The West's time in the economic sun may be over

Great news. On July 21, 2009, Access Economics announced it expects Australia’s economy to grow slightly during the current financial year as China’s early recovery will boost demand for Australia’s raw materials, while retail spending had been aided by the government’s stimulus package. The only drawback is that Australia’s unemployment rate will rise until late next year as business profits and spending fall away, and with interest rates also likely to increase in the longer term.

Days later, 57 respondents to a US survey in July predicted that growth will be 1.5 per cent in the July-to-December period, although the US jobless rate will exceed 10 per cent early next year (Sydney Morning Herald, July 24, 2009).

With the US federal government effectively putting up $23 trillion to back its economic system, an amount equivalent to more than 150 per cent of its GDP, greater confidence has indeed returned.

But hang on. What about all the pessimistic information we get from around the world, particularly from John Mauldin and Dan Denning (two financial experts)?

From July 12 to July 27, I learned that Chinese banks which were hiding as much as $500 billion in bad debts and had lent more than $1 trillion in the first six months of 2009, about four times the rate of 2007.

Debt levels of some Western nations are also becoming unsustainable. The IMF recently urged Britain to map a path back to solvency. By 2009, 12 OECD nations had gross government debt levels of more than 60 per cent of GDP with Japan highest at 173 per cent and rising. This does not include the loan guarantees and toxic asset purchases administered by the G20 nations, estimated by the IMF to be around a third of their combined GDPs, nor record household debt to disposable income ratios with US consumer debt alone rising from 12 to 18 per cent of GDP since 1982.

Declining revenue has already seen the US federal government produce a $US1 trillion budget deficit in just six months. California’s government recently agreed to a $26.3 billion budget deficit that includes $15.5 billion in spending cuts, while Ireland passed two emergency budgets to stop its deficit soaring to 15 per cent of GDP as unemployment reached 12 per cent.

And governments need to finance debt. The Hayman Company recently estimated that the US will need to issue $US3 trillion in 2009 to support government financing. The estimated global amount needed was $US5.3 trillion with Japan next on $US536 billion.

The truth is that the real US economy, central to a revival of the world economy, has serious problems ahead. For instance, California (the world’s 8th largest economy) lost another 65,000 jobs in June, while the number of Americans with no unemployment payments at all is predicted to reach 500,000 by the end of September.

There are still possible global ramifications from US debt should a recovery not occur. In addition to the sub-prime market disaster which involved $US1.5 trillion of debt, prime mortgage debt is near $US4.5 trillion, commercial real estate near $US3.5 trillion, and Alt-A mortgage loans more than $US2 trillion. Other sectors with debt levels of $US1.0-1.5 trillion are commercial and industrial, jumbo prime, home equity, credit card, and auto. Most problematic are Alt-A mortgages, which will have interest rates reset from 2010 to 2012, and jumbo prime loans (on average $750,000), because they occurred mostly in the inflated bubble states (such as California and Florida).

Sure, we must always live in hope, but when individuals like billionaire Warren Buffet expect inflation to rival rates in the 1970s (13.3 per cent in 1979), we need to pay greater attention to what is happening overseas.

So what are the solutions? Do we just crackdown on bank behaviour? With lending crucial to creating investment opportunities, many banks are presently reluctant to lend in such difficult economic times. With a tighter capital market, foreign banks have reduced their lending activities to Australia with syndicated loans falling by 80 per cent in the first six months of the year to $US9.7 billion, although global syndicated loans fell 49.2 per cent to $947 billion. (Syndicated loans refer to loans where one or two banks organise an overall loan package in which multiple foreign banks are lenders to reduce the risk to individual lenders).

Australia’s relatively prosperous banks are reluctant to unleash a new credit boom through lending, although consumers too may choose to save more in response to any gloomy news.

It has also been reported that corporate Australia has $200 billion of debt which will need to be financed in the next three years, and that this figure (derived from publicly accessible databases) does not include private deals companies do with banks.

It appears that the days of endless credit are over for now after increasing by $US22 trillion in the US alone during the 2001-2007 period while its GDP increased by just $US4 trillion.

And can we rely on governments raising taxes to boost public spending. When one takes account the further effects of policy, Barro and Perotti suggest that each $1 increase in government spending reduces private spending by about $1, while Romer and Romer (including Christina Romer who now chairs the US president’s Council of Economic Advisors) note that each $1 increase will reduce private spending by $3.

Yet, the US Center for Budget and Policy Priorities indicates that 23 states have imposed tax increases in 2009, with another 13 considering them, after ten states imposed higher taxes or other revenue boosters in late 2007 or 2008.

