Friday, December 19, 2008

Spend cure the wrong advice for us

Kevin Rudd's announcement that he would inject a further $4.7 billion of infrastructure funding into the Australian economy brings the Federal Government direct contribution to $15 billion.  On top of this, the 3 percentage points reduction in official interest rates means a total of some $40-50 billion has been injected into the economy.  That's a Government stimulus equivalent to a massive 6 per cent of total GDP.

In the case of the US, some estimates place the measures so far already taken to tackle the credit crisis at $4.6 trillion.  In real terms, this is more than it cost to fight World War II and tenfold what was spent in the 1930s New Deal.

The US Fed's decision to reduce official interest rates to zero was designed to encourage lending and to provide a hand-out to those who were overcommitted.  But the banks' problems are not liquidity but the risk of non-payment.

Politicians and treasury advisers all over the world have panicked in reaction to the credit market collapse.  Treasury secretaries from the US's Henry Paulson to Australia's Ken Henry are sudden converts to fiscal deficits.  "Spend big and go consumer" was said to be Henry's counsel to Rudd on tackling the financial crisis.  Treasury advisers have been transformed from seeking to rein in government spending to instigating a new era of government pump priming.

Triggering the present downturn was the collapse of the $6.5 trillion US mortgage-backed, debt market.

Real estate speculation had masked the inflation that is the inevitable corollary of central banks' easy credit policies.  Once the real-estate bubble was pricked, much of the mortgage-backed paper became worthless.

Australia has had falling house prices and house sales down 25 per cent, banks and miners are announcing major employment lay-offs, major retailers, car yards and airlines are desperately cutting margins to maintain business and business confidence plummeting to new lows last month.

Yet, there have been few tangible effects of the meltdown for Australia.  Even the latest unemployment data looks comforting.  And although GDP only rose 0.1 per cent in the September quarter, at least it rose.

Treasury advisers are right to foresee the coming economic blitzkrieg.  But their prescriptions for dealing with it are wrong.

A very severe downturn is inevitable.  The ubiquitous nature of financial markets means every institution is infected by the US financial collapse.  This has included even those seemingly unrelated to the subprime housing, such as GEMoney, which has been forced out of Australian car financing, where it was formerly the market leader.

In Australia, the market collapse has led many people to recognise they have less saved than they believed.  Savings have to be rebuilt and this means less consumption.

Government hand-outs like Australia's $10.4 billion consumer package will fail to trigger the hoped-for sustained lift in consumption.  These measures will only make the correction more difficult.  Adding to government debt and boosting credit means higher future taxes or a money supply boost with inflationary consequences.  Either result means a long, and painful recession rather than a short, sharp shock.

As is so often the case, the best government policy is to stand back and allow market forces to correct the imbalances.  But such advice does not resonate with governments that have persuaded themselves it is they who have caused the previous levels of prosperity and therefore will be blamed for inaction.


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