Austrade's Chief Economist Tim Harcourt interviews eminent US economist David Hale
(Instead of Frost and Nixon here’s Hale and Harcourt)
12 November 2008
As part of the Australian Export Awards, the Commonwealth Bank and Austrade hosted a road show in October featuring the eminent US economist David Hale and Austrade’s Chief Economist Tim Harcourt.
During the road show, Tim Harcourt undertook a series of interviews with David Hale on his views on the causes of the global financial crisis and its likely impact on Asia and Australia. A key theme throughout the series was the impact of the crisis on the emerging economic superpowers China and India and whether their ties with Australia would make us less immune from a global slowdown in 2009.
Tim Harcourt: David, the commentary of the global financial crisis seems to have gone from the sub-prime to the ridiculous. What’s your take on the causes of the financial meltdown from a US perspective?
David Hale: I think it would be fair to say the turbulence we've seen in the financial markets over the last 4 to 6 weeks is truly unprecedented in all of our lifetimes. I have never seen in my career, and I'm now in my mid 50s, such a profound loss of confidence and distrust as we've seen grip in the financial markets since August.
This was brought on, I think, by the decision of Hank Paulson three weeks ago to let Lehman Brothers go bankrupt. I suspect today he greatly regrets that decision because it led to a series of shocks, rising interbank lending rates, commercial paper markets shutting down, credit spreads widening, it went way beyond what he imagined would happen on the weekend when he let Lehman Brothers go into bankruptcy. But the reality is we've had the crisis, it's been very severe, and now we can see, as a consequence of very dramatic government actions in America, in Europe, Australia a possible way out.
Tim Harcourt: But if it is a US crisis in origin, is it mainly a result of weak financial institutions in the US?
David Hale: Now at the corner of this crisis is the American residential real estate market. America had, over the last seven or eight years, a great property boom. Between 2002 and 2006 real estate prices increased by 70per cent. In the hot markets like California and Florida they doubled and tripled and this helped to spawn a phenomena called sub prime lending. This was mortgage lending for low income people, disadvantaged people, unemployed people and it simply spun out of control because bankers believed that with rising real estate prices you can't make a bad loan. Bankers were also incentivised to make these loans because two and three years ago 70 per cent of the loans they made were securitised. They were turned into collateralised general obligations and sold to banks in Germany and Switzerland, country towns in New South Wales, banks in China, they were sold all over the world. So the banks did not retain the credit risk for these very, very high risk loans.
This also has a cultural dimension to it. America, as a country, has an obsession with home ownership. We have many public policies designed to encourage home ownership. We have unlimited tax allowances on mortgage payments. When people sell their home they have a $500,000 tax free allowance for capital gains. We created two government mortgage banks in the last 60 years to promote home ownership. Their balance sheet today is over $5 trillion and we have something called non recourse mortgages, you don't have that in Australia or practically in any country in the British Commonwealth or in Europe. But with a non recourse mortgage it's easy to default. We have a phenomena called 'jingle mail'. You put your house key in the envelope, you mail it back to the bank and you say goodbye and our banks don't have the power or the authority to pursue your other income and other assets. The result is you can default easily and freely with no immediate penalty. And right now 16 per cent of the American people have negative equity in their homes and if they live in California, Florida or Nevada that negative equity might be equal to 30 per cent or 40 per cent of the value of the mortgage, so the temptation to default is very, very large.
Tim Harcourt: But how has housing market weakness led to such a dramatic global external shock?
David Hale: Here's the arithmetic of the crisis. The IMF produced a report in April estimating that US banks and global banks would lose in the year ahead about $965 billion on American real estate loans. A fortnight ago the IMF amended this report to estimate the losses would be $1.4 trillion. They also reported about half of these loans have already been written off. So we have $700 billion to go. The total equity capital of the US banking industry is $1.3 trillion so these loan losses could potentially wipe out 40 per cent, 50 per cent of US bank capital. Needless to say that would be a major shock to the American financial system and the American economy.
Tim Harcourt: Has the policy response been adequate in your judgement?
David Hale: Over the last couple of months we've had a very, very dramatic policy response to this crisis into this challenge. First the Federal Reserve board has cut our core interest rate from 5.25 per cent 15 months ago down to 1.5 per cent. They went to 2 per cent in April, they did nothing for three or four months because they were worried about commodity inflation, but last week we had a coordinated global interest rate cut in which America, Canada, Great Britain, the European Central Bank, Switzerland and Sweden all cut interest rates by 50 basis points. You led the rate cutting the day before by cutting your rates 100 basis points, far more than the markets expected, and 12 hours after the American and European banks acted, China cut interest rated 27 basis points. So in the space of 72 hours we had eight countries cutting interest rates and had had not been expected in the financial markets only a few days before. So it was a very dramatic policy gesture.
