KRUGMAN WINS THE NOBEL PRIZE!

A fierce critic of the Bush administration and a specialist in the kind of kind of financial crisis now gripping the globe has won the 2008 Nobel Prize in Economics.

Professor Paul Krugman of Princeton University has repeatedly attacked the Bush administration in his twice-weekly New York Times columns and extensively studied the so-called "liquidity trap" into which Japan fell for more than a decade and into which it is now feared the US might fall.

Describing what was happening in Japan as "a scandal, an outrage, a reproach" he wrote at the beginning of this decade that it was a human disaster on a truly heroic scale that a great nation with a stable and effective government should operating far below its productive capacity, simply because its consumers and investors do not spend enough.

The solution that he put forward was for the authorities to deliberately create inflation in Japan, something now being talked about as a last resort should spending dry up in the US.

In Monday's New York Times he wrote that the intial response of President Bush and his Treasury Secretary Hank Paulson to the US crisis was "distorted by ideology".

"Remember, he works for an administration whose philosophy of government can be summed up as private good, public bad. All across the executive branch, knowledgeable professionals have been driven out; there may not have been anyone left at Treasury with the stature and background to tell Mr. Paulson that he wasn't making sense," he wrote.

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The subprime primer

Here it is: a user-friendly cartoon guide to how it began. Try it.

Greg Mankiw warns that the language is a bit blue, as it is in many places right now.

And below the fold is CommSec's excellent more-cerebral guide:

Is this as bad as 1987?

The magnitude of the declines is similar but the 1987 experience is still worse than the current period. The drop from peak to trough in late 1987/early 1988 was far quicker as well.

The Australian sharemarket peaked at 2376.88 on September 21 1987 and fell 49.2 per cent to its low point of 1207.51 on 10 February 1988 – a span of 103 days.

In the current cycle, the All Ordinaries peaked at 6853.6 on November 1 2007 and has fallen 42.5 per cent to 3939.5 on October 10 2008 – a period of 243 trading days.

How long did recovery take back in 1987?

The sharemarket hit its lows in February 1988. Four months later the sharemarket had lifted by 36 per cent. A year after the lows, the market had lost some of those gains but was still up 29 per cent on the low point. However full recovery to the previous high took some time. In fact it took just over six years to get close to the previous highs but nine years to decisively push through the previous high. But the period did include a significant recession in 1991 and a slow economic recovery.
In 1987 the sharemarket was significantly overvalued. In fact the price-earnings ratio hit 21.1, 79 per cent above the previous long-term average of 12.

In the current cycle the PE ratio stood at 14.25 in November 2007 – below the previous decade average of 16.9 and the 28-year average of 15.2. The current PE ratio stands at 10.

Why caused the sharemarket to slide?

It all began in the US. Bad lending practices led financial institutions to provide loans to people who shouldn’t have got loans in the first place – sub-prime borrowers. Those loans were bundled up and turned into investments (securitised).

These mortgage securities were also combined with other securities to try and reduce the risk (called collateralised debt obligations) and entice more investors to invest.

Unfortunately when interest rates rose, sub-prime borrowers started to default. And the house of cards started to come down around the world.

Financial institutions began to fail, causing banks and other institutions to become more wary about lending. Interbank lending rates rose to reflect the increased risks but still financial institutions were wary about going about normal business.

At the same time the massive residential construction and borrower defaults led to an oversupply of homes. The downturn in the housing and finance sectors has dragged down the US economy with the reverberations felt across the globe.

In Australia, some highly geared Australian companies and property firms have been placed under strain by tight global credit conditions. Banks have had to pay more for funding in overseas markets and been forced to pass on some of the higher costs to borrowers.

Overall, however the Australian economy has remained sound. The Australian banking system has also not suffered the same stresses experienced in the US, UK and Europe. The Australian banking system was recently ranked the second strongest in the world. The failure of banks and investment banks in the US, and the need for US, UK and European authorities to bail out other institutions has taken its toll on investor confidence.

Effectively banks are worried about lending to one another, causing credit markets to fail. And worried investors have withdrawn from the sharemarket. While sharemarkets are now super-cheap across the globe, investors aren’t keen to buy.

Were other factors involved?

The sharp rise in the oil price (and commodity prices more generally) over 2008 has put additional pressure on the US economy. At the same time, the rise in oil prices and other commodity prices put upward pressure on global inflation, causing central banks to maintain tight monetary policies.

Investor confidence was already under pressure from the US housing crisis, and record oil prices didn’t help. Between mid March and mid May, the All Ordinaries rose by over 16 per cent with the US Dow Jones up by 9 per cent. But oil prices were also on the march, up 25 per cent, prompting more jitters about the state of the US economy and derailing the sharemarket rally.

The industrialisation of the Chinese economy has coincided with the US housing shakeout and consequent global financial crisis. These significant events in world history have occurred at the same time, making it more complicated for central banks and regulatory authorities to deal with the clean up process.

The US and UK Government announced rescue packages. Central banks have cut rates. Why haven’t they worked?

There was much hope when the US rescue package was announced. The problem is that the US House of Representatives failed to approve the deal. While the package was subsequently passed, the initial failure further destabilised investor confidence.

However, it is important to recognise that the US plan is a long-term solution and the measures are yet to be implemented.

The UK Government announced a rescue package but the impact was dulled by the slowness of central banks to announce co-ordinated rate cuts. Australia’s Reserve Bank announced a hefty rate cut of 1 percentage point on Tuesday October 7. Other central banks were also expected to slash rates but the co-ordinated rate cuts happened on Wednesday, not Tuesday. The UK Government package was also announced on Wednesday. But it failed to provide guarantees for inter-bank lending – essential to get banks lending to one another again.

The rate cuts in Europe and the UK also fell well short of the move made in Australia. And that is despite the Australian economy being in a far better position to handle the global financial crisis.

The UK Government has proposed that major industrial powers guarantee all interbank lending. The US has indicated they will consider the proposal. Given that banks have no confidence in dealing with each other, this proposal is very positive. It would quickly unfreeze credit markets.

The G7 finance ministers met over the weekend. What did they say?

There were some fine sounding words but the statement was short on action. The G7 said it would “take all necessary steps to unfreeze credit and money markets” and that it would “take decisive action and use all available tools”. But there were no details on what they will actually do. We will have to wait and see what concrete measures are taken.

What else are countries doing?

The UK and US Governments will buy shares (equity stakes) in financial institutions. US Treasury Secretary Hank Paulson hopes to take stakes in a “broad array” of financial institutions “as soon as we can”. It will be the first time since the 1930s that the US Government has bought stakes in banks. In the 1930s the Reconstruction Finance Corporation invested US$50 billion in over 6,000 companies.

The move by the US to buy equity stakes in financial institutions follows the lead from the UK in its financial rescue package announced last Wednesday.

The Russian government proposes to invest 175 billion rubles (US$6.7 billion) in stocks this year as part of a US$200 billion rescue package. It proposes to invest a similar sum next year.

In August 1998 during the Asian Financial Crisis, the Hong Kong government bought shares in companies. In total around HK$118.1 billion (US$15 billion) was invested with the Government taking 7.3 per cent of all shares in the 33 companies comprising the Hang Seng index. The intervention was successful and the legacy of the move, the Tracker Fund, still exists today.

And our bank deposits are safe?

Yes. The Federal Government has guaranteed all bank deposits for three years. It has guaranteed all term wholesale funding of Australian banks operating on international markets. The NZ Government has guaranteed all bank deposits for two years.

in the US, UK and Europe, governments have been forced to bailout banks that have got into difficulties. Understandably depositors across the world have been worried by this development. In response, the Irish government has pledged to guarantee 100 per cent of bank deposits. The UK Government responded by lifting its guarantee on bank deposits from £50,000 to £100,000. In the US, the guarantee on bank deposits has been lifted from US$100,000 to US$250,000.

