Science Forums 2

[Michaelangelica]

if people still insist on buying Toyotas and Volkswagens.

i'm not sure they are even doing that, are they?
Here the "Socialist" (in Yankee eyes) Labor Govenment has bailed out GM because of electoral backlash concerns. But they have insisted that GM smarten up its act-- get innovative and stop making gas guzzlers. I am not sure you can decree that sort of corporate transformation of culture. Maybe going broke would clear the decks for a truely innovative young firm. -- But where would they get finance these days?--- especially in Oz, not known for supporting its young entrepreneurs and innovative inventors.

Yes socialist USA is amusing, I find, considering Yanks are paranoid about socialism ( socialism = communism= the evil, devil incarnate).

Here is a "What went wrong?" speech
I am not sure about people not seeing this coming. How long ago was this thread started and it was not the first?
I will go back to amusing-if pointed- posts after this

Reflections on the Global Financial Crisis
Address to the Sydney Institute
Tuesday 16 June 2009
David Gruen*
Executive Director
Macroeconomic Group
Australian Treasury

It is a pleasure to be here at the Sydney Institute talking about a topic that has consumed a good proportion of my waking hours, and a few of my non-waking hours, over the past eighteen months or so.
. . .
. . . I confess to being continually amazed, and shocked, by the still evolving global financial crisis. If this crisis hasn't changed at least some of your views about how the world works, then I reckon you haven't been paying attention – or, alternatively, your views are so tightly held as to be impervious to the arrival of new information.

The global financial crisis is a huge event and a huge topic, and with the limited time available, I will be selective in my comments.

Let me start with a sound bite, from January this year, from Alan Blinder, Princeton Economics Professor and former Deputy Chairman of the US Federal Reserve:

"Nobody thought this might happen. Things can go wrong. But the number of things that have gone wrong, and the ferocity with which they have gone wrong I think was beyond the imagination of almost everyone."2

That is a sentiment with which I agree. There were economists who warned about aspects of this crisis, and I am going to touch on some of them in my remarks today, but almost nobody thought that something as severe as this was remotely likely.

I don't intend to give a blow-by-blow account of the financial crisis, nor a detailed analysis of the reasons for the crisis. But I thought it would be helpful to provide a list of the factors or causes that I think made a material contribution to the crisis.

I have divided my list into those causes that were directly related to the US housing market – the proximate causes – and those that should be considered wider causes of the crisis.

I have been mindful to keep my lists as short as possible, but I have still ended up with thirteen items on one or other of my lists.

Let me start with five proximate causes.

First, global imbalances implied a huge flow of funds from developing countries (particularly in Asia) to developed countries (particularly the US).

Second, low global real interest rates contributed to strongly rising asset prices and, eventually, to house price bubbles in the US and several other countries. Global real interest rates were low both because of the global savings-investment balance (the 'global savings glut'), and because of expansionary monetary policy, particularly in the United States.

Third, there was incoherent financial regulation in the US mortgage market. There were at least four relevant regulators in the prime mortgage market and, in the subprime mortgage market, many of the largest lenders were not subject to any supervision by bank or thrift regulators.3

Fourth, there was long-term public sponsorship of home ownership for low-income households in the US, many of which ultimately could not afford to own homes.4

Fifth, there were serious flaws in the 'originate to distribute' model for mortgages. This model involved mortgages being bundled up and 'securitised' and, in the case of many financial instruments based on sub-prime mortgages, given inappropriate AAA credit ratings and then spread to the winds, via global capital markets. The consequence of a loss of integrity in the relationship between original borrowers and final investors was that eventually no-one was doing due diligence on borrowers' ultimate capacity to repay their loans. In theory, risk was supposed to be spread to those most able to bear it; as events turned out, it was instead spread to those least able to understand it.5

Let me turn now to the wider causes, of which I have three.

First, financial instruments became so complex that eventually literally no-one understood fully the nature of the instruments they were buying and selling.6

Second, there was a range of perverse incentives in financial markets – too much pay for short-term returns, and not enough downside for losses. Many individuals faced strong financial incentives to take risks with other people's money – risks that generated good returns most of the time, but with a small probability of disaster.7 When the disaster struck, it was a disaster for the other people whose money had been put at risk, for the financial firms that had put it at risk, and for the wider financial system.

Third, large banks and the financial system more generally, mainly in US, UK, and Europe, gradually became more highly leveraged (more loans for each dollar of bank assets).

This final cause is one of the most important, because it rendered the global financial system much more fragile than most people realised. And so it is worth spending a little time fleshing out in some detail why the financial system gradually became more highly leveraged.

This leads me to a third list, which enumerates the reasons why the financial system gradually became more highly leveraged. There are five items on this list.

First, the 1999 repeal of the US Glass-Steagall Act – which had been enacted in the teeth of the Great Depression in 1933 – allowed commercial banks to run large investment banking businesses.

Second, regulatory frameworks encouraged banks to shift loans 'off balance sheet' and encouraged growth in the 'shadow banking system', largely outside the regulatory net.

Third, times were good and it was therefore very profitable to become more highly leveraged.8

Fourth – and this is another implication of low global real interest rates combined with investors continuing expectation of high returns – financial firms were searching for innovative ways to generate higher returns, and more leverage was a natural way to achieve this.

But surely that meant that financial firms were taking huge risks to their own solvency? This leads to the final reason for the increased leverage, and therefore the crisis: a widespread failure of risk management. Banks thought they had a better understanding of financial risk than ever before, based on sophisticated mathematical models of risk and return. The banks' new risk-return models were indeed sophisticated, but as it turned out, they were also fatally flawed.9

As a result, as house price bubbles collapsed in the US, UK, and several other countries, the cascading of problems from one counterparty to another, and from one financial market to another, generated a shock well outside the experience of the banks' risk models and this, combined with their high degree of leverage, bankrupted large parts of the global financial system.

We are all now living

Reflections on the Global Financial Crisis - Address by David Gruen to the Sydney Institute