The thing you need to remember if you want to understand the dramatic gyrations in the world’s markets over the past week is that the global financial crisis never went away.
In 2008, the GFC swept across the northern hemisphere — and then the entire world — after the failure of the merchant bank Lehman Brothers. As we know, its proximate cause was the collapse of the US sub-prime mortgage bubble — the result of lax lending practices, US financial deregulation and plenty of outright fraud.
But the deeper causes of the GFC were far more complex. The current economic malaise that grips much of the rich world is the result of decades-long trends that have created huge imbalances in the world economy, and which cannot be unwound easily or painlessly.
The US domestic economy, for instance, has been hollowing out for decades. There has been significant growth in the US economy in the past 30 years, of course, but soaring income inequality in America has seen the super-rich capture most of it. In contrast, real wages for Americans with high-school diplomas have actually fallen. In the 1950s and 1960s, US industry created millions of jobs in offices and factories that paid living wages and allowed a middle-class lifestyle. But that process has reversed since the mid-1970s, with US manufacturing stagnating and working conditions becoming more and more precarious. The city of Detroit is the starkest example: a once-wealthy metropolis, Detroit has shed hundreds of thousands of jobs in recent decades as its auto manufacturers have failed.
For a time in the mid-2000s, it looked as though the indomitable US consumer would continue to spend, no matter the underlying economic conditions. But we now know that this spending was largely driven by massive credit growth in the form of easy mortgage loans and credit cards. US household debt more than doubled between 1999 and early 2008, much of it squandered in expensive gambles on rising house prices. According to Chicago University economist Amir Sufi, US household balance sheets are now "in worse condition than at any other point in history since the Great Depression".
But despite the debt-fuelled spending binge, underlying economic conditions in the US were surprisingly weak. Even before the massive job losses of 2008 and 2009, the United States economy had been creating jobs very slowly, in a comparatively weak recovery from the recession of the early 2000s. As a result, the current downturn has erased all the job creation gains of the 2000s: by January 2011, the Washington Post was reporting that "there has been zero net job creation since December 1999".
By the time Lehman Brothers collapsed in September 2008, debt-laden parts of the US economy were already in deep recession. The terrifying credit crunch that followed triggered the onset of a deep economic contraction across the US. Recent revisions to the US statistical data show that in the last quarter of 2008, the US economy was shrinking almost as severely as during the Great Depression.
From there, the contagion spread to Europe and the north Atlantic, claiming over-leveraged financial institutions wherever local conditions or lax regulation had allowed similar unsustainable bubbles to inflate. By mid-2009, entire nations such as Iceland and Ireland were insolvent.
What enabled all that cheap consumer credit during the 2000s? The answer, in global terms, was Asian savings — the so-called "giant pool of money". Loose US monetary policy throughout the 2000s, aided by the ideological foibles of Federal Reserve chairman Alan Greenspan, kept US treasury bonds at very low rates. As a result, investors increasingly sought out higher-returning investments, without necessarily understanding the risks. The deep savings pools of Chinese and other Asian countries meant US banks could raise all the money they wanted on wholesale international credit markets, and the corrupt US ratings agencies came to the party, rating ridiculously risky financial instruments such as collateralised debt obligations at safe-as-houses "AAA" levels. Of course, the houses weren’t safe, and the CDOs weren’t either.
Hence, by 2007, a global economic system had developed in which cheap Asian savings were financing over-leveraged US consumers to buy over-valued US houses and cheap Asian goods, fuelling trillions of dollars of speculative investment in the process. When the real estate bubbles finally burst in the US, UK, Spain, Ireland and the rest, that system unravelled.
We seem to have already forgotten how seriously the GFC affected China, especially Chinese export industries. Thousands of factories closed and millions of Chinese workers were thrown out of work. The Chinese government responded with one of the biggest stimulus packages of any economy, ploughing trillions of yuan into local economy in a bid to keep factories open.
Much of that money came in the form of cheap loans from state-owned banks to provincial governments, and much of it was spent on huge infrastructure programs of dubious value. The stimulus meant China was able to ride out the crisis and emerge strongly from the downturn in recent years. But the legacy includes significant inflation pressures, a nascent Chinese property bubble and huge debt issues for those state banks and provincial governments.
Indeed, across the world, the legacy of the financial crisis can be summed up in one word: debt. The response of rich world governments to the crisis was to drop interest rates to zero, borrow money to stimulate the economy, and to take on the damaged liabilities of failed banks. In Australia, where the stimulus was relatively large and surprisingly effective, the medicine worked. But in many northern hemisphere countries, the recession was much deeper and the eventual stimulus was not large enough.
