Posts Tagged ‘debt’

Why bailouts and ‘stimulus’ crutch will screw up the US economy even more?

Wednesday, August 31st, 2011

August is the most volatile month in the global financial market since the GFC. We had a near default of the US government (see What will happen if Uncle Sam does not raise the debt ceiling?), followed by the downgrade of the US government debt by S&P. On top of that, there’s worries about a double dip recession in the US and fears that the Europe sovereign debt crisis can cause a financial earthquake that can rival the panic triggered by the fall of Lehman Brothers in 2008.

Regarding the raising of the US debt ceiling, we have some things to say. President Obama said that if the US government’s debt ceiling is not raised, the US government will default on its debt. Dear readers, do you see what message the US is sending with this simple statement? Basically, he is saying that if the US is not allowed to borrow more money, they are going to default on the money already owed. In other words, they need to borrow more money to repay the monies (plus interests) that they are currently owing. As China is the biggest lender to the US, this is basically telling them that if they don’t lend more money to the US, they can kiss their existing money goodbye.

If a private citizen comes to the point that he has to borrow more money to repay the ones already owed, it is no-brainer that he is on his way to bankruptcy! As we wrote back in October 2008 at? America?s balance sheet,

To make it easier for you to understand these colossal numbers, imagine owing $200,000 and earning $3640 per year on your job (that is, optimistically assuming that the economy can grow at 2% per year)! In other words, the earnings per year are only 1.82% of the total outstanding debt, which is far below the rate of price inflation. Based on market rate of interests (i.e. the long-term bond yield), the earnings will not be enough to even cover the interest payments.

So, the US government is in the same situation! Unless the US can? somehow create miraculous economic growth that will result in miraculous growth in tax receipts of the US government, the amount that the US government is going to owe will go up exponentially! And no, unlike private citizens, austerity measures will not solve the problem. Why? Thanks to the GFC, the government spent BIG on bailouts and ‘stimulus’ that does not stimulate, resulting in the government becoming a big part of the economy. So, slashing government spending will shrink the economy, which in turn will shrink tax receipts. As we wrote in August 2009 at 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??.

Do you see why we oppose ‘stimulus’ spending and bailouts in 2008? The government is going to have a colossal funding challenge in the first place (see Is the GFC the final crisis?). Spending big money in bailouts and ‘stimulus’ crutch is going to make the government the economy. Once the government becomes the economy, austerity measures becomes out of question. If austerity is out of question, then debt repayment becomes out of question. If debt repayment becomes out of question (i.e. default), then printing money is the only option. Yes, the US government can print money because the debt that they owe is denominated in their own currency.

Now, back to the real world. What are we hearing about the US economy today? We are hearing market chatter about a double-dip recession in the US. Bernanke had announced that he is going to keep short-term interest rates at zero for the next two years. There are talk about the coming lost-decade for the US where the economy will stagnate for the next 10 years.

Do you see the implication for this dismal forecast?

If we are right, the 2008 GFC is nothing compared to the coming US government debt crisis. That is why the message in our book, How to buy and invest in physical gold and silver bullion is so urgent and important.

Think Greece is bad? Look at China’s provinces

Sunday, June 27th, 2010

We all hear about how bad Greece?s national debt is. We hear about how the rest of the PIIGS countries are threatening to derail the Euro. Then there?s Japan, followed by UK. Also, most of the US states are like mini-Greece (see Inside the Dire Financial State of the States). Worse still, the US Federal Government itself is projected to face bankruptcy. You can see the who?s who list of potentially bankrupt major governments in our previous article- Next phase of GFC is when governments go bust.

But no one looks at China. Since it is the world?s greatest creditor nation, surely its fiscal position must be solid right?


Firstly, China?s US$2.4 trillion of reserves must not be mistaken as ?cash at bank? to be spent (see Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?).

Secondly, many Chinese local government are heavily indebted too. According to Liu Jiayi, the head of China’s National Audit Office, some Chinese provinces have serious debt problems. As this news article reported,

Mr Liu said the ratio of debt to disposable revenues at some local governments was over 100pc and in the highest case it was 365pc.

He said the audited debts of 18 of China’s 22 provinces, together with 16 cities and 36 counties amounted to 2.79 trillion yuan (?279bn) in 2009.

