The Great Crash Of 2008

David Llewellyn-Smith, Ross Garnaut

• Publisher: Melbourne University Press Digital
• Year: 2009
• Print ISBN: 9780522857023
• eBook ISBN: 9780522860016
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

As the world enjoyed the prosperity of an unparalleled boom, an economic earthquake was looming, and then struck abruptly. Bastions of finance collapsed, long-standing policy beliefs were abandoned, and governments charged into the rubble without time to watch their steps. But for those who were looking, the faultlines that ran beneath the boom had been apparent for years.
In The Great Crash of 2008, Ross Garnaut and David Llewellyn-Smith take us through the imbalances that led to the global financial crisis, tracing the cracks that were appearing within the modern economy and presenting a whole-world view of reasons for the downturn. They assess the implications of the global financial crisis and offer hope for finding order in the wreckage, in restoring development and building a stronger and more sustainable world.

PART I

Boom

1

The Platinum Age

In 1986 An Australian delegation met the diminutive Chinese leader, Deng Xiaoping. As the little great man aimed a projectile into his spittoon, the Australian ambassador successfully resisted an impulse to withdraw his adjacent shoe. He had just asked Deng what he had meant when he said that his long-term ambition was for China to enjoy the living standards of middle-income industrialising countries by 2050. Did he mean the incomes of people in economies such as Taiwan and the Republic of Korea at that time, or the expected incomes of the mid twenty-first century?

Deng finished clearing his chain-smoking throat and replied: ‘The average of those middle-income economies now. Then I hope that the Chinese people will be satisfied’.

By 2009 the output per head of the Chinese on the mainland had reached the level that Deng had hoped for. But being an ungrateful lot, there is no sign of the satiation of their desire for material progress. Whatever this great twentieth-century leader may have wished for them, the Chinese people have made it clear that they will not happily settle for less than Americans, Japanese or Europeans. And the experience of another quarter-century of reform and growth has made it clear that they probably won’t have to.

The early twenty-first century brought the most widely based and rapid sustained economic growth that the world has ever known. Its essence was the extension of the beneficent processes of modern economic growth to the vast interiors of the populous countries of Asia. China led the way and was followed by Indonesia, India and others. More people were elevated from poverty than ever before over a comparably short period. We call this period the Platinum Age.¹

The strong sustained growth of the large developing countries is transforming the global economy and its geostrategic context. It is fundamentally changing the way in which people look at their history and their prospects. Yet it is a natural phenomenon, growing from roots established in much smaller societies more than 200 years ago, and evolving over the years since. These powerful historical processes now have their centre in East Asia, and yet there is no East Asian miracle. What is at work is the extension into new places of well-established, well-understood economics.

Sustained, rapid economic growth is now the process by which a poor and economically backward country catches up with the technology, business organisation and capital intensity of the advanced economies. The ‘catching up’ happens naturally when certain conditions are met. The central precondition is that there is an effective state, able to offer stability in political and economic institutions, and to enforce the legal basis of market exchange.

Within a framework of political stability, the society has to accept the priority of the economic growth objective.

Rapid economic growth is disruptive. It churns and reorders elites. It challenges the myths and institutions that give meaning to many people’s lives. All of these tendencies generate reaction and resistance. But governments persist with policies that underpin rapid growth if the reasons for doing so are powerful enough to overcome the resistance.

Such growth requires a relatively high rate of investment, including in education. A high investment rate, if it is to be sustained during years that can be smooth or rough for the international economy, in turn needs to be built on a relatively high domestic savings rate. This is not so demanding a condition as it once seemed. There are now many cases of rapid economic growth in what had been a poor developing country being associated with significant increases in the savings rate. This has been evident in China throughout the reform period since 1978, and has recently been powerfully evident in India.The education requirement becomes more demanding as successful economic development raises the technological complexity of the economy.

Sustained, rapid economic growth also requires the acceptance of a considerable role for markets in domestic and international exchange. It is necessary to get rid of the extremes of protection against imports that have been present in almost all developing countries.

