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The danger of fear - Australia's flawed response to the Global Financial Crisis

Australia is economically tied with Asia but it seems to be psychologically tied to America and Europe. This psychological tie to Europe and America was apparent in 2008 when 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 three largest export markets were in Asia and these export markets experienced continued economic growth during the crisis in America and Europe. Furthermore, the 2008 panic in Australia 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 2008, 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 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.

American origins

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. In America, the Clinton administration instructed 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 low income earners 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.

In many ways, making money via capital gain was like a pyramid scheme. As soon as new entrants stopped entering the market, the model failed. In 2005, property prices started to collapse but like the sinking of the Titanic, it was not immediate obvious that a disaster was on the way. With property prices going down, home owners decided they would be financially better off to simply default on their mortgages.

As of July 2008, over 800,000 Fannie Mae mortgage holders had defaulted on their payments at roughly $250,000 per loan, which were described using the euphermism of "sub-prime" mortgages. Collectively, this amounted to around $200 billion of bad debts.

Unscrupulous people in Fannie Mae then worked out a way to transfer the bad debts onto others. Fannie Mae bundled up the loans as derivatives known as Mortgage Backed Securities. Derivatives are financial instruments that have no intrinsic value but derive their value from something else. Theoretically, a derivative can have nothing of value underpinning it, yet still be profitable for people as long as long as others keep buying them.

Finally, in September 2008, creditors finally became aware that all their derivatives 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, they had a choice of either creating more derivatives based on the worthless derivatives they owned in order to keep the masquerade going, or just try to cash in what they had before the inevitale collapse happened. It was the later that some creditors took and the banks collapsed.

Although the subprime mortgages were 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 in Europe. This caused two major problems on both sides of the Atlantic. Firstly, the collapse of the financial industry left a massive short fall in consumer spending. To be more precise, all the financial workers who had been spending money on architects, sports cars, expense accounts, holidays, wine etc had no money to spend so the industries they spent in struggled as well. Secondly, European economies are based on borrowing money and if banks collapsed, there would struggle to borrow money.

The misplaced fear that Australia was under threat

When American and European banks started collapsing, panic hit Australia. This fear was largely irrational and stoked by the Australian government for electoral gain. As quoted in the Australian newspaper:

"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."

For numerous reasons, Australia was not under threat. 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

House Prices

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.

Source:http://www.treasury.gov.au

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.) Furthermore, 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 had 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 business 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, Australian 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.

The flawed Keynesian response

In response to the collapse of the American and European banks, the Rudd government whipped up fear that Australia was in danger, which it in turned used to justify stimulus spending.

The stimulus spending was based on the outdated economic theories British economist John Maynard Keynes. In short, Keynes proposed that when an economic contraction resulted in a decline of private sector spending, the government should compensate with public sector spending. To put it another way, if the population of kangaroos crashed, to maintain the health of the ecosystem and all the animals that depended on the kangaroos in some way, the government should breed and release lots of wallabies.
Keynesian economics worked reasonable well the 20th century when economies were relatively simple and lacked the same degree of international connectivity that exists today. Unfortuately, in 2008, the Rudd government’s stimulus spending in response to the lack of spending from the financial industry was akin to responding to a crash in kangaroo numbers by breeding up and releasing loads of migratory birds and a load of rabbits. Not only did the birds and rabbits not adequately substitute for kangaroos, but they could fly off to different countries or skew the local ecosystem. In Australia's case, the capital flight came in the form of the government giving case handouts to voters. Much of this went straight into online consumer spending where money basically flowed straight out of Australia. Very little of it went to the industries that had previously been taking the salaries of workers in the financial industry. Furthermore, $30,000 home buyer grant pushed further air into a housing bubble and transferred wealth to those domestic and foreign property owners. An excesive amount of wealth thus became locked up in property and an excessive amount of the economy was geared towards property speculation.

The Keynesian response in Australia was consistent with responses in England, Spain and Greece; however, it was in contrast to Sweden which had promoted austerity.  After the crisis, Sweden emerged with a lower debt to GDP, higher per capita GDP and a stronger economy. On the other hand, the Keynesian European countries were mired in debt, recession and a weaker economy. Not only had Sweden avoided unnecessary debt, by failing to save certain industries, it allowed a market based correction that allocated production in a more optimum way.

The inappropriateness of the spending would have been obvious to the Rudd government as would have been the dangers of talking down the Australian economy in a time of crisis. This begged the question, why would the government do something so stupid?

In a nutshell, the answer was self-interest. Mindful that voters always gravitate towards the ruling party in a time of a crisis, the Rudd government exagerated Australia's problems. The result was a crisis in confidence that saw even more investors selling Australian stocks. This gave Rudd the excuse to raid Australia's savings and spend it in ways that would increase his electoral prospects.

Perhaps the decline in the Australian dollar acts as best evidence of the failure of the Rudd government's response. 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 American crisis started with self-interest, 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.

 

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Rebellion

John Caesare
The first

Our Ned Kelly
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Eureka Massacre
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Post Convicts

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White Australia Policy
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Nancy Wake
A larrikin and a hero

The Depression
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"Let no-one say the past is dead, the past is all about us and within"(Oodgeroo)