The Post-2007 Financial Crisis and Policy Challenges facing Australia

Authors


Richard Pomfret, School of Economics, University of Adelaide, SA 5005, Australia. Email: richard.pomfret@adelaide.edu.au

Abstract

The post-2007 financial crisis had similar roots to many previous crises since the 1970s: moral hazard and easy credit. It had a global impact because it was centred in the USA and UK, and hence triggered a fall in global demand and international trade. The paper argues that financial deregulation and innovation contributed to economic growth in the 1990s and 2000s in the USA and UK, as well as Australia and elsewhere, and with a dynamic risk-taking financial sector crises are the flip side of high growth as some risk-taking institutions end up making bad loans. The policy challenge is to reap the advantages of a dynamic financial sector while ensuring sufficient prudence to offset the inherent moral hazard when depositors are insured by the state. Australia did not experience a serious financial crisis in 2007–9, but active macropolicy was necessary to address the economic crisis. Nevertheless, future bank failures are to be expected and policy-makers need to design appropriate financial sector regulations in preparation.

1. Introduction

The crisis that began with the US subprime mortgage crisis in 2007 was one of a sequence of crises across the globe since the 1970s. The crisis became global in 2008, but this was not a crisis whose roots were only in the United States of America and it was not just about poorly judged mortgage lending; it was also driven by poor loans for construction and housing in countries other than the United States of America and by poor risk management unrelated to real estate loans. The crisis in the United States of America was the most important because of the size of the US economy and the post-2007 crisis is unique among post-1945 crises because of the severity of the associated US recession, but the increasingly frequent financial crises in an integrated global economy have common roots.

Increased financial crises are a consequence of financial development. Nobody welcomes crises, but they must be placed in a longer-term context of financial reform generally delivering greater prosperity. Financially more developed economies grow faster, but are exposed to sources of instability unknown in less developed economies. The business cycles of the last two centuries are consequences of financial intermediation that opened up the possibility of a mismatch between desired saving and desired investment, and modern macroeconomics was the response. As macropolicy succeeded in dampening business cycles and fears of unemployment approaching 1930 levels receded, governments became more willing to loosen financial regulations or permit innovations which undermined the scope of regulations.2

Australia faces challenges because it experienced an asset bubble that has burst and because it is an open economy affected by the downturn in world trade. Nevertheless, Australia has been fortunate in avoiding a major domestic financial crisis. It may also be reasonably well placed to weather the global storm. The collapse of the Aussie dollar from 98 US cents in July 2008 to 60 cents in October added pressure to living standards but provided a springboard for export-led recovery.

The next section examines the positive relationship between financial development and long-run economic growth, emphasising that more regulated financial sectors are prone to adverse selection in lending decisions and that less regulated financial intermediaries are more likely to make lending decisions and to promote financial innovations conducive to increased economic wellbeing. Section 3 analyses the dilemma arising from the political imperative of protecting individual depositors and the moral hazard implications of such policies, and the consequent need for financial sector regulation. In a period of rapid innovation, financial regulators inevitably find difficulty in striking an appropriate regulatory balance, and in the final decades of the twentieth century this played out against a background of easy credit, which exacerbated the moral hazard problem by making leveraging and risk-taking less costly (Section 4). Section 5 addresses the more familiar territory of aggregate demand management. The final section draws conclusions about the challenges facing Australia.

2. Innovation and Deregulation in the Financial Sector and Economic Growth

Financial innovation has been a component of economic development, and there is overwhelming evidence that financial repression, or a heavily regulated financial sector, is deleterious. In a market-based economy in which prices largely capture social costs and benefits, impediments to financial intermediaries directing funds to those borrowers willing to pay the most are likely to have economic costs, and because these costs are largely in the form of a suboptimal capital stock they will result in reduced long-term growth. The evidence from dozens of new independent countries in the 1950s and 1960s which tried to promote economic development by directing resources into import-substituting industrial projects is that, after initial success in mobilising resources, the efficiency of the capital stock declined and so did long-term economic growth.3

It is more difficult to prove that financial deregulation is good for economic performance, because historically financial reform has often been part of a broader package and overall performance is determined by the package rather than simply by the extent of financial reform. Since 1983 Australia has been at the forefront of deregulation among Organisation for Economic Cooperation and Development (OECD) countries, with a largely bipartisan policy that included some deregulation of the financial sector. The most striking consequence was continuous economic growth in the decade and a half before 2008. Asset holdings per capita more than doubled. On a material level (wealth, incomes and the range of goods and services on which to spend this wealth), the majority of Australians benefited from the reforms.

