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.