In Bed With The Basket Cases


It’s the first Tuesday of the month — interest rate decision time. Many will be blissfully unaware of the fervour with which financial markets and mortgagees greet the monthly announcements from Australia’s Reserve Bank.

But for those with an interest in the economy, speculation about movements in official interest rates is something of a contemporary obsession.

Today will be no exception. With the stock market falling below 4000 in recent days and global financial markets in a gathering state of panic over the state of the world’s economy, local financial markets appear confident of a quarter per cent interest rate cut at the very least.

Europe is, of course, the source of the global economic miasma. The European currency union was negotiated in sunnier times, when it was thought that the benefits of expanded trade and freer movement of goods and labour would more than compensate for any structural issues thrown up by the currency zone.

But even back in the 1990s, critics were pointing out that a currency union without appropriate fiscal transfers had the potential to end up in an Argentina-like situation.

This is because countries that borrowed heavily in euros would have to pay that debt back in euros: devaluing their currency to make their exports more competitive would not be an option, and neither would inflating the debt away by printing more money.

Amazingly, the drafters of the various EU treaties also neglected to provide a treaty mechanism for a country to leave.

Sadly, the pessimists have been proved comprehensively right. Europe’s huge and disparate economy is struggling to deal with the internal imbalances that have flowed from the interaction of a single currency and oceans of debt.

With advanced industrial export nations like Germany unavoidably coupled to basket cases like Greece, the only way to keep debt-ridden Greece in the zone is massive bailouts from the so-called "troika" of the EU, IMF and European Central Bank.

Of course, if the problems were merely confined to Greece, an economy roughly the size and population of Queensland’s, then the EU might be in better shape. But the whole of Europe has been buffeted by a devastating recession in the wake of the 2008 global financial crisis.

Big economies like the UK, Spain ad Italy are going backwards. Britain’s economy contracted last quarter; indeed, its gross domestic product is still below pre-GFC levels. Italy’s economy is expected to shrink by 1.5 per cent in 2012, with unemployment to reach 10 per cent.

And then there’s Spain. For sheer destructiveness, the Spanish property bust looks like rivalling the carnage inflicted in some of the worst parts of the US sub-prime mortgage debacle.

Fuelled by cheap money from European banks and bonds, and driven by a classic housing bubble that seemed like a licence to print money while the going was good, Spain’s banks have racked up hundreds of billions of dollars in bad loans for over-valued Spanish property.

In May, the Spanish government was forced to step in to rescue the country’s fourth-largest bank, Bankia, in a bail-out that will now cost as much as €23.7 billion (on top of the €5.6 billion it had already received from a previous bailout).

Things could get worse before they get better. Spain is now asking for a Greece-style bailout from the German taxpayer, via the European Financial Stability Fund, but, unsurprisingly, the Germans are resisting.

While the policy-makers prevaricate yet again, a slow-motion bank run (sometimes called a "bank jog") appears to be developing in Spain’s banking system.

Will a bailout solve Spain’s problems? Of course not. As we’ve seen in Greece, bailouts on their own can’t address the fundamental economic issues of low growth and a fixed currency.

Countries like Greece and Spain remain trapped inside the currency union. Inside the euro cage, their low domestic demand can’t be solved easily; their exports are expensive, their labour is uncompetitive and their debts are growing in real terms.

And with austerity impacting negatively on economic growth across the eurozone, the problem is getting worse, as the size of that debt relative to their economy grows. Steen Jakobsen, chief economist at merchant bank Saxo Bank, was quoted by Bloomberg overnight as saying "Spain’s problems are multi-dimensional, from having to deal with real estate to fixing the budget deficit and all at the same time".

"The idea that you can solve the situation with 40 billion euros of European money for the banks makes no sense," he continued.

Where does that leave Australia? Unfortunately, Australia is part of the global economy, and that means we are exposed to trouble in Europe. Indeed, it’s becoming obvious that the Chinese economy is slowing, which could mean real pain for Australia’s commodity exporters down the track.

Much of Australia’s resource exports go to China in the form of coal and iron ore, where they are made into steel for China’s construction sector. Chinese construction is slowing rapidly. And Chinese growth is also influenced by the export markets it manufacturers sell into, including Europe.

According to Stephen Roach in today’s Australian Financial Review, Chinese export growth has fallen from 20 per cent in 2011 to 5 per cent in April 2012. "The bad news is that Asia seems to be learning little from repeated external demand shocks," Roach concludes.

The problem for Australia is that the resources boom is the main engine of Australian economic growth. Much of this resources investment is already committed or locked-in, but that doesn’t mean resource projects can’t be shelved or put on the back-burner if commodity prices start to nose-dive.

BHP Billiton has recently announced a six-month pause on all investment approvals, which puts the next stage of its vast Olympic Dam development in South Australia on hiatus. The South Australian government is understandably concerned.

A rapid slowdown in Australia’s resource exports would be welcome in some respects, as it would take the inflationary pressures off the over-heating parts of the Australian economy. But it would also kick away the main prop that supports Australian economic growth.

As we know, some parts of the domestic economy are in the doldrums. Manufacturing continues to contract, as we’ve seen with the recent collapse of the Hastie Group, while construction is also in the doldrums; the April reading for the HIA’s (HIA) Performance of Construction Index (pdf) was a contractionary 34.9, where 50 indicates neutral settings and anything above 50 is growth.

A 25 basis point cut in interest rates will provide a short-term fillip for local markets, which have been heavily sold off in recent days. But a cut of this magnitude is unlikely to do too much to solve the underlying issues troubling parts of the Australian economy, such as falling house prices and slack consumer confidence.

And it can do nothing to alleviate the global imbalances that are the course of the current market instability, such as slowing Chinese economy and a European currency zone on the brink of collapse.

Given this domestic weakness, the turbulence in Europe and the continuing weakness in the US, it’s not surprising markets are pricing in a rates cut today. Stand by for more interest rate cuts throughout the year, as the Reserve Bank continues to reduce rates in an effort to stimulate the weakening economy.

Ben Eltham is New Matilda's National Affairs Correspondent.