ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Global financial crisis - is the end in sight?
, October 27, 2007
What are the likely long-term consequences for Australia of the recent global financial crisis? And what can we learn from this episode for the future? Colin Teese reports.We have all watched financial markets, worldwide, being disturbed by the collapse of a high-risk part of the US house-lending business - what the finance industry calls the "sub-prime" market.
Effectively, this term describes housing loans made to house-buyers who haven't really got the resources to buy houses. What happened was that all of a sudden, in the wake of a raft of defaults, lenders were no longer willing to advance funds for these purposes. The market collapsed, with severe and immediate adverse effects on those lending institutions directly or indirectly exposed to sub-prime lending.Collapse averted
An unanticipated outcome was that overall lending dried up, not merely for the sub-prime market, but altogether. Banks would not lend even to each other, and, as a result, the financial system was totally locked up - with nobody willing to lend money for any purpose at any interest rate. The US Federal Reserve bank pumped money into the economy to avert a total collapse of the US financial system.
Later, we will look at why and how this all happened, and what could be the wider implications - long and short term. But first let us have a kind of selfish look at how what has happened is likely to affect us here in Australia - and in the rest of the world with which we relate closely.
The immediate reaction of our financial markets was to do what they have always done: follow the US market into blind panic - this despite the fact that so-called sub-prime loans were virtually unknown in Australia.
For a couple of weeks, share prices tumbled, and something of the lock-up experienced in the US began to affect our financial markets, even though they were facing none of the US problems. We seem to have grown accustomed to following US economic and financial trends, regardless.
After the initial panic, however, share prices quickly bounced back and are now peaking at record levels. No doubt this quick recovery was helped, if not generated, by the fact that our Reserve Bank followed the lead of the US Federal Reserve, and pumped an appropriate amount of liquidity into our financial system to unbind the lock-up. In other words, the sector had to be saved from itself.
The first question to ask is this: are we and the rest of the world out of the woods yet, or will the US crisis plunge that country into a recession and take the rest of the world down with it? Nobody can yet say for certain, one way or the other.
We can't rule out the possibility of recession, especially as we know that some banks in Europe and Britain have large exposure to sub-prime loans. But what about the US economy? How will it fare? We know that money for sub-prime loans has dried up. We know that the building of new houses in the US has slowed as a result. And we know that the construction of new housing was driving much of US economic growth.
Obviously, growth will slow down. What we don't know is whether growth will slow enough to trigger a recession. We know the US Federal Reserve will do all in its power to avert that possibility, certainly by maintaining liquidity and fiddling with interest rates.
But if this latest crisis has taught us anything, it is that the market - rational or otherwise - determines interest rates in the real world. The second unknowable is that, even supposing the US plunges into recession, we can no longer assume (thank goodness) that any slowdown will be passed on to the rest of the world.
Twenty years ago, things were different. We could have said for certain that a downturn in the US economy would have flowed on to the rest of us. The US was then the main driver of world economic growth.
Today, however, a US economic slow-down need not have such adverse effects, and, compared with before, could leave the world economy relatively unscathed.
As we all know, much more of the impetus behind world economic growth is now grounded in Asia. China, in particular, is becoming an economic power of real significance. There are those saying it will rival the US in total output (though not, of course, in per capita output) within the next 30 years.
It is also no longer the case - compared with even a decade earlier - that Chinese economic health depends almost entirely on its access to the US market. China has worked hard, and successfully, to diversify its exports away from the US. What's more, China and the rest of the emerging Asian economies now have the capacity to be important players in financial markets.
Perhaps these new realities explain why, despite the immediate panic reaction by our financial sector to the US's sub-prime crisis, our economy has bounced back so quickly and does not seem to have suffered any enduring damage.
But that is not to say that the consequences of that crisis have been unimportant, for either the US or the rest of the world.
Consider a few obvious consequences. For a start, it's been demonstrated that central banks do not control interest rates in the real world. For a very long time we have seen the consequences of an apparently inexhaustible supply of cheap money. Until a couple of months ago, such was the over-supply of money that lenders were compelled to accept comparatively high-risk activities at unrealistically low rates of return, just to get their money placed. That's precisely how the US got into its sub-prime lending mess. There won't be any more of that.Cheap money
How much of world economic activity was being propped up by the availability of cheap money is not easy to measure. But we may make certain observations. If money is going to be tighter and cost more to borrow in the future, then that outcome will affect every aspect of economic life throughout the world. Businesses will obviously have to pay more to borrow, and that will flow on to prices for goods and services - and, no less importantly, to profits.
As profits shrink, so business will have to borrow more for expansion rather than, as previously, funding it from retained profits. All of that will flow on into share prices. Householders will have to pay more for housing loans. Bank charges will increase. And the heavily indebted nations, such as Australia, will have to cope with higher interest payments on their offshore borrowings.
Maintaining low inflation without the benefit of cheap money will be the challenge to governments throughout the Western world in the coming years. More than ever before, they will have to rely on cheap imports from China and India to maintain their countries' living standards.
Taking account of all this leads us to important and wider considerations. The financial system went off the rails in the US because, whatever might be held to the contrary, an unregulated financial market failed us. Thus we are able to point to yet one more sector where markets without regulation have not settled at equilibrium, as we have been assured they do, but instead have descended into instability.
Mind you, that outcome is hardly surprising, while prudent and imprudent lenders alike are permitted, with impunity, to dip into apparently bottomless pits of cheap money. That the end result of all this has resulted in huge losses to individuals and certain lending institutions should be of major concern to the rest of us.
But what we can't ignore are the unintended and wider consequences. The market broke down. The market, instead of denying loans only to those irresponsible traders, became ultra cautious. Sources of capital for any purpose at any price dried up. The market froze to the extent that it threatened to paralyse the real economy.
Central banks had to step in around the world and pump billions of dollars' worth of additional liquidity into the system. Effectively, they had to rescue failing financial markets. Unavoidably, the bailout also, in some cases, worked to the benefit of some irresponsible traders and their companies.
The most publicised case relates to a British lending institution. For the first time in some hundreds of years, the Bank of England did what it said it never would: it underwrote the losses of a lending institution to protect the deposits of small investors. The action was widely criticised by some, and applauded by others.Fundamental question
But it does raise a fundamental question about bailouts. Should we be bailing out investors - large or small - who chase the more generous returns of risk markets? Or should we quarantine, against loss, inside a publicly-owned bank, the savings of small investors at relatively low interest rates the way we used to do in Australia with our various state savings banks? Should we also make the funds available for housing loans for low-income families, and/or other projects which benefit the wider community?
These are considerations which governments may well have to confront in the future.
Recent market malfunction within the financial sector also points to the need for some return to regulation, if regular financial crises of one kind or another are to be avoided.- Colin Teese is a former deputy secretary of the Department of Trade.