In 1987, investors shifted from shares to property. Could the same happen?

Certainly. The Reserve Bank has already slashed the cash rate from 7 per cent to 6 per cent but monetary policy still remains tight. The cash rate could fall to previous lows of 4.25 per cent set in 2001 when the US was last in recession.
Clearly inflation is the least of our concerns at the moment.

If interest rates come down, investors will be attracted to move into the property market. Demand for property is strong but supply hasn’t kept pace. As a result rental markets are the tightest in 19 years, rents are rising and so are house prices.

In response to slowing economic growth unemployment is likely to rise in coming months. However unemployment is lifting from “full employment” – unemployment rates near generational lows.

People only sell up their homes if they have to. And for the majority of Australians there is no need.

Unemployment is still low, and if you sold up, you would still have to live somewhere. Given the tightness in the rental market, it is hard to find affordable accommodation, let alone in the area you want to live.

Some analysts are worried about household debt levels. But as the Reserve Bank has been at pains to point out, higher real incomes have caused more Australians to take on debt. And while debt has risen, so have assets.

The other key factor is rising population growth – the fastest in 18 years, boosted by record immigration. The International Monetary Fund said that migration was the key reason why Australian house prices are not overvalued: “if country-specific factors, particularly the impact of long-term migration on housing demand, are taken into account, the results do not produce evidence of a significant overvaluation of house prices.”

Should I move my investments into cash?

Moving investments from shares and property into cash is not without its costs and is a short-term decision. It also represents an attempt to “time the market”. And countless studies show that it is near on impossible to time the sharemarket.

A widely quoted study in the US tracked sharemarket movements from 1963 to 2004. It found that 96 per cent of market gains occurred on only 0.9 per cent of trading days. (Towneley Capital Management study undertaken by Dr H. Nejat Seyhun). The bottom-line being that if you move money out of the sharemarket and then back in, you would have to be either extraordinarily astute or lucky to get the timing right.
If you are aged below 55, you no doubt will experience more events like we are experiencing at present – although hopefully not as significant. Corrections occur regularly, reflecting the “animal sprits” that underpin investor behaviour. In short, we all get over-confident and over-pessimistic – fear and greed.

How is Australia placed?

The Australian economy is probably the strongest major developed economy at the current time. Unemployment is just above 33-year lows, the economy hasn’t had a recession in 17 years, government debt has been paid off and the budget surplus stands at $20 billion.

The Australian banking system is amongst the strongest in the world – ranked equal second by the World Economic Forum behind Canada in a recent survey.

Australia is more dependent on China rather than the US, UK or Europe for trade and economic growth. And China continues to expand strongly.

Clearly Australia is not insulated from the world’s problems. Our banks need to raise money on global markets and are forced to pay higher interest rates. If the US, UK and European economies slow then they will buy less goods from China and China will demand less raw materials from Australia.

But Australia’s Reserve Bank has plenty of room to move to cut interest rates and stimulate the domestic economy. If the job market were to slow markedly, then the Government would revise down its immigration target.

The dramatic fall in the Australian dollar – while bad news for overseas travellers, represents good news for Australia’s exporters, especially in the farm sector.

In short, Australia has plenty of options available and plenty of safety valves to shore up growth – something which clearly can’t be said for many other developed nations.

-- Craig James

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Kevin Rudd has dodged a bullet

Had he gone ahead with his plan to legislate this week to guarantee only the first $20,000 of each bank deposit he could have sparked a run on the banks.

It's easy to see how.

When he said Friday the guarantee would protect up to 85% of depositors he was implicitly telling the other 15% they would be unprotected.

In order to get that protection a depositor with, say, $120,000 in an account would have to withdraw $100,000 and split it up into five separate accounts.

The resulting withdrawals could have caused chaos.

Professor John Quiggin from the University of Queensland says while the money withdrawn would have been quickly redeposited, “the churn process might not be symmetrical, and would in any case be likely to generate considerable alarm”.

He says the possibility of it turning into a run was “far from remote”.

No bank can cope with a sustained run of withdrawals. The little-acknowledged truth is that they lend out more money than they have.

That Kevin Rudd saw sense over the weekend is a tribute to him and to his advisors, and also to Malcolm Turnbull who pointed out early that the scheme was unworkable...

Just as important is the guarantee the government will be extending to the foreign funders of Australian banks that their money is safe.

Lending to an Australian bank has always been extremely safe, but foreign funders have become so scared by their experiences with US banks that they are now unlikely to lend at a reasonable price unless they know their money is absolutely safe.

The Australian government will give them that assurance and charge a fee for it. It will act like a commercial insurer – charging an insurance premium in order to make good their loans in the extremely unlikely event that they defaulted.

The extra $4 billion to be spent buying mortgage-backed securities from non-bank lenders will extend the same sort of benefit to them. If foreign lenders are too frightened to finance Australian mortgages (which are among the safest investment propositions in the world) the Australian Treasury, with much better access to information can do it, and make money along the way as well.

The G7 Finance Ministers meeting in Washington on the weekend agreed on a 5-point plan of action to keep their financial systems afloat. On Sunday Kevin Rudd ticked every one of those 5 boxes.

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Rudd sees sense

A lot of it. I feel glad to live in Australia (after having had some doubts on Friday)

PRIME MINISTER - MEDIA RELEASE - GLOBAL FINANCIAL CRISIS - CANBERRA - 12 OCTOBER 2008

Global financial markets are experiencing some of the most challenging conditions ever witnessed.

In recent days, as global financial conditions have deteriorated markedly, governments around the world have taken unprecedented steps to guarantee the liabilities of their financial systems.

The Australian financial system is demonstrating its resilience to the international financial market turbulence. Australia’s banking institutions remain sound, well-capitalised and profitable with high asset quality.

The Australian financial system is however being affected by global events. Recent developments in the international wholesale funding markets have created acute funding pressures that now pose potential risks to the total supply of finance to the Australian economy.

This has the potential to slow further domestic economic activity.

The G-7 met on 10 October and agreed that the current situation calls for urgent and exceptional action to stabilise financial markets and restore the flow of credit, to support global economic growth.

Guarantee on deposits

In response to these developments the Australian Government will guarantee all deposits of Australian banks, building societies and credit unions and Australian subsidiaries of foreign-owned banks.

This guarantee will operate for a period of three years. This is similar to action that has been taken in a number of countries.

The guarantee will be legislated as part of the Financial Claims Scheme (FCS). For the first three years of its operation, there will be no cap.

The guarantee will operate from the date of this announcement. From today there will be no limit on deposits covered by the FCS. In three years time, the Government will review this position.

New measures to enhance the powers of the Australian Prudential Regulation Authority (APRA) will be legislated.

Guarantee of term funding for institutions

The Australian Government will also guarantee wholesale term funding of Australian incorporated banks and other authorised deposit-taking institutions (ADIs).

The Government will offer the guarantee in return for a fee in respect of eligible non-deposit debt obligations of Australian ADIs and foreign subsidiary banks operating in Australia.

It will enable Australian institutions to raise funds overseas in the current tight conditions and will restore confidence in credit markets. The facility will be withdrawn once market conditions have normalised. Details will be finalised in the next few days.

Purchases of RMBS from non-ADI lenders

Further to the Treasurer’s announcement in September, the Government has decided to direct the Australian Office of Financial Management (AOFM) to purchase an additional $4 billion in Residential Mortgage Backed Securities (RMBS).

