Friday, December 07, 2007

Saturday Forum: How serious is the US financial crisis becoming?

You know things are serious when the most pro-business US president in living memory promises to freeze mortgage interest rates for half a decade.

That’s what George W Bush did on Thursday. Everything he had said about personal responsibility and about getting the government out of Americans’ lives was put on hold.

We saw it in this country at the end of the 1980’s.

The ultimate deregulator – the man who had floated the Australian dollar, let in foreign banks and abolished the ceiling on bank mortgage rates announced that henceforth they would go no higher.

Paul Keating as Treasurer declared that 17 per cent was high enough. It would be illegal for banks to charge any more, whatever their underlying costs.

Within months we had plunged into a recession that lasted years. Things had indeed been serious...

Bush’s announcement, like Keating’s roughly two decades ago, is symbolic rather than particularly helpful. The loans whose repayments will be frozen are those at low honeymoon rates that were due to jump to market rates next year. Borrowers judged able to pay the market rates won’t get access to the freeze and nor will those who are judged unable to pay the starter rate because they are behind in their repayments.

The real problem looks unsolvable and its extent unknowable.

What is known suddenly looks worse.

Our Reserve Bank’s groundbreaking decision this week to release the minutes of its monthly board meetings makes clear how sudden.

Just one month ago our Bank painted a relatively benign picture of global economy. The minutes for its November board meeting report that despite a downturn in the US housing sector, “other parts of the economy had been resilient”. Although the US economic growth would slow, other nations including China, Singapore and Korea would grow very strongly. Global growth would remain “still well above the average of the past three decades”.

Not by December. The report of this week’s board meeting declared that “market sentiment had deteriorated after an earlier improvement and that prospects for growth in the major economies appear to be weakening”.

“It is unclear to what extent that will affect Asia, where conditions at this point look quite strong. But overall, it now appears likely that global growth will be closer to trend in 2008, after several years of above trend growth,” the Bank reported.

This week a former US Treasury Secretary Paul Samuelson, now in his nineties, is regarded as one of the fathers of modern neoclassical economics. He holds a Nobel Prize and he wrote the best-selling textbook that explains how everything is meant to work.

Last month he wrote that the tools that have worked for most of his lifetime may no longer do so.

“It used to be enough for a central bank to ‘lean against the wind.’ That means lower interest rates when unemployment is too high and when deflation threatens. And when business growth is too brisk, central banks are supposed to raise their interest rates to dampen growth and to forestall price-level inflation.”

He said that right now it no longer clear that the mechanism works, and it is no longer even clear in which direction rates should be moved.

“This is surprising, but true. Interest rates are indeed low. But financial panic engendered by the burst bubble of unsound US and foreign mortgage lending means that even a mammoth corporation like General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.”

The implications for Australia of such a development here would be awful.

Our governments have effectively outsourced management of our economy to the Reserve Bank. At its first Cabinet meeting this week the Rudd government increased the Bank’s status still further making its Governor a statutory official safe from the sack and giving him a partial veto over new appointments to his board.

In his quiet moments the new Treasurer Wayne Swan might be prepared to concede that the tax cuts he promised in the election were unwise, but he has been able to feel confident that if they do cause trouble, the Reserve Bank will be able to adjust interest rates and fix things up.

Veteran Australian economist Fred Argy, a visiting fellow at the ANU and an advisor of prime ministers from Menzies to Keating says that in recent years we have come to regard it as “unthinkable that we will have a serious recession ever again. The Bank will always come to the rescue.”

He isn’t sure that Samuelson is right about the growing impotence of central banks. But he says the prospect “makes one think”.

It would mean that Australia might be powerless to prevent the next recession when it loomed and that government’s would have to use its own tools – tax and spending powers – in an attempt to stop it happening.

This might mean aggressively going into to deficit to pump money into the economy, regardless of Labor’s formal pledge to run surpluses over the business cycle.

It’s a view put forward by Larry Summers in the United States. He says the crisis facing its financial system is too important to take second place to the aim of long-term deficit reduction.

Not everyone thinks that what is happening in the US will turn out to be that serious. The Organisation for Economic Co-operation and Development painted a relatively upbeat picture of the US in its Economic Outlook report released on Friday.

It says that while the housing market problems will drag US growth down to low levels it will “not trigger a recession”.

As well Europe, China and Japan are not as dependent on the US as they once were. A good deal of China’s economic growth is now being fuelled by its own citizens as their living standards rise.

Although its OECD growth forecasts have been revised down “the baseline scenario is actually not that bad in view of the recent shocks”.

But it says the risks to its forecasts are heavily weighted to the downside.

The most important things to avoid catastrophe are for every country to do all that it can to make sure financial markets continue to function, and to avoid permanent tax cuts.

Yes. What we think of as a domestic issue, and what leaders on both sides during our election campaign regarded as an irritation, is actually one of the top priorities identified by the OECD to stave off a worldwide economic collapse.

Its reasoning goes like this. Throughout the OECD budgets have come in above expectations in recent years because of better than expected revenue.

But “part of this revenue bonanza is likely to be temporary, reflecting among other things high profits in business activities related to finance and housing”.

Its warning: “There is a risk that decisions could be taken in countries that cannot afford it to permanently raise spending or reduce taxes on the basis of temporarily high receipts.”

There’s no doubt that the OECD is thinking about Australia in delivering the warning because it makes the same point in the section of its report devoted specifically to Australia.

It says to permanently give away extra revenue in tax cuts when a downturn might come and take that extra revenue away “would imply a weakening of the underlying budget position”.

“Were the downside risks subsequently to materialize, such weaknesses would likely surface and could impede the full working of the fiscal stablisers at a time when they were needed.”

In other words, because it will have given away its (probably temporary) mining-fuelled revenue bonanza in $31 billion of permanent tax cuts our government won’t have the store of money it will need to splash around to get us out of a recession when one hits.

Even if the mining boom ends without recession our government will find itself having to continue to fund historically low rates or personal income tax rates without the necessary revenue.

It’ll have to slash its own spending or push up other taxes to compensate at a time when such action will not be helpful.

On taking office this week Kevin Rudd and his Treasurer Kevin Rudd spoke of making “evidence-based” decisions as if with good management Australia’s future would be secure.

But right now the evidence is anything but clear and it’s not particularly clear whether the traditional tools of economic management will continue to work.

They’ve taken office at a challenging time.