Long-term performance must be separated out from potential negative short-term consequences of financial reform. Mexico and Thailand continue to be associated with the 1994 Tequila Crisis that spread to other Latin American countries and for igniting the 1997 Asian Crisis. Yet, the cumulative growth since Mexico’s reforms in 1986 and Thailand’s in 1982 has been substantial despite the severe short-term crises. Ranciere et al. (2008) provide more systematic evidence of a positive relationship between crisis-prone economies and growth.

In the fifteen years before the 2007 financial crisis, the OECD countries with the most deregulated financial sectors and biggest asset bubbles had substantially faster income growth than those with more regulated financial sectors (Table 1). Among the largest economies, nominal gross domestic product (GDP) in the United States of America and United Kingdom increased by 120 and 150 per cent, respectively, while the corresponding figures for Germany and France were 60 and 87 per cent. Spain’s nominal GDP increased by 133 per cent, while Italy’s increased by only 67 per cent. Among smaller European Union (EU) members, the 370 per cent increase in Ireland, with its deregulated financial sector, far outpaced any of the others (e.g. 180 per cent in Greece). Such pairwise comparisons suggest that, even though the countries in the left panel of Table 1 were to suffer more severe crises after 2007, they had a cushion of added prosperity from the financial deregulation era.

Table 1. Gross Domestic Product in Current US Dollars (Billions), 1992–2007
 19922007Per cent change 19922007Per cent change
  1. OECD, Organisation for Economic Cooperation and Development.

  2. Source: World Bank World Development Indicators – accessed on 27 January 2009 at: http://ddp-ext.worldbank.org/ext/DDPQQ/member.do?method=getMembers

USA6286.813,811.2119.7Germany2062.13297.259.9
UK1074.02727.8154.0France1372.82562.386.6
Spain612.61429.2133.3Italy1265.82107.566.5
Ireland54.3255.0369.6Greece128.4360.0180.4
Australia320.6821.7156.3    
High-income OECD19,764.138,219.093.4World24,533.654,347.0121.5

The global economy grew rapidly during this period, to a large extent because of positive spillover effects from the growth and diversification of the real economy in high-income countries with dynamic financial sectors. Around the world billions of people enjoy consumer goods which would have been less abundant and varied in a less integrated global economy. The countries best able to take advantage of these opportunities were those most integrated into the global economy and an innovating and increasingly less regulated financial sector contributed to increased prosperity in many countries. Those countries that were passed by, such as many of the formerly centrally planned economies and the sub-Saharan African countries, were outside the global financial system in the 1990s and still had repressed domestic financial sectors, so that their economic performance was less affected by developments elsewhere.

The flipside of rapid growth after financial deregulation is increased vulnerability to financial crises. The anatomy of the post-2007 crisis differs little from that of dozens of crises in the preceding quarter century: easy credit, bad loans, weak regulation and supervision, insolvency of financial institutions, loss of confidence, asset sell-offs and cash hoarding. The financial problems affected the real sector as traders and businesses found credit hard to come by and as participants attempted to rebalance their portfolios in the face of large wealth loss. The deeper issues concern the source and the consequences of increased financial instability.

3. Financial Sector Regulation, Easy Credit and Frequent Crises

Australia faces the same financial sector regulation challenges as any other economy. In the current financial setting the challenges are more acute because there are more opaque toxic assets floating around in financial markets, but the basic challenge remains unchanged: how to ensure that small depositors are protected, while not creating an undesirable degree of moral hazard.

