Perhaps This Recession Will Be One for the Ages After All

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Ordinary people are getting poorer day by day, but this decline seems to be stabilising. That appears to be the official line on the news of the last twenty-four hours.

In today’s Daily Reckoning, we’ll review the contradictory claims. We’ll also tell you what Alan Greenspan whispered in our ear the other night about gold, inflation, and the bond market. And we’ll ask more stupid questions about government.

First, “Australian wealth held in the form of shares, investments and property is collapsing at the fastest rate on record, shrinking an extraordinary 12 per cent in the past year,” reports Peter Martin in today’s Age. “Federal Treasury calculations released to economic modelers yesterday suggest that the average Australian lost an inflation-adjusted $26,400 in 2008 – 11.8 per cent of their real wealth.”

Ouch. Perhaps this recession is going to be one for the ages after all.

The Treasury model says the average Aussie household had a $250,000 net worth at the beginning of the year and just $223,985 at the end of the year. That actually seems like a pretty mild decline when you consider that the ASX/200 fell by 42% last calendar year. Relatively stable property prices may have made up for falling share prices.

It raises an interesting question, doesn’t it? What is wealth? Is it money? Is it material? Is it spiritual? Hmmn.

Yesterday we wondered if unemployment was a leading or lagging indicator. Are things getting better because people are getting fired, or are they getting worse? Later in the day came the news that an Aussie index of leading economic indicators fell at its fastest pace since 1982. The Westpac/Melbourne Institute of leading economic indicators shrank at annualised pace of 5.1%. So what does it mean?

Well, it means the recession is worse than anyone thought. It means the Reserve Bank may take the cash rate lower (watch the Aussie dollar for signs of weakness). And it means all these clowns who are predicting a big recovery by the end of the year are whistling past the graveyard.

Shares in the U.S., however, paid no attention to the Westpac survey. In fact, the Aussie market may take its lead from the Fed’s Beige Book (a survey of economic activity in the twelve Fed districts in the U.S.). Stocks on Wall Street rallied by the end of the day after investors had a chance to thumb through the pages of the latest survey from the Fed.

The Book said that, “Five of twelve districts noted moderation in the pace of decline, and several saw signs that activity in some sectors was stabilising at a low level.” There you have it. The pace of decline is slowing. Activity is stabilising at a low level.

Isn’t this what happens in a coma?

Seriously, we have a case of competing numbers and a priority dispute brewing. The leading indicators in Australia are breaking down. In the U.S., they are breaking down, but less bad. Is that good?

How about GDP numbers? Well, remember that U.S. fourth quarter GDP fell by 6.3% annually. If the first quarter number is less bad, is that good? And what do you do with the Singapore GDP number released on Monday? That showed Singapore’s GDP contracting at a stunning 20% annualised pace, and down 11.5% over the year before.

Is Singapore trade collapsing because American demand collapsed before it? If that were the case, then the “less bad” American data and the really bad Singapore data might indicate that things really were “stabilising at a low level.” They could stay there for awhile, mind you. But we reckon there is more instability ahead, which probably means more and greater GDP contraction.

But it has to end sometime doesn’t it? Yes, of course it does. This brings us to our dream the other night with Alan Greenspan, which we promised we’d tell you about yesterday. Here goes…and don’t ask us why the Maestro showed up in our dream. He just did. So we took the opportunity to ask him a few questions. We’ve reconstructed the conversation as best we can.

“Maestro…you hardly look yourself. It looks like twenty years have dropped from your face. It must be liberating not to have to worry about inflation anymore.”

“What’s inflation?”

“Ah yes. About that. Why haven’t we seen it yet? You’ve seen massive fiscal stimulus plans the world over, a huge increase in the monetary base, and lower interest rates. But no inflation. Bond traders don’t seem especially worried either. They are not demanding higher interest rates because they fear future inflation. And gold? Well, it’s plodding along. But shouldn’t it be going much higher as the supply of fiat money explodes?”

“You’re thinking is so old fashioned. It’s true. Or at least it used to be true. In the days when we had a gold standard, it was a great defense against government monetary fraud (that’s what I used to call inflation, before I became a central banker).”

“Oh. What do you mean?”

“If each unit of paper currency in your hand is redeemable for gold, then each holder of paper units has the power to hold the government accountable for its fiscal and monetary policy. If the government prints too much money to pay for its spending programs, unit holders can redeem their paper for gold. This draws down the governments stores of real gold, forcing it to either reduce the supply of paper money, or lose all its gold.”

“Why would it worry about that if it could just print more paper?”

