The international financial crisis - return of the liquidity trap?

All those years ago when I did macro-economics for the first time, one thing that we learnt about was the Keynsian concept of the liquidity trap. This came about where no matter how much you lowered the interest rate or expanded the money supply (=liquidity), there was no impact on economic activity.

This came about because, among other things, plans to save were greater than plans to invest. In these circumstances, economic activity would contract no matter the expansion in liquidity. The only solution was fiscal policy, an expansion in real spend.

I think that this where we are now.

Postscript

I had no idea when I penned this simple post this morning just how right I appear to be. Listening to the news tonight - it is now 10.50 -the continuing financial meltdown is flowing straight across into the real economy. In Australia, consumer confidence is down 11 per cent.

In all this, there are rich pickings for some such as the Commonwealth Bank's acquisition of BankWest.

We managers need to be easier on ourselves

Much of my writing on management issues deals with the way that we as managers might improve our performance. Yet recently I have had cause to question whether this constant focus on performance improvement might not be wrong.

Don't misunderstand me. All managers have a professional responsibility to improve their skills and performance. It's just that I feel that we are in danger of setting absolute benchmarks, expectations, that cannot be delivered.

Our management skills vary. Further, all of us are better managers in some circumstances than another. None of us can be perfect.

My feeling is that we should stop agonising over the question as to whether we are a good manager or not. Instead, we should just focus on improving what we do.

Yes, this is still a focus performance improvement. But the emphasis is on relative improvement, not some focus on an absolute benchmark that none of us can meet.

We cannot aim to be perfect. We can only aim to improve what we actually do now.

The remarkable fall of the Australian dollar

After many years as a professional economist and strategic consultant, I know better than to try to predict the market. Still, both my wife (she is also an economist) and I blinked at the current decline in value of the Australian dollar as, and I quote, a "risky" currency.

Australia's economic fundamentals are some of the best in the world. Yes, local interest rates will fall, but so will they elsewhere.

Still, one should not complain. While the decline in the aussie will add to local inflationary pressures, it will also provide gains to exporters while discouraging imports. That's not a bad thing just at present.

The international curse of the ratings agencies

I know of no solution to this, but the ratings agencies have become something of an international curse.

As originally envisaged, their role was to aid transparency through the provision of information. Who could argue with this? The difficulty is that they have really become players in their own right, exercising authority without responsibility. The problem here lies in part with the agencies, more with those responding to them.

At Government level, the Australian state of NSW provides a current example. Maintenance of the state's triple A credit rating has apparently become the key policy driver. But to what purpose?

NSW faces a difficult budget position because of the current downturn in the State's economy. The state also needs a range of new infrastructure because of previous under-spending, driven in part by the perceived need to limit debt to retain the triple A rating. Further, the desire to limit debt has also driven the state into various forms of private-public partnerships, some of which have been fairly spectacular failures.

Just at present the NSW economy is in a slump. In the old days, this would have provided the opportunity to expand capital spending to catch up on the infrastructure back-log without adding to resource pressures. Not now.

Would it matter if NSW was slightly down-graded in credit terms? Not really.

Debt as a proportion of state GDP is low in historical terms. By global standards, NSW is a highly secure borrower. Given a shortage of Government debt in Australia at the present time (the Commonwealth itself has no net debt), I suspect that any NSW public loan raisings would be rushed. NSW simply does not need the rating agencies at this point.

At private level, the most significant problem is the way in which changes to ratings have become market players in their own right. Assume a sound company. A change in ratings can lead to loss of support that then affects company funding. In worst case, sound businesses may actually be forced down because of reduced capacity to fund activity.

In all, a bit of a mess!

Postscript

Winton Bates, an economist with long Government experience, had an interesting post on this one - Why did the rating agencies put their reputations at risk?

Why the US financial package should be rejected - and why Australia will ride out the storm

This post deals with two issues, one macro, one local.

Listening to the debate on the proposed US financial rescue package, I have slowly come to the conclusion that it should (at least from a US perspective) be rejected. I say this for one core reason.

The package mixes together two very different things. The first is the maintenance of liquidity so that financial institutions can lend to each other. This is a good thing. The second appears to be the maintenance of US property values. This is plain silly.

