tuvalahiti listening station

Grace – it is said – refers to a Single State only – whereas Sin refers to a multitude.  Good Lending – like a State of Grace – is hard to maintain – but easy (and dull) to analyze if maintained.  But – at the moment – I am studying US regional banks who are – to extend the analogy – no longer in a State of Grace.

Bad Lending however – like Sin – comes in many forms.  There were bad mortgage loans with nothing down, no proof of income, no proof of assets and brokers incented to fraud.  And there were milder Sins (with much lower loss rates).  With commercial lending there were also a multitude of Sins – from lending to real-estate subdivisions in the desert (in towns with no market for the end product) to a commercial loan to a auto-mechanic to own their property.  The desert housing development loans will probably default and average severity on such loans is above sixty percent.  The auto-mechanic is probably underwater on the loan – but may have a personal guarantee and will not default even if they went delinquent as the economy soured. 

Most bloggers are righteous people – and they bang-on about the fall from Grace.  Get over it – we are not Virgins any more.  What I am trying to compile – and I want my readers to help – is a Morphology of the Sin of bad commercial real estate lending.  So I am begging for comment: I would like feedback on the state of debauchery in various markets.  Some things I am observing are surprising me.  Desert state vacant housing lot loans are – unsurprisingly – still a bust.  But much to my surprise some Midwest banks have reported that they can now sell (for non-trivial money) vacant housing land from their real-estate-owned inventory.  In that lies some redemption.

So consider this a request for recent anecdotes – by region and by commercial real estate class.  Like some good Minister I want to understand your Sin...

In the financial crisis governments seemingly regularly guaranteed their banks to stop their banks from collapse. This worked in preventing mass bank collapse and a consequent Great-Depression-Event. But it transferred the risks to government. Since then yield on bank debt has tended to converge with yield on the domestic sovereign. And the financial crisis has morphed into a sovereign debt crisis.

The crisis-of-the-moment is Greece. Greece runs a fiscal deficit which is a low teens percentage of GDP (a couple of points worse than America) but unlike America it does not control its printing press* (Greece uses the Euro) and (believe it or not) its political system looks more dysfunctional than the US.

I do not want to blog about Greece. I blogged about the issues with Spain and the issues are the similar. It is just that Greece was first to the breaking point.

This post is not about short term sovereign solvency. Short term a sovereign is insolvent when it can't find anyone to lend to it and it is seemingly impossible to pick the moment of panic. People have talked about Portugal, Italy, Greece and Spain (the so-called PIGS) being insolvent for many years. It is not as if the collapse of one was unlikely. [I thought it would be Spain first – but hey – I was wrong...] Today people add Ireland to the list (since it guaranteed huge banks) and talk about the PiiGS. If you picked that it would be Greece first and that it would be 2010 that the crisis happened then you are better a the short term stuff than me. (Italy always struck me as a marginal member of the PIGS but I could be wrong about that too.)

This is a post about long term solvency – the things that we do now that determine whether we have an economic crisis in twenty or thirty years. In that sense this is a post about Australia, the US, New Zealand, Canada and Japan and possibly even China. The PIGS have rolled their dice. Most the rest of us are still shaking the dice in the tumbler.

I will start with the Australian Treasury Intergenerational Report – a report required of the Australian Treasury every five years. Whilst the projections (including economic growth projections for forty years) are to be taken with a grain of salt the basic tradeoffs are the ones detailed in the report. Let me summarize quickly:

Australia – like much of the developed world – has a demographic problem from aging baby boomers. Our dependency ration (the ratio of people of non-working age to working age) is increasing and likely to increase dramatically. Moreover the dependent group will shift from young people (who impose schooling expense) to old people who impose nursing home and medical expense. Old people generally cost more than young people and as we live in a country with (semi) socialised medicine that expense is likely to fall (heavily) on the Federal Budget.

Australia's national budget will thus become a little tighter each year. [This is in contrast to the glory days of the 70s and 80s where economic growth and baby boomers going through their years of peak productivity made the budget just a little easier to balance every year.]

The net effect is that something has to give. Either

(a) Australia cuts benefits to old people (and with socialized medicine that means deciding when you turn the respirator off) or

(b) Australia sharply increases taxes or

(c) Australia sharply change the mix of our population by having more babies or importing more people through immigration.

