End of another month.
The following photo taken while we were in China in September shows the view across the river to Shanghai's Bund. I thought the photo was a good way to end the month because of the importance of China to the global economic outlook.
I had been wondering how the various elements of the Australian Government's bank guarantee scheme were working in practice after the initial negative fall out in the mortgage funds market. A story by Mathew Drummond in today's Australian Financial Review provides some hints. I cannot give you the full link - the story is behind the FR's pay wall.
As an aside, I have been meaning to do an update on the media and the internet. Just a reminder to myself to do so.
From today, Australian banks will be able to use the Government's guarantee to raise funds off-shore, creating triple A borrowings. In Parliament, Australian Corporate Law Minister Nick Sherry said that sixteen institutions had already advised that they would make use of the new facility. However, Mr Sherry did not know at this point just what sums might be involved.
Mathew Drummond notes that the similar British scheme that has now been in operation for a month has lowered funding costs with quite fine margins because of investor demand.
Also from today, domestic depositors with deposits of more than one million dollars will have to decide whether or not they are prepared to pay the insurance premium required to gain the Government guarantee on their deposits. Apparently only Macquarie Bank is planning to absorb this.
My feeling is that a good number won't bother. It all comes back to a risk assessment.
More broadly, I find it interesting that the heat and worry generated by the global financial crisis itself has, at least so far as Australia is concerned, largely vanished.
The topic is no longer a BBQ stopper, although withdrawals from many mortgage funds remain frozen. People are far more worried about changes to the real economy.
In an earlier post, What is the difference between recession and depression? Saul Eslake's View, I referred to Saul Eslake's discussion on the differences between recession and depression. Australia may avoid technical recession, but to most Australians it certainly feels as though the country is in recession.
I had to laugh. One of my old colleagues (old I hasten to add just because I have known him for a long time), Winton Bates, ran a post Can budget deficits cure the debt problem? reporting on a conversation he had had.
Now that conversation captured pretty well some of the things that I have been talking about. I leave it to you to make your own judgements.
There is considerable discussion in Australia at the present time about the Australian Government's apparent reluctance to run a budget deficit. There is also criticism of the Government's apparent desire to still cut costs at a time of downturn. To a degree, the discussion confuses different issues.
The first key thing to note is the difference between cyclical and structural deficits.
In simple terms, a cyclical deficit comes about because revenue rises and falls with changes in economic activity. With given spend, the budget is in surplus at one point, then goes into deficit, then comes back into surplus. This provides a cushioning effect. Counter cyclical spend fits within this definition because it is specifically time limited.
A structural deficit is different. Here changes to the pattern of revenue and expenditure occur such that a deficit appears independent of the level of economic activity, continuing even at times of higher activity.
The 1970s saw the end of the old concept of the welfare state. One reason for this was that Government spending patterns in many countries ended up with specific built in features that ensured growth in spend faster than could be supported by the longer term trends in economic activity. This could not be accommodated through increased taxation, leading to persistent structural deficits. This crowded out private sector activities and helped build in inflation.
We do not want to go there again. So the issue about deficits is not just the immediate impact, but also the nature of the deficits themselves. We need to avoid the creation of structural deficits.
This leads me to my second point.
The need to control spending, to get the best value from Government spend, continues independent of the state of the economic cycle. We need to prune fat just as much during downturns as at other times. More so in fact, because in this type of downturn financial disciplines can easily become relaxed. Further, Government has a continuing need to re-set priorities as needs change
Pruning spend has an economic impact. In times like this, every dollar we save is simply a dollar that we can then spend in another way.
It is very easy to get depressed just at present about the global economic situation, especially if you listen to the news too much. In my economics posts I have tried to educate myself and, hopefully, others about some of the economic parameters involved without getting too caught up in the short term detail.
In this post I want to continue the discussion by focusing on a few macro numbers.
The table below sets out 2007 GDP for the top twenty global economies. Between them, they amount to a bit over 81 per cent of global GDP.
First the bad news.
