Are we headed for another economic big bang?

The Deputy Prime Minister, Ken Henry, believes that Australia is headed for a China fueled resources boom that will last to 2050. I still have in my garage a redback spider infested copy of the Australian Financial Review from well before September 2008 that had then BHP boss Chip Goodyear also predicting that the commodity price boom would last for decades.

The economic policy debate in Australia has shifted very quickly following Henry's remarks. The issue now is how this coming boom should be managed. The debate is being led by two big hitters, with Henry pitted against Ross Garnaut. The latter warns that the boom threatens to distort the Australian economy and will lead to unsustainable current account deficits, thus preventing a resources lead escape from the boom-bust cycle. This point, as we shall see, is crucial.

Even if Henry should prove to be correct, notice that any long term escape from the business cycle would not be due to the structure of the Australian economy itself. His case depends upon what is happening in the global economy.

There seems to be an underlying presupposition that another big boom is on the horizon. The current debate concerns its longevity, its impact and how best we can benefit from it. But could we instead be heading for another global financial bang?

We tend to think that the current crisis is sui generis that's why we call it "the" rather than "a" global financial crisis. I think, however, that the crisis of 2008-2009 should be dubbed "global financial crisis 2.0".

We have been through a post-depression global financial crisis before this one; in fact that crisis subsists underneath the contemporary one. This is known as the global debt crisis. We don't notice it because it affects primarily the world's poor and has done so for decades.

In the late 1970s western private and multilateral borrowers extended credit to third world countries on a grand scale. It was assumed, Ken Henry like, that the world was headed for a commodities boom. At the time Malcolm Fraser was pinning his hopes on this supposed boom to ensure longevity of government in the face of a resurgent post Whitlam Labor Party.

It was felt that third world debtor countries would be able to pay back these loans on the back of rising commodity prices, given that they relied upon commodities to maintain favourable terms of trade, much like Australia. Instead, commodity prices went into decline and, subprime mortgage like, many developing countries were not able to meet their debt obligations. Some were on the verge of default (read foreclosure).

This threatened to unravel the entire financial system of the West. Because the debt crisis affected the developing world and threatened the global financial system based in the developed world it would be fair to call this a global financial crisis. The financial system, like today, was essentially bailed out.

This bailout involved extending further loans to third world countries multilaterally through the IMF but also bilaterally making these countries even more indebted.

Ultimately, however, the bailout took the form of IMF imposed "structural adjustment programs" designed to extract capital from the developing world and then funnel it back to the western financial system. These programs were based on enforced neoliberal economic policies that were highly contractionary. The affect on the poor was devastating.

Structural adjustment programs were put in place despite the fact that these loans constituted "odious debt". Most of the debt was not used for economic development projects but rather went into the pockets of grossly unrepresentative and corrupt regimes. Yet it was the poor who were basically slugged with the duty of repayment. What happened was that the rich of the West and the rich of the Third World engaged in a fancy little game which involved offsetting risk to the poorest of the poor.

This offsetting of risk is known as moral hazard. What lies at the core of the global debt crisis is the "too big to fail" syndrome. There have been other financial crises since the advent of the debt crisis such as the Savings and Loans crisis, the Asian financial crisis as well as a few others smaller in scale.  These were not truly global although perhaps we could argue the point on the Asian crisis. Again moral hazard loomed large in all of these.

In the wake of the current global financial crisis we are told that regulators will address moral hazard. Surely only the wayward Electric Monk of Dirk Gentley's Holistic Detective Agency could possibly believe that.

Consider for instance Barack Obama's financial industry friendly toxic asset relief program. The best characterisation of this is due to Joseph Stiglitz who called it "ersatz capitalism". Stiglitz reveals that, "What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses" which has "perverse incentives, worse even than the ones that got us into the mess".

Moral hazard is very important for the future given that GFC 2.0, to a very significant extent, can be described as a global market failure arising from a global externality. Crucial to the development of this externality was the under pricing of risk by financial institutions. That is to say, systemic risk was under priced from the point of view of society. From our perspective rational financial market entities took on far too much risk, enabled by both deregulation and lax regulation, in the pursuit of dazzling short term profits.

Whenever we have moral hazard systemic risk will be under priced by financial markets. It seems that future regulatory reforms won't have many teeth. One important measure would be the break up of the large financial institutions. For instance, we might once again seek to separate run-of-the-mill banking from investment banking. However, the British Prime Minister, Gordon Brown, has rebuked the head of the Bank of England, Mervyn King, for suggesting this.

