Will government solutions create a new set of problems?

KEVIN Rudd has adopted a firm war footing as Australia confronts the equivalent of a rolling national security crisis.

KEVIN Rudd has adopted a firm war footing as Australia confronts the equivalent of a rolling national security crisis.

The GFC is the enemy, he says. The GFC, if you are not familiar with it, is the new lingua franca as world leaders grapple with what the rest of us call the global financial crisis. Politicians tell us these are extraordinary times. The world has changed and we are in new territory with the global credit freeze. Fear has gripped the markets. Banks are teetering, investors are nervous, consumers are wary, business is slowing.

Long-time market watchers say they have never seen such a crisis of confidence. Long-time opponents of free-markets cheer from the side-lines with “I told you so” smiles. We are all Keynesians now, they shout over at Fairfax, happy to see government back in the business of running business. And it’s true that government stimulus is required. As Nancy Koehn, a historian at the Harvard Business School said, "the goal is to get the engine of capitalism going as productively as possible. Ideology is a luxury good in times of crisis."

In this new war, the rules of engagement have been thrown wide open. Each country’s move into the market is overtaken by another country’s more aggressive package of government intervention. Why, even Gordon Brown, the British Prime Minister, has, as one headline declared, gone from “Zero to Hero” as his muscular intervention into the UK banking sector lifted his flagging political future.

But in this new world order, is it possible that some critical old lessons may still apply? At the moment, as leaders rush to act quickly for fear of acting too late, few seem willing to listen to the old rules. Or at least, they are not talking about them. Nor are they assuring us that the old lessons have not been forgotten.

So let’s talk. And start with the basics. Is it possible that we are, once again, watching politicians devise solutions to problems that they created when they last time tried to devise solutions to problems they created?

I wondered about this as I read in The Australian on Wednesday about a 22-year-old Wodonga electrician and his 20-year-old girlfriend who will use the Rudd Government’s new $21,000 grant to build a new home. They had planned to borrow 100 per cent of the money they needed for their $285,000 land and home package. “This has made our dream a lot easier,” said Daniel Grubisa. “I’m shocked at how much money we will get.”

Now without knowing Daniel and his finances, I wouldn't want to say whether his borrowing is prudent or not. But it did set me thinking. Is it possible that the Government’s stimulus package will encourage people who cannot afford to borrow responsibly to leap into a mortgage? Isn’t this what caused the sub-prime mortgage mess that ripped apart the US financial system in the first place? Reckless borrowing by people unable to afford homes, but brought up in a “give it to me now” society, got us into this mess.

The sub-prime crisis erupted because fiscal prudence – both on the borrowing and the lending side – became distinctly uncool. Saving for a deposit was no longer a prerequisite. In the new culture of instant gratification, if you wanted a home, you got one by borrowing 100 per cent of the purchase price. And here we are, potentially encouraging further financial recklessness with a stimulus incentive for new home owners who couldn't get a loan in more prudent times.

Now, don’t imagine I’m a follower of Clive Hamilton’s dreary school of tearing down and second-guessing the choices and aspirations of Australians. I say if you’ve got the money, buy what you want. If you haven’t got the money, borrow it if you can afford to do so. What people do with their money is their business. This is not about telling people how to spend their money. But it is about personal responsibility. If you can’t afford to pay back your debts, then don’t borrow. And if you do borrow money you can't repay, don't expect the Government (meaning your fellow citizens) to repay it for you. Regrettably, other people’s debts have become our business because we know now that when things go pear-shaped, people come crying to the Government and the taxpayer for help.

In the US, it was case of wrong regulation – not deregulation – that helped fuel a housing bubble. Laws allowed borrowers to walk away from their mortgage debts. Congress created two quasi-government bodies, Fannie Mae and Freddie Mac, to encourage loans to low-income people, many of whom could not afford to pay off their debts. Yes, homeownership jumped. And the sub-prime disaster followed.

At the National Press Club on Tuesday, the Prime Minister said that "when markets fail, governments must act’. But wait a minute. Much of what has happened is due to government action, not market failure. As much as it suits the populist narrative to describe the current crisis as one caused by greed and unbridled, unregulated capitalism, the fact is that government action is also to blame. When successive US administrations tried to fix problems after the Depression and during every decade since, they laid the seeds for a new set of problems they are now trying to fix.

On the bank side, too, there are dangers that the Rudd Government’s actions will only encourage a new set of problems. The Government has promised to guarantee – in return for a fee - the wholesale funding of Australian banks until market conditions have normalised. But how will they price that guarantee for risk? Banks have different risk profiles that should attract a different price for a guarantee. If the risk is not priced properly, the Rudd Government will in effect be encouraging banks to borrow recklessly. If they can borrow at cheaper rates than their standalone credit rating deserves why not pin your ears back in a search for growth and profits? The Government might think it is encouraging competition by helping smaller banks and non-banks to get back into the market, but if the Government gives them an effective subsidy - by undercharging for its guarantee - it risks perpetuating the problems that brought us to this pass in the first place. Risk must be priced properly - if you underprice risk you encourage people to take more of it.

Rudd is not blind to the lessons of history. He said on Tuesday that “there are critical messages and lessons to be learned from history here, which is act decisively, act responsibly and act early”. But there are other lessons from history that seem to have been sidelined in the rush to act. And what a shame it will be if in due course, governments will have to step in to fix a problem they created when they tried to fix the current problem.

Over to you…