FINANCIAL CRISIS: by Colin TeeseNews Weekly
Can the world expect a sustainable recovery?
, December 26, 2009
The financial crisis which took hold of the US banking system in the northern summer of 2007 was the worst in a hundred years. In lesser or greater degree it quickly engulfed most of Europe's banks. In a more complicated and different way, Japan also became tangled up in the chaos.
The crisis also threatened to bring down the entire world banking system, and began undermining world trade. Worse still, it opened the prospect of driving the real economies of the West into a deep and lasting depression rivalling that of the 1930s.
Fortunately, Western governments of all political persuasions responded quickly with reasonably well-coordinated responses. The US Government and Federal Reserve Bank immediately injected relatively small amounts of capital into a few big ailing banks. These measures were quickly revealed to have been inadequate. Indeed, the depth and breadth of the crisis began to envelop the entire banking system. Without help, hardly a bank would have been left standing.
Much more funding was still needed, and, with some reluctance on the part of the US Congress, this was eventually made available. However, the process of stabilisation created a very large overhang of public debt.
As a result of this operation, bank debt totalling about $US1 trillion was transferred from private bank shareholders and investors to become a public liability. Bank debt - if not the institutions standing behind it - was effectively nationalised. If ever there was a perfect example of socialising losses by bailing out stakeholders in the financial system, this was it.
A further interesting fact about this bail-out is that it was directed exclusively towards saving the big banks - that is to say, in the current jargon, those banks which were deemed TBTF ("too big to fail"). Meanwhile, little publicity has been given to the fact that more than a hundred small US banks have been allowed to go under. There has been no socialisation of losses for the shareholders and other investors in these unfortunate institutions.
Whether in retrospect this kind of policy approach will turn out to have been the best possible way of rescuing the financial system from its own follies is by no means clear. No less important is whether it will have a moderating effect on the future behaviour of large financial institutions. If a rescue operation does no more than reinstate them in unchanged form, then we almost guarantee a repeat of previous bad behaviour. Only next time it could prove to be much more damaging to the real economy.
More will be said about that later.
Meanwhile, notwithstanding the bail-out, almost immediately afterwards the US government - along with most others in the West, including Australia - were faced with a drying up of credit as banks set about the task of rehabilitating their balance sheets. Inevitably, the most immediate consequence of these efforts was the collapse of consumer demand.
As inhabitants of the biggest and most indebted economy, consumers and the unemployed in the US, once they were denied access to cheap money, were unable to continue maintaining their customary levels of consumer spending. The flow-on effect of this for manufacturers and distributors of consumer products was an immediate downturn in demand. Business had no option but to get rid of staff. The crisis began to feed on itself. As unemployment rose, consumer demand shrank even more. The economy was accelerating into a downward spiral.
Moreover, since US economic activity was the main driving force of the world economy, the US downturn threatened to undermine world prosperity.
Led by the United States, governments of all political persuasions - including China's - quickly embraced the idea of Keynesian-type stimulus packages. In each case, the precise nature of the package was tailored to the economic and political needs of individual countries. But the various governments all agreed that if the financial system could not ensure an adequate level of total spending in the real economy, then - as J.M. Keynes argued during the 1930s Depression - governments could and should.
There is widespread belief across political divides that the various measures which made up the recent stimulus package have, at least for the moment, plugged a hole. At the time of writing, the world does seems to have been prevented from sliding into a disastrous slump, though some have suffered more than others. (It is worth noting, in passing, that here in Australia the Liberal/National Party Opposition is one of the few mainstream political groupings in the Western world to have questioned the wisdom of a Keynesian stimulus approach.)
Looking back we can say some packages might have been better targeted. But an immediate response was necessary. There simply wasn't time for painstaking evaluation of the various options. And, as always, political constraints influenced the shape of many packages - not necessarily for the better.
All governments faced the basic problem, apart from bank bail-outs, of how to stem the tide of rising and perhaps embedded unemployment. The US took what might be called the indirect route. It pumped money into projects it hoped would generate new economic activity from which would flow more jobs and thus regenerate domestic consumer spending. This, unfortunately, took some time to work; and almost a year later it is only now beginning to reduce joblessness and to lift consumer spending.
Nevertheless, there remains the unanswered question: as the stimulus package winds down, has the economy been sufficiently "kick-started" for the recovery to be self-sustaining? US economic commentators remain divided on that issue.
