After the crisis Paper presented to Whitlam Institute Series on the Financial Crisis, 23 July 2009

John Quiggin Federation Fellow Risk and Sustainable Management Group, Schools of Economics and Political Science,University of Queensland

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The magnitude of the crisis Worst global contraction since the Great Depression Some countries experiencing 10 per cent output loss (or more) Iceland Ireland Latvia All free-market darlings a year ago Huge losses in financial systems

Australia’s lucky escape (so far) Some good management Previous crises produced more cautious bankers, more aggressive prudential regulation RBA discouraged asset-based speculation (compare Greenspan) A lot of good luck Four pillars = limited competition = less motive for risk-taking Current account deficit = limited pool of savings = less means to invest in toxic assets Deposit guarantee – a close shave Big risks still ahead House prices, foreign debt

Some dead ideas The Efficient Markets Hypothesis Financial markets provide best possible estimate of asset values, hence best guide to investment decisions The Great Moderation Macroeconomic outcomes from late 1980s better than any previous period Trickle-down economics Growing inequality not a problem, since everyone benefits Together, these ideas provided the basis for: limited financial regulation, laissez-faire attitude to financial innovation massive growth of financial sector

Navigating the crisis Extensive guarantees Failure of quasi-guarantees, limited guarantees Replacing failed markets Bond insurance, car finance Massive fiscal stimulus More likely to be needed Rebuilding household balance sheets Debt transferred to governments

After the crisis Rebalancing private and public sectors Tax, expenditure and public debt Savings and investment Guaranteeing financial stability Taming the global financial system

Rebalancing private and public sectors Big expansion in public sector needed in response to crisis Permanently expanded role needed after crisis The state as the ultimate risk manager Need to expand services sector, while contracting financial services

Tax, expenditure and public debt Return to surplus to stabilize public debt Demand for public expenditure will continue to grow More tax revenue the only solution Obstacles to higher taxes have diminished

Savings and investment Public investment in infrastructure has played a key role in responses to the crisis Reversal of previous trend to reliance on the private sector This is likely to continue End of PPPs, partial reversal of privatisation Rebalancing with more private saving, more public debt

Guaranteeing financial stability Have shifted from quasi-guarantees to explicit guarantees No going back Either explicit guarantees or explicit exclusions from guarantee Guarantee without tight regulation = moral hazard Permeable boundaries = regulatory arbitrage Links from savings banks to investment banks = systemic risk

Narrow banking Sharp distinction between guaranteed/protected institutions (banks) and unprotected non-banks (shares, managed investment schemes) Banks fully guaranteed with a defined set of allowable investments, low-risk allocation of funds. Non-banks have limited regulation to prevent fraud, manipulation Government commits not to bail out bad investments Sharp separation between banks and non-banks No cross-ownership No cross-marketing No/limited exposure through loans and other finance

Taming the global financial system Need to reduce size of financial sector in all dimensions Share of employment Share of profits (including remuneration of senior staff) Value of short-term financial flows Gross and net value of obligations Political and economic influence Tighter national regulation New global architecture Tobin tax

Crisis and opportunity Finance-driven era resulted from failures of social democratic policy in the postwar period Stagflation Financial instability Fiscal crisis of the state A chance to get things right this time around

After the crisis Paper presented to Whitlam Institute Series on the Financial Crisis, 23 July 2009