Guarantees to depositors are essential to maintain trust in the retail financial sector, but they can be expensive. In the United States of America, bankruptcy of Savings and Loan institutions, which specialised in lending to homebuyers, led to the insolvency of the Federal Savings and Loan Insurance Corporation at the end of 1986; by 1995 over a thousand S&L institutions had failed, at a cost to taxpayers of $153 billion for reimbursing depositors (Curry and Shibut, 2000). The S&L crisis was blamed on the institutions’ weaknesses and the cupidity of some owners, and after the bail-out the problem was declared solved. However, the bail-out reinforced beliefs that deposits in the financial sector were safe, although scapegoating and punishment of a few high-profile owners allayed fears of there being a systemic problem.

By the late 1980s explicit deposit insurance existed in all OECD countries except Australia, and here it was implicit. When the State Bank of South Australia collapsed in 1991, the state government rolled the bank over into a new BankSA, protecting depositors’ funds at an eventual cost of $A3.1 billion (McCarthy, 2002). A few scapegoats were blamed (the CEO and the state premier), and the taxpayer paid the tab.

Deposit insurance creates a moral hazard problem which regulatory authorities have to address. If depositors do not fear losses, they will not be concerned about financial institutions’ exposure to risk. The institutions have an incentive to accumulate high return (even if high risk) assets or, at a minimum, not to pay due diligence to their accumulation of risk. Regulators have been addressing the problem by specifying capital adequacy ratios aimed at ensuring that, in the case of poor lending, the owners of financial institutions lose some of their own money as well as that of their depositors. However, rapid innovation with many new financial instruments made it increasingly difficult for regulators to know exactly what a bank’s capital ratios were at any moment.

The final ingredient in the crisis-prone recipe was monetary policy. As deficit spending became discredited and macropolicy emphasis shifted from fiscal to monetary policy, central banks set monetary policy to maintain a balance between low inflation and full employment without paying adequate regard to the nature of investment that was underpinning aggregate demand. Since the early 1970s, global real interest rates have, apart from their early 1980s’ spike, been kept below their savings/(prudent) investment market equilibrium.4 Easy access to credit permitted potential risk-takers to become highly leveraged and led to aggressive development of financial vehicles such as options and swaps (bond swaps, interest swaps, credit-default swaps), which provided for almost unlimited menus of degrees of risk. The opportunities to take advantage of such financial instruments were magnified by the low cost of money.

A credit-driven boom accompanied by financial innovation was good for economic growth, but had two major drawbacks. First, in a period of rapid financial sector growth and innovation, lenders and regulators had less and less knowledge of institutions’ asset position and solvency. The second problem was moral hazard, as lending institutions took overly risky positions. An expanded and more complex financial sector is more likely to contain institutions which will go bankrupt, but the degree of risk-taking is endogenous to a deposit-insured system unless the government can devise policies to offset the moral hazard impact of deposit insurance. Inevitably, this balance is hard to attain, and governments that are happy to take credit for prosperity are less willing to burst bubbles.

4. The Decades of Frequent Crises

The first act in this era was the massive lending to low- and middle-income countries by banks awash with petro-dollars after 1973. This intermediation was potentially efficient, and countries like South Korea and Taiwan borrowed at low or negative real interest rates to good advantage. However, many inexperienced borrowers and lenders contracted loans that were poorly used. The catalyst for the 1982 Debt Crisis came when interest rates were increased in the United States of America and United Kingdom in the early 1980s to address internal balance, but the fundamental problem was that loans had not been used to generate revenue to service the debt, eventually causing problems for over-indebted countries and over-exposed banks.

The 1986–1989 US Savings and Loan crisis signalled that, with inflation under control, credit was again readily available and financial institutions were not adequately assessing risk. The recurrent financial crises during the 1990s had specific national roots, but also reflected the globalisation of financial markets and in several cases similar issues to those that would strike in 2007–2008.5 In both Mexico before 1994 and in Thailand before 1997 economic growth was soundly based after economic reforms in the 1980s, and large amounts of capital flowed into the countries. In both Mexico and Thailand, governments basked in the prosperity, for which they could take some credit, but when signs of trouble emerged (adverse political developments in Mexico and slower export growth in Thailand) governments were unwilling to accept that some of the boom had been cyclical, some investments were overoptimistic and the scale of capital inflows was not sustainable. In both countries the strengthening of democracy added to this psychological barrier, as governments preferred not to be blamed for reducing the pace of prosperity in case they would be punished by the voters.

