There are four big parts. One was a normal boom and bust of a kind familiar from economic history — though unusually large – beginning with one of the strongest periods of expansion the world has seen and having the special characteristic that it took new parts of the world into modern economic growth.
The crash was preceded by a period of large international imbalances in current account payments. There was huge growth in savings in some economies that wasn’t matched by growth in investment. The big new feature on the global scale was the growth of Chinese savings, which became by far the world’s largest source of surplus savings for international investment. But it wasn’t only China, it was East Asia as a whole, and then after commodity prices rose in the commodity boom, the commodity exporting countries as a whole became big surplus countries. The other side of this coin was imbalances in the deficit countries, especially those we call for short hand the Anglosphere: the United States, Australia and Britain. The international system was transferring huge surplus savings from some countries to the Anglosphere. From our reading of economic history we know that large imbalances are vulnerable to disruption from international financial intermediation.
Another special feature of this crash was what we call clever money: the development of new instruments for transferring financial assets on an immense scale and of immense complexity. Of a scale and complexity the world has never seen before. Galbraith said ‘there’s no such thing as financial innovation, there’s just re-inventing the wheel over and over again, in a more unstable form.’ He wrote that quite a long time ago. Well some people saw the development of the complex new financial instruments, new financial derivatives as a problem waiting to happen.
And a fourth element of the story that has been emphasized by Christian social democrat leaders in the Anglosphere, people who’ve come to office recently, is that there were new boundaries drawn for greed. The boundaries within which personal enrichment at the expense of the enterprise or society were widened, and this created vulnerabilities.
These are all part of the story, and they all helped the boom become a bigger boom than it otherwise would’ve been until it became the greatest bubble in history.
By the middle of the first decade of the twenty-first century the psychology of the boom was well established. After multiple years of strong growth and rising asset values, risk seemed to diminish in financial asset markets. The gambler has thrown the dice a number of times and each time has won, while the investors who remain cautious are less successful and fall from favor. Those with money to lend as equity or speculative ventures watch the gambler throw and win and begin to think that he has skills beyond the ordinary human. The gambler who borrows heavily for speculative investment, the lender who accepts high margins for disproportionate risk and others who suspend the normal judgments of prudence appear on the rich list. They become responsible for investing higher proportions of the world’s capital. The speculators become popular heros and more influential in political systems. Those in leadership positions who take seriously their responsibilities for imposing constraints on the use by investors of other people’s money are pushed to the margins of public life. Some of the prudent, including regulators, come to believe that risk is not what it used to be and are less confident of their old positions. If they make this transformation in perception early enough, they retain their influence and may even become maestros of the new financial order. This is the eternal story of the bubble in capitalist economies.
Of course, the clever new financial instruments, when tested, busted open, and the new shadow banking system that emerged in the twentieth century disappeared upon itself like a dying star. That precipitated a great economic collapse. All around the world, normal financing of trade and investment just stopped. That was followed by a very quick response – a bailing out of financial enterprises, including in Australia.
Australia was engulfed by a different kind of crisis than that consuming other Anglosphere countries. In the US, falling asset prices had triggered the collapse of shadow banking. In the UK, the fallout from that collapse had undermined the larger banks whose assets had been devalued or which had depended on the continued reliability of the shadow banking mechanisms. The subsequent withdrawal of credit undermined the UK’s own housing market.
In Australia, however, the difficulties were on the liability side of bank balance sheets. Banks had become heavily reliant on foreign borrowing. Suddenly they were unable to borrow internationally. The non-banks had had no buyers for their securities for almost a year.
Once the essence of the financial bailout was in place, we were left with much lower levels of global economic activity – there was a much bigger fall in global economic activity than had ever been experienced, even in the early period of the Great Depression.
The timely intervention of the Australian government in guaranteeing banks wholesale borrowing was decisive in avoiding a very severe downturn in this country.
The aftermath of the crash
The aftermath of the crash is a story of differential rates of recovery. The old developed countries have a much larger battle, and are probably looking forward to a much lower trajectory of economic growth for quite a long time into the future. But the big Asian developing countries (China, India and Indonesia especially) were relatively little affected by the crash.
The gap between growth rates in the established industrial countries and China and some other large developing countries will grow wider in the years of recovery from crisis. If the emerging quadripolar world (the US, EU, China and India) with a bipolar core is to manage this process for sustained peace and prosperity it must accelerate reform of some international institutions and development of new ones.
The new approaches will require greater international support for the United States in the supply of international public goods related to the maintenance of international order. It will require United States’ acceptance of greater consultation and the sharing of influence that will accompany greater international burden sharing. It will require the new economic powers to accept leadership roles to which they are unaccustomed. These are difficult requirements. For a while at least, we will live in a riskier world. There are economic risks, as well as geostrategic, in the aftermath of the crash.
There was a fault in some but not all of the exposition of liberal ideas about economic policy in the late twentieth and early twenty first centuries. The mistake was to ignore or underplay the essential role of law, institutions and moral restraint in constraining market outcomes to secure socially or environmentally or politically or economically sustainable development. The moral and institutional framework were taken for granted. This was most dangerous and costly in relation to the financial sector.
The universe of ideas within modern economics can handle these issues well enough; so long as we are open to the whole — the whole includes the objectives of policy alongside economic efficiency, the special issues that surround the supply of public goods, and income distribution. But the wider framework was often lost as economic ideas became instruments in commercial interests’ wars over policy, and have been simplified in popular discourse.
Now we must go beyond the over-simplifications and the slogans. There is now no alternative to careful application of old ideas to the new circumstances that have been revealed by the Great Crash.
That would be a mistake. To expand the role of Government in the economy in general would be a mistake with fateful consequences. To do this at the same time as hanging back from the hardest and most necessary interventions in the financial sector, that would throw out the baby, and keep the bath water.
This is a digested transcript of Professor Ross Garnaut’s presentation [mp3] to a Public Forum at the ANU before the launch of his book (in association with David Llewellyn-Smith) on ‘The Great Crash of 2008‘.
More information on Professor Ross Garnaut’s work is available at his website: www.rossgarnaut.com.au