Several observers believe the situation is far worse. The China Daily newspaper, which is run by the government, suggested that the total sum could add up to between 6 trillion and 11 trillion yuan (?590bn-?1.08 trillion).

Victor Shih, a professor at Northwestern University in the United States, believes the sum in 2009 was 11.4 trillion yuan, equivalent to 71pc of China’s nominal GDP.

Mr Shih has warned that local governments have also succeeded in rapidly funnelling large amounts of debt off their balance sheet and into public-private investment vehicles.

Mr Shih forecasted that by next year, China?s government debt will hit 96 percent of GDP as ?infrastructure projects continue to eat up cash and produce negligible returns.? According to him,

The worst case is a pretty large-scale financial crisis around 2012. The slowdown would last two years and maybe longer.

The good news is that the Chinese government is doing something about it today. But we doubt it will be painless. Fingers crossed on that one.

Hidden weak foundations covered by high tide of debt

Thursday, June 17th, 2010

Today, we read this interesting article, Nothing can save Spain,

"Greece is not Spain", has been how European politicians have been trying to reassure the markets. Once analysts had a closer look at the Spanish figures they concluded that this was indeed true ? Spain?s troubles are much worse.


In fact, before the crisis struck the Spanish were seen as Europe?s model citizens. Public debt was low, the economy grew rapidly, and in 2007 the government could still report a healthy budget surplus of 1.9 per cent of GDP. There was no sign of grave economic mismanagement, let alone on a scale comparable to the Greek basket case.

So what turned the Spanish miracle into an economy on the abyss? How can a country be regarded as a role model one day and almost a failed state the next?


But whereas in Greece the lower interest rates were taken as an opportunity to incur greater public deficits, in Spain it was the private sector which accepted the invitation to go deeper into debt.

One sector in particular benefited from this injection of cheap cash thanks to the euro: real estate. For many years, Spanish house prices only knew one way, and that was up. Between 1998 and 2007, property prices increased by about 10 per cent per year on average.

When the global financial crisis struck, the bubble burst. Since 2008, Spanish house prices have declined 15 per cent and there is no end in sight to the correction. Some real estate experts are predicting further falls of up to 35 per cent.

Suddenly, the weak foundations of Spain?s economy are exposed, especially its over-reliance on debt coupled with low productivity.

Consequently, the pristine clean Spanish public debt turned into deficit as unemployment rate soared to 20% and bad debts plagued the banking system.

Note that we highlighted the word ?suddenly? in the final paragraph.

The key to remember is that the economy looked rosy until something suddenly gave way. The high tide of debt kept the weak foundations hidden under the water. Finally, when the debt tide receded, the weak foundations were exposed. With the weak foundations in full view, the financial market reacted in horror accordingly.

Spain?s situation reminds us very much of Australia. As the Reserve Bank of Australia (RBA) governor hinted in a speech last week,

Markets can happily tolerate something for an extended period without much reaction, then suddenly react very strongly as some trigger brings the issue into clearer focus.

Again, we highlighted the word "suddenly.? As we wrote in Serious vulnerability in the Australian banking system, there is a serious weak underbelly in the Australian economy. All we need is a trigger for all eyes to be on its weak foundation (see Will there be an AUD currency crisis?).

However, many pundits in the mainstream media are still putting on Turkey Thinking (see our book, How To Foolproof Yourself Against Salesmen & Media Bias for more information on Turkey Thinking).

Turkeys fattened for slaughter in the Chi-tralia bubble

Sunday, January 17th, 2010

In our previous article (Is the coming ?crash? in China not a real crash?), one of our readers sent us a link to a very good article (Trapped Inside a Property Bubble) written by a former Morgan Stanley economist named Andy Xie. He is a very contrarian and provocative analyst who called China’s economy as a “Panda Economy” (named after the cartoon movie,? “Kung Fu Panda”). His bearish call on the Chinese economy attracted a fair amount of criticism from Chinese government officials.

One of our readers, Pete, had highlighted sections of Andy’s article, with some good questions and comments…

Once a country loses export market share on rising costs, it stagnates because property bubbles during high growth periods deter consumption while overwhelming the middle class with housing expenses.

