A recession is coming, but don't blame debt

Commentators with negative views about the state of the economy have homed in on Australia's record-high debt levels. In fact, the cause of the next recession will be a little more traditional.

Yesterday’s GDP numbers confirm that the Australian economy is in excellent shape. Indeed the figures show that once again, the nation’s economy is growing comfortably above trend -- as it has done consistently for these past three years. Importantly, economic growth is well above where the Reserve Bank of Australia thought the economy would be earlier in the year. So far so good.

Now that hasn't stopped the usual negative commentary on the economy, which revolves around the notion that growth has slowed sharply or it showed our standard of living falling etc. This is fiction (Shifting gears: Is Australia going backwards or forwards? August 22). It must be viewed in the broader context of commentary these past five years. Many Australian commentators and economists have spent the best part of that time anticipating recession -- or some form of crisis. Seemingly even craving it.

Much of that analysis is based on the view that debt is at records levels, and the premise this is a grave danger to the country going forward. I dealt with this view in my piece (Why Garnaut is wrong about Australia's debt challenge, July 22). It’s not that I disagree that debt is high. It clearly is in some respects. Yet that by itself is not sufficient to cause a recession. Debt was at records a decade ago too -- for the times -- and of course as we know, that didn’t cause a recession. Debt can’t cause recessions.

In modern economics debt simply works as a defining parameter -- in the sense that monetary policy, instead of controlling debt, ends up controlled by it. This isn’t by policy design but it is what ends up happening. Policy is shaped by it and central banks work actively to accommodate whatever the existing level of debt is. They have too.

Consider that in any given downturn, a central bank cuts rates in an attempt to boost spending, get credit flowing and avert or alleviate recession, to promote growth. The higher the level of debt, the lower rates must go to get the process moving. But as confidence returns and credit flows again debt levels rise. This is the usual transmission mechanism. However as time goes on, in each cycle, what you tend to find is that as these debt levels rise, we get ever small peaks in rates and ever lower troughs.

Recession is coming though, this I don’t doubt. But if it’s not going to be caused by debt, then what? The slump in the terms of trade is often thrown up as another candidate, but this too is not probable.

Remember the terms of trade is not a real economic variable -- it’s only an indicator variable for the demand for Australian exports and moves in national income. Usually if the terms of trade slumps, then that means the demand for our exports is weak and national income will fall. Right now that isn’t the case.

The terms of trade is falling, yet demand for our goods is strong, and rising. It’s giving false signals. More to the point, a fall in the terms of trade has never caused a recession or downturn. Sure, it’s been associated or correlated with them, but it’s never caused them.

That really only leaves two main domestic candidates for the next recession, baring some external shock.

1.       Financial instability or;

2.       Inflation.

The choice that policymakers have made to keep rates at ultra-low levels -- on a permanent basis -- virtually ensures one or the other or both. It will exacerbate the hunt for yield and increase appetite for risky investments. This is happening in real time. That will and is encouraging a misallocation of resources and there are only two outcomes from this: financial instability as bubbles eventually deflate -- and/or inflation. Even attempting to treat the second will probably cause the first.

This is what we saw in the lead up to the GFC, and markets can panic. Economic systems can panic and unfortunately, financial instability and inflation often go hand in hand. Indeed, the fact is, in modern economic times, pretty much every recession has been caused by inflation.

So don’t go looking for debt or the terms of trade to cause our next downturn. They can’t and won’t. The cause will be a little more traditional, and on the current policy trajectory, it is guaranteed. 

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