The Global Financial Crisis

On April 3rd 2009, I was made redundant from my job as an IT specialist with EDS after 11 years – the main reason I was given was the “current economic environment”, in other words the Global Financial Crisis (GFC). On the plus side, with termination benefits equal to two years income, I consider myself better of than those who remain - working for an American company is going to be hell in the next few years.

In the six weeks since that time, I have done a lot of research on the GFC, mainly to determine what caused it in the first place – I have come up with what I believe are the three key events which were the root cause:

If you are interested in my reasoning for identifying these 3 events, read on.

Gold Standard Abandoned

In the days before paper money, gold coins were used for trading for the necessities of life. The supply of gold is relatively stable and being a precious metal, you didn’t have to carry around a whole lot of it, even so, it was still very inconvenient, especially for large transactions. Eventually, institutions called “banks” appeared on the scene – for a small fee, banks would store your gold bullion for you and give you a receipt for same. This led to the practice of trading with the receipts only, while the gold gathered dust in the bank vault. Of course, if you wanted the physical gold for some reason, you could always take your receipts to the bank and trade them for gold bullion. Government-run central banks became the preferred storage locations for gold and national governments guaranteed the gold supply.

After World War 2, the United States of America became the economic powerhouse of the world, and the US dollar became the de-facto world currency. Everybody had confidence in the US dollar and at that time the US treasury guaranteed to exchange $35 for one ounce of gold. The US dollar and most other currencies in the world were theoretically based on a gold or silver standard.

In 1971, the United States formally revoked its guarantee to redeem US currency in gold bullion. Foreign counties were starting to redeem their US dollars in gold and by then the US had printed way too much than it could possibly redeem in gold - the US dollar then lost two thirds of its value by 1980. The US was now officially using the “fiat money” standard, that is, money that is backed up by government assurances only. I am not familiar with the arguments for and against the gold standard, but I believe this event unleashed the dollar printing presses in the US and sowed the seed for financial crisis we are now experiencing. I suspect that this was also the roots of whole plethora of non-productive industries such as currency speculation, I’ll do some more research into this subject later.

From the 1970’s to the present time the United States gradually moved from a production based economy, financed by savings to a consumption based economy, financed by debt. Factories that actually made things were moved overseas (mainly to Asia) and employment gradually moved to non-productive occupations such as financial engineering. As the US trade deficit gradually rose the US Treasury sold government bonds to productive countries in order to finance its ever-increasing consumption. The figure generally accepted for the value of US bonds currently held by China is one trillion dollars. China is very worried about the ability of the US to repay these bonds and has now discontinued buying US bonds and started increasing it gold and copper reserves instead.

To my way of thinking commodities such as copper or steel would be much more negotiable than gold, but apparently, the rest of the world disagrees with me.

A couple of interesting points:

·     The United Kingdom abandoned the gold standard after World War 1.

·     China was on a silver standard at the time of the Great Depression and was largely un-affected.

US repeals the Glass-Steagall Act

In 1933, to prevent a re-occurrence of the Great Depression, the US government passed the Glass-Steagall Act. This act imposed some restrictions on banks, that is, a bank is either a regular deposit/lend retail bank that most of are familiar with or it is a merchant bank. A retail bank could not indulge in merchant banking activities and vice versa. This gave retail banking depositors an assurance that the bank was not gambling with its money and also curtails the ability of banks to grow to a size where they would be “too big to fail”.

For reasons unknown to me, the Glass-Steagall Act was revoked in 1999, with the resulting explosion of products called “derivates”, a lot of which were house mortgages which were purchased from the original lender, packaged up with a bunch of other mortgages and sold on to investors around the world as AAA rated investments. These investment vehicles are known as CDOs (collateralised debt obligations), they spread around the globe like a cancer in an unregulated manner. In many cases these CDOs were re-packaged multiple times, each time the "packager" (usually a merchant bank) would take a hefty commission, but the risk ratings remained the same! How could the ratings agencies do this? - this smacks of criminal behaviour.

US Government Forces Interest Rates Down

In the years from 2001 to 2004, in the wake of the dotcom bubble and various corporate scandals, the US Federal Reserve gradually lowered interest rates to 1%. This had the effect of flooding the US economy with cheap money which was financed by selling Treasury Bonds to producing countries such as China. These producing countries had a surplus of US dollars anyway and what better investment could you have than a US Treasury Bond? (famous last words).