As property bubble grows further, debt servicing burden will grow as well. That in turn will deter consumption further as more and more of income will be spent on repaying debts. The only way to increase consumption whilst debt servicing burden is increasing is to increase debt further. Obviously, if a consumption-based economy is dependent on increasing debt to sustain consumption, then it is an economy that is addicted to debt. Once credit growth stalls, the die is cast for the economy. Back in January 2007, we wrote in Myth of asset-driven growth,

… asset-driven growth magnifies the consumption debts of the economy, which will have to be serviced in the future. By deferring the burden of debt servicing to the indefinite future, it can only mean that the nation?s wealth will shrink in the future. Hence, asset prices cannot rise in perpetuity. Eventually, the weight of future debt servicing burdens dooms the bubble to collapse under its own weight.

Since the Chinese economy is still dependent on cheap labour to achieve low cost production, labour costs increase will kill its competitiveness. As a result, exports will decline. If at that point in time, citizens are burdened heavily with debt, there is no way they can increase their consumption to replace the lost exports.

Similarly, Australia is already a highly indebted nation. The only thing preventing the Australian economy from falling into deflation is Chinese demand for Australian resources. As we wrote before in Hazard ahead for Australia- interim crash in China,

Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.

There are some signs that Australian consumers are binging on debt once again. Should this translate into a resumption of increasing credit growth, it will mean that Australia is increasing its vulnerability to any slowdown in the Chinese economy. Worse still, Australia is selling more and more of its businesses, capital and resource companies to China, which means that more and more future economic growth will no longer benefit the next generation.

Enough about Australia. Let’s look at Andy Xie’s article further,

The dollar has bottomed. The Fed will begin raising interest rates in 2010.

Andy Xie reckons that the US dollar has bottomed and that the interest rate cycle has bottomed as well. What are our views?

As we wrote in Permanently low interest rates for Uncle Sam?, the more indebted the US government is, the harder it is for them to raise interest rates. According to Marc Faber, currently, 12 percent of US government’s tax receipts goes to interest payment on their debt. In 5 years time, it could be at 35 percent. Should the US raise interest rates to combat any potential price inflation, that will increase the debt burden of the US government unless the US economy can put on a miraculous feat of super-turbo-charged growth. This means that the higher interest rates goes, the higher the risk of the US government becomes insolvent sooner.

Next, Andy Xie wrote,

One possible way to prolong the bubble is to appreciate the currency, as Japan did after the Plaza Accord, to contain inflation and attract hot money. Such a strategy will not work in China. Japan’s businesses were already at the cutting edge in production technologies and had pricing power during currency appreciation. They could raise export prices to partly offset currency appreciation. Chinese companies don’t have such advantages but rely on low costs to compete.

That’s a reason why China cannot let the yuan appreciate too much too soon. Next, Andy wrote,

China has been trying to promote consumption for a decade. However, consumption’s share of GDP has declined annually. The reason is the policy environment has been squeezing China’s nascent middle class through high property and auto prices along with high income tax rates.

Recently, there’s a Chinese soap opera titled “Dwelling Narrowness.” That was a very highly popular show because it strikes a cord with the Chinese middle-class, who are burdened with taxes, corruption, high property prices, inflation and so on. Unfortunately, that soap opera was terminated early by the Chinese government.

As we wrote in Chinese government cornered by inflation, bubbles & rich-poor gap,

In other words, the paradox is that the further the Chinese government delay in tackling inflation, the more reliant they will have to rely on American consumers, which means it is harder for them to let the yuan appreciate.

The inflationary policies of the Chinese government are hurting Chinese consumption more and more.

Andy wrote further,

China’s property market is creating winners and losers based on timing. All other factors ? including education and experience — have been marginalized as the economy rewards speculators. And as more play the game, the speculator ranks rise and fewer people work, perhaps contributing to a labor shortage.

Our reader, Pete was wondering how could it be that China can have labour shortage. Our take is that it is skilled labour shortage that China is increasingly short of. Anyway, as we wrote in Harmful effects of inflation, an economy based on inflation and asset price bubble to sustain growth is an economy that rewards speculation instead of hard work.

Finally, Andy wrote,

The killer is inflation driven by a surge in money printing. The average lag between currency creation and inflation is 18 months in the United States. China’s lag could be two years since the government uses subsidies to suppress inflation. By 2012, China could experience 1990s-like inflation. And that’s when the property bubble will probably burst.

We will add this: in a highly indebted society, price inflation without adequate wage inflation will contribute to the bursting of the asset price bubble.

