Nobel laureate, Joseph Stiglitz, is bleak in his prognosis for the world’s largest economy. At a dinner co-hosted by CEDA in Sydney on August 5, the acclaimed international economist warned that the US was facing multiple challenges in the years ahead, beyond the immediate crisis in the financial sector. As the Obama Administration oversees a tentative recovery, Professor Stliglitz warned the US faced a “new normal” of higher unemployment, sluggish aggregate demand and significantly lower growth in tax revenues. He believes another round of stimulus spending is essential.

Of wider fears that volatile global capital markets will eventually spurn a US unable to bring under control its spiralling government deficits and public debt, Professor Stiglitz cautioned that the more pressing concern was the fate of Europe, where the average public debt-to-GDP ratio exceeded 60 per cent: “I don’t think Greece is going to be the country that will bring down the euro. Greece is so small. If it is to happen, it will be one of the bigger countries… that will really be the test.”

In delivering the Sir Douglas Copland memorial address, Professor Stiglitz provided a comprehensive analysis of the global financial crisis and its ongoing implications. The Copland Memorial Address is in honour of CEDA’s founder, Sir Douglas Copland, and was reinstated to commemorate CEDA’s 50th anniversary, and to recognise Copland’s significant contributions to Australian economic life. Attended by more than 300 prominent leaders of business and academia, the CEDA dinner was co-hosted by the NSW branch of the Economic Society of Australia.

We should have seen it coming

Professor Stiglitz is renowned for his searing critique of the failures of America’s financial market regulators in responding to the sub-prime mortgages crisis – in particular, by tolerating over-geared and non-transparent housing and derivatives finance. “This is not 20/20 hindsight. It was very clear at the time that this was not a good way to allocate the world’s scarce capital,” he said.

“There are important lessons for the financial markets that got us into this mess. What we’ve seen in the last 15 years is a long-term capital management debacle, one that has threatened to bring down the whole global financial system.”

Professor Stiglitz took his audience back to 1998, and the multi-billion dollar failure by the US-based hedge fund, Long Term Capital Management (LTCM), which he argued carried the seeds of the crisis to come a decade later. Despite a taxpayer bailout, policy-makers at that time had adopted a reckless approach which, in effect, ensured “the regulators never regulated derivatives.”

“We didn’t learn the lesson. In fact, we did the opposite. So all of the losses suffered in this crisis are in fact not a new lesson. They are old lessons we have to relearn,” Professor Stiglitz said.

Professor Stiglitz said there were many factors contributing to the meltdown: “There is no single factor. If only one or two things had gone wrong, we might not have had this downturn. But many things went wrong simultaneously.”

This is proof, according to Professor Stiglitz, that markets are not always stable and efficient.

One of the pre-conditions for the financial crisis was an abundance of cheap capital in the US, in part because of the policy of historically low interest rates adopted by the Federal Reserve since the burst of the tech-bubble, and compounded by the increasing investment by China in US Treasury bonds.

“Cheap capital could have been used as a basis for investment that would have led to sustained prosperity,” Professor Stiglitz said. “We in the US had the strongest financial markets in the world and we are supposed to allocate capital to the highest-value use and to manage it well.

“But they didn’t manage risk – they created risk. They created new products which amplified risk…. this is not how an efficient market behaves.”

Professor Stiglitz said the abuse highlighted by the collapse of the sub-prime mortgages market and the worldwide spread of the damage through trading in derivatives had demonstrated the existence of what he described as a “global marketplace of fools…. and the banks were very good at finding those fools wherever they were. Europe bought 40 per cent of our toxic mortgages.”

In part, Professor Stiglitz blamed greed:”You should try to make sure that gambling is undertaken only by those who ought to be gambling. The pursuit of self-interest by some American financial institutions has not led to the well-being of global society… it has led to weakness in the global economy of an enormous magnitude.”

And hubris: “We thought we were so much smarter. We were living in the New Economy. We were so much smarter than those who came before. We would never lead ourselves into a bubble.”

Gambling with other people’s money

Other factors included the evolution of financial institutions to a point of separation between ownership and control, where the consequences of poor decisions and risk-taking could be offloaded onto third parties, including the cost to taxpayers of bailouts. “The reason we try to regulate banks is because if they falter, it has consequences beyond the banks,” he said.

