Tuesday, September 30, 2008

The best case: two years of recession

So says Tyler Cowen

And the worst case?

"The best case scenario: The bad banks continue to be bought up, there is no run on hedge funds next Tuesday, only mid-sized European banks fail, money market funds keep on buying commercial paper, and the Fed and Treasury continue to operate on a case-by-case basis. Since Congress doesn't have to vote for something called "a bailout," it can give Paulson and Bernanke more operational freedom than they would have otherwise had. The American economy is in recession for two years and unemployment does not rise above eight or nine percent.

The worst case scenario: Credit markets freeze up within the next week and many businesses cannot meet their payrolls. Margin calls cannot be met and the New York Stock Exchange shuts down for a week. Hardly anyone can get a mortgage so most home prices end up undefined rather than low. There is an emergency de facto nationalization of banks to keep the payments system moving. The Paulson plan is seen as a lost paradise. There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag. The quasi-nationalized banks are asked to serve political ends and it proves hard to recapitalize them in private hands. In the very worst case scenario, the Chinese bubble bursts too.

I still think some version of the best case scenario is more plausible, but I wish I could tell you I am sure."

Let's talk tulips

'cos nothing else makes much sense

"If a weaver scraped together, say, 50 guilders, he might buy a new loom and increment his income slightly. But if he invested the same amount on a bulb he could make a small fortune quickly by speculating on a commodity whose value had never fallen."

That's from one of the best economic historians Australia has produced - Trevor Skyes. As he says in this after-dinner speech delivered to an Australian Reserve Bank conference in 2003:

"I'm not sure I need to give the rest of this speech, because we can all see where it's heading, can't we?"

But the ride is wonderful, and tells us that so much that is new is old again... a good, if awful, feeling.

The full talk, Tulips from Amsterdam, is here.

Below the fold I'll summarise by selecting choice paragraphs..

Tulips from Amsterdam

"There are four key foundation blocks for any hysterical boom.

First, a long period of growing prosperity in which the investing classes enjoy
a rising tide of disposable income – as Australia enjoyed in the 1960s ahead of the
nickel boom. And the deeper this prosperity spreads downward into society, the
better the chance of a boom because disposable income is in the hands of people
who are inexperienced at investing it.

Second, the arrival of an exciting new commodity or industry, such as railways
in the United States in the mid-19th century or Silicon Valley in the late 20th. And,
the early investors in that industry should be showing substantial returns, thereby
attracting more risk capital. Typically, there is a long groundswell in a commodity
price before it goes wild.

Third, within that commodity or industry there should be one or two star performers,
such as Poseidon in the nickel boom or Microsoft in Silicon Valley.
Fourth, a marketplace that is liquid and unregulated enough for prices to

By 1636, Holland had all four ingredients.

The merchants were growing rich on the Indies trade. Tulips were a status symbol
and – as the years went by – were becoming increasingly accessible by the lowerpaid
members of society.

And there was a star performer. Rosen tulips were one of the most highly prized
varieties, and the most highly prized of them all was the Semper Augustus.
It had a slender stem which carried the flower well clear of the leaves, showing
off its colours to best effect. The base of the flower was solid blue, turning quickly
to pure white, while slim blood-coloured flares shot up all six petals and around
their tips.

Everyone in Holland agreed that tulips were beautiful. Now came the widespread
realisation that a fortune could be made from them. The prices of tulips had been
rising steadily since their arrival in Holland. The early investors from 1630 were
showing rich returns.

By 1633, tulips were becoming widely available in Holland, although the most
prized were still scarce and expensive. But in 1633, we have the first recorded
instance of tulips being used as money, when a house in the town of Hoorn changed
hands for three bulbs.

From then, the prices started rising strongly.

The Semper Augustus, priced at 5,500 guilders in 1633, hit 10,000 in January 1637.
At that price only a handful of Dutchmen could have afforded it. It was enough to
feed, clothe and house a Dutch family for half a lifetime. Or, enough to buy one of
the grandest homes on the most fashionable Amsterdam canals for cash, complete
with a coach-house and 80ft garden, at a time when Amsterdam property was the
most expensive on earth.

At that date, a big-time merchant might have been making 20 000 guilders a
year. So a single bulb of Semper Augustus was worth half his income. As a modern
equivalent, one tulip bulb was worth half Rene Rivkin's income.

Bulbs had already been used as a unit of exchange. Now they became a promissory
note – a scrap of paper listing the variety and weight of the bulb, the name of the
owner and the date upon which it would be lifted. Because the lifting date was
usually several months away, this encouraged dealing in the piece of paper rather
than the bulb.

What we are talking about here is a future.

The futures market was not entirely novel to Holland. The very earliest futures
markets had been organised in Amsterdam 30 years earlier by merchants who traded
in timber, hemp or spices on the Amsterdam Stock Exchange.

However, the traders in tulip futures were gambling upon an essentially unknown
commodity. If I buy a future on BHP shares, I know what I'm getting upon delivery
(or at least I hope I do).

But when I buy a future on a broken bulb I don't know what sort of flower I'll
have upon delivery.

But that no longer matters, because the buyer is no longer a botanist or gardener
who wants to own a beautiful fl ower. The buyer is only interested in the bit of paper,
which he hopes to trade at a profit.

So yes, the tulip was the underlying commodity that fuelled the boom of 1636–37,
but in reality it was leveraged into a derivatives boom. And one of the characteristics
of derivatives is that few of the traders are ever interested in final delivery.

So in Holland in 1636, it became perfectly normal for a florist to sell bulbs he
could not deliver to buyers who did not have the cash to pay for them and no desire
to plant them.

The second ingredient was leverage. Where bulbs or offsets were not available
for instant delivery, it was common to put only 10 per cent of the price down.
Also, the buyers quickly worked out that they could build a fortune faster if they
borrowed to buy tulips, or futures on tulips. So they began mortgaging their homes
to play the bulb market.

I mentioned earlier that weights of bulbs were one indicator given to speculators.
A healthy tulip bulb increases in size while in the ground. So if prices on weight
stay constant, the bulb will increase in value as it grows.

Artisans on low wages had been making money slowly. If a weaver scraped
together, say, 50 guilders, he might buy a new loom and increment his income
slightly. But if he invested the same amount on a bulb he could make a small fortune
quickly by speculating on a commodity whose value had never fallen.

And if he leveraged by borrowing, he could make a medium to large fortune.

I listed earlier the four requisites for a hysterical boom. We now have three of
them. We have a prospering society with surplus investible cash. Not only are the
rich investing but the middle classes are getting into the act, so there's volume. We
have a prized commodity which has never fallen in price. We have a bunch of star
performers, led by Semper Augustus. All we need is a marketplace.

Tulips were never traded on the Amsterdam Stock Exchange, which in any case
only traded from noon until 2 pm. Tulips were an unregulated market.

Tulip trading happened in taverns, mostly in Haarlem, where the participants
were quite frequently drunk. And sometimes the taverns doubled as brothels, which
would seem about the perfect ambience for an unregulated derivatives market.

The taverns were very smoky and the inhabitants drank vast quantities of wine
and beer. Each deal struck was followed by a toast. And this was in the days when
wine in Dutch taverns was served in pewter pitchers that held anywhere from two
pints to more than a gallon. The mania of December 1636 and January 1637 occurred
in this drunken, licentious ambience.

The deals were usually done on slates. A bidder would write down the price he
wanted to pay, a seller would write down the price he would accept. The slates were
passed to intermediaries nominated by the principals, who would write down what
they considered a fair price, which was not necessarily in the middle.

The slates were passed back to the buyer and seller. If either of them did not
agree, they would rub out the price. If the deal was struck, the buyer would pay a
commission, usually around 3 guilders, to the seller. The commission was called
‘wine money'.

One flaw in this system was that there were no credit checks. Buyers did not
have to prove they had the money to pay for the bulbs. Sellers did not have to prove
they owned the bulbs they sold. So the taverns combined unbridled speculation,
stimulated by alcohol, while providing no safeguards for anyone.

