Asset bubbles, speculation in the financial and non-financial markets, systemic risks and the role of regulation - Professor Tony Ciro, Deputy Head of ACU’s School of Business, looks at the economic and financial catastrophe since the Great Depression
“The speed and intensity of the collapse in global financial markets in 2008 was unparalleled in recent times. In undertaking research for my book I was particularly interested in the underlying triggers of the crisis as well as the policy responses from policy makers and governments around the world.
There were in fact a number of triggers for the Global Financial Crisis (GFC), which included: the US housing bubble; the collapse of Lehman Brothers; systemic market failure in US financial markets; elevated global sovereign debt risk; opaque financial markets; and ineffective market regulation.
Although all of these events contributed to, or made worse, the impact of the GFC on global financial markets and the real economy, none was more serious then the collapse of Lehman Brothers. The consequences flowing from the collapse of Lehman were nothing short of catastrophic. Almost overnight credit markets froze, wholesale corporate lending stopped, global equity markets plunged and many other financial markets became dislocated. The US Federal Reserve Chairman, Ben Bernanke was of the view that the situation was so grave that he uttered the chilling phrase “There will be no economy on Monday.”
The policy responses of major global institutions such as IMF, the World Bank, the US Federal Reserve, the EU Central Bank and the G20 were particularly relevant. So too, the critical timeline of events leading up to the collapse of Babcock & Brown in Australia, Lehman Brothers in the US, and Northern Rock in the UK. Key policy decisions should be the subject of critical analysis and review especially in the light of the serious nature of the GFC as well as the ongoing European debt crisis – which continues to present significant challenges headwinds for the overall global recovery.
Particularly relevant as a policy response to the GFC, central banks led by the US Federal Reserve responded with aggressive easing of monetary policy. This not only led to central banks adopting conventional monetary policy measures in the form of reducing the official cash rate, but also unconventional policy responses which included quantitative easing and bond buying programs, designed to increase liquidity and unfreeze global credit markets. Easy monetary policy was coupled with traditional fiscal pump priming as governments around the world adopted tax stimulus measures along with significant public expenditure programs designed to spur on consumer demand.
Debate continues to this day as to whether or not the policy responses by the various monetary authorities along with the government stimulus measures were an effective policy response to the GFC. Some commentators have argued that the fiscal stimulus measures in the form of expenditure programs were less effective relative to the monetary policy measures that had been adopted.
Other commentators and policy analysts have argued that monetary policy may have become less effective today because commercial banks have failed to pass on to bank customers all of the reductions in the official cash rate. On balance, it would appear that the expansionary policy measures that had been adopted during the crisis and in particular, the easing of interest rates and increasing monetary liquidity did have a positive impact on the real economy.
Arguably, without such measures the downturn in industrial production and economic growth, and consequential rise in unemployment following the GFC would have been much worse. In fact one of the clear and discernable differences between the Great Depression and the recent crisis has been the proactive policy responses adopted by monetary authorities around the world.
During the Great Depression, policy makers and governments failed to appreciate or understand fully the inner workings of the economy. Instead of increasing the money supply and preventing bank failures, governments had become paralysed following the Great Crash of 1929. It was not until President Franklin Delano Roosevelt’s New Deal after his election as President in 1933 that any arm of government played a significant role in boosting demand and economic growth within a flagging US economy.
The expansionary measures that were undertaken initially following the onset of the GFC were later largely offset by restrictive policy measures adopted by European authorities. What appeared to be a unified global policy response initially during 2008 and 2009, quickly moved to a bifurcated policy response where governments would provide monetary and quantitative easing but at the same time adopt fiscal deficit reduction strategies designed to reduce government deficits and sovereign debt.
Hence, we now have a situation where some countries have low interest rate policy settings and active bond buying programs sitting alongside restrictive fiscal policy measures in the form of tax increases and reductions in government expenditure.
Other countries including Australia have not enjoyed any meaningful monetary easing. Instead, policy makers here are concerned with managing the mining boom and avoiding a breakout in inflation. This is despite constant dire warnings from retailers and small and large businesses operating in the non-mining states. The high Australia dollar coupled with relatively high interest rates has contributed to painful structural readjustments which have included the laying off of workers, closure of businesses, and the relocation of small and large scale manufacturing offshore.
Especially relevant for today’s continuing European debt crisis, analysing and researching the issues surrounding the GFC provides useful insights into the challenges which continue to confront policy makers, central banks and governments today. Recently, Ben Bernanke described continuing developments in Europe as particularly challenging for policy makers:
“Most recently, European policymakers agreed on a new package of measures for Greece, which combines additional official-sector loans with a sizable reduction of Greek debt held by the private sector. However, critical fiscal and financial challenges remain for the euro zone, the resolution of which will require concerted action on the part of European authorities.”
The ongoing nature of the European debt crisis has demonstrated that significant challenges and headwinds remain for the global financial system and the world economy. The risk of further contagion or fallout from a European default is a very real possibility and one that has the potential of leading to systemic risk in the world’s financial markets.
The European debt crisis has shown that the GFC continues to present challenges for policy makers around the world including Australia. Hopefully, regulatory and monetary institutions, including the European Central Bank, the European Commission and the International Monetary Fund as well as other central banks, monetary authorities and governments can learn the lessons from the past and avoid a repetition of the catastrophic consequences that contributed to the GFC.
Recent problems which almost led to Greece defaulting on its sovereign debt and the bail-out package which had been premised on bond holders accepting losses of over 70 per cent of their initial investment has caused much angst and uncertainty in international financial markets.
Bond yields continue to be elevated in major European economies, namely Italy, Spain and Portugal. Many European countries have had sovereign ratings downgraded by rating agencies which has led to a further increase in borrowing costs. Even in the United States, which is enjoying its “green shoots recovery” and has the significant benefit of being the holder of the global reserve currency, US sovereign debt has been downgraded by at least one rating agency, with the prospect of further downgrades by other agencies if its fiscal deficit is not significantly reduced.
Policy makers can learn to avoid the mistakes from the past by undertaking further in-depth research concerning the regulation of financial markets and the interlinked nature of financial markets with the global real economy. The globalised and interlinked nature of the world’s financial markets with the real economy provide unique challenges particularly at the policy level when governments and market regulators respond to the onset of financial and economic crises. This is because governments cannot easily intervene with additional regulation without first taking into account its intended or unintended effect on the domestic and international real economy.
Professor Tony Ciro is Deputy Head of ACU’s School of Business in Melbourne, and has completed extensive research into tax, global economic events, the regulation of global financial markets, business law, corporations law and general commercial law.
Author and co-author of 12 books (including The Global Financial Crisis: Triggers, Responses and Aftermath, published by Ashgate in the UK) and more than 40 journals, Professor Ciro has published in several fields of law and business, and in leading international and Australian journals.