From The Melbourne Age on 1st October 2008
Monday nights rejection by the US House of Representatives of the US Treasury Secretary Paulsons Troubled Assets Recovery Plan, which had been modified to accommodate the concerns of Congressional leaders, has propelled the financial crisis which began in July last year into a new and much more dangerous phase.
The Paulson plan was by no means flawless. But the history of financial crises which has been neatly summarized in a paper by two IMF researchers published last week shows clearly that financial crises such as the present one are rarely solved without the infusion of large sums of taxpayers money, as the Paulso plan proposed in this instance.
Together with what has been lent to Bear Stearns and AIG, the US$700bn envisaged by the Paulson plan amounts to around 6% of GDP which, as it happens, is equivalent to the average cost of the bailouts required in response to the 42 financial crises which the IMF researchers identify since 1970. It represents a lot less than what was eventually required to resolve Japans banking crisis of a decade ago, which amounted to 24% of GDP in part because the Japanese political system took so long to agree to the use of public funds in this way.
Far from saving their constituents US$700bn, the 228 members of the US House of Representatives who voted nay to the Paulson plan will ultimately cost them more more by way of the bigger bail-out which will be required the longer it takes a majority of Congress to get a grip on reality; more by way of the greater declines in house values and retirement savings accounts which will occur in the meantime; and more by way of the larger number of job losses which are likely to occur as the spillover effects of the financial crisis on the real economy (in which most Americans are employed) continue to mount.
Although Australias financial system is, as Ministers and Reserve Bank officials have (appropriately) continued to emphasize, in a much sounder condition than its counterparts in the United States and many European countries, it is not immune from the additional pressures which the rejection of the Paulson plan have set in train.
Australian banks have not engaged in imprudent mortgage lending to anything like the same extent as their American counterparts partly because of better and stronger prudential supervision, partly because the Australian legal system has more safeguards against reckless behaviour on the part of both borrowers and lenders, and partly because Australia (almost uniquely among Western countries) did not experience an extended period of excessively low interest rates in the early years of this decade (a tribute to the wisdom and courage of our central bankers in the face of political pressure to do otherwise).
Australian banks are thus continuing to add to their capital (and hence to their capacity to lend) through profitable operations, while American and European banks are destroying capital (and hence eroding their capacity to lend) through loan losses and write-offs.
However the Australian banking system has one point of vulnerability, which stems from the fact that Australians dont save enough in the form of bank deposits to finance all of the loans which they want to take out from banks, obliging the banks to rely on wholesale funding for the difference, to a greater extent than most overseas banking systems. This is the direct result of the fact that Australia runs the worlds fourth largest current account deficit (in absolute terms), and relies almost exclusively on the overseas borrowings of the Australian banks to finance it.
That borrowing has become more expensive since current financial crisis began to unfold in July last year, and dramatically so over the past two weeks. Yesterday, banks were having to pay almost a full percentage point above market expectations of where the cash rate will be for 90-day wholesale funds, compared with less than one-tenth of a percentage point before the present crisis began.
The intensification of this upward pressure on banks funding costs means that, if the Reserve Bank wishes to prevent the rates which household and business borrowers are paying from rising, it will need to cut the official cash rate at next Tuesdays board meeting. And if they judge that in the light of the deteriorating outlook for the global economy the rates which borrowers are paying should come down, then they made need to cut the official cash rate by more than the customary quarter of a percentage point.
And politicians who wish to continue to re-assure Australians of the soundness of their economys fundamentals by highlighting (among other things) the profitability of the banking system need to think twice about the wisdom (in these circumstances) of urging banks to reduce their profits by cutting their lending rates when their funding costs are actually going up