The global housing bubble?

One paragraph in an article entitled World in Reaction in The Weekend Australian January 31-February 1 2009 by Michael Stutchbury contains a few of the wrong and self-contradictory ideas held about the causes of the global financial crisis in so few words that it presents a good opportunity for me to point them out and to suggest an alternative view.

The article makes rather odd reading because several of the quotes and ideas which are represented to the reader are worthy of fuller and properly-reasoned treatment, especially about the direction of the US in respect of the apparent strengthening of support for the spectre of protectionism. Aside from the dissonance forced upon the reader by the recitation of material, and blithely made claims including that "the old Davos consensus failed to recognise that financial markets are not always self correcting and are prone to bubbles," the words I am particularly troubled by are as follows:

This [the world economy] came undone because the excess Chinese savings pumped up the American housing bubble, facilitated by the new era of financial products. Financial engineering allowed the movement of Chinese peasants from the rice paddies to the city factories to finance home loans for poor Americans. The trouble came when the borrowers couldn't service the debt. The securitised mortgage products had hidden the dud loans. That broke trust in the banking system, an essential element of a market economy.

Let's analyse the fallacies of these statements in three parts:

1. "Chinese savings pumped up the American housing bubble" is obviously untrue. The nexus between the funding of expenditure on imports by Chinese purchased of American bonds and the price of housing is tenuous at best. The US economy is strong because it is a diversified and efficient economy that reaps the most financial benefits of globalisation, both exporting premium goods and services and importing low inflation. The American housing bubble is no different to that in the UK, Spain, Australia or Hong Kong who do not benefit from Chinese savings propping up their economies.
2. "Financial engineering allowed the movement of Chinese peasants from the rice paddies to the city factories to finance home loans for poor Americans" provides a second stanza of the same mantra with "home loans for the poor" in place of "housing bubble [for the rich]." Which is it, or is it somehow both? Low-income, owner-occupied housing is entirely distinct from aspirational middle income owner-occupiers climbing the "ladder of opportunity" and upper income earners purchasing investment properties.(*) I note that predatory lending is abhorrent and has an awful impact on those caught in its net so should be prosecuted vigorously by the authorities.
3. "The trouble came when the borrowers couldn't service the debt. The securitised mortgage products had hidden the dud loans. That broke trust in the banking system, an essential element of a market economy." Okay, I mostly agree with this point; but I'm really not sure about broken trust except for between the banks. I note that the banking system as a whole is secure in the US even as parts have fallen over (likewise in the UK and Europe), in contrast to the Australian banking system which is well-capitalised and profitable. The causes of the breakdown in inter-bank lending and resultant slowdown in commercial and general loans are at the root of the current underlying problems.

(*) Notably from the Australian perspective, the property market in the US bubbled along even in the absence of the financial benefits of negative gearing available to Australian tax payers, posing another conundrum for Australian policy makers seeking to decouple first-home ownership from rent-seekers and those seeking capital gains in the property market.

Credit tightening during the down slope in the economic cycle (i.e. recession) is normal and expected which gives a glimmer of silver lining to the billowing clouds of gloom. The positives are the repricing of asset values to realistic levels (as asset price speculation is dampened), the reduction in the cost of labour and resources (due to the relaxation of production capacity constraints), lower interest rates and disinflation (i.e. a decline in inflation - so long as deflation can be avoided), which together should soften the economic landing and give a platform for sustained growth during the ensuing upswing.

None of this offsets the personal dislocation of those workers, and their families, who have been displaced in the workplace whether by being made redundant, or being asked to reduce working hours or take a cut in income. The goal of targeted economic stimulus should be to minimise the effects and duration of the economic downturn so as to avoid stimulating cost and wage inflation during the return to economic growth. With a little courage, governments, enterprises and individuals can benefit from counter-cyclical investment in a slowing economy and at the same time help to pull up the economy in order to hasten a return to economic growth and full employment.

I am surprised there is so little commentary in the media about the Glass-Steagall Act being repealed (in 1999) and more importantly the repudiation of the reforms that were enshrined in these pieces of legislation in the aftermath of the Great Depression, the most relevant being the effective separation of commercial and investment banking. I do not know if this is a good or a bad thing overall but the erstwhile reason was to rebuild lost trust in a stable banking system.

Many commentators appear to have rediscovered the role of directors in managing financial and non-financial risks, eg. reputational risk, of the companies they manage, albeit largely by delegation of specific responsibilities to a chief executive officer and his nominees. The major part of the remaining, non-delegated role of directors is specifically to consider and approve strategy, as proposed by management, and to oversee risk primarily through the Audit and Risk Committee that is a subcommittee of the board of directors.

It is equally surprising that the Sarbanes-Oxley Act has got little airplay in the context of the current crisis; hastily enacted after the last crisis, it is no surprise that it has made no real difference to the risks prevalent then and now. There is something to be said for avoiding black-letter law for principle-based reporting standards as exemplified by International Financial Reporting Standards as adopted by Australia and on the way on the US. The right regulation is desirable instead of over-regulation in order not to dampen entrepreneurial risk taking and innovation which provide the most benefit to the economy in the long term.

A quick comment on the article as a whole is warranted because while many of the ideas in the article are sound, in my opinion the combination of quotations from respected sources together with 'editorial' remarks is misleading in an insidious way that conveys the selected quotations and the authors conclusions as reliable beyond their merit.

Reporting from Davos, the Russian Prime Minister Vladimir Putin is quoted as one bookend to the sentence, "The epicentre of this crisis is the US, the heart of global financial capitalism," cutely contrasting the pseudo-free society and markets of the main entity of the formerly socialist Soviet Union with their capitalist nemesis. The other bookend is this unattributed quote, "If there are no people in Wal-Mart to buy your product, what is your export strategy?" referring to export-led growth of developing nations as a result of globalisation.

This meandering is partially saved by the wonderful line that, "It's been the greatest poverty reduction program in human history," in reference to the "triumph of global capitalism in absorbing the population masses of China, India and Brazil." Kevin Rudd would do well to remember this in light of his recent disparaging remarks about the last 30 years of global development.

After posing as a fiscal conservative before the last Federal election, if he is not careful Rudd's current foray into fiscal adventurism could set Australia up for a period of prolonged stagnation and low growth instead of heralding another sustained period of growing economic prosperity.