Many of what Andy Xie wrote also applies to Australia. When the Chinese bubble burst, Australia’s bubble will burst too. Marc Faber, while he agrees with Jim Chanos that China is in a bubble, believes that the implosion of the Chinese economy will not happen soon (see China bubble will not burst right away: Marc Faber). If this is true, it means that many Australians will be suckered into more debt (property prices may even be inflated further), which is akin to a turkey being fattened for the day of slaughter. The difference between 2008 and that day of reckoning is that more Australian businesses, mines and capital will be under Chinese control by then.

Why is the modern economy so dependent on ever-lasting growth?

Tuesday, August 11th, 2009

Have you ever wonder why economists and policy makers are so obsessed with economic growth? Why is it such an acute problem if the economy is not in a treadmill of growth (i.e. ever-lasting increase in the quantity of goods and services produced)? What is so bad with zero economic growth (i.e. an economy that takes it free and easy)?

As one of our readers wrote in our previous article,

This is all to say that the [modern capitalist] system is much more fragile than anyone would have guessed and that the cult of markets and efficiency have left the world with a system that is less and less resilient. The crisis that has begun over the last couple years begins to bear that out. In fact we’ve become dependent on efficiency and without it the system may just fail under it own weight. Time will tell but the process has begun.


We believe the root of the problem lies in the monetary system. Today, we have a monetary system that is at its heart a system of credit. That is, the ‘money’ that flows around the system is loaned out of existence. To understand what this means, read on…

Originally, mankind started with commodity money. Money was a physically tangible thing. In the 15th century, Spain found gold in the New World. As gold was money back then, Spain found a lot of money and became ‘rich’ as a result. Today, most of our money has become virtual, intangible and in the form of electronic information. The overwhelming values of transactions are made in the form of electronic fund transfers instead of exchange in physical paper cash.

Now, think of your cash at bank- it is an asset to you and a liability of the bank. Say, when you make a non-cash purchase (either with cheque, credit card, bank transfer, etc), that transaction ultimately becomes a transfer of liability from one entity to another. This text-book idea implies that assets have to exist first before it can be loaned out as someone’s else’s liability.

The real world does not conform to this text-book idea: liabilities are created by banks first (in the form of loans) before the assets exist (we recommend you read Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model if you need a deeper understanding). After the liabilities are created out of thin air, the bank then go hunting for the assets by borrowing from another entity (e.g. central bank, depositors, another bank, investors, etc). Ultimately, either directly or indirectly, that asset (currency) originates from the central bank.

The central bank is the only institution that can create assets (currency) out of thin air to be loaned out as liabilities. Imagine you are a central bank- all you need to do is to declare $100 into existence, lend it to the banking system and then have the power to demand that the money (which you created out of thin air) to be paid back to you at an interest rate that you decide.

The observant reader will then be asking this question: “If the entire economy pays back all the currency that was borrowed into existence, but still owes the interest, where does it get the currency to pay the interest?” The answer is startling simple: more currency has to be borrowed into existence to pay back the original interest!

Now, you can see that total debt in the economy will grow exponentially (compounded interest) continuously and can never be repaid fully. That means the economy has to grow continuously in order to generate the income to pay back the continuously growing debt. Since the physical world has a finite quantity of resources, the quantity of goods and services produced in the economy cannot always grow fast enough to match the continuously growing debt. Therefore, the only way to keep the system running is to add in price inflation (growth in the nominal value of the goods and services produced) so that the nominal value of the continuously growing debt can be repaid. That’s why, as our reader observed, the “cult of markets and efficiency” in the modern capitalistic economy is there by necessity to keep the economy growing continuously.

For the past decade, total private debt is growing at a speed far in excess of GDP growth (i.e. growth in income). For a while, it seemed sustainable because asset prices (most notably, house prices) were rising fast enough to keep the financial system solvent (i.e. able to pay back the continuously growing compounding debt in nominal terms). As you can see by now, if asset prices stops rising in the context of adequate economic growth, the game is over. That game-over situation is what we all know as the Global Financial Crisis (GFC).

The GFC trigger the economic phenomenon called deflation. Once the debtors (e.g. banks, households, businesses) become insolvent, they can cause their creditors to become insolvent, who in turn threaten the creditors’ creditors with insolvency. This systemic debt defaults will now reverse the debt growth, which means the currencies that are loaned into existence will be written off into non-existence, which means money supply will shrink, which in turn will cause vast tracts of the economy to shave off its productive capacity (e.g. unemployment, idle factories, excess capacity).

