9.3  How financial and economic crises came out of the blue: three examples (3.1)

Three examples support the warning that financial crises can come out of the blue (or at least take countries by surprise despite warning signs) and do serious harm to the wider economy. They also illustrate that markets left to their own devices cannot always be relied upon to avoid the consequences of imprudent behaviour by entrepreneurs, investors and financial institutions and that the costs of regulatory or other policy inaction can be very high.

Ireland – how the Celtic Tiger feasted on debt and got a nasty case of indigestion

Ireland earned its “Celtic Tiger” label based on its stellar economic performance over 1994 to 2001. This consisted of rapid, productivity-driven and export-oriented output growth with little inflation. Ireland's position within the European Union, its strong growth in inward foreign direct investment and a ready supply of skilled labour boosted growth in modern, hi-tech sectors.

Things began to go wrong from around 2003 and culminated in the shock set off by the GFC in 2008. Associated with low interest rates from Euro membership and easy bank credit, the Celtic-Tiger economy became overlaid with a domestic property and construction boom. This proved to have strong bubble elements. Developments in this period included:

• Rapid credit growth fuelled spending on housing, commercial real estate and consumption.
• An explosion in the NFL of the Irish banking system provided funding.
• Property prices and construction activity grew rapidly.
• Property investors maximised tax breaks.
• Windfall tax revenues led to rapid growth in public spending.
• The real exchange rate appreciated and the tradable sector contracted.
• The current account moved strongly into deficit.

When the global crisis struck, Ireland's property-exposed banks suffered a hard landing taking the rest of the economy with them. This featured:

• A shuddering halt in the construction sector.
• GDP growth falling from +6% to -7% in two years.
• House prices declining approximately 50% (more for development land).
• A collapse in investment.
• Government intervention to guarantee Irish banks and rapid falls in tax revenue, which turned the bank crisis into a fiscal crisis and eventually into a liquidity crisis for the government.
• Big job losses and a large jump in unemployment.
• Very large fiscal deficits and large projected increases in public debt.
• A series of tax increases and harsh cuts in public expenditures including public-sector wages and welfare benefits.
• The reliance of Irish banks – increasingly unable to access private wholesale funding markets – on the European Central Bank and the Irish central bank for funding.
• Ireland forced to seek and accept an EU/IMF 85 billion euro rescue package with conditions on fiscal consolidation and other policy settings.

Ireland is still far from being out of the woods. While the rescue package should go a long way to meeting its short- to medium-term liquidity needs, and exports are doing reasonably well, the path of recovery is uncertain and likely to be long and hard.

The lessons for Ireland are:

• Celtic Tiger-type growth is good; debt, property and consumption-fuelled growth is bad.
• The costs of a banking crisis can be very high.
• Institutional reforms (both regulatory and fiscal) are required to ensure “never again.”
• The overhang of high debt means a tepid recovery in domestic spending.
• “Internal” devaluation through price and wage adjustment is a slow process, but likely to be faster in Ireland than in less flexible Euro economies.

And for New Zealand specifically:

• New Zealand enjoyed the debt, property and consumption fuelled growth but missed the positive, Celtic Tiger elements of strong export and foreign investment growth
• The high and still rising debt overhang is a major problem, as are the structural and other weaknesses in the economy.
• New Zealand faces a slow and potentially very difficult adjustment and recovery process – but at least we missed out on the worst of the banking crisis.

How sub-prime mortgages in the US triggered financial mayhem and a large economic shock

The strong growth of sub-prime mortgages from 2001 to 2006 was a feature (in part cause, in part consequence) of the US housing bubble.

Features of this period of unsustainable credit growth, asset-price inflation and consumption included:

• The price of a typical US house increased 124% between 1997 and 2006.
• Median house prices in the two decades prior to 2001 were around 3 times median household incomes. This ratio increased to 4 in 2004 and 4.6 in 2006.
• US household debt in 2007 was 127% of household income, up from 77% in 1990 (NZ household debt grew to 160% of household income in 2009 from 80% in 1994).
• Foreign funds flowed into the US on a large scale, banks provided easy credit, household saving fell (equity withdrawal played an important role), and the US current account deteriorated.
• Market participants sought higher yields without adequate appreciation of the risks and failed to exercise proper due diligence.
• Weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and excessive leverage combined to create vulnerabilities in the system.
• Policy-makers, regulators and supervisors failed to adequately appreciate and address the risks building up in financial markets, or keep pace with financial innovation and its systemic ramifications.

From their peak in 2006, US house prices began a sharp descent, foreclosures climbed rapidly, and the value of the trillions of dollars worth of mortgage-backed securities began to look increasingly shaky. Despite the hopes of many for a “soft landing,” the negative momentum continued to build. Large investment banks and other important financial institutions began to bleed red ink. All this came to a head in the latter half of 2008 with the failure of Lehmann Brothers, and a banking liquidity crisis that suddenly cut the supply of credit to businesses globally. The crisis plunged the world into economic recession from which it still struggles to recover. Even today, up to quarter of US homeowners and/or mortgage holders are in negative equity.

Some of the lessons of the crisis in the view of critics such as Warren Buffett, Paul Volcker and Joseph Stiglitz are:

• Housing and other asset prices can fall dramatically.
• Free and open financial markets supported by sophisticated financial engineering cannot be relied on to support market efficiency and stability, or to direct funds to the most profitable and productive uses.
• Economic imbalances, such as large trade deficits and low savings rates indicative of over-consumption, are not sustainable.
• There were flawed incentive structures and inadequate regulatory systems. Policies to de-regulate banking, and allow self-regulation of investment banks proved costly failures.

How New Zealand suffered the worst hangover in the OECD after the 1987 share market crash

New Zealand is no stranger to financial crises that have damaged the economy. The October 1987 crash hit stock markets around the world but in New Zealand the impact was compounded by a business environment highly dependent on debt and dubious financial engineering. The fall in share prices in New Zealand (60%) was the largest amongst developed-country share markets and recovery to pre-crash levels took longer than elsewhere.

Some features of the pre-crash market mania included:

• Banks provided easy credit including for share purchases following the 1985 to 1987 financial deregulation.
• Rising share prices attracted many non-traditional investors.
• The share boom allied with America’s Cup fever drove prices relentlessly upward – the Barclay’s Index rose over 100% from the beginning of 1986 to the close on Friday, 7 November, in the same year.
• High interest rates (the 5-year government bond rate stood around 16% in November 1986) did not deter eager share investors leveraging their purchases.

Share prices and commercial property values collapsed after the share price crash of 20 October 1987. While the crash was by no means the sole cause, the New Zealand economy entered a prolonged recession (GDP per capita declined at an average annual rate of 1% from 1987 to 1992).

The backlash and loss of trust in financial assets and issuers continues to this day. The New Zealand share market's capitalisation as a share of GDP fell below 40% and has languished there while in other countries it has grown.

The disillusionment set the scene for the subsequent boom in direct investment in residential property.

An important lesson is that sweeping away the old, pre-1984 financial-sector regulation did not lead to an optimal regime. Rather, it swung incentives and behaviour to non-transparency, excessive risk-taking, poor advice and a lot of suffering on the part of savers and retail investors. The consequences have been felt for many years.