CAUSES OF THE GLOBAL FINANCIAL CRISIS

Talk to Whitlam Institute public forum, Parramatta
Tuesday, May 26, 2009

David Gruen has given us a highly competent and comprehensive economists’ exposition of the causes and consequences of the global financial crisis and the global recession it has precipitated, both for the globe and for Australia. I disagree with very little of it. So using David’s exposition as a base, I want to give you my take on the causes of the crisis and, in doing so, step back from all the detail and try to identify the more general patterns of behaviour involved.

In a nutshell, my take is that the crisis was caused by the failures of human nature, compounded by the economic managers’ reliance on a model of human behaviour that fails to take account of many aspects of that human nature. If that sounds so general as to be saying very little, let me try to give it some substance.

Human beings aren’t rational as the economists’ basic, neo-classical model assumes, but are highly emotional. Even economists themselves are more driven by their emotions than many of them realise. Particularly because people are so influenced by the behaviour of those around them, the people who make up an economy are prone to an alternating cycle of optimism and pessimism. So much so that this is now - and probably always has been - the main factor driving the business cycle of boom and bust. During the optimistic phase people happily take on ever-increasing risks and obligations. They spend rather than save, expanding their possessions and activities, pursuing status symbols, piling into the markets for property and shares, forcing prices up, then piling in some more just because prices are rising.

They do all this confident in the belief that the good times will role on forever and prices will only go higher. We now see more clearly than we did at the time just how much this mentality drove the Howard Government’s response to the way its coffers overflowed during the resources boom. But, of course, as we all know but keep forgetting, some event inevitably causes the boom to end and, when it does, the prevailing mood flicks from optimism to pessimism. People become afraid, they worry about all the commitments they’ve taken on, they abandon their plans for expansion and tighten their belts. On many asset markets (but probably not our housing market) prices go from being unrealistically high to being unrealistically low. The result is business failures, lay-offs and rapidly rising unemployment. This causes the fear to deepen into a pessimism which assumes the world will stay bad forever.

My first point is that, though economists know full well that the economy moves in cycles of optimism and pessimism, boom and bust, and a large branch of economics is devoted to studying the management of the business cycle - macro-economics - economists don’t have much of a handle on the factors that drive the cycle, especially those that derive from human psychology. They accept that ‘confidence’ is a major influence on the cycle, but they can’t get confidence into their mathematical equations, so they end up underrating its importance. A big part of the problem is that conventional micro-economics has no place for psychology or the business cycle, assuming the economy is always at full employment because it is self-equilibrating, self-correcting. Alan Greenspan admitted he’d made a mistake in believing the banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions. He had too much faith in the economy’s self-correcting powers because he assumed we’d behave rationally, not emotionally.

My second point is that this chronic underestimation of human failings tempted economists and regulators to run a partially deregulated financial system and not to worry about weaknesses in the remaining regulatory system, such as the US’s multiple regulatory agencies sharing responsibility for the system, and the operation of the hedge funds completely outside the regulatory regime. Here we have a fatal combination of model-blinded thinking on the part of the economics profession and blatant self-interest on the part of powerful vested interests in the financial markets. When they’re in optimism mode, business people always want to be completely free to do as they please in their push for profits.

But because the big banks and other players in the financial markets aren’t rational and are capable of getting carried away in a boom and doing stupid things they later come to regret, they do need fairly close supervision to protect them from themselves and to protect us from them. In the absence of that supervision it was inevitable the episode would end in disaster.

In Australia, your econocrats - particularly those at the Reserve Bank - have been an honourable exception to this naivety. They’ve been a lot more worldly wise, always being very conscious of the problem of asset bubbles. The former governor, Ian Macfarlane was highly conscious of the risks involved in the long housing boom. He devoted much effort to studying and trying to talk down the boom, with some success. So we avoided making the same errors with our banking system, partly also because of two accidents: first, the four-pillars policy banned mergers between the big four banks because politicians fear the displeasure of the electorate more than the displeasure of the banks and, second, our Australian Prudential Regulation Authority was riding herd on the banks because it was still smarting from the caning it got over its inadequate supervision of the HIH insurance company.

In their drive for profits, people in the financial markets invented ever more sophisticated and artificial - weird and wonderful - financial contracts known as derivatives. In theory, these synthetic contracts were about ‘risk management’ - spreading and shifting risk to those most able to bear it. In practice, as David said, the risk was spread to those least able to understand it. Even the inventors of these derivatives didn’t fully understand how they worked and the circumstances under which they could come unstuck. Individual financial institutions didn’t understand the size of the risks they were taking on and no one - neither other institutions nor the regulators - knew where the risk was accumulating. So my third point is that derivatives were a case of the market being too smart by half and not nearly as smart as it imagined itself to be.

I don’t know whether you noticed, but at many points in David’s exposition of what went wrong he alluded to the consequences of excessive gearing or leverage or plain old excessive borrowing. His story was littered with references to debt. The reason booms go on for so long and get so big is that they’re fed by excessive borrowing. While everything is on the up and up, borrowing is a very easy way to magnify your gains from investment. Trouble is, once prices start falling, being highly geared is a way to magnify your losses and risk your own survival.

