Friends or foes?
Regrets and floggings
Very odd laws
Myall Creek Massacre
How to use history?
Dying for liberty
Rasputin meets Ned Kelly
Mary Anne Bugg
Our Ned Kelly
A story heard and considered
Not a good fence builder
Australia and the Global Financial Crisis
She'll be Right
"Conversely, talking up the extent of the crisis and talking down the economy, to which both the Rudd Government and the Obama administration can plead guilty, is to risk their worst expectations becoming a self-fulfilling prophecy." The Australian newspaper
Snapshot of Australian economy 2008
|| 20,600,856 (July 2008 est.)
|GDP per capita ($US)
|| $36,300 (2007 est.)
|GDP - composition by sector:
services: 70.6% (2007 est.)
|| 15.4% of GDP
|| Japan 19.6%, China 12.3%, South Korea 7.5%, US 6.2%, India 5.5%, NZ 5.5%, UK 5% (2006)
Australia is economically tied with Asia, but psychologically, it seems to be tied to America and Europe. This psychological tie to Europe and America was apparent in the 2007 “Global” Financial Crisis, in which the bankruptcy of European and American banks caused panic in Australian financial markets. The panic was particularly evident in prime minister Kevin Rudd's address to the nation in which he declared:
"Many Australians have become concerned, anxious and even fearful as to the future.
The truth is that we are going through the worst financial crisis in our lifetime. I've described it as the economic equivalent of a national security crisis."
The panic was particularly irrational considering that Australia’s export markets in Asia experienced continued economic growth during the crisis in America and Europe. Furthermore, the panic in Australia in 2007 was in marked contrast to the relative calm during the 1997 Asian Financial Crisis where Australia’s export markets in Asia collapsed and hedge funds attacked the Australian dollar in the belief Australia should collapse as well.
Unlike in 2007, in 1997, the Australian government didn't give speeches about a national security crisis, didn't embark on massive stimulus spending, and didn't give cash handouts to voters to “save” the economy. Most importantly, instead of the Australian superannuation holders losing most of their money and the government virtually bankupting itself but going from having $60 billion in savings in one year to a $100 billion in debt the next, the Australian economy proved its economic credentials that laid the foundations for two decades of exceptionally strong economic growth.
Origins and response to the crisis
The Global Financial Crisis, which really should have been referred to as the European and American Financial Crisis, was caused by a combination of government idealism and banks gambling with derivatives that left them holding an interconnected string of worthless IOUs with each other. In America, the Clinton administration said it wanted to implement a feel-good policy of increasing home ownership amongst “disadvantaged” communities. To achieve it's feel-good aim, the administration encouraged mortgage giants Fannie Mae and Freddie Mac to give home loans to disadvantaged people that lacked the capacity or inclination to repay the loans. To further ease entry to the market and stimulate the economy, Alan Greenspan, Chairman of the Federal Reserve, set interest rates at just 1%.
Even though it was unlikely they would ever repay the loans, the entry of disadvantaged people into the market increased demand for houses, which in turn increased the value of property. With property prices going up, banks wanted to lend as much money as possible and in their quest for profit they declined to ask borrowers to outlay a deposit or even pay off the loan. The banks only asked the borrowers to pay the very low interest. As far as the banks were concerned, it was a risk-free strategy. If borrowers defaulted, the banks could foreclose, take the property, resell it and reap the capital gain.
It was a model that would work as long as real-estate prices kept going up and prices would keep going up as long as new demand could be stimulated. Demand kept being stimulated because, as far as borrowers were concerned, it was also risk free. They could live in a house simply by re-paying a loan at 1% interest, which made owning a home far cheaper than renting a home. If ever they decided to move, lost their job or the value of the house went down, they could default and they wouldn't be out of pocket.
On top of the risky lending, a massive derivative industry developed. Derivatives are financial instruments that have no intrinsic value but derive their value from something else. Because they are gambles that derive their value from something else, it is not always clear what derivatives are and whether they are indeed valuable. Not even people in the financial industry always know what the are buying and selling. Theoretically, a derivative can have nothing of value underpinning it, yet still be profitable for people as long as a buyer is ignorant to what it is they are buying. Much like a pyramid scheme, as long as people keep buying, then dividends can be reaped and the derivative can be sold to someone else.
Unscrupulous people in the finance industry took advantage of the ignorance associated with derivatives in order to create pyramid schemes based on them. Financial products called mortgage-backed securities (MBS), which derived their value from mortgage payments and housing prices, enabled financial institutions and investors around the world to invest in the booming U.S. housing market.
