We are enduring the most serious financial crisis since the Great Depression. There is no doubt of the depth of this downturn and that many people have been hurt very badly. In this environment, it is not surprising that some have suggested that the financial crisis represents an implosion of the market system. A picture is painted of a wholly corrupt edifice crumbling from its inherent weaknesses. There is a sense that “it had to happen”. This kind of thinking overstates the case. Moreover, the financial crisis did not have to happen. Insufficient regulation is cited as a principal cause. That is only one-half right.
The financial collapse was not the long expected and inevitable collapse of a corrupt system. It rather can be attributed to two primary and very concentrated causes. Both causes could have been avoided with skillful regulation: one would have required more regulation, the other less. Finally, both causes were American, pure and simple.
Regulatory failure #1: profligate lending
The first cause of the international financial crisis was the profligate home mortgage lending that occurred in the United States. Loans were made to people who would never have qualified under the criteria of banks elsewhere, including Australia. Households were induced into (and accepted) “teaser” mortgage payment rates, which were to adjust substantially upward in the future. Households were loaned far more money than historic standards would have allowed.
Within a matter of years, mortgage foreclosure rates ballooned, as households were unable to pay the higher mortgage payments that should never have been offered them and that they should never have accepted. As the number of foreclosures increased, house prices fell and financial institutions found themselves unable to remain solvent saddled with assets that were worth less than the loans against them. All of this led to the credit market seize-up that has monopolised the attention of governments and the financial community for months.
There are continual reminders of the connection between the mortgage meltdown and the international financial crisis. Only recently, the United States government made $450 billion available to Citibank to guarantee mortgage backed securities.
If the profligate lending that led to the American housing bubble had not occurred, neither would the international financial crisis. Not all bubbles lead to such intense financial disruption. For example, the “dot.com” bubble, for all of its losses, did not lead to anything resembling the current financial meltdown.
Wise regulatory limits by Washington could have minimised profligate lending and the financial crisis would have been avoided. It could have started with raising questions when mortgage exposures exploded in the early 2000s and house prices with them. The first cause of the financial meltdown was a failure to regulate sufficiently – insufficient regulation.
Regulatory failure #2: land use policy
The second cause was also American and resulted from regulatory failure – though not too little regulation, rather too much regulation. As the incredibly easy money made its way into the mortgage market, demand increased across the United States. In some metropolitan areas, this demand led to house price increases, doubling or tripling relative to household incomes. In others, there was little price escalation at all. House price increases of this magnitude had never before been experienced.
A number of economists had noted for years the association between overly stringent land use regulation (a number of such strategies are classified as “urban consolidation” in Australia) and house price increases. Simply put, where government regulations make it more difficult for the housing market to respond to increased demand, there is likely to be inordinate price escalation. Nobel Laureate Paul Krugman noted in 2005 that the US house price bubble was restricted to areas with much stronger land use regulation, while little increase had occurred elsewhere.
Indeed, more than 80 per cent of the house price escalation above historic norms since 2000 was in the more highly regulated markets. As would be expected, the foreclosure losses in these areas were far more costly than in the areas with more traditional land use regulation. Further, foreclosure rates tended to be higher in the metropolitan areas that had experienced the largest price increases. The most intense losses occurred in Florida, California and its “spillover” markets of Nevada and Arizona, where land use planning systems were simply unable to handle the stronger demand.
Liberally regulated markets with even stronger demand had no difficulty handling the additional demand. For example, historic house prices remained within historic norms relative to household incomes in Atlanta, Dallas-Fort Worth and Houston, the three fastest growing metropolitan areas in the developed world with more than 5,000,000 population. If the more liberal (and, by the way, environmentally sustainable) land use regulations typical of most of the United States had been in place in the more stringently regulated areas, the extraordinary house price increases would not have occurred and the overall financial losses would have been far less. The international financial crisis might have been avoided. It certainly would have been less severe.
The regulatory failure was that regulations in some metropolitan areas were so strong that demand outstripped supply, driving the price of houses to new heights. Thus, the second regulatory failure was too much regulation, not too little.
Contrasting Australia and America
There are two important differences between Australia and America with respect to this issue. The first is that all major markets of Australia have stringent land use regulations, and, as a result, all major markets have experienced unprecedented house price escalation relative to incomes since 2000. In the United States, only some markets have stringent land use regulation. Australia’s housing bubble is cause for concern.
The second difference is that Australia’s financial institutions are more sound than America’s. The World Economic Forum ranks Australia’s banks as the fourth most sound in the world, behind only Canada, Sweden and Luxembourg. The United States ranks 40th out of 134, trailing, for example, Botswana, Brazil and Indonesia.
At the same time, there is rightful concern about the extent to which financial institutions may have become over-exposed in the Australian housing bubble. At this point, the cash rate policy of the Reserve Bank appears to have worked quite well. Australia may escape the pain suffered in America because Australian lenders were not caught up in the hysteria of lending to unqualified applicants and inducing them into financial payment schemes they could not meet. Only time will tell.
The bottom line
It is not at all clear, at this point, that the expensive actions being taken by governments around the world will bring a quick conclusion to the international financial crisis. Many economists continue to believe that virtually none of the government strategies employed against the Great Depression had much of an effect, which is why, a decade later, economic conditions were still very difficult. Only time will tell how wise or foolish are the responses of governments.
Nonetheless, it is well to review what the market system has produced. We have attained profound affluence that is far above anything dreamed of by our parents and grandparents. Poverty has been reduced substantially. By 2007, the nation’s gross domestic product per capita had risen to more than a four times the 1945 level and more than five times the level of 1928 (in 2008 dollars). Even now, the unemployment rate is well below 5 per cent, a fraction of the nearly 30 per cent reached during the Great Depression. No other economic system has ever come close to producing such wealth for so many people. Further, the same economic system, with appropriate corrections, will doubtless produce an even more affluent society in the years to come.
It is quite appropriate to question fundamental principles. However, any such inquiry requires a clear understanding of the context. For all of its problems, the market system has produced far better lives than we ever had before. It will be important to correct the causes of the financial collapse, to ensure that they cannot again inflict similar damage.