Two economies

The Australian economy is still booming, but the shadow of the global credit crisis is growing longer every day. Some items

* Most observers now agree the US is in recession
* With negative real interest rates in the US for terms up to five years (you can actually buy negative-rate inflation-protected bonds) commodity price inflation seems bound to continue. This is good for the Oz economy while it lasts
* It now seems clear that someting like half of all subprime mortgages will eventually go into default (many have already been foreclosed and 20 per cent are currently delinquent
Much the same is true for Alt-A and other limited-doc loans. The big question now is whether mortgages guaranteed by the quasi-public Fannie Mae and Freddie Mac are in fact secure. As with all implicit guarantees, the assumption that the Federal government stands behind these corporations is marvellously effective until it is actually tested.

Can we keep on growing while all these processes and more work themselves out? I don’t know and I doubt that the Reserve Bank does either. But if I were setting monetary policy, I’d be very cautious about any further increase in interest rates.

71 thoughts on “Two economies

  1. Forgive my ignorance, but how exactly does a “negative-rate inflation-protected bonds” work? Is the inflation protection for the lender or the borrower? If the latter, then how does the lender make money or mitigate risk with it?

  2. The US may be heading for a recession but it can’t be there yet unless I missed two vital things. Firstly the actual data: negative GDP figures. Secondly, the change to the definition of a recession: 2 consecutive quarters of decline in GDP.
    Are we in the second quarter of decline? I thought economics was the science of hindsight not futurology. Can we have a small “r” recession without having a capital “R” one?

  3. Are there figures on Australian ‘low-doc’ mortgage defaults and on the number of such mortgages? Do we have a big potential problem?

  4. JQ, this makes me ask a theoretical question – do we have adequate ecoomic theories to explain what happens when markets collapse, and more importantly, what to do to restart them? I ask because, reflecting on things like the Asian banking crisis and the collapse of the former Soviet Union, the record does not look good.

    In short, if ther eis a major market collapse, what does economic theory say we should do?

  5. “Do we have a big potential problem?”

    Apparently not. The Treasury rep who appeared at Senate estimates recently gave the figures, and we don’t have many low docs.

    The bigger danger is the contagion effects, with local banks withdrawing credit lines or not making new loans because of perceived higher risks. And the more they do this, the more chance the perception will become reality.

  6. In any case the low doc loans here would mostly qualify as US prime loans as they are either 80% loan to valuation loans or fully mortgage insured (or, frequently, both). There simply is not a major problem here.
    At least in WA the US is barely a factor – we are much more closely tied to Asia (particularly China and, increasingly, India). The only real problem is the increasing borrowing rates due to the premium currently being paid for liquidity.

  7. soc, is that ‘we’ as in ‘me’, or ‘we’ as in orstalia?

    big difference. if you just want to get rich while all about you are losing their shirt, no problem! someone will be in touch with a sure-fire method before you can get off-line.

    orstralia, now, is harder. the only people who can do anything are the ones who got us into it in the first place[insert democracy rant]. their only source of information is bankers and business leaders, none of whom will give unbiased appraisals. or they can consult academics, all of whom are vulnerable to the “can-do, can’t-theorize” rule.

    normally, this sort of situation is resolved by time, pain, and the close reliance of an official’s wife with a ‘wonderful astrologer.’

  8. A bigger concern than the number of low doc loans issued here in Australia is how much Australian institutions (including super funds) invested in US low doc loans either directly or through investing in or lending to US companies with exposure to that market.

  9. DJM, an inflation-protected bond will repay you your original principle plus inflation over the term of the loan. (So if you invest $100 for a year and the inflation rate is 2% per annum you’ll get back $102.00).

    If inflation (currently somewhere around 3.5-4% in the IS if memory serves) is higher than the nominal interest rate (currently official rates are around 2% in the US)then an inflation-protected bond is an attractive proposition.

    If an investor thinks inflation is headed up and interest rates are headed down, they may actually be willing to pay a small percentage of the face value of the bond to the issuer to get the bond.

