Wednesday, June 2, 2010

Stay calm, this too shall pass

Talk about a two-track economy. Have you noticed how the government and others have been focused on the return of the resources boom, with all the tax bonanzas and challenges that could bring, while the rest of the world has been worrying itself sick about the debt problems in Europe, sending our sharemarket and the Aussie dollar tumbling?

Surely the two don't fit. Are we living in fantasyland? Is reality about to hit us on the head? Or could it be that Europe's problems don't have all that much to do with us and before long the global financial markets will stop panicking and our share prices and currency will recover?

Standard product warning: no one knows what the future holds and economists aren't good at predicting it. But my guess is the end of our world isn't nigh.

Although the Greek government was in over its head even before the global financial crisis reached its peak in late 2008 (and was fudging its figures to hide the truth), most of the other European governments now have big budget deficits and huge levels of debt because of their efforts to rescue their banks and their heavy spending to stimulate their economies.

Those national governments with rocky banks (including the United States) have, in effect, transferred their banks' debt on to their own books. So what started as excessive private debt is now excessive public debt.

I don't criticise them for this. Had they not rescued their banks the outcome would have been a lot worse. No, the real problem is that, unlike us, their affairs weren't in order before the crisis. They'd been running budget deficits even in the boom years and had high levels of debt even before they were obliged to borrow so heavily.

The particularly acute problems in Greece served to draw the attention of the world financial markets to problems in other countries - Portugal, Spain, Italy and Ireland. Even the Brits have huge debt levels.

As often happens, the markets flipped from inattention to panic. When they're in that sort of mood, all the news is catastrophic. The Chinese had jammed on the brakes to burst a property bubble, putting an end to the global recovery. The Australians had nationalised their mining industry (something like that, anyway; not sure of the fine detail).

Whenever the players in world financial markets are gripped by panic their tendency is to sell whatever shares they can wherever they can and buy US Treasury bills. Even when it's the US economy that's at the heart of the problem, they still do it.

The result is a fall in sharemarkets around the world and a rise in the value of the US dollar at the expense of most other currencies. If you remember, this is what happened after the collapse of Lehman Brothers. Our dollar went from US98 in July 2008 to US63 in November. It stayed there until March, then eventually climbed back to US92.

The likelihood is that, as the present panic subsides, our share prices will recover and our dollar will go back up (as it has already begun to). But this return of the staggers is a reminder that a lot of the underlying problems exposed by the global financial crisis are still with us, and will be for a long time.

So perhaps the recovery of sharemarkets in the months following the crisis was a bit too optimistic and this time it won't be as strong.

Certainly, the Europeans won't easily dispense with their debt problems. And the more they feel pressured by the markets to turn around their budget balances by slashing government spending and raising taxes the more they'll slow the recovery in their economies.

The Europeans' problems are compounded by the existence of the euro currency arrangement, and their efforts to hold it together may end up extracting a high price in terms of economic growth. All the troubled member-countries would be better off being able to set their own interest rates and allow their own currency to fall against those of their stronger European trading partners, but

they can't.

The Greeks are so deeply in hock their best solution would be to default on their debt and start again, but that isn't possible. Even leaving the euro would be terribly messy.

So Europe isn't likely to show much growth for the rest of the decade. But this won't hold Australia back as much as it would have in the old days. Our fortunes are now much more aligned with those of China, India and the rest of developing Asia. Are they likely to be adversely affected by Europe's troubles? My guess is, a bit but not a lot.

China's efforts to deal with its property bubble are quite circumscribed, so I don't expect its growth to suffer too much. If so, our authorities' expectations of a return of the resources boom aren't likely to be too far astray.

The thing about financial markets is they make judgments in haste and repent at leisure. If it's right that the prospects for our economy haven't been greatly impaired by the problems of the Europeans and the fine-tuning of the Chinese, eventually our strong position relative to the other developed economies will again be reflected in our higher share prices and exchange rate.

As ever, the ups and downs of the sharemarket will prove an unreliable guide to the prospects for the economy (even though the innocent souls who write headlines sometimes seem to imagine the sharemarket is the economy).

Similarly, the headline-writers' assumption that a fall in our dollar is an unmitigated evil says more about their innocence of economics than their grip on reality.

On this I'm with our farmers, manufacturers, tourist operators and education industry in hoping the dollar's return to the 90s takes as long as possible. There's more to life than overseas holidays.