You just know that we have come to a pretty pass when the Bank of England lies to the Left of the Labour Party.

Recognising the presence of an externality does not necessarily tell us much about its underlying cause. The best causal explanation that accounts for GFC 2.0 is the Post Keynesian financial instability hypothesis of Hyman Minsky. The current crisis is an example of "debt-deflation". We should not place too much store on the "global imbalances" theory. One of the purposes of a well designed and regulated financial system is to manage imbalances in savings.

One important facet of Minsky's work concerns what he called "financial simplification". Measures put in place to avoid a repeat of the Great Depression given financial instability effectively set up conditions for the next crisis, possibly leading to a series of crises of increasing severity. This is because in a depression scale contraction excessive debt is wiped out hence leading to "simplification" as financial markets become correspondingly less complex.

We were indeed headed for a Great Depression era level contraction this time but for a whole raft of globally co-ordinated government measures that were truly grand in scale.

But are these measures in fact setting us up for a bigger bang given the absence of simplification? The most important thing to do now is to lower private debt levels, which are far too high. Public policy should be directed towards facilitating this. Good high paying full time jobs developed through a strategic industry policy would help by boosting incomes. Greater consumption should be a function of wages growth not rising debt and property bubbles.

Debt-deflation in the US has had class war right at its core. Since the 1970s real wages for non-supervisory workers have largely been stagnant, despite rising labour productivity. Workers are more productive but the proceeds have gone to the rich. In order to maintain the American dream US workers have relied upon a mountain of debt.

But the Henry debate suggests that our focus should be elsewhere for it's all about what to do with the boom which is but around the corner, if not already underway.

In Australia our leading economic thinker, Steve Keen, continues to put prime importance upon reducing private debt and he continues to be ignored as he was during the "age of prosperity". We might suggest a kind of big bang theory. When Keen is being ignored a big bang is coming.

The Henry thesis would actually make matters worse. This is because a resources boom would lead to Australia becoming hooked on foreign debt to finance the extraction of minerals and energy for export. It is this that, counter-intuitively, leads to high current account deficits as Garnaut points out. The Henry-Rudd strategy will massively increase private debt.

In addition, we seem to be in the midst of two bubbles. One is global which actually includes commodity prices and the other is local, which also includes property prices. The commodity price bubble has been superbly documented by Nouriel Roubini and our bubble by Kenneth Davidson. These bubbles have been fuelled by public policy.

Moreover, in Australia we have a real estate market geared towards investors not home buyers. A lot of the Rudd Government's policies can be read as an attempt to sustain the property bubble, which was reinflated by the tax payer guaranteed financial spivs rebuying property in the affluent suburbs of Melbourne and Sydney. Remember when Mark Latham was attacked from all quarters for suggesting that we get rid of negative gearing? In his diary he called the property boom a "spivs paradise". Latham could have been a great Labor leader, but despite the bravado he never really had the courage of his convictions.

The new bubbles got started when all those stories started to appear in the world’s financial press about the return of “an appetite for risk”. Of course, the appetite should return following the bailout. That’s moral hazard.

If we put moral hazard, no simplification and thereby no significant deleveraging in the context of a renewed appetite for risk, together with a purposely inflated series of bubbles (perhaps including in China) then we might have a case for global financial crisis 3.0.

We should note that we could have a ticking time bomb because a good part of all those toxic assets remain hidden in the balance sheets of US and especially European banks. The system can still crash.

Since the 2007 election, and probably a bit before it, Brand Rudd has dominated Australian political life. This domination has been based on stratospheric poll numbers. In fact, those poll numbers were always the only thing going for him. His leadership of the Labor Party is based on nothing else.

The problem for Rudd is that his very high poll numbers are not real. I submit that they represent a bubble for they are based on spin control and a pathetic opposition. If Rudd is Labor's chief asset then the Prime Minister is really an asset price bubble. We all know now what happens when an asset price bubble bursts. Labor's lead in the polls can fall rapidly because Rudd is a flaky.

For Labor the Rudd bubble coexists with a bubble in the economy. If the bubbles in the economy burst again then the Prime Minister is finished because the Rudd bubble is now indexed to the economic bubble.