Tim Harcourt: Is the Australian banking system immune because of its differences with the US banking system?
David Hale: We've had a whole series of interventions to rescue banks and to stabilise financial systems and of course in this country two weeks ago the Commonwealth Government announced a program to ensure all bank deposits. You didn't need this policy historically because you only have four or five big banks. You're not like America with 9,000 banks. But because of the crisis, because of fear, the Commonwealth Government felt this would be a way to stabilise the situation and to assure confidence in the banking system.
So we've had, over the last few months, very, very dramatic policy actions everywhere and I do believe they have the potential to stabilise things in the year ahead and indeed this week we've seen a big decline in the interbank lending rate in London, some reductions in credit spreads. The bad news though is this cannot prevent a recession in America and Europe in the year ahead.
Tim Harcourt: In Australia we used to worry about 'the tyranny of distance' in terms of our geographical distance from world markets, now with the rise of Asia and the emerging economies, we talking about 'the power of proximity'. Will Asia save Australian from the worst impacts of the global financial crisis?
David Hale: Because of this region's dependence on global trade we'll feel this downturn as well in East Asia. I think in the ASEAN countries we had growth rates last year of 5 per cent, 6 per cent, 7 per cent, the year ahead will be 3per cent or 4 per cent. This is not catastrophic like the Asian financial crisis 10 years ago when GDP fell by 5 per cent or 10 per cent but it will still be a slow down.
Tim Harcourt: We're all ready seeing a drop in commodity prices in China and the attempt by the Chinese government to stimulate the economy. How will China weather the coming storm?
David Hale: The most important country, of course, for Australia is China and China will have a slow down as well. Export growth will go from 30per cent a few months ago to maybe 5 per cent or 6 per cent next year. China also imposed lending constraints a few months ago on real estate to try and slow down their housing inflation and they have now broken their residential sector. Real estate prices in Guangdong are down 20 per cent. So we are looking at a slowdown in China as well. And the most important number in the world for the Australian economy, one single number to project where this country's going is Chinese industrial production and that number will, in the year ahead, slow from 17 per cent, 18 per cent to 10 per cent and that's why you have seen in recent weeks a big decline in commodity prices in the Australian dollar because with that pressure on Chinese industrial production, that negative correction, China will have much less need for raw material imports than it's had here in recent years when production growth was 17 per cent or 18 per cent.
Tim Harcourt: How does India fare? Will it be different from China?
David Hale: India will also get caught up in this recession. India's manufacturing sector is tiny compared to China's, barely 10per cent of China's output but India has a big software industry. India's developed in the last 10 years probably the most successful dynamic software industry in the world. Its export last year were 42 per cent and the problem is two thirds of these exports go to the United States, one of the biggest consumers is financial services and with America's banking crisis and Wall Street crisis, information technology spending can only decline over the next 12 or 18 months and this will have an adverse effect on India's leading software companies. India will still have a good growth rate but it won't be 9 per cent, it will be more like 7 per cent over the next 12 or 18 months. So the Asian economy is going to slow down but it's not going to be catastrophic. It will be a moderate adjustment.
Tim Harcourt: Australia has been described as a two-speed economy with fast growth in the resource rich states of WA and Queensland and slower growth elsewhere, how with the crisis impact Australia regionally?
David Hale: When I was in Australia last year one of the great concerns was that there could become a two tier Australia, a boom in the west, a boom in Queensland and slow growth if not recession in Melbourne and Sydney. Melbourne and Sydney last year were suffering from high mortgage rates, high inflation rates, they didn't feel they were sharing in the boom in Perth and Brisbane. But now, as a consequence of this global shock, the boom is going to slow down in Perth and Brisbane and the Reserve Bank here is going to slash interest rates dramatically, bringing down mortgage rates in Sydney and Melbourne and in time bringing down the inflation rate as well. So the great benign side effect of this global financial crisis for Australia is to reunify the country. You're not going to have a two tier Australia in the next 12 or 18 months, you're going to have one Australia and you're going to have a broadly similar business cycle throughout this country. So we've had some extraordinary shocks, we will have to live with the consequences of recession in Europe and North America in the year ahead but we will see as well a reunified Australia.
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