Europe invested heavily in America because European policy makers had decided that their futures would be assured by relocating manufacturing to Asia, leaving just financial industries to secure the region's economic future. To make a profit, the financial industry needs gambles to be taken, and for European banks, America had the best odds at the time.
Aside making money via pyramid practices, by creating and selling derivatives, financial institutions were able to take advantage of the money multiplier effect to literally create money. For example, a bank may take a $100 deposit from a member of the general public and keep $20 in its vault. The bank then lends out $80. This money may then be deposited in another bank, which keeps $16 in its vault and lends out $64 and so on. With a fractional reserve of 20%, the $100 loan can be lent out 10 times and expanded into $457.05. If two banks lend to each other in the form of derivatives, between them they could have the original $100 loan in their vaults, and $357.05 worth of gambles based on the original $100 loan. In a sense, they have created $357,05 between them. The more money that is circulated between the institutions, the more wealth that can be created. In other words, the more derivatives that were created and sold, the more money that was "made."
Of course, the increased bank profits caused by the creation of wealth required bonuses to be paid and new staff to be hired to create even more derivatives. One derivative might be built on a risky loan, then another derivative might be built on the first derivative and so on just to keep the money being circulated amongst banks. More and more money was created, and more bonuses were paid. In a nutshell, America developed a huge financial industry that didn’t actually produce anything and was all tied back to rising property values and lending between lenders to create wealth. It was a house of cards that would keep getting bigger until a base card was pulled away.
Financial managers knew the dangers so like a good financial manager should, they diversified their products. They bought some financial instruments that were based on things going down, and others than were based on things going up. Banks also covered all their bases by buying and selling financial instruments with American banks and international banks. Unfortunately, all the instruments were in the same house of cards. If the house fell, all would become worthless.
Like all industries based on just pushing money around, eventually the bubble had to burst. In 2005, property prices started to collapse. Although many borrowers were from poorly-educated “disadvantaged” groups, they were still smart enough to realise that the value of their houses was less than their mortgages, and they simply stopped repayments. Demand for houses contracted even further, and more borrowers decided to default.
As of July 2008, over 800,000 Fannie Mae mortgage holders had defaulted on their payments at roughly $250,000 per loan. Collectively, this amounted to around $200 billion of bad debts. The bad debts were compounded by the fact that Fannie Mae had bundled up the loans as derivatives known as Mortgage Backed Securities. They then sold them to financial institutions like Lehman Bros, who in turn sold them to other financial institutions, who also sold them to other financial institutions.
It was like 1000 people at the race track having a $1000 bet on a horse in the upcoming race, and in turn, offering the opportunity for others to invest in their gamble by offering a rate of return for anyone who invested. By offering the chance for others to invest, another $10 million could be raised, which covered the initial gable and the rate to be paid to investors. Before the race was run, lots of investors were feeling wealthy because they had a share portfolio that was making money and could be sold. However, once the race was run and the horse turned out to be a cripple that ran last, all that money just disappeared. People who thought they were rich discover they owned nothing. With no assets, they couldn't buy a drink in the pub, a new outfit for wearing at the track, or even petrol for their sports car. Associated industries then suffer as well, including the bookies who need people to gamble to make money themselves.
The collapse of property prices became known as the subprime mortgage crisis. Much like the sinking of the Titanic, the inevitable was not immediately obvious and time was spent shifting deck chairs while the band kept playing the music. Finally, in September 2008, creditors finally became aware that all their gambles were basically worthless. They also became aware that if they asked for their money, or tried to cash in their worthless pieces of paper, then the banks would collapse.
Aware that the ship was sinking and nothing could be done to keep in afloat, overnight they reacted by asking for their money or cashing in whatever they had before anyone else to cash in before them. The effect was a money multiplier in reverse. When the derivatives became worthless and banks started withdrawing from each other, the $457.05 soon contracted back down to the original $100. Of course, all the money that had been spent on bonuses, salaries, promotion, real-estate, rent, promotion, holidays etc could not be recovered. Needless to say, the banks started going bankrupt. Via their gambles with each other, the financial industry had created money, spent money, paid massive sums in bonuses, but hadn't actually produced anything in the process. With interest rates being so low, they hadn't even made much money from the traditional loan model. With almost every bank in danger of going bankrupt, the American government had to step in to inject capital in the hope that it could stop the contraction and the further disappearance of wealth.
