Saturday, September 27, 2008

Saturday Morning Musings - longer term impact of the US financial crisis

Apart from one post on another blog discussing why the sub-prime crisis - a US crisis - should have had such a flow-on effect in Australia, I have not said anything about the US financial crisis because of the sheer scale of reporting elsewhere. What could I say that might be new?

While in China the only English language programs that we could watch were BBC World and CNN. Since we had the TV on in the background much of the time while in our room, I watched the latest crisis unfold in real time with a growing degree of bemusement. I say bemusement advisedly. I had never seen anything quite like it, and I have been through a fair number of crashes, have studied others in history.

If you look at the responses to the crisis, you can see two key threads to the discussion. The first is the need to find an immediate solution, a quick-fix that will keep the financial system working. The second is the need to improve regulation to stop all this happening again. There has been less discussion on the underlying economic causes of the problem, less still on the longer term implications for the global economy.

When I look at the US scene over recent years, a couple of things stand out. The first has been the rapid rise in personal debt. We have seen something similar in Australia. The second has been a series of asset bubbles, culminating in a housing boom.

The two are linked. Rising household wealth has allowed people to borrow for both consumption and investment. In turn, this has helped support growth in asset prices. Financial institutions played to this by finding new ways of raising and selling money.

During this same period, US economic policy has not been especially sensible. I have to be careful here because I have not checked the details. I am providing my own impressions.

To begin with, US monetary policy has been far more accommodating than its Australian equivalent. The response to the earlier bubbles in this long growth cycle has been to ease monetary policy to cushion the impact of asset declines. Fiscal policy, too, has been less balanced than the Australian equivalent, in part because of the War on Terror, in part because of the nature of the US system with its divided constitutional responsibilities.

In combination, the two have acted to support continued speculative activity.

Of itself, the ending of a housing boom need not to lead to crisis including collapsing house prices. So long as people can afford to meet repayments, they simply hang onto the properties until the market rights itself.

We have seen this pattern in Australia in the post war period. House prices do fall, but the money falls have not been huge in percentage terms. Rather, sales slow down until the impact of inflation reduces both the real value of the houses and the associated debt to more acceptable levels. Economic activity may slow because there is less building while people have less money to spend on other things, but the asset slowly rights itself.

The problem becomes much more difficult where, as appears to be the case in the US now, people cannot afford to hang onto houses and have to realise at a loss. Add to this financial institutions under pressure who must themselves realise cash and prices collapse.

The US case is further complicated by the presence of multiple economies in the one country.

Not all parts of the US benefited during the long boom. Manufacturing areas in particular have been in structural decline as a consequence of the hollowing out of many traditional US manufacturing industries as economic forces shift manufacturing off-shore. With a slowing economy, these areas are especially hard hit in real terms by the flow-on effects of the crisis.

Again, we can see something similar in Australia. Loan arrears rates, repossessions and forced sales are all higher in Sydney's Western Suburbs than in other parts of the country. However, the rates are all far lower than the US equivalents.

I think the bottom line in all this is that it is going to take some time for the US position to unwind itself, and that during this period US economic activity will continue to be depressed.

In conventional terms, depressed economic activity provides an opportunity to use fiscal policy to stimulate the economy especially through new Government capital spending. Governments can invest in things such as new infrastructure without placing pressure on other parts of the economy. This investment can then help support new growth.

The difficulty from my viewpoint with the dramatic US rescue package is that it appears mis-directed, while its sheer size must reduce the capacity of the US Government to do other things.

I say misdirected because it appears to be addressing two very different problems. The first is the need to restore confidence in financial markets, to get banks lending to each other again. I think that this is necessary. However, the package also appears to trying to stablise US house prices, to stop the cycle of foreclosure and price decline. I think that this is very dangerous because it risks preventing necessary corrections, actually prolonging economic stagnation.

In all this, the thing that perhaps interests me most of all is the way the crisis is indicative of, and also reinforces, longer term shifts in economic power.

Currency is both a means of exchange and a store of value. Here the US currency has been the dominant store of value in global terms. This has allowed the US to fund its trade deficits through off-shore borrowings and to act as the leading global financial centre.

The US remains a huge continental economy. However, the US share of the global economy has been steadily shrinking. To a degree, this shrinkage has been concealed by the US's continued dominance of the global financial system. The current crisis has badly damaged this dominance. In this sense, it marks a shift in the global economic seismic plates.

While I was in China, opinion pieces in the English language press suggested that it was time that the yuan or RMB became a fully traded international currency.

I think that this is too soon. I doubt that the current Chinese Government is prepared to cede the control required to make this happen. However, what we can say with a degree of certainty is that the current US financial crisis has already seen shifts in economic power that will have long term implications.

The Australian position in all this is a little clouded.

In the short term, we are all going to be affected by the global economic downturn. This is of considerable personal interest given that I chose to change work directions at what became a time of economic turmoil. Talk about jumping into troubled waters!

Current official prognostications at international and domestic level suggest that Australia is in a better position than most to ride out the troubles. I think that this is true, although as I have argued before I also think that there are a number of structural weaknesses in the Australian economy. Here the downturn may in fact be an opportunity in disguise.

