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Behind the market turmoil of the past two weeks

By Saul Eslake - posted Friday, 19 August 2011


Financial markets have been more volatile – and more erratic – over the past two weeks than at any time since the weeks following the collapse of the investment bank Lehman Brothers in September 2008. Markets are of course always more volatile than the things of which they are supposedly ‘leading indicators’ – economic activity, company profits or changes in official interest rates. But the underlying meaning of the upheavals of the past two weeks has been especially difficult to ascertain.

Almost certainly, a key underlying reason for the volatility of the past two weeks has been a major shift in investors’ views about the short-to-medium term outlook for the US economy. That shift was, in turn, prompted largely by the release of the annual revisions to estimates of US national income and expenditure at the end of July, when investors’ attention was diverted by the continuing stand-off over legislation to raise the US Government’s debt ceiling.

It’s perhaps worth explaining that, unlike in Australia where previously published estimates of national income and expenditure (GDP and its components) are revised (sometimes significantly) each quarter, in the United States the Bureau of Economic Analysis (which compiles and publishes the US national accounts) has three goes at estimating GDP and its components for each quarter – in the last few days of each of the three months following the end of that quarter – and then leaves them unrevised until the following July, when it makes whatever revisions it considers necessary to the estimates it has published previously, as well as releasing the first of its three estimates of GDP and its components for the June (or second, as the Americans call it) quarter of the year.

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Sometimes these revisions aren’t particularly important. But this year, they were, in three important respects. First, they indicated that the recession which followed the financial crisis was even deeper than previously reckoned. The Bureau of Economic Analysis now estimates that the US economy contracted by 5.1% between the December quarter of 2007 and the June quarter of 2009 – a full percentage point more than it had previously reported (and almost 2 percentage points more than the recession of the mid-1970s, which prior to this one had been the worst since the 1930s).

Second, these revisions also indicated that the recovery since mid-2009 has been weaker than expected. Instead of growing by 4.9% between the June quarter of 2009 and the March quarter of this year – and in the process regaining the previous peak level of output during the December quarter of 2010 – the Bureau of Economic Analysis now thinks that the US economy grew by 4.6% over this period; and since this was from a lower base than previously reckoned, that means that by the June quarter, the US economy still hadn’t regained the level of output it had on the eve of the recession. Indeed, since the American population has increased by 3.0% since the onset of the recession, the level of per capita GDP is still 3.3% below where it was in the December quarter of 2007. Little wonder, then, that the unemployment rate has only fallen by 1 percentage point since peaking in December 2009, or that the proportion of adult Americans with a job is still more than 5 percentage points below its pre-recession peak, and lower than at any other time in the last 28 years.

Third, the downward revision to the previously published estimates for the March quarter combined with the first estimate for the June quarter suggest that the US economy has slowed almost to ‘stall’ speed, growing at an annual rate of just 0.8% over the first half of this year. And such data as are available for July don’t suggest that the pace of economic growth has picked up any during the current quarter.

That leaves the US economy very vulnerable to any kind of shock. And that, in turn, brings us to more recent events.

Although the ‘deal’ reached between the Administration and Congressional Republicans and Democrats earlier this month falls well short of what will ultimately be required to put America’s public finances back on a sustainable footing, it nonetheless does amount to a tightening of fiscal policy (on top of the quite substantial tightening of fiscal policy that has been going on at the state and local level) at a time when, if anything, the US economy could do with some further fiscal stimulus.

On the other side of the Atlantic, the European authorities have continued to mishandle the ongoing sovereign debt crisis. Indeed the wave of panic selling that began the Thursday night before last (our time) was initially prompted by the European Central Bank’s failure to deliver on hints it had previously given that it would start buying Italian and Spanish government bonds, the interest rates on which had blown out to more than 6% - a level which is widely considered beyond the capacity of the Italian and Spanish Governments to shoulder for very long. By the time the ECB did start buying Italian and Spanish bonds (and succeeded in bringing the yields on them down by more than 1 percentage point), the ‘melt-down’ had begun.

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And it’s not as if growth in Europe has been anything to write home about. Although Germany’s economy is doing well, the economy of the euro area as a whole is still 2.1% smaller than it was immediately ahead of the recession induced by the financial crisis, while the euro area’s unemployment rate has fallen by just 0.3 percentage points from its recession high of 10.2%. 

The risk of a renewed financial crisis along the lines of the last one is pretty remote. US banks are in much better shape than they were in 2007, as are European banks – provided European governments don’t default on the much larger volume of government bonds which European banks now hold. In marked contrast to the darkest days of the financial crisis, which banks hold how much of whose debt is now pretty well known.

Rather, the growing concern is with the risk that the US, or Europe (or both of them) could lapse back into recession – and that if they do, governments and central banks will be powerless to respond. The former can’t do fiscal stimulus – indeed, they’re now all committed to doing the reverse; and the latter can’t cut interest rates. All that central banks can do is ‘quantitative easing’ (popularly described as ‘printing money’) – which may well be good for asset prices, but whose impact on economic activity or unemployment remains highly uncertain. Hence any second recession on either side of the Atlantic could be a much more protracted affair than the most recent one.

Luckily for Australia, the fortunes of the US and Europe don’t matter to us nearly as much as they once did – although another recession in either of them would have ramifications here, not least through the impact of another round of falling share prices on consumer confidence and spending. There’s no compelling reason to believe that China, which matters far more to us than either the US or Europe, is likely to have a ‘hard landing’.

And unlike either the US or Europe, the Australian government and central bank do have the means to respond to any economic downturn that might occur here. The Government can ‘do’ fiscal stimulus again if it needs to (although it might well want to do some of it differently from last time); and the Reserve Bank has plenty of room to cut interest rates if it needs to – although the need for either course of action is a long way from being established yet.

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This article was first published in the business section of The Age on August 17, 2011.



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About the Author

Saul Eslake worked as an economist in the Australian financial markets for 25 years, including as Chief Economist at McIntosh Securities (a stockbroking firm) in the late 1980s, Chief Economist (International) at National Mutual Funds Management in the early 1990s, and as Chief Economist at the Australia & New Zealand Banking Group (ANZ) from 1995 to 2009. Since leaving ANZ in August 2009 Saul has had a part-time role as Director of the Productivity Growth Program at the Grattan Institute, a non-aligned policy ‘think tank’ affiliated with Melbourne University, and more recently also as an Advisor in PricewaterhouseCoopers’ economics practice. The views expressed are his own.

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