The global financial crisis (often abbreviated as the GFC) is a series of disruptions, upheavals and failures in international financial markets that began in the United States in early 2007. The crisis deepened and spread across the rest of the world over the next two years, especially after US investment bank Lehman Brothers was bankrupted in October 2008. Now, in mid-2009, it is continuing to cause financial firm insolvencies, sharply reduced economic growth and rising unemployment across many of the world’s major economies.
Fortunately, Australia has largely been spared the huge bank losses and insolvencies that have been a signature of the GFC in other economies. This is because Australia’s banks are very strong by world standards and Australia has a robust, carefully designed system of financial regulation that was put in place over more than 11 years of Coalition government between 1996 and 2007. Nevertheless, the Australian economy is being affected by the global downturn, which has slowed economic growth and increased unemployment.
ORIGINS OF THE CRISIS
The GFC was triggered by investors fleeing from what in early 2007 was a little-known segment of the US financial markets – the market for securities backed by ‘subprime’ home mortgages. But the origins of the crisis go much deeper, and arguably extend back a decade.
One important factor behind the recent problems was a lengthy period of very low interest rates and relatively relaxed bank lending standards in many major world economies, including the US and the UK, after 2001. Cheap credit contributed to the GFC by encouraging lenders to make loans to borrowers whose prospects of repaying these funds were not strong. Low interest rates also encouraged some borrowers to take on larger loans than they could afford, and contributed to a rapid rise in the values of many assets (such as residential properties) in many economies in the period between 2001 and 2007.
A related factor underpinning the recent crisis, in the eyes of many economists, was the persistence of large external account imbalances between a group of so-called ‘surplus’ countries (China, Japan, the Gulf states and others) and a group of so-called ‘deficit’ countries (in particular the US, UK and Australia).
Over many years there was an outflow of savings from surplus countries and an inflow of savings into deficit countries. While some of the inflow of funds into deficit countries was used for investment in productive assets (particularly in Australia, where foreign capital contributed heavily to our resources boom), in economies such as the US it appears the influx of money may have been largely used for less productive purposes such as bidding up housing prices and financing consumption.
A third contributor to the GFC, at least in the US and UK, was poor government regulation of financial systems. Regulators were a step behind the rapidly evolving financial markets, and often lacked the resources and expertise to understand the impact of innovative financial technologies on the way the financial system works and on the location and dimensions of systemic risk. Regulators also failed to keep pace with the explosive growth of the so-called ‘shadow banking system’ – the hedge funds, investment banks, private equity firms and other unregulated or lightly regulated financial entities that accounted for an increasing share of financial activity over recent years.
Finally, an important contributor to banks taking on too much risk and behaving in ways that ultimately cost their shareholders billions of dollars was a misalignment of the interests of various stakeholders – particularly the owners of financial institution shares, and the executives that managed those financial institutions. Financial industry executives were often paid heavily (in some cases excessively) for delivering short-term earnings from risky activities that in the longer term turned out to not be profitable at all. There were also misalignments in interests between financial institutions in some economies – for instance, in the US, the company that made a home loan to a risky borrower was often not the same as the entity that ended up owning that loan and having to collect on it.
THE U.S. SUBPRIME MELTDOWN
All these issues – low interest rates, poor regulation, complicated financial markets and instruments, misaligned interests, and risky lending – came together in the US ‘subprime’ meltdown of early 2007, which saw investors and banks around the world suddenly become far more reluctant to own or make risky loans. This was the catalyst for the GFC.
The subprime crisis was caused, in large measure, by banks in the United States lending money to people to buy homes whose prospects of repaying that loan were poor. These subprime loans accounted for more than 15 per cent of home loans in the US by 2007 (but less than 1 per cent in Australia, where the financial system was better supervised).
Accelerating the problems in the US was a steep fall in house prices, which left many borrowers with negative equity in their homes. The US regulatory system also contributed – not too little regulation, but the lack of appropriate and effective regulation and supervision. Indeed in some respects excessive US government involvement (such as through the government sponsored enterprises Fannie Mae and Freddy Mac which ultimately stood behind most American mortgages) probably exacerbated the problem.
THE GLOBAL FINANCIAL CRISIS SPREADS
While the flight by investors from risk first affected subprime mortgage-backed securities in the US, the turmoil soon spread to other complex and hard-to-value instruments used by banks to transfer lending and risk or to hedge against default. The sudden re-pricing of risk rapidly affected other types of debt beyond US mortgages, and spread to Europe and Asia. All around the world it became far more expensive and difficult to obtain credit, and for some borrowers it became impossible.