  10. Bill Gross at PIMCO uses three terms to describe the current situation; shadow banking, ponzi scheme and chain letters.The US Fed appears to need to find a way to keep the shadow banking system solvent, while it unravels the ponzi schemes and stops the chain letters. It would seem that relying on interest rate reductions may stave off total insolvency but the guess is for a credit supply induced recession. Roubini’s 12 steps seem to chart the progress well. It also seems precisely because of the unknown liabilities and outlays of the ‘shadow banking’ system is the credit/funds injection unknown as well. Gross suggests a 1 to 100 ratio for credit reduction, every one dollar of default will lead to a 100 dollar credit contraction. I guess were all going to find out.

  11. Meanwhile, companies in the billion dollar capitalisation bracket continue folding like houses of cards.

    “The CBA alone is staring at almost $1 billion in exposure to the likes of Allco, MFS, City Pacific and ABC Learning” – SMH 5/3/2008.

    Well as we know Allco has gone belly up and MFS appears to have done the same according to tonight’s 7:30 Report on the ABC.

    What does this all mean? Well, it could easily be the case that people who had $250,000 in their super fund a year ago will soon find they have $200,000 this year. In another 4 or 5 years time they will likely find they have $50,000 IF they are lucky.

    This crash has not even broken through the crust. Under the crust is a great big magic pudding of NOTHING. But don’t worry, when we hit the bottom of the baking dish we’ll get properly cooked!

  12. But if I were setting monetary policy, I’d be very cautious about any further increase in interest rates.

    Tactically if I was the RBA I’d dirty the float and push up the aussie dollar. That would be disinflationary without necessarily translating directly through to higher nominal interest rates. Strategically I’d be moving to targeting a commodity basket perhaps diluted with a small measure of US dollars and/or Euro. Anybody for the Bancor?

  13. Get real, Terje. If you were the RBA you’d start talking about either returning to the gold standard or abolishing the RBA.

  14. Ikonoclast,
    Contrary to what you may have heard, None, repeat none, of those companies have “folded”. All of them have some trouble and may fold in the future – or they could all continue to trade successfully. The point is that all of them have substantial assets out of which employee benefits and bank loans will, in all probability, be met.
    Contrary to “NOTHING” being behind Allco, for example, the “NOTHING” behind Allco is what is flying most Australians around Australia (i.e. Qantas jets on lease from Allco) along with many other assets. The chances the CBA will get “NOTHING” out of Allco would be vanishingly small. ABC has a lot of valuable real estate and the others also have good assets.
    The wonder of capitalism – creative destruction. If one person or company cannot make the assets pay, another one gets a chance. Put them into government and we all pay for the mistakes of the few.

  15. AR, where liabilities exceed assets the individual company is worth nothing. Where the paper economy contains claims for inflated values of assets and hides debts “off-book”, a significant portion of the total “wealth” claimed to be in the economy is illusory. This is the “nothing” I am talking about. There are paper trillions in the derivatives market which will soon be shown to be worthless.

    Also, there are many real assets, for example the world’s jet aircraft and internal combustion engine powered transport (and all the tooled factories which make them) which will soon have to be written down in value as the oil runs out.
    Large fishing fleets will become worthless as the oceans yield up no more catch and so on.

    Endless growth capitalism is in fundamental confict with the finite nature of the earth and its natural resources.

  16. that last sentence, ike, ought to be memorized by 1st year economist students.

    in the 2nd year they can be told: “if you want to work in academia, learn to extol endless growth capitalism.”

    in the 3rd year, tell them, “it’s rafferty’s rules, economics is a science hobbled by secret data, public lies, and a necessity not to rock the boat of politics, lest personal and social disaster ensue.”

    if they are in an honors course, tell them: “but you can make a good living by counting economic angels on economic pinheads.”

  17. Andrew, you don’t know that employee benefits and bank loans will “in all probability” be met.

    As you do know, when companies go down, debtors rarely if ever recover most of the money oweing to them, if they recover any at all. You don’t know that CBA would be first in line to get what assets remain at Allco. By the time it’s CBA’s turn, there might not be anything left. How do you know that CBA has any legal claim on those Qantas jets? Does Allco actually own them? Or is it leasing them from someone and sub leasing them to Qantas?