For the first century and a half after the beginnings of modern capitalist development, contemporary economic growth was mostly confined to Western Europe and its overseas offshoots in North America and Oceania. The one major exception was Japan, which, after early rejection of the new ideas and technologies of the West, changed dramatically in the 1860s. Japanese elites realised that Japan’s autonomy and sovereignty would be undermined by a commitment to the old ways.²

A huge gap emerged between the productivity and economic and military weight of the countries that had accepted the new ways of economic organisation, and those that had not. This became the basis of modern colonialism, through which a small proportion of the world’s people ruled vast numbers far and wide. Colonialism mostly retarded the establishment of the essential conditions for sustained, rapid economic growth among the colonised peoples with histories of an effective state.

The first new participants in this growth, after Japan in the nineteenth century, emerged in the third quarter of the twentieth century. All were relatively small economies in East Asia: Hong Kong, Taiwan, South Korea and Singapore. Their success encouraged emulation by neighbours, and by the 1970s they had been joined by Thailand and Malaysia. The success of internationally oriented growth policies in relatively small East Asian developing economies was influential in the region’s more populous countries. China moved decisively to a new development strategy when the senior revolutionary general and victim of the Cultural Revolution, Deng Xiaoping, received majority support in the Communist Party’s Central Committee in December 1978.

Deng and his supporters had no blueprint for a new economic policy. In this they were like the leaders of Taiwan and South Korea in the first two decades after World War II, or Japan at the time of the Meiji Restoration. What was common in the early stages of all of these success stories was a commitment to the greater use of markets in domestic exchange, to international orientation, to making foreign trade a normal part of economic activity, and to absorbing successful technology, business organisation and capital from abroad.

China’s progress has been inexorable, except for two years around the political traumas of 1989–90 when the reforms were seriously challenged within the political elite. In the first thirty years of the reform era, real output grew at an average of 9.8 per cent per annum, real exports by 12.5 per cent and real imports by 11.7 per cent. The investment share of GDP rose from 29 per cent in the eighties to 38 per cent in 2008. The savings share over the same period rose from 29 per cent to 48 per cent.³

Ideas and technology from abroad were absorbed through students studying overseas, the purchase of technology and, over the past decade, increasingly through direct foreign investment and the internet. Direct foreign investment in China has represented a significant part of capital formation from the early 1990s, reaching an average of $80 billion per annum in the early twenty-first century, in some years the largest in the world, and around half of all such investment in developing countries.⁴

Indonesia, the world’s fourth most populous country, committed itself unambiguously to deeper integration into the international economy in a series of steps from the mid 1960s, but most decisively in the decade from the mid 1980s. It was followed by the Philippines and Vietnam in the early 1990s, making the South-East Asian countries a substantial and rapidly growing part of the world economy. India committed itself to internationally oriented growth policies from 1991. Its growth in output and foreign trade, and its use of direct foreign investment, has accelerated steadily since then.⁵

The South-East Asian economies and South Korea suffered a major setback in a financial panic that precipitated deep recession in 1997–98.⁶ This was the first major financial crisis of the era of globalisation. It had its origins in the private sector, rather than in the government budget deficits that had caused many earlier troubles in developing countries. The crisis emerged from the interaction between two weaknesses. One concerned flaws in financial institutions and in financial regulation. The other was corruption and cronyism in relations between government and business. In these and other ways, it was the precursor to the global Great Crash of 2008.

By the early twenty-first century, two decades of sustained economic growth had made China a substantial player in the world economy. It became so big that rapid growth in its output, demand and trade raised the world’s rate of growth. In 2001, China became a member of the World Trade Organization, making stronger promises to open its economy to foreign trade than any other country had made on entry to the group. Even faster growth followed in China’s trade: from 2001 to 2008, the country’s output, exports and imports increased at average rates of 10.2, 20.8 and 18.6 per cent per annum respectively. China’s share of world output measured in purchasing power rose from 1.8 per cent in 1980 to 11.4 per cent in 2008. Its share of world exports rose from 1.6 to 11 per cent, while its share of world imports grew from 1.4 to 8.3 per cent. China’s exports grew at nearly five times the rate of growth of the world total and imports at almost four times the world total in the first eight years of the new millennium.

