May 1st 2008

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ECONOMIC AFFAIRS: Australia reels under sub-prime fall-out

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Australia reels under sub-prime fall-out

by Colin Teese

News Weekly, May 1, 2008
Could Australia be heading towards another bout of 1970s-style "stagflation" - that is, stagnant growth, unemployment and rising inflation?

When the sub-prime financial crisis hit the United States, received opinion in Australia - which included this writer - believed that our economy would be unaffected by it, except perhaps for a slight backwash effect.

That view seemed to make sense at the time. Our banks were not involved to any great extent in sub-prime lending, and thus should not have suffered significant losses of liquidity. Nor should there have been any of the flow-on effect to the real economy as happened in the United States.

We now know that the fall-out from the US financial crisis propelled its real economy into recession; what we can't yet discern is how serious that recession might be. Also, it is uncertain how widespread the fallout might be beyond the United States.

The mere suggestion of a US recession would once have rung alarm bells in Australia.

Our economy was in past times so closely tied to the US that we could hardly have avoided an adverse reaction from any downturn in that economy. We all assured ourselves in 2008 that this was no longer so.

Chinese manufacturing

It is, of course, recognised that in the 21st century our economy is tied much more than previously to China's economic fortunes. Much of Chinese manufacturing output of course still finds its way into the United States. However, we also know that other export destinations in Asia, along with the Chinese domestic market, take up a far greater proportion of total Chinese manufacturing output.

Australia's economy benefits enormously from all of this. China's manufacturing output relies heavily on imports of Australian raw materials and energy. If most of China's manufacturing output is destined for markets other the United States, then any US recession these days will hurt Australia less than it once might have done.

At least, that's the direction that informed thinking was heading a few months ago. What, then, has caused so many to revise their view? Facts. That is, new and additional information on the nature and extent of the financial crisis in the US has added a fresh dimension to the US financial crisis.

For a start, it is now clear that misdemeanours on the part of US financial institutions are not confined to a few downstream maverick lenders who took their eye off the risk-management ball and got into trouble lending to unsafe borrowers for house purchases.

Major banks are now known to have been caught up in the whole mess. One has had to be rescued from collapse - effectively with the help of the US central bank, the Federal Reserve. Others have been obliged to take doubtful to bad debts onto their balance sheets, having committed themselves to risky loans at unrealistically low interest rates.

Nobody seems capable of calculating the full extent of these bad loans in the case of individual institutions. What can be said is that the impact of these misdemeanours has had unanticipated and decidedly uncomfortable consequences. Indeed, the overall US finance sector has been seriously disabled.

Inter-bank loans, the vital financial lubricant of the entire sector, became the first casualty. These virtually dried up, because reputable banks' solvency was no longer being taken on trust - even between banks themselves. Nobody knew the extent of banks' commitment, formally or otherwise, to unsafe loans. To prevent a total freeze-up of inter-bank lending, the Federal Reserve moved quickly to pump money into the system. This helped, but only to a small extent.

Months later, banks remain hesitant about lending to each other. To the extent that lending is taking place, it is at much higher interest rates than previously, to take account of what are perceived to be, quite possibly, much higher risks. And this is where the knock-on effect begins.

Speaking generally, financial market deregulation has internationalised not only the movement but the cost of money. Thus, movements in US interest rates - up or down - can no longer be quarantined within that market. Neither can interest rates necessarily be set officially by nations' central banks in the way they once could be. When stress hits the system, as now, commercial bank lending-rates run ahead of those official rates set by central banks.

For countries such as Australia, which are heavy offshore borrowers, this development presents serious problems, the full extent of which we are perhaps only now beginning to see.

The sub-prime crisis in the US was caused by deregulation of a market awash with cheap credit, the availability of which itself induced investors (private and institutional) to disregard risk in favour of writing more investment business.

