GFC’s long shadow over growth

The Lehman Brothers collapse in September 2008 — the biggest bankruptcy filing in U.S. history, with Lehman holding over $600 billion in assets — was a representative milestone for the Global Financial Crisis. Yet, seven years on we still can’t agree on the exact causes of the GFC, the largest financial crisis since the 1929 stock market crash.

In the Journal of Economic Literature, MIT Sloan Professor of Finance Andrew Lo reviews 21 books on the GFC, written by academics, journalists and policymakers. His conclusion: “no single narrative emerges from a broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed”.

The usual suspect in the list of possible culprits is the ‘reckless and shameful’ financial deregulation movement preceding the crisis. Although there were (as still are) areas for improvement — for instance, demanding more informative and accurate product material for some hybrid securities — the epicentre of the GFC started at the heart of the US mortgage industry, which is one of the most regulated markets in the world. If anything, misleading government intervention in the American housing market through Fannie Mae and Freddie Mac is much to be blamed for the financial mess.

Further, the problem with financial regulation (or for that matter, most regulations) is that it easier to agree that something must be done rather than what should be done. It’s not uncommon that the solution is worse than the problem. For instance, just look at a few counterproductive financial legislations enacted following the crisis — in particular the 2010 US Dodd-Frank Act — that so far have only increased costs and regulatory uncertainties, crowding out small players and creating strong incentives for a swelling shadow banking sector.

Another culprit for the GFC lies in the mischievous financial practices — if not outright fraud — such as the act of predatory lending, imposing unfair and abusive loan terms on borrowers through deceptive means. Although in hindsight it might be easier to spot those unlawful operations, the difficulty for future policymaking is to prevent them from happening without excessively curbing legitimate financial innovations. Moreover, even if all forms of predatory lending had been prevented, this would not guarantee that the GFC would not have occurred.

A case can also be argued that global imbalances at the time were the main driver of the GFC. According to this view, the tacit agreement between export-driven countries (e.g. China) and high-deficit nations (e.g. the US) made possible an unsustainable path of debt and leverage. And indeed, the trade and investment patterns derived from global imbalances fuelled years of fiscal and private largesse that culminated in a severe financial hangover since 2008.

Nonetheless, although all these explanations above have some validity, they cannot — either individually or as group — fully account for the GFC. In fact, that we cannot agree on or fully identify the causes of the GFC is in itself quite telling about the current challenges to global growth. Despite the tremendous fiscal and monetary efforts to revive the global economy, growth is at best lukewarm and fragile. Or worse: our ability to fight the next recession is deeply undermined, with little wriggle room to promote further expansionary government measures.

For Australia, this means we should be engaging in deep structural reforms to improve our resilience. Accordingly, it is high time to fix our outdated tax system and industrial relations, and to insert more competition in our domestic markets.

We might not agree on the causes of the last crisis, but we can still agree much has to be done to prepare for the next one.