“Because paper is not money. And your trading partners will not accept your paper if it is not backed by either real money or the ability to collect taxes from your people.”

“I’m not sure I follow. Back up a bit for me.”

“Okay. Back when everyone was on a gold standard, before the Great Depression, international accounts were settled in gold. It wasn’t just citizens who could demand gold for their units. Nation states could do it to. Governments who ran up fiscal imbalances would see international holders of their currency redeem those paper units for real gold. This encouraged a kind of competition among nation states, or at least a kind of accountability. If you ran up deficits and borrowed a lot of money, gold flowed out to pay your creditors and to pay for your exports. Your inflationary monetary policy cost you your national inventory of gold and silver.”

“So what happened?”

“My you ask a lot of questions.”

“Hurry up. I think I have to wake up soon.”

“Well, under a gold standard, governments are forced to manage their monetary system for the benefit of their people. You get a stable price level because the value of the money is not fluctuating constantly with changes in the money supply. Governments want to avoid causing a run on their gold supply that would result from fiscal and monetary mismanagement.”

“Why did the world go off the gold standard if it was so good? What changed?”

“Lots of things. For example, with a gold standard, governments and people must live within their means. This is deeply unpopular with politicians, who must bribe populations with bright new shiny things to get elected. Gold makes it harder to bribe your people and win an election.”

“Okay. What else?”

“For whatever reason, perhaps because it is in their nature, governments like to take their people to war. It keeps them distracted from other problems, usually caused by the government. But war is expensive. To pay for a war you must increase taxes or borrow money. If you increase taxes (directly or indirectly) you risk alienating your population and causing a tax revolt (and sending a lot of economic activity underground, out of the view of the tax collectors). So you have to borrow. It’s the only way to greatly expand spending without raising taxes to punitive or socially disruptive levels.”

“Ah. I see. Under a gold standard, you couldn’t borrow excessively without causing a run on your nation’s gold. So…a gold standard was a natural constraint on a nation’s ability to make war.”

“Yes. That doesn’t mean nations didn’t go to war before there was a gold standard. It just means that if you had to pay for your war with real money, it made it an expensive proposition. And if it undermined the value of the currency your citizens held, they were unlikely to support you. In a monarchy or dictatorship, that doesn’t matter so much. But in a democracy, it matters a lot.”

“If what you’re saying is correct, Maestro, then there’d be a clear connection between the creation of fiat money which is not backed by gold at all, and war between nation states.”

“There might be. But you’re still thinking too small.”

“What do you mean?”

“It’s true that most nations suspended the gold standard upon entering World War I. This allowed them to run up ruinous debts to private bankers. They tried reinstating it, but then the Great Depression hit. And more than ever, governments needed the ability to print money to pay for domestic ‘wars’ on poverty and unemployment.”

“Right. And then World War Two-which was partly a consequence of the ruinous debt and reparations Germany could not repay-came along and you saw a huge explosion in government debt, this time mostly through bonds.”

“That’s right. Which brings us back to inflation today. When the government finances exploding debts through the issuance of new bonds, investors typically demand higher interest rates to compensate for the inflation that results from the increase in the money supply. But today, in a kind of conundrum, bond investors are not demanding higher interest rates.”

“Why not?”

“Who knows? For one, they don’t see inflation. They see falling prices that come with a collapse in global demand. But it could be that they fear the world wide recession more than they fear inflation. The contraction in global trade and national GDPs has investors fleeing for the safety of bonds. This allows governments to print money and expand the monetary base with apparent impunity.”

“Apparent?”

“Yes. Why, there in Australia where you’re sleeping, the government is going to announce a budget in May which may include a $50 billion deficit. This is a country that had a surplus just a short time before.”

“That’s not as bad as my home country. In the U.S., the government is going to run a trillion dollar deficit this year. And it’s told everyone that number will double. But it doesn’t seem to have dented demand for U.S. bonds yet.”

“No, it hasn’t. And that’s because without a gold standard, governments don’t have to compete for capital as fiercely as they used to. They can all sell bonds to investors to finance deficits, provided the deficits aren’t too jaw-dropping and provided they can continue to collect taxes to pay interest on the debt. Plus, they’re colluding with one another to eliminate tax competition among countries, which gives them an even stronger grip on your wealth.”

“I’m with you Maestro. But I don’t see where this is going.”

“Let me show you. Governments can only raise direct taxes (income taxes) so much before it negatively affects the economy (and social cohesion), which in turns lead to falling tax revenues as real economic activity slows. So a sure sign of governments that are getting desperate for revenue is an increase in indirect taxes.”

