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John Quiggin

Win or lose in second half

John Quiggin Australian Financial Review

31 July 2008

As the tragedy in Iraq unfolded after the US invasion in 2003, New York Times columnist Thomas Friedman became notorious for asserting, every six months or so, that ‘the next six months will be crucial’. This habit became such a byword that the term ‘Friedman unit’ was coined to refer to a period of six months, particularly in the context of punditry.

Despite this cautionary example, I’m going to argue that the next six months will indeed be crucial for the US economy, and therefore for the Australian economy as well.

So far, there has been a striking disconnect between the year-old crisis in financial markets and the relatively strong performance of the real economy in the US. The financial sector has written off hundreds of billions of dollars and seen the failure of major firms like Bear Stearns and Indymac.

By contrast, the real economy has barely blinked. Admittedly, the housing sector has contracted sharply, unemployment has risen and growth has slowed. But the downturn so far has not even matched the mild recession that followed the dotcom boom and slump.

In part, this reflects the long lags associated with housing market downturns. Although problems with subprime loans emerged in 2007, it is only now that high levels of foreclosure are taking place, as millions of households with adjustable-rate mortgages face interest rate resets and the prospect of refinancing homes in which they have negative equity.

The second half of 2008 will be the peak period for loan resets. If the economy can get through this period without substantial contraction, a recovery in housing can be expected from 2009 onwards.

While housing is important, it is only part of the economy. The most important fact explaining the limited impact of the financial crisis is that, until recently, it has had little effect on the ordinary business activities of the financial sector. Firms with highly leveraged capital structures have run into difficulties, but major corporations have maintained access to capital markets and credit has continued to flow to small and medium-sized businesses.

The second of these activities, at least, is now under threat. The New York Times recently reported that the volume of commercial loans and commercial paper outstanding has declined over the past year, and that banks are continuing to tighten access to credit. The decline so far has been modest, but in the wake of the collapse of the IndyMac bank, amid scenes of a bank run reminiscent of the 1930s, a severe credit squeeze seems to be under way.

The next six months also mark a crucial political transition. In six months time, the Bush Administration will finally draw to a close, as the new president elected in November, is inaugurated. John McCain’s flagging campaign, already laden with the failures of the Bush Administration, is unlikely to survive any further deterioration in the economy.

On the other hand, an Obama Administration is likely to take office under very challenging circumstances indeed. The downturn has already produced a large cyclical deficit, estimated to reach 3.3 per cent of GDP this year. And the structural fiscal problems ignored or exacerbated by Bush will start to bite over the next eight years, as health costs rise and social security goes into deficit.

Yet, if the economy contracts sharply, the new Administration may well need to expand the deficit further, to finance the bailout of the financial system that is already underway, and to offset a likely contraction in consumer demand. Although the dangers in such a course are obvious, it’s hard to see a politically and economically viable alternative for a newly-elected Administration. The long-term task of restructuring an economy dependent on ever more elaborate forms of debt will have to wait upon the resolution of more immediate problems.

The next six months will also be vital for the Australian economy. For the last year, policymakers have had to weigh the obvious inflationary pressures arising from a long expansion and an export boom against the danger of a sudden contraction driven by problems in financial markets.

The large writedowns annnounced by major banks suggest that it is the second danger that now predominates. This is particularly true of the ANZ, whose losses have arisen from domestic problems rather than from bad investments in the US.

As in the US, Australian households and businesses need to move away from an excessive reliance on debt. The next six months will determine whether this process of deleveraging is comparatively smooth, or painful and chaotic.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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