If you look at the relative size of the economies that are either in or likely to enter recession, you can see why the world has an economic problem. In simple back of envelope terms, with countries controlling over 55 per cent of the global economy entering recession, the remaining 45 per cent must inevitably be affected.
The numbers also show why a degree of caution needs to be exercised in talking about the role of countries such as China or India. The US economy is presently a bit over four time the size of China's, so every one per cent fall in US GDP requires a four per cent increase in China's GDP to maintain the economic status quo.
The figures also indicate the size of the tectonic shift now underway in the global economy.
At present, India and China between them are a bit under one third the size of the US economy. If, as seems possible, the US records average zero growth over the next three years while India and China average 8 per cent over the same period, then (assuming my rough maths is correct), the combined India/China GDP will rise to around 41 per cent of the US total in just three years.
Table: World GDP 2007
| Country | Rank | GDP (millions $US) | % World |
| World | 54,347,038 | ||
| US | 1 | 13,811,200 | 25.41 |
| Japan | 2 | 4,376,705 | 8.05 |
| Germany | 3 | 3,297,233 | 6.07 |
| China | 4 | 3,280,053 | 6.05 |
| United Kingdom | 5 | 2,727,806 | 5.02 |
| France | 6 | 2,562,288 | 4.71 |
| Italy | 7 | 2,107,481 | 3.88 |
| Spain | 8 | 1,429,226 | 2.63 |
| Canada | 9 | 1,326,376 | 2.44 |
| Brazil | 10 | 1,314,170 | 2.42 |
| Russia | 11 | 1,291,011 | 2.38 |
| India | 12 | 1,170,968 | 2.15 |
| Korea, Rep | 13 | 969,795 | 1.78 |
| Mexico | 14 | 893,364 | 1.64 |
| Australia | 15 | 821,716 | 1.51 |
| Netherlands | 16 | 754,203 | 1.39 |
| Turkey | 17 | 657,091 | 1.21 |
| Belgium | 18 | 448,560 | 0.83 |
| Sweden | 19 | 444,443 | 0.82 |
| Indonesia | 20 | 432,817 | 0.80 |
| Top 20 | 44,116,506 | 81.12 |
Source: World Bank
Now for the good news, the reason why I remain optimistic, especially so far as Australia is concerned.
Major developed countries are going to have a nasty downturn whether we like it or not. This is already flowing onto other countries including China where unemployment appears to have risen sharply as a consequence of the downturn in manufactured exports.
In some ways the global financial system is awash with liquidity. However, and putting the financial crisis itself aside for the present, this will not translate into extra activity because people (consumers and business) are reluctant to borrow unless really forced to and then banks are reluctant to lend.
Most governments are putting old fashioned pump priming measures in place intended to stimulate consumption and investment. These will take time to come into effect. Further, the initial effects will be muted because some of the initial spend is likely to flow into savings and debt reduction. People just don't want to spend when things are so uncertain.
To my mind, the big kicker will come as increased government investment spending kicks in. This will vary from country to country, but in all cases will take time. With exceptions such as China which already has projects in the pipeline, governments will have to create project pipelines. From experience, it is likely to be eighteen months before spend accelerates in most countries.
Note that I have said nothing about confidence effects. My personal view is that there may well be more shocks and that, in any event, pessimism is likely to remain dominant until things have clearly started to improve.
Pulling all this together, my best guess is that we are going to see a deepening recession in most major industrial countries over the next twelve months. I do not see how this can be avoided, although the effects are going to vary from country to country.
Beyond this point, I would expect to see progressive strengthening in global economic activity as further investment spend kicks in. This is based just on mechanical economics 101 style analysis.
I really can't see in all this just how a depression might occur in global terms, barring some total catastrophic collapse. My bigger worry is the likelihood that the combined total of Government responses will over-shoot, creating a new set of problems on the other side.
Finishing with a note on Australia.
It would be a brave person who would say categorically that Australia can avoid recession. However, whichever way I look at the numbers, I think that we can say that Australia is better positioned than most to avoid a serious downturn .
We are also better positioned than most to benefit from increased investment spend since we are a key supplier of the commodity products that will be required as inputs into new infrastructure.