The Government has been monitoring the market closely and has determined that this additional $4 billion in funding is required for the purchase of RMBS from non-ADI lenders (those being lenders who are not banks, building societies or credit unions) by the AOFM.

This will benefit Australia’s mortgage market by levelling the playing field for non-ADI institutions and ensuring that this sector of the lending market has access to funding for their operations.

My officials have done considerable work on the design of these arrangements and, in developing these measures I have received advice from the Governor of the Reserve Bank of Australia, the Chairman of the Australian Prudential Regulation Authority and the Secretary to the Treasury.

Collectively, these measures will reassure Australian depositors that their deposits are safe and that they can have full confidence in the Australian financial system.

In addition, these measures will assist Australia’s financial institutions weather the global financial turbulence.


Background...

INTERIM GOVERNMENT GUARANTEE OF DEPOSITS AND FUNDING OF AUTHORISED DEPOSIT TAKING INSTITUTIONS

The Australian banking system continues to demonstrate its resilience to the international financial market turbulence. Australian authorised deposit-taking institutions (ADIs) continue to be assessed as sound and the sector remains well‑capitalised and very profitable with high asset quality.

The Australian banking system is, however, affected by the global events. In recent days, as global financial conditions have deteriorated markedly, governments around the world have taken unprecedented steps to guarantee the liabilities of their financial systems.

European governments (Ireland, Germany, Denmark and Iceland) have moved to insure 100 per cent of eligible deposits. Other jurisdictions have significantly increased their deposit insurance caps. For example the Federal Deposit Insurance Corporation in the United States has lifted its cap from $100,000 to $250,000 per depositor until 31 December 2009; the UK has raised the value of deposits it insures to £50,000 from £35,000; the EU has increased its minimum deposit insurance limit to €50,000 from €20,000.

Governments are also providing unprecedented support to their financial institutions in order for them to recapitalise and gain access to wholesale borrowing. For example, the UK Government has made available to eligible institutions a Government guarantee on short- and medium‑term debt issuance. This will assist institutions operating in the UK to refinance their wholesale funding obligations as they fall due.

Having carefully reviewed international developments, the Australian Government, acting on the advice of the regulators, has decided that it must act to provide the same guarantees for our banks and other financial institutions. If we do not do so, Australian financial institutions could, over time, find it more difficult to borrow in international financial markets. They would become uncompetitive in attracting funds in markets that have become increasingly tight and risk-averse as this global financial crisis has deepened.

Guarantee on deposits

As part of the Government’s Financial Claims Scheme, the Government is guaranteeing all the deposits held in Australian-owned banks, Australian subsidiaries of foreign-owned banks, building societies and credit unions.

The guarantee will apply immediately, and remain in place for three years. This means from today, there will be no limit on the deposits covered by the Financial Claims Scheme. At the end of the three-year period, the Government will review the cap on the guarantee.

Deposits covered

The guarantee applies, from today, to all deposits held in Australian-owned banks, Australian subsidiaries of foreign-owned banks, building societies and credit unions. These institutions are authorised to accept deposits by APRA and are subject to prudential regulation to protect the safety of these deposits.

The guarantee applies to all types of deposits, regardless of the type of account through which the deposit is made. For example, it includes savings accounts, passbook accounts, cheque accounts, pensioner deeming accounts, term deposits, mortgage offset-accounts, farm management accounts, first home savers accounts and retirement savings accounts. Both retail and wholesale deposits are covered by the guarantee.

The guarantee applies to deposits held by all types of legal entities in Australia, including individuals (including joint accounts), partnerships, businesses, trusts and government entities.

The guarantee applies to deposits denominated in any currency.

The guarantee does not apply to deposits held in branches of foreign banks in Australia. These deposits are not subject to the depositor protection provisions of the Banking Act 1959.

Guarantee of term funding for institutions

The Government is making available to Australian-owned banks, Australian subsidiaries of foreign‑owned banks, building societies and credit unions a guarantee on eligible wholesale borrowing.

The Government will offer the guarantee in return for a fee in respect of eligible non-deposit debt obligations of eligible institutions. It will enable Australian institutions to raise funds overseas in the current tight conditions and will restore confidence in credit markets. The facility will be withdrawn when market conditions normalise.

To ensure that taxpayers are not disadvantaged by this guarantee, the Australian Government will charge financial institutions for providing the guarantee. This charge will be similar to an insurance premium. Effectively, the Australian Government is insuring the eligible liabilities of Australian financial institutions.

Funding covered

The guarantee on wholesale borrowing will be made available to Australian-owned banks, Australian subsidiaries of foreign-owned banks, building societies, and credit unions. It will be available, on application, for new and existing term debt issuance out to 5 years (60 months). The guarantee will be available for eligible debt instruments issued in all major currencies.

The guarantee will not be available to foreign banks, including those with branches in Australia, or entities that are not APRA-authorised deposit-taking institutions. These latter entities are not subject to Australia’s prudential regulation regime.

Lenders that are not APRA-regulated will have access to the Government’s complementary initiative to invest an additional $4 billion in residential mortgage-backed securities (see below).

Purchases of RMBS from non-ADI lenders

On 26 September, the Treasurer announced the direction to the Australian Office of Financial Management (AOFM) to purchase residential mortgage-backed securities (RMBS) from a wide range of Australian lenders in initial tranches totalling $4 billion.

The Government has been monitoring the market closely and has determined that an additional $4 billion in funding is required for the purchase of RMBS from Australian non-ADI lenders (those being lenders who are not banks, building societies or credit unions) by the AOFM. This will benefit Australia’s mortgage market and ensure that this sector of the lending market has access to funding for its operations.

This initiative will also provide a level playing field for the non-ADI lenders who will not have the benefit of the guarantee of the term funding facility.

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How much extra do US banks want to part with their money?

At Odd Numbers, Zubin Jelveh points out:

"It was little a little more than a year ago when the [spread between what the banks could get overnight with the Fed and what they then charged each other] blew open from its typical spread of 8 to 10 basis points to 100 basis points:

It was quite a dramatic jump which indicated that interbank lending was drying up, prompting the Fed and other central banks to introduce measures like to bring down the spread.

And here is how that jump looks in comparison to everything that followed:



You'd almost think that Aug '07 to Sep '08 was peaceful."

UPDATE: Jelveh's graph is out of date already. On Friday the spread climbed to a new record of 3.64 and is set to climb higher still !

Michael Stutchbury explained the phenomina well on Saturday (below the fold)...

"THE world is flush with money. The Americans are working overtime printing it. The Chinese have piles of it. So have the Middle East petro-countries.

But the once-in-a-century financial crisis is getting even worse because the normal channels for connecting savers with borrowers have seized up.

The key global middle-men -- American and European banks -- have lost everyone's trust.

They can't get access to other people's money.

As international credit markets have seized up, there's been no global regulator to get them liquid again.

Individual governments have taken drastic steps, such as buying up hundreds of billions of dollars of bad bank loans or even partly nationalising their banking systems.

But, if anything, these unco-ordinated efforts have tended to make things worse.

Panicked financial markets are looking to this weekend's meeting of finance ministers and central bank governors in Washington to produce some big co-ordinated solution.

The markets need a guarantee that governments around the world will stand behind the banks.

Although Australia's banks have remained strong through the crisis, the Rudd Government may be forced to provide them with stronger backing.

A global deal could suddenly disadvantage them in comparison with weaker banks that have been backed by their own governments.

That would increase our banks' cost of raising funds on offshore capital markets."

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Maybe McCain's okay

Look at this, pointed to by Nicholas Gruen, who says quite reasonably that he is prepared to believe that McCain is genuine. So am I, thank God.