“You mean like the alcopops tax here in Australia?”

“I’ve never heard of that. But if it’s a tax that the supplier of a good or service passes on to the consumer then yes, that’s exactly what I mean. It’s an efficient way for the government to raise revenue without looking like it’s being grubby, desperate, or just plain greedy. It can also claim the taxes are being raised to discourage socially undesirable behavior, but this is generally just a lie to disguise the need to raise revenues.”

“Ah. I see. You know the alcopops tax is illegal anyway, by the way. The government collected revenue on a tax using a law that hadn’t been properly been passed by the Parliament. How is that possible? What about the Rule of Law?”

“What about it?”

“Never mind. You need to finish your lecture before I wake up. When will inflation result from the large increase in the monetary base?”

“I have no idea my boy. You see at its core, fiat money greatly accelerates the rate at which scarce resources are depleted. Land, labour, capital, and raw commodities are allocated based on a demand that isn’t sustainable. If you do that long enough-let’s say for the last seventy years or so-you get an entire global economy (and population) that exists because of the increase in credit. That’s the world we live in. And it’s all falling apart with the credit depression you’ve been writing about.”

“Wait a second Maestro. Are you saying that the scope and scale of this economic contraction is a lot greater than anyone expects because the fiat money system itself is failing?

“You said it. Not me. But it does make sense to say that the last twenty years or so of building national economies around the growth of residential real estate and the finance sector has greatly hastened us to a day of reckoning, as your friend Bill Bonner might say. We will find out if all that investment made by banks is merely ‘temporarily impaired,’ or if it represents an enormous misallocation of our collective resources and has made us poorer for years to come.”

“So what should we do?”

“This is your dream. You decide.”

And then we woke up. We’ve faithfully recollected as much of our conversation with the Maestro as clearly as possible. But what about the “what should we do” part? We have a few ideas. We’ll send them your way tomorrow.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Very interesting article. I like your fictional dialogue, it’s pretty well written.

    Speaking of sneaky taxes…isn’t inflation the biggest one of all?

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  2. Good article, very enjoyable. With respect to inflation I liken it to counterfeiting. I could have (in theory) a billion dollars of funny money stashed in my house but it will have zero effect on the real economy until I start using it to buy goods, services etc and get it in circulation. In the same way all the money that the US and other governments have pumped into their banking sectors is being hoarded by them to save their balance sheets. It is only when things pick up again and this fake cash comes flowing out will we see inflation take off.

    As far as the Aussie deficit is concerned – pfffft Kevin will fix this no problem. We will have “GST 2” where the rate will be increased to say 12% while the states will “promise” that they will drop their taxes and fees to compensate for the increase – sound familiar? It’s all due to the “extraordinary financial pressures brought upon by the GFC” – and to sweeten the pot chuck in a couple more government handouts which the voters are currently lapping up. I really hope this doesn’t happen but you always bet on form I guess. Keep up the good work guys.

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  3. not everything is GST yet

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  4. Pete – Re inflation – Yes, governments and central banks specifically target positive inflation. (Rather than no inflation and no deflation – Which would mean preservation of the buying power of the currency.) I guess I wouldn’t mind quite so much, if they hadn’t been masquerading as good guy type “inflation fighters” for so many years – Who had always tried to do their best of course, but just never quite managed to be successful. That is one of the positives that has come out of the GFC for me – I’ve finally starting getting a few insights on how these chappies really work. Better late than never I guess.

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  5. This is a good article. I recently stumpled across this site. I am quite interested when some people comment on the coming inflation because I have a house and an almost cash-low positive investment property and am keen to read about that to get a clue about whether to fix the interest rate. However I have a question for anyone that thinks they might be able to have a go at answering it for me. (Please excuse my simplicity as I can see from the quality of comments here that my knowledge is not at your level). But if inflation is coming then isn’t it likely that the RBA will again be reactionary rather than proactive and be chasing it down with small increases in the cash rate (ie as per the 12 x 0,25% increases that we had from 2003 up to early 2008). Therefore inflation that is not chased down effectively should lead to a reinflation of asset prices. Lets say that $500K now is diluted in its purchasing power by half over the next 5 years due to this inflation and further compounded by money printing (or Quantative Easing as they like to call it). Right now $500K is enough to purchase the median property in all Aus cities, however after the QE is will only buy half the house. Therefore I find articles like this (that talk of the coming inflation) contradict with others saying that house prices have to fall by 20% or so. Both can’t be true. My guess is that the Mining states might be the first to recover from this crisis, thus holding up property values in those states whilst the financial industry will suffer for some years. (I’ve marvelled for years that we have an industry that makes money from simply shuffling money around. No tangible wealth is being created, just paper wealth and hence real wealth will only flow to those industries like Mining that actually value-add). The RBA can only come up with one cash rate for the whole economy. Mostly populated are Sydney and Melbourne who do not have value-add economies except for Melbourne’s very weak manufacturing industry), therefore I can see them coming under pressure and the RBA cannot raise rates to curb the re-inflation of the resources boom because they must look after Melbourne and Sydney. Also other articles on this site point to China investing in materials for the next 50 years rather than US dollars – a huge substantial shift in their investment profile. This should also be good for the resource states of WA, QLD and more recently SA. Your thoughts?