Like most booms, the end came suddenly. On the fi rst Tuesday in February, a
group of fl orists gathered as usual in a Haarlem tavern to offer pound-goods for
sale. One member offered a pound of Switsers for 1 250 guilders, a fair price in the
market then. He received no bids. Nobody wanted to buy.

From there, panic spread in the market. Nobody wanted to buy tulips
any more.

The collapse was so sudden and complete that there is virtually no information
on post-boom prices. The only buyers left were a few rich connoisseurs who did
not depend on the trade for their wealth.

According to one anecdote a tulip that had been worth 5 000 guilders before the
crash was later sold for only 50. A bed which would have fetched 600 to 1 000 guilders
in January, changed hands for only 6.

The collapse was total and very fast. Even the great modern computer-aided
meltdown of October 1987 did not produce such instant eradication of wealth.

What happened was that the market had been killed from the bottom. The very
cheapest tulips had been driven so high in price that there was nothing for new entrants
in the market to buy (which looks a lot like the current Sydney real estate boom).
With no fresh money coming in from the bottom, the boom lost its foundation.

And, of course, as soon as any over-priced commodity reaches its peak and turns,
every trader becomes a seller trying to get out as quickly as possible and destroying
prices as he sells down.

The pain of the crash was worst for those who had borrowed to speculate. Men
who had pledged their farms and houses suddenly lost them. In the days before social
security that meant the workhouse or starvation and probably early death."


"Consequences that would haunt humanity until the end of time"

That's what Garnaut says is in store if we fail to contain atmospheric carbon.

Here is his summary of the final chapter of today's final report of his Garnaut Review:

"There are times in the history of humanity when fateful decisions are made. The decision this year and next on whether to enter a comprehensive global agreement for strong action is one of them. Australia’s actions will make a difference to the outcome, in several ways. The chances of success at Copenhagen would be greater if heads of government favouring a strong outcome set up an experts group to come up with a practical approach to global mitigation that adds up to various environmental objectives. On a balance of probabilities, the failure of our generation on climate change mitigation would lead to consequences that would haunt humanity until the end of time."

Below the fold is the entire final chapter, and a summary of the report prepared by the ANZ Bank:

Chapter 24 - Fateful decisions

"There are times in the history of humanity when fateful decisions are made. The
decision this year and next on whether to enter a comprehensive global agreement
for strong action on climate change is one of them.

Or rather, in this case, a fateful series of decisions. The world will not arrive at
a satisfactory single settlement in one meeting in Copenhagen, or in one meeting
after that.

If things go well, the decisions of many governments will lead into a
comprehensive global agreement in Copenhagen. That agreement will lead to
the world taking major new steps on mitigation in all major countries. Substantial
financial flows to developing countries for mitigation and adaptation will expand
beyond recognition. Structures and incentives will have been established to
support a large increase in investment in the new technologies necessary for
mitigation to occur at reasonable cost.

If things go well, very well, Copenhagen will be the end of one process, and the
beginning of others that will lead, over time, to effective global mitigation at a level
that reduces risks of dangerous kind to an extent that seems acceptable to most
informed people.

If things go badly, they could go very badly.

When human society receives a large shock to its established patterns of life,
the outcome is unpredictable in detail but generally problematic.

Things fall apart.

The initial financial shocks that hit Australia in the 1890s, central Europe and
the industrial world in the 1930s, or Indonesia in the 1990s, were in themselves
substantial, but turned out to be small in comparison to the chain of events that
followed. In themselves, these shocks could have been expected to cause a
pause in growth, but not one that would throw history from its course. But each
shock was large enough to exceed some threshold of society’s capacity to cope
with change. In each case, what might have been a recession of substantial but
ordinary magnitude became a great depression. Total output fell by a fifth or more.

The associated social convulsions changed political institutions fundamentally and
as permanently as human institutions can be changed. They shifted the whole
trajectory of economic growth.

Unmitigated climate change, or mitigation too weak to avoid dangerous climate
change, could give human society such a shock.

The case for strong mitigation is a conservative one. Even at the levels
of mitigation that now seem to be the best possible, the challenges could be
considerable. In the absence of mitigation, we can be reasonably sure that they
would be bad beyond normal experience.

We know that immense shocks unsettle basic institutions, with unfathomable

We know that the possibilities from climate change include shocks far more
severe than others in the past that have exceeded society’s capacity to cope, and
moved societies to the point of fracture.

Here we are talking about global fracture.

If sea level rises by a metre or more this century and as much again in the first
half of the next, and displaces from their homes the people of the low-lying coasts
and river banks of the island of New Guinea, it will not be a problem for Papua
New Guinea and Indonesia alone.

If sea level rises and displaces from their homes a substantial proportion of the
people of Bangladesh and West Bengal, and many in the great cities of Dhaka,
Kolkata, Shanghai, Guangzhou, Ningbo, Bangkok, Jakarta, Manila, Ho Chi Minh
City, Karachi and Mumbai, it will not be a problem for Bangladesh, India, Pakistan,
China, Thailand, Indonesia, the Philippines and Vietnam alone.

If changes in monsoon patterns and the flows of the great rivers from the Tibetan
plateau disrupt agriculture among the immense concentrations of people that have
grown around the reliability of water flows since the beginning of civilisation, it
will not just be a problem for the people of India, Bangladesh, Pakistan, Vietnam,
Myanmar and China.

There will be no islands of normality in Melbourne or Mildura, even if the same
forces on climate have not displaced the people around the edges of Port Phillip
Bay and scorched the economic life from the Murray-Darling Basin.

The problems of unmitigated climate change will be for all humanity.

During the discussions following the release of the Review’s draft report in early
July 2008, some critics said that my descriptions of impacts had been ‘alarmist’. I
responded that I was simply telling the story as it fell out of the analysis, when the
emissions growth suggested by the Review’s own work was applied to ‘centre of
the road’ scientific judgments on the relationship between CO2 concentrations and

I was talking then about impacts in the middle of the probability distributions
that come, as best we can judge, from contemporary science.

I did not then talk about some of the possible shocks that I am discussing now:
shocks that until recently were a fair way along the ‘possible but not very likely’
end of the probability distribution, but have been moved closer to the centre by
the Review’s work on business as usual scenarios. Some shocks that would be
severe and damaging that were once near the edges of the distributions are now
near the middle. In the absence of mitigation, as we move beyond this century,
some of these shocks move to the higher probability ends of the distributions. As
noted in Chapter 11, without strong mitigation, the melting of the Greenland ice
sheet, sooner or later, becomes something close to a sure thing.

In Chapter 2, the Review accepts the views of mainstream science ‘on a
balance of probabilities’. That formulation allows the possibility that the views on
climate change of the IPCC and the learned academies in all of the main countries
of scientific achievement are wrong.

There is a chance that they are wrong. Just a chance. But to heed instead the
views of the minority of genuine sceptics in the relevant scientific communities
would be to hide from reality. It would be imprudent beyond the normal limits of
human irrationality.

It is prudent to give the major weight to the mainstream science. This is fully
compatible with investing more in improvement of knowledge to narrow the
dispersion of the probability distributions. The improvement of knowledge, the
narrowing of uncertainty, the sharpening of predictions: all these can and should
proceed alongside the commencement of international collective action in pursuit
of strong mitigation.

The annual costs of strong mitigation continue to increase over the first half
of the century. The mitigation process can be cut short, with due notice to those
who have committed their capital to a new economy of low emissions, if at any
time the international community comes to the view that new scientific knowledge
establishes that the concerns of 2008 were erroneous to the extent that mitigation
judgments based on them have become obsolete. Mitigation could come to a stop
in 2020, for example, on the basis of new knowledge that it was unnecessary, after
mitigation had been put in place to return to concentrations of 450 ppm.
In this case, Australia would have paid 2 per cent of GNP as insurance against
what would otherwise have been a high risk of immense damage. It would be a
high price, but one that was reasonable on the basis of the evidence available at
the time when decisions had to be made.