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Get up to speed on the ACT election

It's next Saturday, and it is likely to further change Australia's political landscape.

On The National Interest, midday Sunday on ABC Radio National Peter Mares will interview both the present Chief Minister - Labor's John Stanhope and his opponent, the Liberal's Zed Seselja. They are good interviews which give a good introduction to the campaign - which you might need because you might have to vote (voting is compulsory, as in all Australian elections).

I know they are good interviews because I have already heard them! - The Natioanl Interest is first broadcast Friday afternoons at 6.00pm - and the audio is already here on the web, available to listen to. You can also download the whole program.

I chaired a community meeting attended by about 20 candidates on Wednesday organised by the Gungahlin Community Council. Jonathon Reynolds has published both the video and the audio on the web here.

I thought the Labor team was tired, dispirited, and I wondered why they even wanted to continue governing. The Liberals were much more together, and most of the smaller party candidates seemed great.

The highlight (for me) was the collection of answers to my question about whether each candidate would support banning political donations of more than a certain size - say $2,000...

Every Labor candidate but one said "no". Every Liberal candidate but one said "yes" (!) and as far as I could make out every other candidate said yes.

Let's hope something happens.

The ACT has multimember electorates, so who you vote for from the party of your choice is important.

My favourites were Mike Hettinger (the only Labor candidate against large political donations), Labor's Andrew Barr, the Liberals Zed Seselja and Clinton White, Frank Pangello and his team, and Democrat Greg Tannahill.

Tannahill particularly impressed me. He "currently works supervising creation of court and parliamentary transcripts". He said that meant he had spent hours listening to ACT Leglislative Assembly debates and had become convinced that he could do better than the members there. My sort of guy.

If you are free this Tuesday lunchtime, attend the Leaders Debate - Seselja vs Stanhope; 12.30 pm to 1.30 pm in the Reception Room, ACT Legislative Assembly, Civic Square, London Circuit, Canberra City. I'll try to be there. After all, I'll have to vote.

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What is Australia doing?

Almost all of what's needed, according to the 5-point Plan of Action agreed at the G-7 Finance Ministers and Central Bank Governors meeting:

"Washington— The G-7 agrees today that the current situation calls for urgent and exceptional action. We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth. We agree to:

1. Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.

2. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.

3. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.

4. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.

5. Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.

The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on other countries. We will use macroeconomic policy tools as necessary and appropriate. We strongly support the IMF’s critical role in assisting countries affected by this turmoil. We will accelerate full implementation of the Financial Stability Forum recommendations and we are committed to the pressing need for reform of the financial system. We will strengthen further our cooperation and work with others to accomplish this plan."

On point 1 - we are advancing banks money through the Future Fund and stand ready to do much more; on point 2 - the Reserve Bank is ensuring there's foreign exchange to go around and doing much more; point 3 is the same as point 1; on point 4 - Rudd may have made a mistake by not agreeing to guarantee all bank deposits; and on point 5 - the government has used $4 billion of the surplus to buy securitised mortgages, and will doubtless do more.

All up B plus, perhaps even A minus. All that would be needed to get a perfect score from the G7 would be to properly guarantee all bank deposits.


Meanwhile, there's a professor of economics from the University of Chicago who argues that things aren't that bad at all.

I think he underrates the extent to which we all depend on a working financial system these days.

It's like information technology. Sure we got by without it in earlier decades, but could we now, given the extent to which it has become part of everything we do?

HT: Steven Levitt

Below the fold are Adam Carr's unflatering observations about the G7 Plan of Action.

No matter how sweet and reassuring they are – the G7 are going to need more than words if they are serious about addressing the crisis. No new ideas have been floated yet but the rhetoric was tough - the G7 statement said “the current situation calls for urgent and exceptional action” and that all tools available would be used to prevent large financial intuitions from failure. One of my favourite quotes to come out of the meeting was from the Italian Economy minister “I always said that Basel 2 was stupid…now the others are agreeing with me”. Gotta laugh where you can. It’s notable that the Italians didn’t sign the text of the statement because they felt it didn’t contain any concrete proposals for dealing with the crisis. In the meantime, two more US banks went under and S&P issued a couple of depressing reports suggesting firstly; if the state of California can’t raise $4bn in the next month or two they’ll have to downgrade their A+ credit rating, and secondly; the large US automakers face bankruptcy if credit conditions don’t ease.

Adam Carr
Senior Economist
ICAP (Australia)

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What to expect for Christmas

Another 100 points.

That's another complete percentage point. So says Macquarie's Rory Robertson:

"**Tuesday's 100bp cash-rate cut from 7% to 6% provided a win for pretty well everyone. Borrowers got a sizeable drop in borrowing rates (80bp off headline mortgage rates), lenders got additional support for their lending margins, and the RBA neatly side-stepped many of its critics by cutting rates decisively.

**And Canberra cheered loudly, like the rest of us. That's because, of all the policy responses available to support ongoing economic growth, large RBA rate cuts were/are the most obvious, and the most powerful.

**After all, much of the developing weakness in the Australian economy in 2008 until now has been a function of the cyclically elevated policy and lending rates that the RBA deliberately put in place to contain previously elevated inflation pressures.

**Now that the world economic and financial backdrop has turned so nasty, those cyclically elevated policy and lending rates no longer are required: if headline mortgage rates above 9% and many business-lending rates above 10% were 1-2pp too high before Tuesday's cut (see attached), they still are too high...

**And the RBA knows it. "Neutral" rather than restrictive monetary policy probably now is appropriate, and that suggests a 5% cash rate, given 2008's elevated spreads/margins/risk aversion.

**My assessment is that another 100bp or so worth of RBA cuts before Christmas is likely, in one step or two. Given the fragile situation globally, the RBA's next cut could easily be 100bp again, although its statement on Tuesday did try to steer us towards thinking in terms of smaller moves.

**The "word on the street" is that Tuesday's 100bp cut was a judgement call by Governor Stevens - departing from his 50bp-Board-Paper recommendation last week - after things went so badly in global financial markets last weekend and then Monday. (If he again cuts by 100bp, The Daily Telegraph might reverse itself and go with a front-page banner headline that says "The Most Useful Man In Australia"?)

**Some observers now see the RBA as one of the few central banks in the world that "gets it", that understands the severity of the alarming financial stresses building globally, and is responding accordingly. They wish the Big Three central banks - the Fed, ECB and BOE - had followed the RBA's lead this week, with synchronised moves of 100bp rather than just the 50bp cuts that had become long overdue.

**My guess has been that the RBA's six-year tightening cycle - hiking from a cash rate of 4.25% to 7.25% between May 2002 and March 2008 - would be fully reversed within two years (see attached). Tuesday's 100bp cut obviously took us a long way fast towards that 4.25% target.

**Now, with the global credit crunch continuing to intensify, to say the least, it's easy to think the move back to 4.25% (or lower) will occur within a single year (within six months?). So here we are, expecting another 100bp worth of cash-rate cuts within the next two months."

Read more >>

Rudd has me very, very worried

The Prime Minister has just announced legislation that will guarantee the first $20,000 of each individual bank deposit. Bloody hell!

What does that imply about the rest of each bank deposit? (One of my family's deposits is quite big at the moment.)

It was fine when there was no explicit guarantee of bank deposits - that mean that everyone was in the same boat. But not now. This wise thing would be to split our family's deposit into a number of individual $20,000 accounts.

Other depositors will think the same way. As John Quiggin says, it'll lead to large-scale withdrawals:

"The possibility of this turning into a run is far from remote".

As commenter Bingo Bango Boingo says:

"Is he mad? One day he says bank savings are safe, the next he comes out with a policy that very strongly signals they are nothing of the sort."