    If it was all that simple, ANZ and Westpac would not have been nearly bankrupted themselves in the early 90s from the dud loans they made in the 80s.

  18. To continue …

    “ABC has a lot of valuable real estate”

    Really? It owns, not leases, the sites where it operates child care centres? Are you sure?

  19. Regarding the question of what to do about this problem, I was struck by the title of JQ’s thread “two economies”. That really is what we have. How do we design policy instruments that stop excessive asset price growth without killing the equity of persons in average houses? IMO we must start reforming our badly distorted housing market, but carefully.

    One possibility would be to have value limits to tax deductability for negative gearing. In another context, I understand that US inheritance tax has a threshold, with houses under a certain market value exempted. Over that value you pay. Why not do the same for negative gearing – limit it to a dollar amount, which could be indexed to CPI, so that you don’t get to negative gear a million dollar apartment overlooking Sydney harbour. The CPI index could also act as a break on above-CPI house price increases. Any thoughts?

    Finally, I find the market reactions to all this curious. I can understand the share price of banks and highly leveraged companies falling, but even owners of assets with fixed revenue streams like supermarkets, miners and toll roads are falling. Unless the market knows something about their debt positions which they aren’t telling, that seems an over-reaction to me.

  20. spiros and Ikonoclast,
    I suggest a look at their balance sheet – the jets and land appear on there, so they are owned or at least under long term finance leases. They would then be available to creditors.
    First, though, the company has to fail – and none of them have – which at the very least makes you wrong on that point, Ikonoclast. All of them are in a reasonably strong to strong net asset position at this point. That may change, but it could change for anyone.
    I am also aware of what happens when a company goes down – I have worked in forensic investigation of failed companies and prosecution of directors before.
    On the “paper trillions”, Ikonoclast, you really are showing your ignorance there. The notional values (which is what you are referring to) is not the amount outstanding. I suggest you at least try to understand what, for example, a simple, basic interest rate swap is (never mind a credit default swap) before you try that one again. Populist table thumpers can say that all they want. It does not make it true.

  21. SJ,

    Regarding comment #15. Yeah actually you’re right. Maybe what I meant was if I was an adviser to the RBA board struggling to influence their direction in the midst of institutional inertia. However you could adopt a gold standard without abolishing the RBA. One step at a time.

  22. Wiki is good enough on this:
    A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).

    Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events such as a default on a debt obligation. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spread.

    Credit default swaps are the most widely traded credit derivative product. The typical term of a credit default swap contract is five years, although being an over-the-counter derivative, credit default swaps of almost any maturity can be traded.

  23. The reason why the notional value of the CDS (like other swaps) is not the actual exposure is that I can hold a CDS of a notional $100m and pay the buyer fee without actually holding any of the underlying debt. My total exposure is nothing like $100m, just the payments on the protection. If they do default then I can buy the debt in the market and sell it straight on to the protection seller. Alternatively, the seller can just pay out the protection value without the debt ever having been bought or sold. Apart from anything else this saves on transaction costs.
    The vast majority of derivatives trade this way – whopping big notional values but comparatively little actual exposure.

  24. lovely stuff,

    heres the thing though, its not new, it doesnt work and its not sophistacated or complex,

    just ask some of the lloyds names

    “…the transparency of risk was eroded in the LMX spiral as successive reinsurers became more remote from the original insurance assessment and contract. The transfer of risk within the market meant that transparency virtually disappeared beyond the initial levels of the spiral..�

  25. the problem i have with your assesment andrew, is that it contradicts all of the available evidence,

    i love your over bearing self confidence, its a great blogging style, but the vast majority of the so called smartest guys in the room have under estimated risks or kidded themselves that they had insured against it,
    and guess what, check out the financial pages and the us fed statements,
    they like you were all wrong,

    except it seems goldman sachs

  26. To prevent another real estate bubble we should reform land use planning, which is mainly a conspiracy (in the proper use of the term) among current land owners to maximise the value of their property.
    The solution is on the supply side.
    Real estate inflation (like all inflation) benefits no-one in the long run. We just feel more wealthy. In the short run, young people suffer. Sad, really.