The consequences of inaction now are not similarly reversible. The arithmetic
of Chapter 3 about the new patterns of global growth takes away the time we may
once have thought we had for experiment, talk, and leisurely decision making. It
tells us that business as usual is taking us quickly towards what the science tells
us are high risks of highly disruptive climate change.

So fateful decisions are to be taken at Copenhagen.

The analysis of the current international situation in chapters 8, 9 and 10 tells
us that a good outcome is not assured.

The international community is on a course plotted before the implications
of the current era of growth we call the Platinum Age had been absorbed into
its decision-making framework. It is on a course plotted before humanity had
absorbed the implications of the acceleration of economic growth in the early
21st century; the concentration of that growth in economies at the stage of
development when growth absorbs huge amounts of energy; and in countries
where coal is the cheapest and most convenient energy source. New knowledge
changes the calculus.

The old calculus said that there was time—time for all developed countries to
take the early steps in mitigation, and then for all developing countries to join at
a later unspecified date. The old calculus said that it was good enough for the
developing countries to begin to contribute through the Clean Development
Mechanism and in other ways that made no additional contribution to the
global mitigation effort, beyond commitments that the developed countries had
already made.

The Review’s updated projections show that approaches based on the old
calculus will not hold the risks of dangerous climate change to acceptable levels.
Success at Copenhagen is not an agreement along the lines of the Bali
Roadmap. Success will need to build on the foundations of Bali and earlier
UNFCCC agreements, because there is no time to start again. But the content
of any agreement will need to go beyond what had been contemplated at Kyoto
and Bali.

Success at Copenhagen requires agreement to large emissions reductions
from developed countries, plus agreement on a framework for early contributions
to mitigation from China and as soon as possible from other successful developing

This formulation underplays the importance of another part of the contemporary
reality. It is much more likely that effective mitigation from developed countries will
be achieved within a comprehensive global mitigation regime. Developing country
participation would remove competitive distortion in trade-exposed industries.

It would demonstrate to the polities of the developed countries that their
contributions are not pointless self sacrifice, but part of a solution to the global
problem of climate change.

So success at Copenhagen, or at subsequent meetings convened for the
purpose, must encompass inclusion of developing countries in a global mitigation
regime. The arithmetic of Chapter 3 shows that the participation of China is urgent.
Comprehensive participation, beyond China, is necessary for the political and
economic viability of the regime.

So the fateful decision at Copenhagen is not just about whether there will be a
comprehensive regime.

It has to be a credible agreement. This means that the sum of national
commitments must ‘add up’ to the environmental objective.

Chapter 9 set out a principled basis for global agreement that meets these
objectives and places manageable obligations on developing countries with a
reasonable chance of acceptance. The Chinese constraints, which the arithmetic
says must be binding, are consistent with domestic goals that the government of
China has set for itself. For other developing countries, acceptance of constraints
would not be binding, but there would be large advantages for them in participating.

The trajectories for emissions constraint, based on modified contraction and
convergence, would provide opportunities for them to do better, and to sell surplus
permits, providing new economic opportunities. Acceptance of constraints would
allow developing countries access to the low-emissions technology and adaptation
funding commitments of the developed countries. They would avoid the disruption
to trade that might come to be associated with standing aside from international
cooperation on mitigation.

Let us be clear about the contemporary reality of global mitigation, and of the
gap between where we are and where we need to be. There are few countries
in which mitigation policies have yet had a substantial effect on emissions
reduction. The large reductions that have occurred in some countries have come
from structural change that was not associated with mitigation policies. Global
expenditure on low-emissions technologies has been at a low ebb—much lower
than had been induced by the high oil prices of the 1970s. No developed country
has yet put in place policies that can be reasonably expected to achieve its share
of the reductions in emissions necessary for 550 ppm concentrations objectives,
let alone something more ambitious. While China and some other developing
countries have implemented policies that are moderating the growth in emissions,
no developing country has been willing to concede that binding emissions
constraints should also apply to its own economy.

The first essential step at Copenhagen is a comprehensive global agreement
that adds up to the environmental objective to which it is directed.
Achievement of a comprehensive agreement around a 550 ppm objective would
be a step forward of historic dimension. Such an achievement and its effective
implementation would avoid the worst outcomes from unmitigated climate change.
It would give confidence to the international community that cooperation is possible
in this difficult sphere. Once in effect, alongside a low-emissions technology
commitment, it would unleash forces for innovation and structural change that
would demonstrate that strong mitigation was consistent with continued economic
growth, and bring more ambitious goals into the realm of the possible. It would
bring the next step to 450 closer to reach.

Effective comprehensive global agreement around a 450 ppm objective, if it
were realistic in conception and implementation, would be better still, for Australia
and for the international community. It would be 450 ppm with overshooting,
because we are already at around 450 ppm and this level will go much higher before
the momentum of emissions growth is slowed, halted and then turned around.

The numbers that add up to a 550 ppm global objective seem not to be
impossible for the separate sovereign nations that will have to form the view, one
by one, that acceptance and compliance is in their own interests.

The numbers that add up to 450 ppm are not yet within the decision frames
of the people who will need to commit to them. More ambitious numbers may
become feasible, and sooner rather than later, through the building of confidence
from the early years of successful implementation of a 550 ppm regime.
There is much that we do not know about the future costs or possibilities of
low emissions technologies, as there is much that we do not know in climate
science itself. Chapters 20, 21, 22 and 23 describe the possibility that the
incentives provided by a substantial and rising carbon price, and public fiscal
support for investment in innovation, could lead to large reductions in the cost of
structural transformation. In the nature of things, we will only learn by doing. It is
important to start taking the measures we need to take within carefully designed
institutional frameworks.

The difference in environmental outcome between successful achievement of
a 550 ppm objective and of a 450 ppm objective is substantial for Australia, as
demonstrated in chapters 6 and 11 in particular. But it is small compared with the
difference between 550 ppm and the complete failure of mitigation. The difference
between 550 ppm and 450 ppm is small compared with the difference between
550 ppm and emissions growth remaining anywhere near its current course.

The fateful decisions at Copenhagen will be for all sovereign nations. But the
fates will be set long before December 2009. They will be set in the earlier national
policy decisions taken by many countries, including Australia.

The Review’s conclusion that it would be in Australia’s interests for the world to
agree on commitments that add up to a 450 ppm objective, and which is capable
of implementation, is the basis of our recommendation that Australia express
its willingness to do its full, proportionate part in such a global agreement. But
Australia and the world have an even bigger interest in ensuring that realistic
and comprehensive global mitigation is begun around some attainable mitigation
objective as a result of Copenhagen.

Australia will matter to the international community’s fateful decision. We can
make a difference by announcing at an early stage that we are prepared to play our
full proportionate part in an ambitious global mitigation effort. We can take the lead
in a global effort to commercialise carbon capture and storage technologies, that
would, if successful, greatly ease the adjustment to low-emissions economies of
the developing world, and incidentally preserve a future for Australia’s coal industry.

We can take the lead in promotion of the Low-Emissions Technology Commitment,
and by commencing with a national commitment.

Australia can take the lead by building on what we have already begun, in
establishing productive cooperation on climate change issues with our neighbours,
first of all Papua New Guinea and Indonesia. An example of successful cooperation
that was advantageous for development, including in low-emissions technologies,
adaptation and permit trading, the latter covering forestry and all other emissions,
would be influential.

Australia can take a lead by placing in the international marketplace for ideas
proposals that add up to realisation of a global environmental objective. Australia
would do this not with any arrogant insistence that this is the only proposal to be
considered, but making it clear that we would also want to consider alternative
proposals, developed in other countries, that add up to specified objectives.
Australia could suggest that a number of heads of government with commitments
to a strong outcome at Copenhagen each appoint a representative to a group of
experts. This group would be given the task of coming up with a practical approach
that adds up to defined environmental objectives for consideration by leaders in
the lead-up to Copenhagen.

