Sue Konzelmann, Marc Fovargue-Davies and Gerhard Schnyder1
‘Global financial crisis’ is an inaccurate description of the current upheaval in the world’s financial markets. The initial banking crisis did not affect all countries to the same degree. Notably, while the US and UK banking systems were badly hit, those of the other two major Anglo-Saxon economies, Canada and Australia, remain largely unscathed and have even gained in terms of global market share. The national business systems and comparative corporate governance literatures underscore the similarities among these four ‘liberal market economies’ (LMEs) and would predict similar trajectories. This paper investigates the reasons behind the differing performance of the Anglo-Saxon banking systems, which defy a verdict of failure of the LME variety of capitalism as such.
JEL Codes:E32, E44, G38, N10, N20, P17
Keywords: Corporate Governance, Regulation, Financial Market Instability, Varieties of Capitalism
‘The largest banks know … that they are literally too big to fail and can count on a helping hand from government if the worst comes to the worst. … Thus, in yet another intriguing but ominous irony of history, 10 years of ultra-liberalism have resulted in a US financial system whose future may only be assured with the help of federal government handouts.’ (Albert 1993, p. 61).
The OECD’s (2009) conclusion that the current financial crisis is the result of a failure of corporate governance at the level of the individual firms involved does not account for the ‘national blocs’ of banks in the list of the 50 largest banks globally (by market capitalisation) (Financial Times, March 2009). Compared with a decade earlier, American and British banks had lost significant ground, whilst those of other countries, including Canada and Australia, clearly gained. This strongly suggests that national factors also played a significant role.
The national business systems and comparative corporate governance literatures underscore the similarities among the ‘liberal market economies’ (LMEs) and would have predicted similar trajectories for the US, UK, Canada and Australia. Indeed, prior to the 2007 crisis, this was (on the surface at least) apparently borne out in reality. Only when the crisis deepened, did it become clear that there were fundamental differences in the four banking systems and in the underlying economic and political ideology upon which they were based.
This paper investigates the reasons behind the divergent performance of the Anglo-Saxon banking systems, focusing on their structural and regulatory differences, but perhaps more crucially, on what gave rise to them. We examine the influences behind financial de-regulation, corporate governance, economic and political ideology, in conjunction with more subjective factors, including cultural legacy and attitude towards risk. Individually and collectively, these factors not only played a part in the genesis of the crisis, they also helped to define the relative resilience of the systems in this study when confronted with its effects. Our analysis reveals significant variation in the interpretation of liberal economic theory and the way it was applied in the Anglo-Saxon countries in our study. Rather than representing a failure of the LME variety of capitalism as such, we argue that the financial crisis was a result of the failure of the neo-classical variety of liberal capitalism.
Section two examines the four major Anglo-Saxon countries in terms of macro-economic indicators of their vulnerability to financial market instability. Section three explores varieties in the form that economic liberalism might take, the context in which it was introduced in the countries in our study and the resulting nature of the system produced. In Section 4, we focus the analysis on financial market liberalisation in the UK, the UK, Canada and Australia; we then explore the ways in which this shaped each country’s response to prior crises in their financial markets and the influence this had on their experience of the most recent crisis. Section five examines the genesis of the current crisis, with a focus on the evolving relationship between the regulator and the regulated in the countries in our study and on the system of home financing that gave rise to the real estate – and in particular, the American sub-prime – bubble credited with igniting the most recent crisis. Section six draws conclusions from the analysis and explores possibilities for policy and regulatory reform.
2. Peas in a pod – The Anglo-Saxon economies before the crisis The US, the UK, Canada and Australia are widely recognized for their institutional and economic similarities. Along with Ireland and New Zealand, they constitute the ‘Anglo-Saxon’ countries or the ‘Anglosphere’. They are also all classified within the ‘liberal market economy’ (LME) variety of capitalism by Hall and Soskice (2001)2 These countries share a variety of macro-economic features stemming from their common institutional and cultural heritage that distinguish them from other advanced economies, notably continental Europe and Japan. Yet although many have interpreted the recent financial crisis as a crisis of Anglo-Saxon capitalism, the divergent experiences of the countries in this study suggest otherwise.
The underlying cause of the recent crisis has been widely attributed to macro-economic imbalances (FSA 2009). Based on extensive historical analysis, Reinhart and Rogoff (2009) identify a series of macro-economic factors that tend to increase the likelihood of financial crisis. Of these, the four main predictors include: i) increasing current account deficits; ii) increasing accumulation of debt; iii) significant increases in asset prices (house prices in particular, but also equity prices);3 and iv) slowing down of GDP growth after a prolonged period of sustained growth (Reinhart and Rogoff 2008: 342). These factors are also features of an asset bubble, with the end result being overvalued assets, excessive leverage and questionable lending practices, all of which are recurring themes in our analysis.