What will happen if the package is rejected? The worst case is that the US economy will slip deeper into recession as necessary corrections for past excesses work their way through. We have seen this before. The right economic answer would be to use monetary and fiscal policy to then expand the real economy.

What will happen if the policy is accepted? At best, it may ease the immediate pain, while leaving the US economy (and Government) saddled with still over-valued assets. The outcome will be slower longer term US economic growth.

Both Australian PM Rudd and Opposition Leader Turnbull are strong supporters of the rescue package. Both have the Australian, not the US interest, at heart. Both are, to my mind, wrong. We do not want a reduction in immediate local pain if the outcome is an enfeebled US.

Australia will survive current US problems. We do have significant structural problems, but they are far less than the US.

Our banking system is sound. Liquidity is a problem because of the flow-on effects of the impact of the sub-prime crisis on international bank lending. However, we also have a very large domestic deposit base. Non-bank lenders have been hardest hit by the collapse in liquidity because they do not have this deposit base. Hence the Government's actions to improve liquidity in this area. Overall, we are not going to see bank collapses even if the banks have to take major write-downs.

Our Government financial position is sound. Even NSW, Australia's basket case economy, has very low debt relative to Gross State Domestic Product. Our Federal Government has a present budget surplus and no debt. The Australian Government system has a whole has great capacity to use fiscal policy without mortgaging the future.

Our trade position is much weaker. However, and here Mr Keating (not one of my favourite people in normal circumstances) deserves credit, we have a floating exchange rate.

We can expect an export hit. Commodity prices will fall, although base demand will continue. Food prices may fall a little, but demand will continue. Service exports will decline. Here I am especially concerned about the education sector because we have built structures that in fact depend upon full fee paying students. If on worst case scenario we get a major decline in this area, all our major universities will need some form of bail-out.

While exports may decline, a floating exchange rate means that the external trade position will tend to adjust with time. We may see a fall in the value of the currency, although this is not certain. Should this happen, there will be flow-on inflationary effects. However, these can be managed.

In all this, both Government and Opposition have been spooked into a short term focus. In my view, now is the opportunity to adopt a longer term perspective. What should we do to build the domestic economy, including especially our infrastructure? What might we do, as we did during the Asian financial crisis, to help our Asian neighbours and trading partners adjust to the crisis?

Take China as an example. Chinese car sales are dropping in part because of price hikes on raw materials. Should the Government in conjunction with our resources sector be looking to lower China's raw material prices to encourage Chinese domestic demand?

I am not saying that we should. I am simply arguing that we need to think about our strength in a more turbulent world.

Management Perspectives - most popular posts 2

Continuing my irregular series on the most popular posts on this blog, the most popular posts among the last 100 visitors have been:

• The Balance of Payments, Australia and the sub-prime crisis. I did something of an update on this post in Saturday Morning Musings - longer term impact of the US financial crisis.
• The Importance of Demography and Demographic Change - update. I need to update this post to take into account later writings.
• Australia's new minimum wage - July 2008.
• Common Management Problems Series 1 - managing up
• The Dangers of Google's Market Dominance
• Alan Sarkissian - Audience of One
• Global Demographic Trends - A few macro numbers

The graphic shows from which countries visitors came. The US retains its number one position followed by Australia.

I don't try to write to attract specific country traffic, although I have been wondering if I should.

Just to explain why.

All bloggers like to be read. I am no exception. I have been wondering whether posts looking at links between countries might not be a useful addition to the blog.

I do know in terms of my own work that country inter-connections are becoming of increasing importance in a globalised world.

The fallacy of modern management

When I first began investing on the stock exchange, things were relatively simple. Select a small but balanced portfolio and then hold it for the long term.

So long as your firms were reasonably well managed, then you knew that continuing business improvement and reinvestment would lead to increased profits over time. In turn, this would translate to increased dividends, higher share prices, plus reasonably regular issues of bonus shares. Further, when your firms wanted new capital, you could either buy new shares or, alternatively, sell the rights for cash.

No more I fear. The failure rate among modern corporations is now so high that the only way to capture the compounding effect in a reasonably low risk fashion is by investing so as to follow the index.