Pointing to other weaknesses in financial markets, Professor Stiglitz drew a contrast between the system of incentives in the banks in Australia as compared to the US and Europe. “In Australia, these issues have been dealt with better than most other countries… not that they are perfect. But you do not want incentives designed to reward short-sighted behaviour and unnecessary risk-taking.”

Singling out stock options, he said the aim was to reward performance where, for example, executives came up with good ideas to manage the company better, thereby delivering higher returns. “But that’s hard. What’s the other way? Knowledge in creative accounting. You move a lot of the risk off your balance sheet, and it makes your books look much better.”

Professor Stiglitz complained that the complex financial instruments used to achieve these outcomes had been hyped as proving the “innovation” of America’s financial sector: “It was Paul Volcker, the former chairman of the Fed, who said he could not think of a single innovation by America’s financial markets that had led to an increase in productivity for America’s economy. Except for the ATM. But he was wrong there, because the ATM was an innovation by the UK, not out of America.”

The painful path to recovery

Professor Stiglitz said plotting a path to global recovery was proving almost as confronting and challenging as the initial crisis itself. “For most countries, monetary policy has reached its limits. If you get down to interest rates of zero, there is very little you can do to stimulate the economy,” he said.

He is critical of the decision by the Federal Reserve in the US to take its intervention a step further, in a way that could eventually come at a serious cost to taxpayers. “The Fed has bought $1.2 trillion in mortgages as part of its huge bailout of the banks…. when interest rates go up, the value of these mortgages will go down and the financial loss to taxpayers will be very considerable.”

Professor Stiglitz said the US economy had been left suffering multiple afflictions, notably an ailing financial sector and sluggish aggregate demand. “We went into the crisis in a very bad position.”

As he explains it, the key contributing factors go back to 2001, and the strategy to steady the American economy in the aftermath of September 11 and the burst of the dot.com bubble.

“Our deficits were increasing, we decided to have another tax cut, and we had a war, a $3 trillion war, and we paid for the war totally on the credit card,” he said. “That’s an illustration of a political system with a problem.”

Policy paralysis in the US

Partisan posturing in the US Congress also worked against sound economic policy outcomes. “Unfortunately, for reasons that are more in realm of political science than economics, something has happened in the political discourse in the last decade that’s made it much more difficult to get bipartisanship on important issues. It’s also the case that the influence of ’special interests’ in the political process has increased…. there are five lobbyists for every congressman.”

Professor Stiglitz said it remained entirely possible to bring the US deficit under control without serious adverse effects on living standards. The US was spending 23 per cent of GDP on its health care system “and getting outcomes worse than countries like France, which spend half as much…. the fact we are so inefficient in this area means we can be more efficient.”

Moreover, he added, the Pentagon was spending $100m a day on “weapons that don’t work against enemies that don’t exist….that we spend so much on the military means we should be able to have more security and yet spend much less money.”

But the politics of hauling back the deficit would be difficult. “One view is we will wait until the last minute, that it’s a game of brinksmanship. But the danger of brinksmanship is that sometimes you go over the brink. I think it’s going to be very difficult to get the compromises you are going to need to deal with that budget deficit.”

Inevitably, the rising US federal debt raises fears that investors might lose confidence in the capacity of the US government to manage its budget, and to make its repayments. An abrupt loss of confidence in global capital markets could see interest rates on US government debt rise sharply, if creditors were to send a message to policymakers in Washington DC that “enough is enough”.

Asked to comment on this scenario, Professor Stiglitz said: “It could happen at any moment but I won’t want to call it. There is a view that it’s unsustainable, that the US is in financial crisis, and that confidence in the dollar would erode.”

Stiglitz cited the mounting unfunded liabilities of US governments. One state alone had unfunded public pension liabilities in excess of $100bn: “We are talking about significant problems in various parts of the US.” Moreover, rehabilitation and disability payments for veterans returning from the Afghanistan and Iraq wars could run as high as $500bn.

The debt crisis

The US debt-to-GDP ratio was well below that of Japan, which was no longer able to finance its debt through domestic savings. America, too, was at the mercy of volatile sentiment in global capital markets: “Today, we have investors who are totally uncommitted to America, who are global in their perceptions. They will be asking where is the safest place for their money. Maybe that’s Australia.”

