The Black Death of financial
collapse By James Cumes
The financial and economic crisis now upon
us is by far the most menacing of the past century
- even more so than the Great Depression of the
1930s. It is not just a "subprime" crisis; it is
systemic - affecting the entire financial system.
It is also global, affecting various countries in
various ways but affecting them all. In achieving
a certain "globalization", we have been uniquely
successful in globalizing collapse, chaos and
misery. It is a globalization which, in our
short-sighted negligence, we never envisaged.
In this crisis, even a country such as
Australia is no more than a subordinate,
neo-colonial, financial and economic dependency.
In essence, we have reverted to what we were
before and during the Great Depression of the
1930s, when Whitehall, Westminster
and
the
Bank of England played the tune to which we
jigged. Then, from 1945 to 1969, for the first
time, we played our own tune of full employment
and stable economic growth. Wild radicals such as
minister Eddie Ward in the governments of John
Curtin (1941-45) and Ben Chifley (1945-49) warned
us to be wary of Wall Street.
The cynics
might now say that Eddie, who died in 1963, was
right. After 1969, we forgot his warning. Indeed,
the Americans themselves forgot to guard against
the chicaneries of Wall Street, where eternal
vigilance should always be the watchword. They
forgot what the mania of Wall Street can do to the
reality of Main Street; and we shared their
amnesia.
From 1969 and especially from
1971, when the United States cut the dollar link
with gold, Australia surrendered any worthwhile
independence in its economic and financial
thinking. We swallowed American financial and
economic formulae, whether we were academics or
policymakers, industrial entrepreneurs, banks or
providers of "financial services."
We did
not entirely switch off tunes played by Britain,
the more so as its prime minister Margaret
Thatcher formed her slapstick band with US
president Ronald Reagan to drum up support for
"free" markets, "free" trade, privatization,
globalization and the free flow of almost
everything, including speculative capital in
unqualified pursuit of private profit. Corporation
and consumer greed marched in step towards global
disaster.
Rational economics based on real
investment, productivity and production died in
favor of speculative and often Ponzi pretensions.
The cowboy junk-bond merchants of the 1980s
metamorphosed into respectable, mostly young and
usually idolized financial wizards who "perfected"
sophisticated, highly complex credit devices. From
the 1990s, these highly leveraged instruments took
the form of derivatives, private-equity,
hedge-fund and mortgage securities, abbreviated to
CDOs, SIVs and the rest. Allied with "free"
markets, deregulation and the uninhibited flow of
all kinds of finance, those financial devices
destroyed industries and the jobs that go with
them. With casual indifference, they also
destroyed the self-reliant working and middle
classes until then typical of robust
free-enterprise economies.
Theirs was not
Joseph Schumpeter's "creative destruction" but
wholesale destruction of their own economies and,
eventually, their own financial "system". They
destroyed personal savings and created massive
indebtedness. They undermined the power and
security of the United States itself as they
"outsourced" real economic strength and stability
to countries especially in Asia.
The Asian
Tigers, China and others grew into "powerhouses"
whose creation, historically, would otherwise have
taken them generations. Our eminently creditable
aim of peaceful change through development of
developing economies was distorted, largely
through negligent inadvertence, into financial,
economic and social self-destruction. Looming
global collapse, with political and strategic
uncertainties, are our inevitable legacy.
Consumerism rages, industry
gutted The speculative, Ponzi mania
spread especially to Anglo-Saxon countries and to
other developed countries in lesser degree.
Australia took to "free" markets, "free" trade,
free-floating currencies, deregulation,
privatization, globalization, derivatives, hedge
funds, private equity, wildcat mortgages and
leverage-without-limit as a duck to water.
Consumerism raged. Industry was gutted. Debts
ballooned. The value of the currency fell at home
and abroad. Despite low-cost imports, inflation
flourished. In 2008, the Australian dollar can
perhaps buy as much in real terms as five or 10
cents did in 1969.
A situation in which
real public and private investment was replaced by
"ownership investment", massive leverage and
speculative finance, in which consumption grew and
debts spread, could not persist, except so long as
ever more money flooded in to support the
insupportable. Once the flood slowed or stopped, a
Ponzi-type collapse was inevitable.
But
few saw it that way. Warren Buffet belatedly
called derivatives weapons of mass destruction;
but most saw the financial devices as belonging to
a "new era". They represented a "new paradigm".
Far from being a threat to stable growth in a
stable financial system, they "spread risk" and
made everyone more secure and of course more
wealthy.
The wealth effect was a
particular feature of the residential mortgage
business. Funds were available from many new
banking and non-banking sources, including hedge
funds and private equity, as well as pension and
mutual funds; and sources that, in their
magnitudes, were new, such as the carry trade.
Funds marketed wholesale and retail mortgages.
Liability could be shifted even or especially for
debt in the deepest sense sub-prime. Mortgages
also enabled homeowners to expand consumption
through mortgage-equity withdrawals (MEW).
In a real sense, MEWs were symptomatic of
multitudes of individuals - and, in effect, whole
societies - high-living it off their capital. That
enabled a process of growth that was both
irresistible and inherently unsustainable.
However, the Ponzi scheme to shame all
others may yet be waiting to deliver its coup de
grace. One commentator has drawn attention to "the
bad news [which] is the US$500 trillion
derivatives market". He says that "This is an area
that the general public does not even know exists.
Few professionals understand this market. There is
no regulation as government just let it go ... and
go it did. You must expect a 5% default problem.