Some smaller things can work at the margin. For instance Australia can change ages at which people qualify for various pensions. This should keep old people in the workforce longer and hence reduce the dependency ratio. Also – as the working age population become the scarce factor wage levels for those still working should rise. The higher wages will attract some older people back into or into staying in the workforce. However these are effects are likely to be too small to overwhelm the main thesis.

With a good size baby boom and old people driving government expenditure (something that is certainly the case in the US) the problem is real and will remain intense.

The problem could be solved with very rapid economic growth – but the Australian Treasury models a quite high real rate of growth and Australia still has a problem. If economic growth were to decline to Japanese levels the fiscal imbalance by (say) 2030 would become very intense. [Australia could get very lucky with sharp increases in commodity prices. That sort of luck is possible because Australia is small – however that sort of luck will not bail out the US.]

By far the easiest solution is (c) - changing the mix of the population. Societies are not good at rationing health care expenditure for the elderly and there are limits to the ability of smaller open economies (such as Australia) to keep increasing taxes. [Though in my view a little of both these things will happen.]

Everyone that matters in Australia knows that the easiest solution is (c). Peter Costello – Australia's last Treasury (in the US context read Secretary of the Treasury) knew this and advocated women having three children – one for mum, one for dad and one for the country. **

Costello had his eye on the future fiscal balance (as he should) but there is an undertone of racism in his pronouncement. Australia's population is a matter of choice because there is an endless supply of skilled and/or needy immigrants who want to live in Australia and the main case for having babies over importing people is that the babies are probably white.

Anyway the core way that Australia is balancing the long term budget is through immigration. If you want to solve the problem that way you need very large immigration now so that in 30 years the you get the right dependency ratio. That – for better or for worse – is what the government is currently doing. Australia's immigration rate is massive – roughly 1 percent of the population per year. That level of immigration will have Australia on the path to a 50 million population (currently 21 million) by the year 2050. Australia will – in resource use and population over fertile areas – look about as crowded as the US.

Obviously if Australia chooses to go the high population path (and there seems little doubt that Government is adopting that path) then environmental pressures (of almost all kinds) will increase sharply. The Report focuses on greenhouse gas pressures (population growth will make it harder for Australia to meet any given emissions target) however it could focus on almost any environmental amenity. Dr Henry (the Secretary of the Treasury) is known to be personally in favor of rationing Australia's limited water with pricing – but also said to be in favor of replacing petrol taxes with congestion taxes on Australia's (and particularly Sydney's) overcrowded roads. Whatever – the high population path will increase pressure on Sydney – a city that is becoming famously dysfunctional with poor public transport and congested road systems.

By going the high-population route Australia replaces intergenerational financial pressure with a litany of environmental and resource use problems.

But by going the high population route the government can remain solvent even with the baby boom. The government is currently running too high a deficit – but most of that is temporary. And the longer run seems to work (albeit with environmental costs described).

The same position sort of applies to the US. Medicare (the US version of single-payer socialized medicine) ensures that an aging population will put enormous stress on government finances. (Whereas US Social Security funds are nearly solvent the Medicare equivalent is unambiguously bankrupt.) However with enough economic growth and some population growth the US will get through. The starting budget position in the US is considerably worse than (say) Australia – but it is only really worse by the cost of the Bush tax cuts, the excess Bush-and-terrorism induced military expenditure and maybe one smaller tax hike. None of those would be hard to achieve with a functional political system (though it is becoming increasingly hard to argue that the US has a functional political system)...***

On the plus side, the US – more than almost any other country – has the sort of economic system that might produce the innovation-led economic growth that would help solve the problem. Australia could luck into a solution (through commodity prices). But the US has – I think – a higher background level of innovation. Not enough to solve the problem entirely – but probably enough that the current level of immigration is almost enough. Things have to give – but with functional politics solutions could be found.

On the minus side – the US with a much larger population than Australia – would require many more immigrants to adopt the population growth solution. Also the US seems very poor at pricing and protecting environmental amenity – and that is in my view a key part of the population growth solution.

New Zealand – a country where I used to be a senior Treasury official – is alas long run insolvent by any count. Its population doesn't grow much even with immigration – and net migration has resulted in sharp negative productivity per head of population as skilled workers tend to move (to Australia) and unskilled workers are imported. The tax and welfare system also does not add up. [New Zealanders are paranoid about Australia as the response to this joke showed. However in truth New Zealand will one day beg to be the seventh Australian state and we will refuse. Also the Treaty of Waitangi is deeply inconsistent with the Australian sensibilities and (I think) law– but that is the subject of another post...]