If the economy is not expected to grow sufficiently and the government wants to keep the wheel running, what would they do? The only course of action is run the money printing press (i.e. create currencies out of thin air, pump them into the system for free). The risk is that without a properly growing economy, they risk igniting another asset price bubble. An asset price bubble may seem to ‘work’ because they can keep the system solvent for a while, until the bubble burst and restart the deflation nightmare again. The government will then have to start the monetary printing press again while the economy shaves its productive capacity the second time. If this process is repeated umpteen times, it will come to a point whereby the only thing to keep the system running is rising asset prices and not economic growth. When that happens, it is hyperinflation.

The current asset price rebound around the world is the stage where rising asset prices are keeping the debt wheel running. We don’t know how long that gig will keep running.

How big is the credit bubble in China?

Monday, July 27th, 2009

In our previous article, we wrote of the credit growth in China. Today, we will show you the size of the total debt in China:

Chinese loan growth

Click on the graph for a full-size image

The Chinese total private debt to GDP ratio is 123% in January 2009. By June 2009, it is 146%. Currently, Australia’s total private debt to GDP ratio is south of 165% of GDP.

No wonder China could achieve such a spectacular ‘recovery!’

Australian government’s contingent liability to exceed AU$1 trillion

Sunday, March 29th, 2009

In October last year, the Australian government splashed its AAA rating to bank deposits (including the deposits of credit unions and building societies) and wholesale bank debt. Last week, there’s news that they’re splashing their AAA rating to state government’s debt.

This is akin to parents giving their children supplementary credit cards unsupervised. Indeed, a particular child named “Macquarie Bank” used the Australian government’s ‘supplementary credit card’ on a debt-gouging spree overseas.

Altogether, the Australian government is projected to have a contingent liability of more than AU$1 trillion, which is almost the entire GDP of Australia (compare that to the last budget surplus of around a puny $20 billion). The nature of contingent liability is that it is not really a liability- it is a liability that arises if certain events arises. This may not be a problem if debt defaults follow a nice Bell curve. But in the real world, is this a realistic assumption? As we said before in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

Bell curve simply means that things revert to the mean in the long run. Also, as you deviate further and further away from the mean, the probability of that deviation will drop faster and faster. Therefore, by the definition of the Bell curve, extreme deviation from the mean is extremely unlikely, so much so that it is close to impossible.

Very unfortunately, it is obvious even from just a casual observation of the world around you, the universe is often not ruled by the Bell curve. Extreme events occur frequently, which by definition of the Bell curve is close to impossibility.

Our feeling is that a huge unquantifiable percentage of all these debts will have a high degree of correlation with each other. Another way to look at this is that what makes a particular debt go bad is what makes the others to go bad as well. This means these debts will not follow a Bell curve. If you look at Australia’s money supply graph in Australian money supply growth in September 2008, you can appreciate the level of leverage in Australia’s financial system. What if Australia faces a huge macroeconomic margin call? Should that happen, there goes the Bell curve.

We shudder to think how the Australian government’s sovereign debt rating will fare when the day of testing comes. With so much contingent liability on their shoulders, we believe the Australian government is setting itself up to be run over by a Black Swan. For those who are new to Black Swans, we recommend Failure to understand Black Swan leads to fallacious thinking.

Nations will rise against nations

Sunday, March 15th, 2009

A few days, as reported widely in the news media, Chinese Premier Wen Jiabao said at a press conference that

We have lent huge amounts of money to the United States. Of course we are concerned about the safety of our assets.

To be honest, I am a little bit worried and I would like to … call on the United States to honour its word and remain a credible nation and ensure the safety of Chinese assets.

Those words, when translated into English in writing, sound bland. But if you watch what he said in full video in the original language, then you will be able to appreciate the immense gravity of the situation from the tone of his voice.

