The financial crisis: The conclusion of a catalogue of errors

And they all fall downEven for the
economically illiterate, it is increasingly impossible to avoid the
news that the global economy is in the grips of a financial crisis. Whether
it be observing the plunging graphs on the evening news, noticing the
increasing number of ‘for sale’ signs at the front of houses, appreciating the reduced cost of petrol at the bowser (which
has been a knock-on effect of the global slow-down), reading the intellectual
musings about the ideological longevity of capitalism in newspapers or simply
spending your own slice of Kevin Rudd’s $10 billion Christmas bonus, the cumulative
effect has been inescapable: we are in the midst of a full-blown,
‘once-in-a-century’ CRISIS. The seriousness of this situation has been
routinely reinforced by the severity of the language used to describe it: ominous
headlines predict economic devastation and ruin on a scale not seen since the
Great Depression in the 1930s.

The two
defining characteristics of this ‘crisis’ have been the rapid speed at which the
turmoil has manifested itself, and the unique causes that underpin it. The origins of economic downturns used to be at least somewhat comprehensible. But even a keen reader of the financial pages must have
found their eyes glazing over when the conversation turned to collateralised
debt obligations and asset-backed securities, alpha-seeking hedge funds and
sub-prime mortgages.[1]
In a paper written a year ago, Robert Hall, an economist at Stanford
University, described this recession as a relatively ‘causeless’ one.[2]
Robert meant that interest rates never got very high and the Federal Reserve
began to lower them before the contraction began. So if this meltdown is
‘causeless’ in the traditional sense, how do we explain why it came about?

The roots of the current economic ‘melt-down’ can be located in the U.S. sub-prime mortgage crisis. The easy availability of credit to borrowers who had a high risk of not being able to repay
their debt underpinned an unsustainable boom in (housing) asset prices. But this alone would not have been enough to prompt the crisis: the real problem was that the risks involved in these mortages were temporarily hidden as they were on-sold through complicated financial instruments. This phenomenon
has been irreverently covered in an unconventional slide-show on the website

The collapse of the housing market when those loans were unserviced had the
knock-on effect of severely shaking consumer confidence. Michael Stuchberry has
written on this phenomenon from the Australian perspective and experience. In turn, as major financial institutions began to topple, bank lending
froze up because the banks were worried about not getting their money back.
Alan Wood, the economics editor of The Australian reflected that ‘the
financial excesses and overblown optimism of the easy money boom have turned
into equally excessive risk aversion and irrational panic.’[4]

It is important to remember however, that this crisis was
not a natural, inevitable catastrophe. The current depressed state of consumer
and business sentiment can be attributed to specific failures on the part of policymakers,
regulators and bankers. Firstly, governments and central banks failed to
constrain an expansion of credit that drove an unsustainable boom in asset
prices. Secondly, regulators failed to perceive the risks inherent in the
financial system, and bankers exploited the latitude they were granted. Banks
created marketable securities out of mortgage debt without a reliable
assessment of the credit quality of that debt.

Who’s worth reading on this?

economists and commentators have, in the latter half of 2008, clamoured to
define the causes of the current economic crisis. Niall Fegurson, writing in Vanity
, combines a broad grasp of history with economic nuance to offer an
extensive explanation of the current situation
The Nobel Prize-winning economist Paul
Krugman, writing in The Guardian, succinctly describes the scale of the housing
bubble that initiated the crisis. Rather than viewing the crisis as a wholly
unprecedented event, he argues that it is like every
economic calamity experienced before coming ‘all at once’. Michael
Stuchberry’s response to Kevin Rudd’s $10.4 billion stimulus
package offers a
succinct summary of the Australian experience of the global crisis.

In seeking to explain the crisis a number
of other commentators have drawn parallels with the Wall St Crash of 1929 and
the economic hardship that followed
that event.
The majority of analysts, however, have been quick to qualify such comparisons.
The general confusion regarding the unfamiliar circumstances of this crisis
means that the severity, length and extent of it estimated by pundits remains,
largely, educated guesswork.    


[2] How much do we understand about the modern
recession?" By Robert Hall, Brookings Papers on Economic Activity 2, 2007

[3] Allan
Wood, The Australian, 9/10/08

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