Home > Economics - General > Worst case scenarios 2 – The economy

Worst case scenarios 2 – The economy

April 2nd, 2004

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.

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  1. Hal
    April 2nd, 2004 at 09:48 | #1

    I’m retired and during the planning I believed the interest in some money that I saved during my working life (not millions) would assist in this retirment. As we all know Greenspan has cut rates to 1% which goes without saying hurts my wife and I. It also seems to have sent a large number of the American public into deep debt, debt that they are having a more and more difficult time repaying. It great to buy a new car a new home or anyting else without the money to pay for it. Just charge it and some day you might repay it. I’m not saying people shouldn’t have these things but to the degree that these interest rates have driven the economy is just plain crazy. Please don’t suggest the stock market. Without question it a fraud, run by crooks and if you don’t believe that please answer the cheating on the sale of mutual funds. You know, the ones that have disappeared from the media.

  2. big al
    April 2nd, 2004 at 11:21 | #2

    With US rates at 1% the Fed is lending money at below cost. This cannot continue.

  3. April 2nd, 2004 at 12:12 | #3

    the whole thing about investing for some fifty years from now is bizarre, increasing stability within the pattern that is the stock market (say) is one thing, greater unrest in larger systems (informed by the stock market or not) can wipe out all your savings, your property and any market in which things like gold look valuable

    just look back fiftey years, i mean what if my grandfather (not that he did) put all his savings in nazi war bonds all their equivalent

    risk managment is impossible in the long term

    and yes superannuation is a fraud, not just because th e stock market/mutuals are frauds, but because it is some weird insurance racket

  4. observa
    April 2nd, 2004 at 18:51 | #4

    John,
    A statistic that is constantly monitored is the rising level of credit card debt. Has there been any definitive answer as to whether this represents a really alarming rise in indebtedness, or is it largely ameliorated by the increasing use of cards for transactions? I know our situation has seen increased transactions(and hence a higher average monthly debt), although it is always paid off at month’s end. Basically the wife chases the Fly-buy points.

    If there is a trend toward merchants recovering their transaction fee, which they can now, then we would shift back to EFTPOS purchasing. This may have a macro impact in future, as I believe some petrol stations are beginning to charge this, in what is a low margin retail field. Will this become more widespread?

  5. James Farrell
    April 2nd, 2004 at 23:30 | #5

    John, what about diminishing oil reserves and their implication for productivity forecasts? When Brett McLean wrote about this a few weeks back, everyone agreed that the peak of daily oil supply is decades away and impossible to pick, but this assignment does relate to worst cases after all. Or is there a ‘Worst Case Scenarios IV: Resources’ in the pipleine?

  6. kyan gadac
    April 3rd, 2004 at 02:32 | #6

    There’s been a bit of discussion lately in some U.S blogs about the downside risk of deflation in the U.S. because of collapsing demand due to stagnant employment growth. The U.S does appear to be caught between a rock and a hard place with pressure for rate increases to cover the twin deficits and fragile consumer demand due to increased competition from overseas manufacturers.

    I saw somewhere that the long term prospect for the U.S$(based on bond yields etc.) is to be 1/10 of it’s current value by 2010. This of course is independent of the current drop in the dollar. The Japanese Central Bank has been supporting the dollar up until 30 March to ensure that the keiretsu can record profitable balance sheets. But their capacity and willingness to maintain support must be getting dangerously close to being exhausted. Similarly the Chinese are maintaining fixed yuan/dollar rates in the face of a growing downside risk to their businesses holding profits in US$. (Holding your export earnings in $US makes sense because it helps keep local inflation low)

    All the above indicates that global currency markets are very unstable and this continuing instability will(is?) retard international trade. The increased threats from terrorism, war disease etc. also directly impact on trade. This is all negative as far as economic growth is concerned.

    Moreover, all the above is about the impact upon of demand on current economic conditions. The other(but rarely discussed)side of the economic equation is the supply side. There is an ideological assumption in many quarters that supply is infinite. This, of course is bosh! Noticeable in the inflation figures in the U.S., Australia and Japan recently has been the fact that it is the food sector that is experiencing the most inflation. This is essentially attributable to, firstly, increasing monopoly control of distribution and, secondly, to increasingly disrupted harvests due to climate change(dare I whisper, dare I wear my trousers rolled).

