Where do the bucks stop? No one actually knows

You know things aren’t good when central banks start sloshing money into the financial system. Next, of course, come politicians’ reassurances of “sound fundamentals”.

French, German and Australian financial institutions, including funds run by the august Deutsche Bank, Australia’s star Macquariebank and France’s BNP Paribas, have got caught in the fallout from the United States lend-anything-to-anybody party.

The European Central Bank, the United States Federal Reserve Board (the Fed), the Bank of Japan and the Australian Reserve Bank shovelled out nearly $400 billion last week as banks belatedly clamped down on all but the safest lending.

But Australia’s Treasurer Peter Costello said there was “no reason why any Australian financial institution will be exposed”. President George Bush’s “the fundamentals of our economy are strong” echoed the words of his inept predecessor, Herbert Hoover, who, as the New York stock market bumped sickeningly downwards into its great crash in 1929, declared: “The fundamental business of the country is on a sound and prosperous basis.” A few days later came Black Thursday and four years later United States gross national product was nearly one-third lower.

Millions were out of work and terrible flow-on damage was done to economies around the world. Here probably two-fifths of men were out of work, bankruptcies soared, farmers walked off their land and a generation was scarred and scared into wheel-clamped financial conservatism.

Instant historians have been dusting off a centennial parallel with the United States banking panic in October 1907 which led to the creation of the Fed in 1913 to do what it did last week — in its absence in 1907 the big banks intervened, with Treasury backing, to save tottering institutions from depositors desperate to get their money out. That year the Dow Jones index dropped 38 per cent over the year — which, if replicated this year, would drop the index to a bit above its post-9/11 lows.

Of course, historical parallels do not determine outcomes. The factors are always different. Each crisis has its own coordinates.

For all the differences, however, the Bank for International Settlements warned recently there might be pre-1929-crash parallels now.

Just as in 1929, wondrous new financial instruments — “magic” was Galbraith’s word for 1929 — divorced lending and share prices from economic fundamentals. Now banks around the world are scrambling to find what bucks stop where. No one knows.

Also, as in 1929, the 2000s boom has been rationalised as a “new economy” in which old rules no longer apply. Not so.

Of course, the world economy and national economies have changed in many ways, even from the 1980s: computerisation and the rise of China, India lurching behind, are two major differences.

But there never is a magical economy. Real people have to make and deliver real goods and services. While efficient financial markets oil that process, real things don’t happen just because a fancy financier designs a brilliant new bit of paper.

There is third pre-1929 parallel. J K Galbraith argued in his eminently re-readable history, The Great Crash 1929, the Fed was remiss for not sobering up investors before the markets went wild. Likewise this decade the Fed allowed money supply to expand apace. A goodly portion fetched up with people who can’t pay it back and can’t pay the interest.

And a fair share fetched up here via the now-out-of-favour “carry trade”, fuelling a house price boom. For that a small portion of blame lies with Michael Cullen, who raised the Reserve Bank’s target inflation band at the very time when inflation would logically have been lower (thanks to China and computerisation), not higher. Another bit of blame lies with his capitulation to spending the inflated Budget surplus to win the 2005 election.

But Cullen’s current anguish, evident in his increasingly gruff warnings to house buyers and foreign lenders and in his (mainly rhetorical) canvassing of alternatives to present monetary policy, is only in small part his own making. This economy is a pingpong ball on world tides.

The huge world imbalances have to unwind sometime. That means this economy’s special and dangerous imbalances also have to unwind. The worry is that if the current financial turmoil turns bad, the unwinding might be rough in this highly indebted, very exposed economy.

There are two bits of good news.

Government debt is low (a tick for Cullen), giving huge fiscal room to smooth the bumps, and the Reserve Bank can, if necessary and willing to look through the inflationary bounce, cut interest rates a very long way.

And beneath the financial froth real people are doing real things. Bush’s and Costello’s “fundamentals” do exist, even if financial uncertainty knocks them sideways or downwards for a bit.

But actually no one knows just what that knock will amount to, not the optimists and not the pessimists. We just have to wait and see.