Worst case scenarios 2 – The economy
For the next few years, the worst-case scenarios for the world and Australian economies involve a combination of rapidly rising interest rates and rapidly declining prices for assets, particularly in housing and construction. Such an increase in interest rates could begin in the United States, if investors (particularly Asian central banks) lost faith in the capacity of the US Government to bring its burgeoning deficits under control and in the capacity of the US Federal Reserve (that is, Alan Greenspan) to keep inflation rates low. A market-driven increase in US interest rates would rapidly spread to other countries with low savings rates and high current account deficits, notably including Australia.
A plausible worst case, with US inflation rates rising to 4 or 5 per cent a year, and real interest rates returning to, or surpassing their long run historical levels, could see the US 10-year bond rate increase from its current level of 4 per cent to as much as 8 per cent (still well below the maximum values of the past). If an increase of 3 or 4 percentage points flowed on to Australia, accompanied by declining asset prices, many borrowers, particularly highly-geared investors, would be forced to default.
As worst-case scenarios go, this is not a particularly drastic one. In broad outline it’s similar to the set of events that produced the last recession from 1989 to 1992. Despite the length of the economic expansion, there is no reason at all to think Australia has permanently escaped the cycle of boom bust. After all, many commentators made the same claim about the United States during the dotcom boom, but that claim turned out to be way off the mark.
It is possible to dream up even worse scenarios, leading to economic crises comparable with the Great Depression. But there’s a lot of evidence to show that the economy has become more stable over time, particularly since the end of World War II. The main factor is the growth of the government sector which typically expands when the rest of the economy enters a recession, thereby acting as an ‘automatic stabiliser’.
The Reserve Bank and other central banks are well aware of the worst-case outcomes and are working hard to prevent them being realised. But individual investors would be well-advised to consider their vulnerability to such an outcome, and protect themselves accordingly.