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Asset bust in slow motion


David Llewellyn-Smith

Last week the RBA finally lowered its growth forecasts for the year ahead but it did so largely with a grain salt, still forecasting a pretty aggressive range of between 2.5 and 3.5 per cent.

Tomorrow night, the federal government will release its budget for the year ahead and, as Ross Gittins suggests today, will no doubt also assume a trend rate of growth.

The real question both should be asking is why the Australian economy has so underperformed since 2008, with below trend growth not the norm since the GFC.

Waiting for the penny to drop

The fear among many is that we are another US in waiting. A massively overleveraged and deindustrialised service economy just waiting for the penny to drop.

The key vulnerability is asset markets and especially house prices, as well as the potential for a China shock.

The thesis goes that once past a “Minsky moment” the bust will accelerate on household deleveraging. Richard Koo calls these balance sheet recessions because they as much about repairing wealth as they are about repairing cash flows.

The Carmen Rhinehardt and Kenneth Rogoff book This time it’s different is a powerful reminder that such dynamics are inescapable, enduring and deeply painful.

But, there are different examples of such asset busts unfolding over different time frames, with different mixes of public and private pain, as well as different ways of distributing the pain of correction across the polity.

Short shock or long misery

The US model is one: swift and painful house price falls, rocketing unemployment, as well as big falls in labour costs and a big jump in productivity and a temporary surge in public borrowings.

Parts of Europe are headed down a different path of correction. Or, having it forced upon them. The credit dependent PIIGS (Portugal, Ireland, Italy, Greece, Spain) are enduring long, grinding recessions, public austerity and wage deflation to improve their competitiveness. The upside, if we can call it that, is that that competitiveness will slowly turn into higher investment and more sustainable growth (politics aside!).

Both approaches effectively let the private sector burn (within reason).

The other model is that of Japan. Take a look at the following chart from Steven Keen last week:

Japan’s asset price falls were paced over a much longer time period than those of the US or Europe. The resulting economic shakeout was different too, with a much longer time frame of subdued economic growth, a more slowly rising unemployment rate and a steady but longer rise in public borrowings to offset the private sector’s slower paced deleveraging. In short, in Japan, collective private losses were socialised over a much longer time frame.

Resources boom a shock absorber

What can these paths of correction tell us about Australia’s future?

Interestingly, Australia is analogous with some of the characteristics of the Japanese experience. Australia is enjoying an enormous mining boom, which has contributed a great deal to the prevention of a swift and merciless correction to our asset inflation model.

Although the boom has not produced a current account surplus – that is, as a country, our savings still don’t cover our investment bill – it has significantly improved the country’s external position without having to go through the far more painful approach of reduced imports and rocketing external funding costs that typically accompanies modern asset busts.

This is not unlike Japan, where its export model of growth was intact throughout its long correction, whereas much of the US bust corrected imports, which quickly flowed out and smashed everyone else. Or the European PIIGS, whose falling imports are slowly but surely sapping the strength of core country exports and banks.

There are other characteristics that Australia shares with Japan in its steady and manageable melt in asset prices.

GDP per capita, for instance, has not tumbled. Rather, it has stalled. Household income has also continued to rise, even as household wealth falls. And some of the hit to wealth has been offset for consumers in stalled and falling dimensions of the costs of living, such as food and apparel, as retail sales volumes hold up but not enough to prevent disinflation and deflation.

We even have our own version of the Japanese “salarymen”, a key plank in the slow melt of Japan, in which workers were kept on despite conditions warranting smaller work forces in many sectors. Australia’s informal kurzarbeit system is certainly closer to Japan (and Germany) than it is the United States. The price for this is probably lower productivity. Although Japan managed a decent performance for many years.

'Golden Recession' in Australia?

The Japanese experience since the end of the 1980s is often described as the “Golden Recession”.  So, is a golden recession possible for the Australian economy?

First, it is sobering to realise that this is the best-case scenario, one in which China continues to boost the nation’s external accounts via historic commodity demand and prices. In that event, a decent current account will prevent global markets from raising the cost of our bank’s borrowing further.

It may even be enough to stall the asset price correction for a time and knock Australia onto a shallower path of correction than that endured in Japan. Certainly we are better placed demographically than Japan, with our aging population able to be offset by better birth rates and immigration.

But there are some BIG differences with Japan too. The most crucial is national savings. In Australia, we don’t have … any. Japan had enormous savings when it’s asset bust began.

Probably the most important factor in its slowed decline was the slow running down of private savings, much of which was redeployed as government spending, which is why the Japanese government now has a debt stock at 210 per cent of GDP, the largest in the world.

It is mostly owed to Japanese citizens and as long they’re happy to lend, the cost of borrowing the money will not rise and no austerity will be required. And so long as the spending goes on, the economy keeps ticking over.

On top of that, as one of the world’s largest economies, and a source of one the world’s most used funding currencies, Japan is able to print money and also fund government expenditure using quantitative easing.

Bitter pill for Australia

Both of these are impossible for Australia, not least because the government balance sheet guarantees our immense external private borrowings, so any deterioration in its quality will not be received as generously by foreign creditors as it has by the monolithic Japanese public. And any attempt to ease monetary policy too dramatically will be met with capital flight, raising real borrowing rates anyway.

So, in the end, can Australia’s track Japan’s golden recession or find a shallower path of correction? The first observation I’d make is that I understand the framing of this question is a bitter pill for Australia. After all, I’m leaving no scope for any outcome other than a decline in living standards, only the pace is in question.

Second, the shallower paths of correction are clearly dependent upon the assumption that Chinese demand for our resources continues to grow.

Finally, Australia shares one last thing with Japan that make me think none of this will be planned for or addressed sensibly. Rather, we’ll sail on as if nothing has changed and deploy all of our resources in fighting the outcome rather than seeking to make best advantage of it.

The rise and rise of vested interests on both sides of politics will prevent us extracting the most value from the mining boom and keep policy focused on restoring our fading asset-inflation model.

David Llewellyn-Smith is the editor of MacroBusiness and the co-author of The Great Crash of 2008 with Ross Garnaut.

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