The GFC: How we got into this terrible mess

But the first half of 2008 saw an unending stream of bad news coming out of the world economy. In a nutshell, US house prices were falling month after month, a significant number of US households were defaulting on their mortgages, and this was in turn causing banks to get into difficulty.

But instead of US banks being the only ones hit by these defaults, foreign banks and others were hit. US mortgages had been parceled up into securities – securitized – and sold on to willing buyers across the globe.

The ultimate holders of defaulting US mortgages turned out to be banks in the UK and elsewhere, pension funds in places like Norway, and others. And the size of this problem was enormous. Initially estimates of defaults in the range of $600 billion seemed scarily high, but estimates now of the size of these losses range from $2 to $3 trillion – which is roughly three times the size of Australia’s annual GDP.

The collapse of Lehmann Brothers in September last year brought home to all the fact that almost any global bank might be made bankrupt, and the global economy ground to a halt. Without banks lending to other banks, or to corporate customers, the global economy simply could not function properly, and many economies that until then had been relatively unscathed began to feel the pinch. This is when the GFC really hit Australia, and other countries in our region.

In Asia exports to the US and Europe went into decline and economies as diverse as Singapore, Hong Kong, Thailand, and Korea went into recession. Even China started to suffer from a slowdown in its growth, especially in the export centres such as Guangdong province in the south of China. Australia was hit by declining demand for our exports as well as falling prices for these exports. This hit the economies of Queensland and WA especially hard. But banks were struggling, and their unwillingness to lend to businesses slowed down the economy across the board.

In the last quarter of last year it became clear that the Australian economy was not going to escape the GFC, and that the government needed to take action. Unemployment had already risen to 4.5% but it looked like rising a lot higher. The government and the RBA took a number of steps to shore up the economy. Bank deposits were guaranteed, stopping the flow of funds out of the banks and helping them to keep lending. The RBA cut interest rates, which are now 4.25% lower than in September last year. And the government announced $10 billion of cash handouts to try and stimulate spending by households. Eventually further handouts and a heavy spending budget were announced to provide further support for the economy.

The measures taken by the government have helped lessen the pain of the GFC. Unemployment has risen to 5.7%, but in the US the unemployment rate is now above 9%. Households that have kept their jobs are probably in a better position than a year ago with mortgages so low, and government spending in areas such as infrastructure should provide support to the economy moving forward.

At the moment there is debate about whether the global economy is recovering from the GFC, or whether the worst is not yet over. The optimists see measures taken by the Obama administration to stabilise US banks, and to spend money to support the economy as showing signs of working. If the US can recover, then surely so can the global economy. The pessimists see still declining US house prices, and therefore further large losses in global banks.

It is always hard to predict turning points in an economy. But US house prices do seem to be stabilising, and I am cautiously optimistic, that we are at bottom, rather than getting worse. However, unemployment often continues to rise for some time after an economy bottoms out, and I think that in the next year or so this is what we are likely to see. I think we will see a slow and somewhat painful recovery, with unemployment still likely to rise somewhere towards 8% in Australia in the next twelve months before stabilising. Hold onto your belts for a little bit longer, but let’s hope that things will start to get better on the economic front pretty soon.