GLOBAL FINANCIAL CRISIS: by Colin TeeseNews Weekly
Rebuilding a functioning financial system
, July 25, 2009
An American journalist, writing in the Australian Financial Review, chided economists for failing to anticipate the financial collapse and its aftermath. This failing he attributed to the notorious dislike orthodox economists have for history.
True enough. Free market economists have certainly turned their collective backs on history. They prefer, instead, to believe in a set of immutable rules that supposedly govern the way economies work, and to elaborate the process by the construction of mathematical models.
Frequently, real-life economics does not conform to modelling expectations; in that event, reality is discarded in favour of theory.
We can't be surprised that such a brand of economics was incapable of anticipating the disaster that befell the world economy following the financial unravelling of two years ago. Did not market theory preclude any such possibility? Did not market operations furnish the necessary built-in corrective mechanisms to maintain financial stability?
But there was always a small core of economists and economic commentators thinking outside that square. A number of them certainly anticipated the crash.
One was Nouriel Roubini, professor of economics at New York University; another was British economist and financial commentator Peter Warburton in his book, Debt and Delusion: Central Bank Follies that Threaten Economic Disaster
Warburton's book ends with the following paragraph, which is worth quoting from at length: "The argument in this book is not that governments are powerless, but that their central banks have let them down. ...
"[T]hey should have been more circumspect about financial innovations and their potential effects on the system. They should have insisted on tighter accounting standards, reporting procedures and capital requirements for derivatives trading. They should have co-operated more readily with other financial regulators, stock exchanges and each other for the sake of financial stability.
"The credit and capital markets have grown too rapidly, with too little transparency and accountability. Prepare for an explosion that will rock the Western financial system to its foundations
." (Emphasis added).
Remember that those words were written in 1999. For those prepared to look, the evidence was there.
It is, of course, deplorable that those practising orthodox economics and their fellow-travellers failed to read and take notice of the warning signs in the run-up to the crisis.
But more serious is what is happening in the wake of the meltdown. Yes, the immediate consequences on the real economy - i.e., output and jobs - have been identified and addressed. Leaders of governments around the world, with the notable exception of Chancellor Angela Merkel of Germany, have embraced and implemented Keynesian-style stimulatory spending packages to keep the real economy functioning.
But governments can do no more than hold the line until private business can get going again. And, without doubt, taxpayers - from whom the money has been borrowed - will expect to be repaid some time in the future. In most cases, this should be manageable, assuming business activity recovers and tax revenues pick up. This is more likely to eventuate if the stimulatory packages have been wisely targeted at genuinely productive, income-producing infrastructure projects.
But don't forget that much of the public expenditure - several trillions of US dollars, in fact (don't, please, call it taxpayers' money; it's "community" money) - isn't stimulatory at all, but is being deployed to bail-out banks.
Consider it this way. Privately-owned banks, whose self-induced profligacy caused the problem, have a built-in expectation that the community will not only recapitalise them, but will pump money into the real economy as a restart mechanism.
The most seriously damaged banks are in Europe and the United States. Consequentially, institutions in those locations are the recipients of most of the bail-out expenditures.
British banks seem to be the most heavily hit of all, and it is quite possible the extent of British government indebtedness arising from the crisis expenditures has blown out to unmanageable proportions - at least, that is the view expressed by many British financial authority figures, including the Governor of the Bank of England. By contrast, the Gordon Brown Government continues to maintain that the economy can handle the massive new debt. We shall see.
As this writer understands the course of that debate, the Bank of England's Governor, Mervyn King, is not necessarily contesting the need for bail-out; rather, he questions whether the British Government is coming clean with the people about the difficulties of paying it back.
Wherever the truth lies in that debate, it seems the onus to outline a feasible alternative still rests on those who, like Chancellor Merkel, criticise the stimulus approach, the more so given that so much of the money spent has been devoted to rescuing private banks - including banks in Germany and other EU countries - from the consequences of imprudent lending practices and incompetent management.
