There has been a lot of talk lately about troubles in the housing market, the liquidity crisis, interest rates, a potential recession in America and the generally uncertain economic future. But what does it all mean?
America is facing some problems. In recent years, lots of money has flowed into American property. Many people were able to take out “sub-prime” mortgages (known as “low-doc” or “no-doc” loans in Australia) that require little or no checks and consequently have a higher risk of default. American retail banks then sold about 70% of these loans (and the associated risk) to other market players, primarily investment banks. While the property market was hot, money kept flowing from investment banks to retail banks and on to people who bought property.
But the property market didn’t stay hot. House prices have stagnated or fallen… and in some places they have plummetted. People started to default on their loans, especially in the sub-prime sector. Banks with exposure to sub-prime mortgage risk have lost billions of dollars, and many people have lost their homes.
But this isn’t the main problem. On it’s own, a few bank losses and mortgage defaults is a relatively small economic bump. The bigger problem is that investment banks understandably don’t want to provide cheap finance to retail banks, who are then unable to provide cheap finance to consumers. Liquidity has dried up, which is pushing up interest rates, which is leading to more people defaulting on their home loans.
The bank losses from these defaults have lead to lower share prices, and could in some cases be a knock-out blow. Bank failures can be big business, and inevitably lead to call for the government to bail out the stricken bank to protect depositors and investors. This would be a mistake.
Like all businesses, banks must be allowed to succeed or fail based on their performance. Government protection of bank deposits (deposit insurance) seems nice, but it undermines the important market pressure for banks to maintain a high-quality investment portfolio. In the long run, the consequences of a protected (and consequently inefficient) banking sector is bad investments which end up with lower growth, further bail-outs and eventually a larger collapse. One example of this is the East Asian Financial Crisis, which was in part a response to the bad investments built up by government banks.
America looks like it’s heading into a recession. One of the best explainations for recessions is the Austrian Business Cycle Theory, which blames monetary policy mistakes. Excessively low interest rates distort prices, leading to mal-investment (investing in the “wrong” capital), and then when prices adjust the mistakes are realised and the bad businesses go bust. Even without monetary mistakes, economic booms often conceal bad investments that eventually will be corrected. And of course, governments can contribute to economic slowdowns by distorting the market with taxes, spending, deficits and regulation. While the housing market and liquidity crunch might be the triggers, a recession is generally caused by one or more of these underlying factors.
In response to these problems, the American federal reserve (“the fed”) has decided to cut interest rates. This is a mistake. The fed is trying to ease the liquidity problem, ensure the continued existence of cheap credit and therefore prevent further losses. But the low interest rates are artificial, and maintaining artifically low interest rates is actually a long-term cause of recessions (as per the Austrian Business Cycle Theory). Previous low interest rates were partly based on an incorrect assessment of risk, and it is appropriate for these to adjust upwards.
Artificially low interest rates cannot undo the fundamental problems in an economy. They can delay the correction, but only by first causing more mal-investment, which will eventually require a larger correction. Not only do the lower interest rates not help, but they are likely to lead to higher inflation. There is a possibility that America is not just heading for recession, but stagflation (recession & inflation).
But we shouldn’t be too pessimistic. Market economies are amazing in their ability to adjust and move forward, and despite a slow trend to bigger government, the American economy is still relatively free. With a bit of luck and a bit better policy, it would not suprise me if the American recession was short-lived.
The Australian economy is in much stronger shape. I believe that nearly all of the problems of the American economy are absent in Australia. Property prices may be too high in some places, but many of the price increases represent real demographic and supply-side factors. More people are moving to s/e Qld than houses being built — so of course prices are increasing.
In addition, while investment banks contributed about 70% of home-loan financing in America, they make up only about 17% in Australia. Consequently, the liquidity crunch will not hit Australian interest rates as hard as it does in America.
We also have had consistently better monetary policy than America. While we do face some inflation risks, I don’t believe that our monetary policy has been far wrong and so I don’t think we’ve suffered much mal-investment. And in the face of inflationary pressure, the Reserve Bank of Australia (RBA) has done the unpopular but correct thing in increasing interest rates. And in contrast to America’s budget deficit, the Australian government is maintaining a large surplus. Perhaps too large.
With coming tax cuts and a continuing good investment environment, I think that Australia remains on track for strong growth while also being able to control inflation. Interest rates will remain high for a while and this will hurt some people, but I don’t see a collapse or recession in the near future. But then… I’m generally an optimistic sort of person.