This surely can't last. He'll have to guarantee the lot. No real loss, they have been effectively guaranteed anyway.

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What the world needs now...

this weekend in fact

...is co-ordinated international action.

As Krugman puts it in today's column entitled Moment of Truth:

"Why do we need international cooperation? Because we have a globalized financial system."

Why this weekend? Because there happen to be two big meetings taking place in Washington: a meeting of top financial officials from the major advanced nations on Friday, then the annual International Monetary Fund/World Bank meeting Saturday and Sunday."

He adds:

"You may think that things can’t get any worse — but they can, and if nothing is done in the next few days, they will."

What is likely is all governments undertaking to buy into private banks if needed in order to inject capital (as Gordon Brown did in the UK) - including ours.

Yes, ours - led by the political party that more than a decade ago part-privatised the Commonwealth Bank, but this is no time for irony.

The creation of some sort of worldwide central bank is not out of the question - the IMF might take on the role. The functioning of the global financial system is and always was too important to be left in no-one's hands.

The folks at VoxEU.org have produced an excellent instant 38-page collection of essays about what should be done. I recommend you download it, print it, and take it home to read on the weekend.

If you want some optimism there is Laurence J. Kotlikoff in the Wall Street Journal:

"Global markets have not been reassured by the coordinated interest rate cuts of several central banks or by recent congressional action, but they should be. Our bet is that financial markets will return to normal in short order and that the U.S. economy will squeak by with a moderate recession."

Other worthwhile reading: (HT: Greg Mankiw)

Vernon Smith
David Leonhardt
Nouriel Roubini
Robert Shiller
Nicholas Bloom

And some light relief (via the BBC)

US debt clock runs out of digits

"The US government's debts have ballooned so badly the National Debt Clock in New York has run out of digits to record the spiralling figure.

The digital counter marks the national debt level, but when that passed the $10 trillion point last month, the sign could not display the full amount."

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What if the money didn't flow no matter how far rates were cut?

That's how things are looking

Paul Krugman explains:

"..the relationship between Fed funds rates and the rates most businesses actually pay is very weak right now, thanks to the messed-up state of the financial system.

A quick illustration: in early July 2007, before the crisis, the target Fed funds rate was 5.25% and the rate on 30-day commercial paper issued by less-than-sterling borrowers — was 5.4%. On Monday of this week, the target Fed funds rate was 2%, down 325 basis points from pre-crisis levels, but the CP rate was 5.61% — up from pre-crisis levels.

So will this latest rate cut make any difference to borrowers? Maybe — but only to a few of them. We’re way past the point at which conventional monetary policy has much traction."

Michael West in an excelent column this morning points out the same thing:

"The TED spread - the purest indicator of confidence which measures the gap between US Treasuries and the rate at which banks lend to each other - blew out to 403 basis points while both overnight and three-month Libor widened too.

In other words, even a round of global rate cuts could not lure banks back to the money market. Unless this radical collective effort begins to stem the losses and restores some semblance of stability, we will soon descend into sovereign risk territory."

If, regardless of how cheap money "should" be, the people with it won't part with it except at an extortionate rate, money will scarcely flow at all.

Even on the ordinary foreign exchange market Australians are suddenly finding it hard to buy US dollars. A week back we could buy almost one for an Australian dollar - now we can only buy two-thirds of one. Here's a tip - don't think about traveling overseas.

Sound familiar? It happened in Japan for a decade...
no-one would part with money at any reasonable price.

As Krugman wrote evocatively at the time:

"The state of Japan is a scandal, an outrage, a reproach. It is not, at least so far, a human disaster like Indonesia or Brazil. But Japan's economic malaise is uniquely gratuitous. Sixty years after Keynes, a great nation - a country with a stable and effective government, [in Japan's case] a massive net creditor, subject to none of the constraints that lesser economies face - is operating far below its productive capacity, simply because its consumers and investors do not spend enough. That should not happen; in allowing it to happen, and to continue year after year, Japan's economic officials have subtracted value from their nation and the world as a whole on a truly heroic scale."

Economists call this a liquidity trap.

Krugman proposed a way out so unconventional that to do it would turn everything on its head.

Heaven forbid that the time is coming when we need to deliberately create worldwide inflation. Oh my.

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The smartest guys in the room

Literally. I mean it.

"Westpac Banking Corporation has reduced its standard variable home loan rate by 80 basis points to 8.56 per cent, passing on most of the Reserve Bank of Australia's (RBA) cut in the overnight cash rate.

Last month, Westpac passed on all of the RBA's 25 basis point rate cut that was announced on September 2, reducing its variable mortgage rate to 9.36 per cent."

Very well played. I reckon Westpac's Chairman Ted Evans (the former Treasury Secretary) would have had a hand in this as well.

Bright bunch. The others will look like also-rans.

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"the sharpest about face in Reserve Bank history"

Who'd have imagined this? - a cut of 1.00 percentage points, when all of the last 16 moves have been by 0.25 percentage points.

The Reserve Bank makes clear in its statement that, as it sees things now, today's big cut is a one-off:

"The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast."

..the Board decided that, on this occasion, an unusually large movement in the cash rate was appropriate in order to bring about a significant reduction in costs to borrowers. The Board does not, however, regard that movement as establishing a pattern for future decisions."

Will it be enough to avert a domestic credit crisis and a recession?

If it is not, the Reserve Bank will do more.

With our cash rate still high at 6.00% Australia - unlike most other developed countries - has plenty of room to cut further.

We have a better chance of avoiding a a domestic credit crisis and a recession than just about anyone else.

Below the fold is instant analysis from the ANZ and CommSec, and below that the Reserve Bank statement in full:

ANZ:

"The RBA has today slashed official cash rates by 100bp to 6.0%. This is the biggest interest rate cut done at a single meeting since May 1992 (when the Australian economy was in deep recession).

The RBA's big move today is based on (1) the view that the global (and thus local) outlook has deteriorated significantly in the last month and (2) that heightened borrowing costs mean that changes in policy rates cannot be passed through in full to retail borrowers. In the RBA's own words "the Board decided that, on this occasion, an unusually large movement in the cash rate was appropriate in order to bring about a significant reduction in costs to borrowers". By cutting by 100bp today, the RBA is hopeful that at least half of this cut (i.e.. 50bp) will be passed through to the borrowers. Today the 3-month BBSW-OIS spread, which represents about one-third of Australian bank's borrowing costs, is at 82bp.

Rumours are now circulating that today's aggressive move by the RBA is the precursor for co-ordinated interest rate cuts by global central banks tonight. Given the depths of the global credit crisis, this cannot be ruled out. Apart from the Fed, the ECB and the BoE, other Central Banks that could possibly move tonight are those currently accessing the US Fed's US$ swap line - the Central Banks of Denmark, Norway, Sweden, Switzerland and Canada. Japan, which can also access this swap line, decided to keep rates on hold at its meeting today.

The much larger than expected rate cut today tells us that the RBA is willing to use the interest rate tool to ward off emerging downside risks to the economic outlook. At the very least the RBA has successfully reminded financial markets that there is plenty of scope to reduce rates in Australia and thus minimise the negative effects of a global downturn on the domestic economy. This has seen the equity market bounce strongly after the announcement.

An easing cycle (from a position of tight policy) will have two phases - reducing the monetary restraint on the economy and then the shift towards a stimulatory stance of policy. We are still in the first stage and as such further rate reductions over the next six months are likely. Today's larger than expected move does, however, give the RBA some breathing space, which may see them sit tight over the next few months. That being said, the global economic and financial situation is moving rapidly and thus nothing can be ruled out.

