No end to gloom until the US fixes its banks

No end to gloom until the US fixes its banks

by Ross Gittins

If you want a handle on developments in the economy this year you need to understand there are two main kinds of recession. The one we're entering is a third kind.

Your classic post-World War II recession is a wage-inflation recession. The economy booms and unemployment falls below the "non-accelerating-inflation rate of unemployment".

In a situation of labour shortages, wages rise excessively thus feeding a wage-price spiral. The authorities become alarmed by the growing inflation pressure and start applying the brakes - raising taxes or, more likely, raising interest rates to discourage borrowing and spending.

Almost inevitably, however, the brakes are accidentally applied too heavily and we get a hard landing, with a large rise in unemployment that takes years to get back down.

This pattern describes the Menzies government's credit-squeeze recession of the early 1960s, the Whitlam government's "short, sharp shock" credit squeeze of the mid-1970s and the Fraser government's early 1980s recession.

The second type of recession is an asset-boom recession. You start with a boom in a market for assets such as shares, residential property or commercial property.

Asset prices go sky-high because the boom is being fed by borrowing. You end up with a bubble - prices that are far higher than is sensible, matched by ever-growing levels of debt owed by households or businesses.

The authorities worry that asset-price inflation will start translating into ordinary, goods-and-services price inflation, so they jack up interest rates.

After a long delay it works. Asset prices stop rising and start falling and the asset boom turns to bust. Eventually a lot of people find themselves with debts that are greater than the value of their assets, or with interest payments on the debt that are too high to manage.

They then embark on a period of "deleveraging" - cutting their spending so they can use any spare income to pay down their debts. If worst comes to worst, they have to sell their asset at a loss just to get their debt down.

When businesses deleverage they cut costs and lay off staff. When households deleverage they just cut their consumption spending.

The trouble with this is that economies are circular: your spending is my income. So when one firm or household cuts its spending, other firms or households end up having to do the same. The negative process feeds on itself and a lot of businesses go bust and workers lose their jobs.

The more that happens, of course, the harder it is to find money to pay off your debts. But the recession keeps going until enough firms or people have ground down their debt to the point where they feel able to resume normal activities.

A good example of this second, balance-sheet (assets versus liabilities) type of recession was our last one, in the early 1990s. Then, it was mainly businesses that had borrowed far more than they should have.

Worse, our Big Four banks found themselves with huge bad debts, having lent far too heavily on projects that were now under water. One or two of them got wobbly.

That recession was long and painful - with unemployment reaching almost 11 per cent - as we waited while the banks and their corporate customers got their balance sheets back in order.

If you see few similarities between our present position and the first type of recession, you're right. Despite the resources boom and the economy travelling close to full employment, wage growth hasn't been excessive - just as it wasn't in the recession of the early '90s.

But if you do see similarities between now and that last recession, right again. The main difference is that whereas last time it was big business and the banks that had balance sheet problems, this time it's households, which borrow far too much as part of our residential property-price bubble.

Our banks aren't in a lot of bother this time and, despite high-profile exceptions, in general our corporate sector isn't highly geared.

Let me get to the point. It would be a mistake to categorise the recession we're entering as just another type II recession. Why? Because so much of our present difficulties stem from overseas, from the global financial crisis. That's what's radically different this time.

In all our past recessions a coinciding world recession has added to our home-grown problems. This time, our economists and politicians wouldn't be nearly as worried as they are were it not for the terrible prospects for the global economy - weakest growth in 60 years - and the US economy in particular.

And the problem with this is on the financial side of the economy. Banks are like the heart of the economy; the many parts of the economic body need a steady flow of blood (credit) if they're to continue functioning normally. If the blood flow stops, they begin to wither and die.

The subprime mortgage debacle that began in August 2007 and the unravelling it precipitated was like the economic body suffering from angina (blocked arteries). Some financial markets stopped functioning properly and business-sustaining credit stopped flowing to parts of the body (non-bank lenders for housing, for instance).

The crisis that arose from the failure of Lehman Brothers in mid-September last year was like a global heart attack. For a while the heart stopped beating, credit stopped flowing and we went perilously close to a global financial collapse that would have wreaked untold destruction on economies around the world.

Fortunately, governments swung into action, guaranteeing their banks' deposits and inter-bank borrowings and propping up any bank that was wobbling.

Point is: that doesn't happen in every recession. In fact, we haven't seen anything so life-threatening since the Depression of the 1930s. That's what's so different this time.

Trouble is, the US banks - the American economy's financial heart - still aren't functioning at even half their normal capacity. They're close to bankruptcy, obsessed by the problems with their own balance sheets, and refusing to do normal business with sound business borrowers.

The obvious answer, as demonstrated by the Swedes in the '90s - temporary nationalisation of most big banks - is one the Americans' hang-ups prevent them from adopting. But the longer they delay, the worse things get.

Punchline: as everyone from the International Monetary Fund to the US Federal Reserve chairman, Ben Bernanke, has warned, until the Americans fix their blocked banking system, no amount of fiscal stimulus or interest-rate cuts will make any difference.

Our economy will remain in trouble until they do.

Ross Gittins is the Herald's Economics Editor.