Juggling The World’s Woes

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Believe it or not, your editor can juggle five balls. But that’s nothing compared to what the world economy has taken on. Everyone has their pet issue – the one ball they watch going round and round in a cycle of ups and downs, waiting for it to land square on the juggler’s nose. Seldom do all the big issues make a gathering in one single article. So below is our embellished list of things to go spectacularly wrong.

And if just one of those ‘balls’ slips outside the world economy’s grasp, the others will likely come crashing down with it. Even the best jugglers make mistakes, so it’s only a matter of time before one gets away, triggering the fall of the rest. The question is which ball will be the one to throw the others out of whack?

1. The Australian Housing Bubble

We might be encroaching on our sister publication Money Morning’s turf, but this is a good way to begin the list. Housing bubbles around the world have popped. Countries as different as the US and Spain suffered the same fate. Only those without booming house prices evaded the subsequent fall. Australia is not in that category. We won’t evade a fall.

As to the endless debate about why house prices are too high, we won’t get into that here. But consider what on Earth the Reserve Bank of Australia (RBA) is up to when it comes to the housing bubble.

According to this research paper from the central bank, there has been ‘a modest increase in policy rates and some regulatory actions’ to ‘lean against’ the build up of a housing bubble. There have also been ‘an increasing number of “open mouth operations” conducted by senior officials’ over concern for house prices, which doubled in five years. The paper also noted how RBA officials were concerned about the ‘rapid increase in housing credit … particularly for the purchase of residential investment properties.’

Sounds like the RBA is on the case, right? Acknowledging the existence of the bubble, its cause and its solution. The problem being that the year the report is referring to is 2002. In other words, the RBA identified and dealt with the housing bubble of that year, before it ran out of control. This time around, it has joined the ‘pretend the bubble doesn’t exist’ camp. That doesn’t end well. Why the change of heart? Probably global warming.

2. The China Bubble

Believe it or not, you can’t have a stimulus-funded boom without a bust. From cash for clunkers to the great moderation, every effort to stimulate ends in a bungled mess. (In Australia, most stimulus efforts are a bungled mess before ending, but that’s another story.)

China’s gargantuan stimulus doesn’t even seem to make an effort to hide its hollow nature. The empty cities, the ridiculous statistics, like fixed-asset investment reaching 70% of Chinese GDP (according to Andrew Hunt Economics) and the obvious political motivation reeks of a bubble.

But here is the kicker. For Australia to encounter serious trouble, asset prices in China don’t have to fall. Banks don’t have to fail. Austerity doesn’t need to be implemented. All that it takes for Australia’s mining boom to disappear is for construction to slow dramatically. And the figures seem to say quite clearly that construction can hardly continue at its current rate.

Federal and state budgets assume China’s demand for resources will continue. Miner’s massive capital spending assumes high prices will be there to sell for. The RBA’s monetary policy is counting on mining to provide jobs and growth.

But the speedy half of Australia’s two-speed economy could drag the other half off a cliff.

3. The Sovereign Debt Crisis

Governments all around the world are in debt well beyond their capacity to pay it off. And they aren’t even changing course to make an attempt to pay it off.

There are several resolutions to the Global Sovereign Debt Crisis. None of them look very appealing. However it ends, it will not end well. As Sound Money. Sound Investments editor Greg Canavan pointed out in his recent issue, it’s always the little guy who gets the rough end of the stick. That suggests inflation or austerity. Note that austerity could be imposed after a default, as markets refuse to finance the welfare state a second time around.

For those of you not relying on the government as much as others, this is just as relevant. Just keep reading to find out how.

4. Frozen Debt Markets

Banks hold a lot of sovereign debt because it is considered risk free by accounting rules. If the debt suddenly becomes worth less, banks themselves begin to look shaky. That could cause them to stop lending to each other, not knowing who is safe and who isn’t. Remembering that money is debt created by banks, this would trigger severe deflation as the money supply shrinks.

But it’s not just the banks that you should be worried about. Banker Walter Bagehot wrote a book about the reliance of commerce on banking. It was published in 1873 and still holds true today. The main idea of the book (Lombard Street) is that rather than relying on their own capital, businessmen can borrow money for short periods of time to increase the size of their transactions (and thereby increase profit).

