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.

Postscript

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.