Saturday, August 11, 2007

Saturday Forum: The week it all fell apart

Nobody emerged well from this past week. The Prime Minister said he wanted the economy placed front and centre of the Australian political and social debate.

This week he got it, with vehemence, in a way he couldn't possibly have wanted.

The US, European and Australian share markets are plunging, financial systems are in turmoil, the Reserve Bank has pushed up interest rates in an election year and looks set to do so again, John Howard’s attack on the states for igniting interest rates has been met with ridicule, and every night on TV the Labor Party is running ads reminding voters of his words from 2004: “This election ladies and gentlemen, is about trust. Who do you trust to keep interest rates low?

The Prime Minister is being buffeted by events he can barely influence, let alone control...

His problem is that by authorizing a publicity blitz three years ago that promised he would “keep interest rates at record lows” and by allowing his Treasurer to boast about the skill it takes to manage a trillion dollar economy, he has given the impression that he should have things under control at a time when it is apparent he does not.

Australian interest rates are higher than those of any western country other than New Zealand. They are higher than the rates in the United States, Canada, the United Kingdom, mainland Europe or Japan for the simple reason that our buying power has soared in a way that there’s has not.

Since 2001 Australia’s terms of trade - the prices we are paid for our exports relative to the prices we pay for our imports - has shot up 37 per cent. Only Norway has come close. Its terms of trade are up 33 per cent. Canada, in third place, has had a terms of trade boost of 13 per cent.

Most of this extraordinary increase in our buying power has been fueled by the powerhouse to our north. China is paying high prices for our iron ore and charging us little for the products it turns it in to. WorkChoices, tax cuts, fiscal discipline - everything that the Australia’s Commonwealth government is responsible for - makes very little difference.

The last time our buying power exploded in this way, during the Korean War boom of 1951, our inflation rate hit 25.3 per cent. To prevent this happening our Reserve Bank has increased interest rates nine times since 2002, and is quite prepared to do so again.

Which isn’t to say that the government has no role to play in what’s happened. It could have worked alongside the Reserve Bank to restrain inflation by withholding tax cuts. Instead it handed them out in 2003, 2004, 2005, 2006 and 2007 and has budgeted to do so again in 2008.

With bonus payments. You get a one-off cash payment of anything from $500 to $3,000 if you’ve had a baby, if your children have difficulty reading, if you are a carer, if you are eligible for the seniors card.

After the baby bonus went up in July last year at least one Harvey Norman store reported a 40 per cent jump in its sales of plasma and LCD television screens.

The government could have responded to the boom completely differently. After Norway discovered North Sea oil in the 1990s it set up a giant government investment fund, named the Petroleum Fund, to quarantine the extra money in until it was needed to ward off a downturn.

It invested the money overseas to ensure that it didn’t push up the currency or Norwegian inflation and watched it grow.

Chris Richardson from Access Economics wishes our leaders had done something similar.

“It’s too late now, but they should have taken the punters into their confidence to explain why handing them tax cuts wasn’t really going to help them that much,” he says.

Richardson thinks our budget surplus should have been locked away as has been Norway’s, and it should have been much bigger.

“Instead of 1 per cent of GDP and a political situation where neither side of politics has tried to say to the punters look, this may not last or even if it does throwing it straight back at you is only going to raise interest rates, they should have made a case for a bigger surplus – 2.5 per cent of GDP. In other words I would go for the tax cuts in the last budget as basically not having occurred”.

It is an argument journalists expected the Opposition to at least acknowledge on Wednesday when Kevin Rudd and his Treasury spokesman Wayne Swan fronted a press conference to condemn the government for the election-year interest rate rise.

What had the government done wrong? Had it unwisely pumped tax cuts into a superheated economy?

Not a bit of it. Four times Mr Rudd said his fiscal policy “mirrored” the governments.

Asked whether he thought the tax cuts and extra spending in the Budget contributed in any way to inflation Rudd didn’t reply. Asked whether there was a single tax cut introduced by the Howard government he would not have introduced he didn’t reply.

Asked how his approach to the budget surplus differed in any way from John Howard’s he replied, “Our budget orthodoxy is identical to the Government’s on this and there is no slither of light between us. That’s just the bottom line”.

Later in parliament Wayne Swan moved a motion condemning “the failure of the government’s economic policy to put maximum downward pressure on interest rates”. It was hard to work out why.

When reminded in the debate that Labor had promised nothing different Swan protested that there were two differences. Labor was keen on skills formation, which he said would put downward pressure on interest rates, and Labor was keen on building up infrastructure – in particular broadband.