Although the subprime mortgages was largely an American problem, their disease proved contagious. Due to the international nature of the banking system, the contraction of the American banking system caused a contraction in other banking systems around the world. Again, wealth disappeared overnight as gamblers realised that they had put all their money on a crippled horse and were now broke. Because few people had money to gamble, bookies did it tough as well, as did the racetrack.
Realising just how much of the economy was based on perception rather than reality, investors started withdrawing their money from the stock market, which further reduced the ability of certain nations, and the citizens of those nations, to buy on credit or support high-income individuals in industries, such as finance, that didn't produce anything. A squeeze on credit also reduced the ability of the market to raise capital for business expansion as well as the willingness of consumers to go into debt in order to buy goods they didn't need.
Europe was especially hard hit because so many European countries had based their economies on the financial industry. Not only did they expect to make profits by gambling, they also financed the gambling by taking out loans. Banks lent to banks, governments lent to banks, banks lent to governments, and money just kept being created via loans and financial packages. In what seemed completely crazy, often the loans were taken out by European governments without any intention of paying them back in real terms. The theory was that if inflation could be kept high, and economies could kept expanding, then the real value of the amount of money to be repaid would be reduced. In other words, governments would try to service debt by borrowing more money, spending more money, and pushing up inflation.
In response to the collapse of their financial industries, most European governments and the American government decided to go further into debt by borrowing money to spend on propping up the banks. This was intended to stabilise the banking system that was about to collapse. Unfortunately, by bailing out banks, European governments went into unserviceable debt levels.
Presently, European governments are like the private banks were between 2005 and 2008 when they were wondering what to do about the subprime mortgages. They all know that the ship is sinking, but until other governments ask for what is owed, they wont actually sink. Consequently, countries like Germany are not only forgiving Greece debt, but lending more money to Greece, and then asking to borrow money themselves from countries outside of Europe. (In 2012, the Australian government gave $7 billion.) The fear is that if Greece defaults on its debt, non-European countries will stop lending to European governments, then Italy, Spain, Portogul will default. These defaults will then be followed by Britain, then France and then Germany. With all European major governments defaulting, they simply wont be able to lend money to each other and the European financial industry will be destroyed. With Europe having few ways of bringing money into Europe from outside of Europe, the whole region will revert to a third-world economy.
Why Australia should not have been heavily impacted
By all rights, the collapse of European and American banks should have inflicted some pain on Australia because Australian banks also had a liking for derivatives; however, for numerous reasons the pain should have been minor. Firstly, most of Australia’s banks had failed when they had tried to expand to American and European markets, thus they didn’t have the exposure to bad debts in American and European markets. Admittedly, the Australian housing market showed signs of being a property bubble; however, Australia had interest rates between 4 and 7%, thus banks had been able to make some money via their traditional loan/interest model. This was quite different from America where derivative trading and capital gain were the most lucrative methods for banks to make a profit.
Ratio of median house prices to average annual earnings
The danger of property bubbles . Too much money going to pay off mortages reduces funds available for alternative forms of spending. Furthermore, when property bubbles burst, banks are left with bad debts, money stops being loaned and circulated, and the economy loses a sector which had been making big profits.
Secondly, aside from having a much stronger banking system, Australia had a real economy based on mining and agriculture (unlike Europe which was based on borrowing money and gambling.) Although America was a useful export country for Australia, it was the prosperity of Japan, South Korea and China that really mattered to Australia’s prosperity. Because both Japan and South Korea had solid economic foundations, they still had the capacity to buy Australian goods. (Europe was not economically important for Australia.) Admittedly, a long-term downturn in their American markets would decrease demand for Asian goods and eventually Asian demand for Australian resources, but with contracts already signed, the reduction in demand would not be immediate unless the Asian companies went bankrupt.
China was the key for Australia and some people believed that Australians should be in fear because China needed America and therefore, whatever harmed America would harm China. Specfically, in 1999, China exported US$42 billion of goods to the United States, accounting for 21 per cent of its total exports. In addition, China's exports to Asian economies accounted for 53 per cent of its total exports. Finally, the Chinese government had bought US currency to ensure that the American dollar would be at a level that would enable Americans to keep buying Chinese goods. A decline in the value of the American dollar deprived China of funds and also reduced America's capacity to spend on Chinese goods.
The saving grace for China was that it had nearly US$2 trillion in foreign exchange reserves. As the world stock markets collapsed, China could use the savings to buy stock in companies that had lost the majority of their value. In addition, China had the funds available to stimulate its domestic economy. In 2008, the Chinese government announced a stimulus package of US$586 billion. It also announced policy changes that made it easier for Chinese companies to invest abroad. The aim was to buy foreign companies cheaply and increase Chinese domestic consumption.
