Why the Aussie Economy is the US Economy Circa 2006

Waving United States of America and Australian flags on the background of the political map of the world

Jeez, that was an ugly day yesterday, wasn’t it?

The benchmark index, the ASX 200, lost 2% and closed below 5,000 points for the first time since mid-2013. It was ugly across the board. The big miners were hammered. The banks all fell hard too.

In an ominous sign, Australia’s largest company, the Commonwealth Bank [ASX:CBA], closed at a new low yesterday. Given it’s the leader of the banking sector, I would expect the other banks to follow in the coming days or weeks and make new lows too.

The market started off on the wrong foot thanks to weakness in the US. But then it got worse. Data on China’s manufacturing sector showed the weakest reading since the dark days of March 2009.

Just prior to that release, China’s President Xi Jingping made a series of speeches in the US. His words pointed to a determination to continue China’s reform process. That means no more major stimulus measures, which is bad news for Australia’s economy.

This is why BHP Billiton [ASX:BHP] fell nearly 4.5% to a new low yesterday. It’s now at the lowest point since 2008.

It’s obvious why problems in China cause the miners’ share price to fall. But it might not be so obvious why the banks are in trouble.

Well, there are a number of reasons. For the past few years the RBA’s interest rate cuts have insulated the banks from the China slowdown. Ironically, China’s slowing economy set off a housing construction and price boom here in Australia. This caused an increase in the demand for credit and banks were the main beneficiaries.

But the boom got out of control. Investors lost their heads. Belatedly, the banking regulator tried to curb unsound lending practices. That’s starting to bite now. At the same time, the construction boom is slowing, meaning reduced demand for finance of new dwellings…which weighs on banks.

Lastly, both the Aussie and Chinese governments are trying to stop the illegal inflow of capital into the Aussie housing sector. How successful such efforts will be remain to be seen.

But the point is, there are a lot of factors combining to provide headwinds for the banks. In short, households look like they have finally lost their appetite to leverage the (dwindling) gains from the mining boom on Australian property.

That’s what falling bank share prices tell you anyway. They’re saying that the east coast property boom is finally running out of puff.

Which brings me to my next point. We had a mining boom that the RBA deliberately replaced with a housing boom. And now what?

Let me remind you of the advice economic luminaries in the US provided back in 2002. The internet bubble bust caused a mild recession and at the time, there were major concerns about a ‘double-dip’.

Of course, the Fed simply had to ‘do something’. In came the advice. This is from Paul Krugman in 2002, writing in the New York Times (my emphasis):

To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

Gee, how did this little piece of insanity work out?

Not good, to put it mildly.

Yet Australia just followed a similar path. The mining boom ended, and we needed something to replace it. So the RBA set off a low interest rate induced housing boom. It’s great while it lasts…

But now it’s ending, and no one knows what the fallout will be like. But you can be sure that everyone in a position of power and influence will tell you not to worry and that everything will be ok.

Maybe they’ll be right. But no one really knows.

The good news is that our politicians are talking sense for the first time in a long time. They know they need to make some hard decisions and some tough reforms.

From the Financial Review:

New Treasurer Scott Morrison will ditch all international commitments and dedicate himself towards convincing ordinary people of the need for tax reform, which will include incentives to encourage retirees to unlock and spend the billions of dollars locked up in their homes and other assets.

In an interview with The Australian Financial Review, Mr Morrison indicated the government under Tony Abbott had failed to explain to voters why changes to the tax system were needed. He said the reform cause now needed retail politics not another expert tax report.

Talking the talk is one thing, walking the walk is another. In reference to retirees unlocking the capital in their homes, all I can say is, good luck.

The new Liberal government has obviously identified future spending increases on the age pension as unsustainable. They want to bring the family home into the age pension assets test. This would probably involve more retirees using their housing equity to fund their retirement, rather than relying on taxpayers.

While this is a sensible reform, it is also risky. It will take much political skill and leadership to convince the electorate that such reforms are necessary.

Sadly, I’m not convinced. As I’ve said all along, the majority of the people won’t be convinced that Australia faces a crisis until it’s too late. And we are running out of time.


Greg Canavan
Editor, The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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