mr. macfarlane discusses the changing nature of economic crises talk by the governor of the reserve bank of australia, mr. i. j. macfarlane, to australian business economists on the occasion of the 13th annual forecasting conference dinner in sydney on 4 / 12 / 97. it is a pleasure to be here this evening to talk to the australian business economists. i looked back over my files and i noted that this is only the second time i have addressed this group ; the previous occasion was nearly seven years ago in february 1991. at that time, i spoke about asset price booms and busts, particularly the latter. you may think i have a one - track mind, but the same subject - - only with a different location - - is going to figure prominently in what i have to say tonight. 1. types of economic crisis i want to talk about the changing nature of economic crises, and then draw out some conclusions for australia. at the risk of some oversimplification, i think there have been two basic types of economic crisis. the old - style economic crisis i will call type i, and the new - style, which has come to prominence over the past decade, i will call type ii. most of these crises occur in developing countries, but developed ones have not been immune from them. the standard way that countries - - particularly developing countries - - got into trouble in the past was that their governments did the wrong thing by running bad fiscal and monetary policy. governments ran large budget deficits and did not finance them properly - - they wrote cheques on the central bank, which is colloquially known as printing money. interest rates were held artificially low ( or negative in real terms ) and money supply ballooned, resulting in accelerating inflation, a loss of competitiveness, large current account deficits and a collapsing currency. this was a type i economic crisis, and the imf has a standard set of arrangements for dealing with this problem. just about every developing country ended up in this predicament at some time or other. some of the latin american countries did it again and again. we skirted perilously close to it in australia, particularly in the mid - 1970s, but did not end up in the hands of the imf. the united kingdom, however, did. it suffered a classic type i economic crisis in 1976, and needed a support package from the imf, with the usual conditionality requirements. the type ii problem is very different.

happens if the insurance needs to be used, that is, if a credit event occurs. then the bank ( the insurance policy owner ) would have to sell a bond corresponding to the credit amount to the insurer at a nominal value. this is despite the fact that the bond has become worth much less or even worthless as a result of the credit event. the bank thus swaps the bond for a cash payment. 2 this is no stranger than a house - owner swapping his burnt down house for cash if he has paid his insurance. why are credit derivatives so popular? the example using teliasonera illustrates some of the properties that have made credit derivatives so popular. the bank can sell its credit risk on the company, entirely or partially, without needing to cancel the loan or to have any discussion at all with the company. at the same time, the buyer of the credit risk ( the seller of the credit derivative ) does not need to tie up more than a fraction of the capital that would have been required to take over the credit directly. moreover, the buyer of the credit risk can in turn easily sell the risk to another party, wholly or partially. reinsurance thus becomes both simpler and cheaper to manage than with regard to traditional credit insurance. large investors such as mutual fund companies and insurance companies often want to have a particular amount of credit risk in their portfolios. the credits can actually reduce their total risk, as the prices of the credits do not have such large covariation with other prices, for instance, the prices of shares and real estate. a certain share of credits provides a more diversified portfolio, which gives lower risk for a given expected return. credit derivatives also makes it possible to divide up credit risks into small parts and to trade these parts at a low cost. this is not possible with traditional credit insurances. as the trade is so extensive, the pricing of credit risk becomes much improved. from the economy ’ s point of view, it is essentially positive that the credit risk is spread to institutions outside of the bank system. although the banks are specialists in assessing credit risk, they are also sensitive to shocks. deposits are liquid, while loans are in practice often tied for long periods. if the depositors suddenly want to withdraw their money, it may be difficult as the bank cannot as quickly call in all its loans for payment. in addition, the banks are of vital importance for ensuring that payments in the economy function. the fact that credit risks are spread to