Economy in 2008

Goodbye easy money, hello billion-dollar bail-outs | theage.com.au

Goodbye easy money, hello billion-dollar bail-outs

WHAT a difference a year makes. Could there have been a more dramatic shift in fortunes than that experienced in 2008 — a world economy, once at full throttle, yanked into reverse? A year ago, with the iceberg that was America's subprime lending debacle still largely submerged, the global economy was steaming ahead, propelled increasingly by the developing behemoths China and India. Their voracious appetite for resources drove a commodities price rally that was stuffing the coffers of big minerals exporters such as Australia, prolonging a decade-long economic expansion.

In fact, such was the strength of the boom locally that the Rudd Government's early days were marked by talk of runaway inflation, and the Reserve Bank, resolute in its anti-inflationary fight, muscled up by lifting interest rates in February and again in March — the 12th successive rise — to quell the fever.

Though the prospect of a US recession loomed large, most economists were proffering that any pull-back in economic activity would be the dip necessary to damp down excessive demand. Alas, they were mistaken. The seeds of disaster had long been sown.

The year was not even one month old when America's big banks began revealing balance sheets soured by billions of dollars of bad loans. The extent of the sub-prime crisis — the result of over-zealous home lending to Americans with poor credit records — was becoming stunningly apparent and an obstacle that would maroon the world economy. Borrowers started defaulting on their loans in record numbers and with sharemarkets plunging in response to the revelations, highly leveraged investors were suddenly wrong-footed and having to find cash to cover margin calls.

Alarmingly, what was also being exposed was a global financial network that was a house of cards. Clever financial engineering gave rise to myriad instruments whereby assets were bundled up, sliced and diced, and then sold on as investment products that even their salespeople found difficult to decipher for clients.

With bad debts escalating, cash again became king: banks and other lenders, increasingly risk averse, started rationing credit as "easy" money was consigned to history. And as the crunch intensified, what at first amounted to a financial markets rout — which pulled share prices from record highs and played havoc with currencies — started hitting the real economy. Some big companies came unstuck. Many more were forced into costly refinancing. The knock-on effects were vast and varied. Speculators deserted equities, looking for a better bet: oil prices, already pushed high by world demand, nudged $US150 a barrel, inviting predictions of a spike beyond $US200. The rising cost of energy, in turn, fuelled angst about prices of goods and services generally and the impact on global production.

Confidence collapsed: banks around the world were forced to issue new capital to shore up their faltering finances, with every announcement sinking the world's financial system deeper into crisis, its worst since the Great Depression. Some funds were frozen as institutions struggled to meet the redemptions of anxious investors. Predators snapped up banks on the brink of collapse. Famous brand names, Bear Stearns and Merrill Lynch among them, were forced to forfeit their independence. Others, such as Lehman Bros, are set to disappear altogether.

And as financial institutions crashed, so too did some of the recently established wisdoms about the sanctity of markets, the role of regulators and of governments. Ultimately, nothing short of gilt-edged guarantees — indeed, the quasi-nationalisation of the banking system itself — would soothe jangled nerves, and the US Government's $US700 billion bank bail-out has become the linchpin of world efforts to unclog credit lines. Its benevolence, ultimately, would extend to America's near-bankrupt car industry, at a further cost of billions.

Australia, too, has been forced to back its banks and, like other countries, reached for the twin levers of monetary and fiscal relief: interest rates have been slashed by 3 percentage points, to 4.25 per cent, with more cuts likely in the new year. The Federal Government primed the economy further by putting billions of dollars into the hands of families and pensioners, as well as unveiling plans for big infrastructure projects, measures that evoked the spirit of John Maynard Keynes and were praised by political and business interests alike.

The prospect of a budget deficit, however, seems inescapable if Australia is to avoid a recession, a move that will also challenge recent fiscal orthodoxy. But with the glow of the festive season's consumer binge fading fast and faced with the prospect of sharply rising unemployment, that path is a necessary — and correct — one.