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Less Ideology, More Economics, The Australian, 3 April 2009

The Australian

by David Hetherington, Executive Director, Per Capita

Four years ago the BBC screened The Man who Broke Britain, an eerily familiar drama in which a bank collapse triggers a global recession. The intriguing question is how a team of scriptwriters predicted a collapse the world's regulators didn't see coming.

This question cuts to the central paradox of the global financial crisis.

While many elements of the crisis are familiar, its speed and depth have shocked policymakers. It is this mix of familiar and unpredictable that makes the downturn so hard to address.

At least four recent developments have shaped this crisis: banks' inability to properly value their liabilities; the savings imbalance between Asia and the West; the emerging divide between executives and other corporate stakeholders; and governments' failure to demand reciprocal obligation in corporate welfare.

To draw meaningful lessons, we must distinguish structural causes from cyclical ones.

The cyclical elements of the crisis - recessions, bank collapses, job losses - are most familiar.

Recessions fall into two categories: wage-inflation spirals or asset price bubbles. This one's a classic house price bubble. The trigger for the bubble bursting was a banking crisis. Again, no surprise; in recent years, banking crises have struck Sweden, Japan and Mexico.

Once the slump begins, familiar symptoms appear. Confidence turns to pessimism, demand stalls, businesses fail and unemployment soars. Unsurprisingly, these classic cyclical stages have provoked classic responses. Lower interest rates were tried with little effect. Policymakers then turned to older remedies - fiscal stimulus and printing money - with mixed success. Already critics claim that more radical steps are needed.

Why have conventional measures failed? The answer lies in the structural changes that have contributed to the crisis, those genuinely new elements whose effects are still poorly understood. Four important structural developments have played a role.

The first is the emergence of a vast, opaque web of cross-liabilities within the global financial system. Banks bet each other huge sums on the likelihood of loans defaulting. Yet when Lehman Brothers collapsed, no one knew the value of its outstanding bets. Worse, no one knew whether these would set off a chain reaction in which banks across the world fell like dominoes. The ensuing fear froze global credit markets.

This was a gross regulatory failure. No accurate accounting of assets and liabilities existed. As most credit derivatives were traded privately or over the counter, no external party knew the traded item's price or how many other parties held claims over it.

So one lesson from the crisis is the need to rethink the design of capital market trading.

Financial markets require transparent trading exchanges that disclose price and contingent liabilities. This must be part of the new "international financial architecture" championed by Kevin Rudd, British Prime Minister Gordon Brown and friends.

The second structural development was the unprecedented debt accumulated by Western households living beyond their means and plugging the gap with East Asian credit. This savings imbalance supercharged growth in Western economies. Banks, particularly in the US and Britain, were earning so much from writing and repackaging loans that lending discipline suffered, allowing unsecured, high-risk loans to proliferate.

A second lesson, therefore, is the need to rethink bank regulation. Financial deregulation is rightly hailed as a key enabler of Australia's economic success. But deregulation is somewhat misleading: banks still need regulatory oversight. Today's task is not to re-regulate banks but to update regulatory design to address the weaknesses exposed by the crisis.

Lax banking rules explain why Westerners were so eager to borrow but not why Asian citizens were so eager to save. In many developing countries, the only means of insuring an income is to save. If these nations (especially China) could provide social safety nets through pensions and welfare, the need for household savings would diminish, reducing the global credit glut.

A third structural feature of the crisis is the divide that has emerged between shareholders, executives and employees. In the present crisis, shareholders and workers have been the big losers while senior executives are the only clear winners.

Last year, shareholders lost half their portfolios and millions of people lost jobs, yet Wall Street bonuses totalled $US18.4 billion despite banks losing more than $US100 billion.

How can executives be rewarded so generously for performing so badly? This, too, is a gross failure in the market for executive management.

The US administration has responded by recouping American International Group bonuses, while the Australian Government has reduced the golden handshake ceiling.

This highlights the next key lesson: community expectations matter if the crisis is to be overcome politically. The notion that executive failure can be rewarded while victims suffer offends the public. These governments are smart to sense legitimate community unease and respond appropriately.

A fourth underlying cause of the crisis has been governments' willingness to distribute state largesse with no reciprocal sharing of risk and reward, encouraging excessive risk-taking.

In the worst cases, publicly subsidised profits are privatised while losses are borne by taxpayers and employees. This approach may be justified for banks whose failure threatens the entire economy, but not for non-finance companies.

Government must demand reciprocal obligation for corporate welfare as it does for individual welfare.

As policymakers work through these lessons, there is a temptation to blame the crisis on ideological excess and respond with similar ideological fervour. Rudd's The Monthly essay rightly identified the ideological currents at play and their effects on the politics of the crisis. But by focusing on ideology, Rudd does not adequately explore the economics underpinning the politics. His argument would have been far stronger if it had buttressed ideology with real-world economics as a basis for addressing the crisis.

Progressives correctly observe that extreme laissez-faire policies have driven the present malaise, in particular the central assumption that markets are self-correcting. But we should not reject outright the economic liberalisation that has delivered Australia such remarkable prosperity.

Instead, we should address the structural causes of the crisis, recognising the singular role of governments in restoring growth and maintaining stability. It should then be some time before the BBC scriptwriters write their next financial drama.