To the degree my overall analysis is right, then we are likely to see strengthening export demand twelve to eighteen months out.
Yesterday I completed another one of my economics 101 posts, More economics 101 - capacity utilisation and inflation in Australia.
I had in fact intended to post it here, but in using Livewriter I still had it linked through to my personal blog rather than this one! So a cross-link post.
One thing that I have not seen much discussed in current discussions on the economy is the importance of fixed costs at a time of economic downturn. By fixed costs I simply mean all those things that the firm must keep paying including financing costs. This is a critical issue, especially for smaller businesses that have often entered into arrangements such as leases on cars in part for taxation reasons.
The maths are simple enough. Say that you have sales or fees of 100, a profit of 10, fixed costs of 80, variable costs of of 10. Sales drop by 20 per cent to 80. Now your costs are fixed 80, variable 8, leading to a loss of 8.
There is nothing magical in these numbers. However, they do illustrate one of the key factors explaining the severity of some downturns.
With time, fixed costs become variable. However, in severe downturns firms do not have this adjustment time and can be forced to close as cash runs out. The higher the fixed cost ratio, the sharper the downturn, the more firms are forced to close, adding to downward pressures.
Those firms with better margins or greater net assets survive because they have the time to adjust. However, their action in cutting costs create second round downwards pressures, extending the downturn.
It is a just under a month since I did my last post on the most popular posts among my last 100 visitors. My stats package only allows me to track the last 100 at any one time.
The top two most popular posts by a considerable margin were:
Then came two posts both previously ranked in the top three:
These were followed after another gap by
Then after a gap came:
In all, a fairly mixed bag with a bias towards my more recent economics posts.
I was greatly struck by some numbers John Taplin included in his post What Now? He quotes Jeremy Grantham.
An amateur economist could summarize and simplify the Chinese economy as 39-37-37: an astonishingly large 39% of the GDP is capital spending, 37% is internal consumption, and an amount equal to 37% of GDP is exported. (These numbers do not sum to 100 as we are not using exports net of imports because we are concerned with the vulnerability of total exports to a weak global economy.) The U.S., in comparison, is 19-70-13, disturbingly on the other side of normal; 70% consumption compared with 57% in both Germany and Japan, for example, and nearly twice that in China.
The position in Australia is not quite as bad as the US although, as amoranthus keeps reminding me in his comments, our consumption is 62 per cent of the economy.
I looked at some related issues in a post on my personal blog, Agriculture, the environment and Australia's future. There I said in part:
For a long time our mainly urban population has been buying more from overseas than we sell. The gap has been met through overseas private borrowing. This is not sustainable in the longer term.
We have to either increase our saving rate or, alternatively, find new things to sell internationally. If we lose our coal and agricultural exports, the position becomes much worse. Should Steve Truman's gloomy prognostication that Australia may become a net food importer prove correct, then we may find ourselves in diabolical trouble, as will those in other countries that we presently feed.
In Robert Shiller on bubbles the Australian economist Harry Clarke looked in part at the way increasing Australian asset prices concealed our low savings rate.
One of the things that it is easy to lose sight of in the current economic climate is that recession is, in some ways, the necessary corrective to periods of boom. This may be hard to accept by those who are hurt, but is still I think correct.
During booms, inefficiencies creep into systems across all sectors because growth compensates. Booms allow us to spend more than we are in fact earning. They lead to asset prices that are out of kilter with real values. When contraction comes it exposes all these weaknesses. We are forced to adjust.
This leads me to a nagging worry about the current adjustment packages. To some degree their aim is to restore the status quo, to put us back to where we were before. This creates a number of risks.
To begin with, to the degree they work they may leave the structural imbalances in place. Because these still have to be worked through, the outcome is likely to be low growth.
They may also leave national governments encumbered with debt, limiting future flexibility.
Finally, they risk over-shooting. I have not totaled up the value of all the global support and stimulation packages, but they must run now into trillions of dollars.
The key point to remember about recession is that it frees up resources for other things. If we simply accommodate this by restoring consumption, things remain the same even if we get an immediate stimulus to economic activity.
