Today the media is full of an ignominious campaign for monetary easing. There’s no need to point it out. It’s all over, with housing and share market spruikers everywhere cajoling, insisting, begging and positioning for rate cuts.
It’s increasingly likely that they’ll be delivered but not yet in my view and not at all if Europe and the US don’t, as I expect, slide into recession. So, for starters, ignore everyone trying to sell you something on the back of rate cuts. They will come only if things get worse.
That outcome looks a little more likely today. Sadly for the FOMC, it’s recent hints at more stimulus has achieved precisely what I feared it would. Metals, grains and oil are all on a tear once more. Any hope that Western consumers were about to enjoy relief from the rising costs of day-to-day goods is disappearing rapidly. And the consequences of such are increasingly apparent in the US, from Bloomberg:
One major source of weakness is consumer spending, which accounts for about 70 percent of the economy. Household purchases adjusted for inflation dropped in June for the third consecutive month — the first such occurrence outside of a recession since 1959, according to economists at JPMorgan Chase & Co.
Household sentiment, as measured by the Thomson Reuters/University of Michigan index for July, has receded to a level seen during the last recession. The Bloomberg Consumer Comfort gauge already is in territory reflective of a slump.
“Consumers are dealing with a labor market that’s gotten weaker, a hit to their wealth through declines in the stock market and just a lot of bad news and uncertainty,” said Julia Coronado, chief economist for North America at BNP Paribas in New York. “It makes them want to be more cautious in their spending.”
The rocketing stock market looks to me nothing but a short squeeze. It can run for a while, but with every pip upwards, the stimulus it craves gets farther distant as, paradoxically, the combination of a temporary wealth effect and rising commodity inflation simply raise the bar on QE3.
I hope the Fed holds off. Their toying with QE is generating a volatility that is tearing Western consumers apart.
If they pull the trigger too soon, economic weakness and the European debacle may overwhelm even the its power to reflate markets.
It seems to me a lesser evil to allow a US recession to take place and disinflation to take effect than to risk losing monetary credibility altogether, engendering a worse recession as markets panic that the Fed is out of bullets.
That may seem a crazy idea but I reckon that’s what we’re coming to. The institutions that govern the liberal market system are slowly being drawn into the collapse.
That is the backdrop for the real purpose of this post, which is to explore what stimulus options are available to Australia in the event that a new recession does reach our shores. I have already described how any Western recession will damage Australian growth via three likely channels, pressure on the Australian banks funding costs, the ongoing global equity market shock and the subsequent hunkering down of consumers, as well as the drop in commodity prices as Chinese growth is hit by falling exports.
You can see that each of these points of transmission is the result of the interconnectedness of the Australian economy with the global economy. That’s poses a particular difficulty when contemplating any likely fiscal stimulus options for the country. As Professor Garnaut pointed out in our co-authored book, The Great Crash of 2008:
Depression Economics theory was worked out for a single economy that was not closely linked to the rest of the world. The policy problem is more complex in a multi-country world.
The level of global output is the sum of the national parts. If the whole world has underemployed resources, as has been the case since the Great Crash of 2008, expansion anywhere will raise incomes, employment and expenditure everywhere else. A substantial proportion of one country’s increased expenditure serves to raise demand for imports of other countries’ goods and services. To the extent that one country’s expanded expenditure ‘leaks’ into imports from other countries, there is less stimulation of employment and incomes in the home country. To the extent that there is concerted expansion involving many countries, the ‘leakages’ will balance out, and each country will get more or less its share of the global stimulus.
For a single country, the extent to which its own expansionary policy raises demand for ‘home’ or ‘non-traded’ goods and services, and to which it increases demand for other countries’ products, depends on the real exchange rate. The real exchange rate in turn depends on what happens to nominal exchange rates (the rates quoted on the news each night) and on domestic inflation.
There are a number of implications we can draw from this framework when considering the likely stimulus outcomes for Australia. Firstly, as Deus Forex Machina has argued so well, the Australian dollar is NOT, thank heavens, a safe haven. As markets continue to price a forthcoming recession, the Aussie will get hammered, just as it was designed to.
The thrust of this weakness will be twofold. General risk aversion is one cause and the second wave will be the initial stimulus response to sliding Australian growth: rate cuts. How low rates and the dollar go will depend obviously on the severity of the recession. But if Europe gets as bad as Delusional Economics is suggesting, then the cuts and falls will be deep.
So, that’s good news. Our real exchange rate will swing heavily in our favour, which means any stimulus here and offshore will be of the greatest possible benefit, just it was in 08/09 when, although some of the consumption-based stimulus leaked offshore to Asian exporters, Chinese and other Asian nations own stimulus fired up our commodity exports and prices.
But, there is also dour news in the Garnaut assessment. In part, one major reason the West is being condemned to this recession is that the consensus surrounding Depression Economics that promoted growth out of the GFC has collapsed.
So, we can’t expect the same global response this time around with hobbled governments and zero bound central banks.
