* By Lounge Lizard
The recession the world has now entered is deepening. It is no mere passing phase.
It may have been started by US housing loans going bad, but the problem for the whole world is much greater than a trillion dollars or so of dodgy US housing loans.
So far, we in Australia have taken comfort from the fact that the US situation is unique in many respects. We are fortunate in that we don’t have the equivalent of the Community Reinvestment Act, a toxic piece of legislation that mandates loans to high-risk borrowers. We don’t have the Association of Community Organizations for Reform Now (ACORN) to pressurise financial institutions to grant such loans. We don’t have government-sponsored organizations (GSEs) such as the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac), both of which were protected politically from proper supervision, to sanitise dodgy loans.
We are also fortunate in that we don’t have non-recourse loans, loans under which the borrower is in effect provided with a put option to sell the mortgaged property to the lender for the balance owing on the loan. We are thus spared a major moral hazard in a declining market.
For years, Americans have saved too little and borrowed too much. Hooked on consumption, they have relied on foreigners to make up their savings deficiency. Now it’s caught up with them, and with those who lent to them.
In both Europe and America, banks are being bailed out left and right, the latest being the giant Citigroup. When you consider that banks are the most financially geared organizations on earth, this is hardly surprising. Even a conservative bank, with a gearing of twenty to one, only requires five percent of its loans to go bad to lose its entire capital, and some banks were geared as high as sixty to one.
Here in Australia, we are fortunate that the previous Federal Government paid off debt and built a future fund, but we shouldn’t feel too superior. The Americans were not alone in their failure to save. For years, our net savings have been low, sometimes even negative. We too relied on foreigners, not our own savings, to provide much of the finance for our houses, our industry and our commerce.
Clearly this was not sustainable. The economy was out of balance. But it worked for a time. Just as in the US, housing prices rose and the stock market boomed. We could shop until we dropped yet still be wealthier at the end of each year than at the beginning.
Now it has caught up with us and we’re all a lot less wealthy.
Older people are less wealthy because the value of their investment in superannuation has declined by up to 40%. Younger people are less wealthy because while their mortgages may be unchanged, the value of homes so financed has declined. Business people are concerned that they may lose everything if their business income proves insufficient to service their debts.
Of course, any changes in behaviour will depend on a person’s position to start with. The very poor already don’t save much as they have little to spare, so there won’t be much change in their behaviour. Provided they are not excessively geared, the behaviour of the very rich also won’t change much. They may economise by merely buying a new Bentley Continental Flying Spur and deferring the Learjet, but this will make little overall difference – there aren’t enough of them for that.
It is those in the middle – neither poor nor rich, but many also shareholders in public companies – who will be most concerned about the loss of wealth, even though they may not yet have experienced any actual loss of income.
Just as banks in Europe and the US must now recapitalise their balance sheets, people in the middle will also feel the need to improve their own personal balance sheets. They have the flexibility to adjust their expenditure patterns and this they will now do. They will spend less on holidays and home entertainment systems and keep the old car. Overall, their consumption will decline and their savings will increase until they are once again comfortable with their financial situation. Only then will a new equilibrium be reached.
This will take time, and government actions can either help or hinder this process.
Unfortunately, the government’s approach so far is to throw money around in the hope that people will be persuaded to continue to consume. The Federal Government’s recent gift to local government is an example of this.
But this ignores the fundamental problem – the drop in personal wealth. If governments want to help, the best thing they can do is give substantial tax cuts to help speed the rectification of personal balance sheets.
Eventually recovery will occur, but given the nature and size of the imbalances throughout the world, it will probably take at least five years. It will take less time if citizens are permitted to control their own expenditure and more time if governments in effect assert that they know how to spend your money better than you do.