A current account deficit that cannot be financed may generate disorderly currency depreciation, the fear of which is a contributing factor in financial market and macro-economic instability. As evident in Figure 1, although trends in the balance of payments have fluctuated, since 1999, only Canada’s account was in surplus. By contrast, the US’s balance of payments has steadily deteriorated; and by 2007, it was nearly matched by that of Australia. But there has been no crisis in the sense of disorderly currency devaluation in the countries in our study. Rather, the current account deficits, which indicate capital inflow, have put downward pressure on interest rates and on the returns from traditional financial instruments while at the same time fuelling asset and equity price inflation.
Figure 1: Current account balance as a percentage of GDP
Source: OECD 2009
In the run-up to the crisis, the four countries experienced very similar trends in interest rates. The steady decline in long term interest rates, evident in Figure 2, made traditional financial instruments relatively unattractive and provided the impetus for financial innovation carrying more risk, and hence, a greater return.
Figure 2: Long-term interest rates
Source: OECD MEI 2010
Massive capital inflows and low interest rates also made it relatively easy for households, as well as financial institutions, to finance their expenses through debt. As evident in Figure 3, there has been a steady decline in household savings rates since the early 1990s in the countries in our study. This suggests that households increased their borrowing to finance spending, which in turn increased the financial sector’s exposure to household debt. A second effect was to reduce the ability of banks to finance themselves through deposits, increasing their reliance on the money markets.
Source: OECD Factbook 2009; UK data: Office for National Statistics
A major component of household debt is mortgage debt, used to finance home ownership and in some cases, additional consumption. In the four countries in our study, patterns of home ownership are comparable and relatively high.In 2000, 65 percent of American households were owner-occupied, compared with 67 percent in Canada and 69 percent in the UK and Australia (The Economist 2002).By 2007, ownership rates in the US, UK and Canada were 71 percent, 70 percent and 68 percent, respectively, but this may have become a source of vulnerability. In the US and the UK, the mortgage debt to GDP ratio was also very high (71 percent and 86.3 percent, respectively) (Vorms 2009: 5); in Australia, it was 85 percent in 2008 (Keen 2009: 347). This is in contrast with Canada, where the mortgage debt to GDP ratio was considerably lower (45.6 percent) (Vorms 2009: 5). The reduction in household savings and high mortgage debt to GDP ratios suggest heightened vulnerability to financial instability.
Asset price inflation is another indicator of financial volatility. As evident in Figure 4, throughout the 1990s, equity prices increased, especially in the US and the UK; and after a brief decline, the upward trend continued from 2002, following a very similar pattern in all four countries, until the 2006 credit crunch.
Figure 4: Equity Prices (Total Market Capitalisation as percent of GDP)
The cost of housing also increased during the past two decades (see Figure 5); and immediately preceding the crisis, house price inflation rose even more quickly, especially in the UK and Australia, as the real estate bubble inflated further.
Figure 5: Consumer Price Index Housing 1990-2009
Source: OECD MEI 2010
Asset price bubbles are a strong predictor of financial crises (Reinhart & Rogoff 2009), particularly when the inflated price of a given asset is used as collateral to raise further debt. This was the case, especially in the US and the UK, where many mortgage holders used their home as a ‘piggy bank’. However, the use of equity in this way increases vulnerability to an interruption in the flow of cheap money. Even more worryingly, some mortgage lenders had effectively done the same, in an effort to maintain the supply of mortgages with which to build increasingly risky derivative products. But the house of cards began to crumble when defaults on sub-prime mortgages soared above the model’s predictions in 2006, triggering a collapse of house prices and undermining the system of payments.
A fourth key predictor of vulnerability to financial crisis is a slowdown in economic growth after a prolonged period of expansion (Reinhart & Rogoff 2009). As evident in Figure 6, after the recession of the early 1990s, average annual growth in real GDP from 1990 to 2007 was relatively strong, ranging from 2.95 percent (UK) to 3.76 percent (Australia), with the US (3.06 percent) and Canada (3.22 percent) in between (OECD 2009). The early 2000s saw a more volatile environment: the Dot-com bubble was the first blow to confidence in the ‘New Economy,’ followed by the corporate scandals at Enron, WorldCom and others, and the aftermath of the terrorist attacks of 9/11. These events contributed to a softening of economic growth after 2004, especially in the US, where the slowdown was a major contributor to the increase in non-performing loans in the American sub-prime sector that sparked off the crisis.
