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link with gold, Australia surrendered any worthwhile independence in its
economic and financial thinking. We swallowed American financial and
economic formulae, whether we were academics or policymakers, industrial
entrepreneurs, banks or providers of "financial services." 

We did not entirely switch off tunes played by Britain, the more so as its
prime minister Margaret Thatcher formed her slapstick band with US president
Ronald Reagan to drum up support for "free" markets, "free" trade,
privatization, globalization and the free flow of almost everything,
including speculative capital in unqualified pursuit of private profit.
Corporation and consumer greed marched in step towards global disaster. 

Rational economics based on real investment, productivity and production
died in favor of speculative and often Ponzi pretensions. The cowboy
junk-bond merchants of the 1980s metamorphosed into respectable, mostly
young and usually idolized financial wizards who "perfected" sophisticated,
highly complex credit devices. From the 1990s, these highly leveraged
instruments took the form of derivatives, private-equity, hedge-fund and
mortgage securities, abbreviated to CDOs, SIVs and the rest. Allied with
"free" markets, deregulation and the uninhibited flow of all kinds of
finance, those financial devices destroyed industries and the jobs that go
with them. With casual indifference, they also destroyed the self-reliant
working and middle classes until then typical of robust free-enterprise
economies. 

Theirs was not Joseph Schumpeter's "creative destruction" but wholesale
destruction of their own economies and, eventually, their own financial
"system". They destroyed personal savings and created massive indebtedness.
They undermined the power and security of the United States itself as they
"outsourced" real economic strength and stability to countries especially in
Asia. 

The Asian Tigers, China and others grew into "powerhouses" whose creation,
historically, would otherwise have taken them generations. Our eminently
creditable aim of peaceful change through development of developing
economies was distorted, largely through negligent inadvertence, into
financial, economic and social self-destruction. Looming global collapse,
with political and strategic uncertainties, are our inevitable legacy. 

Consumerism rages, industry gutted The speculative, Ponzi mania spread
especially to Anglo-Saxon countries and to other developed countries in
lesser degree. Australia took to "free" markets, "free" trade, free-floating
currencies, deregulation, privatization, globalization, derivatives, hedge
funds, private equity, wildcat mortgages and leverage-without-limit as a
duck to water. Consumerism raged. Industry was gutted. Debts ballooned. The
value of the currency fell at home and abroad. Despite low-cost imports,
inflation flourished. In 2008, the Australian dollar can perhaps buy as much
in real terms as five or 10 cents did in 1969. 

A situation in which real public and private investment was replaced by
"ownership investment", massive leverage and speculative finance, in which
consumption grew and debts spread, could not persist, except so long as ever
more money flooded in to support the insupportable. Once the flood slowed or
stopped, a Ponzi-type collapse was inevitable. 

But few saw it that way. Warren Buffet belatedly called derivatives weapons
of mass destruction; but most saw the financial devices as belonging to a
"new era". They represented a "new paradigm". Far from being a threat to
stable growth in a stable financial system, they "spread risk" and made
everyone more secure and of course more wealthy. 

The wealth effect was a particular feature of the residential mortgage
business. Funds were available from many new banking and non-banking
sources, including hedge funds and private equity, as well as pension and
mutual funds; and sources that, in their magnitudes, were new, such as the
carry trade. Funds marketed wholesale and retail mortgages. Liability could
be shifted even or especially for debt in the deepest sense sub-prime.
Mortgages also enabled homeowners to expand consumption through
mortgage-equity withdrawals (MEW). 

In a real sense, MEWs were symptomatic of multitudes of individuals - and,
in effect, whole societies - high-living it off their capital. That enabled
a process of growth that was both irresistible and inherently unsustainable.


However, the Ponzi scheme to shame all others may yet be waiting to deliver
its coup de grace. One commentator has drawn attention to "the bad news
[which] is the US$500 trillion derivatives market". He says that "This is an
area that the general public does not even know exists. Few professionals
understand this market. There is no regulation as government just let it go
... and go it did. You must expect a 5% default problem. That is a $25
trillion number ... It can create insolvent institutions all over the world
... It is the making of the first global depression. The world is not
ready." 

Unprepared for depression Australia is not ready either. Prime Minister
Kevin Rudd told us late in March that Australia's economic prospects remain
"sound, strong and good". The Reserve Bank of Australia shares that view.
Eerily, they echo US President Herbert Hoover in 1929 immediately before the
stock market crash of that year. 

Australia's situation contains some positive features. High commodity
prices, it can be argued, are likely to persist, even though volatile, at
least in the short term. A member of Iceland's central bank board recently
said that "fears of a meltdown in my sub-arctic homeland are vastly
overblown. True, the current account deficit was 16% of GDP last year, but
that's an improvement from more than 25% in 2006. And while net
private-sector debt is about 120% of GDP, there is virtually no public debt
in Iceland. This is largely the result of unparalleled political stability
and continuity." 