The thing about debt - or ‘credit’ as economists prefer to call it - is that it’s like fire: a wonderfully useful and beneficial thing, but also something that, if not understood and carefully controlled, can do immense harm. Yet economic theory focuses almost solely on the benefits of credit, hardly acknowledging how dangerous it can be if allowed to get out of hand. Why such a cavalier attitude towards debt? Because of the assumption that we’re all rational; because of the economic model’s unrealistic assumptions about human nature.

So my fourth point is that a primary cause of the crisis was the failure of regulators to understand the need to impose constraints against excessive gearing. The sudden discovery of all the trouble derivatives had got us into wouldn’t have caused nearly so much devastation had not the institutions that found themselves holding the parcel when the music stopped been so precariously geared. Indeed, some of the derivatives were themselves aimed at helping people gear up.

In the past 15 or 20 years, central banks have become proficient at controlling the former scourge of inflation by means of inflation targeting. What they have not managed is to find a way to prevent the build-up of speculative asset price bubbles. That’s because the instrument they use to fight inflation - the manipulation of interest rates - can’t simultaneously be used to fight asset bubbles, a point Guy Debelle of the Reserve Bank reiterated recently.

But all this means is that, as part of the move back to a more carefully regulated financial system, we need to revert to direct controls over borrowing levels.

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PUBLIC HEALTH CONSEQUENCES OF THE GLOBAL FINANCIAL CRISIS

Talk to AFPHM Congress, Sydney
May 20, 2009

Because I’m no expert on public health, I’m going to focus on the nature, size and duration of the crisis, and say something about the likely impact of the crisis on the developing countries and on Australia, leaving Steven Jan to focus on what the crisis will do to the social determinants of health.

I must start by warning you that economists are hopeless at forecasting what will happen in the economy. All they - or I - can do is offer you educated guesses, which will probably be wrong for reasons we haven’t thought of. But humans are incurably curious animals, with an insatiable desire to know what the future holds, so they go on asking economists for their predictions, and economists go on pretending to know what will happen. Now I have your informed consent, I’ll get down to it.

I’m going to skip explaining the origins of the financial crisis and take up the story at the point where the crisis reached its climax in mid-September last year with the collapse of the US investment bank Lehman Brothers. This prompted panic in global financial markets, which froze. The global banking system rocked on its foundations as governments in the US, Britain and continental Europe struggled to avert the collapse of various banks. The whole world watched these frightening events on television every night and the effect was a sudden loss of confidence among businesses and consumers in many countries. Around the world, fearful consumers tightened their belts and abandoned plans for big purchases, while businesses postponed expansion plans and wondered about laying off staff. In consequence, the global economy hit a wall at that moment. It dropped off a cliff. Just about every developed country contracted - went backwards - in the last quarter of 2008, and the contraction continued in the first quarter of this year. Over that six month period, the US economy contracted by more than 3 per cent, Europe by more than 4 per cent and Japan by maybe 6 per cent.

Those are huge figures. Australia would also have contracted over that six months, but by a lot less (we’ll get the figures for March quarter a fortnight today). Most developed economies had been slowing (as we had) or were in already in recession before the crisis reached that climax in September, but from that point it became indisputable that the global financial crisis had become a global recession, that the problem had spread from Wall Street to Main Street, from the financial markets to the ‘real’ economy of production and consumption that you and I inhabit.

As the immensity of the global contraction slowly dawned on officials, the IMF - the International Monetary Fund - revised down its forecast for growth in the world economy in 2009 five times in seven months. Its latest prediction is that the world economy will contract by. 1.3 percent in calendar 2009. This would be the first annual contraction in 60 years. It compares with record world growth of more than 5 per cent just two years earlier (2007). Virtually every advanced economy is in recession and the advanced countries as a whole are expected to contract by 3.8 per cent. The developing countries should grow, but by just 1.6 per cent. Normally, any rate of global growth below 2 per cent is regarded as a world recession, because recessions usually roll around the world, hitting different countries at different times, because the developing countries always grow a lot faster than the advanced countries (because they’re coming off a low base) and because they aren’t as closely connected to the advanced countries as the advanced countries are to each other.

The IMF is predicting that the world economy will grow by 1.9 per cent the following year, 2010, with the developing countries recovering to 4 per cent (still weak by their standards), but the advanced economies just breaking even. This, of course, would still be in recession territory.

The IMF is uncharacteristically gloomy about this recession. It’s worried by two unusual features of the present episode: first, unlike most recessions, this one has been caused by a crisis in the financial system, and second, it’s highly synchronised - everyone’s going down together, partly because of shared trauma of the events in September-October. History tell us that recessions brought on by financial crises are deeper and longer, with a weaker recovery. History says the same about synchronised recessions. Put those two negatives together and you’ve got a particularly bad prospect.

