After our Economic Dunkirk

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The last quar­ter’s GDP fig­ures, show­ing that Aus­trali­a’s GDP con­tract­ed by 0.5% in the last quar­ter, end­ed the “pho­ny war” debate over whether we’re in reces­sion. The pre­vi­ous quar­ter’s 0.1% was so close to zero that it’s seman­tics to ques­tion whether we’ve seen six months of neg­a­tive growth or not: we are in a reces­sion.

Now that we’ve had our Dunkirk moment, it’s time to con­sid­er what pol­i­cy should be, giv­en that avoid­ing a reces­sion is no longer an option.

A first step there is see­ing why we recov­ered from pre­vi­ous reces­sions, and ask­ing whether we can pull off the same trick again this time.

My answers are that our escape route from pre­vi­ous down­turns was to renew the pri­vate lend­ing engine, and that this is a trick that is one reces­sion past its use-by date.

The 1990s reces­sion saw pri­vate debt to GDP ratio top out at 85% in late 1990, and then fall to 76% by ear­ly 1994. From then it took off once more, with house­holds tak­ing over the bor­row­ing binge man­tle from busi­ness, which actu­al­ly reduced its debt lev­el from 56% of GDP to 40% in mid-1995. The house­hold debt binge, which began in 1991 in the depths of Keat­ing’ reces­sion, took the house­hold debt to GDP ratio from 30% to a peak of 99%, from which it is now falling.

Mean­while, busi­ness bor­row­ing like­wise began a Chi­na and Pri­vate Equi­ty fuelled blowout in mid-2004, ris­ing rapid­ly from 46% of GDP to 66%–a new record–by ear­ly 2008. The com­bined debt total reached 165% of GDP in March 2008, and it has since fall­en to 160%.

So what are the odds of encour­ag­ing busi­ness­es or house­hold to start bor­row­ing again, from their now record lev­els of debt?

Not good, I would think. Instead, they will be de-lever­ag­ing, not just for the dura­tion of a stan­dard reces­sion but per­haps for a decade or more, to bring debt lev­els back to some­thing like 1960–70 lev­els of 25–50% of GDP. Delever­ag­ing has only just begun, and it has a long, long way to go.

So we can’t encour­age busi­ness­es to bor­row, or house­holds. Who else does that leave?

And the bin­go award goes to Kevin Rudd: gov­ern­ment can get into debt instead. That is what is now hap­pen­ing of course, and from a posi­tion in which the gov­ern­men­t’s debt to GDP ratio is cur­rent­ly close to zero. So it has capac­i­ty to bor­row and thus boost demand, but how does that weigh up against what the pri­vate sec­tor might do in the oppo­site direc­tion?

Not well. Rud­d’s stim­u­lus is a whop­ping $42 billion–a big num­ber. But our pri­vate debt is now over $2 tril­lion. If the pri­vate sec­tor de-levers by as lit­tle as 5% of its cur­rent debt lev­el, that will with­draw $100 bil­lion from spend­ing. In the new eco­nom­ic Rock vs Scis­sors game, Delever­ag­ing trumps Gov­ern­ment Stim­u­lus every time.

This is why Japan is still mired in a Depres­sion, 19 years after its bub­ble econ­o­my burst. You can’t solve a prob­lem caused by too much debt by going into more debt. Ulti­mate­ly, the only solu­tion is to reduce debt.

There Aus­tralia is in a quandary. We don’t yet have insol­vent banks–the USA on the oth­er hand has noth­ing else. So dras­tic means of attack­ing the prob­lem are pos­si­ble in Amer­i­ca, once the Yan­kees get over their usu­al pussy-foot­ing about nation­al­i­sa­tion. But we can’t fol­low that path while it still appears that our banks are sol­vent.

So all we can do is brace our­selves for a mas­sive increase in unem­ploy­ment, and do what we can to ame­lio­rate the pain. Sev­er­al poli­cies are obvi­ous there: remove the wait­ing peri­od for receiv­ing the dole, elim­i­nate (or dras­ti­cal­ly prune) the require­ments that unem­ployed per­sons exhaust their sav­ings before they receive the dole, get rid of the puni­tive job appli­ca­tion require­ments, and take the stig­ma away from being a vic­tim of a glob­al finan­cial cri­sis that is well beyond the con­trol of those whose jobs will be destroyed by it.

That will neces­si­tate a mas­sive increase in the gov­ern­ment deficit, but that is jus­ti­fied in mak­ing sure that the pain of a Depres­sion is shared more equi­tably. It is also a far more sen­si­ble way of going into deficit than throw­ing a fist­ful of mon­ey at soon to be unem­ployed con­sumers.

We can also change the rules on mort­gage defaults, so that a failed bor­row­er becomes a renter from the bank or lender that extend­ed the mon­ey, and pays a rent based on a pro­por­tion of their income. That might mean a lot less rev­enue for banks, but it will also mean a lot less mort­gagee sales–and there will be a tsuna­mi of those com­ing our way if the econ­o­my con­tin­ues to shrink by 0.5% or more every quar­ter.

On that front, the most recent fig­ure was a drop in the buck­et com­pared to what we’ve already seen over­seas, and what we are like­ly to see here as delever­ag­ing reduces debt-financed spend­ing, our terms of trade col­lapse, and our export voumes plum­met. It seems that the days of Kan­ga­roo Economics–“We won’t suf­fer a reces­sion because we have marsupials”–are over. Bye Bye, Boom Boom.