Most economists would regard a cash rate of around 5.5% as a neutral policy setting. With the credit crisis pushing market funding costs up by around 50 -100bp, then a neutral cash rate maybe somewhat lower - say 4.75% to 5%. This suggests that if the RBA wants to take policy back to neutral there will be more rate cuts to come.

Best regards,
Warren Hogan and Katie Dean"


COMMSEC:

• Decisive and courageous – not words that you normally associate with the Reserve Bank but entirely appropriate.

These are desperate times, requiring desperate measures, and the Reserve Bank hasn’t been afraid to act. No doubt the Reserve Bank felt it couldn’t rely on other central banks and regulatory authorities to take decisive action to shore up their economies – it had to take up the cudgels itself.

• There’s a time to worry about inflation, but now isn’t one of them. With a global recession a 50:50 proposition, and commodity prices falling across the board, risks have now shifted in favour of deflation, not inflation. Today’s rate cut is not only appropriate in the current environment, its entirely prudent in order to extend the length of our record-breaking economic expansion.

• Ordinary Australians can be thankful that we have both a responsive and responsible central bank in the form of the Reserve Bank as well as a strong banking system. Australian banks are recording profits, not losses, and looking at making acquisitions, rather than being acquisition targets. The Reserve Bank has given the banks plenty of elbow room to cut rates so the stimulus flows through to the wider economy.

• Finally home borrowers have a reason to celebrate. And there may be even more good news down the track. A cash rate of 6 per cent still constitutes restrictive monetary policy. It is only when the cash rate gets to 5 per cent or below that the Reserve Bank is again pressing on the accelerator rather than the brakes.

• Today the Reserve Bank has removed the rate hikes delivered in November last year and February this year together with the rate increases delivered by the major banks over 2008.

• The Reserve Bank has clearly front-loaded its rate-cutting cycle in order to address negative psychology and deliver significant stimulus to the economy. The Reserve Bank rightly believed that shock treatment was necessary to change the mood and momentum of the economy.

• When a central bank cuts rates by such a large amount, the question is whether it knows something we don’t. The Reserve Bank may very well be spooked, but not by the
domestic economy, but rather the US and Europe. This may be the start of co-ordinated central bank rate action. Hopefully it will be.

Interest rate decision and past cycles

• The Reserve Bank has cut the official cash rate by 100 basis points (one percentage point) to 6.00 per cent. This was the biggest rate cut since July 1992 and follows the 25bp decline on September 2. The cash rate now stands at 6.00 per cent – the lowest since August 2006.

• Before the September rate cut there had been twelve rate hikes in the cycle extending back over five years (since May 2002), the last occurring on March 4. Over that period, rates lifted 2.75 percentage points to 7.25 per cent.

• Just like 2000/01 there was a gap of six months between the last rate hike and first rate cut. In the 2001 rate cut cycle, rates were cut by 2 percentage points in the space of 11 months (to 4.25 per cent).

• In the prior 1996/97 rate cut cycle, cash rates were cut 2.5 percentage points in 12 months, followed by another 25 basis point move just over 16 months later. The low point for interest rates was 4.75 per cent.

What are the implications for interest rates and investors?

• Initially we thought that the Reserve Bank would hasten slowly with rate cuts, but clearly we were wrong. In 2001, the Reserve Bank was forced to cut rates by 2 percentage points in the space of 11 months in response to the deterioration of the global economy, especially the US. Now with the global economy again staring down the barrel of a major slump, the Reserve Bank felt that similar dramatic action in cutting rates was required.

• Investors will have to re-assess the strategy of putting the bulk of funds in cash-based investments rather than other asset classes. Property clearly looks a much more attractive investment, especially with rents soaring and demand super-strong. Investors also need to put shares back on the radar screen. However given the on-going global risks, we still advocate a relatively defensive posture. Healthcare, utilities and consumer staples are favoured at present and diversified mining for longer-term investment.

• The Reserve Bank may not cut by 1 per cent again, but rate cuts still lie ahead. Tight monetary policy settings are not appropriate in the current environment and a cash rate of around 5.00-5.50 per cent is likely over the next 6-9 months. Neutral monetary policy is around 5.50 per cent.

• The next inflation figures won’t be a barrier to another rate cut in November. The Reserve Bank has already flagged an inflation rate of 5 per cent – but that is expected to be the peak.

Craig James, Chief Equities Economist, CommSec



STATEMENT BY GLENN STEVENS, GOVERNOR MONETARY POLICY

At its meeting today, the Board decided to lower the cash rate by 100 basis points to 6.0 per cent, effective 8 October 2008.

Conditions in international financial markets took a significant turn for the worse in September. Large-scale financial failures in several major countries were accompanied by serious dislocation in interbank markets and heightened instability in other markets, including sharp falls in share prices. Official actions in a number of countries have been aimed at restoring stability, by adding to short-term liquidity and laying a foundation for longer-term recovery in the health of balance sheets. Nonetheless, financing is likely to be difficult around the world for some time ahead. This is also affecting Australia, albeit by less than in many other countries, given the relative strength of the local banking system.

Economic activity in the major countries is also weakening, and evidence is accumulating of a significant moderation in growth in Australia’s trading partners in Asia. The expansionary effects of the recent surge in Australia’s terms of trade are still coming through, but some decline in the terms of trade now looks likely over the coming year, with many commodity prices having declined from their peaks. This, combined with the likelihood of below-trend growth in the global economy, suggests that global inflation will moderate in 2009.

Thus far, the overall path of economic activity in Australia appears to have been close to what the Board had expected, with the needed moderation in demand occurring. The next CPI is likely to show an increase of around 5 per cent over the four quarters to September, but the Bank remains of the view that inflation will start to decline in 2009.

The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast.

Given that background, the Board judged that a material change to the balance of risks surrounding the outlook had occurred, requiring a significantly less restrictive stance of monetary policy. The Board also took careful note of movements in funding costs in wholesale markets. Having weighed these considerations, the Board decided that, on this occasion, an unusually large movement in the cash rate was appropriate in order to bring about a significant reduction in costs to borrowers. The Board does not, however, regard that movement as establishing a pattern for future decisions.

The Board will continue to assess prospects for demand and inflation over the period ahead, and set monetary policy as needed to bring inflation back to the 2–3 per cent target over time.

Read more >>

Going down: 50 points is just the beginning

Macquarie's Rory Robertson says "expect at least another 200"

Here's his note:

**My sense remains that overseeing a significant reduction in intermediary lending rates is fast becoming the Reserve Bank's policy priority. Today at 2.30pm, the RBA will cut its cash rate by 50bp (to 6.5%), if not more.

**With the US recession clearly deepening and global growth stalling under the weight of tightening financial conditions (the pessimists were right), the case for a bigger RBA cut (75bp or 100bp) today is stronger than the case for a smaller cut (25bp), in my opinion. That's notwithstanding the big drop in the A$ in the past week, alongside big drops in many other currencies against the US$.

**The RBA is beginning to cut aggressively because it has become more worried about (the risk of) recession and excessive unemployment than about excessive inflation...

Policymakers are increasingly confident that emerging economic weakness - sub-par GDP growth, rising unemployment and lower commodity prices - will kill, over time, earlier widespread inflation pressures.

**As observed here previously, now that domestic demand has slowed, and the global backdrop has deteriorated so markedly, headline mortgage rates above 9% and many business-lending rates above 10% are inconsistent with the RBA's desire for ongoing economic growth. If rates are not brought down by 1-2pp reasonably quickly, the Australian economy almost certainly will go into recession within 12-18 months.