Far more serious than New Zealand is Japan. They too have a baby boom – but unlike the either Australia or the US they have very limited immigration. The underlying reason is racism. Japan is a deeply racist country.

I know I am going to get into trouble for saying that – so I will defend it. I was walking through downtown Fukuoka. The area my hotel was in looked like a red-light district. I peered into a brothel (which the Japanese call “soaplands” and which was illustrated with the pictures of a Turkish bathhouse). The doorman rushed out – and almost violently – and in broken English – said “ no foreigners”. Brothels that will not take your money because you are the wrong race set a new standard for racism. A country that does that is hardly likely to solve it's demographic problem with high immigration.

Now in all of this I did not mention the country with the largest forthcoming shift in dependency ratio. That country is China – and the explosive ratio change (which will occur later than the US) was self-induced – a product of the one-child policy. China is – of course – not going to solve that problem by massive immigration. China is too big – and even with a population crash will remain too crowded. The forthcoming population crash in China is one reason why Chinese elderly can never get the sort of Western socialized medical care or old age social security that people in Australia just expect. But there is something to make the Chinese budget balance in their forthcoming population crash. And that is that the Chinese – more than all other people – have accumulated vast piles of claim-checks from rest of the world in form of Treasuries and direct ownership of equities and other property. One day they will need to cash them to produce what their aging population with its high dependency ratio cannot.

The economic problem of our time is – as much as anything – excess Chinese savings and how the world deals with them. I blogged about that – when – to slightly exaggerate the point - I blamed the financial crisis on the Chinese one-child policy. The economic problem of a future time will be huge Chinese dis-saving as they deal with a massive increase in the dependency ratio. Unlike Japan however the sovereign will not go insolvent because unlike a Western country the Chinese will never get committed to state support of the elderly.

John

Post notes:

*One of my German friends – a well-to-do guy worried about the future of Europe – notes with alarm that one of the printing presses for the Euro is physically located in Greece. He seriously believes that Greece –through control of the press – could blow apart the whole of the European economy. I have no opinion on this – other than to note my friend is nervous about European monetary zone expansion.

**Just so people get the titles right – the Treasurer in Australia is the senior political appointment in economic policy – the equivalent of the Secretary of the Treasury in the US or the Chancellor of the Exchequer in the UK. The Secretary of the Treasury in Australia (Dr Ken Henry) is the senior public servant in the area of economic policy. There is no obvious equivalent in the US but the Permanent Head is the equivalent in the UK.

***I note that almost everything I suggested to balance the budget is a tax hike. Get used to it. True deficit hawks know that you can’t fix a US budget without either large tax hikes and/or large cuts to defense and benefits to old people. There is not enough “waste” or “discretionary expenditure” to solve the problem any other way. If you are prepared to cut defense and turn the respirator off on medicare expenses then you can do with lesser tax hikes. But unless you are prepared to deal with such things you are not really a deficit hawk – more a deficit peacock.

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Finally a little post-script is required. The PIGS (or is it PIIGS) are bundled together but they look different. Greece is a fiscal disaster area. Spain looks like one now (running a large government deficit) but it has not always been one. Spain looks more like Latvia - a fixed exchange rate and a profligate private sector. Bundling them together oversimplifies the problem.

The one thing they all have in common is a fixed (Euro) exchange rate and large current account deficits.

A second postscript: Ampontan (Bill Sakovich) writes a blog about Japan which I have been (irregularly) reading for some time. He obviously has not been reading me as he refers to me as "some Australian blogger". He suggests I should observe Australian racism (something incidentally I have commented on several times on this blog). He uses the usual glass houses line.

The question in this post was whether Japan would be willing to import anything like enough people to offset its demographic crash. That looks unlikely to me. Japan is famously xenophobic (a word with lesser connotations than racist) and that xenophobia has manifested itself over very long periods of Japanese history. That said the BBC has suggested that attitudes to immigration are beginning to change for reasons outlined in this post - and if Bill Sakovich wants to take up attitudes to immigration I am very willing to listen as he knows far more about Japan than me. (He is an immigrant in Japan so his knowledge would be detailed and specific.)

Finally if you read Ampontan he lets you know his viewpoint - check out his "what readers say" section...