Yet, as Stiglitz pointed out, a dollar crisis would not be a first for the world’s largest economy. He recalled the upheaval of the early 1970s, when America struggled with the costs and debt burden of the Vietnam War. “People lost confidence in the dollar, and that was when the US went off the dollar standard, and the Bretton Woods system fell apart. That is the historical context for us because it could happen very quickly.”

However, he warned that he was more worried at present by the potential repercussions of the debt crisis in Europe. “It’s really being held up by Germany right now. The low exchange rate (of the euro) helps exports, and Germany is quite happy. But don’t count on this because, at any moment, the focus (of the financial markets) could shift onto Europe’s problems. The average debt-to-GDP ratio in Europe is about 63 per cent. It’s much higher than the US in your catalogue of problems.”

Ultimately, said Professor Stiglitz, averting a double-dip crisis would depend on global, regional and European recovery. “Greece will do well next to some of the other countries if Germany goes well. But what worries me is if Germany and others go into this extreme austerity, and do not do so well.”

Professor Stiglitz said fears of inflation, mounting deficits and debt and the risk of default were driving some governments in Europe to begin heavy cutbacks in stimulus spending. “This is a real source of concern. The moment when we are all Keynesians has passed and, increasingly, we are all Hooverites…”

Austerity measures – or another round of stimulus?

Professor Stiglitz said policies to cut deficits, raise taxes and cut spending after the initial crisis seemed to have passed carried echoes of the approach of Hoover during the Great Depression. While another crisis on that scale may not eventuate, austerity policies did carry the risk of producing “a long, slow Japanese-style malaise with protracted unemployment and all the social and political consequences that may follow that.”

According to Professor Stiglitz, the critical and over-riding priority should be to build greater strength into global aggregate demand. For the US economy, he strongly advocates another stimulus spend.

“The stimulus package did work,” he said. “The problem was it wasn’t well designed in the way the Australian stimulus was well-designed. Without a stimulus in the US, unemployment would be something between 12-13 per cent.

“Obama thought what was needed was $1.2 trillion over two years. What he got was a little less than $800bn and a lot of that was tax cuts which did not get spent. With the overhang of debt, people didn’t go out and spend money. The nature of stimulus is that people have to spend it.”

Another complication was that fiscal policy settings adopted by the states and local governments during the peak of crisis were working at cross-purposes: “While the federal government was increasing spending by about $800bn, the states and localities were reducing spending by about $400bn. So the net effect was much smaller than advertised.”

“So a third of it went to things that were not very stimulatory, and the rest of it was not big enough to deal with the magnitude of the problem.”

“What we clearly need at this juncture, I think, is another stimulus.”

Even so, Professor Stiglitz forecasts that recovery for the world’s leading economy will be slow and painful:” The general view among economists now is that, even when we return to ‘normal’, the new normal may involve unemployment of 7-7.5 per cent. That’s going to mean more needs of one kind or another, a weaker economy and less tax revenue. There are multiple problems for the US economy going forward.”

Most global equity markets have now recovered the pullback of mid January to mid February to end the March quarter higher. Fears stemming from sovereign debt issues and Chinese authorities slowing growth have largely been put aside as markets focussed on other factors. We would expect a sustained, but uneven, global recovery in 2010 and beyond with Asia and Australia leading and Europe lagging. Increasingly, a number of central banks have started exiting their earlier policy support measures and are now starting to look to raise their official interest rates. In China, higher reserve provisions have not sufficiently curbed credit growth and higher interest rates and an appreciation of the Yuan will probably be required to prevent a further overheating in its economy.[more...]]]>

Overview

The June 2010 quarter was characterised by resurgent uncertainty in growth prospects for the global economy. That uncertainty has had a large negative impact on global equity markets during the last quarter and continues to overhang them. The uncertainties have centred on the sovereign debt issues in Europe, the strength of the US recovery and a slowing of the economy in China.

In Europe, uncertainty is likely to continue for some time as the extent to which austerity measures currently being introduced in many EU countries, and the UK, drag on demand both in the EU zone and globally. In the US, there are now tentative signs of economic recovery with increasing consumer spending and equipment investment data released in recent weeks. In China, inflation looks to have been contained at around target levels of 3% which would indicate the prospect of a contained slowdown.