The 1997–1998 Asian Crisis illustrated the resilience of soundly based economies. Although there were contagion effects (stemming from increased competitiveness of exports from countries forced to devalue in the crisis, or from reassessment of risk across the region), Asian economies were not equally harmed. Economies with sound financial systems such as Hong Kong, Singapore and Taiwan (and Australia) were relatively little affected. The countries most affected were those whose financial institutions had the most non-performing loans (Thailand, Indonesia, Malaysia and South Korea), although even these economies resumed economic growth within a few years.

In the high-income countries, the debt-financed equity boom burst in 2000 with the dot.com crunch, but consumers continued to run up debt and governments were happy that people were happy. After the turn of the century the asset bubble shifted to housing markets, especially in the United Kingdom, United States of America, Australia, Spain and Ireland.6 The phenomenon of negative aggregate saving in the United States of America, Australia and elsewhere caused only minor concerns, despite aging populations and inadequate public pension funds. Governments, as in Mexico or Thailand, were eager to accept the praise for good times and did not want to spoil the party. Governments fuelled leveraging by maintaining low interest rates and subsidised the bubbles by tax codes which gave tax breaks for mortgage payments and favoured corporate borrowing over financing through shares.

The sub-prime crisis is conventionally dated from February 2007 when HSBC and New Century Financial declared greater than expected loan loss provisions. New Century went bankrupt a few months later. Subsequently many other financial institutions revealed their exposure to delinquent mortgage payments. In July, with loss of confidence in securitized mortgages, the Federal Reserve injected liquidity into the system.7 In August 2007 Countrywide Financial, the largest mortgage lender in the United States of America, encountered liquidity problems, and was eventually bought by Bank of America. However, the magnitude of the US sub-prime crisis was alone not enough to drive a global crisis.

The international nature of the problem was illustrated by a run on Northern Rock in the United Kingdom in September 2007, and the nationalisation of the bank in February 2008. Northern Rock’s problems were primarily domestic; in September 2008, the bank had 4201 repossessions on its books, a tenth of the UK total, and borrowers owed on average 105 per cent of the supposed value of the house. When Bradford and Bingley, another major UK mortgage company, went bankrupt and was nationalised in September 2008, its problems stemmed from misjudging the buy-to-rent market in the United Kingdom. Among middle-income countries, Kazakhstan’s banking crisis, which originated in the mid-2000s when Kazakh banks borrowed overseas at lower interest rates than they could charge borrowers in the booming property markets of Almaty and Astana, was another example of the international sub-prime crisis not being driven by US mortgages alone.

National financial crises were not all driven by loans for construction or for mortgages. France’s weakest financial institutions were mutuals, whose ownership structure created a bias towards excessive risk-taking. The large numbers of owners of the mutuals could only claim back the initial value of their shares, so that the boards, which were elected from among the members and hence were likely to lack financial expertise, had control over large amounts of residual cash. This system encouraged weak supervision of complex activities. After 2004, mutual after mutual was tempted to use its funds in high-return, but high-risk, markets and nobody reined in the traders until the mutual took a big loss.8 The details were often covered up, but a “rogue trader” was usually blamed for the loss.

Some company failures reflected changes in the structure of financial markets. When perceptions of credit risk made a quantum shift in the United States of America in the summer of 2008, the investment banks which relied on wholesale funding were more exposed than retail banks with their stable federally insured deposits. Within a few months the five major investment banks had either changed their status to wholesale banks (Goldman Sachs and Morgan Stanley), been taken over by banks (Bear Sterns by JPMorganChase and Merrill Lynch by Bank of America) or gone bankrupt (Lehman Brothers).9 As with the collapse of any large businesses these events led to job losses, especially in financial centres such as New York City and London, but the simultaneous disappearance of these specialised institutions suggests that the business model had become obsolete and it was time for pure investment banks to disappear.

