Sunday, October 19, 2008

Financial crisis, Australia & unknown unknowns

One of the refreshing incidental features of the current financial crisis is that many economists are displaying uncharacteristic humility. They don't know what is happening and they know that they don't know. Humble pie is also being eaten by supporters of theories that our real savings performance has been boosted by capital gains on the stock market and in house prices. I have even gone a bit quiet myself on the irrelevancy of current account deficits - I am a long-term supporter of the Corden/Pitchford thesis - although still thinking about this one.

A few strident Keenly-alert alarmists are 'predicting' a doomsday as a consequence of the financial collapses but this seems to be media-tartism as much as 'prediction'. A few have predicted a deep U or even L-shaped rather than V-shaped recession in the Australian economy with median estimated duration of about two years. When pressed to back up their judgements these 'experts' appeal to past recession characteristics (which seem irrelevant now) or to the need to make an educated guess - in other words they are guessing but giving their naked guesses a modest cloak.

We can easily gawk and gasp at the startling financial shocks that are occurring around the world but no-one really understands how these shocks will feed into the real economy. How will employment and incomes change? Of course these are the substantive issues.

What are my guesses? I think it is likely Australia will experience a sharp contraction in economic activity over the next few years that is a recession. The share price collapses of the mining giants Rio Tinto and BHP-Billiton - along with a collapse of the Australian dollar - jointly don't make a lot of sense in themselves since the falling dollar should largely offset lower resource prices. But the implication is that more than 50% of Australia's exports are destined to be severely impacted on by the recession. The market is implicitly forecasting much more bad news not less. The 'big end' of town is forecasting a quite severe slowdown. Unfavourable movements in the terms-of-trade and reduced investment activity will end or severely slow down the mineral boom and reduce our living standards just as the boom enhanced them.

The destruction by about 40% of stock market wealth savings - more if you value assets in US dollars - and the fear that the housing market is subject to a threat of near collapse will put a dampener on private sector spending and encourage community-wide efforts at deleveraging. While these are individually rational for households (I have already done it!) and firms these moves will put a dampener on demand and economic activity.

Much of the growth in borrowing in recent years has been in business investment and this will inevitably slow, even if interest rates fall dramatically, as retail sales and other indices fall off.

Could we have a dramatic recession that leaves more than say 10% unemployment? I would not rule out this possibility partly because of the high probability that further adverse financial shocks will occur in response to real shocks engendered by the first round financial shocks.

More specifically however Australian real estate prices have not tumbled as they have in Europe and the US and Australian private debt levels remain high. The claim that there is a housing shortage due to high immigration is fine but a deteriorating economy, and rising unemployment, will raise severe solvency issues among those who took on huge mortgages on the assumption that the economy and their incomes would grow at a rapid rates forever. It is a substantial threat that could ultimately threaten thebanks and lending institutions and call into play the Government's deposit guarantee.


Anonymous said...

How much do you think can really be inferred about this recession based on previous history?

If you're saying 10% unemployment, then, given aging trends, that's obviously very serious, since it means there will be more and more old people not working at one end of the spectrum, and lots of unemployed young people at the other.

Any predictions for what percentage of the workforce is employed and under-employed? Perhaps this is more meaningful than the unemployment rate.

Anonymous said...

What do we know about markets with a semi-functioning capital market?

What do stock prices reveal in such circumstances?

What do exchange rates tell us?

Not much really. We know a lot about prices and their transmission of information regarding scarcities with well functioning capital markets. We also can probably work out what prices are telling us when financial markets have entirely collapsed. As for the intermediate case; well who knows?

The main aim of governments should be to fix the financial market so that prices start revealing relevant information. Or perhaps let it fix itself.

It's probably not a good time to advocate policy aimed at mitigating whatever catastrophe prices are predicting. The gauge is broken.

ps. regarding your stock portfolio. Not to worry the Tel-Aviv exchange is rallying as right now

Anonymous said...

I'm with Keenie on this one. The sleeper is the margi call caper. The banks are not telling about this bit of exposure. Just as you are deleveraging, so are the other punters. Hence the falling stocks.
I tried to go cash with my acct at unisuper but they only effect this once a month, on the first of the month. In the spread between cash rates (up 4%) and securitised investments of "growth" portfolio (down 10%) I have taken a 14% bath.

I just hope that not all supe funds "effect" their clients wishes on 1 Nov. Otherwise there will be a bath for everyone. A bloodbath.

We'll be taking in ironing i think Harry this time next year.

hc said...

Jack, I think the sleeper for the Aussie banks are just high levels of private debt.
Rabee, I agree with you. The confused signals are recognised as confused - e.g. high value of US dollar - so no-one knows what is happening.

Anonymous said...

My main fear Harry is that economists in Australia will revert to the ideologically driven narratives of the 70's and the 80's. That will probably make things worse.

We have a rather good understanding of what's going on and it has nothing to do with the nonsensical recipe's associated with the various murky cults that used dominate what was called macroeconomics a generation ago.

I hope that kabbalistic and alchemical economics doesn't emerge from this crisis and that sound prudent and scientific economics dominates the policy debate this time round.

Anonymous said...


Don't get so pessimistic. There are further hurdles, but we're past the worst of it.
Trust me.

The S&P is now trading at book value. It will come back quickly unless we have a major policy mistake which could happen with Obama's policies but left on its own the economy will begin pointing up 2nd quarter next year.

As for us... we'll have a harder time but we'll get out fine.

Anonymous said...

My apologies for not making my comments explicit previously.

The relationship between property prices and shares in margin call share buying is that some banks like Macquarie, NAB and HSBC, for example, widely lent for buying shares on a margin call basis.

They used the shares in the punter's portfolio as security, PLUS, note this, security in real estate or cash management account.

As marging calls came in, in a rapidly falling market, much of the cash had been sucked up by the diminishing value.

Should they fall steeply again, then the bank will be holding a lot of domestic property as security which it will then attempt to liquidate as quickly as possible.

This is the exposure I was talking about before. Nobody wants to say how much funny money debt there is. And this is why Turnbull is giving Swannie and Kevin a hard time.

Anonymous said...


Credit spreads are coming in. If they continue to come in and you combine it with the monetary expansion from the CBs the rally in stocks could be of epic proportions.

I think they have nailed the credit problems and now through monetary expansion they are going to try and nail the recession. Stocks are going higher, Harry,. Much much higher is my bet.

Anonymous said...

given how deregulated labour markets are now unemployment getting to 10% would see a ginormous drop in domestic demand.

I really do not think you have thought through your scenario very well.