So far so good for the Australian government’s response to the economic crisis, not so in the US and much of Europe.  Why is this happening and what is to be done about it?

The Rudd government’s response to the financial crisis has so far been a good effort, strong spending, rapidly applied and strong support to states to maintain their spending activities.

The only misstep seems to be on the banks.  While some form of guarantee was necessary to stop contagion of the wholesale bank funding collapse spreading to the Australian markets, the simplistic implementation has resulted in the ‘Big Four’ now looking to dominate the Australian market at the expense of consumers and then expand internationally on the back of a public guarantee.  While it can be argued that the Australian financial system has so far weathered the financial crisis well, this is more due to luck than design.  Australian banks were focusing on the booming Australian mortgage market rather than buying dodgy US mortgage assets, and the Australian housing market has so far had a soft landing, supported by China’s commodities buy-up, resilient employment and first home buyers subsidies.  However allowing this to then evolve into a cosy banking oligopoly could have dire consequences on Australia’s long-run competitiveness, and when competitiveness fails, house prices will eventually follow.

It was wrong for the competition authorities to allow the ‘Big Four’ to vacuum up the regional 5th mini pillars such as BankWest and St George that were the greatest source of competition and innovation in the market.  Perhaps these institutions took some risks in building market share, but there was never any question as to their solvency.  The authorities were simply caught in the financial panic they were trying to overcome.  By allowing financial institutions that are not systematically important to be swallowed up, the overall systematic risk actually increases, investors do not learn from the necessary occasional failure and those that remain believe themselves invincible.  Also, by allowing the banks to form an oligopoly, the Reserve Bank of Australia’s monetary policy capacity, the ability to influence the macro-economy by changing official interest rates has been severely weakened.  This is not so much a problem in the short-run, quite frankly any interest rate below 3% will fuel bubbles in susceptible asset markets more rapidly than genuine economic activity.  However the problem comes in supporting investment by businesses in the long-run and the cost that must be borne by the Australian economy in supporting oligopoly profits and or international empire building.

Monetary policy impotence is now a global phenomenon (with the exception of China) with zero or near zero interest rates across most of the rich world.  This has left fiscal policy, basically government expenditure and tax plans, to try and raise the world out of crisis.  In Australia this has worked so far, assisted by robust exports.  In Europe this has been hamstrung, firstly by a lack of coordinated effort and the fall in exports.  Some countries like Germany fear the debt and inflation bogeyman and hide behind their automatic stabilisers, effectively generous unemployment benefit regimes, to say they are doing enough.  Unfortunately paying people to stay at home or only to work part time is not the same as stimulating economic activity.  It may support some levels of spending, but people will still not have the confidence to make the major purchases that get factories working.  They will also not try as hard to find new work by being willing to move, geographically or into new sectors.  These payments are palliative, not stimulatory, effectively the government making payments that in the US would be made up from private savings, private insurance, asset sale or borrowing.

In the United States the problem is fundamentally driven by the vertical fiscal imbalance between the States and the Federal Government.  The Federal Government is trying to spend money, but is having trouble spending it fast enough, while states are trying to cut spending to balance budgets as state revenue streams collapse.  The crisis in California, where the state government is putting public workers on furlough and is about to issue IOUs to pay its bills after failing to pass a budget through its legislature is simply the most extreme example.  In such an environment, not to mention continuing falls in house prices, the collapse of General Motors and other corporations, it is not surprising that employments is rising and the confidence in ‘green shoots’ is being snapped by frost.

The problem is fundamentally a lack of a coherent understanding of what the global economic crisis represents.  While the financial crisis was created by an excess of debt relative to income, the economic crisis is fundamentally different.  Concepts like ‘debt’ do not exist at a global macro-economic level; debtors and creditors cancel out.  The world as a whole cannot ‘indebt’ itself; there are no Martians from which to borrow and no goods that can be delivered from Mars.  The financial crisis was created at a macro level by the desire of emerging economies, particularly Asian and aging European economies to build up financial assets.  These financial assets were created by the United States financial system.  In the process both the European, Asian and US economies were able to achieve impressive levels of economic growth and stability.

There is now a global lack of demand, people are not ordering the goods that others are willing to produce, and everybody is worse off.  Part of the problem is the perverse impact of interest rates on saving.  Part of the willingness of global savers to buy ‘dodgy’ US financial assets was their rational greed for higher yield against a back drop of low financial volatility, however now faced with significant losses and even lower yields, people are trying to save more and not less.  The interest rate pricing signal is failing.  To save is to spend less than one earns, to demand a little less of others than is demanded of oneself.  Unless there are borrowers to match the savers the collective impact is a collapse in demand, and currently only governments are willing to borrow.

The fundamental problem is the lack of ‘real’ financial assets.  With the exception of gold, every financial asset represents a claim of liability against another party, be it Lehman Brothers or the Bank of England.  Understandably the price of gold has risen, but during the boom years, most financial assets were created privately, rather than publicly, so there was a risk of default.  The value of many of these assets has collapsed and while governments have significantly increased their creation of financial assets, this is not yet enough to replace the collapse in the private sector, particularly in the face of increased demand for ‘financial security’.

The solution is therefore obvious, the central banks must create more financial assets, which they are doing.  The problem is the lack of international coordination.  If one central bank creates excessive financial assets then there is the risk of a failure of confidence, the price of those financial assets fails, leading to depreciation and inflation.  Globally there cannot be inflation until demand exceeds supply, but any individual currency can collapse if confidence fails.  The doomsayers of debt are at the ready to decry any individual currency that appears to be creating too many financial assets too fast.  Of the significant economies, the British Pound seems most at risk, while only posturing politicians need be worried about Australia’s low levels of debt.  The elephant in the room is the United States dollar.  As the global reserve currency, an expanding supply of US financial assets is fundamental to resolving the global money shortage, but with such massive holdings of US dollar assets by other central banks such as China, and a policy of denial by the European Central Bank, there may well be turbulence on the road.  Any slow-down of US financial asset creation will doom the world to long period of recession, depression and deflation.  There is talk of another US stimulus plan, this is probably necessary, but will it be enough if other countries won’t play their part.

An alternative source of global financial assets would be a significant large issuance of Special Drawing Rights or SDRs by the IMF.  The benefit of such instruments is that they are not coloured by the United States origins of the financial crisis and could also be used to finance demand at an international level.  The G-20 authorised the creation of $250 billion in new SDRs in April 2009 to support IMF members, but the mechanism for its allocation has not been finalised.  The coming global talks on climate change in Copenhagen are another opportunity.  These talks need to succeed to create a reason for investment and new demand that will help feed a global economic recovery.  A sticking point is the creation and funding of a $120 billion climate adjustment fund for developing economies.  This fund could be managed by the World Bank and funded by the creation of new SDRs by the IMF without any individual country having to indebt itself.  All countries would need to do would be to ensure that their central banks were willing to accept the SDRs in return for their own currency, be they Euros, dollars, Yen or Yuan.

While nay-sayers still talk of the global slow-down as a reason to do nothing about climate change, it is more likely that saving the planet and saving the world’s economy are intrinsically linked.