On the other hand, if we use the free resources for investment purposes then we have assets that can generate future income.
The US has focused in many ways on attempting to protect or restore the status quo, China on future investment. Which do you think is likely to give the best result?
Don Arthur had a good post, Lessons from California’s housing bubble, on Club Troppo that is relevant, among other things, to my discussion on the views of Reserve Bank Deputy Governor, Ric Battellino. I will leave you to read the post, but in the meantime I wanted to make a simple supply and demand observation on one point arising.
The amount people pay for a house depends in part upon how much cash they have, in part upon the value placed upon the house This may reflect personal utility, but also takes into account expected future returns on the house from capital gains and, in the case of rental properties, rentals.
Just because housing is in short supply does not mean that prices will not decline. In simple terms, if people cannot afford to or are unwilling to buy because prices have got so high, then prices will fall.
In a bubble, the demand curve shifts because of people's expectations about the future. With inelastic short term supply, this quickly drives prices up.
In a crash, the demand curve shifts back. Prices fall quickly.
A very interesting feature in Don's article lies in the role of scarcity.
Where rising prices can be accommodated by increased supply, price rises are choked off. Bubbles depend upon inelastic supply responses.
In my last post, A non-economist's crib to Australia's economic outlook - part one, I focused on the views of Reserve Bank Deputy Governor, Ric Battellino on the current reasonably strong financial position of the Australian household sector.
In this post, I want to look at the latest Mid-Year Economic and Fiscal Outlook prepared by the Commonwealth Treasury. There has been much commentary on this in yesterday and today's media, looking especially at some of the headline numbers. My concern is what we might learn from the document about Australia's economic outlook. All numbers are in $A unless otherwise noted.
At the time of the May budget, the 2008-2009 Australian Government cash budget surplus (accrual figures are a little higher) was projected at $21.7 billion. This has now shrunk to $5.4 billion. A pretty big fall.
If we look at the reasons for the fall, we find that projected expenditure has risen by $10.6 billion, largely due to the recently announced fiscal stimulation measures.
Taxation revenue is projected to fall by $4.9 billion, largely because of falls in receipts from capital gains and company tax.
Turning now to the forward estimates. For the benefit of international readers, these are longer term budget projections taking into account approved expenditure, including the Rudd Government's election commitments.
The forward estimates show projected cash surpluses of $3.6 billion in 09-10, $2.6 billion in 10-11, rising to $6.7 billion in 11-12.
The headline $40 billion figure used by many commentators to describe the total deterioration in the Australian Governments financial position is the combined change in the surplus from budget time for the total period from 08-09 to 11-12. Expressed in this way, the change is not quite as dramatic as might appear at first sight.
In considering the projected surpluses, I was struck by the following chart (2.2), showing the projected budget position in various developed countries. Australia and Canada stand out. I will discuss some of the economic assumptions on which the projections depend in a little while. For the moment, Is imply note that the figures are indicative of Australia's comparatively strong position.
Chart 2.2: Budgetary positions for selected countries in 2008 and 2009 
A further point to note is that Australia's position is very different this time as compared to the previous big crashes of the 1890s and the Great Depression. In both cases Australia was heavily dependent on international borrowings. In this case, the Australian Government has no net debt, adding to fiscal flexibility.
It is important to be clear here.
One measure of international indebtedness shows Australia with high and growing debt. However, that debt is private. The Australian Government's net debt position is positive to the tune of around $47 billion, with debt more than offset by things like the Future Fund, Australia's largest sovereign fund. The Government actually gets more interest than it pays! Full marks to Mr Costello as former Treasurer.
All this leads, as shown in the chart below, to immediate growth projections far better than those in most developed countries.
Chart 1.1: Forecast economic growth rates for G7, Euro area and Australia in
2008 and 2009
I am not going to be too detailed in the following comments. After all, this is a crib, not a full scale analysis. Further, the variables are all inter-related, so a change to one flows elsewhere through the system. Treasury uses full scale economic models to test this. I will just point to the linkages.