In Australia, household spending appears to be slowing with some recent fall back in leading indicators. Recent comments from the Reserve Bank of Australia suggest that interest rates will be on hold at least for the short term, however with unemployment continuing to fall, there is the prospect that any resurgent inflation may need to be contained with harsher monetary policy settings in the future.

Ultimately, the Australian economy’s recovery will depend largely on how the current uncertainties impact world recovery.

Most global equity markets have now recovered the pullback of mid January to mid February to end the March quarter higher. Fears stemming from sovereign debt issues and Chinese authorities slowing growth have largely been put aside as markets focussed on other factors. We would expect a sustained, but uneven, global recovery in 2010 and beyond with Asia and Australia leading and Europe lagging. Increasingly, a number of central banks have started exiting their earlier policy support measures and are now starting to look to raise their official interest rates. In China, higher reserve provisions have not sufficiently curbed credit growth and higher interest rates and an appreciation of the Yuan will probably be required to prevent a further overheating in its economy. [more...]]]>

Overview

Most global equity markets have now recovered the pullback of mid January to mid February to end the March quarter higher. Fears stemming from sovereign debt issues and Chinese authorities slowing growth have largely been put aside as markets focussed on other factors. We would expect a sustained, but uneven, global recovery in 2010 and beyond with Asia and Australia leading and Europe lagging. Increasingly, a number of central banks have started exiting their earlier policy support measures and are now starting to look to raise their official interest rates. In China, higher reserve provisions have not sufficiently curbed credit growth and higher interest rates and an appreciation of the Yuan will probably be required to prevent a further overheating in its economy.

In Australia, the economy continues to grow strongly. Fundamentals are continuing to point upwards and the risks to domestic growth and commodity prices continue to be on the upside. This would suggest that the Australian equity market overall should be well supported by both revenue and earnings growth in the remainder of 2010. Risks however remain and we believe that a level of volatility in markets will continue for some time.

Going forward, sovereign debt issues of European countries, fears of the effects of a moderation of growth in industrial growth in China, are likely to continue to pose risks to the improving global growth outlook.

This 2010 edition of CEDA’s economic and political overview (EPO) introduces CEDA’s 50th year. Looking back, CEDA was an organisation groundbreaking for its day with a mission to undertake ‘objective economic research on national growth’. The EPO publication and the accompanying conferences in all capital cities have a thirty year history – comprising a remarkable catalogue of Australia’s economic and political development. Like its predecessors, this edition gives context and perspective to economic and political events of the previous year and prepares us for events and challenges over the coming year. In 2009, the world suffered the tail end of a financial crisis without precedent and the deepest economic downturn since the Great Depression. Yet the Australian economy showed a remarkable resilience compared to most, with positive GDP growth of about 1 per cent in 2009, compared to a global fall of 1.3%. A favourable starting fiscal position with no debt, stimulus spending, rapid recovery in China and solid prudential oversight of the financial sector allowed Australia to withstand the crisis and emerge in remarkably good shape.[more...]]]>

CEDA Economic and Political Overview 2010 part 2 of 2 pdf

This 2010 edition of CEDA’s economic and political overview (EPO) introduces CEDA’s 50th year. Looking back, CEDA was an organisation groundbreaking for its day with a mission to undertake ‘objective economic research on national growth’. The EPO publication and the accompanying conferences in all capital cities have a thirty year history – comprising a remarkable catalogue of Australia’s economic and political development.
Like its predecessors, this edition gives context and perspective to economic and political events of the previous year and prepares us for events and challenges over the coming year.
In 2009, the world suffered the tail end of a financial crisis without precedent and the deepest economic downturn since the Great Depression. Yet the Australian economy showed a remarkable resilience compared to most, with positive GDP growth of about 1 per cent in 2009, compared to a global fall of 1.3%. A favourable starting fiscal position with no debt, stimulus spending, rapid recovery in China and solid prudential oversight of the financial sector allowed Australia to withstand the crisis and emerge in remarkably good shape.

Fig. 1 Contributions to Growth (World GDP figures).

As the world now moves towards a still tenuous recovery, the 2010 context is different. The worst of the crisis may be over but substantial economic policy challenges lie ahead. In Australia and globally, the past year has been marked by a considerable expansion in the direct involvement of government in the economy. Stimulus spending with seemingly limited cost benefit scrutiny has been the order of the day. Through 2010, adjustments will be needed to fit with improving economic conditions. A disciplined reeling in of expansionary policy settings will become the new order.
2010 also shapes as a politically charged year with a federal election and three state elections in Tasmania, South Australia and Victoria to be held through the year.