**So, not only is the RBA set to cut by 50bp (or more) today, but it seems likely to cut by 50bp again in November and/or December. Actually, RBA staff might want to keep their plans for summer holidays tentative, as the need for an extra Board meeting in usually meeting-free January would not be surprising, given current deteriorating circumstances.

**Overall, my guess remains that the RBA's cash rate is on the way from 7% to 6% to 5% and towards 4%. Having spent some six years - from May 2002 to March 2008 - hiking rates by 3pp in total - to 7.25% from 4.25% - the RBA seems likely to cut its cash rate all the way back to 4.25% within two years. In part, that's because - with term-funding markets difficult to say the least - reductions in the cash rate over time are likely to be larger than the reductions in average lending rates they prompt.

**The debate locally about the extent to which major lenders will pass today's cash-rate cut into key lending rates generally misses the point that the RBA cares more about average lending rates than it cares about its cash rate, and will keep cutting the latter to deliver the desired level of the former. That is, the RBA's cash rate simply is the tool it uses to drive average lending rates. To the extent that lenders' (smaller) cuts leave average lending rates above the RBA's desired level, the RBA simply will cut its cash rate further.

**Naturally, existing borrowers want maximum rate relief, and they want it now. But, remember, there are two types of borrowers out there: existing borrowers and potential borrowers. The latter benefit only to the extent that lenders keep lending. In a global credit crunch, it matters a lot that lenders keep lending, because if the marginal borrower can't borrow, because the marginal lender won't lend, then marginal activity doesn't happen, and GDP growth stalls. For lenders to keep lending - rather than simply "hunker down", as in the US and UK - they need to remain profitable.

**Thus, to the extent that lenders "pocket" some of the benefits of lower funding costs (via the RBA's cash-rate cuts), existing borrowers can comfort themselves with two critical facts:

. there are more RBA cash-rate cuts and further lending-rate reductions in the pipeline; and

. with major lenders remaining profitable and continuing to lend, the economy - and particularly jobs growth - will be stronger than it would be if "credit rationing" became more severe.

Critics lining up to take an axe to the RBA

**As noted above, my sense is that the RBA's priority now is to manage lending rates significantly lower. Naturally, policymakers are very keen to avoid recession, for two main reasons. First, recession was never part of the RBA's plan. It always has been confident that a "soft landing" (1-2% GDP growth at the low point) would be sufficient to return inflation to its 2-3% target.

**Second, if the economy does eventually fall into recession, and unemployment rises to 6%, 7% or more, critics will line up to pin the blame on the RBA. The critics' strongest point will be that the RBA delivered the most-aggressive phase of its six-year tightening cycle after the global credit crunch began last August.

**That is, over the year to July this year, the RBA oversaw increases in key lending rates of 1.5-2pp, the largest increases in rates, and to their highest levels, in over a decade, despite growing stresses in global financial markets. The Board's minutes suggest that at least one member still was talking about the need for tighter policy as recently as May.

**With financial turmoil having intensified savagely in recent months, the outlook for local and global growth has deteriorated much more sharply than the RBA - and other central banks - had expected. When things turned nasty, the RBA was "caught with its rates up".

**RBA policymakers now will do what they can to avoid excessive rises in unemployment. That means managing key lending rates lower, with some urgency. And not worrying too much about the recent weakness of the A$, which may or may not be sustained; if it is, recession will be easier to avoid.

**The RBA's response to its growing chorus of critics might be to concede that it doesn't have perfect foresight: it did what it thought was right, given the facts at the time and its objective of keeping inflation low (while minimising unemployment).

**Indeed, it might even get on the front foot and highlight the fact that - to this point at least - unemployment - at 4.1% - still is lower than core inflation - at 4.3% ("trimmed mean" CPI) - which, in turn, remains way above the 2-3% target. That is, the latest hard data on inflation and unemployment emphasise the basis for the RBA's earlier policy tightening cycle. (Is unemployment lower than core inflation anywhere else in the world?)

**In any case, to the extent that the RBA now believes recession is an increasingly serious risk, it will lower rates with some urgency, to limit any tendency towards excessive unemployment.

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Unbackable: Today's rate cut

Both Sportsbook and Centrebet have stopped taking bets. When they were, there was no possible combination of bets which would have allowed you to make money by merely predicting that rates will be cut.

A cut of 0.50 percentage points was by far the favourite, the first time since rates have been cut by that much since 2001.

The banks are likely to pass on only half of it.

The Reserve Bank's decision will be announced here at 2.30pm Australian Eastern Daylight time. (2.00pm in SA, 1.00pm in the NT, 1.30pm in Qld, and 11.30am in WA)

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Would my pay drop if I became a woman?

Something to ponder this weekend

The answer is "yes". But until now we couldn't be sure.

We did know that in aggregate women get worse-paying jobs than men.

We also knew that where a woman and a man do a near-identical job, most of the time the woman gets paid less.

But until now it could have been argued that many of the men just happened to have been better workers than many of the women.

Now we know beyond all doubt that if the same person in the same type of jobbecomes a woman he/she gets paid a lot less.

This isn't a penalty for the act of changing gender. Women who become men actually experience an increase in their pay.

Nifty, eh?...

Here's the study:

Before and After: Gender Transitions, Human Capital, and Workplace Experiences

Kristen Schilt, University of Chicago and Matthew Wiswall, New York University

The B.E. Journal of Economic Analysis & Policy, Vol. 8 (2008) / Issue 1

"Using an original survey of male-to-female and female-to-male transgender people, we estimate that average earnings for female-to-male transgender workers increase slightly following their gender transitions, while average earnings for male-to-female transgender workers fall by nearly one third."

HT: Marginal Revolution

It demonstrates the truth of this bumper sticker I remember fondly:

"A woman has to do twice as much as a man in order to be regarded as half as good. Fortunately this is not difficult."


On that subject see: Sunday dollars+sense - Who works the hardest in your office? Feb 24, 2008

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Just when you thought NSW couldn't get more stupid...

it has handed over $30 million to the organisers of a V8 Supercar race

Really.

The new Premier Nathan Rees says the event will "contribute $A110 million to the state's economy between 2008 and 2013, at a cost to taxpayers of just $A30 million.

Does he read widely? (Unlike his Education Minister.)

If so, he'll know about the alleged economic "benefits" of V8 Supercar races.

To quote from myself:

In Canberra in 2000 a series of V8 car races was meant to bring the city $11 million to $13 million each year by creating a “vibrant city”.Our government kicked in $4.5 million in capital works and a $2.5 million per year subsidy, which climbed to $4.7 million.

The ACT Auditor General looked at the books. Mark Harrison, the consultant who prepared the report, was stunned.

Here’s what he told me at the time: “The Cabinet submission couldn't even add up the numbers properly in its columns. It didn't discount future cash flows, which had the effect of exaggerating the net benefits of the project by more than a third. It involved double counting, and the benefits it did list were vastly exaggerated.”

He concluded that the event had actually cost the territory money. In his language, it brought “significant negative economic results”.

As I went on to outline (all this is really very well known):

Most of the people who go to these events are locals. If they spend money or time there, it is likely they are not spending money somewhere else.

Most of the non-locals come from other states. Even if their spending boosts the ACT’s economy, it doesn’t boost Australia’s.And if ever thousands (or millions) of visitors did come from overseas for a big event and spend like crazy, the main effect would be to push up Australia’s exchange rate and hotel room rates. And perhaps even interest rates.

It's not as if the NSW Premier can spare the money.


ACT Auditor-General’s Office, Performance Audit Report. V8 Car Races in Canberra, Costs and Benefits July 2002.

Peter Martin, The Economics of Big Events, Insight, SBS TV, October 09, 2003.