But dear readers, you must understand that Premier Wen was just stating the obvious. There’s nothing new in what he said. All you have to do is to turn back to what we wrote in December 2006 and read Will the US dollar collapse? and Awash with cash?what to do with it? to see the big picture of what’s going on for years. As we wrote back then,

Lately, we are again hearing that central bankers are murmuring about diversifying their foreign reserves away from the US dollar. Does it mean that there is an imminent liquidation of their US dollar reserves? Well, this is not the first time they murmured about it and it is definitely not in their (including the Federal Reserve?s) interest to see a collapse of the US dollar. The Chinese, with their US$1 trillion of reserves, would not want to see their stockpile of US dollars to lose significant value.

That paragraph was written in the final days of 2006. Today, China’s US dollar reserve had doubled from they had more than 2 years ago. The major difference between today and back then is the emergence of the Global Financial Crisis (GFC).

Thanks to the GFC, the status quo, which had been running for decades, is stressed towards a breaking point (but who knows, perhaps that inevitable  breaking point could still be delayed for longer before an almighty snap happens). There are far too many contradictory and conflicting interests among nations.

For the US, as we said before in How is the US going to repay its national debt?, is facing a situation in the coming decades of having to pay a colossal amount of public debt. The public sector is facing a massive debt many times its GDP from the unfunded Medicare and social security liabilities. With the GFC, the US government is transferring more and more private debt to the public sector through bailouts, handouts and stimulus. It is either the US mobilise its monetary printing press to massively inflate away (i.e. print copious amount of money) all these debts or they face up to the reality that they are bankrupt and go through the cold turkey of an almighty deflationary collapse (read: almighty depression). If the US chooses the former, China will be furious because that will be doing the very opposite of what Premier Wen called on the US to do, namely to “honour its word and remain a credible nation and ensure the safety of Chinese assets.”

Unfortunately, the big problem is that the US (along with countries like Australia and UK) has been de-industrialising and hollowing out its economy for a very long time, while the China has been doing the opposite. To put it simply, the US is consuming more and more while China produces more and more. This gross imbalance has been playing out for too long. With the GFC, the US consumers are effectively bankrupt and cannot borrow any more to buy from China. China has lost its biggest customer and is in trouble too.

The coming G20 Summit will be filled with countries with conflicting agendas. The US (and UK) wants more stimulus (and of course, bailouts when required), which can only happen if they print money (i.e. devalue the US dollar), which is as good as spitting on China’s face. Europe (headed by Germany and France) wants the focus to be on regulations and prevention, which means they are less keen on stimulus and bailouts. This is because the latter will involve the tax-payers of countries like Germany rescuing the tax-payers of other EU nations. China, on the other hand, wants an overhaul of the current world order so that they can have more power and say to better reflect their status as America’s creditor. Obviously, the US will not like that because that will mean they have to voluntarily descend for an ascending China.

There are plenty of temptations to take the easy way out. For example, if the Chinese expect the US to inflate away their debts by printing money and thereby, devaluing the US dollar, they will be likely to devalue their RMB in order to continue the process of hollowing out the US economy. The US (and the Europeans), in response, could impose trade barriers on Chinese imports. The Chinese could retaliate by dumping their holdings of US Treasuries. Remember, these are just examples of what may happen and they are by no means predictions. But we trust that you get the idea here.

Therefore, outwardly, the world may be at peace. But inwardly, we believe there will be jostling for power, influence and resources between the major nation blocs. Bigger nations will use smaller nations as pawns, international armed non-state groups will intensify their activities and inter-ethnic conflicts will arise. We have no doubt that there will be plenty of Black Swans appearing in the days to come.

What will happen if RBA cuts to zero?

Tuesday, February 10th, 2009

In the United States, the Federal Reserve had set the interest rates to almost zero. In the United Kingdom, interest rates have reached 1%. Japan had cut her interest back to almost zero again. Canada’s interest rates have reached 1%. In Europe, it’s 2%. All over the world, central bankers are busily firing their interest rates guns to fight this global recession. Already, Japan and the United States had already ran out of ammunition.

As for Australia, the goods news is that our Reserve Bank of Australia (RBA) still has some ammunition remaining after cutting its rates to a low of 3.25%. The bad news is that Australia is about to enter recession, possibly a very severe one (see Realisation of hard landing ahead for Australia). So, what if Australia’s RBA runs out of ammunition too?

If Australia’s interest rates ever reach zero (as Professor Steve Keen believes it will by 2010), it will happen in the context of a hard landing or even a depression. It will be a time of debt deflation, which as we said in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

Chances are, such economic malaise will drag on for many years, similar in length to Japan’s lost decade. For investors, this will be a very trying time. The key thing for investors and savers to watch out for is the Aussie dollar. As we explained before in Can falling interest rates and rising mortgage rate come together?,

A large fraction of Australia?s borrowed money is sourced from overseas through the ?shadow? banking system. In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country.

