Sydney, Monday, February 13, 2012
Greg has asked me to talk to you about the state of the world economy we find ourselves coping with, particularly the problems in the euro zone. But before I do I have to issue a standard consumer warning: economists have a very bad record in forecasting what will happen in the economy, so you’d be wise not to take a blind bit of notice of anything I say.
I can say that confident you will take an interest in what I say because everyone already knows economists aren’t good at forecasting but it’s never stopped them asking for another forecast. That’s because the human animal has an insatiable curiosity about the future - an incurable belief that it’s possible to know about the future and the more we know about it the better our chance of controlling it. John Kenneth Galbraith said economists were created to make astrologers look good, but I prefer to say that if people don’t have economists to ask about the future, they’ll settle for asking witchdoctors.
Perhaps economists are modern-day witchdoctors. But I draw a distinction between understanding what’s going on in the economy and predicting what will happen next, so I’m going to focus more on what and why things are happening rather than what will happen next.
I’ll say a bit about China eventually, but I’m sure you realise the big problem area in the world economy at present is the North Atlantic economies, the United States and Europe (including Britain). Most people automatically assume that if these big economies are in trouble that spells trouble for us, but I think it’s important understand the various ‘channels’ by which developments in other countries flow through to us. The first and most obvious channel is via trade: if they reduce their demand for our exports that’s bad for us, of course. But these days the EU accounts for less than 10 pc of our export income and the US for only 5 pc, so direct trade with the North Atlantic shouldn’t be greatly affected. A second channel is via the global financial markets. We know that worries about worries about major problems in the world can push our sharemarket down. And now compulsory superannuation has made a lot more Australians conscious of sharemarket falls. We also know problems with banks can cause some international funds markets to freeze or can push up the cost of overseas funding to our banks, as is happening to a small extent at present. The third channel thru which adverse developments in other economies can adversely affect our economy is via confidence. Consumers and business people hear all the bad news and it tends to make them less confident and more uncertain about the future. Consumers tighten their belts, increase their saving and pay down debts and avoid making new commitments. Businesses put expansion plans on hold, try to improve their gearing, cut non-essential spending such as advertising and maybe lay off staff.
It’s clear this third, psychological channel is the main channel by which worrying developments in the North Atlantic economies become a worrying development in our economy. The more I see of the ups and downs of the business cycle, the more convinced I become that ‘confidence’ - and particularly our collective swings from excessive optimism to excessive pessimism - is the biggest single factor determining the swings in the economy. There are ‘real’ factors at work, of course, but they are greatly amplified by the way business people and consumers are feeling at the time. The trick is that when the way we feel affects the way we act, the merely emotional becomes real. To take an example close to home, when I decide to cut my advertising budget because I’m uncertain about the future, the effect on businesses that sell advertising is very real. And when negative sentiment takes hold, it tends to feed on itself, becoming self-fulfilling and self-reinforcing. This is why, as you may have noticed, in my writing I’m putting a lot more emphasis on ensuring I give our readers a reasonably balanced assessment of how good or bad things are, even tho it’s a lot more fun to scare the pants off them.
Two factors do most to explain why the North Atlantic economies have been in so much bother since the global financial crisis reached its peak with the collapse of Lehman Brothers in 2008, and why they’re unlikely to be completely out of bother for many years. The first is ‘debt’ and the second is the euro. The crisis in 2008 brought an end to a debt-fuelled boom in the developed economies that lasted - with interruptions from mild recessions - for about 20 years. In the US it’s clear households borrowed too much, for housing and to maintain lifestyle; in their efforts to maximise profits banks became too highly leveraged, and the US government ran too many annual deficits and racked up too much debt. In Europe, the banks became far too highly geared and governments were far too undisciplined in their budgeting. When the crisis peaked, governments in the US and Europe borrowed heavily to rescue their banks, then borrowed again to get their economies moving. Coming on top of the already high debts acquired during the long boom, this took most governments to quite unsustainable levels.
But this brings us to a paradox: for individual households or businesses or banks, the best way to get on top of your debts is to tighten your belt; for whole economies, however, the best way is to grow your way out of them. The ideal for governments is to keep growing, while slowly mending your ways. The trouble for governments with lax budgeting records, however, is that markets, German governments and others don’t trust their promises to be good boys tomorrow but not today. This does much to explain the flirtation with policies of austerity which, by making economies even weaker, can make it even harder to reduce budget deficits. Then markets react badly when they see economies weakening. Of course, when a government reaches the point where people are no longer willing to lend to it - as with Greece - it has no choice but to accept austerity.