Ironically, another saving grace for China was that it didn't have an advanced banking system that traded in derivatives. The banks still operated very much on the simplistic deposit-lend model. They hadn't developed a massive paper industry to churn money around and create wealth via an interconnected series of IOUs. Furthermore, the average Chinese have a culture of not going into debt. As a consequence, they had money in the bank, not loans to repay.
Most importantly, the fundamental benefit that China offered the Australian economy, the demand for resources, remained in place. As of 2008, China remained massively under-urbanised and the continued construction of cities maintained demand for Australian resources. To put things in perspective, 98 million people lived in Henan province. If the province were to achieve Japanese levels of consumption, demand would increase by 41 million tonnes, which would be equal to Germany’s annual steel consumption. No matter what happened to the Chinese economy, the cities would still be going up and demand would still exist for Australian resources. As long as China kept buying Australian commodities, then Australia would keep getting financial inputs into its economy which could subsequently be deposited into banks and churned around in a form of wealth creation.
Admittedly, the global crisis led to a dramatic collapse in the commodities market as Chinese companies simply stopped buying. Whether this was a forced decision by Chinese companies, or a voluntary one, was open to debate. From a economically rationally perspective, it would have made sense for Chinese companies to cancel orders, spread fear amongst Australian mining stocks and then buy the Australian companies at depressed prices. Such a course of action was also consistent with Chinese government policy that aimed to increase acquisitions of foreign companies using some of the $2 trillion war chest. Needless to say, the biggest investments China has ever made in foreign companies were taken in Australian resource stocks, such as Rio Tinto, that were suffering from the credit crunch. In what sounds completely irrational, shareholders feared that their mining companies would go bankrupt because the Chinese would not have money anymore, so they sold their shares to Chinese investors.
Needless to say, China never went into recession.
Although America and Europe had reason to be afraid of the credit crunch, Australia didn’t. The only real problems for Australia were caused by investors pulling money out of the stock market, which undermined Australia’s own credit culture that allowed the economy to exist beyond its means. Although this caused some short-term hardship, it was hardship that needed to be endured. Ultimately, an economy can't survive long-term by simply pushing money around. It needs to mine, produce, or manufacture something. The profits can then be churned around by the produce-nothing industries like the financial industry or service industries. Much like a drought forces a farmer to become more efficient, the financial crisis forced Australian banks to cut some of their dead wood products. Potentially, it could have also inspired the Rudd government to cut its dead-wood spending in favour of investing in undervalued stocks, as the Chinese government was doing.
Unfortunately, the withdrawal of funds was exploited by the Rudd government, which exploited irrational fear as an excuse to put Australia into debt. Mindful that voters always gravitate towards the ruling party in a time of a crisis, the Rudd government exagerated Australia's problems, when it really needed to show its confidence in Australia's strengths. The result was a crisis in confidence that saw even more investors selling Australian stocks and the Australian dollar. This also gave companies an excuse to erode business confidence. By talking down the prospects of the economy, businesses were able to increase their chances of getting a government handout. In effect, they were being rewarded for acting against the interests of the economy.
The Australian dollar then fell sharply against the American dollar and Asian currencies. In a nutshell, investors had less faith in Australia than the countries Australia exported to, and the American economy that had started the crisis. Although it was the American banks that had gone bankrupt and American property prices that collapsed, the Australian dollar fell more than 23% against the American dollar. The savaging of Australia demonstrated just how much economics is governed by psychological considerations, instead of true monetary considerations.
Even though the Australian economy was showing few signs of genuine weakness, the Rudd government put the budget into deficit with by giving away tens of billions of dollars to the banking industry, the car industry, the housing industry, the childcare industry and straight hand outs. Not only did this create billion of dollars of debt that future generations would have to pay off, it also undermined faith in what was a strong economy. Furthermore, it delayed market corrections that needed to be made.
The American crisis started with cheap money, rampant debt and unrestrained spending. For its own self-interested reasons, the Rudd government took over where the American financial system had left off.
White Australia Policy
From Convicts to Chinese
What to celebrate?
Science and survival
The father of the blitzkrieg
He died so others may live
Desert Rats defy Hitler
The White Mouse
Never giving up
Which side would Convicts choose?
A history of "no"
Skeletons in the closet
Australia's engagement with Asia