The Ponzi mania: free markets, free trade, free ride?

The wealth effect was a particular feature of the residential mortgage business. Funds were available from many new banking and non-banking sources, including hedge funds and private equity, as well as pension and mutual funds; and sources that, in their magnitudes, were new, such as the carry trade. Funds marketed wholesale and retail mortgages. Liability could be shifted even or especially for debt in the deepest sense sub-prime.

Mortgages also enabled homeowners to expand consumption through mortgage-equity withdrawals (MEWs). In a real sense, MEWs were symptomatic of multitudes of individuals - and, in effect, whole societies - high-living it off their capital. That enabled a process of growth that was both irresistible and inherently unsustainable.

However, the Ponzi scheme to shame all others may yet be waiting to deliver its coup de grace. One commentator has drawn attention to “the bad news [which] is the 500 trillion derivatives market”. He says that “This is an area that the general public does not even know exists. Few professionals understand this market. There is no regulation as government just let it go … and go it did. You must expect a 5 per cent default problem. That is a 25 trillion number … It can create insolvent institutions all over the world … It is the making of the first global depression. The world is not ready.”

Australia is not ready either. Prime Minister Rudd told us late in March that Australia’s economic prospects remain "sound, strong and good". The RBA shares that view. Eerily, they echo President Hoover in 1929.

Australia’s situation contains some positive features. High commodity prices, it can be argued, are likely to persist, even though volatile, at least in the short term. A member of Iceland’s central bank board recently said that “fears of a meltdown in my sub-arctic homeland are vastly overblown. True, the current account deficit was 16 per cent of GDP last year, but that's an improvement from more than 25 per cent in 2006. And while net private-sector debt is about 120 per cent of GDP, there is virtually no public debt in Iceland. This is largely the result of unparalleled political stability and continuity."

Australia’s situation may not be as dire as Iceland’s; or indeed as dire as that of the United States or New Zealand; but all three of us have some negatives like those of Iceland. Like all booms of such size and speculative character, the Australian housing boom must soon demand payment of its account. From their peak, prices could fall 30 to 50 per cent. BIS Shrapnel does not agree; but we must expect that our housing boom, even more robust than the American, will collapse along the same general lines as the bust occurring right now in the United States.

The high “unaffordability” of housing for the average home-seeker, as distinct from speculator, suggests that the bust will be savage. The real-estate, building and associated industries will suffer severely, with massive job losses. Simultaneously, profitable investment opportunities elsewhere may have vanished with the widespread collapse of the “financial services industry”.

How likely is such a collapse? So far, although some non-banking financial institutions have gone to the wall, the four major banks have seemed largely immune. "The take-up of the Australian economy is still good," Mr Rudd said last week in New York. Australia had "limited exposure" to the sub-prime mortgage woes that erupted in the United States last year, he said. "We have excellent balance sheets in terms of our principal corporates and the banks themselves … The default rate in Australia is minuscule by Organization for Economic Co-operation and Development standards."

We don’t know how far banks and other potentially exposed institutions have concealed their liabilities and to what extent and how soon they will be forced to reveal whatever bad news there is. Within this broad question, we also do not know how far they are exposed to losses from the massive and still largely mysterious menace of derivatives.

In some measure, Australia’s major banks have certainly been involved in the wide range of structured securities - CDOs, SIVs, and the rest. A report on April 4, 2008 that local New South Wales councils have lost $US200 million and perhaps up to $US400 million on investments in CDOs is a worrying sign that other and even bigger losses may yet be revealed in a variety of institutions, including banks.

It seems scarcely credible that an economy which, for so many years, has absorbed so much of American theory and practice - so much of the American financial character - can be wholly immune from the penalties inflicted on its American model.

The sub-prime crisis first hit the United States after a housing about-turn which began as far back as 2005 or 2006. An unequivocal downturn in housing in Australia has yet to check in; but non-bank lenders are already withdrawing from the market. Wholesale mortgage lenders are closing shop, perhaps as a prelude to a sharp housing decline.