Australia can take a lead by preparing to implement at reasonable cost the
full range of mitigation programs necessary to meet the commitments that we
make to reduce emissions. Australia will be more effective if we are introducing
a well-designed emissions trading system. It will help if Australia makes it clear
that we are proceeding in any case with national mitigation, within the parameters
suggested in this report.

It is sometimes said that Australia’s influence would be greater and more
positive if, in the absence of comprehensive international agreement, we would
unilaterally implement much more radical reductions in emissions than those
put forward in Chapter 12. This neglects the economic reality. A world of partial
mitigation, in which individual countries do their own thing, is a world in which
mitigation is more difficult and more expensive. To go it alone beyond certain levels
of ambition would be to demonstrate the problems rather than the feasibility of
mitigation. It is doubtful that this would encourage the global mitigation effort. It
may deter it.

So the fateful decision at Copenhagen will follow many decisions in Australia
and elsewhere between now and then.

And after Copenhagen, there will be more big decisions to be made. If there
is a comprehensive and effective global agreement, the scene will be set for
reconsideration of ambition once it has been demonstrated that mitigation is
consistent with continued economic growth.

If there is no such agreement, the outlook is an unhappy one.

On a balance of probabilities, the failure of our generation would lead to
consequences that would haunt humanity until the end of time."

Key points (summarised by the ANZ)

. Today the Garnaut Climate Change Review released its Final Report. This Report has advisory status only.

. The Garnaut Review recommends larger emissions cuts than the long-range target already set by Government: 80% of 2000 emissions levels by 2050 compared to the Government’s stated target of a 60% cut.

. In the medium term, Garnaut recommends a cut of only 10% of 2000 levels by 2020, but if international agreement can be reached, then a cut of 25% from 2000 levels by 2020 would be preferable.

. Garnaut recommends an emissions trading scheme that is wide in coverage, has no free permits and no price limits after the initial transition period (to 2012). At least half the proceeds from the sale of permits should go to low income households to assist their adjustment.

. Garnaut calls for more national research on climate change and greater adoption of currently available technologies, goods and services that can reduce emissions from transport and households. Low-emissions technologies are already available and should be better utilised.

. As the Australian climate changes, strong, flexible, well-informed markets will become even more essential in insurance, water and food.

. For rural and regional Australia, Garnaut recommends large-scale ‘biosequestration’ (i.e. re-vegetation) and up to $1bn to assist coal-based power generation through the structural adjustment phase.

. Treasury research detailing the costs and benefits to the economy of Emissions Trading will be released sometime in October.

. The Government’s White Paper and draft legislation setting out the Carbon Pollution Reduction Scheme will be released at the end of 2008.


Next Tuesday's RBA board meeting will be very interesting

Macquarie's Rory Robertson is taking up the case for synchronised global rate cuts.

He writes:

**It was observed here last week that despite growing global financial turmoil, "large cuts in policy rates by key central banks have remained conspicuously absent. ...in not cutting rates - the policy action most households and businesses most understand - in recent months, the Fed, the BOE, the ECB and others have been fighting the developing crisis with 'one hand tied behind their backs'"

**After the Monday's sharp US market declines - now in the process of spinning around global markets in Tuesday's sessions - the case for large synchronised global rate cuts seems strong. Indeed, the case for large synchronised global rate cuts is stronger than ever before, and little else seems available at present to slow the "adverse feedback loop" threatening to stall the global economy, or worse.

**Whether synchronised global rate cuts will happen or not, I do not know. On the positive side, one suspects that the ECB, the BOE and other central banks now have, like Dallas Fed President Fisher, come belatedly to the conclusion that "inflation" no longer is the main threat to their economy's long-run health."

The US: "a banana republic with nukes"

So says Paul Krugman this morning after the US Congress rejected the $700 billion rescue plan.

He is quoting a warning he issued some days ago about what would happen unless Congress approved a plan. He says its coming to pass.

The entire world financial system will be dragged down (unless the Congress reconsiders and relents).

The Dow has suffered its biggest single points drop in history...

Here's Adam Carr at Australia's ICAP Securities this morning:

"As the expletives race around my mind - the jaw drops. By a vote of 228-205 the US House knocked back the rescue package – a variety of reasons were offered for the collapse - including that a speech made by one Democrat Representative was too partisan!? Republicans voted 2-1 against, while Democrats were generally in favour. Yet voters on both sides of the spectrum turned against the plan on concerns that it would merely be a Wall St bailout that ultimately wouldn’t work. A new vote can be held but the earliest I’m seeing is that would be later in the week with neither the House nor the Senate in session on Tuesday."

Here's Daniel Gross in the on-line magazine Slate:

"Well, maybe we don't need much of a private-sector financial system after all. That's the conclusion that most House Republicans, and a minority of House Democrats, seem to have reached in voting down the $700 billion bailout bill on Monday."

Read Michael West on this morning's Age and Herald website for a taste of what's now in store, and he didn't even like the rescue plan).

At a minute past midnight Australian Eastern Time the Australian Reserve Bank emailed me with the following:

"In response to continued strains in short-term funding markets, central banks today are announcing further co-ordinated actions to expand significantly the capacity to provide US dollar liquidity. Central banks will continue to work together closely and are prepared to take appropriate steps as needed to address funding pressures.

The Reserve Bank of Australia and the Federal Reserve have agreed on a US$20 billion expansion of the swap line to provide US dollar liquidity in Australia in exchange for Australian dollars. This is in addition to the US$10 billion swap line announced on 24 September 2008. The US dollars will again be made available against collateral to local market participants by the Reserve Bank via auction, and will be used to address year-end funding issues."

What was $10 billion has become $30 billion - all in order to make sure that the Australian companies wanting to enter forward foreign exchange contracts can actually get access to US dollars. Otherwise they almost certainly would not have been able to at any price.

Quarterly foreign exchange forward contracts are coming up for renewal. If they are unrenewable, trade will become more difficult - worldwide. Sand will be thrown into the wheels of the economic engine.

Monday, September 29, 2008

Why $4 billion spent buying Australian mortgages is government money will spent

And why it's good Australian politics as well

Commentator Michael S wrote

"Sorry Peter, but this is a terrible idea. I don't know how you could support it. All that will result is even higher house prices, and people requiring even more complicated financing arrangements (such as Rismark's equity finance mortgages - hmm ... who is associated with Rismark?) to buy places for living.

Anyone who supports this actively wants affordability to decrease."

Commentator Darren Lewin-Hill asked the same question more politely.

So, why is $4 billion spent buying Australian mortgages government money will spent?

Australian mortgages should be cheap to fund. Strewth, they should be. The loans are nearly always repaid on time in full...

Foreign lenders used to recognise this. That was when they were eager to lend and when they believed what ratings agencies told them (which in the case of Australian mortgages was the truth).

Aussie, RAMS, The Adelaide Bank et al got access to this money and exposed Australia's big banks to real competition. So much so that from 1996 Westpac et al began to cut their margins of their own accord in order to hang on to their mortgage business.

The result was cheaper home loans - and less unearned margin accruing to the banks.

Call it economic efficiency if you like, call it real competition, call it the market working, it was good for just about everyone - except perhaps the Westpacs of this world.

Move forward 12 years and because foreign lenders no longer trust the ratings agencies and because they wrongly assume that Australian mortgages are low quality they no longer lend, or demand a fortune for doing so.

Aussie, Rams, The Adelaide Bank et al are virtually out of the mortgage business. And guess what - for the first time in more than 12 years the big banks have widened their mortgage margins.

They will keep them wide until competition returns.

What's needed? Medium term Joye and Gans propose an Australian government body essentially certifying that Australian mortgages are of good quality (which they are) and taking upon itself the very tiny risk that they are not.

