John Key gave his first speech as Prime Minister to the APEC CEOs Summit. While the invitation was not for him personally (it was for the PM), it proved very fortunate, as it allowed Key to demonstate that he understands the causes of the credit crisis better than most. Some extracts:
To understand the potential scope of the changes that may be required is to understand the changes in the global economy over the past 10 to 15 years.
Over the past decade or so the global economy was fuelled by a private sector credit boom made possible by a combination of large macroeconomic imbalances with and between economies, relatively low global inflation, new waves of financial innovation, and huge amounts of leveraging by hedge-funds and other financial institutions.
These forces were, in turn, fuelled by excessive optimism in asset markets, and a more relaxed, and in many cases, recklessly complacent attitude to risk.
The result was a global credit boom like none other.
And one desired response:
New Zealand knows very well that one of the critical factors for getting out of this current downturn will be our ability to trade our way out of it. We’re a small cog in the global economy and we know that the only way we can lift our living standards is by growing our role in global markets.
This I believe is true for all of the economies represented in this room, particularly the small and developing economies. Indeed, APEC was founded on the collective goal of pursuing an open trade agenda. There is no doubt in my mind that the APEC region still stands to be the growth engine of the world.
The G20 has pushed the idea that Doha should be resolved – and I can’t speak loudly enough to that. The G20 leaders have put their reputations on the line, calling for an agreement by the end of this year on the crucial decisions needed to take this Round to a successful conclusion. Our Trade Ministers at this meeting have issued a similar strong call for action. I am certain APEC leaders will follow suit.
Let me put it bluntly. Against the backdrop of those political statements and against the background of the international economic turmoil, a failure to follow through in Geneva and deliver the results we need would represent nothing short of a political failure.
Now is most definitely not the time for any individual country to allow their worsening domestic economy to lead to a retreat from global trade and engagement.
In particular, central bankers across the world are grappling with the issue of asset price cycles and their consequences for price stability. Housing market booms occurred this decade not only in New Zealand, but throughout this region and the world. The aftermath of these booms is at the heart of current financial market dysfunction.
The question is: faced with this situation again would we do something different to address it? To my mind, this question should lead economies to consider whether monetary policy, fiscal policy, and prudential policy should be more counter-cyclical, and lean against credit growth in an upswing.
This will keep the economist blogs busy arguing pros and cons!
What is now apparent is that as the pressure to boost profits grew, Wall Street assumed more and more risk. The quantity, and also the complexity, of this risk saw investment banks evolve into pseudo hedge funds with balance-sheets and risk exposures well beyond what anyone would have previously deemed acceptable.
But leverage wasn’t, and hasn’t been, the sole preserve of the banks.
The hedge-fund community has mushroomed in size and significance. Gone for the most part is the traditional macro hedge fund, where risk was based on the views of an individual trader who undertook conviction trades that bore some sense of balance when compared to the overall size and structure of the market.
Today, hedge-fund leverage is for the most part unregulated, opaque and, arguably, globally unmanageable. The regulation that does occur is for the most part focused on the fitness of the manager to report to their investor.
All of these factors have helped contribute to the explosion in credit, completely out of proportion to the real economy, with cheap equity leveraged to the hilt.
So now the party is over and the taxpayers of the world are left to underwrite – in one form or another – the liabilities and obligations of banks and, by extension, their hedge-fund clientele.
We can no longer afford to ignore the fact that the amount of risk that hedge funds are able to take through the leverage of their funds is arguably completely disproportionate to the real economy.
These realities and the associated bailout of financial institutions are expected to prompt a widespread review of financial regulation. This is entirely appropriate.
A review is appropriate, but Key also reminds us of the positives from easy credit:
Reforming the global financial system will require a balancing act between, on the one hand, moving away from the largely unregulated environment of today and, on the other, ensuring we do not completely undermine financial markets.
Let us not forget that global growth over the past couple of decades has bought hundreds of millions of people out of poverty.
For global growth to continue, the world needs financial markets to function and it needs liquidity. Furthermore, the world needs to trade and to interact.