  27. Good old AR sums it up really “credit default swaps can be used to speculate”.

    It is the unchecked proliferation of essentially speculative instruments which has led us to this sorry pass. The US Govt now “has” to loan $200 billion of public funds in Treasury Bonds to the holders of this junk which AR extols. Otherwise the holders of this junk can’t keep lending and the wheels of commerce seize up.

    Would it not have been better to have adequate regulation of these instruments in place in the first instance? I would suggest all financial instruments (especially speculative ones) should be strictly limited by law.

    The range of legal financial instruments should be fully specified by legislation (not contracts between parties) hence a newly invented instrument would be ipso facto illegal. The general purpose and spirit of such a law would be that all financial instruments would be required to exist for primarily productive purposes and not for speculative purposes.

    We need to develop a culture where pure speculation is held in deep cultural and legal opprobrium.

  28. The two economies idea is interesting – linked to the ‘decoupling’ hypothesis which, IIRC, has been mentioned here before. The problem that the RBA and other policy makers face in this country is that of understanding the extent to which the booming Chinese economy, with its resource demand, can insulate us from the clearly collapsing US financial sector.

    Anecdotal evidence coming out of the US, in the absence of the ex post data, suggest that recession is upon them. We, on the other hand, seem to be in some sort of limbo between fear of a US recession and fear of inflation brought on by shortage of resources (oil? food?). In other words, the likelihood of another round of stagflation. The worst of all possible worlds if you happen to be poor.

  29. i’d personally be astounded if the booming chinese economy is able to continue apace without any customers,

    our second biggest export destination japan is almost certainly in the sh*t as well, and the eurozone is also doubtful,

    the optimists are delusional

  30. Ikonoclast & smiths,
    It is amusing that you seem to take the financial news as published in such flagships of journalistic knowledge of financial services as “The Australian”, or one of the other local rags, as the gospel truth.
    The simple fact is that it is not the “great majority” of the “smartest guys in the room” that have been caught by this. Not a single major bank, not one, has gone bankrupt over this. Northern Rock (hardly a major) has had liquidity issues, but it is not (sensationalist journalism aside) bankrupt.
    Some have mis-priced risk – sure. Those who have mis-priced it have lost some money on those instruments. Others have got caught short in liquidity at what was (in retrospect) an important time. Is this market failure? No – it is what markets do. You get it wrong, you lose money. Get it right, make money. Either way, the productive output of the economy benefits by having the financial resources they need.
    Government gets it wrong (as they have, repeatedly, on monetary and fiscal policy) we all lose.
    On the idea of regulating instruments – you seem to think that a bureaucrat stuck behind a desk is going to be able to properly assess all the risks involved in an innovative instrument – or even be capable of understanding if something is a genuinely new instrument. LOL.
    On the China point – do you even have a clue where China’s largest markets are? No? I will give you a clue – it is not the US and it is growing at about 10% per annum. By far the largest market for Chinese goods has the initials of “PRC”. Delusional I may be (not conceded), but at least I have an idea about the area I am talking about. Yours seem to come from “Green Left Weekly”.

  31. “Is this market failure?”, AR asks and answers with a “NO”.

    To some extent I can agree with him. The term ‘market’ is sometimes (mis) used to refer to ‘capitalism’ (which I define as an institutional environment that favours financial capital, be it out of habit or ideology doesn’t really matter as far as I am concerned). It is a failure of ‘capitalism’ rather than ‘market failure’ that we are observing repeatedly since 1987. The historical accounts of the era preceding the Great Depression fit the pictue quite well, too.

  32. So, Ernestine – would you count the hundreds of millions of people lifted out of dire poverty in the same period by the extension of the reach of market capitalism to be the shining example of the success of capitalism, with the only downside being comparatively minor financial market turmoil* – or did you have a different take on the matter?
    *which I would argue was predominately caused by government, rather than market, failure

  33. AR, I’ve said all I wanted to say. If you don’t agree that is fine. My post was inspired by the quote from your post. That is all.

