deterioration in global demand for goods and services that occurred late in 2008 and early this year. there are some important features of this event that help us to understand both our own experiences in australia and those of other countries. historians will study this episode for years to come. they may find additional nuances, but one very clear trigger for the sharp collapse in demand was the heightening of stress in financial markets. a sequence of extraordinary events occurred in september and october last year. these included : • the us government taking over the two largest housing finance entities ; • the bankruptcy of one of the four remaining large us investment banks, which people had presumed was “ too big to fail ” ; • the us government taking over one of the world ’ s largest insurance companies ; and • in short order, pressure on systemically important institutions across the united states and europe. combined, this previously almost - unthinkable sequence resulted in a sharp increase in perceived systemic risk in financial markets and systems everywhere. stock prices fell sharply around the world. risk spreads on all sorts of debt instruments blew out, and capital markets for issuing ( or rolling over ) debt and equity essentially closed. it was the most turbulent period in international finance any current banker, economist, market trader or policy - maker has lived through or, we hope, ever will. unlike most previous financial crises, moreover, the news about this set of events reached people all over the world very quickly. they did not learn about it the way they once might have : sequentially, with varying lags, via delayed print media, word of mouth, high - brow publications and so on. instead, they learned about it simultaneously, via the 24 - hour news cycle, in every country, more or less in real time. not surprisingly, people everywhere suddenly became much more fearful of the future. in the face of this acute uncertainty, firms and households across the world did what you would expect. they acted in a precautionary way. they postponed discretionary purchases, shelved expansion plans and did what they could to consolidate their balance sheets. the result was a highly synchronised slump in demand especially for consumer durables and investment goods. production and consumption of more “ everyday ” non - durable goods and services did fall, but by much less than for those products that could easily be purchased tomorrow rather than today ( graph 1 ). graph 1 the nature of this slump helps us to understand both the relative performance of various national economies and the

central bank to manage liquidity and provide last - resort funding in a crisis. banking systems tied to a commodity standard were simply not flexible enough to cope with periodic bank runs and liquidity crises. no doubt, the true believers in free banking would argue that the theory was never properly tried, and that, if it were, the market would find a solution to the apparent problems. but that is to make the theory unassailable by pure assumption. the other school of thought on free banking is an even more radical one. it proposes a system of competing private currencies that would not have to be linked to any standard of value. the banks operating in such a system would compete with one another to offer sound currencies on terms that who would like to introduce money base targeting, see macfarlane ( 1984 and 1989 ) and goodhart ( 1995 ) for the contrary view. another interpretation of what " leaving it to the market " could mean is that the reserve bank should move the cash rate to where the market expects it to be. this could mean, for example, moving the cash rate to where the 90 - day rate currently is. the problem with this approach is that the current level of the 90 - day rate is mainly a reflection of where the market expects the reserve bank to set the cash rate 90 days hence. the process then becomes completely circular. see pope ( 1989 ) for a discussion of " free banking " in australia prior to 1910. the more commonly cited case of free banking is in the 18th century scottish banking system ( see white, 1984 ). note, however, that other writers such as goodhart express scepticism that this was a true case of " free banking ". the best known proponent of this view is hayek ( 1976 ). were attractive to the public. in effect, a country operating such a system would depend upon competition between commercial banks to ensure stability in the financial system and low inflation. to my mind, these free - banking proposals really belong in the world of technical curiosities. they can be argued to work in theory, but the fact is that there is no working example of such a system anywhere in the modern world. so i have to conclude that those who say interest rates should be left to the market are proposing something that is either not workable ( if they mean simply shutting down central bank operations ) or something that is much more radical than most people would be prepared to accept. this brings me to my third