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Spend cure the wrong advice

By Alan Moran - posted Friday, 19 December 2008


Kevin Rudd’s announcement that he would inject a further $4.7 billion of infrastructure funding into the Australian economy now brings the federal government direct contribution to $15 billion. On top of this, the three percentage point reduction in official interest rates means a total of some $40-50 billion has been injected into the economy. That’s a government stimulus equivalent to a massive 6 per cent of total GDP.

In the case of the US, some estimates place the measures so far already taken to tackle the credit crisis at $4.6 trillion. In real terms this is more than it cost the country to fight World War II and tenfold what was spent in the 1930s New Deal.

The US Fed’s December 16 decision to reduce official interest rates to zero comes on top of this.

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As with earlier reductions, it was designed to encourage lending and to provide a hand-out to those who over-committed in terms of mortgage debt. However, the banks’ problems are not liquidity but risk of non payment. Low interest rates will therefore make them even less likely to see value in using their own liquid resources other than in buying government bonds. This was precisely the outcome in Japan between 2001 and 2006 which also used a near zero interest rate policy in response to attempts to stimulate the economy.

Politicians and treasury advisers all over the world have panicked in reaction to the credit market collapse. Treasury Secretaries from the US’s Henry Paulson to Australia’s Ken Henry are sudden converts to fiscal deficits. “Spend big and go consumer” was said to be Ken Henry counsel to Kevin Rudd on tackling the financial crisis. Treasury advisers have been transformed from seeking to rein-in government spending to instigating a new era of government pump-priming.

Triggering the present downturn was the collapse of the $6.5 trillion US mortgage backed debt market. Financial engineering created silk purses out of the sows’ ears of housing loans. Those loans were fuelled by lowered credit risk standards and over-rapid money supply expansion and seemingly underpinned by regulatory induced price rises in the north east, California and Florida. The UK and Australia saw similar ramping up of house prices - here prices have doubled relative to incomes in spite of abundant potential land supplies and house building costs remaining low.

Real estate speculation had masked the inflation that is the inevitable corollary of central banks’ easy credit policies. Once the real estate bubble was pricked, much of the mortgage backed paper became worthless, setting in motion a chain of downward economic pressures. Throughout the world, these have included price collapses of shares and commodities, business bail-outs and the first fall in a decade of Chinese trade which has underwritten the Australian economy.

Australia itself has seen falling house prices and house sales down 25 per cent, banks and miners are announcing major employment layoffs, major retailers, car yards and airlines are desperately cutting margins to maintain business and business confidence plummeting to new lows in November.

And yet, there have been few tangible effects of the financial meltdown for Australia. Even the latest unemployment data looks comforting - in broad terms only a 0.1 per cent tick up in November. And though GDP only rose 0.1 per cent in the September quarter, at least it rose.

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In this respect the crisis resembles the “phony war” of 1940. Treasury advisers are right to foresee the coming economic blitzkrieg. It’s just that their prescriptions for dealing with it are wrong.

A very severe downturn is inevitable. The ubiquitous nature of financial markets means every institution in the world is infected by the US financial collapse. This has included even those seemingly unrelated to the subprime housing, like GE Money, which has been forced out of Australian car financing where it was formerly the market leader. Loans that formerly were readily available are now unobtainable at any price.

In Australia, as elsewhere, the market collapse has also led many people to recognise that they have lower savings than they thought they had. These have to be rebuilt and this means reduced consumption.

For these and other reasons, government hand-outs like Australia’s $10.4 billion consumer package will fail to trigger the hoped for sustained lift in consumption. In fact, such measures will only make the correction more difficult. Adding to government debt and boosting credit means higher future taxes or a money supply boost with future inflationary consequences. Either outcome means a long slow and painful recession rather than the short sharp shock that would otherwise have occurred.

As is so often the case the best government policy is to stand back and allow market forces to correct the imbalances that are in place. But such advice does not resonate with governments which have persuaded themselves that it is they who have caused the previous levels of prosperity and therefore will be blamed for inaction.

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This is a longer version of an article first published in The Age on December 18, 2008.

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Alan Moran is the principle of Regulatory Economics.

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