As many economists warned in 2008, the recovery from the Great Recession has been weak. For many of the unemployed, it has been non-existent. Huge debts mean consumers and households are still struggling to de-leverage and to build their savings back up. Many lost their jobs and their houses. Hence, consumer spending is understandably weak. The years since 2008 have therefore seen anaemic growth in the northern hemisphere. Many rich countries have been left with huge budget deficits and weak economic growth.
What’s worse, political reaction to the crisis has moved policy in the wrong direction at the wrong time. Worried by fears of sovereign debt, many politicians in the US and Europe have decided that their government budgets must be moved rapidly back to surplus in order to start paying down all that increased debt. As a result, countries like the UK have embarked on deep cutbacks in government services at the very time their sickly domestic economies can least afford another hit to growth. The US budget is headed in the same direction in the wake of the deal brokered bteween the White House and the Republicans to end the stand-off over the debt ceiling.
In fact, neither the US nor the European countries are well-placed to weather a round of austerity. The UK economy is almost at a stand-still, while the US economy looks like it has a chance of going backwards. What is required is more deficit spending to create jobs now, followed by a return to surplus in several years. Instead, the US debt ceiling deal appears to have committed America to the worst of all worlds, with no extra spending to ward off a double-dip recession right now, but no credible long-term strategy to deal with America’s public finances either.
And then there’s Europe. As we observed in June, the sovereign debt problems of Europe’s periphery nations like Greece, Portugal, Ireland Italy and Spain (the so-called "PIIGS" nations) are all related to the broader problem of the European monetary union. With all countries sharing the Euro, they can’t devalue their currency to improve their export competitiveness. Nor can they inflate their way out of debt problems by running an inflationary monetary policy — that too is set centrally, essentially by the Germans.
As leading economist and former Reserve Bank board member Warwick McKibbon pointed out on Lateline on Monday night, Greece, Ireland and probably Portugal are insolvent. "They need not only to have their debts written off, but they also need to have about a 30 per cent depreciation of their exchange rate," he remarked. But they can’t do this while staying inside the Eurozone, so the only way out for the so-called PIIGS countries therefore has been to cut wages and to cut government spending. This has improved balance sheets, but it has also harmed economic growth — according to McKibbon, "the policy approach is to deflate by 30 per cent".
Italy and Spain are in a different position. Their balance sheets are nowhere near as parlous as Greece or Portugal, even if their government debt is relatively high. In fact, Italy is actually in surplus currently and continues to pay down debt, even if its economic growth remains weak. But they have become victims of the notorious bond market vigilantes who now see potential weaknesses in the Italian fiscal position. Both too big to fail and too big to bail, serious trouble on the bond markets for Italy and Spain may well pose an insoluble problem for the European Union. Given the size of their economies, the likelihood is that both countries will eventually muddle through. The same cannot be said for the broader EU project, which may end up being forced into a radical experiment such as splitting the Euro currency into two zones, or perhaps issuing whole-of-Europe government bonds through the ECB (so-called "Eurobonds").
The US will most likely muddle through too, even if "muddling through" means significant unemployment for a long time and large parts of the US devastated by economic blight. The US, after all, still has huge reserves of human capital, the best universities in the world, vast productive potential and the unbounded optimism of millions of ordinary citizens. When the US finally does get back to work, its economy will be very different, but no less dynamic, for the wrenching changes of the last decade. Even so, a lost decade looms.
The outlook for China may be more mixed. Facing a serious property bubble of its own, China also has significant problems in its political apparatus, not least the rampant corruption that seems to envelop its provincial governments and lower levels of the bureaucracy. This will pose challenges for Australia if and when the Chinese miracle finally slows down.
In the very long run, the only thing that will halt the after-effects of the GFC is a solution to the debt. The trillions of dollars of debt wracked up in the 2000s binge needs to be either paid down or forgiven, or it will act like a millstone round the necks of governments and households for years. Because political and business elites throughout the world have refused to countenance writing off debts — even in countries like Ireland, where the Irish government had no sensible reason to guarantee all the debt of the breathtakingly irresponsible domestic banks — the current work-out is to slowly pay down debts at the cost of higher unemployment and slower growth.
But economic policies have political consequences, as we’re seeing in the London riots right now. As Stratfor’s George Friedman argued recently, the policy of bailing out banks and financial elites at the cost of economic pain for the poor has contributed to a rising sense among ordinary citizens of the illegitimacy of the global political system. Eventually, the madness of austerity will become political unsustainable, and one or more countries will begin the fraught process of defaulting on debt.
At that point, the stock market volatility of the last few days will seem like child’s play.
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