Figure 6: Real GDP Growth 1990 – 2007
Source: World Development Indicators.
In short, during the two decades prior to the crisis, the Anglo-Saxon economies evolved in similar ways. Whilst Canada appeared somewhat less vulnerable (in terms of its current account balance and mortgage debt to GDP ratio), most of the major indicators of financial market instability were present. Yet there are compelling differences in the relative performance of the four countries’ financial systems. Table 1 shows that the largest Canadian and Australian banks gained in terms of market capitalization whilst the American and British banks lost.4
Table 1: Change in bank market capitalisation
Change 1999-2009 ($bn)
Source: Financial Times, 23 March 2009, p.9. 1999 values are as of 31 May 1999; 2009 values are as of 17 March 2009.
These divergent experiences are further illustrated by the magnitude of the bank bailouts in the four countries. By March 2009, the US government’s bailout packages amounted to 6.8 percent of GDP, while the UK’s accounted for a staggering 19.8 percent of GDP (Stewart 2009). By contrast, Australia used only 0.1 percent of GDP to help struggling banks and Canada, none at all.5
Another important trend in the world’s advanced economics, which was particularly pronounced in the countries in this study, is the transition from a manufacturing to a service-based economy. In the Anglo-Saxon world, during the latter part of the twentieth century, financial and related services replaced manufacturing as the key driver of employment and economic growth. This followed the breakdown of the post-war mass production-based model during the 1970s; and in many countries – especially the US and the UK – financial services became the engine of growth (Gamble 2009).6 This was made possible by a process of economic liberalisation, in which the financial services sector was transformed from a pure financial intermediary into an industry in its own right; and competition among financial services companies intensified, with product innovation and price serving as the basis of competition (Toporowski 2000).
The extent of the shift is illustrated in figure 7, which tracks the relative contribution of financial and related services to total value added.
Figure 7: Value Added By Financial Services ( percent of total VA)
Source: OECD Factbook 2009
Although the general increase in the relative contribution to value added made by the financial services sector in the major Anglo-Saxon countries follows a similar trend, it masks their differing approaches to the process of economic liberalisation. As we argue below, it is the nature of this process and the form that economic liberalisation assumed that explains differences in the performance of these countries’ banking systems during the most recent crisis. Whilst Reinhart and Rogoff (2009) identify financial market liberalisation as another indicator of financial crises, the resilience of the Canadian and Australian banking systems suggests that liberalisation can indeed be achieved without creating major instabilities.
The following section examines the process of economic liberalisation in the US, the UK, Canada and Australia, focusing on its interpretation and implementation. The way that economic liberalism was understood, introduced and developed would have a crucial effect on the nature and extent of regulation, on the relative position of the financial sector in the broader economy and on its relationship with government.
3. Some are more liberal than others – doctrinal differences In his book The Affluent Society, Galbraith argued that the ‘conventional wisdom’ in economics is inherently conservative and gives way not so much to new ideas as to ‘the massive onslaught of circumstances with which [it] cannot contend’ (Galbraith, 1999, p.17). This creates the environment in which different ideas find favour and reconstitute the conventional wisdom. Friedman (1962) articulated the process by which the conventional wisdom becomes embedded in policy. In his view,
‘Only a crisis – actual or perceived – produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes politically inevitable.’
Once a crisis had struck, Friedman believed that it was crucial to act swiftly, before the moment was over-taken by the ‘tyranny of the status quo.’ (Friedman and Friedman, 1984, p. 3) 7
One example of this process was the replacement of classical ‘laissez faire’ economic liberalism by Keynesian conventional wisdom, triggered by the mass unemployment and poverty of the inter-war years, which eventually led to the state’s management of the economy. The growing inflationary crisis of the 1970s may also be regarded as a massive onslaught of circumstance. But this time, the ‘ideas lying around’ were those of Friedman and the Chicago School economists; and the conventional wisdom reverted to pre-Keynesian, liberal economic ideas that success in combating inflation depends on controlling the money supply whilst efficiency in the use of resources is most effectively secured by unrestricted markets. Analogous developments can be observed in theory and policy relating to corporate governance, with the efficient market hypothesis emerging to provide the orthodox explanation for – and justification of – the role of the stock market in reorganising industry and its ownership.8
We are currently in the midst of another crisis which has given rise to doubts about the conventional wisdom of economic liberalism and debate about the appropriate direction of theory and policy. The fact that Canada and Australia have apparently achieved sustainable economic liberalization argues against a wholesale abandonment of the current system per se and suggests a closer examination of how this has been accomplished and to what end.
