Fasten your seatbelts: we’re in for a bumpy ride.
The dramatic fall in share prices over recent weeks has been contained, for the moment, by the intervention of the US Federal Reserve to cut the discount rate, the interest rate it charges banks.
The sudden recovery of global stock-markets was widely seen as the end of the crisis. But is it?
John Authers, investment editor of London’s Financial Times, noted: “Despite the Fed’s move, the loss of confidence in asset-backed loans and bonds appears greater than the loss of confidence in stocks in October 1987”, when an earlier crash occurred (Financial Times, August 20, 2007).
In any case, further losses are still expected to be reported in the subprime mortgage market. Paul Krugman, the noted US economist, said: “The housing slump will probably be with us for years, not months.”
How far the turmoil in stock and financial markets will go, is impossible to say.
Since the largest mortgage-lender in the United States, Countrywide Financial Corporation, announced that it was in trouble and has had to draw down a line of credit of $11.5 billion, the shock waves of the collapse of the US subprime lending market saw share prices go into freefall around the world.
In announcing its move to prop up the US stock market, the Fed Chairman, Ben Bernanke, indicated that the Fed would take further measures, if necessary, to stop the stock-market crash affecting the real economy. This was a dramatic reversal of previous policy.
An irony in the situation is that governments and economists who had long criticised government “interference” in the financial system were the first to applaud the central bank’s intervention.
For Australia, the effect of recent events extended beyond the stock-market into financial markets. As one of the most highly traded currencies in the world, the Australian dollar collapsed from a high of about 88 cents against the US dollar to 78 cents in just over a week, as currency traders fled the Australian currency in favour of more secure ones, like the Japanese Yen.
If these levels continue for any appreciable period, it will have significant effects on the Australian economy, in a number of ways.
The first impact is likely to be seen in domestic prices. Motor fuel, both petrol and diesel, is produced mainly from imported petroleum, at a cost of about $14 billion a year.
The effect of a 10 per cent fall in the Australian dollar will be a corresponding increase in the price of fuel, which will not only hit ordinary families directly, but will quickly flow into consumer prices, and push up the prices of imported goods, including cars, many foods and electronic goods.
The effect on the domestic inflation rate will be almost immediate, adding pressure to the Reserve Bank to lift interest rates later in the year. If this were to happen, it would probably be a fatal blow to the Coalition Government’s prospects in the forthcoming federal election.
Already, the government’s economic credentials have been tarnished by five successive interest rate rises, following its promise, in the run-up to the last federal election, to hold down rates.
Separately, the sudden fall in the value of the Australian dollar will have immediate consequences for Australia’s foreign debt, which at last count was above $520 billion. Although much of the foreign debt is in Australian dollars, the balance will push up the foreign debt and associated interest payments.
In recent years, the Australian Government and Treasury dismissed concerns about the growth of the foreign debt, saying that as Commonwealth Government debt has fallen dramatically since 1996, the rise in the foreign debt was a matter between lenders and borrowers.
More recently, Canberra has tried unsuccessfully to blame the growth of state government debt for rising interest rates.
The dramatic fall in the value of the Australian dollar shows that lenders look at national debt levels, not just at government debt, nor at corporate balance sheets.
The drop in the US discount rate was not the only or even the most important element of the package of measures which stabilised the financial system. Before reducing the discount rate, the US Federal Reserve, the European Central Bank and the Bank of England collectively pumped $240 billion into the world’s financial system in a desperate attempt to halt the stock-market slide.
If that money remains in the system, it will eventually fuel inflationary pressures, threatening to end the period of low inflation, largely caused by low-cost Chinese manufactured goods flooding world markets since the 1990s.
On the other hand, if central banks maintain their anti-inflation policy and withdraw money from the system or raise interest rates, they could precipitate a recession. Fasten your seatbelt: we’re in for a bumpy ride.
– Peter Westmore is national president of the National Civic Council.