ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Can we avoid a second global financial crisis?
, March 5, 2011
Is the GFC over - or are we waiting for a repeat performance?
We can't know yet for certain. The banks in the United States and the major economies of Europe have been rescued from bankruptcy by large injections of government money. For the moment, their capacity to destroy the real (that is, productive) economy has been halted.
But manifest financial sector problems remain to be fixed, both inside and beyond the US. Those European nations within the EU's currency union are of notable concern. The EU is passing through its greatest ever crisis.
Not nearly enough has been done to insulate the real economy from the consequences of imprudent banking practices in the US - and Europe is hardly better.
The future of the European Union is at risk, unless the economies within the currency union of the EU that have reached the edge of bankruptcy can be resurrected. All need huge injections of capital. The question is: who will provide it?
Essentially, it will have to come from within the EU. However, funds from the EU as a whole, including from member-countries outside the currency union, are not available for these purposes.
In any event, those member-countries outside the currency union would not agree to such expenditures. Would the British people, for example, who have retained the pound sterling and are not party to the euro, and who are already paying for the follies of their own banks, be likely agree to take on, in addition, the liabilities arising from the follies of others?
All of this makes the politics of handling bail-out issues among members of the European Union within the euro system much more complicated - and more so because, in some cases, it is concerned with governmental as well as bank indiscretions. Some of the troubled governments have magnified their difficulties by overspending.
Any bail-out for the troubled economies must come from the richest of the EU member-countries - and so the finger has been pointed, in the main, at Germany.
But if Germany is asked to bail out, say Greece, then the German Chancellor Angela Merkel has a political problem. She must persuade her parliament and people of the wisdom of spending German money to pay for the follies of the Greek government and its banks. The same is true for the other troubled countries.
Mrs Merkel is not finding this easy. Apart from some issues under German law, German politicians and people are entitled to believe that EU monetary union was never intended to create such situations.
The problem won't easily be fixed; and, as commentators keep warning the public, unless a solution is found, the currency union - and even, some say, the future of the EU itself - is threatened.
Curiously, while the problems of European banking and government spending wallow along, mired in uncertainty, Western European economic recovery seems to be following a smoother path than that of the United States - at least so far as employment is concerned. That having been said, questions will be asked about its sustainability, so long as the matter of bail-outs of countries and their banks is not resolved.
Poor Chancellor Merkel hardly knows which way to turn. She faces major political hurdles at home over rescue packages, yet keeps insisting that monetary union - so absolutely dependent on the packages - is the essential cement of the EU.
The EU can't survive without the currency union; the currency union can't survive without the bail-out; the bail-out faces formidable political and legal obstacles. Something, or somebody, has to crack.
But let's be optimistic, if only for purposes of argument. Supposing, against the odds, all of this gets fixed in some manner or other. However, the only result will have been to patch up what went wrong. It does not even begin to tackle the problem of what might need to be done, and what can be done, to prevent a re-run of past catastrophes.
Of course, the same is true for the United States.
There is a body of banking opinion, heavily concentrated in the United States, and widely believed though less obviously stated in Europe, which suggests that nothing really needs to be done for the future. Be assured, its advocates insist, banks (both central and commercial) have learnt their lesson. The same follies that led to the financial collapse of 2007/08 won't be repeated.
All the evidence from past experience suggests otherwise. The idea of learning from experience necessarily assumes the existence of an institutional memory of decisive influence.
However, financial institutions have no such memory - and, even if they did, it would always be eclipsed by the onset of newly-created financial instruments guided by a new, optimistic breed of banking practitioners.
The 1929 New York stock market crash, which triggered the banking crisis that ushered in the Great Depression, was caused by imprudent bank lending. It was less sophisticated and on a much smaller scale than we have recently experienced, but it was no less damaging, given the circumstances of the time.
In contrast with the 2007/08 GFC, the cause of the post-1929 American banking crisis did, however, seem to be confined almost entirely to overly generous lending for the purchase of shares. Banks in those days did not have access to the technologies needed to create new, extravagant instruments by which banks could lend vastly increased sums without the risk of these practices showing up on the banks' balance sheets.
In the early years of the 21st century, US banks in particular were certainly lending in various ways to support the purchase of shares as in 1929. The weight of these activities had the effect of inflating prices for these assets, and ultimately destabilising the marketplace in which these assets were exchanged.
To that extent, the behaviour of financial institutions in the run-up to 2007 was the same in kind as 1929, but on a much larger scale.
But this time, a further element of uncertainty was introduced; it concerned the manipulation of the funding of household mortgages.
Banks actually found a way to make handsome profits by encouraging the poor to purchase houses even when they lacked the ongoing means to make the necessary mortgage repayments.
Lenders well understood that the borrowers could not possibly service the mortgage repayments, yet they remained unconcerned about the status of the debt.
Their perfidy was further compounded by tempting low-income borrowers into mortgage commitments with encouragingly low start repayments and later raising them to prohibitive levels.
That this would inevitably create certain mortgage default was of no concern. The banks got their fee for lending the money, and the construction industry got to keep on building houses.
By the time this particular merry-go-round of fantasy stopped turning, the banks, by means of new and clever instruments, had cleared their own balance sheets of these unsavoury loans. The debt was transferred to other sorts of ownership. A collapse of the US housing market was ushered in.
But the damage was done, and the US government had to embark on a gigantic bail-out and rescue mission of the US finance industry. Worse still, this crisis precipitated a collapse in overall demand and a fall in output and employment. The US economy is only now on a rather uncertain path towards recovery.
The flow-on to Europe came as a result of European banks being locked into US practices.
If you believe a global financial crisis of this magnitude can't happen again, forget for the moment how it all began - just look at what gave it its great push forward.
In 1999, in the dying years of his administration, President Bill Clinton was persuaded by the Federal Reserve Bank chairman Alan Greenspan and certain other influential Wall Street figures, to persuade Congress to repeal the 1933 Glass-Steagall Act. The act had been put in place, in the depths of the Great Depression, to regulate banking and control financial speculation and thereby avoid the stock-market excesses that had preceded the October 1929 Wall Street crash.
More than 60 years on, all the lessons of that crash were in the process of being unlearnt.
It was all part of the deregulationist push which began in the early 1980s. Twenty years of apparent economic prosperity were enough to convince Greenspan that the safeguards put in place all those decades ago were no longer needed.
Self-regulation and the greater sophistication of markets, we were assured, were all the regulation that the financial industry needed. Greenspan was convinced that much had been learned, and the operation of markets had become so much more efficient, that what happened in 1929 could not happen again.
The irony of this misguided faith is that at the very moment the Federal Reserve chairman was persuading President Clinton to further deregulate, the banks were launching into their most sustained ever burst of irresponsible lending which led directly to the financial collapse of 2007/o8.
Now that the banking system in the US is back on its feet, not remotely embarrassed or concerned about what the damage its excesses did to jobs and output, it is already turning its attention to opposing any form of re-regulation - even such as was put into place after 1929.
Neither is there, on the part of bankers, any guarantees that the past cannot be repeated. Which perhaps is just as well. Because without suitable banking "reform" - to use the current jargon - we can be certain that another crisis situation will be created.
There is, it should be noted, no shortage of suggestions for how the banking system could, and should be, made safer for customers and community alike. Many are thoroughly worthwhile, not especially restrictive of banks; but there appears to be no inclination on the part of governments to impose them on banks.
The climate for introducing suitable regulation might be more favourable in Europe than in the US, but only marginally. This being so, we will probably have to wait for the next crash before appropriate measures are finally taken.Colin Teese is a former deputy secretary of the Department of Trade.