The foreign money should flow more cheaply, restoring the competition that will stop Westpac et al from ripping us off.

Short-term they suggest the Australian government, through the Office of Asset Management, buying mortgages from Aussie and so on itselelf. They are of good quality. The government knows that. It will do well on the deal, and force Westpac et al to act competitively.

Competition and the keen prices it brings matter.

Michael S says that Christopher Joye's company will benefit. So what?

What's important is whether it is good policy. It is. It'll restart competition in the mortgage business, with big benefits for bank customers and political ones for the Rudd government down the track.

Michael S also says that cheaper mortgages will result in higher house prices. All other things equal, of course they will. But do we really not want keenly priced mortgages?

There are better ways of taking pressure of house prices than expensive mortgages - scrapping the 50% tax holiday on income from capital gains made from trading property would be start.

Saturday, September 27, 2008

The week good policy won!

I say that because George W Bush - the man who believes in minimal government - came to accept that at times government has a very big role, and because of our own Wayne Swan.

First Bush:

The words of his speech say it all:

"I'm a strong believer in free enterprise. So my natural instinct is to oppose government intervention. I believe companies that make bad decisions should be allowed to go out of business. Under normal circumstances, I would have followed this course. But these are not normal circumstances. The market is not functioning properly...

The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal."

Thank God!

And then there's Wayne Swan...

When the Opposition leader Malcolm Turnbull suggested on Sunday that the Treasury's Office of Asset Management should buy mortgages from second-tier banks, Swan rubbished the idea.

Here's what his media advisor emailed to me Sunday afternoon:

Gday - as discussed - from Wayne:

"It is very worrying that despite all his claims to financial literacy, Mr Turnbull is out there today asserting the Government should be following the US in taking on bad debt, when the fact is Australia simply does not have the type of bad debts prevailing in the US banking system.

"It is either a monumental gaffe or intentionally irresponsible for Mr Turnbull to be out there again asserting that our banking system faces the same problems facing the US banking system.

"As Governor Stevens pointed out, the reality is that the health of our banks is light years away from that of US banks, and it is plain reckless for Mr Turnbull to be out asserting otherwise and talking down our banking sector.

"In the national economic interest, it's important Mr Turnbull stop shooting from the hip in an attempt to promote himself, and in the process talking down our banking system at a time of global uncertainty."

(For the record - Mr Turnbull never suggested buying bad debt. )

On Friday came the backflip - in order to implement good policy.

One of the architects of the idea, Christopher Joye, has been assiduous in talking to the Prime Minister's office and his co-architect Joshua Gans in talking to the Treasurer's office, even though the Treasury was pooh poohing the idea and even though Joye was close to Turnbull.

It was such a good idea (I described it as a nobrainer) that it won out.

Swan and Rudd are to be congratulated for putting politics last.

Joshua Gans outlines what happened here.

As he told me, it doesn't really matter now who talked to who - good policy won.

There is hope for us, and the United States, after all.

I am very, very happy!


Friday, September 26, 2008

Malcom Turnbull is Wayne Swan's pacemaker

At the start of this week I wrote:

The Opposition Leader Malcolm Turnbull has stepped up debate on the health of Australian banks suggesting that the Prime Minister follow the lead of the US President and use public funds to help them out.

Over the weekend President Bush unveiled the largest financial rescue in American history, asking to let the Treasury buy as much as $700 billion of bad mortgages from financial institutions in trouble.

In an Australian television interview Sunday Mr Turnbull called on Mr Rudd to consider doing the same thing.

“We know that it has been very, much harder for banks, particularly the second-tier banks and financial institutions, to re-finance mortgages,” he told the Nine Network.

“In the US, the government is taking a role, proposing to buy some of these securities, in effect to provide additional liquidity to take the pressure off mums and dads.”

“We've got the capacity to do that through the Office of Financial Management.

That's something I'd like to talk to the Prime Minister about to see if we can agree on some bipartisan measures.”

The Treasurer Wayne Swan immediately rejected the idea, labelling it “either a monumental gaffe or intentionally irresponsible”.

Now Swan's gone ahead and bloody done it!!!...

"AUSTRALIA'S Treasurer has said the Government will invest in residential mortgage-backed securities to boost competition.

Wayne Swan today said that the Australian Office of Financial Management, which manages the country's debt program, will invest in AAA-rated RMBS.

The AOFM will invest in 2 tranches of $2 billion each of RBMS, the Treasurer said, speaking after the Australian stock exchange had closed.

“The actions are about making a strong banking system even stronger and about making our banking system much more competitive,” Mr Swan said.

“Boosting competition is something the Government has been emphatic about.

“We need to have a competitive mortgage market so people under financial pressure can get a fair go.

“This is an important measure to introduce competition into the mortgage market over time.”

Joshua Williamson, TD Securities, writes:

News just to hand is that the AOFM will invest up to $4.0 billion in RMBS in two tranches. The funds for the investment will come from the 2007-08 Budget surplus, which has come in $2.9 billion higher than expected at the time of the Budget, totalling $19.7 billion. The initiative appears designed to shore up mid-tier banks and non-bank lenders and politically at least shroe up the Government against criticism that competition in the mortgage sector is diminishing as non-bank lenders find it harder to obtain funds in wholesale markets. Note that these devlopments do not require parliamentary approval but it would typically take around four weeks to get this deal up and running with two weeks for documentation alone.

TD Securities doubts whether the Government would be willing to put tax payers funds at risk if the Australian banking system was in as much risk as the US system. In this regard, it is not surprising that this initiative has come about after the RBA's positive financial stability review.


RBA "increasingly likely to cut by 50 points"

"It seems likely that our economy will fall into recession if interest rates are not reduced significantly over the next 12-18 months"

-- Rory Robertson, Macquarie's interest rate strategist, who usually has a good reading. Here is his excellent note:

**Most global economic and financial variables still are trending in the wrong direction. After last week's massive shock to the global financial system - with the sudden failure of a couple of US household names (AIG and Lehmans) prompting increased "risk aversion" everywhere - there's obviously an increased chance that the RBA's 7 October cut now will be 50bp (to 6.5%) rather than just 25bp.

**The case for the larger 50bp RBA cut simply is that the outlook for local and global growth continues to darken - and (so) the outlook for lower inflation continues to brighten - as the global credit crunch intensifies...

As I have highlighted here regularly over recent months, the basic story across the developed world remains disturbing: credit growth, consumption growth and employment growth all are trending towards weakness, gradually pushing up unemployment.

**Pretty well everywhere, highly geared firms and households are "hunkering down", trying to economise on spending, sell "non core" assets, pay back debt and build cash reserves to survive any worst-case credit-crunch scenario. Weak (highly geared) balance sheets are being forced to sell assets to stronger balance sheets. The problem is that all this "hunkering down" reinforces the trend towards economic weakness. And capital-constrained lenders generally are responding with tighter credit standards, causing further stresses, and so on.

**With most intermediary lending rates in Australia at 9% or higher, RBA policy remains extremely tight. At the same time, the global credit crunch continues to intensify, and solid local firms increasingly are struggling to get funding for expansion ("credit rationing") as the banking system finds it more difficult to fund its existing loans/balance sheet.

**The recent drops in the A$ and fuel prices are supportive of growth in Australia, but - given the clear weakening of household demand over 2008 so far - it seems likely that our economy will fall into recession if interest rates are not reduced significantly over the next 12-18 months.

**The list of OECD economies hovering in or near recession is growing: the US, the UK, Japan, Italy, Canada, Germany, France, Denmark, Ireland, Iceland, New Zealand, Portugal, Spain and The Netherlands (others?). Growth already has stalled across the big G7 economies. Sooner or later, the NBER will confirm that the US economy is indeed in "recession".

Meanwhile, the biggest fast-growing developing economies - read China - also are slowing, but the poor quality of the (mostly year-to) activity data make it hard to know by how much. Probably more than most observers currently realise.