In recent years, Australian Governments have simply not invested enough in infrastructure. I think that we all know this.

Public investment projects can have very long lead times. This makes it difficult to use them as an effective counter-cyclical weapon.

If I were Mr Rudd, I would be strongly focused not on the immediate financial crisis, but on infrastructure planning. How do we set investment priorities? How do we get projects ready so that they can roll-out quickly?

If we could do this, then we may be in a better position to weather the current storm while laying a base for continued longer term growth.


My thanks to Ramana Rajgopaul for drawing my attention via a comment to this rather nice and quite funny explanation for the current financial crisis.


Nick said...

Contrary to what the main stream media says, wall street as a whole (capitalism) should not be blamed for the actions and policies set forth by OUR congress. There are, in fact, corrupt men in wall street who partnered with corrupt men in government to engineer a win-win situation at the expense of the taxpayer. Capitalism (and our nation or any nation) will only survive when the good and virtuous people are running it. Which means, come this November, you must vote for good men and women who stand by principle and uphold our constitution and not just give lip service to causes that seem noble and just.

Jim Belshaw said...

Hi Nick. Good to have a new commenter, although as an Australian I will clearly not be voting in November!

I am a supporter of capitalism. The difficulty as I see it in achieving what you want is to find a way to break through the control of the party machines.

Jim Belshaw said...

Hey Nick, you have been a busy boy. I picked up an identical comment on!

Anonymous said...

Hi Jim

Welcome home from treading on the Great Wall of China to slip-sliding down the Fall of Wall Street.

I don't actually agree with 'nick'.

I start getting very worried whenever 'good and virtuous people' are suggested as my saviour.

(Were they the ones crucifying Christ - or were they the bystanders? I forget.)

This present 'must resolve by Monday' crisis seems to me to be just the proverbial tip of the iceberg, given that all those really clever private equity buyouts will be searching for new funding over the next few years.

We will see I guess - and suffer for our indifference and second hand greed.

Your post was fair I thought. And the more honest for not offering any solution.

I honestly don't think there are any 'underlying economic causes' as you put it. I just think there has been a slackness in regulatory constraints on pure and simple greed.

For which we will all pay - be we self-righteous or just simply greedy.


Jim Belshaw said...

I take your points, KVD. And thanks for the welcome back!

I agree with you strongly on the greed point. This has been a feature of every asset bubble probably since the invention of money. I wonder if there were real estate speculators in ancient Sumeria?

That's actually an interesting question, come to think of it. When was the first ever asset bubble?

I think that I disagree on two linked points.

The first is the centrality of regulation. The second the issue of economic causes.

If you take the Australian experience, each bust in at least the post war period has been followed by new regulation. This has not prevented the following bust. So regulation on its own cannot prevent collapse.

If you look at each boom, the economic drivers (the things that allowed the boom to go) have been a little different. Consequently, the recovery pattern has also been different.

This boom could not have survived in the way it did without accommodating monetary and fiscal policy settings. Regulation deals with the specific excesses, not the underpinnings.

And yes, will all be paying.

Anonymous said...


I would like to pick up a point - ‘centrality of regulation’ - if I may, with great respect. (But bear in mind this is your term not mine, so maybe I am interpreting a little differently?)

I think regulation is quite central to any dealing between humans. Quite apart from providing some sort of basis for ‘who won and by how much’, regulations provide the ultimate basic framework for all interactions.

What is it called when neither party understands or abides by ‘rules’? Deliberately or otherwise, would that be ‘anarchy’?

Anyway, in your own words:

This boom could not have survived in the way it did without accommodating monetary and fiscal policy settings. Regulation deals with the specific excesses, not the underpinnings.

I disagree completely with this last comment: ‘not the underpinnings’.

On a balmy Spring afternoon, I spend time on this? It’s probably important to at least my own understanding I guess. I will look forward to any comment you may make.


Jim Belshaw said...

I am not sure about this David.

As a starting point, I think that I would argue that ethics and customs are central to relations between people. Laws and regulations came into effect largely to govern relations between individuals and the state or central authority and to punish individual behaviour considered in some way to be wrong. There is also a linkage here to the evolution of the concept of private property and of trade - laws governing succession and inheritance are an example of the first.

There is a definitional issue here. An Aboriginal group may not have had a central government, but relations between people were closely regulated by custom. Further, sanctions did exist did exist to enforce custom. In this sense, there were clearly laws or regulations that changed with time.

That said, to my mind, the central feature of modern regulation is that it substitutes a centrally imposed control on behaviour previously governed by ethics and custom. Law replaces ethics, so that all things are permitted unless explicitly banned.

I am not sure that my argument is actually going anywhere because I am mixing in to many things! I need to think some more.

Anonymous said...

This post from a very interesting blog sums it up nicely

william said...

McCain is losing crucial states (new polls show Florida and Ohio going to Obama). Voters appear to be associating the Republican nominee with Republican President Bush, and voters are blaming McCain for the economy.
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