David Llewellyn-Smith - The Great Crash Of 2008

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On the morning of 30 September 2008 I handed the Garnaut Climate Change Review to the Prime Minister of Australia, Kevin Rudd. The review had absorbed the majority of my waking hoursand quite a few more for eighteen months.

The Prime Minister at first mainly wanted to talk about a cataclysm in financial markets. Overnightthat morning Australian timethe New York Stock Exchange had suffered its largest ever points fall in a single day and all of the media talk was of collapse of the international financial system and of imminent global recession. Certainly when it was time for us to meet members of the media, the financial crisis was in the forefront of their minds.

In other times, I would have closely followed the unravelling of global finance as it was happening, as international money is one of my oldest and closest professional interests. In 1998 Ross McLeod and I had published the first book on the Asian financial crisis, but this new crisis had crept up while I was submerged in my preoccupation with a diabolical long-term policy problem.

I had a lot of catching up to do. After three months intensive discussion of the climate change review, I began reading the serious things that had been written about the financial crisis. Melbourne University Publishings Louise Adler came across me at this time and said that the subject needed a book that pulled it all together. Glyn Davis, the universitys vice-chancellor, added his weight to the call.

So then I had to write it, quickly and in an unconscionably busy life. Fortunately David Llewellyn-Smith had just created some room in his own professional life by selling The Diplomat, the international affairs magazine that he had founded and run through a successful decade. David had followed international finance in the magazine, and was assiduously following the news through the blogs and other channels. We found ourselves in long con versations about the clever money that was coming undone. Here was rich complementarity!

The rest, as they say, is history. The publisher kept reminding us that readers were anxiously waiting for the answers to their questions. And here they are, six months after the books conception.

Ross Garnaut

University of Melbourne

August 2009

Like the cave paintings of Dunhuang, the thoughts that are captured in a book have been partially formed in many minds, and transmitted backwards and forwards by voice or script through many channels before taking their final shape. Rosss thoughts on these issues have been formed over many decades through interaction with old and current colleagues at the Australian National University and the University of Melbourne. Davids were strongly influenced by the productive interaction with many contributors to The Diplomat, and many other interlocutors during those years and since.

We would like to acknowledge the special assistance of a number of people for insights and for gathering the material that is the empirical flesh of the book: Philip Bayley, Andrew Boughton, Kym Dalton, Matthew Hardman, John Hampton, David James, Brian Johnson, Alister Maitland, Graham ONeil, Ian Rogers, Bernard Salt, Christopher Selth and Grant Turner. Sui Lay, a graduate student at the Melbourne Institute, University of Melbourne, gave us valuable assistance with data. We thank Veronica Webster for library research and other support.

We are grateful to colleagues and other friends who discussed ideas at length or commented on drafts, including, Max Corden, Andrew Charlton, Peter Drysdale, John Garnaut, Jill and Michael Lester, Justin Lin, Sri Mulyani, Steve Sedgewick, and participants in the seminar at the Melbourne Institute of Applied Economic and Social Research at the University of Melbourne.

Ross thanks Jayne for sharing it all again. David thanks Belinda for her support and endurance through authors widowhood.

Ross Garnaut

David Llewellyn-Smith

Many articles and books have already been written in search of the cause of the Great Crash of 2008. In reading these, we are reminded of the old Indian story of the blind men seeking to describe an elephant. One blind man feels the trunk and says that an elephant is like a snake. One feels the tail and disputes the serpentine explanation. No, he says, an elephant is like a rope. One puts his arm around a leg and likens an elephant to a tree. One feels a large ear and says that an elephant is like a fan.

A phenomenon as complex, large and damaging as the Great Crash of 2008 has many parts. This book seeks to describe the whole elephant.

There are Boom and Panic explanations for the crisis. Financial euphorias and crises have ended in recession and depression since the emergence of capitalism in Western Europe in the seventeenth century. Some economists have noted the increasing frequency and severity of major financial crises in recent decades. For them, the Great

To this we can add the more recent views of the behavioural economists. They observe that humans are not always the rational, calculating beings familiar from economic texts. Individuals tend to run with the herd, behaviour that was hard-wired from human experience long before the origins of the modern market economy. The herd behaviour exaggerates the booms and also the panics, as well as the contractions that follow.

There are Global Imbalances explanations for the crisis. At first the imbalances were principally between English-speaking (Anglosphere) Old economics says that such large imbalances end in tears, especially for the deficit countries. We saw it in the lead-up to depressions in the 1890s and the 1930s. Something would happen to make it hard to fund the deficits, and this would force a huge contraction. In the modern era of floating exchange rates, many economists said that imbalances didnt matter anymore. The Global Imbalances theorists say they do, and were an important cause of the Crash.

There are Clever Money explanations for the crisis. These propose that the modern world of complex finance and its many new financial instruments, all managed on an incomprehensible scale, were an accident waiting to happen. Astute observers of the financial markets argue that the people introducing Clever Money neither understood, nor wanted to understand, its risks.financial instruments contained risks that were bound to lead to a collapse.

There has also been considerable discussion of the role of Greed in the Crash. Reduced moral standards in financial markets and weakened constraints on private enrichment created risks for others. This explanation has been emphasised as a causal factor by new Christian Social Democratic leaders in the Anglosphere, notably Barack Obama in the United States and Kevin Rudd in Australia. These leaders came to office after the first whiff of rotten finance wafted from markets in early 2007.6

Booms and Panics, Global Imbalances, Clever Money and Greed are all part of the story of the Great Crash of 2008. The elephant takes its form from the way in which these four parts fit together.

The Anglosphere asset booms that preceded the Crash were encouraged by a long period of historically low interest rates in the 1990s and even lower beyond the millennium. Fiscal and tax policies, demographic shifts and migration exaggerated the boom. The illusion of wealth created by the asset booms drove a huge consumption binge. This was part of the story of the large growth in imports from Asian developing countries that specialised in exports of low-cost manufactured goods. Over time, as Anglosphere nations spent more than they earned, they developed large balance of payments deficits. These were matched by equally large surpluses elsewhere, especially in the export-oriented developing economies. These surpluses were then lent back to the Anglosphere, further extending asset inflation and completing what seemed a virtuous cycle.