We all know that
The huge spike in 1950-1951 is the wool boom where demand for uniforms for the Korean War on top of rising consumer demand sent the prices we received for our wool through the ceiling. Wool reached a pound a pound, to the joy of our rural community.
With spikes, our terms of trade then declined until the early nineties. This meant that we had to sell more to get the same volume of imports. Then we had the huge resources boom. We sold more and at increasing prices, while the prices of our imports stayed down because of the emergence of new suppliers and especially Chin
This period has now come to an end. Chart 3.2 shows the collapse in the spot price for two key commodity exports, iron ore and coal. Now here we need to take into account price and volume effects.
We have existing contracts that will hold at least some prices up in the short term. Then prices for commodities can be expected to fall towards the spot price, so that our terms of trade will deteriorate.
To accommodate this, the Treasury projections forecast a decline in the terms of trade of 8½ per cent in 2009‑10. As a result, nominal GDP growth in 2009‑10 is forecast to grow by only 3 per cent, compared to growth of around 8 per cent over the last two years.
Export prices are usually expressed in US dollar terms, while producers receive Australian dollars. This means that with a lower dollar, domestic receipts may stay the same so long as volume of sales hold up, a cushioning effect. In this context, the projections assume that the Australian dollar will stay at a lower level, with reduced but continuing growths in volume because of lower but continued growth in certain countries and especially China.
If the terms of trade deteriorate by more than expected, if the Australian dollar increases in value by more than expected, if export volumes fall, then the projections will change. The Mid-Year paper models two effects, showing how GDP growth might drop to zero or even negative.
Turning now to investment.
High business investment has been one of the recent drivers in economic growth. The projections assume that this will continue in the short term because of projects already underway, but then flatten in 09-10.
Housing investment, another past driver, has been low and falling.This is where Mr Battelino's analysis, A non-economist's crib to Australia's economic outlook - part one, comes in. He suggests, and I think that he is right, that Australia is several years in front of the US housing cycle. We do not have surplus housing stocks, really the opposite. So the projections assume a pick-up in housing in 09-10, driven in part by the first home buyer grants in the economic stimulus package.
On the Government side, the projections show the Government sector making a positive general contribution to growth, driven in part by new infrastructure spending into the medium term.
By size, consumption demand is a key part of the economy. The projections assume that growth in consumption demand will be well down in 08-09, with the economic stimulus package making a contribution in the second part of the year.
Private consumption depends in part upon expectations, more upon consumer incomes. This is where employment conditions are critical. Here the projections suggest an increase in employment of one and a quarter per cent in 08-09, well down from the original budget estimates, just 3/4 of a per cent in 09-10, rising to one and a quarter per cent in 10-11 and 11-12.
This means some rise in unemployment in the short tem at least. The unemployment rate is forecast to rise to 5 per cent by the June quarter 2009 and 5¾ per cent by the June quarter 2010.
Again, we can see the way things inter-connect. If, as seems to be happening at the moment, consumers cut back on spending because of fears for the future, then this will feed through to lower demand and higher unemployment. In this context, the present job market has become very soft.
Troubled times. There are obviously great uncertainties built into the projections, and indeed some commentators have already suggested that the underlying assumptions are too positive.
They may be right. However, we can say two things.
First, the projections do provide an framework for looking and assessing future economic performance independent of immediate day-to-day fluctuations.
Secondly, they and Mr Battelino's analysis do suggest why Australia is in fact in a better position to ride through the current economic storms than many other countries.
Postscript
Even as I was writing this post, the IMF was releasing new forecasts showing a further sharp fall in projected world economic growth. You can find full details on the IMF site. While the Australian economy is still projected to grow if lower than the Treasury estimates, developed countries as a whole are projected to drop into negative growth.
The new IMF forecasts illustrate the difficulty of making economic projections at a time like this, but do not invalidate the analysis in this post.
The projections have been made on the basis of current policies and ignore the effects of further stimulatory action in various countries. I must admit to a growing concern that the combined effect of the various stimulatory measures may lead to over-shoot in the opposite direction, fueling inflation in due course, leading to another round of corrective measures.