Australia followed the US idea of project-funding, at least in part. Whether by design or not, our efforts mainly targeted the building industry. It was, however, supplemented by direct hand-outs amounting to tax rebates. While the packages seem to have worked so far, we cannot really measure which part of the stimulus package made us better able to ride out the recession.
The European countries - especially Germany - preferred the direct approach to tackling the problems of the real economy. German businesses, rather than retrenching workers, put them on shorter working weeks with lower pay. The German government applauded this and said it would subsidise pay packets of those on short working weeks so that they could continue spending as before.
Thus, consumer spending on which the economy was so heavily dependent was kept up at relatively small cost. Germany still has to deal with the problem of its banks, but it is better able to deal with that problem in a healthier economy.
Britain faces a big problem with its banks, which matters more because financial institutions comprise such a big slab of its economy. Britain is very much concerned with fixing the problem for the future, though it can't go it alone. Britain will certainly end up having to be part of some kind of world-wide - and therefore heavily compromised solution - worked out in the context of the G20.
The same will be true for Australia, and it appears that such an outcome could hit our banks badly. They might end up having to comply with more onerous rules on capitalisation and deposits should they wish to continue to tap into international capital markets.
Make no mistake, changes of this kind will bite deeply into bank profits and push up the interest rates they will have to charge business and housing borrowers - regardless of what our Reserve Bank does with "official" rates.
The short golden era of having the Reserve Bank manage consumer inflation by fiddling with official interest rates and pretending that nothing else matters is behind us. From now on, hands-on and much more intrusive interventions into economic activity will be the order of the day. The question is whether either side of politics and, for that matter, the business community are ready for it.
But where we are heading depends mainly on how things play out in the United States. And China will be important in that.
The US is in dire straits. Morris Newman, currently chairman of the Australian Broadcasting Corporation (ABC) and who used to be chairman of our stock exchange, explained the problems of US debt to a gathering of the Committee on Economic Development of Australia (CEDA) recently.
He explained that the credit and debt explosion between 1990 and 2007 totally unbalanced the world economy, including world trade flows, creating, in the process, debtor and creditor nations. A legacy of this imbalance has left the US with an unfunded liability of $US100 trillion - yes, that's right, $US1.3 million for every family of four - which will eventually have to be paid off.
Meanwhile, the US Government will have to raise US$3.5 trillion this year. This is the equivalent of all US debt raised between 1789 and 1994. To pay it back will take 75 years of double-digit growth.
To be fair, this can't all be blamed on President Obama's stimulus package or even on the policies of his predecessor. It goes back to the reckless spending and tax policies of the Reagan years and before.
At this stage, who is to blame matters less than how to fix it. But nobody seems to have much of an idea on that.
However, one thing is certain: the US may be a declining world power, but for the moment its economic health is still vitally important for the continuing prosperity of the world. If its debt problems can't be solved, then the rest of the world, including Australia, will share in the consequences.
From what can be gathered, China, which might have to be a major player in helping the US deal with its problems, seems to have some understanding of the role it must play. We can't really know what it can or will do, but it does seem to be looking at solutions which will in some way or other aim to ensure a steady sustainable level of domestic demand.
Let us hope it succeeds, because in the end nothing else may work.Colin Teese is a former deputy secretary of the Department of Trade.
French economist in 1991 predicted US banking bail-outEighteen years ago, French economist Michel Albert, then president and CEO of Assurances Générales de France (AGF), France's largest insurance company, warned about the irredeemable flaws of the "neo-American model" of a capitalistic market economy, introduced by the conservative administrations of Ronald Reagan and Margaret Thatcher.
In his internationally bestselling book Capitalisme contre Capitalisme
(Capitalism against Capitalism
), first published in 1991, Albert made the following astonishingly accurate prediction. He said: "The largest [U.S.] banks know, however, that they are literally ‘too big to fail' and can count on a helping hand from government if the worst comes to the worst. America's political leaders would step in to prevent the crash of a major financial institution on the grounds that it could set off a lethal chain reaction culminating in widespread disaster. … Thus, in yet another intriguing but ominous irony of history, 10 years of ultra-liberalism have resulted in a US financial system whose future may only be assured with the help of federal government handouts."Michel Albert, Capitalism vs. Capitalism , English trans., revised edition (New York: Four Wall Eight Windows, 1993), p.61.