That is a $25 trillion number ... It can create
insolvent institutions all over the world ... It
is the making of the first global depression. The
world is not ready."
Unprepared for
depression Australia is not ready
either. Prime Minister Kevin Rudd told us late in
March that Australia's economic prospects remain
"sound, strong and good". The Reserve Bank of
Australia shares that view. Eerily, they echo US
President Herbert Hoover in 1929 immediately
before the stock market crash of that year.
Australia's situation contains some
positive features. High commodity prices, it can
be argued, are likely to persist, even though
volatile, at least in the short term. A member of
Iceland's central bank board recently said that
"fears of a meltdown in my sub-arctic homeland are
vastly overblown. True, the current account
deficit was 16% of GDP last year, but that's an
improvement from more than 25% in 2006. And while
net private-sector debt is about 120% of GDP,
there is virtually no public debt in Iceland. This
is largely the result of unparalleled political
stability and continuity."
Australia's
situation may not be as dire as Iceland's; or
indeed as dire as that of the United States or New
Zealand; but all three of us have some negatives
like those of Iceland.
Like all booms of
such size and speculative character, the
Australian housing boom must soon demand payment
of its account. From their peak, prices could fall
30% to 50%. Industry researcher BIS Shrapnel does
not agree; but we must expect that our housing
boom, even more robust than the American, will
collapse along the same general lines as the bust
occurring right now in the United States.
The high "unaffordability" of housing for
the average home-seeker, as distinct from
speculator, suggests that the bust will be savage.
The real-estate, building and associated
industries will suffer severely, with massive job
losses. Simultaneously, profitable investment
opportunities elsewhere may have vanished with the
widespread collapse of the "financial services
industry".
How likely is such a collapse?
So far, although some non-banking financial
institutions have gone to the wall, the four major
banks have seemed largely immune. "The take-up of
the Australian economy is still good," Rudd said
last week in New York. Australia had "limited
exposure" to the subprime mortgage woes that
erupted in the United States last year, he said.
"We have excellent balance sheets in terms of our
principal corporates and the banks themselves ...
The default rate in Australia is minuscule by
Organization for Economic Cooperation and
Development standards."
We don't know how
far banks and other potentially exposed
institutions have concealed their liabilities and
to what extent and how soon they will be forced to
reveal whatever bad news there is. Within this
broad question, we also do not know how far they
are exposed to losses from the massive and still
largely mysterious menace of derivatives.
In some measure, Australia's major banks
have certainly been involved in the wide range of
structured securities - CDOs, SIVs, and the rest.
A report on April 4, 2008, that local councils in
New South Wales have lost US$200 million and
perhaps up to $400 million on investments in CDOs
is a worrying sign that other and even bigger
losses may yet be revealed in a variety of
institutions, including banks. It seems scarcely
credible that an economy which, for so many years,
has absorbed so much of American theory and
practice - so much of the American financial
character - can be wholly immune from the
penalties inflicted on its American model.
The subprime crisis first hit the United
States after a housing about-turn that began as
far back as 2005 or 2006. An unequivocal downturn
in housing in Australia has yet to check in; but
non-bank lenders are already withdrawing from the
market. Wholesale mortgage lenders are closing
shop, perhaps as a prelude to a sharp housing
decline.
The carry trade which has
presumably provided funds for mortgages and other
financial services in Australia has been volatile
for some time. If it unwinds completely, that
could not only intensify mortgage problems but
also impact on Australia's external balances.
Our deficits have so far tended to persist
at a less healthy level than the commodity boom
might have encouraged us to hope. Our aggregate
private overseas debt is said to amount to the
order of half a trillion dollars. Against that
background, the current depreciation of the United
States dollar might foreshadow what awaits our own
currency.
Lagging
impact Economic and financial change
in the United States tends to have a lagging
impact on Australia. An acute awareness of the
severity of our crisis may consequently not emerge
before the second half of 2008.
When it
does, what will the Rudd government do? Currently,
it seems as unaware of the magnitude of the
challenge it faces as the James Scullin government
was in 1929. So the present government might
become just as bewildered as Scullin and stagger
just as blindly and ineffectually when they are
called on to act. In the 1930s, we listened to the
likes of Otto Niemeyer of the British Treasury who
was also a director of the Bank of England. Will
the Rudd government this time listen to the
Americans and the likes of US Federal Reserve
chairman Ben Bernanke? If they do, catastrophic
outcomes might not be in short supply.
Our
only real hope lies in clear, independent thinking
by those not too steeped in the flawed policies
responsible for our current crisis. We must see
clearly that fundamental, comprehensive financial
and economic reform is imperative. We must adapt
that fundamental reform to our own needs, as the
John Curtin and Ben Chifley governments did
between 1941 and 1949. As we did then, we must
simultaneously try to guide the international
community out of the calamitous course that has
evolved since 1969, and return it to the goal of
stable, peaceful, global change which, as a
primary objective, we pursued between 1945 and
1969.
While we embark on this journey, a
high level of political volatility in Canberra is
inevitable. Rudd might succeed; but the Labor
Party and government might split two or three ways
as they did between 1929 and 1932. Another Joe
Lyons, prime minister from 1932 to 1939, might
emerge. Whoever he might be, the odds are that he
will be even less likely to find quick or easy
solutions than Lyons was during the long and
bitter years of depression. Those years ended only
in the even deeper tragedy of world war.
James Cumes is a
former Australian ambassador to the European Union
and Australian representative at the United
Nations. He is the author of among other works
The Human Mirror: The Narcissistic Imperative
in Human Behaviour.
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