Observers blamed the crises on a principal-agent problem which arose because employees of financial institutions had an incentive to focus on short-term results which drove their annual bonuses rather than on increasing long-term value. Owners were, however, happy to accept risky behaviour as long as short-term returns were high. Senior managers gave free rein to risk-takers who made profits, but entered into denial when the “rogue traders” made losses. Spectacular losses by traders such as Nick Leeson, who lost over a billion dollars for Barings in 1995, Yasuo Hamanaka, who lost $2.6 billion for Sumitomo in copper futures markets in 1996, and Jérôme Kerviel, who generated 1.4 billion euros profit for Société Générale in 2007 and then lost 4.9 billion in three days in January 2008 were routinely ascribed to “rogue traders,” but they were not isolated occurrences.10“Rogue traders” were sometimes illegally individualist, but more often they were the (deniable) instrument for financial institutions to garner high profits from risky operations – the faces of moral hazard.

In sum, many of the financial crises since the 1970s have common features, primarily high leveraging and excessive risk-taking. The crisis that began to unfold in 2007 was the most serious because it affected large institutions in the world’s largest economy, as well as having independent roots in other economies. Failures of large multinational financial institutions are more important for the global economy than the failure of British mortgage companies or Kazakh banks, but there were common underlying causes and the failure of financial institutions was selective. In all cases, the unfolding of the crises was associated with governments promising large amounts of taxpayers’ money to fix the problems.

Finally, in the midst of collapsing financial institutions it is important to bear in mind that most banks across the world are not insolvent. Well-managed (or lucky) banks have avoided the fate of the US investment banks or Northern Rock. Indeed, some banks have prospered by buying assets from troubled banks at fire-sale prices. Because of the complexity of some traded assets, predicting which the good and bad banks are is not easy, but so far the Australian financial sector has avoided major casualties.11

5. Aggregate Demand Management

Even if Australia continues to avoid a domestic financial crisis, as an open economy the country faces contagion owing to reduced demand for exports. Even here Australia seems to be relatively lucky, as alone among G20 countries its trade did not shrink during 2008. However, it would be foolhardy to expect that an economy as open as Australia’s can avoid negative effects from a shrink in global trade.

In an interdependent world, financial crises in the United States of America and United Kingdom reduce global demand, hurting Australian exports directly and indirectly, as major customers’ economies shrink. World prices of important Australian exports such as coal or iron ore have plummeted. Some ramifications are difficult to predict, for example, as Chinese families become more price conscious they may send their children to Australian universities rather than to more expensive US colleges. Some industries will suffer more than others, and policy-makers will be under pressure to help the most severely hit, but such pressures for microeconomic management should be resisted. Price signals will direct resources from less to more competitive activities. The government should focus on easing the pain of relocating and on macropolicy.

The argument for demand management is well known and policy-makers are experienced in implementing countercyclical fiscal policies. The challenge is to combine short- and long-run perspectives, ensuring that the short-run stimulus from expansionary policies is directed at improving infrastructure and other contributions to future growth rather than at simply stimulating current consumption.

6. Challenges

Financial crises have become more frequent since the 1970s. Easy credit reinforced the propensity for moral hazard which is inherent in financial systems with deposit insurance, and financial sector deregulation and innovation facilitated risk-taking. Policy-makers used the interest rate as an instrument to maintain internal balance between inflation and unemployment, ignoring its role as the price of capital and standing by as asset bubbles emerged. In many countries the financial sector in the 1990s and 2000s was characterised by excessive risk-taking, and by blaming scapegoats when the risk-taking backfired, rather than seeing it as systemic. Governments were unwilling to burst bubbles and say that belts had to be tightened, because voters do not want to hear this – until a crisis erupts, and then they want a quick fix.

In 2008 the overwhelming view in the United States of America and western Europe was that governments needed to do something, but there was confusion over whether the “something” was necessary: (i) to prop up financial institutions (or major non-financial corporations) whose failure would have economy-wide negative effects; (ii) as a Keynesian stimulus to aggregate demand; or (iii) to regulate financial sectors to prevent further crises. The first two in particular were blurred; many economists advocated fiscal stimuli through, say, spending on infrastructure or education (especially if they were teachers), whereas policy-makers more often responded to demands to bail-out individual firms (especially if they were in politically sensitive locations).

In 2007–2008 Australia avoided a major financial crisis. This does not rule out a future crisis, and indeed it is likely that one will occur. However, Australian policy-makers do have a breathing space, with the luxury of separating financial regulation and financial sector management concerns from macroeconomic policy pressures.