This strong growth in China, India and other large developing countries created trade opportunities for others. Japan’s long stagnation, for example, was broken by large increases in exports to China. Growth in demand in these countries pushed most metals and energy prices to unprecedented levels, and boosted incomes and opportunities for profitable investment in commodity exporting countries. Exceptional global prosperity followed. Increased specialisation across countries in all economic activities, and greater international trade and investment, raised productivity and incomes almost everywhere.

2

The Greatest Bubble in History

In 1997 A Low-Budget Australian movie dominated the national box office. The Castle cost $500 000 and took nineteen days to shoot. The movie’s title was drawn from the platitude ‘Each man’s home is his castle’. Its major theme was an examination of the rights and value pertaining to home ownership.

The lead character, Darryl Kerrigan, was an iconic figure of Australiana: working-class, egalitarian and down-to-earth, someone who might have been described as a ‘good bloke’. He was played by the lanky, laconic Michael Caton, whose moustachioed credulity encapsulated Australia’s most adored self-image. The film held an ironic mirror up to Australia. On display were those dimensions of the nation that did not fit with its self-image of giving everyone a ‘fair go’.

The Castle’s launch coincided with changes that curtailed the realisation of traditional, passionately held goals of home ownership. That great Australian (or American or British) dream was mutating into volatile and dynamic asset trading. There is no better symbol for this shift than the subsequent career of Michael Caton. After the success of The Castle, he was recruited to host a major television series called Hot Property. In a case of life ignoring art, the man behind Darryl Kerrigan, the embodiment of passionate owner-occupation, became the face of asset speculation. The program offered tips on how to buy, renovate and sell property. This theme grew so strong with passing seasons that in 2000 it was renamed Hot Auctions. This was the very opposite of the quaint owner-occupier culture venerated in The Castle.

What drove this transformation?

Anglosphere house prices had boomed before. They had surged in the late 1980s as corporate freewheeling stoked growth within economies that had experienced recent financial liberalisation. However, the rise in prices was soon brought to heal by high interest rates and then the early 1990s recession.

But the boom that emerged in the mid 1990s went much further. It was described by The Economist in 2005 as the ‘greatest bubble in history’:

Never before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stockmarket bubble burst in 2000. What if the housing boom now turns to bust?¹

The Economist estimated that from 2000 to 2005, global housing more than doubled in value to more than $70 trillion.

The Great Moderation

The story of the great Anglosphere asset bubble begins with an atypical period of economic calm. Western economists and officials began to note in the late 1990s that volatility in their economies was in decline. By this they meant that the frequency and depth of swings between periods of growth and recession had diminished. Inflation was under control and there was less need to raise interest rates to high levels.

This phenomenon was called The Great Moderation by the economist James Stock of the Kennedy School of Government, Harvard University.² The term caught on. Central banks around the world claimed that The Great Moderation was the result of their increasingly competent use of interest rate policy. However, Stock attributed the decline in volatility as much to the good luck of living through a period with limited external shocks, such as commodity price spikes induced by supply disruptions.

Other explanations for The Great Moderation have included the mitigating effects of information technology on the inventory cycle; the anxieties and competitive pressures of globalisation deterring labour unions’ pursuit of higher wages; the increased role of services in the economy and the corresponding reduction in the potency of the ‘stock cycle’; and the disinflationary effects of expanding exports from China and other developing countries with low labour costs.

Whatever the mix of forces t...

Table of contents

• Cover
• Title
• Contents
• Preface
• Acknowledgements
• Introduction
• PART I—BOOM
• PART II—BUST
• PART III—AFTERMATH
• Notes
• Index
• Copyright