This article is the second part of a digest of a public forum at the ANU.

Ross Garnaut’s book, ‘The Great Crash of 2008’, is an important contribution to the ongoing critical discussion of the global economic crisis.

However, it lacks in one respect: the book is written as if Australia went through basically the same experience as the US.

In the US it was an old fashioned financial crash, like 1907 when JP Morgan locked the bankers in his library and told them that he wouldn’t let them out until they had sorted out the mess. 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

1. Garnaut on understanding the Great Crash of 2008
2. The role of macroeconomic management in the Great Crash
3. The Great Crash – Weekly editorial

There has been quite a bit written, including several books, on the Great Crash of 2008. Reading those all at once recalls the old Indian story of the blind men and the elephant: one blind man putting his arms around the legs described the elephant as a tree, another feeling the ear described it as a fan. One felt the trunk and described it as a snake, while a fourth felt the tail and disputed the serpentine explanation. The Great Crash of 2008 is the story of the whole elephant. It tries to show how all the parts fit together.

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

1. The Great Crash of 2008 and getting financial regulation right
2. The role of macroeconomic management in the Great Crash
3. The Great Crash – Weekly editorial