Sunday, October 19, 2008

So China will save us from a recession, right?

On Saturday the Age's China correspondent John Garnaut took us inside the faltering boom:

"On September 1, after eight boom years, the daughter was told to take an extended "rest" without pay. She knew the factory was in trouble. In March Han's 20-year-old son started work, loading the dust-like iron ore "fines" into compactors so that it doesn't all blow away when dropped into the furnaces. On September 27 he was stood down on a fortnightly roster of unpaid leave. "If the factory closes this whole village will have nothing to eat," Han says.

For five years China has been the saviour of the Australian economy. Its massive urbanisation has pumped up the prices of Australian resources and began to fill the economy with cash when it was needed after the housing bubble earlier this decade. Now, with the world rocked by the financial crisis, if China can no longer afford to pay inflated prices for commodities then the Australian economy is in deep trouble."

Also I attempted to sum up how things look at the moment:

"This was the week that fear of a financial meltdown morphed into fear of a global recession.

Believe it not, it’s an improvement. A meltdown of the financial system would have destroyed the needed to recover from a recession...

It has taken massive injections of government funds into formerly private banks in order to shirt back from the brink of a meltdown to do it as well as government guarantees of bank to bank lending and near-global unlimited guarantees of bank deposits.

Australia did its part on Sunday, abandoning an ill-conceived plan to guarantee only the first $20,000 of each Australian bank deposit and declaring that Australian taxpayers would guarantee the overseas borrowings of every Australian bank, building society and credit union without limit, in return for a fee.

Both in Australia and the US the enormous premiums that financial institutions were charging each other just to do normal business have begun to shrink. They have a long way to go until they have shrunk back to where they were, but at least they are no longer inexorably climbing.

A day later the US economist Paul Krugman was awarded the Nobel Prize for Economics. He has specialised in examining the collapse of trust in Japan at the end of the 1990s. There, no matter how low official interest rates fell (and they got close to zero) Japan’s banks wouldn’t part with whatever money they could get and Japan’s citizens were reluctant to borrow from them and deposit with them because they had lost faith in the system itself.

Japan remained in or near recession for a decade, a situation Krugman described as “a scandal, an outrage, a reproach,” and a human disaster which had “subtracted value from Japan and the world on a truly heroic scale.”

Until the US modified its flawed $US700 billion financial system rescue plan this week to make it more like that introduced in the UK, and until the much of rest of Europe and Australia followed suit Krugman was worried that Japan’s lost decade would be repeated worldwide.

The Washington meetings attended by leaders including Australia’s Wayne Swan on the weekend brought forth a shared determination to do whatever is necessary to ensure that financial institutions lend to each other rather than hold on to their money - even if it means taking them over.

As Krugman put it on Australia’s ABC radio within hours of receiving his Nobel Prize, “if you can’t persuade people to lend to each other, then one way or another the government has to take over the function of getting money moving – it has to do whatever is necessary”.

On Wednesday at the National Press Club Kevin Rudd seemed to revel in the turn of events. “What we have seen is the comprehensive failure of extreme capitalism – extreme capitalism which now turns to government to prevent systemic failure, an institution it spent decades deriding,” the Prime Minister said.

What’s at stake is more serious than a game of blame.

It is well accepted that poor people and poor nations usually find it hard to borrow from banks, even for good projects. Economists call this a market failure. What’s concerning them is that that failure would spread to everyone – that after being too generous with funds, investors and financial institutions will no longer lend them out at all. Nothing was more emblematic of the problem than the failure of the fast food giant McDonalds to extend its loan with the Bank of America last month. “If McDonald’s can’t get a loan using one the best business models on earth, who can?,” the critics asked.

In Australia, even after Sunday’s financial rescue package, funding for potentially worthwhile projects has become to find. Funding for potential duds has dried up. Most of the members of the consortium which was to bid against Telstra for the right to build Australia’s fibre-to-node broadband network are reported to have withdrawn. Telstra itself is said to be finding it hard to find the finance. As the ANZ pithily put it in a note to clients, “investment in Australia cannot be expanded if it cannot be cost-effectively funded”.