The printing presses at the US Treasury went into overdrive, one effect of this flood of cheap money was to encourage US residents who previously could not afford to buy their own home, to do so. Unscrupulous mortgage brokers encouraged buyers to borrow even more than they needed for their house so they could purchase additional consumer goods like cars and holidays. Even at these artificially low interest rates some borrowers could not see their way clear to pay their monthly payments – “no problem” said the banks, we will give you a honeymoon rate for the first 3 years and by then your house will be worth so much, who cares if you can pay or of or not? By then, house prices were increasing at 7% to 8% every year and the housing bubble was well under way. This type of loan is called sub-prime and at the time they were being packaged up into CDOs, and re-sold globally with AAA risk ratings.

By this time there was a massive conspiracy taking place between the US Federal Reserve, merchant banks and the ratings agencies that were all profiting massively from the huge financial bubble they were helping to create. There was also a revolving door between jobs in these 3 sectors and the “old-boys” network in Wall Street were raking it in.

The Situation Now

I guess everybody knows what happened next, the honeymoon interest rates on sub-prime mortgages ended, borrowers could not pay their monthly payments, a trickle of bank foreclosures turned into a flood. Housing prices collapsed, leaving other home owners owing more than their house was worth – they walked away from their properties leaving hapless investors around the world carrying the can. This had a knock-on effect we are all familiar with, bank collapses and a world wide recession.

What really worries me now is President Obama’s response to the GFC. With one notable exception (Paul Volcker) he has surrounded himself with the very conspirators that help cause the problem in the first place and is sending the country into even deeper debt and more artificially low interest rates to “fix” the problem. Bailing out corrupt financial organisations with taxpayer’s money is a big mistake in my view.

Here in Australia the government has blindly followed Obama’s lead and had just spent billions of dollars on cash handouts to Australian pensioners and taxpayers which was mainly spent on imported consumer goods or retained as savings. In my view 90% of this money was wasted – my $900 went straight into the bank and stayed there.

As I wrote the last paragraph, I stopped to listen to the broadcast of the 2009 Budget Speech and the follow-up commentary by financial analysts. The budget deficit is a record $57.6 billion, two thirds of which has been caused by additional spending rather than reduced government income. Also, apart from vague promises stretching past 2020, the promised plan to return to a surplus budget did not materialise (well- there was a plan, but its based on an assumption of 4% grown for the next umpteen years - which won't happen). So the Australian government is now part of the problem rather than part of the solution. Pumping taxpayers' money into the economy in an attempt to prevent recession, will:

• postpone but deepen the eventual recession

• cause inflation

• saddle our children and grand-children with the debt

The Future

I really don’t know which way to turn now as I believe the US economy is headed for a total collapse, this will happen when the US runs out of buyers for US treasury bonds, that could be tomorrow or in 5 years time, I just don’t know. When the US economy collapses, what becomes of Australia? I'm thinking that American companies with operations in Canada, New Zealand and Australia, will try to maximize their profits in those locations, but reduce their expenses, so outsourcing of Australian jobs to Asia will accelerate in the initial stages. Mining and agriculture will be the star performers and as wages rise in Asia, manufacturing may also make a comeback. The Chinese Yuan will displace the greenback as the global currency and China will use their 1 trillion US dollars they are currently holding in US bonds to buy American assets at bargain prices. Australian, New Zealand and Canadian resources will boom as Asians make things for their own consumption instead of exporting stuff to America.

Essay on the GFC by Kevin Rudd (Prime Minister of Australia)

In my research over the last few weeks, I read Kevin Rudd’s much publicised essay on the GFC and I basically agree with his conclusions on what caused the GFC - he did not mention the departure from the gold standard, so I assume that he agrees with that decision.

Unfortunately, 90% of the essay is an attack on his political enemies, whom he calls “neo-liberals” and praise of his political comrades whom he calls “social democrats”. This part of the essay is comical and overshadows his analysis of what really caused the GFC, which is basically correct. For example, he omits to mention the fact that it was a “social democrat” president (Bill Clinton) who signed the bill to repeal the Glass-Steagall Act or that it was a Labour “social democrat” government in the UK that 10 years ago sold of half of the UK gold reserves for one third of today’s value. On the other hand, the presidency of George W. Bush was a disaster for the world economy and Rudd is correct in attacking “neo-liberals” in that context.

The essay does not reveal where Rudd stands in relation to solving our current problems, but it does hint he is a fan of John Maynard Keynes who advocated a highly interventionist approach, which is exactly what got the US into this mess in the first place. Recent Australian government actions have confirmed this.

Mike Kelly

mike at kirrawee dot net