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Surely Congress wouldn't deliberately have endangered the financial system

...in order punish 'Wall Street types'

David Leonhardt tells the following story in the NYT:

"In 1929, Meyer Mishkin owned a shop in New York that sold silk shirts to workingmen. When the stock market crashed that October, he turned to his son, then a student at City College, and offered a version of this sentiment: It serves those rich scoundrels right.

A year later, as Wall Street’s problems were starting to spill into the broader economy, Mr. Mishkin’s store went out of business. He no longer had enough customers. His son had to go to work to support the family, and Mr. Mishkin never held a steady job again.

Frederic Mishkin — Meyer’s grandson and, until he stepped down a month ago, an ally of Ben Bernanke’s on the Federal Reserve Board — told me this story the other day, and its moral is obvious enough. Many people in Washington fear that the country is starting to spiral into a terrible downturn. And to their horror, they see the public, and many members of Congress, turning into modern-day Meyer Mishkins, more interested in punishing Wall Street than saving the economy."

Could that really be what was happening?

I wrote last year about an experiment in which people playing a game for real money were given the opportunity to spend some of their winnings “burning” another player’s winnings. It cost money and could't possibly have made anyone money...

And yet

"an astonishing two-thirds of the players gave up real money in order to burn another player’s. Surprisingly it didn’t seem to matter how much the burning cost. The decision to burn was unrelated to the price.

Two types of players were burned the most - those that were the richest and those that were seen to have made their money 'unfairly'."

Dan Ariely has just written about a similar experiment with the added twist that the participants were connected to a brain scanner:

"The basic picture that emerged from the brain imaging was activation in the striatum, which is somewhat surprising as this is a key part of the way we experience reward. In other words, according to the brain activation it looks like punishing others or, more specifically, the decision to punish others is related to a feeling of pleasure in the brain. What’s more, it turns out that those who had a high level of striatum activation, punished others to a higher degree. All of this suggests that punishment, even when it costs us something, has biological underpinnings. And this behavior is, in fact, either pleasurable or somewhat similar to pleasure."

So perhaps Congress members enjoyed punishing 'Wall Street types' and were prepared to pay (by endangering the economy) in order to do so.


Zizzo, D.J. & Oswald, A., 2000. Are People Willing to Pay to Reduce Others' Incomes?, The Warwick Economics Research Paper Series 568, University of Warwick, Department of Economics.

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Meanwhile, Australia is raking it in

despite what you've heard

The Reserve Bank has just released its latest monthly index of commodity prices - the ones Australia sells.

It's looking better than good:


Alan Kohler thinks it worn't last:

"Australia’s terms of trade boom is over, whatever happens in China, and if China’s economy also slows significantly, then the Australian economy is in serious trouble."

But it is lasting, well into the crisis.

Read more >>

A different kind of banking crisis

"Australia's big four are among a handful of the most profitable banks in the world. Unlike America, the problem here is not that our banks might collapse. It is that the credit crunch may result in them becoming too powerful."

That's my colleague Jessica Irvine in today's SMH. She digs well and reveals the background behind Swan's decision to buy $4 billion worth of mortgages.

And she includes a lovely tounge-in-cheek homage to the forces of nature that are Australia's four biggest banks:

"Amid the global crisis now is the time to congratulate ourselves on how lucky we are to have such well capitalised and profitable banks. How prescient to have been paying a premium all this time so that our banks could weather this international financial storm."

Quite.

Below the fold, one of the thinkers behind the $4 billion bail out proposal, Chris Joye, outlines his thinking. It was in a comment, but it deserves a full airing:

chris joye said...

In our paper we argued that when critical economic markets fail because of the absence of the ‘public goods’ of liquidity and price discovery, governments have a responsibility to (temporarily) intervene to assist in restoring normalised activity. We were careful to note that the government should intervene--not a subsidised private corporation such as Fannie Mae or Freddie Mac--and that such injections of liquidity should be justified only by extreme emergencies. In particular, we proposed that the government capitalise on its AAA credit rating to issue bonds and use these funds to acquire very high quality, low risk ‘prime’ mortgage backed securities in order to staunch the severe illiquidity that had resulted in the securitisation markets effectively closing in November 2007. We were also at pains to state that we were agnostic as to how our idea was operationalised, but did, for the record, advise the government to use the Treasury’s Australian Office of Financial Management (AOFM).

Despite the predictions of many, Australia’s mortgage securitisation market, which has served as such an important source of funding for non-bank lenders, building societies and smaller banks, has not yet recovered and remains economically shut to this day. By this we mean that the pricing available in the market is not sufficiently low to enable lenders to source capital to underwrite home loans on an economically viable basis. Even the RBA agrees with this point.

The closure of the securitisation markets has--according to Fujitsu Consulting--resulted in the big 5 (now 4) major banks’ market share of new home loans increasing from around 75% prior to the sub-prime crisis to circa 90% today. At the same time, many non-bank lenders have fallen by the wayside while the smaller banks and building societies have struggled to compete. As we anticipated, the illiquidity in this market has had other consequences, such as contributing to the severe credit rationing seen in the corporate and small business lending markets, and wreaking havoc on the conduct of monetary policy with a deterioration in the linkage between the RBA’s cash rate and actual lending rates.

We pointed out that market failures of the kind can occur because of information asymmetries, such as we have seen in the US with the non-transparent AAA-rated investment structures that held sub-prime securities, and because investors have a tendency to over- and under-react to events that can in turn trigger protracted asset-price booms and busts. George Akerlof won the Nobel prize in economics for showing that while markets are ordinarily the best means to allocate goods and services, when you have imbalances in the information that people possess when engaging in transactions--like an understanding of the true risks underpinning complex financial market securities--markets can fail with catastrophic consequences. The introduction of ‘mark-to-market’ accounting practices has only served to reinforce these distortions.

We also argued that that in today’s highly interconnected world global financial crises are being transmitted with ever greater frequency. In just the last decade we have been rocked by the Russian debt crisis and consequent LTCM collapse, the tech boom and subsequent wreck, and now the credit boom and bust. The point is that notwithstanding the intrinsic strength of Australia’s economy and financial system, we can be adversely affected by events that are seemingly far removed from our shores.

Despite some of the protestations to our proposal, the notion that governments have a critical role preventing financial market crises is, in fact, a cornerstone of our capitalist system. One of the main reasons central banks were established is to serve as a lender of last resort and prevent bank runs. Bank panics in the US led to the establishment of its centralised banking system in 1913. The stability of the financial system has also been a long-standing responsibility of the Reserve Bank, which “focuses on the prevention of financial disturbances with potentially systemic consequences.” The Reserve Bank also regularly intervenes in the currency market in order to stabilise our exchange rate on the basis of its belief that currency values have a tendency to deviate significantly away from fair value.

Another less noted, but equally important, issue we raised was that when Australia’s central banking system was set up in 1959, home loans were funded almost exclusively through deposits. That is, securitisation markets and non-bank lenders did not exist. So while today banks and building societies are regulated by APRA and have their liquidity needs protected by the RBA, the securitisation market that has grown to provide nearly a quarter of all the funding for home loans, and which was a key source of funding for so many non-banks lenders, building societies and smaller banks, benefits from no government infrastructure to protect it during times of crisis.

This speaks to going back to first-principles and thinking about how we can improve the current regulatory regime in order to accommodate recent capital market innovations such as the emergence of securitisation. As the RBA and Treasury have noted over the years, there is a fundamentally sound economic basis as to why securitisation should exist. But we currently have an asymmetrical regulatory system that disproportionately favours deposit-taking institutions—indeed, it barely acknowledges these new markets. The system should, therefore, evolve to accommodate these changes.

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Light relief: a loan interview

HT: Greg Mankiw

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