It had been thought that Australia would escape the recession set to sweep through the industrialised world. The US, the UK, the European Union and Japan are all on the brink of recession and New Zealand has already slipped into it.

Our strong card was our exports. Huge increases in the prices and volumes of our coal and iron ore shipments gave us our second biggest trade surplus on record in August. Coal export prices have jumped 70% in the past three months after jumping 54% in the three months before that. We are earning 30% more from our exports than we were a year ago, and many of the prices are locked well into the future.

But the future beyond that looks awful. When the current contract prices end they will be replaced by new ones much lower. TD Securities is predicting a drop of around 30% in Australia’s terms of trade. The Baltic Exchange Freight Rate Index, usually a good predictor of commodity prices, is down 75% from its peak and is expected to fall further.

“Having ridden the back of the commodities boom over the past 5 years, the sharp reversal in prices now well and truly unfolding spells huge trouble for Auistralia,” says TD Securities.

“The further commodity prices fall, the more problematic is the outlook. Indeed, it is easy to see why the Reserve Bank is embarking on one of the most aggressive interest rate cutting exercises seen in Australia, and the government is willing to spray money around to the embattled household sector.”

The problem isn’t that the Australian economy has begun to turn down. Employment is continuing to grow. It’s that the psychology of employed Australians has begun to change.

For years now Australian households in have been spending more than they earn – behaviour that seems irrational until you consider what’s been happening to their wealth. As the value of Australian’s houses has soared (along with their ability to get access to that value through refinancing) and the value of their share market and superannuation portfolios have also soared it’s felt rational to spend up.

Now the mechanism has been thrown into reverse. Although Australians are still earning just as much as they were, they are now seeing the value of their savings and their houses shrinking. It feels right to pull in their heads.

Gerry Harvey of Harvey Norman says this week he had “stores out there where sales are up 5% and 10% and lots of stores that are down 5% and 10%, but the sum total is we are down 4.7%… I can't remember when that last happened”.

Tuesday’s $10.4 billion economic security package was designed to turn things around. There is little doubt that it will, at least during the fortnight in December when around $8 billion of the package hits the accounts of pensioners and family benefit recipients. When the US pumped a similar proportion of its income into cheques paid to families in May it managed to avoid a recession. But it’s a trick that only works for a while.

The government’s thinking - or perhaps it’s a hope – is that by the time the effect fades, perhaps in a few months, Australians will have noticed the sharply lower mortgage rates and feel better about spending anyway.

If that doesn’t happen, the Reserve Bank will cut rates again, and then again. And we may just get another economic stimulus package. Australia is blessed compared to its counterparts in that it has begun the process with a very high interest rate so it can do a lot of cutting until it gets to zero. By contrast the US has an official interest rate of 1.5%. There’s not much more it can do. The Australian government is debt-free and has tens of billions awaiting spending in special funds. It can afford many more stimulus packages than the US.

Some observers think that that was one of the reasons it made its package is so big – to show that it could. The actors in the ABC’s Hollow Men noted that “$10 billion” is a figure that gets attention.

The competing theory is that the government is expecting such an economic downturn that only $10 billion can prevent it. By not making public its forecasts until the release of the Mid-Year Economic Review next month the government is fuelling that suspicion.

"This package is bigger than we have ever seen before," said Professor Bob Gregory of the Australian National University this week. "That must mean that their forecasts are worse than anything we've ever seen before."

An unspoken government aim appears to be maintaining Australia’s high house prices. Yeas ago a Howard government Minister Ross Cameron observed that rising house prices “makes for happy voters.” The authorities’ aim right now is to stop voters getting much more unhappy. The government and the Reserve Bank can’t control share prices, but they can influence house prices by doubling and in some cases tripling the First Home Owners Grant and by slashing interest rates.

Having the Treasury’s Official of Financial Management spend another $4 billion funding the mortgages sold by non-bank lenders is another way of keeping downward pressure on mortgage rates.

We have moved a long way from the days when these sorts of measures would be seen as unwelcome signs of government interference in “the market”. The financial market has been barely functioning, and even now no one is certain that it is back on the road to health.

Avoiding recession will need everything that Mr Rudd and his advisors will come up with.