The financial sector caused the US downturn. The Australian experience, on the other hand, was our usual externally generated shock. This affected our financial sector, exacerbating other problems through knock-on effects. But our cycle wasn’t caused by the weakness of the financial sector.
Understanding what happened, and the state of the new world economy, is vital for good policy making. The question for Australian policy makers now is when to wind back the fiscal stimulus. The financial sector made it through the crash reasonably well, and there are no major issues.
If we take the rankings of banks in the world, there’s only one AAA bank and 8 AA banks left. Australia has 4 of those top 9 banks. Of course, isolated examples exist: Opes Prime, Allco, Babcock & Brown, and Storm Finance were all messy, but they caused no structural damage to the financial sector.
Asset price bubbles are still an unresolved policy problem, but the interest rate cannot be used by central banks to eliminate this issue. Central banks may be given some so called macro-prudential instruments, but at the moment those instruments lie with the prudential regulator.
You could imagine a world where, instead of the financial sector having a pro-cyclical effect on the cycle, capital ratios, liquidity ratios and maybe loan-to-valuation ratios would be altered over the course of the cycle.
Leaning against the asset price increases, or cleaning up after the event still seem to be the two choices available.
Even before the crisis some central banks, including the RBA, understood that sensible leaning against asset price increases would be a good idea.
Australian real estate agents fought the Reserve Bank in the early part of the 2000s, believing it to be pushing interest rates up too much.
I don’t think the Efficient Markets Hypothesis(EMH) was a central policy belief among the Australian authorities. The failure of HIH cleaned out any EMH proponents that might have been in policy circles. There wasn’t any light or ‘soft’ touch supervision in Australia. The four pillars probably helped by restraining the degree of competition between the big four.
I think of the guarantee that was given on banks’ overseas borrowings as similar to a lender-of-last-resort facility. We’ve always known that financial sectors were fragile and you needed some authority like a central bank that would stand ready to lend in extreme circumstances. If for some reason the banks had not been able to borrow in New York they would simply have come to the Central Bank and borrowed there, shifting the problem of funding the current account to someone else.
In the United States, they had a dispersed regulatory framework that encouraged regulatory shopping, and extraordinary mortgage contracts that allowed renegotiations if interest rates moved.
Australia had nothing equivalent to the NINJA borrower. There were non-complying loans in Australia, but they comprised some half a per cent of outstanding loans. There was no physical overbuilding here.
The very low interest rates that in America were a response to the 2001 tech-wreck weren’t present here. There was no shadow banking sector, with its high leverage and dependence on the money market. Most of the lending action in America was in the securitised sector of the market, relying on derivative credit wraps and credit rating endorsements – what one might call paid endorsements. Likewise, there was no Wall Street lobby.
If Australia is in a relatively good position, what about America? There are four areas that need fundamentally reform in the US.
Firstly ,regulation, including more stringent capital requirements. This is an important step to take, but it won’t solve the problem. Looking back on this crisis, it’s unclear what amount of capital would have actually saved us from this crisis. I don’t have much hope that a minor shift in capital is actually going to solve the problem.
Secondly, the structure of the financial sector requires a great deal more thought. What we see in recent years is the way it conglomerated and became inter-connected, losing those old (and valuable) separations achieved through the Glass-Steagall act. We need a financial sector in which the institutions are more specialised, and where the structure can be seen more clearly. If these are the core institutions that take in the money from widows and orphans and lend in simple ways, they need to be protected and supported. We also need the institutions which supply high-risk capital to fund innovation, but these institutions shouldn’t be protected and supported by the government. We need to make sure that casinos aren’t mixed with the utilities.
Thirdly, the most serious problem for America is the political economy of all of this; the way Congress was basically in the pocket of Wall Street. Money, jobs, the whole story of excessive influence.
Finally, macro policy. There is a macro mistake behind every crisis. In this case, it’s clear that low interest rates in America following the tech-wreck were a serious macro fault.
Australia and the US face very different tasks. The US has almost 10 per cent unemployment, a current account deficit nearly as big as Australia’s, a fiscal deficit running at 12 per cent of GDP, and an exchange rate which has fallen already and needs to fall further.
This is part of the process of fixing the imbalances. But this fall will create additional problems because they still need the Chinese to keep their money in US dollars. Their banks still contain large volumes of non-performing loans. On top of that, the shadow banking system – which Greenspan once described as the spare tyre, ready if anything went wrong with the banking system – has been doing the heavy lifting for some years. Securitisation of the kinds that we’ve seen over the last 5 years, with complex structured products, cannot return any time soon.
To function again, securitisation needs credit wraps, reduction in the complexity of slicing and dicing, and credible credit rating agencies. The credit wraps and the credit rating agencies are both discredited. AIG won’t be there to provide the credit wrap next time.
The role of markets and their interaction with governments and regulation still needs a lot of sorting out. Ross’ book takes us some way in addressing this challenging task.
Stephen Grenville is a visiting fellow at the Lowy Institute for International Policy and a former deputy governor at the Reserve Bank of Australia