**Central banks generally have tried to keep their "liquidity provision" function separate from their "monetary policy" function. Some see this distinction as artificial and unhelpful: indeed, one might argue that in not cutting rates - the policy action most households and businesses most understand - in recent months, the Fed, the BOE, the ECB and others have been fighting the developing crisis with "one hand tied behind their backs".

**If things continue to go badly, as well they might, and the global credit crunch continues to drag down global growth - with global inflation pressures continuing to subside (see attached) - sizeable rate cuts will be the next course of action pursued by the major central banks.

**My guess remains that, over the next 12-18 months, we'll see the Fed cut to 1% or lower, the Bank of Canada cut to 2% or lower, and the ECB and BOE cut to 3% or lower; meanwhile the RBA and RBNZ still look set to cut to 5% or so (from policy rates at present, respectively, of 2%, 3%, 4.25%, 5%, 7% and 7.5%).

**It is the job of central banks and governments to do what they can to limit the severity of recessions. And the Fed and the US Treasury have been working overtime - every weekend recently! - to limit the damage from the intensifying credit crunch.

**We've recently seen the US Government's takeover of Fannie and Freddie, an $85b loan to AIG, Lehmans let go, Merrills sold to BOA, Goldman Sachs and Morgan Stanley made "banks", money-market funds guaranteed, and new restrictions on short-selling. (What have I missed?)

**In terms of preventing financial-system meltdown, it's a case of "so far so good". But massive global financial and economic turmoil remains a serious risk.

**On US Treasury Secretary Paulson's proposed $700b (5% of GDP) package to buy "troubled" (mostly) mortgage-related assets, I'm in the camp that says "do something now", please. The US/global bus is hurtling backwards down the hill towards a ravine, yet many politicians seem to be arguing about the colour of the rocks/logs that need to be put under tyres NOW to avert disaster.

**For what it's worth, my sense is that Chairman Bernanke and Secretary Paulson - and their large teams of highly qualified officials - are smart and determined to do what they can to hold the system together. So give them the cash and let them keep busy!

Chairman Bernanke clearly has all the goodwill in the world towards US taxpayers and the US economy overall. And that's probably true of Secretary Paulson as well, given that his net worth reportedly is way in excess of US$100m - that is, he doesn't actually need his current job, or the stresses that must go with it.

**Assuming something like the proposed US$700b package passes Congress in the coming week, the main debate now seems to be about the "right" prices at which officials should buy these troubled assets - at the current "market"/"firesale"/"distressed" prices or at the "underlying"/"inherent"/"hold-to-maturity" prices.

**In any case, won't market prices naturally shift up a bit when a gorilla appears on the scene with US$700b to spend? If analysis by the Fed, the BIS and the RBA is right (see yesterday's note), there is potential for a win-win outcome for US taxpayers and banks at a range of prices between these two still-shifting marks. Warren Buffett reckons US taxpayers will make big capital gains - not losses - on the proposed US$700b trade.

**Officials naturally will be hoping that the first few US$10b purchases by the US Treasury will spark further purchases by global real-money funds (ungeared players), who also recognise the underlying value in the damaged-but-still substantial mortgage-related cashflows but so far have - rightfully! - been scared of the mark-to-market risks.

Rising local funding costs suggest growing case for significantly lower RBA cash rate

**Early this month, the RBA - for the first time in over six years - cut its cash rate, by 25bp to 7%; major lenders immediately reduced their headline mortgage rates by 25bp, to about 9.35%. And until recently, we looked to be set for an "action replay" of that 25bp-rate-cut process after the RBA's next meeting, on 7 October.

**Over recent weeks, however, growing global stresses have seen Australia's three-month bank-bill rate - a key indicator of bank and business funding costs - jump sharply, from about 7.2% in the first week of September to about 7.4% this week (7.43% today).

This has put a big question mark beside the idea that major lenders will follow any 25bp cut by the RBA. The RBA may be forced to cut harder to achieve the desired effect on intermediary lending rates.

**Looking way down the track again, my guess remains that RBA policymakers over the next 12-18 months will decide - as unemployment rises beyond 5% and inflation pressures subside - that policy again should be mildly restrictive, as it was last July, rather than extremely restrictive, as now. That would imply a reduction in headline mortgage rates to about 8%, from 9.3% today, and similar reductions in other lending rates.

**In that case, the main question will be whether the RBA's cash rate needs to be reduced by a further (say) 1.25pp to 5.75%, or by (say) 2.25pp to 5%, or lower.

That latter scenario - aggressive easing - may well be required if longer-term funding markets remain difficult or deteriorate (as they have recently): large drops in average lending rates will require much-larger reductions in the RBA's cash rate.

**Importantly, the RBA cares much more about average lending rates than it cares about its cash rate - the latter simply is the tool used to deliver the former.

The RBA eventually will reduce its cash rate by whatever amount is required to reduce average lending rates to the level policymakers see as being required to support the economy as inflation pressures subside.

Clearly, much will depend on future developments - good or bad - in global credit markets. Again, the good news is that, in a pinch, the RBA has a big 7pp to work with.

**Eventually, the cyclical downtrend in the global economy will bottom and recovery will emerge. But the process probably will be very painful, and perhaps several years in the making. In the meantime, most big western economies will need to deal with tight credit, weak spending and rising unemployment. Central banks in these economies - once they judge that inflation risks have subsided - probably will find themselves kept busy delivering rate cuts.

**My guess that the RBA's cash rate will be reduced to 5% by the end of next year is the most-aggressive forecast in the market. Time will tell if I got too carried away, or wasn't aggressive enough. Keep those end-2009 forecasts in your mind - 1%, 2%, 3% and 5%. Right now, it doesn't take too much imagining to think rates might end up even lower.

Australia gets a crisis action plan

The Reserve Bank has detailed grave concerns about the future of the worldwide financial system as Australia's four key regulators have signed a historic pact outlining how each will act in the event that an Australian bank fails.

The "crisis management" memorandum agreed to by the Bank, the Treasury, the Prudential Regulation Authority and the Securities and Investments Commission sets out a "co-ordinated response to potential threats to the stability of Australia's financial system."

The Bank's Financial Stability Review released yesterday says while the four organisations have worked together well so far during the financial turmoil, the memorandum will "further strengthen these relationships and improve public understanding".

The memorandum sets out which organisation will do what, the overall objectives to keep in mind, and the way in which the organisations will work with each other.

Lack of co-ordination is thought to have been one of the main reasons that the US was slow to respond to its crisis in its early stages...

In the United States President George W Bush warned that the entire US economy was in danger unless the Congress passed the Treasury's $US700 billion financial sector rescue plan.

"We are in the midst of a serious financial crisis,'' he told the nation in a televised address.

"Major sectors of America's financial system are at risk of shutting down. Our entire economy is in danger.''

In Australia the ANZ chief executive Mike Smith said there would a depression if the plan was not approved by Congress.

"I actually believe that the sheer seriousness of last week's events is not properly recognised," he said.

"I think the banking system in the US would go into a complete, yes, would freeze is a good word, and the knock-on effect of that on payments systems throughout the world would be huge."

"If Congress does not approve the plan I think I'll take up farming".

The Reserve Bank also came out in favour of the plan, warning in its Financial Stability Review of a "damaging feedback loop running from the financial sector to the economy and back to the financial sector".

The danger was compounded by "a straining of the bond of trust between many banks and investors".

This has come after "a number of years in which investors were prepared to borrow heavily to buy risky assets at fine margins".

"With the pendulum now having swung the other way, the adjustment is proving more difficult and costly than many had expected," the Bank said in its review.

Australia's financial system has coped better "than many others".

Australia's big five Australian banks reported headline profits after tax of around $10 billion in the first half of this financial year, up 12%

By contrast the total profits of the US institutions insured by the Federal Deposit Insurance Corporation were down 75%.