3.1 Varieties of economic liberalism It is perhaps ironic that the perspectives of Galbraith and Friedman with regard to the process by which theory and policy evolve are so congruous because their economic doctrines could not be more opposed. Nevertheless, the varieties of liberalism flowing from the work of these two influential economists – Galbraith a Keynesian and Friedman a Neo-classical – might well form the basis for an understanding of the differing experiences of the Canadian / Australian and the Anglo-American systems in the current crisis.
In the US, UK, Canada and Australia, the return to economic liberalism during the period preceding the crisis was strongly influenced by the political and economic climate of the 1970s and early 1980s. In the US and the UK, it is associated with the rise to power of the politically conservative governments of Ronald Reagan and Margaret Thatcher. However, its origins can be traced to the early 1970s and the liberal responses of the Nixon and Heath governments to the economic challenges of that decade. In 1971, in response to its first balance of trade deficit since before the first World War, US President Nixon announced that the US would no longer provide gold backing for the American dollar. This effectively lifted the capital controls that had been introduced in 1944 under the Bretton Woods Agreement. With the collapse of Bretton Woods, international capital movement restrictions and fixed currency relationships were eliminated.
In the UK, the Heath government introduced a policy of ‘Competition and Credit Control’ in 1971, as part of an effort to liberalize the money markets and stimulate competition among banks. Quantitative limits on bank lending were removed, banks’ liquidity requirements were reduced, and interest rates were allowed to play a more central role in the allocation of credit. At the same time, in response to rising unemployment, the Heath government made a ‘dash for growth.’9 In this, fiscal and monetary expansion and macroeconomic growth were accelerated by an increase in bank lending. However, against a backdrop of international inflationary conditions during the 1970s, property market speculation inflated a property bubble which resulted in the Secondary Banking Crisis of 1973-5. The Bank of England responded quickly, launching a ‘lifeboat’ to provide emergency liquidity for the secondary banks and thereby averted a widening collapse.
Heath’s varying policy responses to the economic turmoil of the 1970s, however, did not save his conservative government. The election of a labour government in 1974 eventually resulted in James Callahan becoming Prime Minister in 1976. Callahan was in fact strongly convinced of the value of many of Friedman’s ideas and gave what is arguably the purest expression of monetarism to the 1976 Labour Party Conference. According to Smith (2006), Callahan warned that ‘You could not spend your way out of recession. It only fuelled problems by injecting inflation into the economy. The result was: Higher inflation, followed by higher unemployment. That is the history of the last 20 years.’ But Callahan was not to get the chance put these ideas into practice. In 1979, Margaret Thatcher, more usually associated with monetarism, was elected Prime Minister, by a large majority.
In Canada, the process of economic liberalization is often identified with Brian Mulroney’s Progressive Conservative Party government. However, its origins can be traced to the implementation of controversial wage and price controls by Pierre Trudeau’s Liberal government as a response to the inflationary crisis of the 1970s (Klassen 2005). In Australia, economic liberalism began in the 1970s, under the banner of ‘economic rationalism,’ which was incorporated into policy by the labour governments of Bob Hawke (1983-1991) and Paul Keating (1991-1996) The economic rationalists adhered to a mainstream post-war view, incorporating Keynesian macroeconomic models with neo-classical microeconomics, based on a simple model of perfect competition that allowed for market failure, market imperfection and externalities. From this perspective, government intervention was justified in order to correct market failures and stabilize the level of employment and output.
The Reagan and Thatcher governments are noted for their commitment to market freedom and to reducing the role of the state in the management of the economy. This took the form of privatization in the UK and de-regulation in the US. In Canada, the introduction of economic liberalization under Trudeau was strongly influenced by Galbraith’s pragmatic economic ideas. Trudeau once said that ‘there is no doubt that he [Galbriath] has permeated my thoughts and those of a lot of other people’ and that he had a powerful impact on the process and extent of economic liberalization in Canada (Hicks, 1977: 88). In Australia, the Hawke and Keating Labour governments followed the blueprint laid down by Thatcher and Reagan in America. But rather than seeking to crush the unions (as had been the case in the US and the UK), the Hawke and Keating governments negotiated compromises with business leaders. Thus, in Canada and Australia, economic liberalism assumed a more moderate form than it did in the US and the UK.