Critical Times

ABC Radio National
PM - Tuesday, 26 June , 2007 18:30:00
Reporter: Stephen Long

MARK COLVIN: When it comes to the economy, we’ve been living in a long boom, one of the longest ever, in fact.

All good things though come to an end, and today the central bank for central banks is warning that the world could be headed for another Great Depression.

The Bank for International Settlements says these may appear to be in benign economic times, with low inflation and strong growth.

But that was also the case before the Great Crash of 1929, the global inflation shock of the 1970s, and the Asian crash of the late 90s.

In its latest annual report, the Bank for International Settlements highlights a series of potential risks for the global economy, including irrational exuberance in a world awash with cheap credit.

Economics correspondent Stephen Long reports.

STEPHEN LONG: Central bankers are a staid lot, not known for their use of inflammatory language. So when the central bank of central banks starts drawing eerie economic parallels, it’s worth listening.

And the Bank for International Settlements has a message for the money men: ignore history at your peril.

For years now the world has enjoyed benign economic times. But in its latest annual report, the central bank for central banks notes that the same could be said about the preludes to the major economic shocks of the last century.

The great inflation of the 1970s. The Asian financial crisis of the late 90s, and the Great Depression of the 1930s.

Each downturn, it notes, was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest a “new era” has arrived, just like today.

Dick Bryan is Associate Professor of Economics at the University of Sydney, and he says it’s a timely warning.

DICK BRYAN: Well, there’s no higher authority in the world than the Bank for International Settlements, the so-called central bank of the central banks.

They have the big research facilities available to them, they have access to all the international data, so if they make a call we should sit up and listen.

It’s not a terribly precise statement, but they’re giving a signal that a downturn could be around, that things are shaping up perhaps like they were before the Great Depression, or the 1960s before the slump of the 70s.

We should all be taking notice.

STEPHEN LONG: As Professor Bryan notes, the BIS is not saying a crash is around the corner.

DICK BRYAN: No, I think they’re saying, look, if a whole lot of things line up negatively, then cumulatively it’s going to be a bit of a catastrophe. The odds of them all lining up that way are quite long.

But nonetheless, what it does tell us is that financial markets around the world are fragile.

STEPHEN LONG: Do you get the impression when you look at this warning from the central bank of central banks what’s being said by players in financial markets as well, that everybody who has an understanding of what’s happening in the world economy knows that there are risks building right across the board, from households running up debt through to the huge levels of leverage that people are using to make money in the good times, but everyone just keeps on saying, well, we’ll close our eyes, take a deep breath, and keep on enjoying it while we can?

DICK BRYAN: Well I think there is the notion that when markets are said to be efficient, it also means they’re on a bit of a knife edge. Yeah, there’s not a lot left in reserve, that they’re running as fast as they can.

So anything that’s running as fast as it can is always going to be a little bit fragile, and I think what the BIS is saying here is let’s name those fragilities.

So we’ve got a lot of investment funds out there around the world flooding into markets, prices keep going up. Let’s not get complacent and say it’s always going to be thus, cause it is the good times in financial markets, but good times don’t last forever.

STEPHEN LONG: But the Bank for International Settlements fears that investors are turning a blind eye to this, and displaying irrational exuberance about good economic times.

It’s annual report notes:

“There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, more collateral, and, in turn, more risk taking. The danger with such market processes is that they can, indeed must, eventually go into reverse if the fundamentals have been over-priced.”

No one knows when that will happen. But the Bank for International Settlements cites a confluence of risks.

These include the prospect of rising global inflation, as energy prices rise and the era of cheap exports from China wanes.

Its also concerned about the possibility that China and the emerging economies of Asia could stop funding the huge US current account deficit

And its worried about the enormous growth in exotic financial investments known as credit derivatives – markets in which speculators are buying and selling high-risk debt and making money out of the risk of default.

That risk is manifesting right now in the US, where hedge funds owned by the big investment bank Bear Sterns are in danger of going under.

They’re exposed to the fallout of the US mortgage meltdown to the tune of more than $US10-billion.

It’s a fraction of the two trillion dollars in securities backed by risky US sub-prime loans. So far, the risk has been contained. But for how long?

MARK COLVIN: Economics Correspondent Stephen Long.