Talk of a recession is premature, and of a depression downright ridiculous. Here’s why: Ruthven
Tuesday, 25 November 2008
Phil Ruthven
As we near the end of the first decade of this new century, Australia has relatively few financial and economic issues of the sort that are tearing the US apart. This century promises to be Asia’s century, after North America’s 20th century and Europe’s 19th century. And Australia is part of Asia’s economy and society.
We have three weaknesses in 2008 – a chronic lack of savings that led yet again to massive off-shore borrowings in F2007 (over $52 billion), overpriced housing (by around 30+ %), and some over-leveraged property trusts. These weaknesses, however, are not enough to panic about.
So talk of a recession let alone a depression is premature, if not almost ridiculous in the case of a depression.
Only four in a hundred Australians have experienced the nation’s last depression from 1929-1933 and they would have been very young then, aged between five and 15 years old. Those older have largely passed on.
For older Australians aged 40 or more at the onset of that depression, it was yet another terrible trauma. They would have already experienced a worse depression lasting nine years from 1890-1899 and with a deeper fall in the economy – a 23% fall in GDP compared with 20% in the 1930s.
So why the 1930s depression was called The Great Depression is odd; after all, it was the least hurtful of all the depressions preceding that one. Nevertheless that generation then experienced the horrific World War I from 1914-18.
So to face two terrible depressions and a world war that saw the death of over 61,000 soldiers – and many times that in injuries and disease – was to have pain etched in the psyche of over a million citizens. We return to the consequences of this pain in terms of life’s attitudes, priorities and lifestyles shortly. Most of this older generation, incidentally, went on to experience a second world war between 1939-45 that took the lives of almost 40,000 more people.
These days, as the saying goes, we don’t know we are alive.
These four traumas were experienced by many other nations, of course, and this helps explain why there was so much resolve by the post-World War II generation of adults to ensure we never had depressions or world wars again. And we haven’t.
Could we again? Possible but unlikely is the short answer in 2008, as we come to the close of one of the most tumultuous years for our economy, in living memory. There is, after all, a much better understanding of both recessions and depressions these days; and more importantly, there are mechanisms available to prevent, or at least ameliorate, recessions and even depressions.
Our nation has had some 26 recessions and four depressions (encompassing 22 years) over its 220 year history since European settlement in 1788, but only five recession years and no depression over the past seven decades. So the mechanisms, and some serendipity, are working for us.
It is important to understand the profound difference between recessions and depressions, and their respective causes.
Causes of recessions
Recessions are short periods of falling economic output involving at least two successive quarters of decline, but rarely extending beyond 15-18 months.
Most of them were caused by poor agricultural seasons before Word War II. Given that this primary industry accounted for between 15-50% of Australia’s GDP up to that time, it took only a 25% fall in farm output from droughts and/or floods to cut our overall GDP by 4% or more that year and trigger a recession. Nowadays, with agriculture being only 3% of the nation’s economy, a 20-25% fall in its output can only take less than 1% off our GDP and in no way lead to a recession.
So in the post-World War II years, recessions are caused by human failings not acts of god. It is now falling investment (capital expenditure) by up to 10% that triggers recessions. Given that each year new investment is around 25% of the economy, a 10% fall is enough to cause a recession by leading to a fall of, say, 2.5% in GDP. Governments seeing this coming can step in and bolster capital expenditure to stop an impending recession in its tracks. They did this in 1966-67 and 2001-02, meaning recessions were avoided.
The most recent parrying of a recession was by the Howard/Costello government in 2001. They stepped in with a $7000 first home buyer’s grant – doubling that to $14,000 a year later – and boosted capital expenditure on housing to such an extent that the overall fall in investment was minimised and a recession avoided.
Interestingly, both Australia and the US have long business cycles of around eight and a half years, and we are recession-prone via potential collapses in investment only at the end of each cycle.
The end of the current cycle is due around September 2009, so our Federal Government has a year to plan a boost of up to $20 billion in capital expenditure in the event that the private sector cuts its investment too much. It has heaps of money to do this as a result of years of surplus budgets by the Howard/Costello years, and continuing surpluses with the Rudd/Swann team.