Among the many challenges to be grappled with this year, the Australian Government faces difficult choices on climate change policy in the aftermath of the failure that was the Copenhagen Climate Change Summit. Its commitment to reform will be tested in its response to the Henry Australian Taxation Review and decisions on health reform and governance at COAG. Delivery of pro-competitive structures for broadband policy and pricing and institutional reforms in water policy also remain stubbornly on the ‘To Do’ list. Tensions are also growing over the operation of the new Fair Work legislation.
These themes and more are addressed in depth in this volume.
Respected NAB economists, Alan Oster and Ben Westmore, analyse the economic downturn and gradual recovery. Their outlook for 2010 is for the continuation of a ‘moderate and disparate’ upturn in activity over the next few years, with global GDP forecast to grow by 3.2 per cent in 2010 rising to 3.5 per cent in 2011. Weak labour markets and limited scope for any further stimulatory government policy will constrain growth compared to previous economic recoveries. For Australia, they expect GDP growth to rise to 2.75 per cent in 2010 with fragile consumer and business confidence, and household and business deleveraging impeding recovery. They caution that the challenge globally will be winding back stimulus spending once recovery is well entrenched. The Australian government should be looking to scale back government guarantees for wholesale funding and deposits as its international counterparts review their own policies.
Professor Kenneth Wiltshire reviews the Rudd government’s performance along with the Opposition leadership turmoil in 2009. In this election year, Wiltshire interprets the polls and identifies the key 2010 political and policy issues. In his view, the significant looming political events for the year include climate change, reviews on tax and superannuation, border protection, Chinese trade relations, federal spending and the necessity of likely cutbacks. Although another term of Rudd Government is likely, Wiltshire highlights the closeness of the margin. He predicts marginal seats in Queensland and New South Wales will play a major role in determining the election outcome.

Peter Jonson, prominent company director and founder and editor of Henrythornton.com, traces the root causes of the global financial crisis, the warning signals we failed to heed and critiques the policy response to the crisis. He believes the biggest threat to the world economy is instability caused by policy swings and advocates the ‘Goldilocks’ solution to the withdrawal of stimulus spending. Bold tax reform, wise investing and entrepreneurial flair will be required in Australia. His outlook is that of a guarded optimist – Wall Street and Main Street having been given the kind of scare that should encourage responsible behaviour over the next decade or two.

CEDA Research Director, Dr Michael Porter mounts the case for a return to the path of rigorous policy reform that has been effectively endorsed by both sides of politics over the previous 30 years and enabled Australia to successfully withstand recent external economic shocks. In a rebuttal of the Prime Minister’s diagnosis of the ‘failings’ of the ‘neo-liberal economic orthodoxy’, Porter describes labels such as ‘neo-liberal’,’ left’, ‘right’, and ‘conservative’ as concealing rather than revealing substance. It is sound economic governance that counts. The key contribution from government lies in the provision of strong and credible institutions, transparent rule of law and the facilitation of efficient market-based structures and choice. He argues for sectoral extension of that model of accountability and efficiency – reviewing reform needs in telecommunications, broadband, emissions trading, water, health and hospitals and tertiary education. In countries suffering post the GFC, lessons can be learned from the Australian experience regarding what makes for sustained prosperity and the capacity to ride out crises.
In closing the volume, Professor Ian Marsh, CEDA Research Fellow, looks at the thirty year history of CEDA’s EPO publication and the highlights of three remarkable decades. He concludes that, despite globalisation, domestic economics and politics have remained dominant throughout. Broad partisanship on general economic strategies has been a feature. But this is often masked by the incentive structure of adversarial politics. The EPO shines a light on our forecasting abilities – and as Marsh shows, it can often be an uncomfortable one!

On behalf of CEDA, I would like to thank our authors for their contributions to this volume. We appreciate your efforts to help us understand the events of 2009 and anticipate what lies ahead in 2010.
Through the EPO series, regular forums, briefings and research reports and policy perspectives throughout the year, CEDA aims to keep its members well versed and engaged in capturing the opportunities and facing the challenges that lie ahead.