Kenneth Davidson
The Age 03 Nov 2008
Is the crisis the result of a temporary liquidity problem or is it the result of systemic insolvency?
The free market fundamentalists are in denial. They are demanding increasingly large doses of government intervention in failed financial markets to restore sound market fundamentals.
It is a bit like asking the devil to save God according to Henry Lieu, chairman of a New York private investment group writing recently in the online magazine, The Asian Times.
The fundamentalist ideological inconsistency is shameless. The implications are more serious if the problem has been misdiagnosed. There is a big question still to be resolved: is the crisis the result of a temporary liquidity problem or is it the result of systemic insolvency?
The crisis itself has built up over decades in part because the response of central bankers to any downturn has been to ensure plenty of liquidity to avoid the risk of a major depression.
This was the lesson that central bankers learned from the Great Depression. Despite their public disavowal of Keynesian economics, they understood that pro-cyclical policies to tighten money supply would increase the amplitude of any downturn in the business cycle.
In Australia, the 1931 Premiers Plan involving a 10% cut in wages led to an even larger cut in prices. Those who held their jobs and had no debts did well out of the Depression. All the burden fell on the 30% of unemployed people and their families. But the plan achieved the main objective of its architects - protecting the interest of the London bondholders.
But the other half of the lesson, that the banks should be kept under tight regulatory control to ensure they played their subordinate role to facilitate the functioning of the "real" economy was forgotten after the generation that experienced the Depression and World War II retired in the 197os.
The iron law of financial deregulation is that competition to increase market share leads to self-destruction because the only way banks can increase market share at the expense of their competitors is by lowering lending standards.
Australia experienced this after financial deregulation in the early 1980s. The increase in the number of banks led to a collapse in lending standards as the banks competed for the dubious multibillion dollar business of the paper entrepreneurs such as Alan Bond and Robert Holmes a Court.
The major product of the period was $20 billion in non-performing loans, the November '87 sharemarket crash, the transfer of many of Australia's finest assets into the hands of foreigners and the response of the monetary authorities in the form of a huge injection of debt/liquidity that financed the subsequent property boom and led to the "recession we had to have" in 1989.
Now the systemic problem is more deep seated. In Australia the problem of household debt has been ameliorated so far by the continuation of the housing bubble. The bubble has burst in Britain and the because of their housing glut.
But the housing bubble is arguably bigger in Australia than Britain and the US and it is reasonable to expect the bust will be proportionately bigger when it comes.
In Australia, the systemic risk to financial markets has been fuelled by capital gains concessions and negative gearing, squeezing first-home buyers out of the market.
Wage earners have no choice but to see their savings flow mainly into domestic and foreign financial markets that are mainly vehicles for speculation rather than productive investment.
The amount going into public infrastructure is inadequate and infrastructure priorities are being distorted by the public-private partnership industry, which is controlled by the financial engineers whose financial "products" have been the major factor in creating the financial crisis that is still threatening to lead to a 1930s-style debt/deflation depression.
What is apparent so far is that the monetary authorities (the central banks seem to have quietly given up their independence for now) have the ability and the financial resources to keep the banking system from failing. What the authorities do not have is the experience and the resources to keep the much larger non-bank intermediaries and capital markets necessary for the operation of the real economy from failing.
Lenders are afraid to lend because they are no longer confident they can assess the credit worthiness of borrowers because of the corruption of the risk assessment process.
And borrowers are afraid to take on more liabilities while there is the risk of an economic slump.
According to Liu "the current credit crisis has evolved from the unregulated global growth of structured finance with the pricing of risk distorted by complex hedging which can fail under conditions of distress. "The proliferation of new market participants such as hedge funds operating with high leverage on complex trading strategies has exacerbated volatility that changes market behaviour and masked a heightened level of risk in recent years.
"The hedging against risk for individual market participants has actually increased an accumulative effect on systemic risk," Liu writes.
How the world goes depends on the US - and how the US goes will depend on the presidential and congressional elections.
Based on the opinion polls, it would appear that Barack Obama will not only win the election but even have a sufficient majority in the Senate to prevent Republicans from frustrating the Democratic legislative program.
The most important legislative reform will be to reverse the 1989 legislation that deregulated hedge funds so they were exempt from supervision and scrutiny.
The new administration must understand that under the present deregulated system, the US Federal Reserve is faced with a Hobson's choice: impose a depression to cut off a long period of stagflation as occurred in Japan in the 1990s or flood the market with unproductive liquidity.
According to Liu, insolvency cannot be solved by injecting liquidity without the penalty of hyperinflation. The new administration should be able to avoid this invidious choice by taking a few sensible measures that show recognition of the true systemic nature of the crisis and by indicating the administration is prepared to co-operate with the major European economies such as Britain, France and Germany, as well as China and Japan, to repair the damage to the Bretton Woods system by the market fundamentalists since the 1971 Smithsonian Agreement to float the US dollar against major European and Japanese currencies.
The Johnson administration foist that deal on the rest of the world to finance the Vietnam War and the "Great Society" without increasing taxes by exporting stagflation to the rest of the world for over a decade.
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