What may not be known by most Australians is that consumption expenditure – mainly by households but supported by government spending on education, health and other consumer services – has never been negative in five decades, as the chart below shows.
It isn’t consumers that cause recessions; rather it is nervous boards of directors in the business world who savagely cut their capital expenditure plans. They are also not helped by difficulties in getting the money from spooked or under-capitalised banks, scared stockmarkets and other fearful lenders.
However, the avoidance of a recession for Australia in 2009-10 should not be that difficult. The Treasury in Canberra and our Reserve Bank are both skilled to act swiftly, and yet again avoid a recession. The Rudd Government has now acted quickly to bolster both capital and consumption expenditure in the middle of October this year so, another potential recession would not be due until 2018 at the earliest. Here’s hoping, but we can do so somewhat confidently.
Causes of depressions
Depressions are altogether different from recessions.
They involve at least two years of declining output and most have lasted for four years or more. We have had four of them: 1788-89 (Captain Arthur Philip’s colony), 1840-1846, 1890-1899 and 1929-33.
Their causes, apart from the First Colony setback, are greed and short-sightedness. The effect is a massive and sustained fall in GDP, unemployment rising to truly distressing levels with widespread hardship, and frightening collapses in asset prices – both property and financial assets. The falls in our GDP ranged from minus 20-31% over these four depressions. Unemployment levels rose to between 17.5-20% of the labour-force.
We certainly do not want to experience another one. And like recessions, they can be stopped in their tracks by appropriate actions by Treasuries and Reserve Banks; although even with such actions a nation usually experiences at least a recession and lingering pain in the society for several years.
This is the price of the greed and madness of crowds, including crazy asset prices, which led to the problem in the first place. After all, the causes of depressions are far more serious than the causes of recessions.
Interestingly, the 1990-1991 recession in Australia may one day be seen to have been a technical depression given that its biggest impact was crashing asset values (housing, other property, shares and our equivalent of America’s “junk bonds”), rather than crashing economic output, which fell by less than 2% of GDP. The greed of the so-called entrepreneurs in the eighties was palpable.
Our government agencies did act decisively on the “recession we had to have” as treasurer Paul Keating said at the time. But as said, we may one day regard this as a controlled depression.
This time, in the troubled late-noughties, we do have some inflated asset prices. In September 2007 our stockmarket was overvalued, by about 15%, but punished by an over-reactive 42% fall by mid October 2008. It will recover within a year or so, and is probably already a source of many bargains for the patient investor. Yes, some of our investment banks and property trusts are paying the price of excessive exuberance, but as a percentage of the nation’s financial assets, this accounts for less than 1% of the $4.7 trillion of such assets; so it is easily manageable.
Housing prices have been very inflated, by as much as 40%, as shown in the chart. This is worrying as the nation has $3.6 trillion in housing at present. The average dwelling for over 50 years after World War II had been around 2.6 times average household gross incomes, but rose rapidly in the new century to four and a quarter times.
However, this was not due to excessive greed, but the shortage of housing. Today we are building the same amount of new homes that we did in 1975 and this is despite record immigration levels of around 180,000 per annum. Simply, state governments have not done adequate planning, released enough land or made it easier for developers and builders to create new housing estates and dwellings.
So greed of the sort that has been the base cause of previous depressions is not evident in 2008. Yet overpriced housing will face some adjustment over the next five to 10 years.
That said, households (the main source of savings) have been poor savers in Australia for decades, despite the introduction of the superannuation levy in 1993, which is now 9% of our wages, as the chart shows.
The US scene: A depression or recession?
The US has a far more serious set of problems than Australia. It is grappling with the cost of two expensive incursions in Iraq and Afghanistan, and with inadequate taxation of its citizens to do so. Indeed, its overall taxation is around 25% of its GDP compared with our 31%. It should be at our level.