Here is an example: Without borrowing, an oil refiner can only buy the unrefined oil he can afford for refining. By borrowing money, he can buy vast amounts, increasing the amount he can sell as well. Because borrowing money for a short time has a fixed cost, the increased profits accrue to the refiner. (Note that competition will drive down price, eventually leaving consumers with vastly more oil at lower or the same price.) Bagehot links the development of British money markets (namely Lombard Street) to Britain’s economic dominance.

If banks cease lending, the prosperity created by this lending structure ends and the world is left with vast capital structures that cannot be fed the vast inputs that justify them. The oil refiner’s factory will be much too big and expensive to run if he can only buy small amounts of oil.

What has us leaning towards inflation, rather than the deflation described above, is the fact that the deflation alternative is soooo ugly. If we reach the point where banks stop lending, deflation will be unavoidable. The result will be much like 2008, but without bailouts from government. The central banks of the world may print a trillion dollars, but if the banks refuse to lend, the trillion won’t flow through the economy. In an attempt to avoid that trap in the first place, you can expect central banks and governments to print money and fudge rules before things get dire. Thus, giving us inflation.

The biggest argument in favour of a deflation forecast is that the global banking system is so intertwined in terms of owing each other money, that a deflation in one part of the world could infect another. A flicker of hesitation from the ECB President could send US debt markets into paralysis.

5. War/Nationalism

Many of the world’s respectable forecasters are predicting a combination of war and/or nationalism. Billionaire investor Marc Faber and former Goldman Sachs trader Charles Nenner come to mind. Political tensions seem likely when you look a little more closely. British Member of the European Parliament Nigel Farage has often warned his colleagues that the re-emergence of nationalism is the natural response to an overbearing EU. Consider that current sovereign debt levels could only be justified under a state of war, if at all. So the convenient political cover for their absurd balance sheets is for the world’s bully nations to pick a fight.

Trying to work out which of the above issues will signal the downfall of the others is very difficult. Let alone figuring out the timing for each. But the chances of none of them going wrong are miniscule.

Now some reader mail from a ‘keen DR subscriber’ regarding negative gearing:

I’m interested in your position regarding property ‘investment’ in Australia and negative gearing. I’m not affected by whether we have or do not have negative gearing for property ‘investment’ so I don’t have an axe to grind either way. However, I’m curious as to why you think that property should be subject to different rules with respect to negative gearing. If I borrow to invest in shares with the expectation of capital growth in lieu of income I am effectively engaging in negative gearing. It may be risky but it is negative gearing. Similarly, if I am silly enough to invest in a managed fund which has an income and a capital growth component, I may be engaging in negative gearing, suffering a net loss on the income side in expectation of a captial gain on the growth side. In all these cases I may be negatively geared; not necessarily, but I may be. So I am trying to work out how the property market could be segregated for negative gearing purposes.

The only thing that I can think of is that you are looking critically at the negative gearing laws across the whole spectrum of investment activity. That’s a possibility but it then starts to impinge on people who borrow to set up and run a business. The interest on the borrowings then would be part of the cost of business. Similarly, I would see interest on borrowing for a rental property as being a part of the cost of being in the rental business. It may not be the smartest way of being in business, but it is still business and I don’t see how it can be separated from other sorts of business which are supported by borrowings. Our whole business structure seems to be built on borrowing and on the cost of that borrowing being treated as a cost of business in the same way as any other business cost.

As I say, I am not negatively geared in the property market and therefore am merely a curious onlooker.

Kerry

Thanks for the thoughtful analysis Kerry. It holds true in almost every sense.

However, consider that a house, a growth share, a dividend share and a business are not the same type of investment. The idea behind all investments in the end is a positive cash flow. In the case of growth stocks, it is the emergence of the potential for cash flow in the future that makes the stock go up. This theory has been lost on the investment markets today, but it still holds true in a logical sense. Why bid up the price of something if it won’t pay out unless a bigger fool is willing to pay even more? That game has to end at some point and someone will be left holding the ‘old maid’.

If houses are seen as investments and they are losing money, there is very little reason to expect them to appreciate in price (absent of a bubble mania or rising rents). It’s kind of like using gearing to invest in high dividend yielding defensive stocks at a loss. You are losing money after dividends and interest payments and the price of the stocks shouldn’t be expected to go up, because they are already overpriced (evident in the fact that you make a loss on the gearing).