Policy-makers need to think about how to reduce the risk of a domestic financial crisis occurring, although it is unclear what form a good regulatory regime would take. Deposit insurance is essential to maintain the trust of small depositors in deposit-taking institutions, but deposit insurance introduces moral hazard, and the counterpart has to be regulation to ensure that financial institutions do not take excessive risks with depositors’ money, secure in the knowledge that if things go sour they can walk away. In a world of complex financial instruments and fast-changing asset portfolios, detailed external oversight of the loan portfolio even by the best-trained regulators is increasingly difficult. Capital adequacy ratios are a way of ensuring that banks’ owners have something to lose, but this requires detailed oversight to ensure that the capital is not withdrawn on the basis of insider information about an imminent collapse. Caps on golden parachutes or other claims by managers who use depositors’ money poorly are also appropriate; if a bank goes under, the senior management should be liable and bear a cost (or, at least, not receive a reward). As it stands, depositor insurance and the ability of institutions on the verge of collapse to ensure that any liquid assets are used to recompense owners and employees mean that creditors and the taxpayer bear most of the cost of a financial institution’s failure. Such exposure of creditors increases the systemic risk of frozen markets in which liquidity dries up.

The government needs to be prepared for a major bank experiencing solvency problems, and to consider options for minimising the fall-out. There will be a cost, at a minimum in protecting depositors. Taxpayers should, however, be concerned about being the fall guys in cases of financial failure, and be sceptical about bailing out insolvent firms and not accept the “too big to fail” argument. Selective bail-outs of firms in trouble reward those who took unjustified risks or keep in business firms that need to die, and are likely to send confused signals about the degree to which creditors can expect protection of their interests.12 Australia can learn from the serial bail-outs of big US firms in trouble such as Citi or AIG, which were costly and have not resolved the firms’ problems. The popular backlash in the United States of America and United Kingdom against saving the skins of well-healed financiers who have taken their company to bankruptcy should encourage the Australian government to stand up to pressure for bail-outs and to allow mismanaged banks to fail, even if it involves one of the Big 4. There must, of course, be a contingency plan to wind up the failed bank by orderly sale of good assets, prioritising creditors over insiders, and protecting small depositors.

Voters must recognise that governments have fuelled an unsustainable credit-driven boom, and that the excesses of that boom are past. This does not mean a long-term fall in average living standards, but rather an end to artificially high growth based on unsustainable credit (e.g. credit card debt, second mortgages and so forth). Banks need to be made to bear the cost if they take on poor credit risks, so that they will be tougher in assessing loan applications. Tax breaks that encourage borrowing should be narrowly targeted, for example, to lower-income first-home buyers and not to buyers of second homes or investment properties, or abolished. Governments should support interest rates based on conditions in the credit market, and not push for artificially low interest rates with the aim of avoiding bankruptcies or reducing short-term unemployment. So much the better that increased interest rates will offer better terms to savers: falling saving rates in countries with aging populations were the dark side of the boom in the United States of America, United Kingdom, Australia and elsewhere.

The messages of this article are positive. The major economies are more resilient than in the past, and the post-2007 crisis will not approach that of the 1930s in its impact on the real economy. However, the psychological message may be hard for policy-makers and consumers to accept: a credit-fuelled boom has to end, and the crisis is not to be averted by cheap money. Just as the fiscal policy biased towards budget deficits that accompanied the prosperity with security of the 1950s and 1960s was not a long-term option, governments in the 2000s must accept that growth based on easy credit is not a long-term option. The moral hazard behind the crises of recent decades was facilitated by cheap money that encouraged excessive leveraging all across the economy, and with global financial markets this could result in a crisis in any part of the world. The severity of these crises can be reduced through better financial market regulation to reduce moral hazard and better macroeconomic policies to underpin a sustainable price of credit.

Footnotes

  • 2

    This article lumps deregulation and innovation together. Laeven and Valencia (2008, p. 26) make the distinction that the rapid expansion of credit in the United States of America and United Kingdom up to 2007 followed financial innovation rather than deregulation, but the two are similar insofar as both innovation and deregulation take segments of the financial sector outside the ambit of existing regulatory mechanisms. The Great Moderation in business cycles over the last quarter century is analysed by Fogli and Perri (2006) and Galí and Gambetti (2009).

