The economic collapse we did not have to have

CEDA's Research Director Dr Michael Porter explores the foundations of global finance and some of the reasons behind the global financial crisis.

We are witnessing a financial collapse that started with a not-so-unusual downturn in housing in the US. The excess lending for sub-prime housing had followed a permissive post 'dot-com-bust' expansion in housing finance underpinned by the Federal Reserve. Again, this was not so unusual and an outcome of political pushing of loans in the US as an egalitarian device. This activism was spurred on by the unusually sustained economic boom since 1990 and an associated boost in confidence, both in part due to the end of collectivism. The surge of China and India post-1990, and the productivity increases due revolutionary information technology probably created a broader spreading of new wealth than any time in history.

What was and is unusual at the end of the boom was the explosion - then implosion - of transactions deriving from the packaging of such (housing) loans, and in particular credit default swaps (CDS). CDS are a form of insurance that allows for the transfer of credit risk without the transfer of an underlying asset. Because the word 'swap' was used such transactions were free of regulation - something that was endorsed by Alan Greenspan, Chairman of the Federal Reserve from 1987-2006.

The Bank for International Settlements reported the notional amount of outstanding credit default swaps to be $42.6 trillion in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). By the end of 2007 there was an estimated $45 trillion to $62.2 trillion worth of credit default swap contracts outstanding worldwide.

The resulting collapse in these derivatives of housing finance involved counterparties including most key financial institutions across the globe. Sadly, financial derivatives and most of the swaps wizardry of the sector are not areas of expertise of most of the economics-trained central bankers and economic advisers to governments. These well trained experts almost all came not from the new world of finance (derivatives, swaps and extreme layering), but from the traditions of political economy, modern economics and central banking - back to Smith, Hume, Bagehot and even Keynes. While financial gurus Soros and Buffet were strong critics of such instruments - they were evidently not strong enough in their opposition to completely exclude such instruments from their own portfolios - or for them to successfully press for regulation.

Sources of growth were real

In order to understand this contagious implosion of the world capital market in 2008, it is helpful to go back over the underlying developments of the past 20 years. What emerged from these growth decades was a new investment and financing boom benefitting some billions of people and expanding real opportunities for all financing institutions. As one example of benefits, innovations in infrastructure finance, and public-private partnerships, in tandem with regulation to make project incomes predictable, allowed substantial expansion of private infrastructure finance worldwide. This enabled scope for sustained governmental fiscal surpluses . While the core reasons for the sustained surge in real growth were a shift to market capitalism for about three billion people, the digital revolution and the newer ICT enhanced set of technologies were lifting and sustaining remarkable increases in productivity and incomes. In terms of ideology and technology it was the best of times, so too in terms of the hundreds of millions of people exiting poverty.

In contrast to the last 18 years, the next few years will be awful - as the unwinding of hidden balance sheets of countless counterparties, and the flow-on from write-offs of wealth will be long and profound in all income groups and most countries. The derivatives markets, notably credit default swaps (CDS) , options and the markets for packages of loans, has simply collapsed because of the layering of loans, with multiples of up to or possibly beyond 30 times the original equity base. Banks could lend, sell off the risks (to unregulated trusts and counterparties), and lend again. The core and usually safest of loan sectors - housing - had been turned into a casino without an owner, an agency without a regulator. Absent the derivative plays adding to over $60 trillion,   the collapse of the housing sector would merely have delivered a Keatingesque 'downturn we probably needed to have' - if only to get back to financial and regulatory cleansing. Instead, we have the most bizarre and unpredictable scenarios where our financial and political leaders appear to have little choice but to make it up as they go along; guarantees, equity injections, compensations, and so on.

In terms of contagion, what was a plus - a virtual horizontal supply curve of finance at the world rate of interest adjusted for project and currency risk - has become a lightning fast international transmitter of withdrawals and terminations; with new official sector (vertical) rationing of largely domestic funds and allocations of guarantees that become a new source of instability. Savings now get shifted according to guarantee status - something that was avoided in past financial crises, even with Whitlam in 1974 following a run on building societies. In today's situation, moral hazard and gaming add to uncertain assets and toxic liabilities.

Investments in sound projects and infrastructure may now stop because of institutional financing reasons and despite the economic fundamentals. The sharing of the pain will be in rough proportion to the relative expansion of finance/real sectors over last decade (eg Swiss and Europe high; China and Australia lower, the US in between) but all deeply significant and at best a source of recession. The internationalisation of the relatively unregulated capital market also means that risks will be transmitted through unforseen channels.  Many innocent bystanders in all income groups are going down, and the capacity of governments to offset the decline is very constrained relative to the size of the implosion or deleveraging.

Was it avoidable?

As noted, some downturn was almost inevitable given the financial mismanagement of housing US aggravated by a massive post-1990 US current account deficit that has inter alia  transferred much financial wealth and elements of potential control to China and other surplus countries. The US external debts and the US take of over 16 per cent share of the flow of world's savings do not look sustainable, nor does the willingness to hold reserves mainly in dollars. As former Federal Reserve Chairman Paul Volker (2005) put it, "At some point, both central banks and private institutions will have their fill of dollars." Additionally, the forces and swings of expectations that made past business cycles almost certainly still apply. The good news is that the growth in China and India remains real, as do the infrastructure needs in Australia and beyond, and where sound financing models can still apply. If there had been a 'normal' cyclical swing, the overlay from China, India and the catch-up needs for infrastructure across the world could have made the emerging crisis quite manageable and a chance to cleanse a few regulatory systems. In particular, if the central banks had monitored derivatives (it now seems to be agreed by all including Alan Greenspan) the excesses that are now being unwound could have been avoided with a 1987 or 1994 style recession in terms of severity.

Capitalism and future banking?

While the economic basics of the capitalist model that gave us the long boom were and remain sound - capitalism has not failed - some of the financial innovations and ultra-leveraging were known by many to be unsound, but criticisms were muted by the boom, and so the financial engineers were not effectively scrutinised, nor the institutions cleaned out or placed under a regulatory watch.

The euphoria of growth and the removal of hundreds of millions from poverty probably meant there was no sense of urgency. But even Alan Greenspan now admits the mistake - which spread from the Fed not regulating derivatives such as CDS to advisory committees such as the Wallis Inquiry in Australia choosing also to leave derivatives aside. What is more critical and worthy of discussion is the broader point - that in the US, a financing but not economic culture was dominant at the top of the Fed - and as now agreed - regulation of securitisation, credit default swaps  and options trading was deliberately rejected by Greenspan et al.

Monitoring this process of securitisation were agencies such as Moodys, Fitch, and Standard and Poors. But if they gave too many BBs and not enough AAs then they would lose the mortgage house or bank next time - and so lose their fees. Conflicts of interest abound!

The banking industry, its associated institutions, including central banking, insurance and investment banking, now need to shake the trees and get back to economic basics, regarding leverage, risk mitigation and management. No doubt there is an overwhelming need for some highly professional inquiries of the sort led by Keith Campbell in 1980. But there is no need to change the basic tools of financing economic development. What is required is a proper documentation of the excesses and financial chicanery, a return to normal simple truths, not a declaration of war against markets, options or debt based systems. The temptation to blame the banks will prove irresistible to some, in large part because it was indeed the leader of the Fed who gave his blessing to the explosion of derivatives, and in particular allowed insurance arrangements to be dressed up as swaps and so avoiding insurance regulation. Greenspan fed the false belief that through derivatives, risk was really being allocated to those best able to handle it. Not so.