The effect of these differences on interest rates this year, next year or the year after was not obvious.

In fact the Prime Minister came closer to acknowledging the link between his repeated generous budgets and the subsequent interest rate hikes when he said on Wednesday that he was aware the rate rise would “hurt some homebuyers” but that it was “all the more reason that we were very pleased that we had a sufficiently strong budget position to provide tax relief and other benefits to other families.”

He restated his earlier argument that Australia’s state governments had brought on the interest rate rise by announcing plans to borrow, but without enthusiasm. It had been savaged by experts including Associate Professor Steve Keen of the University of Western Sydney had described it as “total, total bullshit. It’s like saying that somebody dropped a pebble into the ocean and that caused a tsunami”.

While Australia’s politicians were ducking for cover and our Reserve Bank was responding to the threat of inflation in a completely orthodox way, in the United States financial corporations were imploding.

The US Federal Reserve had left interest rates too low for too long. It slashed them after the 2001 September 11 terrorist attacks and when the economy was slow to respond kept slashing.

For an entire year it left its federal funds rate at 1 per cent.

With money close to costless in the US an entire industry grew up offering money to people who had never realised they would be able to get it and would never be able to repay, especially if rates rose.

The so-called sub-prime borrowers had bad credit histories and about half couldn’t document their income.

This week the Wall Street Journal carried an account of what happened from Lou Barnes, the co-owner of a small Colorado mortgage bank called Boulder West.

He said until the 1990’s all borrowers had to fully document their income. The first no-doc loans were limited to 70 per cent of the property’s value. Then big financial wholesalers demanded that he push their products to less and less creditworthy customers.

“All of us felt the suction from Wall Street. One day you would get an email saying, we will sell no-doc loans at 95% loan-to-value, and an old-timer like me had never seen one. It wasn't long before the no-doc emails said 100%,” he said.

A wonder product was the “2/28” sub-prime loan. It offered a low starter rate for 2 years, then adjusted the remaining 28 years to a rate that often three percentage points higher than that normally charged to a good customer.

At first, few borrowers defaulted. With home prices rising, they could meet the payments by refinancing. When prices stalled and when the cheap introductory rates ended hundreds of billions of dollars of loans worth became worthless.

The fallout hit pension funds and financial institutions from the US to Europe to Australia.

Two funds operated by Australia’s Macquarie Bank lost 25 per cent of their value. The Bank itself was savaged on the Australian share market, losing 15 per cent of its value. Australia’s Treasurer Peter Costello took the unusual step of declaring the Bank sound saying he didn’t “see any grounds to think that the exposure of these funds in the US will reflect on the parent in Australia. We know that the parent in Australia is a well capitalised highly profitable bank”.

In Europe several corporations admitted to big losses including BNP Paribas which suspended three of its funds, and late Thursday Australian time in order to prevent a run on such institutions the European Central Bank advanced them $150 billion and said they could have more if they wanted it.

The US injected less cash into the market - $28 billion before the start of trading very late Thursday our time and in the event US share prices collapsed around 4 per cent, as did our prices a few hours later.

On Friday Peter Costello was keen to point out that the Australian market was still well up over the year and Australia’s mortgage market was nothing like that in the United States.

He said in the US sub-prime loans accounted for about 15 per cent of the market. “In Australia to closest analogy that we have is what we call non-conforming loans which are generally aimed at borrowers who have a poor credit history. In Australia that is about 1 per cent”.

“So the Australian exposure to non-conforming or sub-prime loans is about one-fifteenth what it is in the United States. In the US the delinquency rate is about 2.5 per cent. In Australia it is about 0.4 per cent, one-sixth.”

The Treasurer stressed that Australia’s financial system was well regulated. “I believe the best regulated in the world. It is regularly stress-tested to make sure that it is not over exposed to bad high levels of non-performing loans. The system is very secure, very profitable and well capitalised with the a low exposure to bad loans comparative to the United States.”

Asked whether Australia’s Reserve Bank had just made a US style mortgage market collapse more likely Mr Costello replied, “Look, one of the consequences of this would be if you are a person who has a bad credit history you will find it harder to get a non-conforming loan; or if you do, you may have to pay a bit more of a premium. So there may be a correction in that respect and if there is a correction in that respect, it would be no bad thing”.

The Treasurer and Prime Minister will be hoping that correction is minor and they might also be hoping that the election is out of the way by the time the Reserve Bank board is next due to meet to consider raising rates, on Melbourne Cup day November 6.