  34. andrew,
    your wild assumptions about reading material are way off the mark,
    anyway here is something from that bastion of leftwing conspiracy writing, the IMF

    The delinking of China’s trade bundle and the shift toward more high-end products implies that China’s exports and trade balance could become more sensitive to foreign demand and relative price changes than in the past. These results cast doubt on traditional views about China’s trade structure.
    This new structure, in turn, gives rise to a number of interesting implications that challenge conventional wisdom both about the vulnerabilities of the Chinese economy and its role and influence in the broader regional context.
    In terms of implications for China’s own economy, our results suggest that its trade balance may have become more sensitive to external shocks such as shifts in global demand or exchange rates than commonly assumed. This underscores the need to hasten the rebalancing of China’s growth, away from potentially volatile net exports that are increasingly vulnerable to exchange rate and demand shifts toward a more sustainable path driven by domestic demand.

  35. in my haste i forgot to mention the other major contributor to the growth which was foreign direct investment,
    if that dries up in a squeeze surely you would have to agree that that would affect manufacturing growth,

    and what about the internal capital constraints they wont hold forever and when those rich citizens have the chance to invest externally dont you think that could affect internal investment growth

  36. the only fact here is that if someone contradicts your opinion andrew you question their knowledge,

    its weak

  37. As long-time readers know, I tend to disagree with Andrew quite a lot when it comes to politics.

    But his comments on economics and markets here strike me as pretty much 100% accurate.

  38. I think what’s happeneing in the financial markets is relatively straightforward. We’re simply seeing a process, albeit on a grand scale, of forced “netting out” of asset and liability positions and the realization of monetary gains and losses on earlier trades in real assets.

    It is simply confirming the previous transfer of money wealth from investors and their bankers to those who previously sold assets to them at inflated prices; i.e. prices that valued the net assets in the system (assets less liabilities) at more than the amount of cash available to buy them. I think its best shown with a simple example.

    A has $100, B has $10, C has house, D has $50
    (Total assets in economy = $160 + house)

    A lends $100 to B
    (A has loan asset of $100, B has cash asset of $110, C has a house, D has $50, B has loan liability of $100
    Total mark-to-market assets in economy = $260 + house)

    B buys house from C for $110
    (A has loan asset of $100, B has house asset of $110, C has cash asset of $110, D has cash asset of $50, B has loan liability of $100
    Total mark-to-market assets in economy = $360)

    A now doesn’t believe house is worth $100, calls the loan from B. B tries to sell the house, but can only sell it to D for $50. A puts B into default
    (A has cash asset of $50, B has nothing, C has cash asset of $110, D has house
    Total assets in economy = $160 + house)

    Alternative ending:
    A now doesn’t believe the house is worth $100, calls the loan from B. B tries to sell the house, but no buyer. A takes house.
    (A has house asset, B has nothing, C has cash asset $110, D has cash asset $50
    Total assets in economy = $160 + house)

  39. And it’s not just paper trillions, either.

    Nouriel Roubini now thinks the actual losses in the US mortages market(s) will be between US$1T and US$3T, or 7-18% of US GDP.

  40. smiths,
    I suggest you read the notice at the top:

    Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

    So – what is there is not necessarily the view of the IMF. Strike two.
    Even the authors of that paper concede the common belief (which I would contend is the one supported by more evidence) is that China is becoming less sensitive, not more.

    As a result of these shifts, China may be becoming more exposed to fluctuations in the strength of the global economy, and changes in its exchange rate could have a bigger impact on the trade balance and the domestic economy than commonly believed.

    Your comment, in any case, contended that China was to be “without any customers” – and not even this paper would support you in that.
    A claim of no customers, to me at least, would indicate either gross and careless hyperbole or simple ignorance.
    On the FDI front you may be interested in the primary source of FDI into China. It is Hong Kong China. Why China you ask? Inbound FDI attracts concessional tax rates, so the capital goes out to HK, gets renamed and brought back in again. It’s also known as a tax dodge.
    If you are insulted by my questions on your knowledge, try being called “delusional” first. If you are going to throw ad hominem, be prepared to receive. If you want to apologise, I am happy to withdraw as well.

