation - the manipulation of interest rates - can’t simultaneously be used to fight asset bubbles, a point Guy Debelle of the Reserve Bank reiterated recently.

But all this means is that, as part of the move back to a more carefully regulated financial system, we need to revert to direct controls over borrowing levels.

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PUBLIC HEALTH CONSEQUENCES OF THE GLOBAL FINANCIAL CRISIS

Talk to AFPHM Congress, Sydney
May 20, 2009

Because I’m no expert on public health, I’m going to focus on the nature, size and duration of the crisis, and say something about the likely impact of the crisis on the developing countries and on Australia, leaving Steven Jan to focus on what the crisis will do to the social determinants of health.

I must start by warning you that economists are hopeless at forecasting what will happen in the economy. All they - or I - can do is offer you educated guesses, which will probably be wrong for reasons we haven’t thought of. But humans are incurably curious animals, with an insatiable desire to know what the future holds, so they go on asking economists for their predictions, and economists go on pretending to know what will happen. Now I have your informed consent, I’ll get down to it.

I’m going to skip explaining the origins of the financial crisis and take up the story at the point where the crisis reached its climax in mid-September last year with the collapse of the US investment bank Lehman Brothers. This prompted panic in global financial markets, which froze. The global banking system rocked on its foundations as governments in the US, Britain and continental Europe struggled to avert the collapse of various banks. The whole world watched these frightening events on television every night and the effect was a sudden loss of confidence among businesses and consumers in many countries. Around the world, fearful consumers tightened their belts and abandoned plans for big purchases, while businesses postponed expansion plans and wondered about laying off staff. In consequence, the global economy hit a wall at that moment. It dropped off a cliff. Just about every developed country contracted - went backwards - in the last quarter of 2008, and the contraction continued in the first quarter of this year. Over that six month period, the US economy contracted by more than 3 per cent, Europe by more than 4 per cent and Japan by maybe 6 per cent.

Those are huge figures. Australia would also have contracted over that six months, but by a lot less (we’ll get the figures for March quarter a fortnight today). Most developed economies had been slowing (as we had) or were in already in recession before the crisis reached that climax in September, but from that point it became indisputable that the global financial crisis had become a global recession, that the problem had spread from Wall Street to Main Street, from the financial markets to the ‘real’ economy of production and consumption that you and I inhabit.

As the immensity of the global contraction slowly dawned on officials, the IMF - the International Monetary Fund - revised down its forecast for growth in the world economy in 2009 five times in seven months. Its latest prediction is that the world economy will contract by. 1.3 percent in calendar 2009. This would be the first annual contraction in 60 years. It compares with record world growth of more than 5 per cent just two years earlier (2007). Virtually every advanced economy is in recession and the advanced countries as a whole are expected to contract by 3.8 per cent. The developing countries should grow, but by just 1.6 per cent. Normally, any rate of global growth below 2 per cent is regarded as a world recession, because recessions usually roll around the world, hitting different countries at different times, because the developing countries always grow a lot faster than the advanced countries (because they’re coming off a low base) and because they aren’t as closely connected to the advanced countries as the advanced countries are to each other.

The IMF is predicting that the world economy will grow by 1.9 per cent the following year, 2010, with the developing countries recovering to 4 per cent (still weak by their standards), but the advanced economies just breaking even. This, of course, would still be in recession territory.

The IMF is uncharacteristically gloomy about this recession. It’s worried by two unusual features of the present episode: first, unlike most recessions, this one has been caused by a crisis in the financial system, and second, it’s highly synchronised - everyone’s going down together, partly because of shared trauma of the events in September-October. History tell us that recessions brought on by financial crises are deeper and longer, with a weaker recovery. History says the same about synchronised recessions. Put those two negatives together and you’ve got a particularly bad prospect.

The IMF has legitimised the comparison of this recession with the Great Depression, suggesting that this episode be known as the Great Recession. However, economists are confident we won’t see anything as bad as the Depression because we’ve learnt from the gross mistakes we made then. In particular, we have four factors going for us. First, we haven’t stood around watching banks collapse, but have done everything necessary to prop them up. Second, we’re well aware of the risk of deflation (widespread and continuous falls in prices) and will resist it, understanding that, in such circumstances, printing money helps rather than harms. Third, we don’t see any virtue in balanced budgets at such a time, and are applying large amounts of timely fiscal stimulus. Fourth, no one imagines a resort to competitive currency devaluations or higher trade barriers offers a viable solution to a global problem, even if domestic political pressures make them tempting.