  • 3

    Fry (1988) surveyed the literature on financial repression in developing countries showing that financial repression had only a small negative impact on the level of savings but, owing to adverse selection, had a large negative impact on the efficiency with which savings were transformed into productive investment. This problem became even more pronounced in centrally planned economies.

  • 4

    Corden (2008), quoting International Monetary Fund data, that in 2007 21 per cent of the sum of surpluses was accounted for by China, 20 per cent by the major oil exporters, 13 per cent by Japan and 11 per cent by Germany, argues that low interest rates were because of a savings glut that became more pronounced after 2004–2005. The savings glut alone would have resulted in lower world interest rates and lower activity, but to maintain internal balance (i.e. avoid increased unemployment) the Fed and other central banks adopted expansionary monetary policies which drove interest rates still lower. In IS-LM terms, the savings glut shifted the IS curve to the left, with lower equilibrium output and interest rates, while monetary policy shifted the LM curve to the right, offsetting the fall in output but augmenting the reduction in interest rates. Although this analysis is true of 2004–2007, that was only the latest episode in an era.

  • 5

    The increased frequency of financial crises since the 1970s is well documented. Eichengreen and Bordo (2002) identify 38 financial crises between 1945 and 1973 and 139 between 1973 and 1997. Caprio and Klingebiel (1997) identified 112 banking crises in 93 countries (and 51 borderline crises in 46 countries) between the late 1970s and 1997, with an average fiscal cost of about 12 per cent of GDP. Laeven and Valencia (2008), excluding “crises” affecting isolated banks, identify 124 systemic banking crises from 1970 to 2007 and examine forty-two of these in detail.

  • 6

    History matters. Lenders were cautious about emerging market debt after the defaults of Russia in 1998 and Argentina in 2001, and about loans to US non-financial corporations since the 2000 dot.com bubble. The countries with the most flexible housing markets and financial sectors enjoyed economic booms as borrowers saw their asset values soar, took on more loans with houses as collateral and increased their consumption.

  • 7

    The specifics of the sub-prime market, in which loans were approved by the local banks, instruments to facilitate risk spreading were constructed by money-centre institutions and the holders of the instruments were spread worldwide, exacerbated the complexity, non-transparency and moral hazard elements seen in other crises (Bathia, 2007; Corden, 2008, pp. 7–8). When the holders of the instruments realised that they did not know the risk of their holdings, the ensuing panic led to a “run” among whose consequences was the government bail-out of the insurer AIG in 2008.

  • 8

    In 2005 Crédit Mutuel lost 320 million euros on equity derivatives. In 2007 Calyon, the investment banking arm of Crédit Agricole, lost 250 million euros on credit default swaps. In 2008 Caisse d’Epargne lost 600 million euros on equity derivatives, and Natixis, an investment bank jointly owned by Caisse d’Epargne and Banque Populaire, was forced into a 3.7 billion euros rights issue to cover heavy losses.

  • 9

    In Lehman’s case the performing assets were bought by other banks (primarily Barclays and Nomura). Citi, which had expanded its activities when CitiGroup was established in the 1990s to allow Citibank to move into investment banking, also ran into trouble, requiring a large government bail-out. In January 2009, the integrated model was abandoned as Citi split into two parts.

  • 10

    Pomfret (2009, table 2) lists about forty “rogue traders” who have incurred trading losses of over USD100 million since the late 1980s, and undoubtedly many more losses went unreported in the press.

  • 11

    Bank heterogeneity is a reason why the financial sector is difficult to incorporate successfully into macroeconomic models. Australian banks’ immunity may be a result of less thorough-going deregulation and enforcement of competition than in the United States or United Kingdom; Australian mortgage-holders can only dream of the one per cent interest rates on UK mortgages. Australia’s financial stability was also helped by the country’s net debtor position; domestic banks were not seeking foreign assets as aggressively as banks in other OECD countries.

  • 12

    In the United States of America in 2008 bail-outs led to inconsistent policies: at AIG only common shareholders suffered, at Fannie Mae and Freddie Mac both common and preferred shareholders lost, and at Washington Mutual all shareholders and senior debt holders lost.

Ancillary