Vast amounts were lent - mostly, though not entirely, for house purchasers - to borrowers who were quite unable to service the loans. Of course, defaulting borrowers could be, and were, dispossessed. But markets flooded with repossessed goods resulted in huge losses for the repossessing lenders. No less worrying was that much of the repossessed property could not be sold, and losses on such transactions have reverted to the books of lenders.

At that point, the impact of what began as a financial crisis could no longer be confined to financial markets and investors.

The house-building industry was the first to take a direct hit. With the market flooded with unsellable repossessed property, and with interest rates on borrowing rising rapidly, demand for new house-building dropped dramatically. The same influences tended to press down house prices overall.

These, it should be understood, had been pushed to hyper-inflated prices by a combination of cheap money and irresponsible lending practices. (And, of course, as in Australia, the housing industry sustains other large parts of the wider US domestic economy.)

Painful realignment

In the US, under the stimulus of Federal Reserve interest-rate cuts in the late 1990s, house prices soared by about 35 per cent in just a few years - far in excess of the historic long-term annual increase of 3.1. Realignment with this long-term trend, as must happen, will be long and painful for the US housing industry and for the US economy generally.

Europe has also been infected by the US sub-prime crisis. The European Union's bureaucracy helped intensify the problems, at least in Germany, by its over-enthusiastic commitment to deregulation. The EU directed the German Government to adopt policies which have threatened the viability of many of the small German banks across the country.

Deregulationists like to imagine that the financial system can, and should, be left to absorb the consequences of its mistakes. This is a fond hope.

Politically, too much is at stake for governments to risk a total collapse of the system. That's why, in the last couple of weeks, central banks around the world seem to have agreed on a similar approach. Money is to be pumped into the system, as needed, to keep it afloat. This will be in the form of loans, though backed only by dubious securities. These are really bailouts.

Our own Reserve Bank of Australia is part of the deal. It seems to have put aside the control of inflation as its top priority - not that inflation isn't a problem. But, like its US counterpart, the Federal Reserve, our Reserve Bank now is, correctly, more concerned about recession.

The end of the era of cheap money, following the US financial crisis, is pushing up interest rates worldwide for business and consumer borrowers alike. Independent of what central banks do or think, supply and demand are now setting interest rates for borrowers, and this process is now feeding inflation.

Apart from money costs, other external factors are exacerbating inflationary pressures in Australia. Petrol prices have risen rapidly, and are continuing to rise. Food prices are rising worldwide, apparently as more investment is poured into growing crops for ethanol, especially in the United States. And energy costs are rising quickly, again connected with international pressures such as fears about climate change. Our Reserve Bank cannot counter these influences.

The last time we had a financial crisis in the US was 30 years ago. Up to that time the US effectively underwrote the world financial transactions by guaranteeing that other governments could swap their dollars for gold. As the crisis grew, the US could not afford to guarantee the dollar/gold redemption policy. It was obliged, for domestic economic policy reasons, to devalue the dollar and thus renege on its commitment to exchange dollars for gold.

In the short-term, the US fixed its domestic economic problem, but it left the world with the consequences of stagnant growth, unemployment and rising inflation. Meanwhile, a new word was coined to describe that condition: stagflation. It took the world almost 20 years to recover.

The question is: are the same circumstances coming upon us again? The United States is furiously devaluing its dollar to rescue its own economy from serious recession. We can't yet say whether economic events will follow the course they did in the 1970s. But Europeans are certainly worried. Devaluing the dollar may be good for US exports, but European industries are being rendered uncompetitive in the process - the same as happened previously.

Australia suffered severely from the consequences of "stagflation" last time, along with the rest of the world. If history repeats itself, we won't be able to avoid some of these adverse consequences; but we might be better off this time because of the way our economy has become somewhat decoupled from the US.

That's the good news. Not so good is the possibility that new circumstances - such as our new economic ties with China - might, as a consequence, drive us more closely into the arms of China than either we or the United States would wish.

It would indeed be ironical for Australia and the US, if the unintended consequence of US deregulationist ideology was to drive us into China's embrace.

- Colin Teese is a former deputy secretary of the Department of Trade.

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