Our current problems lie in a fundamental conflict between management styles and the underlying financial maths.

To illustrate, assume that the real economy is growing by 3 per cent per annum. In simple terms, this provides the growth umbrella across the economy as a whole. Now assume that firms as a whole set annual growth targets of 15-20 per cent.

Quite clearly, they cannot all achieve this. The more individual firms get to 15-20 per cent, the more other firms will have have to fall below 3 per cent to accommodate the faster growing firms.

It has always been the case that some firms are more succesful than others. That, after all, is the market. However, when all firms strive for very high growth targets the risk of failure inevitably increases.

Our problem today is that there is very little scope for conservative, rational management in a world dominated by high growth targets on one side, quarterly reporting requirements and the desire for quick profits on the other.

Assume, for the moment, that a firm thinks that 6 per cent real growth is a reasonable target. This is twice projected economic growth, but still within conservative bounds.

Over a ten year period, annual profits will grow from $100 to approximately $180 or by around 80 per cent. If dividends are set at 50 per cent of profits, then the dividend stream will increase from $50 to $90. On a constant PE ratio, share prices will also increase by 80 per cent. So over a ten year period you will get an 80 per cent increase in dividends plus 80 per cent capital appreciation. Plus, of course, the compound return on reinvested dividends. Not bad really.

The problem with modern management approaches is that it turns investment into a gamble on management's ability to achieve ambitious growth targets. The higher the aggregate growth targets, the greater the gamble because of the increase in the number of firms that must fail just on plain maths to deliver.

Australia's Productivity Commission proposes new maternity leave arrangements

Australia's Productivity Commission has released a draft report proposing new maternity leave arrangements.

For the benefit of international readers, the Commission is an independent official economic advisory body funded by the Australian Government.

The Commission's proposals involve a taxpayer-funded parental leave scheme of 18 weeks at the adult minimum wage ($A544 per week) that would benefit around 140,000 mothers and their newborn children each year and yield community-wide gains in the long term. The scheme also provides for two weeks paid leave to over 225,000 eligible fathers.

The Commission suggests that its proposed scheme is designed to integrate with existing workplace practices. Thus, it requires genuine attachment to work as an eligibility requirement and a capped superannuation contribution from employers for most employees. Typically, initial payment of the leave benefit would be by the employer, with early reimbursement by government. Importantly, the scheme covers full time, part time and casual employees, as well as the self-employed and contractors.

The scheme would cost the government budget around an additional $A450 million annually - after offsets from taxing the benefits and reduced social transfers, including removing eligibility for the baby bonus for those who take paid parental leave. Business would put in a net $A74 million a year through superannuation contributions, whilst benefiting from greater retention rates of women employees.

The low cost of the scheme means that it has been generally welcomed by business groups.

The Commission is now seeking responses to its draft findings, including through public hearings before submitting its final report to the Australian Government in late February 2009. Those who are interested can find the draft report here.

The US financial crisis and the consequent loss of trust

The Balance of Payments, Australia and the sub-prime crisis continues to be one of the most visited posts on this blog. I have now updated the analysis somewhat in in a post on my personal blog, Saturday Morning Musings - longer term impact of the US financial crisis.

From a long term perspective, one of the worst outcomes of the financial crisis is the loss of trust in business and in management. The crisis itself is all about loss of trust between institutions, a loss that has brought the financial system to a halt. However, the crisis has also further eroded community trust not just in the financial sector, but in the broader business sector. We will all pay a price for this.

I have tried to argue in favour of less business regulation because of the way it increases compliance costs. The current crisis makes this hard and will certainly see an expansion in finance sector regulation.

I do not think that anybody could argue, at least it would be very hard to argue, against the need for improved regulation in the US so far as the financial system is concerned. There is little choice when a sector imposes costs on all, threatening to bring down the entire global financial system.

The difficulty that then arises is to find the best way of doing this. I do not think that the US has a good record in this regard because of the way that that US regulation designed for the big imposes compliance costs on all.

Welcome Visitor 6,000

Back from China.

Welcome to visitor 6,000 who came from the United States searching on Australia minimum wage. This led him/her to Australia's new minimum wage - July 2008.