Economics 101 - What the global meltdown means
- Steve Keen
- October 6, 2008
IN MAY 2007, the Organisation for Economic Co-operation and Development (OECD) commented that "the current economic situation is in many ways better than what we have experienced in years. Our central forecast remains indeed quite benign".
Three months later, the financial crisis began: the US stockmarket started its long decline and house prices fell. Financial institutions began to resemble tenpins rather than the pillars of society they had once been.
G4 leaders stop short of bailout
European leaders vow to help banks out at the end of an emergency summit in France to try to shore up confidence in the banking system.
A year later, the crisis has become even more extreme, with five more large international banks failing the weekend the US
Government devised a $US700 billion ($897 billion) bailout plan, only to have it rejected by Congress.
WHAT CAUSED THE CRISIS?
The immediate cause was the collapse in American house prices, which had doubled between January 2000 and August 2006, and have since fallen by 20%. More than 1% of American households have defaulted on their mortgages.
Up to a quarter of mortgages were "subprime", and fi nanced by the issuing of "residential mortgage-backed securities" rather than by traditional bank loans. The bonds were then sold to investors, pension funds and councils all over the world. Those buyers have since lost not just their anticipated interest but also much of their principal.
The bonds were also used by lenders to raise money through repo agreements - a contract in which one finance company sells another a bond in return for cash, and is then obligated to buy the same bond. By August 2007, so many households
had defaulted that the bond prices began to plunge, and suddenly lenders refused to accept them as collateral for loans.
The wholesale money market collapsed, and the credit crunch began. The long-term cause of the crisis was the dramatic growth in private debt in America - from a low of 37% of GDP in 1945 to 290% now - and across the OECD. The subprime fiasco was the final stage in a process that has seen lending extended to progressively riskier and less viable borrowers.
This final lending spree drove both stock and house prices to historically unprecedented levels, from which they are now falling, bankrupting both borrowers and lenders.
WHY DOES IT MATTER THAT THESE SUBPRIME BONDS ARE WORTHLESS?
The long-term problem is that buyers of these bonds are getting far lower returns than they expected from their investments. The money they used to buy the bonds has essentially been lost. They will have far less income - and far less capital - than they had anticipated and may face bankruptcy.
The more immediate problem is that, when the financial bubble was at its biggest, these bonds were the mainstay of the repo trade. Now no one wants to buy a bond in case the seller is unable to buy it back as promised. The repo market has
therefore dried up, and the bonds are effectively worthless.
However, many financial institutions still record the value of these bonds at the original sale price - their nominal or "book value" - rather than their market value.
If they were instead valued at what they could be sold for now, next to nothing, the recorded value of those companies' assets would fall, making them effectively insolvent and unable to lend. Their managers live in dread of some event forcing
them to do that - such as a distress sale by a company trying to avoid bankruptcy.
This is why the US rescue plan was devised: to buy these toxic bonds, euphemistically called "troubled assets", before the
fi nancial institutions were forced to value them.
If a global recession results from this crisis, it would be diffi cult for us to avoid a recession here as well.
WHAT IS THE US RESCUE PLAN?
The plan involves the US treasury buying up to $US700 billion worth of "troubled assets" from financial institutions, then covering that cost by selling $US700 billion in new government bonds to the public.
SO WOULD THE PLAN WORK?
That's very hard to say, but the details are not promising. This is a rescue plan devised by people who didn't see the crisis coming in the first place - otherwise they would never have allowed subprime loans to be created. If they didn't understand
the problem with subprimes, then it's possible they don't understand the system they're now trying to rescue.
Even the amount nominated, almost US$150 billion more than the US has spent on the war in Iraq, was not chosen in any scientific way. A US treasury spokeswoman told Forbes magazine: "It's not based on any particular data point. We just wanted to choose a really large number."
There's also the problem of how much the plan would pay for these toxic bonds. The initial proposal was to set the price through a "reverse auction": start by offering a low purchase price, and progressively increase it until individual financial
corporations decide to sell.
However, this could result in sales by more solvent firms at prices that would bankrupt less solvent ones, so it is likely that this, and many other, aspects of the plan will change in time - if it is passed into law by Congress.
If the US financial system is to continue, then the assets of financial institutions must be increased - and this bailout would enable them to replace some of their impaired assets with $US700 billion in cash. But this could still cause a significant fall in their assets, depending on the sale price. And the book value of outstanding mortgage debt is $US14 trillion. With mortgage defaults at unprecedented levels and still on the rise, there's no guarantee the plan is big enough to succeed.
SO HOW DOES ALL THIS AFFECT AUSTRALIA?
In our globalised fi nancial system, crises anywhere can cause ructions elsewhere. Banks and investors throughout the world hold CDOs linked to the American crisis, so that bankruptcies in the US can damage the financial security of a municipal council in Australia.
ARE COMPARISONS WITH THE GREAT DEPRESSION JUSTIFIED?
The real comparison now is with the financial crisis that preceded the Great Depression, centred on the stockmarket collapse of 1929. Then, despite a 36% fall in the share index that year, all the Wall Street merchant banks made it through
the Great Depression.
This time, all fi ve Wall Street behemoths have either failed (Lehman Brothers), been taken over at bargain-basement prices
(Bear Stearns, Merrill Lynch), or have sought to change their status to that of commercial banks before they failed (Morgan Stanley and Goldman Sachs). And the expected economic downturn has only begun. So the financial crisis is much worse than in 1929.
So is the level of private debt. When the 1929 crisis began, America's private debt was equivalent to 1.5 years of the nation's GDP.
It is now equivalent to 2.9 years of GDP - and that doesn't include the net debt involved in the $US500 trillion derivatives market. So the debt situation is almost twice as bad.
One attenuating factor is that the US is not as economically dominant as in the 1920s, and the emerging economies of China and India may counteract America's downturn.
But the US is still the world's largest economy, and many other OECD nations are as indebted as the US. How the now widely expected economic downturn compares to the Great Depression remains to be seen.
Associate Professor Steve Keen is from the school of economics and finance at the University of Western Sydney.http://www.theage.com.au/national/education/economics-101--what-the-global-meltdown-means-20081006-4urk.html?page=-1
