Sunday, September 21, 2008

Bet your sweet bippee it's a crisis

The meltdown on Wall Street will hit all world economies.

The cataclysm follows from bankers combining and repackaging mortgage and other debt to make it attractive to different sorts of investors.

The mortgages on our houses or businesses no longer remain with the bank we borrowed from.

Nowadays that mortgage is just as likely to be owned by a pension fund in Iceland as by an Australian bank.

Repackaging mortgages combines the good with the bad.

So, for example, debt from people with little equity in their homes was cocktailed with debt from those who had largely paid off their homes and could easily service their obligations.

Stirring this financial brew, the US Federal Reserve has been suppressing interest rates.

This cheap money policy was first introduced to restore confidence following the terrorist attacks of September 11 2001.  For a variety of reasons it has been kept in place most of the time since then.

Cheap money causes inflation, which unlike most recent experiences, impacts on asset prices rather than consumer prices.

Asset price inflation includes prices of company shares, which have increased well in excess of potential earnings.

The inflation of asset prices was especially evident with houses in areas where planning controls restrained new supply -- a regulatory approach seen in much of the US and the UK, Australia and New Zealand.

Once the US Fed tightened credit, houses prices and shares started fell.

Debt packages that included assets in which owners had little equity became vulnerable to non-payment.

Because investors were unable to identify the more exposed debt packages, they started bailing out of all markets.  This caused a general and cascading weakening of prices.

Hand in hand with these financial developments have been policies to reduce carbon emissions.

All developed countries, including Australia, have measures that deter the building of new coal-based power stations and require use of high cost wind power.

This has raised the cost of producing goods and services and helped cook up the perfect storm that now threatens to engulf economies.

Many argue that the excessive lending of US banks and UK building societies has not been seen in Australia.  Perhaps so, but will Australia still face a crisis?

In the words immortalised by the Rowan & Martin's Laugh-In, "You bet your sweet bippee we will!"

Like the US, Australia has also experienced poor financial management, restraint on new house building and investment-sapping policies on electricity generation.

This aside, financial crises are contagious.  Lenders and borrowers are no longer confined to national boundaries.

As well as our debt being held in overseas institutions, our superannuation savings are also spread around the world.

The declining prices of US shares and houses have joined with domestic weaknesses to lower our wealth.

The issue for Australia is will our governments amplify the national and international shock waves?

At the least, Commonwealth and state governments must reverse the policies on housing and energy that have boosted costs.  And the Reserve Bank also has to avoid over-expanding credit by a low interest rate policy.


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