How bad and how protracted will the Great Recession end up being? I don’t know. Even if it’s not as bad as some people fear, it will be plenty bad enough. The main risks are, first, a new crisis somewhere in the global financial system, and second, inadequate efforts to fix the balance sheets of ailing banks, so that businesses and households fail to receive the flows of credit necessary to allow them to resume normal activity.

On the positive side, world financial markets are a lot more settled than they were, there are reasonably convincing signs that the US, which has already been in recession for a record 17 months, is stabilising and could start recovering later this year - although it could still be a year or more before there was any improvement in unemployment - and there are convincing signs that China is recovery, just as the recovery from the Asian crisis of 1998 was much stronger than (more V-shaped) than we expected. Developing economies are more resilient than advanced economies; they have a greater ability to bounce back.

Last week’s budget argued that Australia’s recession - which has hardly got started yet - will be much less severe than those of the major developed economies and much less severe than we experienced in the recessions of the early 1980s and early 1990s, even though the recession itself will last longer: three years, rather than one year in the 80s and two years in the 90s. But whereas the rate of unemployment peaked at 10 per cent in the 80s and almost 11 per cent in the 90s, this time it will peak at only 8.5 per cent, in the second half of next year. Treasury is certainly right in arguing that, when recovery finally arrives, the usual pattern is for the economy to bounce, achieving surprisingly high rates of growth as it comes up off the floor. There are three good arguments for Treasury’s relative optimism. First, thanks to the four-pillars policy and strong regulation, our banking system is in very good shape. Second, the alacrity with which we slashed interest rates and applied budgetary stimulus to the economy after September last year will prevent the economy from descending too far into the depths. Third, the recovery in China, as it switches its engines of growth from export demand to domestic demand will limit the fall in our export income. The counter argument is that we haven’t yet felt anything like the full effect of our loss of income arising from the collapse of coal and iron ore prices, nor from the rise in unemployment and the debilitating and hence compounding effect this will have on business and consumer confidence.

Edging closer to our goal of assessing the consequences of all this for public health, let me just make the obvious point that the burden of recessions is shared most unequally, with the increase in unemployment concentrated heavily on the unskilled, early school-leavers and the disadvantaged, including Aborigines and the mentally ill. Considering what we know about the social determinants of health, this does not bode well. However, though an increase in health problems as a result of the recession may lead to the overstraining of unchanged levels of provision, I don’t believe that explicit cutbacks in government health spending will represent a significant addition to the problem.

Finally, let me turn to the problem in the developing countries. On the face of it, their economies will grow faster than those of the advanced countries, but this is misleading. The developing countries’ rapid population growth means they need to grow at faster rates just to stop going backwards. In these countries I think we will see both an increase in the demand for medical assistance and a decrease in its supply. The reduction in supply will come from increased pressure on government budgets (less revenue but more spending demands), reduced official and unofficial aid, and less ability on the part of patients to bear out-of-pocket costs. In 23 developing countries more than 30 per cent of their total health spending is funded by donors. I am hopeful, however, that, where countries are obliged to apply to the IMF for financial assistance, the criticism the fund received for its mishandling of the Asian crisis will make it less inclined to provide assistance conditional on ultra-harsh cutbacks in government social spending.

According to the World Bank, each 1 per cent decline in growth causes 20 million people to be pushed into poverty. After for once enjoying a period of decent growth - a half-decade above 5 per cent a year - Africa is forecast to manage growth of just 2.8 per cent this year. So I don’t doubt that the Great Recession will lead to great suffering among the world’s poor. In developing countries as in Australia, the burden of economic downturn will be distributed unequally and unfairly, with the poor bearing most of the brunt. Similarly, in any competition for inadequate public health resources, you’d expect to see the better-off elbowing out the poor.

Even before the onset of the global recession, only a handful of African countries were on track to meet the Millennium target of halving the share of the population living on less than a dollar a day by 2015. But the gloom and doom is not total, however. One small mercy is that, at a time of global recession, you’d at least expect to see food and energy prices coming down. Another is that the African economies’ generally improved economic management in recent years leaves them better positioned to weather the crisis than they were a decade ago. It’s also fortunate that so many of the world’s poor live in China and India, which are likely to recover fastest.

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THE GLOBAL FINANCIAL CRISIS AND ITS EFFECT ON AUSTRALIA

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.

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