22 November 2009

It isn't over until its over and it isn't over yet

This is an interesting item but it misses so much. Extremely unbalanced economies resolve by way of painful adjustments. We have dodged nothing but the new methods and tools have transferred risk to the dollar system and our ability to sustain capital inflows. We are not out of the woods yet by any means and even our denial at this point is part of the pattern.


What would be surprising is the misplaced confidence and complacency when you consider the US and UK are still in the ICU on full life support but this is just as it was then, hope springs eternal.

Market wrap: Leading stocks made further progress on the rally. Bulls encouraged by optimism from steel industry and Farm Board, by more foreign buying, and by market ability to resist bad news. Major industrials including US Steel, American Can, and GE, staged good gains in first 4 hours. Reactionary tendencies developed in late afternoon on profit taking, but sales were well absorbed on moderate price recessions, with the setback appearing technical. Bond market more active; US govts. and high grade corp. strong; speculative corp. irregular; foreign govts. mixed.

Broad Street Gossip: The head of one prominent Exchange firm has been seeking opinions among his 1,200 customers; finds that experienced traders are now optimistic, having “been through numerous panics” in the past only to see the country recover and become “more prosperous than ever before”. On the other hand, the young trader with less than 10 years experience “can see nothing but black clouds ahead ... and just cannot see how industry can get back on its feet again.”

In past few weeks, fire insurance company funds have been increasingly invested in common stocks of leading companies with safe dividends; viewed as significant since these investments “are directed by shrewd and conservative observers.”

S. Strawn, Montgomery Ward chair., says recovery depends on business men not politicians; warns against “drift toward Bolshevism”; says great problem now is gearing production down so that it will “synchronize with consumption”; implies some wage cuts may be needed.

Market ability to resist bad news is in contrast with a short time ago, when it “ignored any favorable development.” In past week, market has dealt with failure of an Exchange house, wheat irregularity, decline in rail car loadings, bank failures, etc., with little more than a hesitation in the upward trend.

See what I mean? The focus is already on why it was all so easy to fix.


The mild recession we've experienced bears no comparison with the much-mentioned Great Depression. But the difference is more the result of hard lessons learnt than better luck.

This week, Dr David Gruen of Treasury gave a lecture about what economists have learnt from the Depression and how the two events compare.

In Australia, the lead-ups to the two crises were quite different. In the present episode, we'd experienced 17 years of uninterrupted growth, falling unemployment and, in the past five years, booming export prices, leading to hugely improved terms of trade.

By contrast, in the lead-up to the Depression we experienced no real growth for five years, with the unemployment rate rising to 7 per cent. After the Depression began, real GDP fell by almost 10 per cent in 1930-31. The unemployment rate peaked at just under 20 per cent in 1930 (but had fallen to 9 per cent by 1937).

This time, of course, the economy hasn't contracted and is forecast to grow reasonably strongly next year, with the total rise in the unemployment rate expected to be just under 3 percentage points.

And this time we have a standard of living five times what it was then (even for the unemployed) and unemployment benefits which, despite their miserliness, are way better than ''the susso'' of the Depression era.

Gruen says the Depression in Australia had three main causes. First, the extremely unfavourable conditions in the world economy, particularly a large and prolonged deterioration in our terms of trade caused by a fall in the price of wool. This deterioration started in the mid-1920s, well before the Depression began.

By contrast, the deterioration in the terms of trade this time has been much smaller, with the latest level still more than 50 per cent above the average of the 1990s.

The second cause of our Depression was our adherence to the ''gold standard''. (Actually, many Depression scholars have concluded that the decision of most countries to return to the gold standard after World War I was the primary cause of the Depression around the world. So much for Wall Street's crash in October 1929.)

The value of the Australian pound was fixed to a certain amount of gold (the same amount as for the British pound) and anyone could demand that their pound note be exchanged for gold.

Without the gold standard, countries have ''fiat money'', where the value of a $5 note comes simply from the issuing government's command that it be accepted as legal tender in payment of five dollars of debt.

For a long time people disapproved of fiat money, fearing that governments could erode the value of money by permitting inflation or by deciding to ''devalue'' their currency against other countries' currencies.

The hyperinflation in Germany's Weimar Republic in the early 1920s convinced central bankers of the need to return to the gold standard. (In those days, the Commonwealth Bank was a government-owned trading bank and the central bank.)

Trouble is, a country that suffers a major fall in the value of its exports - a deterioration in its terms of trade - needs to respond by devaluing its currency. So sticking with the gold standard ensured the avoidance of inflation, but did so by crunching the economy.

Despite pressure from our deteriorating balance of payments to devalue our currency, we held the line until March 1931, when we left the gold standard and devalued by 25 per cent against the British pound. By then, however, our foreign exchange reserves were run down.

Subsequent research has shown that the sooner a country left the gold standard, the sooner it recovered from the Depression. Big Mistake No.1.

By contrast, in the present crisis our dollar was floating. It acted as a shock absorber for our economy, first by depreciating by 25 per cent in the four months to November last year, then by recovering almost as rapidly.

The third cause of our Depression, according to Gruen, was our inability to borrow abroad from early 1929. Australian governments had borrowed heavily from the London capital market during the 1920s to fund a string of large infrastructure investments, rapidly increasing our foreign debt.

London banks pressed Australian governments for repayments. Our banks restricted their loans to businesses, which put pressure on the economy.

By contrast, although the latest crisis would have shut our banks out of world capital markets, our Government used the strength of its own balance sheet to guarantee the banks' overseas borrowings, for a fee.

Turning to monetary (interest-rate) policy, it was ''tragically tight'' in the run up to the Depression because of the defence of the gold standard, and even after the devaluation the banks delayed cutting interest rates for two years. Big Mistake No.2.

By contrast, this time the official interest rate was slashed late last year and early this year, even while our exchange rate was depreciating rapidly. That we got away with this without adverse reaction from the market or fears of high inflation is a testament to the credibility of the inflation-targeting framework we installed in the early 1990s.

Turning to fiscal (budgetary) policy, the low level of foreign exchange reserves caused by the delay in devaluing the pound prevented fiscal policy from being used to stimulate activity and actually forced governments to curtail their spending.

Then, under the Premiers' Plan of 1931, government spending was cut by 20 per cent and federal and state taxes were increased to finance repayments to the British banks. So fiscal policy was managed in a way that made the economy worse rather than better. Big Mistake No.3.

By contrast, this time the Federal Government's financial position was strong and the Rudd Government quickly lashed out with big stimulus spending.

Now, you can conclude that this time we were lucky to have the economy in good shape when the crisis struck. But we weren't in better shape by accident. Economists have been studying the mistakes of the Depression for decades and have been taking steps for just as long to ensure they aren't repeated.

One lesson was to steer clear of the gold standard and (later) to move to floating exchange rates. Another was that fiscal and monetary policies should be used to stimulate private demand during downturns, but also (and more recently) that they should be ''reloaded'' during the good times to be ready for the next recession.

And don't forget that the better shape of our external environment this time is thanks largely to other countries - including China - having learnt the same lessons.

Ross Gittins is the Herald's economics editor.


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