Australia's situation may not be as dire as Iceland's; or indeed as dire as
that of the United States or New Zealand; but all three of us have some
negatives like those of Iceland. 

Like all booms of such size and speculative character, the Australian
housing boom must soon demand payment of its account. From their peak,
prices could fall 30% to 50%. Industry researcher BIS Shrapnel does not
agree; but we must expect that our housing boom, even more robust than the
American, will collapse along the same general lines as the bust occurring
right now in the United States. 

The high "unaffordability" of housing for the average home-seeker, as
distinct from speculator, suggests that the bust will be savage. The
real-estate, building and associated industries will suffer severely, with
massive job losses. Simultaneously, profitable investment opportunities
elsewhere may have vanished with the widespread collapse of the "financial
services industry". 

How likely is such a collapse? So far, although some non-banking financial
institutions have gone to the wall, the four major banks have seemed largely
immune. "The take-up of the Australian economy is still good," Rudd said
last week in New York. Australia had "limited exposure" to the subprime
mortgage woes that erupted in the United States last year, he said. "We have
excellent balance sheets in terms of our principal corporates and the banks
themselves ... The default rate in Australia is minuscule by Organization
for Economic Cooperation and Development standards." 

We don't know how far banks and other potentially exposed institutions have
concealed their liabilities and to what extent and how soon they will be
forced to reveal whatever bad news there is. Within this broad question, we
also do not know how far they are exposed to losses from the massive and
still largely mysterious menace of derivatives. 

In some measure, Australia's major banks have certainly been involved in the
wide range of structured securities - CDOs, SIVs, and the rest. A report on
April 4, 2008, that local councils in New South Wales have lost US$200
million and perhaps up to $400 million on investments in CDOs is a worrying
sign that other and even bigger losses may yet be revealed in a variety of
institutions, including banks. It seems scarcely credible that an economy
which, for so many years, has absorbed so much of American theory and
practice - so much of the American financial character - can be wholly
immune from the penalties inflicted on its American model. 

The subprime crisis first hit the United States after a housing about-turn
that began as far back as 2005 or 2006. An unequivocal downturn in housing
in Australia has yet to check in; but non-bank lenders are already
withdrawing from the market. Wholesale mortgage lenders are closing shop,
perhaps as a prelude to a sharp housing decline. 

The carry trade which has presumably provided funds for mortgages and other
financial services in Australia has been volatile for some time. If it
unwinds completely, that could not only intensify mortgage problems but also
impact on Australia's external balances. 

Our deficits have so far tended to persist at a less healthy level than the
commodity boom might have encouraged us to hope. Our aggregate private
overseas debt is said to amount to the order of half a trillion dollars.
Against that background, the current depreciation of the United States
dollar might foreshadow what awaits our own currency. 

Lagging impact Economic and financial change in the United States tends to
have a lagging impact on Australia. An acute awareness of the severity of
our crisis may consequently not emerge before the second half of 2008. 

When it does, what will the Rudd government do? Currently, it seems as
unaware of the magnitude of the challenge it faces as the James Scullin
government was in 1929. So the present government might become just as
bewildered as Scullin and stagger just as blindly and ineffectually when
they are called on to act. In the 1930s, we listened to the likes of Otto
Niemeyer of the British Treasury who was also a director of the Bank of
England. Will the Rudd government this time listen to the Americans and the
likes of US Federal Reserve chairman Ben Bernanke? If they do, catastrophic
outcomes might not be in short supply. 

Our only real hope lies in clear, independent thinking by those not too
steeped in the flawed policies responsible for our current crisis. We must
see clearly that fundamental, comprehensive financial and economic reform is
imperative. We must adapt that fundamental reform to our own needs, as the
John Curtin and Ben Chifley governments did between 1941 and 1949. As we did
then, we must simultaneously try to guide the international community out of
the calamitous course that has evolved since 1969, and return it to the goal
of stable, peaceful, global change which, as a primary objective, we pursued
between 1945 and 1969. 

While we embark on this journey, a high level of political volatility in
Canberra is inevitable. Rudd might succeed; but the Labor Party and
government might split two or three ways as they did between 1929 and 1932.
Another Joe Lyons, prime minister from 1932 to 1939, might emerge. Whoever
he might be, the odds are that he will be even less likely to find quick or
easy solutions than Lyons was during the long and bitter years of
depression. Those years ended only in the even deeper tragedy of world war. 

James Cumes is a former Australian ambassador to the European Union and
Australian representative at the United Nations. He is the author of among
other works The Human Mirror: The Narcissistic Imperative in Human
Behaviour. 

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