Non-performing assets accounted for only 0.7 per cent of Australian banks' balance sheets, and non-performing housing loans accounted for only 0.4% of housing lending.

However in parts of western Sydney non-performing loans were much higher - exceeding 1.6%.

"Nationwide, the six areas with the highest arrears rates are all in western Sydney, the Bank said.

The evidence suggested that the "newer lenders, seeking to increase their market share, in part through looser lednign standards" had been "particularly active" in western Sydney

Memorandum of Understanding

Parties: Reserve Bank, APRA, ASIC, Commonwealth Treasury


RBA- maintain financial system

APRA - protect depositors, policyholders and fund members

ASIC - ensure market integrity

Treasury - advise on implications and threats


. Minimise super fund and bank losses where possible

. Maintain confidence in financial system

. Ensure that owners and directors of distressed institutions bear appropiate responsibility

. Minimise economic impacts


- Information to be shared.

- The Treasurer to communicate with the public.


Thursday, September 25, 2008

Is our Reserve Bank worried? You bet.

From today's Financial Stability Review

"Over the past year, the US financial system has faced its most challenging conditions for many decades, prompting exceptional responses from the US authorities. In the early phases of the turmoil, the main concern was liquidity, with inter-bank spreads, particularly at longer terms, increasing sharply. The Federal Reserve, and other central banks, responded to these tensions with a number of measures that helped alleviate tensions in money markets. Attention then turned to specific institutions’ difficulties associated with sub-prime related products.

These pressures prompted the US authorities to: assist with the sale of the ivestment bank Bear Stearns; place the government sponsored housing enterprises, annie Mae and Freddie Mac, under conservatorship; and provide the world’s largest insurer, American International Group, with a secured line of credit up to US$85 billion. More recently, the authorities have announced several major initiatives intended to provide a comprehensive approach to relieving systemic stress in the financial system. These initiatives include a plan to purchase up to US$700 billion of troubled assets from banks with significant operations in the United States, and insurance arrangements for short-term money market funds. In addition, and reflecting spillover effects to the global financial system, the Federal Reserve, in collaboration with other central banks, has introduced new international swap agreements. ..

At the time of writing, it appears that the most recent announcements by the US authorities have seen sentiment improve somewhat in a number of markets. Nonetheless, conditions remain strained, with uncertainty and risk aversion still at elevated levels and concerns persisting about the capital strength of a number of the world’s largest financial institutions.

At the centre of the problems in the global financial system has been a marked reduction in confidence in many financial institutions. One important reason for this is that investors have been uncertain as to the exact value of the assets on many financial institutions’ balance sheets and, as a result, about these institutions’ underlying capital strength. As many commentators have noted, reducing the opacity of banks’ assets and increasing the level of capital in the global banking system are key to resolving the current problems.

The recent difficulties and the high level of risk aversion come after a number of years in which investors were prepared to borrow heavily to buy risky assets at fine margins. With the pendulum now having swung the other way, the adjustment is proving to be more difficult and costly than many had expected a year ago. Risk margins on many financial assets have increased to historically high levels, and investors are seeking to reduce leverage and are eschewing asset classes which up until a year or so ago were in extremely strong demand. This cycle has been reinforced by financial institutions which up until recently were eager to provide, on very favourable terms, the leverage that investors sought but are now tightening lending standards and becoming much more cautious about providing credit to both households and businesses.

An important factor weighing on a return to more normal conditions is the deterioration in various property markets, particularly the residential property market in the United States.

Declines in property prices, together with the greater uncertainty within the financial system, have increased the risk of a damaging feedback loop running from the financial sector to the real economy and back to the financial sector. Rebuilding confidence in the financial system is obviously important here. From this perspective, the recent initiatives by the US authorities are to be welcomed."

Wednesday, September 24, 2008

The IMF lectures Australia


The International Monetary Fund has cast doubt on the wisdom of next month’s expected interest rate cut, warning that Australia may soon need to increase rates.

The assessment comes in a generally positive assessment of the Australian economy released on as the Reserve Bank struggles to keep Australia’s foreign exchange market working.

The Bank late yesterday announced plans to auction $US10 billion of US currency in order to stop the so-called forward foreign exchange market from seizing up.

The market stopped working for some hours last week and is under pressure as the end of the quarter approaches and Australian companies try to roll-over foreign currency swap contracts.

The Reserve Bank has injected into the market several US billion of its own reserves in the past week. The $US10 billion advanced to it from the US Fed will enable it to continue to keep the market open...

The $US10 billion will be auctioned on Friday, and the outcome announced on Monday.

The Australian auction plus others announced yesterday and those announced last week will take the total the US has injected into offshore markets to $US210 billion.

The IMF report expresses doubt about whether Australia’s economic growth will slow by enough to contain inflation saying that the “balance of risk to growth lies on the upside, stemming from an extraordinary jump in commodity prices”.

It concludes that a portion of the boost to Australia’s terms of trade is “likely to be permanent,” boosting the Australian dollar above its long-term average and putting pressure on inflation.

It recommends that “monetary policy be tightened quickly if leading indicators suggest that domestic demand will not slow as expected or the outlook for inflation deteriorates.

In New York the Prime Minister Kevin Rudd welcomed the IMF’s assessment saying it had “delivered a very strong positive report card on Australia, and on the robustness of our regulators, the strength of our banks, and our ability to see our way through this global economic downturn''.

He did not address the IMF’s concern about inflation.

Mr Rudd emerged from a round-table discussion with investment bankers to declare that “Australia's main banks are seen to be strong, and are robust also in the market place.”

The group included senior figures from the Macquarie Bank, Goldman Sachs and UBS Investment.

Mr Rudd appealed to Republicans and Democrats Congressmen to deal quickly with the US Treasury’s proposed $US 700 billion bank bailout.

Media magnate Rupert Murdoch spent an hour with Mr Rudd at the residence of the Australian Ambassador to the UN. He told reporters he thought the American financial system would get through the financial crisis if the bailout passed quickly, but was ``in for a hard time''.

Although released Wednesday, the IMF report was finalised in August, before the September rate cut and before the latest turbulence on world financial markets.

An update to the report added in September concedes that the Australian economy is now slowing but maintains that it may still be necessary for the Reserve Bank to adjust interest rates in order to contain inflation.


Australian banks were creaming it in as they pushed up rates

54.8 cents profit in every dollar earned!

David Uren in today's Australian:

"AUSTRALIA'S major banks were enjoying record profit margins when they cried poor and lifted mortgage interest rates independently of the Reserve Bank.

Official figures show the profit margin for the major banks was 54.8 per cent in the March quarter, resulting in $1 profit for every $2 in interest and fee income they charged.

The banks' profit margin during the quarter was more than double the long-term average return of 26.9 per cent."

UPDATE: The Australian Bankers Association responds.

The Shadow Treasurer's bumpy debut

**Updates below

Julie Bishop has been labelled “the Helen Demidenko of Australian politics” after she at first denied - and then conceded - that part of her maiden speech as Shadow Treasurer was lifted from theWall Street Journal.

The speech, delivered in Parliament Monday just moments before a radio interview in which she stumbled when asked to identify Australia’s official interest rate, included two sentences found in their entirety in a Journal article about the US financial crisis dated 20 October.

In Question Time yesterday the Treasurer Wayne Swan congratulated his opposite number on what he said was “an insightful piece of analysis”. But he said it sounded familiar and then read out the two sentences from the Journal article along with identical sentences from Ms Bishop’s speech...

“I have taken advice from many quarters, but I have never stolen something directly from the Wall Street Journal and passed it off as my own wisdom,” the Treasurer told Parliament.

“I think following this that the member for Curtin will be forever known as the shadow minister for plagiarism — the Helen Demidenko of Australian politics! Two gaffes in 24 hours is quite a start from people who are lecturing others about competence and standing in the community.”

In a personal explanation to the House Ms Bishop denied that she had plagiarised the article.

