While this was going on, the third element was playing out. Central banks were following flawed theories, Ferguson says. They were running lax monetary policies, which were causing asset price inflation, but were using measurements of core inflation to gauge the effectiveness of their policies. So even as core inflation remained low, asset prices inflated rapidly, but central banks did not regard this as an issue they had to address.
Ferguson says a fourth cause was the “contamination of the once honest business of insurance by a whole complex of derivatives”. When selling an insurance policy against a default by an investment bank or a country, “the reality is that the risk is not calculable”.
“You’re really selling insurance against uncertainty – and that I don’t think is something it’s wise to do,” he says. “And yet it’s what AIG did on an absolutely vast scale. And we have to remember it was AIG’s bust, as much as Lehman Brothers’ bust, that tipped the American financial system over the edge of a cliff.”
Fifth, says Ferguson, it’s impossible to imagine a crisis the scale of the GFC happening without there being something “fundamentally wrong” in the political system.
“You can’t understand what was happening in US real estate if you don’t see that both parties, Democrats and Republicans alike, had become convinced of the need to incentivise ordinary Americans, including those right at the bottom of the income distribution, to borrow as much money as they possibly could, in order to invest it in a home,” he says.
Whatever its political justifications, such a policy was “economically slightly mad”, Ferguson says. “You can think of it this way: We decided to find out what proportion of American households could become homeowners before the financial system crashed,” he says.
“The answer was 69 per cent. It was pushing the home ownership rate up from the low-60s to 69 per cent that tipped the system into instability. You were bringing households into the property market that could not afford to service a mortgage over any length of time.”
The sixth and final cause was “a strange beast” that Ferguson calls “Chimerica”.
“It involved a relatively poor country – China – lending large amounts of money to a very rich country – the United States,” Ferguson says.
“This happened, of course, because the Chinese wanted as far as possible to maintain a relatively weak currency in order that their exports should remain irresistibly attractive to the rest of the world.”
China purchased $US-denominated debt, effectively extending a line of credit to the US that the US spent not on investment in productivity and technology, but on consumption and property speculation.
“So that’s the six-part answer to the question of what caused the crisis,” Ferguson says.
“You have to start, it seems to me, with excessive leverage on bank balance sheets; you have to look at the contamination of the bond market by AAA-rated toxic waste; you have to bear in mind a fundamental error of monetary policy by the Fed; you have to look at the way insurance went awry with the explosion of derivatives that offered insurance against uncertainty; you have to remember the politicisation of the real estate market; and finally you have to look at Chimerica – the huge global imbalance that resulted when China began to channel funds on a massive scale into the US economy – and particularly, into its real estate bubble.”