As a result, there is a great potential for a complication that we described in Another complication in RBA?s interest rate cut,

Today, we will talk about another issue that can complicate matters for the RBA- the pullout of foreign capital.

When debt deflation takes hold of Australia, the RBA can easily run out of ammunition. In the absence of government intervention, credit will be extremely scarce in Australia. Our guess is that in such a scenario, foreign capital will flee out of Australia, leading to another fall in the Aussie dollar. The only mitigation against our dollar in such a scenario will be to the extent that the Australian government opens up our mining and resource assets to predatory foreign sovereign wealth fund (read: China).

Everything else being equal (we will talk about the not-being-equal scenario further down), a falling dollar will be, as we described in Falling currency and inflation,

Now, we will look at the context of Australia, which is another import-dependent country. A rapid depreciation of the Aussie dollar will result in rising price inflation for the same reasons stated above.

Now, imagine the food that you eat everyday. Most of them are produced in Australia. A falling Aussie dollar implies that foreigners will have greater purchasing power for Australian-made food. Assuming that the market is still free, that means that Australians will have to compete with foreigners for our own food. Also, since Australia is hardly self-sufficient in manufactured goods, a falling Aussie dollar will imply falling purchasing power for the many imported things that we enjoy today.

What if we combine debt deflation with falling Aussie dollar? In that case, there will be massive aggregate demand destruction in the economy. Basically, this means a very drastic drop in the standards of living for many.

We shudder to think of the implication of this. We wonder whether there can be a scenario whereby there is a combination of (1) crashing asset prices (due to debt deflation) and (2) rising inflation for price inelastic consumer staples (due to the depreciating Aussie dollar)? If such an mishap eventuates, even savers have to worry about the return of their savings!

Realisation of hard landing ahead for Australia

Sunday, January 25th, 2009

History will look at this week as the turning point in the Australian public’s perception of what is to come for the economy. Before this week, the mainstream assumed that Australia was on track to a soft landing (see Soft landing hope built on faulty framework assumptions). But with the release of much worse than anticipated economic data from China, that perception was changed. Prime Minister Kevin Rudd said that (see After 17 years on the way up, a rush back down)

China has been hit much harder than forecasters had predicted, its slowdown will affect Australia.

Last Friday’s The great stall of China in the Sydney Morning Herald (SMH) made it to the screaming front page headline.

Our readers should not be surprised at this news. 12 months ago, we already warned (based on deductive reasoning) that China was facing a major economic correction in Can China really ?de-couple? from a US recession?,

We may be wrong, but our theory is that this may be an epic boom waiting to be a bust. Note: we are not making a prediction here- we are merely expressing our scepticism on the de-coupling theory.

In reaction to this bad news from China, Treasurer Wayne Swan promised bold action from the government. The Prime Minister warned that the tests for Australians are yet to come. On another issue, the government also announced that they will organise a fund to help businesses roll over AU$75 billion of loans should foreign banks pull out of Australia. Again, we had covered that issue in November last year at Effects of retreating foreign banks in Australia.

You can see that the rhetoric from government are shifting from (1) denial to (2) underplaying the gravity of the situation to finally, (3) warning of hard times ahead. Denial, for whatever reasons, is the typical reactions of governments. In China, the government denied the truth to save face. In South Korea, the government even went as far as arresting a blogger whose forecasts of doom were disturbingly accurate. In the US, Ben Bernanke was forced to confess that he was completely wrong on his assessment of the US economy. The captains of the finance industry (including their armies of economists, analysts and forecasters) were deep in their denials too (e.g. see Aussie household debt not as bad as it seems?).

So, our dear readers, how can we trust ‘them?’

Is it too late to avoid a hard landing? We’re afraid the answer is a categorical “No!” As we said in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

The question is, how long and severe that hard landing will be. Our view is that since this hard landing is unavoidably long and severe, the best thing the government can do is to do nothing and let the bottom of the economic cycle come as soon as possible, clearing out the years of mal-investments and structural damage. Any intervention will drag out the pain for longer and postpone the day of sustainable recovery.