  41. Ian says: “But his comments on economics and markets here strike me as pretty much 100% accurate.”

    I disagree. He tends to look at things only from a finance perspective, which can be overly narrow.

    Will’s explanation is pretty good. Securitisation allowed a huge increase in money supply, i.e. it allowed dodgy mortgages to be treated as a close equivalent to cash. This is all unwinding now, and money that people thought that they had is effectively disappearing. The money supply is suddenly contracting.

    Andrew would probably say that that’s just how markets work, but that’s not a sufficient answer. It’s the job of policy makers to decide whether that’s the way we want things to work in future, and the answer’s almost certainly no.

  42. Thanks SJ, but I would also note that I just used the one-step mortgage as a simple toy exmaple. Its not just securitization of mortgages, but all secured short-term lending against mark-to-market values (notice how many large loan exposures are now structured as margin loans). And in reality there hasn’t been just one step from loan to ultimate asset holder; there has been releveraging after releveraging of the same assets with a more inflated implied asset value each time, hence the massive scope of the unwind going on now.

    But I would also invoke a kind of conservation law to say that for all the losers today, somewhere out there is a group of people who were winners (in cash terms) by exactly the same amount. They were the ones who sold the assets at inflated prices. In light of this, it makes the calls by the losers for handouts to “save the system”, or for “asset price support”, to look like little more than bald requests to redistribute the cash back. But so what if we don’t go back to the status quo? Why does it matter if Merrill Lynch doesn’t go back to ripping billions of dollars out of investors for doing exactly nothing productive. Perhaps a better system will naturally emerge where investors finally learn that they have to invest long-term against real cash flow, not leveraged short term against inflated MTM asset values.

  43. Will Says: “Thanks SJ, but I would also note that I just used the one-step mortgage as a simple toy exmaple.”

    Sorry, I thought you were actually trying to give a simplified example of money creation through fractional reserve type systems. My mistake. No harm, no foul.

    “But I would also invoke a kind of conservation law to say that for all the losers today, somewhere out there is a group of people who were winners (in cash terms) by exactly the same amount. They were the ones who sold the assets at inflated prices.”

    No, there is no conservation. “Money” is a claim on something of value. For example, under the gold standard, money was a claim on a chunk of gold. Under a government backed fiat money system, the money is a claim on the government’s future revenue stream, i.e. a sort of general claim on the economy of the country. Under fractional reserve banking, it’s a claim on the bank’s future revenue stream, which used to be mainly secured by claims on real property.

    Note that by this point, the money supply has become much larger, and is backed by claims not on a just a small pile of gold in Fort Knox, but by claims on most of the countries real assets, and alternatively, on the future earning capacities of the people who have pledged the assets.

    That’s as far as we need to take the example.

    If the value of the underlying security falls, e.g. real estate, money evaporates from the system. It’s gone.

  44. SJ, I’m in finance (practical not academic) so I’m not talking about “money”, I’m talking about cash. And cash is conserved. And a shorfall in cash is the problem people are now facing.

    I understand that money or money supply is defined differently, but its the confusion between money/value and cash that seems to be the root of the problem in the markets today.

    Note from my example that while money supply as you define it has increased, the net assets (after liabilities are deducted) and the amount of cash and real assets is the same at each step.

  45. Will, even if we limit the definition of “cash” to paper currency, and exclude any kind of bank deposits, (this is M1) it’s still not necessarily conserved.

    If the economy is expanding at x%, the government can safely print x% more currency each year, without affecting the value of the existing currency.

    Let’s say you’ve got a $100 note, and you want to use it to buy groceries next week. Overnight, the government decides to double the amount of currency in circulation. By next week, you find that the groceries cost $200.

    Even though the value of your $100 is preserved in nominal terms, when you try to use it you find that half of it is gone.

    Somebody probably benefited during the intervening week, and you can’t tell who it is, but someone definitely made off with half of your money.

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