    Worldwatch Institute recently pointed out that China has been drawing down it’s wheat reserves(which are considerable) over the last 18 months or so due to the loss of irrigation water in north China where the underground water table has dropped 2m plus. They predict that China will need to import between 30-60 millon tonnes of wheat within 2 years. This is roughly double Australia’s total annual export of wheat.

    Along similar lines it has been recently pointed out that the collapse of funding to the International Rice Research Institute and it’s commercialisation has led to a dire situation when it come to predictions of rice production over the next 10 years. Rice yields are not expected to keep pace with demand as they have done over the last 20-30 years.

    Of course the other supply bottleneck (that the war in Iraq has excarbated)is the price of energy which impacts directly upon the price of food through the cost of fertililzer, harvesting, transport, refrigeration etc. etc.

    A single mum of my acquaintance brought this home to me at Xmas when she pointed out that a few years ago a basket of fresh vegetables in the supermarket was cheaper than the same volume of processed food, whereas now, she complained, it was the reverse.

    Lest this appear too pessimistic, I should in passing that the price of vegetables has fallen in the last couple of months in my local supermarket in south western Australia.

    Nevertheless, the thing to realise is that food is a reproductive good as opposed to a productive good. We can’t get along without it.

    Hence, my worst case scenario, is that we wake up one day soon and discover that it really is important to understand the meaning of the phrase “sustainable supply” and that this is not just some greenie fancy.

  7. April 3rd, 2004 at 13:22 | #7

    you know how sustainable supply is going to come about…by people starving…

    there is no supply problem. the world creates more food than it ever has before…the problem is demand. too many people.

  8. April 3rd, 2004 at 20:05 | #8

    Meika,

    A few years ago I did some simple back of the envelope modelling of how simple systems’ risks would go, just looking at the amount of real things and not any notional money value. (I used the repeated composition of probability generating functions, if anyone is interested.)

    I found that the usual case was that financial risk would grow exponentially at twice the exponential rate of the things themselves (if they were growing – if there was a decline, the rates were the same, and there was a borderline case too).

    Anyhow, this all suggests that the rebalancing of portfolios that is supposed to keep risk and return balanced merely reduces the multiplier, that over time unexpected events will throw things out of whack just like any roulette system. Results that look different are ignoring the possibility of these events, just renormalising to model what happens apart from that; it leads to looking not at stable long run behaviour but at what is called “quasistable” behaviour.

    It’s all like a formulation of the three laws of thermodynamics I once heard: you cant’ win, you can’t even break even, and you can’t get out of the game.

  9. kyan gadac
    April 3rd, 2004 at 23:50 | #9

    Like that Meika :-) , thinking back on what i wrote today, it occurred to me that most economics is actually about surprises. Obviously countries have plans for dealing with currency fluctuations, hedge their bets etc. But what ends up driving things are the surprises, the absence of expected plans, the sudden outbreak of war somewhere, a fire in an oil refinery, a drought, a coup, etc. etc. It’s dat old time chinese curse – may you live in interesting times!

  10. Brian Bahnisch
    April 4th, 2004 at 13:12 | #10

    Kayan, you mentioned the term “sustainable supply” in relation to food. A term often used by the socalled ‘glodal justice movement’ is “food security”.

    This seems to be a significant issue in India, where small farmers, producing a rich variety of crops, are under pressure from a model of industrial corporatised farming, pushed by the government, the World bank, the IMF and the WTO, plus of course the global corporations.

    Vandana Shiva often writes on this issue. In a recent article she described the pattern of debt, low prices, the dumping of subsidised output from rich countries and farmer suicide.

    She says that “as farming is delinked from the earth, the soil, the biodiversity, and the climate, and linked to global corporations and global markets, and the generosity of the earth is replaced by the greed of corporations, the viability of small farmers and small farms is destroyed.”

    People with such views are often termed anti-globalists and anti-free trade. More accurately they are pro democratic decisionmaking and pro fair trade. They want to take food out of the purview of the WTO so that countries can make their own decisions in this vital matter.

  11. kyan gadac
    April 6th, 2004 at 01:34 | #11

    I couldn’t agree more Brian, I’ve been trying to find a link to a recent article in Asia Times(but no luck).

    The radical wing of the BJP in India is calling for a policy of food self sufficiency and an emphasis on high value exports for India in a very forthright fashion. The reporter suggested that this could be of concern to the WTO if the BJP was to start to take these ideas seriously. Quite a reasonable possiblity given the US recently snubbing India as they cosy up to the precarous Musharraf, meanwhile India is head over heels in love with China….

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