Wednesday 11 April 2007

Pic of the day: "House bubble" in The Sims 2. The real thing will be less funny, I'm afraid.

Global bubble-bursting

On April 2nd I wrote about the American economy, and the way the government and the populace both have failed to pay their bills as they came in, preferring instead to borrow and look another way. This is not unique to the USA, I'm sorry to say, but it is particularly prevalent there, and the nation has 300 million people and a lot of money passing through it. So whatever happens there is bound to have an effect on the whole world. Shortly after my previous entry I got a question about how I thought this would affect other western countries, including Australia.

This is a hard question to answer, because the countries are different. They have different economic structures, they have made different preparations (if at all) and are likely to react differently to a global recession. For instance, Japan had the property bubble in the 1980es, and suffered a decade of stagnation and rapidly growing national debt afterwards, from which they have just recently emerged. (Did anyone learn from this? Not for long, it seems to me.) Australia and the UK had a property bubble before the US, and managed to get a soft land. But that was during a time of rapid worldwide growth. Will they manage to keep their balance when the shock wave hits?

There are those who are worse off, most notably Spain. The country was poor by European standards when it joined the European Union. It received huge transfers of money from richer member states to build roads, railroads, ports and airports. This giant influx of money would create some inflation, and the central bank would counter this by rising interest rates. But since Spain joined most of the Union in a common European currency, the Euro, they have no central bank anymore. And the European central bank needs to consider not just the boiling economies of Spain and Ireland, but also the large, sluggish economies of Germany and France. So interest rates have stayed low.

Spaniards are not idiots, whatever some disgruntled tourists may tell you. So they didn't drink up all the money. (Well, most of them didn't.) Instead they invested in property. Property is investment, right? It keeps getting more and more valuable, so it is an ideal place to put your money. (No, it isn't. Housing for yourself is a pure expense, unless you plan to sell it at a profit and move to somewhere cheaper. Business property is an investment only if you can rent it out at a profit.) Spain did not have much of an economy to begin with, so much of what industry they have built since then is about construction, directly or indirectly.

Here in Norway we have a saying: "We can all live by cutting each other's hair." But in Spain this is in a sense what has happened: They all live by building each other's houses. OK, not all, but it is a big part of the economy. Think car making in Detroit. That kind of big part. People are employed in the construction industry, invests in the construction industry, and borrow money against their future earnings there to build more houses for themselves, thus employing more people like themselves. You can imagine that if this ever grinds to a halt (and it has already begun to make loud grinding noises) the dominoes will fall. People who lose their jobs in the construction industry will not be able to pay their loans on time. The banks will not be able to lend more money when they don't get the payments (besides, they will panic, if history tells us anything). Businesses unable to borrow will go bankrupt. Their workers will lose their jobs and not be able to pay their loans. Repeat from start.

On the other hand, you have my native Norway. We also have a frothy property market lately, but the government has tucked away a huge amount of money during the fat years. When the lean years come, at least the government will be able to continue running without raising taxes at the worst possible time. I believe Alaska has something similar. Most countries and states don't, though.

***

Now let us look at the most likely scenario for the US economy: A benign devaluation. In this case, the dollar slides rapidly but not out of all control. American exports become cheaper in other countries, while imports become more expensive to Americans. This favors their export industry and their local industry competing with foreign import. These competitive benefits help cushion the economic blow from collapsing the property bubble. (Of course, if this happens in many other countries too, there won't be any soft cushion, but most are not as overheated as the USA.) On the other hand, prices will go up, from expensive import and because local industry tends to become less efficient when not squeezed by competition. Rising prices will cause rising interest rates. This will further sink property prices and consumption, until some kind of compromise is reached between the two forces.

In this scenario, other nations will notice three distinct effects: 1) Export to the USA will take a hit. It may not even be profitable anymore. 2) American goods and services are suddenly growing cheap and eating into markets where they used to not be. 3) Interest rates are higher, or credit is harder to get. (Depending on how your central bank reacts to the American rise in interest rates.) All other things being equal, you should see higher unemployment and higher interest rates.

Unemployment tends to vary with different sectors of the economy: If you work for the government, you will likely not notice any difference. If you work in "cyclic" businesses, those that vary with the economic climate (fashion, luxury goods, travel, construction...) there will be insomnia and biting of nails. Somewhere in between and you may still keep your job, but pay rise will be a thing of the past for a while.

Unemployment and high interest rates both make it hard to buy homes. This will correct itself over time, as the real price of housing will fall. People hate to sell at a loss, most notably nobody wants to sell for less than their loans on the house! You would no longer have the house but still have the debt. People will try almost anything rather than that. They will fail to pay their loans, or only pay parts of them, but the banks will hesitate to auction the house since they too would not be able to get the full amount of the loan. So people sit tight hoping for better times. This is where inflation comes in handy: With it, the real price will eventually come down because the inflation catches up, not because the nominal price goes down.

So if you are planning to buy a home, you may find that there is a period of some years where you will not be able to afford it. The loans are just too expensive and hard to get, and the prices are just too high compared to the cost of ownership. But this is temporary. Hopefully you have somewhere else to live in the meantime, or can make do with a really small place.

It is not the end of the world, after all. It is just the end of an era. There is still enormous potential for growth in much of Asia and those developing countries that are not in a state of war or civil war. With or without America, this growth is likely to continue unless politicians panic. (Always a big if.) With so much of the world being peaceful, democratic and at least partially developed, it seems likely that the global economy will bounce back eventually. But it could take precious years of our lives to wait it out. How much better it would have been to prevent it in the first case!