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Wednesday 23 Aug 2017 | 18:39 | SYDNEY
Wednesday 23 Aug 2017 | 18:39 | SYDNEY

Things I have changed my mind about this year

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18 December 2008 14:40

The big thing I have changed my mind about this year is the severity of the global financial crisis, a process which has involved a continuing re-evaluation of just how bad things were going to get, and just how wide-ranging the consequences might be.

When New Century Financial  – the second largest sub-prime lender in the US – filed for bankruptcy on 2 April 2007 (shame it wasn’t 1 April, really), I had no expectation that the problems in the US subprime market would turn out to be the trigger for the biggest international financial crisis since the 1930s. 

Like many global economy watchers, I was surprised by the virtual disappearance of risk premia in financial markets and was sure that those markets were mis-pricing (or maybe just failing to price) risk. I had also taken note of the warnings of a housing bubble in the US (and elsewhere). But the issues I was worrying about for much of 2007 were global imbalances, a backlash against globalisation arising more from its successes than its failures, and signs of some irrational exuberance as far as emerging market risk was concerned. 

So when the IMF’s John Lipsky spoke at the Lowy Institute in July last year, his cautiously optimistic assessment of the likely consequences of the prevailing financial market volatility did not strike me as unreasonable. The crisis rolled on, and in November 2007 I wrote a paper trying to think about what some of the lessons from recent events might be. 

Re-reading that piece now, I’m still fairly happy with my analysis of some of the things that had gone wrong, and with most of the lessons I drew, although my cost-benefit analysis of structured finance would be much harsher today. But while I did note in that paper that the crisis was rumbling on, and that there were likely to be more lessons to come, I had no sense of just how dramatic things were going to get in 2008.

By about March this year, I started to catch on. It was becoming clear that the subprime crisis was going to produce some fairly dramatic changes in the world economy, a theme I touched on in one of our regular Wednesday Lunch talks at the beginning of that month. I even proposed a series of dates linked to the subprime crisis that would mark the birth of a new, new global economy. 

But at that point I still saw the crisis as just one of a series of developments leading to a shift in the world economy, rather than being a game-changer all on its own, and one that would lead to dramatic changes in some of the other factors I was talking about (for example, by providing a new lease of life to the IMF or by turning the commodity boom into a commodity bust). Over the next few months, that changed. 

In fact, by the middle of March we had already seen the fire sale of Bear Stearns to JP Morgan, a dramatic signal that the financial crisis was worsening, not moderating, and I jokingly warned my colleagues to hunker down for the financial apocalypse. By now I was also becoming more worried about the real-economy consequences of the crisis, noting that work on past crises suggested output declines were likely to be both large and protracted. 

Increasingly, however, I was also thinking about another crisis – the global food crisis – which was harming millions of the world’s poorest and threatening to undermine political and economic stability across a range of developing economies. So when in July this year I started to work on a new Lowy Paper, it was the food crisis, rather than the financial crisis, that I chose as my topic (that paper, The Spectre of Malthus: Lessons from the 2007-08 food crisis, will now be published next year). 

As the food crisis peaked – at least in terms of food prices, if not on other indicators – the financial crisis continued to worsen and the September 2008 failure of Lehman Brothers catapulted it into a new and even more dangerous stage. After 15 September, I think it became obvious to pretty much everyone that the world had changed.

In my November 2007 piece on the subprime crisis, I argued that one key lesson to be drawn was that ‘It’s never different this time’. My point then was that financial or credit cycles are always with us, as are manias, panics and crashes. It’s just that the assets at the heart of the story – be they emerging market debt, dot.com stocks, or real estate – tend to change. 

I still think this is right. But in another sense I was quite wrong. The sheer magnitude of the crisis, and the unprecedented scale and nature of the policy response we have seen, mean that it really is different this time.

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