At the same time, banks and other financial institutions around the world came under pressure as investors sold their shares and bonds, fearful the loans these banks had made in the past might not be able to be paid back. Banks suffered huge falls in the value of the assets (mostly loans and debt securities) they had on their balance sheets, and most banks had to raise extra capital as a result. In the US and Western Europe, many banks suffered such large losses that they had to seek additional capital from governments to stay afloat. More recently, this trend has seen huge banking groups such as RBS and Lloyds-HBOS in the UK and Citibank and Bank of America in the US come partially or substantially under the control of governments.
When the US government was forced to step in and take control of Fannie Mae, Freddie Mac and the insurance company AIG in mid-2008, and Lehman Brothers collapsed in October 2008, what had until then been largely a financial crisis started having a far more severe and immediate impact on the rest of the economy, particularly in the US and Europe. Since that time, economic growth has slumped and unemployment rise in most of the world’s major advanced economies including the US, Japan, and Western Europe. Growth has also slowed in emerging economies such as China, Russia and India.
AUSTRALIA’S RESPONSE TO THE GFC
Australia is fortunate to have a well regulated and supervised financial sector. The 1996-2007 Coalition government legislated for Reserve Bank independence and created our prudential regulator – the Australian Prudential Regulation Authority – with the explicit mandate to closely supervise deposit-taking institutions. By comparison with much of the rest of the world, our banks are well-capitalized and sound. They have remained profitable through the downturn.
However, Australia’s economy has felt the effects of the global financial crisis in the form of lower prices and volumes for our exports, slower growth, higher unemployment, and less available credit.
Unfortunately, the Rudd Government made this difficult situation worse than it needed to be when in October 2008 the Prime Minister announced an unlimited bank deposit guarantee. This went much further than comparable countries, and caused severe dislocation and hardship to thousands of Australian with accounts in unguaranteed funds such as mortgage funds and cash management trusts. These accounts were frozen. Even after the guarantee was subsequently capped at a still-excessive $1 million, the confusion and loss of confidence in our financial system continued.
The Rudd Government also made a poor choice when it decided to hand out $23 billion in ‘cash splash’ payments to individuals as the centerpieces of its fiscal stimulus packages of October 2008 and February 2009. While the money was no doubt welcomed by those who received it, most of it was saved – and so had little impact on economic growth. In April 2009 the chief economist of the International Monetary Fund, Oliver Blanchard, publicly confirmed what the Coalition had long asserted – the cash splashes were a very ineffective and poorly targeted stimulus measure. Instead, Blanchard agreed with the Coalition’s argument that a far larger share of the stimulus money should have been spent on economic infrastructure – projects such as ports, highways and rail links which add to Australia’s long-term economic potential.
A final concern over Labor’s response to the GFC is the vast public debt and contingent liabilities to which taxpayers are being exposed. While the ‘automatic stabilizers’ (the natural tendency for an economic downturn to reduce tax collections and increase outlays on welfare) would have caused a budget deficit regardless, the size of the deficits and debt over the next few years has been greatly enlarged by Labor’s heavy spending. In fact since November 2007 Labor has announced policies that have increased Commonwealth spending by $124 billion – which in turn accounts for about two thirds of the $188 billion in net public debt the 2009 Budget predicts that Australian taxpayers will owe by 2012-13. This represents the largest increase in public spending since the mid-1970s.
And the debt will not stop at $188 billion. Already, since the 2009 Budget, Treasurer Swan has admitted the actual ‘peak net debt’ figure will instead be at least $203 billion, and gross debt will rise as high as $315 billion. These figures also don’t account for the additional borrowings Canberra will take on to pay for Labor’s off-Budget ventures such as $28 billion for RuddBank and $43 billion for the national broadband network.
It took a decade of Coalition leadership and hard work by the people of Australia to pay off Paul Keating’s $96 billion debt legacy after 1996. Mr. Rudd and Mr. Swan plan to run up two to three times as much public debt over less than half as many years. The ultimate consequences of that borrowing frenzy will be higher real interest rates for Australian borrowers, higher levels of foreign debt, and higher taxes or lesser services in the future.
The global financial crisis is without a doubt a major challenge to governments everywhere, but Australia would be far better off under the sound economic management of the Coalition.