Fear factor keeps purses shut

W as it only five days ago that the prospects of an interest rate rise were strong, and inflation loomed as the big bogeyman of the Australian economy?

Now, things look very different. Yesterday, about $60 billion was wiped from the sharemarket as the ASX200 plunged more than 4 per cent to a two-year low - its fourth successive day of trading losses. The S&P/ASX200 has now fallen 10.8 per cent in the past two weeks.

For the second time in just three years, Australian investors - including every Australian with a superannuation fund - have been shaken by their vulnerability to panic and terror on global financial markets, and to the economic troubles of nations on the other side of the world.

Fear has taken hold that the debt-laden US - its people struggling to find work, its political system the scorn of the world after the protracted debt ceiling stand-off - is about to return to recession.

And across the Atlantic in Europe, long-running fears about the ability of Greece to repay its debts have spread to the bigger economies of Spain, and especially Italy, with yields for bonds linked to the so-called PIIGS (Portugal, Ireland, Italy, Greece, Spain) rising as fast as sharemarkets dived. Italy, economists say, is too big to fail, and too big to bail out - its debt stands at ?1.6 trillion ($2.14 trillion), or 120 per cent of the country's gross domestic product.

On that measure, it is the third-biggest debt in the world.

This time last weekend, the world was sweating on the debt ceiling negotiations in Washington. But even as Congress was stumbling towards some sort of compromise, economists were mulling over a troubling set of figures released by the US Commerce Department on Saturday.

The figures - revisions to previously released statistics - revealed that not only had the US recession in 2009 been deeper than previously reported, but also that the nation's recovery had been weaker than assumed.

Worst of all, US economic GDP in the first three months of the year had been slashed to just 0.4 per cent - a massive retreat from the previously reported figure of 1.9 per cent. And there was more bad economic news to come during the week.

As Congress finally settled on a deal on Monday to raise the debt ceiling, it was clear that investors had other things on their mind. On Tuesday, Wall Street crumbled. The Dow Jones Industrial Average posted its eighth loss in a row, dropping 2.2 per cent, and Australian shares followed the next day - in a decline that would last all week and would culminate in yesterday's savage rout.

"Are we in a recession, again?" asked analysts at Bank of America Merrill Lynch on Thursday, in a research note that calculated the odds of a US recession at 35 per cent, "about double where we put the odds this spring".

Meanwhile, in Europe, Italy's punchline of a Prime Minister, Silvio Berlusconi, was attempting to call for calm. As yields on 10-year Italian bonds surged to a record high - above 6 per cent - he urged his countrymen and women not to be scared.

Investors expected the European Central Bank to wade in and start buying Spanish and Italian bonds. They were astonished when it didn't - and responded, with shares in Europe on Thursday night falling almost as steeply as on Wall Street.

Yesterday, as Australian shares plunged as much as 4.6 per cent, the Treasurer, Wayne Swan, urged Australians to "never forget" the nation's credentials were among the "strongest in the developed world". As he addressed reporters in a windy street in Brisbane, he hearkened back to the global financial crisis, which Australia managed to survive without sliding into a recession.

"Australia has a proven track record of dealing with global economic uncertainty," he said. "There is just a world of difference between the situation in Australia and the situation in Europe and the United States."

Yet Australia's retail sector is reeling from the high dollar and battered consumer confidence. On Wednesday came news that, in the 12 months to June 30, retail spending grew just 2.6 per cent - the weakest rate of growth in 50 years. On Thursday, yet another venerable clothing brand - Brown Sugar - called in the administrators.

And yesterday, in its keenly awaited statement on monetary policy, the Reserve Bank slashed its forecast for economic growth this year by 1 per cent to 3.25 per cent, and warned inflation would remain above its 2 to 3 per cent target range for the rest of this year.

While it assumed there would be an "orderly resolution" of US and European debt crises, it said there were still "many hard decisions" to be made for the US to get its finances back on track.

So what will happen next week? And the week after that? "We are in a good position," Saul Eslake, economist with Melbourne thinktank the Grattan Institute, says.

Mr Eslake points out that with interest rates at 4.75 per cent, and comparatively low national debt, Australia has more flexibility to stave off recession than its developed peers.

But even if interest rates were to fall, there's no guarantee that would convince people to borrow more. Unemployment stands at just 4.9 per cent. Australians have jobs, yet they are afraid to spend. And this week's events will not convince them otherwise.