ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Reaping the whirlwind of financial deregulation
, April 26, 2008
Nine years ago, under pressure from Wall Street, US Congress repealed the Glass-Steagall Act, which had been introduced during the 1930s Great Depression to regulate banking and control financial speculation. Now the US — along with many of its trading partners — is facing the unanticipated consequences of this decision. Colin Teese reports.No serious observer any longer disputes that the United States economy has slid into recession. Not so much slid, really, but pushed by the excesses of the US finance industry. Based on previous experience we won't know the extent of the downturn until we can look back objectively on what has happened.
We already know the cause. That can be sheeted home to market failure in the finance industry, which has been force-feeding, with cheap mortgage money, hyper-inflationary house prices.
Now that cheap credit has dried up — and not only for the risky sub-prime borrowers who had borrowed more than they could afford in order to buy houses in an overheated market. They were the headline factor, but it seems that the knock-on factor is now shaking a good part of the rest of the economy to its foundations.Without regulation
Cheap credit, which managed to inflate the housing bubble, is now history — over-reaction, one might say. That is quite possible, but that is how financial markets work. Bubble and burst — without regulation, that is.
It began with housing. Eric Janszen, a commentator with high-level experience in the finance industry, has explained why in the February edition of Harper's Magazine
Back in 1933, in the depths of the Great Depression, the United Congress enacted the Glass-Steagall Act to regulate banks and financial speculation. In 1999, the act was repealed, at the joint instigation of Wall Street and the then chairman of the US Federal Reserve, Mr Alan Greenspan, with President Bill Clinton watching on benignly.
From then on, the credit-creation floodgates were opened. The supply of credit immediately multiplied. As a result, undiscerning investors were ready to offer unlimited funds for house-purchasing and thus building. Under pressure of demand, house prices skyrocketed. Mr Greenspan made things worse by reducing interest rates from 6.4 per cent to 1.24 per cent in the space of a year.
Welcome to cheap money and its inevitable concomitant, house-price hyper-inflation. Moreover, the same cheap credit replicated the hyper-inflationary effect on shares.
As Eric Janszen points out, historically, US house prices follow the cash rate of inflation — about 3.3 per cent annually. Hyperinflation quite obviously pushes house and share prices far above this trend line. But, sooner or later, prices revert to the long-term price-trend level. That process has already begun with shares and housing.
Mr Janszen concludes that to take house prices back to the long-term trend will require a 38 per cent price fall over the next six or seven years — about 6 or 7 per cent a year. On this basis the financial industry will need some sort of bail-out of the order of some US$12 trillion. Yes, that's right — not billions, but trillions.
Where will such money come from? Janszen guesses from some new price bubble. Meanwhile, he is predicting big trouble for the US economy.
Unfortunately, general opinion in the US, unlike Janszen, is not yet identifying asset-price inflation as the source of downward pressure on the real economy. The same is true here in Australia.
Of course, to Australians the matter of how the effects of the US economic downturn will play out in our economy is still unclear. For this writer it will be the subject of a future article.
The Glass-Steagall Act, whose repeal started all this, was originally a piece of enlightened financial legislation arising out of President Franklin D. Roosevelt's New Deal program back in 1933. In light of what happened in the Great Crash of 1929, its specific purpose was to stop commercial banks from underwriting or dealing in shares, commercial bonds or investment banking. It worked for 66 years.
Nevertheless, the finance industry and the recent chairman of the US Federal Reserve, Mr Alan Greenspan, were able to persuade the US Congress to repeal the Act in 1999.
Dr Sam Wylie, a research fellow at the Melbourne Business School writing in the Australian Financial Review
, recently said that Congress became convinced that the legislation "was an old-fashioned impediment to the global competitiveness of the US financial services industry".
New legislation in 1999 reinstated the right of commercial banks to own or operate as investment banks. It is worth reflecting that, on being let off the leash in 1999, the industry took a mere seven years to induce a financial market collapse mirroring in kind — if not in intensity — that induced by much the same processes in 1929.
Looking back, Glass-Steagall stood the test of time. For the financial system to work effectively, commercial banks have to have confidence in lending short-term to each other. That can only happen if each is certain of the financial integrity of the other. Ultimately, that certainty is best ensured by the commercial banks being backed by government guarantee. Of course, this kind of undertaking can only be given if the lending practices of commercial banks are constrained.