Its capital expenditure – the source of growth and productivity in any economy – is a lowly 17% of its economy compared with our 27%, which means its infrastructure is decaying.
Its finance industry is in disarray, the result of sloppy if not criminal practices associated with mortgage lending (low-doc and especially sub-prime lending) and reckless investment bank lending and leveraging.
Lehman Brothers has gone to its grave, Merryl Lynch was snapped up by Bank of America, the Federal Reserve saved IAG by taking an 80% equity share, and saved both Fannie Mae and Freddie Mac (the dominant mortgage institutions of the US). No one suggests this carnage is yet over.
The 2008 meltdown in the US has so far seen asset losses of over $US300 billion by failed institutions, and Treasury allocation of bad-debt absorption funding of $US700 billion.
Assuming a Treasury exposure by end 2008 of say, $US1 trillion, this would represent only 1.2% of the assets of all financial institutions in the US ($84 trillion). This is a small price to avoid a potential depression, and would still be if the ante rose to $2 trillion. So getting carried away with big numbers is irresponsible and fear-mongering.
A depression, if not a recession, is certainly avoidable in the US. They have worked hard for a recession, however, and may well experience one sometime over the next 18 months. Their recovery into a once-again vibrant economy could take some time.
But the ripples, indeed financial Richter Scale tremors, have made their way from the US around the developed world. A scarcity of capital for credit and capital expenditure purposes is a problem for Australia going into 2009, hence the necessity for the government to make up a shortfall in private sector capital expenditure—which they can do comfortably, and are doing.
How people react and societies change
Recessions do not have too many lasting impacts on society at large, although a small minority of households and individuals are affected, including some getting financially “wiped out” as they say. They are usually much more conservative in their attitude for many years, if not the rest of their life, as a result.
But depressions change the whole society, creating conservatism, a degree of regression in thinking and the evolution of furphies and some muddled thinking. They also lead to extraordinary energy, ambition and economic and productivity growth.
As Australia came out of the 1930s depression and World War II, our economic growth was breathtaking for more than two decades as people made up for lost opportunities from 1929 to 1945; more so than during our exit from the 1890s depression.
At the same time households developed some financial conservatism. It was not uncommon in the post-war years for parents to have empty cans and jars along a mantelpiece in which to divvy up a man’s pay-packet into moneys for rent, gas, telephone, school fees, and beer money, etc. The penchant for home ownership was such that the saying “rent is money down the drain” was born and lingers to the present day, even though for decades interest payments and other costs of home ownership have been twice the amount of rent for an equivalent home!
Hire purchase, introduced in Australia in the late 1920s was eschewed by The Depression generation, and only really adopted by the baby boomers in the late 1960s, who were not prepared to wait forever to have quality furniture, TV sets and cars like their patient parents.
Time also created some misconceptions about the good and the bad of the 1930s depression. As a young adult I once asked my grandfather, who was brave enough to start a small chemical company with two partners in The Depression, if other types of businesses also did well. He thought about it for a while and said yes. Bread (as a necessary staple), lollies (to cheer up the kids) and beer (to cheer up the breadwinner) were all good businesses he thought.
Many years later, as an analyst, I found they were all terribly tough businesses! Families had begun to make their own bread during The Depression, as it was cheaper. They made toffees with sugar and treacle in the oven, being cheaper than bought lollies. And beer? Well port was a cheaper source of alcohol, and “fourpenny darks” were a better proposition than beer to drown one’s sorrows.
The effluxion of time has muted the fears that older generations had. When only 4% of the population has any experience of a depression, it is no wonder.
Some 75 years later we are a less fearful society. We have advanced the means of preventing or ameliorating such potential catastrophes.
We may not be economically and financially bullet-proof here in Australia, but we are possibly the best placed in the OECD. Our government has virtually no debt and has money in the bank, and we have the serendipity of a mining prices boom. Our businesses have conservative and manageable debt/equity ratios, and less than 5% of our households are debt-servicing stressed (mortgages, more than credit card or personal loan debts).
It doesn’t get much safer than that.
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