Nonetheless, there are reasons for optimism that Australia will be able to stimulate with some success. The first hope is that China is certain to pour monetary and fiscal fuel onto its infrastructure bonfire. Whilst this is part of the global imbalance problem in the long term, it will at least boost Australia’s exports at a useful juncture of weakness. That, in turn, should prevent too much winding back of the capex plans in Australia’s mining sector.
For example, look at the following chart of mining capex expenditure:
As you can see, the falls in 08/09 were substantial but hardly catastrophic. To reinforce the point, here is a chart of long term mining capex plans:
Again, we can see the 08/09 drop, but what is also obvious is that any falls in the future will be from extreme levels.
So, Australia is likely to still have a strong impulse of mining capex even in the event of a very serious recession emanating from offshore. The problem, however, will be in the rest of the economy. That forlorn and lonely beast: services.
In the event of a Western recession, some relief will arrive with the cutting of interest rates, but the contagion of Western consumer retrenchment and a surging paradox of thrift will more than offset that effect. There is also the danger that the housing market will crack as unemployment rises.
So, the critical question confronting the Federal government will be whether to use the Budget for fiscal stimulus aimed at the services economy and especially housing as it did in 2008.
The 08/09 stimulus was big. Very big. $52.5 billion or four and change per cent of GDP. The first tranche, in October 2008, was $10.4 billion of cash payments to low-and medium-income households, and First Home Owners Grant to A$14 000, with an additional A$7000 grant if it related to a new house.
The second was in February 2009 and included another cash payment, a large-scale program that subsidised energy-saving private investments in housing insulation, and a similarly large program of school construction the total value of which was $12.2 billion.
The third tranche, delivered within the annual Budget, confirmed promises of broadly based tax cuts made in more prosperous times, made major commitments to large-scale transport and communications infrastructure, and introduced new support for the commercialisation of new technologies to reduce greenhouse gas emissions in the energy sector.
Not surprisingly, the whole caboodle was wildly effective, literally stimulating a mini boom in housing and consumption that blew the lid off the labour market. It left Australia with a gross public debt of 22% to GDP.
And, now we come to it. Could it be done again?
To find out, I had a chat this morning with Moody’s sovereign rating analyst responsible for Australia’ rating in New York, Steven Hess. I asked Mr Hess what are the strengths underpinning Australia’s AAA rating. He replied:
Strong government finance as evidenced by both the policy framework (including the Charter of Budget Honesty) and the goal of both major parties of attaining fiscal balance and keeping government debt low. A relatively diverse economy that has shown resilience to external shocks, including the recent global financial crisis. A strong banking system that limits the government’s contingent liability from this source. Strong monetary and regulatory institutions. A good record of economic growth in the past decade resulting in part from a high level of investment.
However, when I probed Mr Hess on whether he sees any vulnerabilities his reply made it clear that the strengths above are alos the source of potential weakness. According to Mr Hess, “dependence on external savings to finance the high level of investment. This is a vulnerability in times of global financial market disruptions. This could potentially cause the government to have to inject funds.” Moreover, Mr Hess went on to say that another vulnerability was “housing market developments that would cause problems for the banks.”
The implications of these risks, according to Mr Hess, is that Australia’s rating would come under pressure in the event of a “weakening of fiscal discipline that causes government debt to rise substantially.” Mr Hess also noted that a “banking crisis” might be one such triggering event. Though he reassured me that Moody’s does not expect one.
Also reassuring was Mr Hess’s emphatic statement that Australia’s public debt would need to be “far above where the ratio is presently. We don’t have a particular number, but a continuous upward trajectory that did not seem likely to be reversed would be a trigger for a downgrade”.
So, we can draw the conclusion that Australia is in a position to fiscally stimulate again if it comes to that. However, the degree to which it can do so will depend upon a number of factors. If it were to be a downturn that triggered a long term slide in commodity prices, even if they remain at high levels, the effects on government tax revenue in the longer term would mean the stimulus had to be small.
And even without such an erosion in commodity price expectations, there are reasons to think that we could not repeat the magnitude of the 2008 stimulus. Let’s not forget the Moody’s warning of a few months ago:
At Aa2, the major banks’ ratings continue to incorporate 2 notches of uplift from systemic support. Moody’s views bank supervisors and the government in Australia to be supportive by global comparison and the banks to have high systemic importance, as implicitly recognized by the government’s “Four Pillars” policy (which restricts M&A among the banks).
In short, the banks credit ratings hinge significantly upon government support. Another round of stimulus as large as the last would take the debt to GDP ratio close to 60% (don’t forge that the 2008 round started from significant surplus). Although Moody’s didn’t provide a figure, that level is, I would have thought, getting uncomfortable for an externally funded economy whose banks rely on on implicit government guarantee in a wildly volatile world.
We might sensibly conclude then, that, any stimulus would need to be modest and monetary easing do more heavy lifting than in 2008. This in turn, however, would need to weighed against the danger of making the housing vulnerability even worse.