Glass-Steagall made that possible by keeping the commercial banks out of the riskier forms of investment banking. For banks thus constrained, governments could properly act as lender of last resort.
With the onset of the current financial crisis, which was stimulated by the sub-prime loan collapse, risk aversion took hold of US lenders. Credit quickly dried up, even for quite sound projects. Short-term inter-bank lending and borrowing — an important lubricator of the entire system — also slowed noticeably. For a while it looked as if money flows could freeze. The US Federal Reserve, under the new chairmanship of Dr Ben Bernanke, quickly stepped in and shored up the banks with credit facilities — in effect a move back to the old system of guarantees, though these were characterised as loans.Collapse
As the problem of bad lending became further exposed, even this wasn't enough. Falling business and consumer confidence — mainly induced by a collapse of the hyper-inflated US housing market as credit dried up — threatened to plunge the US economy into deep recession, even in the face of evidence of rising inflation.
Dr Bernanke again acted decisively, though controversially. Putting aside considerations of inflation, he set about cutting interest rates. While not averting recession, Dr Bernanke's efforts appear, for the moment, to have helped contain that which could have been (and may still yet become) something much worse.
All of these measures were taken in response to the development of the crisis which began with irresponsible lending practices by financial institutions. However, the problem could not be quarantined. It now appears to be infecting a large part of the financial sector.
As the extent of the problem has deepened, so, accordingly, have the US authorities' involvement. The fifth largest US bank of 85 years standing — Bear Stearns (an irresponsible lender) — was facing bankruptcy until the US Federal Reserve stepped in with financial assistance which facilitated its takeover by another bank.
In all of this the International Monetary Fund (IMF) has appeared quite impotent. We can all remember its immediate and robust response to the Asian financial crisis in 1996.
Asian governments were instructed that, in order to qualify for IMF loans, they must undertake strict economy measures. These would, as everybody knew, inflict hardship on their populations. Moneys owed to international lenders — whether or not by private borrowers — were, ultimately, the responsibility of governments. Interest rates were to rise to curtail local demand. (Incidentally, those Asian economies who heeded the IMF advice were the slowest to recover. Those who ignored the IMF prescriptions recovered quickly).
The wiser of the Asians, along with others, had already noted that the IMF's draconian economic advice — the kind it always offered to developing countries, usually with bad results — was never judged appropriate to Western developed countries.
The IMF's response to the US financial crisis confirms its "westo-centric" focus. For the US, the IMF endorsed the idea that help should be provided in the form of liquidity, both to companies and to the market as a whole. The IMF believed that this would help restore confidence and avoid fire sales of assets. And it seemed little concerned about interest rate cuts undermining the US dollar, feeding inflation or leading to any destabilisation of global financial balances — all of which have been identified as problems in Asia.
The IMF scores low marks for consistency, and no doubt its international standing outside the Western developed bloc has dropped a further few notches.
About the path being pursued by the US financial authorities, Eric Janszen in his Harper's Magazine
article has sardonically observed:
"Since the early 1980s, the free-market orthodoxy of the Chicago School [University of Chicago school of economics] has driven policy on the upward slope of an economic boom, but we are all Keynesians on the way down: rate cuts by the Federal Reserve, tax cuts by Congress, deficit spending, and dollar depreciation are deployed in heroic proportions."
To the dispassionate observer, all this looks like free-market economists paradoxically endorsing the idea of financial markets capitalising their profits but socialising their losses. Why, we might ask, do they deny the same advantage to farmers and manufacturers?
And what happened to the old strict free-market orthodoxy that there should be no bail-outs under any circumstances — certainly not for manufacturers or farmers? And, if not for them, why for financial institutions?Reckless lending
If governments are prepared to bail out banks, won't this enshrine reckless lending policies in the financial sector? I recall that free-market economic theory even has a phrase for it, although it is somewhat obscure: "moral hazard".
We all know financial bail-outs can't be avoided. When financial markets collapse, for whatever reason, and threaten to bring the entire capitalist system down around our ears, ideology — economic or otherwise — is shown the door, in favour of common sense.
At least, that's what happens in the United States. We can but hope that the same may be possible in Australia.— Colin Teese is a former deputy secretary of the Department of Trade.