Last week Ric Battellino, the Deputy Governor of Australia's Reserve Bank, delivered what was written up as an optimistic view of the Australian economic outlook.
Following some bad economic news, the Reserve Bank cut official interest rates yesterday (Melbourne Cup day) by 75 basis points. Commentators focused on the apparent difference between Mr Battellino's views and the decision. If things were so good, why was such a deep cut necessary?
Today the Australian Treasurer released the Treasury Mid Year Economic and Fiscal Outlook. Commentators focused on the headline numbers, the decline in the projected budget surplus.
I don't know about you, but I sometimes get confused in the flow of daily commentary and news, in part because I cannot always remember enough of past data and analysis to put it all into a context. For that reason, I thought that it might be helpful if I provided a sort of an economic crib to recent official statements.
Those interested can find the original of Ric Battelino's speech here.
Headed An Update on Household Finances, the speech was concerned to reinforce confidence among Australian Australian households worried about recent developments.
Mr Battelino began by suggesting that the past five years had been an extraordinarily favourable period for Australian household income. This is an important starting point because it sets a context for the challenges Australia now faces.
During that period, real disposable income of the household sector grew on average by 6.1 per cent per year, resulting in a cumulative increase over the five years of more than 30 per cent.
This is quite a remarkable increase, meaning that the growth in household incomes in Australia greatly exceeded that in any other developed economy, round twice that in the US. For example, growth in real household disposable income was only about half that in Australia. Mr Battelino also noted that the growth in income in Australia was fairly evenly distributed through the household sector in that the percentage increase in real income was very similar across all the income quintiles.
This is a pretty good result, although it also means that income disparities increased because the rich have more bucks on which to get a bang than the poor.
Mr Battelino then looked at the impact of growth on household balance sheets.
This is an important issue because in Australia, as in the US, household debt has been rising. However, unlike the US, the Australian household position is quite strong.
If you look at the attached graph, financial assets at 30 June averaged around $275,000 per household while liabilities averaged $150,000 per household. Since then, the Reserve Bank estimates that average assets have fallen to around $245,000 per household, leaving quite a strong average positive position.
Note that these are financial assets. They include housing debt, but do not appear to include the value of the family home.
The graph shows just how important superannuation is to average household financial assets. Much superannuation is invested in shares, making the equity component much greater than the formal equity value in the graph.
This is important, because in the short term it means that over a million Australians approaching retirement are suffering from current falls in share values. However, in the medium term it also means that a large majority of Australian households are poised to gain from future increases in share values. Here Mr Battelino i
The next graphic shows the total annual return on Australian shares over the last one hundred and something years. The return goes negative every five years or so, sometimes by significant margins, but the average return is very good.
He then compares the return on shares with the return on bonds, a safe cash equivalent, taking $100 in 1908 as a base. The hugely different returns on shares are easy to see in the graphic.
Quite simply, shares have beaten cash hands down over a very long period. This is likely to continue, providing a base for improvement in household financial positions as the share markets recover.
Mr Battelino then turns to look at the value of housing, the other key household asset.
Here he makes the very interesting point that the boom in Australian housing prices, one that peaked some time ago, did not elicit the same supply side response as in the US. This means that we simply do not have the same number of surplus properties, placi
This, in combination with a better underlying household position than the US, helps explain why Australian banks have far fewer non-performing housing loans than in the US.
There are some hot-spots, Sydney's western suburbs for example. Further, non-performing loan figures are worse among non-bank lenders. Even here, though, the Australian position is better, with non-performing loans in Western Sydney by mortgage originators running at about 1.6 per cent as compared to over 2.5 per cent for US banks as a whole.
The main media coverage of Mr Battelino's speech focused on some of the supporting comments he made dealing with the broader economy. Here he flagged that inflation was still a problem, while pointing to some of the reasons why he thought that Australia would avoid recession.
These broader comments are best discussed in the context of the Mid Year Economic and Fiscal Outlook, the subject of the second post in the series. In the meantime, Mr Battelino's speech provides some interesting insights into the structure of aggregate household finances in Australia.