Finally, is the answer to rely on China which is predicted to generate 74 per cent of the worldwide GDP growth in the 2007-2010 period and is the prime reason why commodity prices have not collapsed?

With China’s communist government unhappy about recent steel price negotiations, as illustrated by China detaining 16 executives from Chinese steel mills and four Rio Tinto officials on the basis that bribes were made; and by it asking Melbourne’s Film Festival to remove a film about a millionaire Chinese dissident (a member of the Uighur minority now living in exile in the US), do we just accept China’s rise and make the most of the relationship?

On July 23, Western Australian Premier Colin Barnett pledged to give Chinese investors “special attention” to overcome investment hurdles (Sydney Morning Herald July 24, 2009). Similarly, Paul Kelly argues that “the naive one-dimensional views on Asia loved by Australian public opinion and fed by much of its media are untenable in handling the future China challenge” (The Australian, July 18, 2009).

China also expresses a mercantile economic approach with state-controlled Chinese companies acquiring resources from around the world: although it does finance vital infrastructure in developing nations - opportunities created by many corrupt or poor nations crying out for assistance. This is despite considerable resentment towards Chinese migrants in Papua New Guinea (PNG), Tonga and the Solomon Islands, Zambia and South Africa where there have been violent incidents. The tension in PNG has hardly been helped by about 300 Chinese workers entering PNG illegally each week without proper immigration checks: an occurrence which led to the arrest of 213 Chinese employees in November 2008 for having improper permits (Geoffrey York, Globe and Mail, March 31, 2009).

And if you thought working conditions and the environment were worsening under US hegemony, spare a thought for PNG workers who were once paid cans of tuna for overtime and had their pay docked for going to church on Sunday (sparking a riot).

In regards to the environment, a Chinese company in PNG plans an underwater disposal of the mine tailings in Astrolabe Bay 150 metres below the surface of the sea, although this method is essentially banned in Canada and the US. And PNG’s forests are being plundered with 80 per cent of the logs (almost two million cubic metres) shipped annually to China, often in breach of the country’s rules (York 2009).

International economics and politics are indeed a competitive game between nations, so we can expect more tension between the West and China to emerge. China wanted to address the dominance of steel suppliers (two companies in Australia and one in Brazil) by seeking an 18 per cent stake and two of Rio Tinto’s board seats, The Australian Government openly preferred a BHP-Rio deal rather than a Chinalco-Rio possibility, although such a concentration of power in the global market would not normally be accepted.

For now, Australians may live in hope that everything will be OK on the back of a booming China, although commodity prices may again fall if world demand does not pick up enough to help offset China’s tactic of stockpiling vast amounts of mineral commodities.

Whether supporters of freer trade like it or not, protectionism is likely to increase as many Westerners realise that they cannot compete with a communist China.

Already protection is rising in both developed and developing nations. Among the rich countries, the EU announced new export subsidies on butter, cheese, and milk powder. And during December 2008, the EU imposed duties on preserved fruits from China as well as on imports of welded tubes and pipes of iron or non-alloy steel from Belarus, China and Russia.

Subsidies for the auto industry are now about $48 billion worldwide ($42.7 billion in high-income countries), with the US alone providing $17.4 billion to its three national companies in 2009. The US government also passed a stimulus bill that would provide a 25 per cent competitive margin for US iron and steel for all expenditures under the bill, although the final version exempted 27 EU member states and the 12 other countries which have signed the WTO Agreement on Government Procurement along with countries with Free Trade Agreements. This legislation was aimed to counter government purchases of iron, steel and other manufactures from China, India, and Russia and others.

So it does not really matter what supporters of freer trade argue (and I include myself). Policy in democracies is decided by votes, and if growing minorities suffer, many Western societies will look to polices that will protect their way of life whether this is detrimental to world trade or not.

In truth, no nation can compete with a giant which can exploit an abundance of cheap labour which is boosting a growing and highly-skilled middle class. With 1.3 billion people, its economy will grow and grow if given a free reign. What will happen when China’s banks rise in value? Will the West allow a communist nation to dominate such key assets? Hardly.

According to some financial experts, a debt-bloated West needs to cut spending for many years to make their economies more competitive. As some suggest, pain now may have been preferable for two important reasons. First, any reliance upon debt to boost consumption will be a long-term mistake as the money will need to be repaid. Second, any real recovery must produce wealth rather than rely on spending.

My gut feeling, however, is that our response will be different. With rising debt, a reluctance of Western voters to accept the destruction of their welfare systems to meet budgetary aims, and a rising China with traditions alien to Western aims, I suspect we are going to see present economic orthodoxy challenged once the majority of Westerners realise that their time in the sun is over under the guise of freer trade. Something indeed has got to give.