A point to note is that, because of this debt overhang, it’s idle to imagine (as I suspect some people still do imagine) there’s some way Europe - or even America - can get back to normal rates of growth within a year or two. For a start, the rates of growth we came to regard as normal in the 90s and the noughties turned out to be debt-propelled. It will be a long time before we see its like again. For another thing, the process of ‘deleveraging’ is always protracted. So the only options available to the North Atlantic economies are weak growth for the rest of the decade, or economic disaster for the rest of the decade.
Starting with the US, its households are likely to be preoccupied with getting on top of their debts for many years yet, which will constrain the growth of consumption spending. It has unsustainably high levels of government deficit and debt, but its ‘debt crisis’ is political rather than economic. The two sides in Congress can’t agree on how and when to get its budget under control but, in marked contrast to the Europeans, global financial markets remain so willing to continue financing its deficit that the yield on US Treasury bonds has fallen to 2 pc.
One point I want to leave you with is that the outlook for the North Atlantic economies has improved markedly since late last year. In the case of the US, its recovery faltered in the middle of last year, but has improved a lot since then. The economy grew at an annualised rate of 2.8 pc in the December quarter and the unemployment rate has been falling slowly for the past five months. The US sharemarket is up about 20 pc on its low point in October. Growth isn’t likely to continue at that healthy rate, but all the talk of a double dip has evaporated.
What makes Europe’s story much more worrying that America’s is the euro. The rationale for the single currency area was more political than economic. Even without the addition of the former communist countries, the economies of the foundation members of the area were at far too disparate states of development for this to be a sensible arrangement. The interest rate and exchange rate levels appropriate for Germany and France were never likely to be appropriate for Portugal, Ireland, Greece and Spain - even for Italy. The removal of currency barriers between the 17 members of the euro does increase trade between them and, for a time, the governments of the less developed and less fiscally disciplined members did benefit from being able to borrow in euros at much lower interest rates then they’d been paying.
But, as is now all too painfully evident, all that did was lure Greece and others into borrowing far more than was good for them. And now they’re having difficulty servicing that excessive sovereign debt, the drawbacks of the currency union are painfully apparent: no ability to regain lost competitiveness with the rest of Europe by devaluing your exchange rate rather than cutting nominal wage rates; no ability to set interest rates at levels appropriate to your own needs. And, indeed, no easy way to escape the straitjacket of the currency area. Greek firms that had borrowed in euro would find their debt levels greatly increased when expressed in new drachmas.
The founders of the Euro understood that budgetary indiscipline was the greatest threat to the single currency’s survival, and established deficit and debt limits and targets accordingly. But they failed to live up to or enforce those limits, and now they’re chained together whether they like it or not.
It’s by no means certain the Europeans can make the euro work. And it’s hard to imagine a way it could break up that wouldn’t turn the mild recession they’re already in, into a deep and prolonged recession that worsened the US recovery and made life a lot tougher for us as well. They’re having a lot of trouble agreeing on what they need to do, and the longer they dither the greater the risk of some unexpected but damaging accident.
But having conceded that, I have to remind you of my point that, even with Europe, the situation is now looking a lot less on-the-brink than looked late last year. Under a more pragmatic president, the European Central Bank has provided its banks with huge amounts of cheap three-year liquidity, which has calmed market concerns about the banks. They’ve used much of that liquidity to buy the bonds of euro governments, which has significantly lowered the rates those governments face when they borrow. The euro governments are moving towards a new fiscal responsibility treaty which, at least, seems to have mollified the Germans somewhat. And the Greeks have passed another milestone.
The IMF, the Reserve Bank and Treasury base their forecasts for growth in Europe on the assumption the euro leaders manage to ‘muddle through’ without a disaster occurring. That’s the only sensible basis on which a forecast could be based and, thankfully, it’s easier to see it coming to pass than it was three months’ ago.
I haven’t left myself enough time to talk about China and the rest of developing Asia, but let me make a few quick points. The adverse effect on trade from the North Atlantic economies comes to us mainly via China. So China is the economy whose health we need to be most concerned about. Fortunately the news from the orient is a lot less worrying. It’s true its exports to the North Atlantic have been hit, but many people overestimate its continuing reliance on export-led growth. It’s true the Chinese authorities have been acting to slow their growth and reduce inflation pressure, but they and other emerging Asian economies retain plenty of scope to stimulate domestic demand should the rest of the world slow by more than we’re expecting at present.
The IMF is forecasting world growth of 3.3 pc this year, which is below the average rate of about 4pc, but well above the 2 pc level regarded as a world recession. When you weight that 3.3 pc to take account of the countries to which we send most of our exports, you add 1 percentage point.