“In my speech I was referring to the United States plans. In fact the words I used were the technical explanation from the US Treasury Secretary Henry Paulson, which have been published widely,” she said.

“It is a shame that the Treasurer seeks to smear rather than manage the economy.”

However later, in an interview with The Age, Ms Bishop conceded that many of the words in question had been taken only from the Wall Street Journal article and not from the Treasury Secretary.

But she said she wasn’t wrong in her explanation to the House.

“No I was not. I was very careful,” she said.

“My whole point was they called me the Helen Demidenko of politics. I made the point that the entire speech was not a lift of opinions and ideas of the Wall Street Journal. The words I used were a technical explanation of the plan that has been published widely.”

When told that they had been published widely in that form only in the Wall Street Journal article, she replied “of course, that’s what I said.”

Asked how those words got into her speech she said she was not going to start pointing the finger at her staff. “That’s not my style. I won’t do it. I have said publicly I did not read the Wall Street Journal.”

“If quoting out of the media without attributing it on every occasion is going to be the subject of this sort of coverage, then people are going to be very busy going through every person’s speech. If we are really going to do these Google searches to make sure that every word is original, I think our priorities are a little skewed in the face of this crisis.”

The sentences found in both:

Among the things the government is asking for is the authority to hire asset managers to oversee the buying of assets.

The proposal would give the Treasury secretary significant leeway in buying, selling and holding residential or commercial mortgages, as well as "any securities, obligations or other instruments that are based on or related to such mortgages."


Samantha Maiden - Australian Online

"JULIE Bishop has now been accused of altering the parliamentary record over her defence against allegations she gave a speech that plagiarised the Wall Street Journal.

MPs and senators are sent the parliamentary record - known as Hansard - each evening before it is printed, allowing MPs to change their words if they don't like it.

Labor's leader of the house, Anthony Albanese, said today the Hansard did not record her actual words on the plagiarism gaffe.

“It records the deputy leader of the opposition saying: `In my speech I was referring to the United States' plans, and in fact, the words I used were the technical explanation of US Treasury Secretary Henry Paulson's plan which have been published widely'.”

Labor says in response, Ms Bishop told parliament: “In my speech I was referring to the United States' plans. In fact, the words I used were the technical explanation from the US Treasury Secretary Henry Paulson which have been published widely”.

The difference is whether Ms Bishop says she used Mr Paulson's words or “a technical explanation of” his words."

Samantha Maiden - Australian Online

"MALCOLM Turnbull has been dragged into the plagiarism row engulfing his deputy Julie Bishop, with revelations it was his office that cut and pasted words from a Wall Street Journal article.

Today Coalition sources confirmed the offending paragraphs of background were provided for her speech from the leader's office. That information was then passed on to Ms Bishop's office.

Ms Bishop was understood to be "ropeable" about the error but willing to take the public flak rather than blame others."


Tuesday, September 23, 2008

Could China be the last hope of the US?

It's a bizare thought, but these are bizare times.

Peter Drysdale and Harold James:

"Only China has the firepower and capacity to be rescue the international financial system from the threats from America’s financial meltdown today.

When the 1920s and ’30s crisis hit, America alone had the capacity to take the big public sector action at home that was needed to stem the panic and economic collapse and the reserves to save Europe and the rest of the world from massive contagion.

Then, and now, a globalised world means that the solution to such crises spans borders. Aside from the United States, only China has the firepower to rescue the global conglomerates at the heart of the global financial system now under stress.

China can’t be expected to play its role in these affairs until it is brought into the centre of the global economic decision-making processes."

HT: Harry Clarke

Krugman outlines his doubts

(I myself am more of a glass-half-full kind of guy) Krugman's blog is here.

What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.

First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

So where in this process does the Temporary Asset Relief Plan offer any, well, relief?...

The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk.

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let’s not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.

Also - Brad DeLong beat me to it. Even if you have full faith in Henry Paulson, Intrade currently gives John McCain a 48 percent chance of being president. Are you willing to give essentially unlimited discretion over the use of $700 billion — with explicit protection against any review by Congress or the courts — to Phil Gramm?

How's this for a poll result?

Mike Nizza in the NYT:

"Some surveys require no analysis whatsoever. A good example emerged earlier today from the American Research Group, which asked Americans a number of questions on an issue that has been dominating headlines of late.

One of them — “Do you think the national economy is getting better, staying the same, or getting worse? — was answered thusly:

No Americans say that the national economy is getting better.

13% say it is staying the same, and 82% say the national economy is getting worse.

In other words, zilch, zero, nothing (apart from the 5 percent who remain undecided). Not one glass half-full among the 1,100 people surveyed. The ruling was unanimous, and also obvious. "

Meanwhile, we are told our export income will boom

In the midst of worldwide economic turmoil Australia's chief commodity forecaster has ramped up its forecast for Australian export growth.

The Bureau of Agricultural and Resource Economics says Australia's income from minerals and energy exports will jump by 53% during the current financial year, up from an earlier estimate of 48%.

It says its latest quarterly forecasts reflect higher contract prices already negotiated for coal and iron ore and higher prices in prospect for oil, aluminum and gold.

While many developed economies will be weak in the year ahead, emerging economies such as China should be resilient.

Income from energy exports should jump 98%, and income from the export of other minerals and metals by 25%.

Total commodity export income should jump by 44% to a record $214 billion as income from farm exports climbs 9%.

The biggest upgrades concern coal exports...

The Bureau says Australia's income from coking coal will jump 181% during 2008/09, up from an estimate three months ago of 123%. Income from thermal coal exports will climb 114%, up from an earlier estimate of 74%. Iron ore export income will jump 91%, up from an earlier estimate of 72%.

By contrast the Bureau has revised down its estimate of export growth from oil and natural gas in response to weaker demand in the United States and Western Europe.

It expects China's economic growth to continue almost unimpeded, slowing from 11.9% in 2007 to 10% in 2008 and 9.3% in 2010.

The Minister for Trade Simon Crean yesterday released the Mortimer Review of Australia's export policies which recommended closer integration with China and more emphasis on services sectors in new Free Trade Agreements.


Why the rush to ban short-selling Sunday afternoon?

Under pressure, in Parliament Monday afternoon, Wayne Swan told what appears to be the unvarnished truth.

His answer is remarkable for its straightforwardness, and for the insight it gives into his the fear about what could happen in Australia.

I typed it up without waiting for Hansard.

The new Shadow Treasurer Julie Bishop had just asked him why the government had taken 3 different positions on short-selling in the last 3 days:

"Let's deal with short-selling. Was there any legislation in 12 years from that side of the House on short-selling? No.

We did say earlier in the year that we would move to legislate for disclosure of covered short-selling, and the government has prepared a bill in that area.

But as everybody in the world knows, financial markets melted down last week Mr Speaker.

Financial markets melted down last week.

And in response to that government's around the globe moved to change their position on short-selling. They moved to change their position on short-selling because of the carnage that was going on stock markets - the carnage that was going on stock markets in an environment that was so destabilising it had lost touch with the economic fundamentals of many companies...

So there was a very strong case at the end of last week for substantial action on short-selling.

ASIC, the independent regulator determined last on Friday that they would take some further action. And of course what happened after the market closed in Australia on the weekend was that further decisions were taken by other governments international.

A further decision was taken in the United States by the SEC; a further decision was taken in Canada, and in at least 3 other countries decisions were taken.

So over the weekend I conferred with all of our regulators... and I conferred with people right across the financial services sector.

Because having all of those other countries ban short-selling in various forms exposed our market first thing on Monday morning to a wall of funding that could have really had a detrimental impact on many many Australian companies.

So we on this side of House make no apology for the decision of our independent regulator to ban short-selling - a decision they announced late yesterday afternoon. A very important decision in the history of this country.

There is a case for short-selling, but there is not a case for short-selling in the market environment in which we now find ourselves domestically and around the globe.

Because we are a small market and it was simply not possible for us to remain open to short-selling when every other market in the world had closed."