Next phase of GFC is when governments go bust

January 19th, 2010

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10 months have passed since the Panic of 2008 brought global stock markets to a low in March 2009. Since then, we had the “green shoots” of recovery (where economies were getting from worse to bad) and hopes of recovery. By today, we have some semblance of ‘recovery.’ But this ‘recovery’ is very uneven. For example, unemployment is not turning around yet in the United States. Much of Europe and Japan are still in the doldrums. Australia, on the other hand seems to be recovering and China is roaring ahead with an expected growth of 10% in 2010.

During the Panic of 2008, we had financial institutions and businesses going bust like dominoes, threatening to pull the world down into a Greater Depression. Governments all over the world suddenly became Keynesians and switched on their massive money printing press to bailout, rescue and spend, spend, spend in the name of ‘stimulating’ their economies. But as we said before in Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven?t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ?stimulating??.

So, with economies seemingly on the path to ‘recovery’ (especially in Australia and China) from a near death experience, this looks like a free lunch from the government isn’t it?

Unfortunately, the answer is “No!” Then what is the risk of governments putting economies on a crutch for an extended period of time?

As we quoted the BIS in July 2009 at Bank for International Settlements (BIS) warning on stimulus spendings,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly.

As we said before, during the Panic of 2008, we had financial institutions and businesses going bust like dominoes. This time round, governments will be going bust like dominoes. Today, if you read the financial press, you will find this disturbing trend: credit rating agencies are downgrading and threatening to downgrade the credit ratings of government debts.

While we do not trust credit rating agencies (since they are the ones who gave sub-prime CDOs triple-A ratings), we will treat their ratings as overly-optimistic in the first place. For investors, what is significant is not the ratings themselves. Rather, it is the pervasive trend of more and more downgrades that is much more indicative. As this article compiled a non-exhaustive list of news excerpt of sovereign debt downgrades, we noticed a very disturbing fact- a large number of countries (some of them are major countries) are involved.

Can this trend turn around (i.e. governments become more prudent in their fiscal management)?

We doubt so. As we said before, the word “stimulus” is a weasel word that is misleading and deceptive. Economies suffering from debt deflation cannot be ‘stimulated’ into self-sustaining growth. A better word is “crutch.” The problem with using crutches to prop up economies is that the longer they are in place, the more dependent economies are on them. Eventually, if they are in place for too long, the economy will descend into stagflation (see Supplying never-ending drugs till stagflation). Once you understand this, you will be able to read between the lines of this BBC article,

The International Monetary Fund head has warned that the global economy could experience another downturn – a so-called double dip recession.

Dominique Strauss-Kahn said countries should not exit from stimulus packages that have bolstered growth through huge amounts of government spending.

The longer governments delay from removing economic crutches, the bigger government debts will become. That, along with Medicare and social security liabilities for the growing ranks of retirees and shrinking rank of workers means that eventually, governments will become insolvent (not technically because they can resort to printing money).

Consider these countries:

  1. Japan, the world’s second largest economy, is a welfare superpower with a rapidly ageing population. Twenty years of economic ‘stimulus’ under debt deflation has resulted in government debt of almost 200 percent of GDP.
  2. The US government is the next to arrive, as they are currently where Japan is 20 years ago, with an unfunded Medicare and social security liabilities looming (see America?s balance sheet).
  3. As this Financial Times article warned,

    After crunching the data, McKinsey estimates that the gross level of British private and public debt is now 449 per cent of GDP ? up from 350 per cent at the start of the decade.

    And even excluding the liabilities of foreign banks based in the UK, the ratio still runs at 380 per cent ? higher than any country except Japan (closely followed by Spain where debt has also spiralled dramatically, according to a McKinsey report issued today.)

  4. Then we have the PIIGS countries, namely Portugal, Ireland, Italy, Greece and Spain, where Marc Faber warned that one or more of these governments will likely blow up in the next couple of years. This will plunge the viability of the Euro as a currency in grave doubt. Will a default trigger a derivative meltdown?
  5. Then we have the other European countries like Latvia and Ukraine…

When governments go bust, we will have currency crisis. How do you protect yourself against this? Keep in tune!

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