Cover Story
Avoiding Armageddon
by Gareth Morgan
How bad is the global economic fallout likely to get and how will it affect us here?
As the world grapples with crumbling financial institutions that threaten to bring economies to their knees, the immediate priority is to ensure central bank and government inertia doesn’t amplify the downdraught. The financial system is in a hell of a mess and the cleanup required needs a ready flow of money to stop it getting so bad we plunge into another global depression.
That can sound highly dramatic from out here at the bottom of the South Pacific, with limited knowledge of this arcane world of structured finance, derivatives markets, swaps and short selling that seems to be holding us all to ransom. But the reality is that global finance has as much influence on the future fortunes of New Zealand as it does on China’s, let alone what we’re already seeing on Wall Street, USA. After all, we are one of the most indebted nations in the world, so our creditors can make our life hell.
When I wrote an investment market assessment for the Listener eight months ago, I noted that the greatest risks of the credit crunch were:
1) the orgy of debt around the world bringing down more fine financial institutions than we were expecting;
2) people in New Zealand still believing the asset we own oodles of – housing – is somehow immune to market forces; and
3) the unravelling of 10 years of gluttony for debt leaving a bruising that takes a couple of years for the private sector to recover from.
I am sorry to say all three of those risks have been realised. We are entering a global recession.
A series of measures has to be taken to prevent this becoming a prolonged global recession, but the immediate step is to prevent a mad global panic run on the banking system. Once, and only once, that is assured, governments and central banks will need to rehabilitate the world banking system to ensure the frenzy of indebtedness – which has allowed economies like New Zealand’s to grow so far beyond their means – never happens again.
Since the mid-1980s, when the first crisis in this deregulated financial world hit, central banks have sponsored a series of boom-bust cycles in financial markets. Each successive boom-bust has been scarier than the last, underpinned by central banks’ benign negligence to control the prudential standards of credit issuers.
The result is that what is commonly known in economic circles as “structural imbalances” – between creditor and debtor nations, and between indebted households and flimsily founded lending houses – have just got larger and larger. It is a shameful indictment of central banking, and the price of that incompetence is just beginning to savage the world economy.
But even if central banks and governments have the will and the fortitude to address the underlying cause – their own behaviour – the excesses can be addressed only in an environment of dull but stable economic and financial activity. It can’t be taken on in the environment of panic we have now. So we first have to get rid of that instability.
How has it come to this?
It started with the financial deregulation of the early 1980s. But financial re-regulation is not the answer – that would be throwing the baby out with the bath-water and is not the way forward.
The 1987 crash was the first sign that given their head, markets do run to excess – in this case, sharemarket valuations became unrealistically high and companies took on too much debt. The central bank response to that market correction was to flood the system with liquidity, the excuse being that instability could threaten “another world depression”.
In the heat of that moment of official panic, this was the correct response. But it should have been only the precursor to what should have followed: an overhaul of the financial sector operating conditions that allowed loans to corporates to expand rapidly with little regard to risk.
Here was the first warning from the deregulated market. Yes, deregulation will unleash financial sector “innovation” and “entrepreneurship” that will take us to a more efficient and effective distribution of the scarce capital an economy needs as fuel to grow.
But it’s naive to think we will arrive at this nirvana immediately and smoothly. It is in the nature of markets to reach this sustainable position only through an imperfect process that has them taking wrong turns at forks in the road and doing U-turns in all manner of cul-de-sacs. It’s a very clumsy way to go, but we know no better economic system.
The inherent volatility of this zig-zagging search-and-correct market path is something regulators – and particularly politicians – love to think they can eradicate from the capitalist system. But get rid of it they certainly can’t. The relevant question is whether the ultimate stability this market approach promises contains an inherent instability.
A “Minsky moment” – named after US economist Hyman Minsky – is the crisis point a market eventually reaches as a result of swinging too far away from what is sustainable: a major sell-off starts because the supply of people prepared to pay the previously high prices has run out.
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