The IMF has legitimised the comparison of this recession with the Great Depression, suggesting that this episode be known as the Great Recession. However, economists are confident we won’t see anything as bad as the Depression because we’ve learnt from the gross mistakes we made then. In particular, we have four factors going for us. First, we haven’t stood around watching banks collapse, but have done everything necessary to prop them up. Second, we’re well aware of the risk of deflation (widespread and continuous falls in prices) and will resist it, understanding that, in such circumstances, printing money helps rather than harms. Third, we don’t see any virtue in balanced budgets at such a time, and are applying large amounts of timely fiscal stimulus. Fourth, no one imagines a resort to competitive currency devaluations or higher trade barriers offers a viable solution to a global problem, even if domestic political pressures make them tempting.

How bad and how protracted will the Great Recession end up being? I don’t know. Even if it’s not as bad as some people fear, it will be plenty bad enough. The main risks are, first, a new crisis somewhere in the global financial system, and second, inadequate efforts to fix the balance sheets of ailing banks, so that businesses and households fail to receive the flows of credit necessary to allow them to resume normal activity.

On the positive side, world financial markets are a lot more settled than they were, there are reasonably convincing signs that the US, which has already been in recession for a record 17 months, is stabilising and could start recovering later this year - although it could still be a year or more before there was any improvement in unemployment - and there are convincing signs that China is recovery, just as the recovery from the Asian crisis of 1998 was much stronger than (more V-shaped) than we expected. Developing economies are more resilient than advanced economies; they have a greater ability to bounce back.

Last week’s budget argued that Australia’s recession - which has hardly got started yet - will be much less severe than those of the major developed economies and much less severe than we experienced in the recessions of the early 1980s and early 1990s, even though the recession itself will last longer: three years, rather than one year in the 80s and two years in the 90s. But whereas the rate of unemployment peaked at 10 per cent in the 80s and almost 11 per cent in the 90s, this time it will peak at only 8.5 per cent, in the second half of next year. Treasury is certainly right in arguing that, when recovery finally arrives, the usual pattern is for the economy to bounce, achieving surprisingly high rates of growth as it comes up off the floor. There are three good arguments for Treasury’s relative optimism. First, thanks to the four-pillars policy and strong regulation, our banking system is in very good shape. Second, the alacrity with which we slashed interest rates and applied budgetary stimulus to the economy after September last year will prevent the economy from descending too far into the depths. Third, the recovery in China, as it switches its engines of growth from export demand to domestic demand will limit the fall in our export income. The counter argument is that we haven’t yet felt anything like the full effect of our loss of income arising from the collapse of coal and iron ore prices, nor from the rise in unemployment and the debilitating and hence compounding effect this will have on business and consumer confidence.

Edging closer to our goal of assessing the consequences of all this for public health, let me just make the obvious point that the burden of recessions is shared most unequally, with the increase in unemployment concentrated heavily on the unskilled, early school-leavers and the disadvantaged, including Aborigines and the mentally ill. Considering what we know about the social determinants of health, this does not bode well. However, though an increase in health problems as a result of the recession may lead to the overstraining of unchanged levels of provision, I don’t believe that explicit cutbacks in government health spending will represent a significant addition to the problem.

Finally, let me turn to the problem in the developing countries. On the face of it, their economies will grow faster than those of the advanced countries, but this is misleading. The developing countries’ rapid population growth means they need to grow at faster rates just to stop going backwards. In these countries I think we will see both an increase in the demand for medical assistance and a decrease in its supply. The reduction in supply will come from increased pressure on government budgets (less revenue but more spending demands), reduced official and unofficial aid, and less ability on the part of patients to bear out-of-pocket costs. In 23 developing countries more than 30 per cent of their total health spending is funded by donors. I am hopeful, however, that, where countries are obliged to apply to the IMF for financial assistance, the criticism the fund received for its mishandling of the Asian crisis will make it less inclined to provide assistance conditional on ultra-harsh cutbacks in government social spending.

According to the World Bank, each 1 per cent decline in growth causes 20 million people to be pushed into poverty. After for once enjoying a period of decent growth - a half-decade above 5 per cent a year - Africa is forecast to manage growth of just 2.8 per cent this year. So I don’t doubt that the Great Recession will lead to great suffering among the world’s poor. In developing countries as in Australia, the burden of economic downturn will be distributed unequally and unfairly, with the poor bearing most of the brunt. Similarly, in any competition for inadequate public health resources, you’d expect to see the better-off elbowing out the poor.

Even before the onset of the global recession, only a handful of African countries were on track to meet the Millennium target of halving the share of the population living on less than a dollar a day by 2015. But the gloom and doom is not total, however. One small mercy is that, at a time of global recession, you’d at least expect to see food and energy prices coming down. Another is that the African economies’ generally improved economic management in recent years leaves them better positioned to weather the crisis than they were a decade ago. It’s also fortunate that so many of the world’s poor live in China and India, which are likely to recover fastest.

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