While debates rage on, there is a tendency to overlook the most important question of all. How do we reconstruct financial institutions so as to quarantine our communities from the future possibility of again having to pour trillions of dollars into a self-destructing banking system?Collapse
Thus far, this debate has hardly touched Australia - perhaps because we appear so far to have avoided a financial sector collapse comparable to that of Europe and North America. Also, the worst effects of the world economic downturn seem to be passing us by - at least for now. Why this has been so is not entirely clear.
Our banks, historically, have proved to be better structured and possibly better regulated, though they share certain unhealthy characteristics of most international banks.
As to the real economy, two things seem to stand out. First, the government jumped in quickly with stimulus packages. These, whatever their shortcomings, seem to have helped. Second, and more important, the minerals boom kept us prosperous while Europe and North America were sinking into recession. That boom is now over, and in the coming year we will find out whether anything other than a mining boom was shielding us from the worst of the present world recession.
We have played almost no part in addressing the international consequences of the present downturn. Instead, we keep insisting - rather stupidly - that what most needs defending is not the future of our financial institutions, or indeed of the entire world economy, but the intellectual purity of "free trade".
We can't seem to grasp that free trade - as we understand the term - is elsewhere identified as part of the problem. If the real financial and economic problems are solved, a durable trading system will emerge. Certainly, the present imbalances between saving and spending nations, which have contributed so much to the present crisis, will not be tolerated in any future system.
The world must first fix the financial institutions. Australia maintains that its banks are okay. They aren't entirely; but even if they were, they must operate in the framework of a world system.
On this matter, the Northern Hemisphere will call the shots. What is it saying? Nothing yet in a coordinated way, but there is much constructive thinking about it.
Some experts are saying that if banks are too big to fail, they are too big. Others, however, argue that size is not the problem: what we need to ensure is that only certain types of institutions should qualify as banks; "real" banks need to be narrowly defined.
Gradually the real problem is being distilled. Most agree that under-capitalised banks were allowed to create too much liquidity and to take on too much risk. (Shareholders currently provide only 3 per cent of bank capital; the rest is borrowed).
If a private bank's CEO knows his institution is too big to fail, and not much shareholders' money is at risk, then competition from other banks will induce him to undertake ever-greater risks. Thus, in the last resort, the risk ends up being borne not by bank shareholders, but by the community.
One obvious solution suggests itself. Licensed banks will have to be much more highly capitalised than they are now. Uncomfortable implications flow from this. First, banks will seem to be far less profitable than they were during the boom years. In this case, bank charges will have to rise significantly in order to attract shareholder capital.
Can market economies handle much higher bank charges? Not easily - in which case the future of a market-based banking system is questionable. However, in this writer's view, the alternative - i.e., bringing traditional banking entirely under government control - is not a realistic option, at least for now.
Banks could, however, be permitted to continue operating under-capitalised as now, but shackled with greater regulatory oversight. This would not necessarily avoid the periodic need for huge public bail-outs. In the present climate, however, selling such a policy might be difficult.Halfway house
The most likely outcome, at least in the short term, is some kind of halfway house, with a nominally private system, slightly more heavily capitalised than now, and hedged (to coin a phrase) by a battery of regulations against excessive risk-taking.
It will be an untidy and imperfect response to the present need; and it won't protect the community against the possibility of another huge bail-out. But it might be the only achievable solution.
So how about Australia? If our banks are also mightily under-capitalised, why have they not suffered the same fate as the rest? Perhaps it is because we have kept the four major banks at their current size by denying them the possibility of merger. Over their own objections, regulation has prevented them from becoming too big. That, and the remnants of the banking legislation passed by the Menzies Government back in 1958, have probably saved them.
Perhaps, almost by default, we can show the world a way to reconstruct its financial institutions.Colin Teese is a former deputy secretary of the Department of Trade.