Think of a growth stock as a house being built or renovated, while a dividend stock is a finished house. One promises future earnings, the other should be judged on its current earnings. The analogy for a business that is losing money after the interest on the loan that finances the business is that money is being reinvested in the house to make it bigger. At some point, you still need to expect the rent to pay off if the whole thing is to be worthwhile.

Nobody can explain it as well as Peter Schiff did before the crisis. If you’re interested, here is a video of his speech to a group of mortgage bankers in 2006.

Nick Hubble
Daily Reckoning Australia Weekend

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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Comments

  1. With respect to Negative Gearing – it’s not the concept that is the problem, it’s the expectation by unsophisticated investors that house prices will always go up over the lifetime of the house, and that they will always have a high tax burden to try and get rid of. Negative gearing was used extensively throughout the dotcom boom – and contributed towards it. It also contributed towards a lot of people going broke. Those people won’t try that again. A widespread markdown on house prices would crush a lot of negative gearing people, and a new meme – ‘negative gearing is bad news’ – would likely emerge. Negative Gearing in Australian Property has only been around as a plan for 30 years or so. It owes it’s existence to the high inflation and taxation of the late 1970’s and early 1980’s. If you sit in a property-spruiker session they’ll show you a chart of house prices going back to 1970. The uninitiated to longer term capital cycles get sucked in. It’s important to remember that this 30 year experiment in investment strategy by Australians is a short spot in capital markets history. No special legislation is needed – it will bring itself undone in good time. You’d be hard pressed to sell a baby boomer a dotcom stock with a 140 PE ratio, when twelve years ago they would have bought with both hands. In good time the same will happen with negative gearing. Once a bunch of people lose their shirts and end up on ‘a current affair’ it will pervade the national concious and the fast-buck people will move onto something else. In short, like any bad investment strategy it’s self-solving with time and governments should just leave it alone. Other, more mature property markets don’t fall prey to negative gearing spruiking (well, not normally, anyhow) and eventually Australia will join those ranks.

    The primary driver behind negative gearing is too-high personal taxation rates. With a lower personal tax rate (say 30% tops unless you’re on million+ per year) the negative gearing property market would dry up overnight.

    Reply
  2. I go with most of this, but there is one thing that is still not clear. You say “In an attempt to avoid that trap in the first place, you can expect central banks and governments to print money and fudge rules before things get dire. Thus, giving us inflation”.

    Describe the fudge. Show me HOW governments will both print money and get it into circulation in sufficient quantities to create inflation. The banks wont permit money to flow into the economy except via their system, any attempt to circumvent that will create a risk of return to actual sovereign control of the money supply instead of the banks; they will refuse to allow it. There must be no alternative or the banks will see themselves being cut out of the process then allowed to fail.

    But while the money continues to flow INTO the banks, yet not OUT of them, there can be no inflation which is, as you indicate, a monetary phenomenon.

    With falling employment and reducing tax flows what mechanism, exactly, will any government have to goose the economy, or at least the flow of cash into that economy? Be precise. I don’t think you can be because there is none. They WANT inflation, they seethe for it, but they can’t make it happen even with trillions in “stimulus” because the pathways for the flow of unearned money into the economy all stop at the banks.

    Deflation is, as you suggest, the only outcome with an actual pathway that anyone can describe.

    Reply
  3. What is playing out in Greece is that the IMF and the ECB (and by linkage other EU states) are trading private investor bonds to relieve the pressure on Greece because it cannot afford to pay the private investor asking rates for further (rollover) funding. So, this roll over funding is being replaced not by new private investor funds but by IMF and EU funds. This is a transfer system. The clear extrapolation of this is, where as it would be damaging to the World economy if private investors lose out on a default, no one cares if national governments and their central banks do. (Apparently!).

    So, this is a private investor unwinding action in order to stabilise Greek private debt (not reduce it) in preparation for a write off that all other governments will absorb.

    The problem is, this may solve one small problem, but there are bigger ones on the horizon in the form of Portugal, Ireland, and then Spain.

    This action won’t work for all of them but then the finance guru’s coming up with this plan are desperately acting short term and do not have the time, ability, vision or funds to concentrate on the long term solutions.

    Fire fighting is the order of the day and will remain so for some considerable time.

    Nab Insider
    June 27, 2011
    Reply

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