Crisis a valuable lesson

Published in The Australian (Sydney), 26 December 2008

WHEN Lehman Brothers went bankrupt and sent its employees home in September, someone in the firm’s London offices had a sense of humour and played an old R.E.M. song through the internal speaker system. It’s the End of the World as We Know It, the bankers heard as they packed their belongings into brown cardboard boxes. It was the swan song to an era in which many saw financial institutions such as Lehman as the masters of the universe.

In the weeks after Lehman’s collapse, the world’s stock markets went into free fall, whole countries were driven to the brink of insolvency and currencies went on roller-coaster rides. I couldn’t help but wonder what the playlist would be on the entire soundtrack to these events. For investors, there would have been Meat Loaf’s Life is a Lemon and I Want My Money Back. Stockbrokers could have swapped their Armani suits for ankle-length denim jackets and rocked out to John Farnham’s Take the Pressure Down, while governments across the world would have rummaged through their LP collections to find Billy Joel’s We Didn’t Start the Fire.

It’s definitely not the time for power ballads or love songs. As nearly all developed economies have entered recession, it does feel like the end of the world. Most pundits agree the global economy will never be the same.

There is little consensus on what will follow from the crisis. The only thing that seems certain is that we won’t return to some of the practices of the past. But is this a bad thing? And does the economic turmoil mean the end of capitalism?

Reports about the death of capitalism are nothing new but, to paraphrase Mark Twain, they have always been greatly exaggerated. In the archives of any newspaper for the past 200 years there are many pre-emptive obituaries for the free market.

They were issued during the American railroad panics of the late 19th century, the Depression in the 1930s, the oil shocks of the ’70s and the stock market crash on Black Monday 1987. These are only the most famous crises. Each time, the prophets of doom proclaimed that, this time, it really was the end of capitalism.

These forecasts had far less life in them than the markets they pronounced dead. Markets have shown remarkable resilience and keep bouncing back. Despite their flaws, they have consistently turned out to be the best way to co-ordinate economic activity. They aren’t perfect, but what is? It was Belinda Carlisle who promised that Heaven is a Place on Earth, not free-market economists.

We also can be optimistic about the future of markets and capitalism because these systems and their participants have the ability to learn. It does not mean that mistakes will never be repeated but markets can and do change when a crisis befalls them.

So what lessons does this crisis teach? The answer lies at the beginning of the US housing boom that preceded the crash now rocking the world economy. Property prices in the US rose steeply for numerous reasons. The Clinton and Bush administrations promoted home ownership for people who couldn’t really afford it. Banks were ready to give those people mortgages. Low interest rates that made repayments on super-sized loans appear manageable enticed even more borrowers. The housing market these factors created, and the vast indebtedness they supported, rested on one crucial assumption: that house prices would keep rising indefinitely.

As Herb Stein, a former economic adviser to Richard Nixon, once put it: “If something cannot go on forever, it won’t.” Rising house prices had become the economic equivalent of a perpetual motion machine. Unfortunately, in the real world there is no such thing. What went up had to come down. Falling house prices revealed how dependent the US economy had become on its property market. It was so dependent, in fact, that it had eroded private savings completely. Even worse, it had diverted investment capital from other, more productive uses into overvalued housing stock.

The crisis demonstrated what happens when banks and consumers put misplaced faith in economic perpetual motion machines. It was always an illusion that society could become ever more prosperous simply by pouring its resources into property development. Painful as the economic readjustment will be, it is nevertheless necessary to lead us back to more sustainable ways of creating wealth.

The low interest, no deposit, government-subsidised housing excesses of the past are history. But if we have understood why this model failed, we will have learned a painful but valuable lesson. And despite the present turmoil, markets remain the best mechanism we know for creating wealth. This is not the end of prosperity. It’s the end of the world as we know it, as R.E.M. sang, and I feel fine.

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