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  6. Brian,
    I’m not an expert either, but I think your analysis is correct.
    The phrase real is used to refer to inflation-adjusted amounts.
    To answer your question about house prices: Say 500k is the current median house price, but that could well be overvalued (its hard to say), in which case prices could be expect to fall in real value.
    If this scenario occurred the actual $ price of houses would depend on whether valuations fell faster than inflation decreased buying power.
    The sale prices for houses could increase, decrease, or stay the same, but in all of those scenarios, the real value could have declined at the same time. It just depends on how severe inflation is.
    This makes timing the housing market extremely tough, as you have to correctly guess future inflation rates, interest rates and how realistic current valuations are. Get one of these wrong and it could hurt.

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  7. Brian: You assume asset inflation will be the same as general inflation levels. Also, as Richo pointed out, the credit deflation vs inflation battle will probably not be in a smooth sailing.

    Remember the highly appropriate quote regarding market assets purchased with debt:
    “The market can stay irrational longer than you can stay solvent”.

    As Richo said, it could hurt.

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  8. Thanks Richo and Pete for your feedback.
    You could say houses are overvalued, by what I don’t know? Certainly not more than 20% I would think because everyone I know would jump at buying a house given the shortage, increasing rents and low interest rates, so we know for sure that they are not 20% overvalued because the supply versus demand balance will not end up there.
    We still have high taxes in the top brackets and hence negative gearing is still very much in play. I think there are quite a few investors who are on the sidelines and scared off. But I reckon that won’t last forever.
    However it is the coming propsect of infltion that alerts me. Anyone who was holding assets (Property or Shares) in June last year and still has them has been hurt. However many countries are running their printing presses at maximum capacity to create more money in the system to repay gov’t debt (ie US).
    My concern is that we know many countries are running QE on their currencies. Therefore if you do not hold assets when that inflation effect hits then you will lose half of your purchasing power.
    If I had spare cash I would be heading off to the US now to buy property. Huge money printing going on with prices down 20% and possibly more if you find the right distressed sale. Its a once in a lifetime opportunity it seems. Pity I don’t have the cash.
    As for Aussie property, I’m guessing it will hold its own because its now a bit more expensive than the US due to US falls.
    However 80% auction clearance rate last weekend in Melbourne proves there is still some fire there. Therefore it seems the low interest rates have provided a floor under further falls. I simply cannot believe the pundits who are forecasting a property price crash. The gov’t lets people write off capital losses against future capital gains, however there is no such write off for people that sit their cash on the sidelines and see half of their purchasing power eroded and house prices double because their country has run with a QE campaign. History tells us that with property its time in the market not timing the market that counts. With shares I think timing the market counts because a share transaction only cost $30 whereas stamp duty runs to thousands and it is too difficult to know when to buy and sell. Therefore it’s sit and wait for me with my properties.

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  9. See ‘my’ website for a PDF link Re: World Property.

    It’s from demographia.com which I’ve seen referenced before on this site by Dan. “Severely Unaffordable” tables etc etc.

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  10. Love your work Dan!
    Re:Wealth types
    A man/woman can possess wealth in the form of money, material or spiritual wealth…..however in regard to wealth types,
    spiritual wealth is harder to obtain, outlasts material wealth and is more likely to exist alongside happiness and contentment….therefore the most valuable wealth type.
    Despite good management material and money can be lost or stolen. Spiritual wealth can endure and grow through hardship such as is coming soon for many. As such hardships are also liberating forces… for some.
    Re: Money and material wealth….”buy gold and hold!”.
    Re:Real estate…my wife just got a 25% discount on a vacant block of 6acres….granted this sort of property is likely to lose value before before the more heavily invested/populated areas but still 25% is pretty steep.
    Lachlan

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  11. Brian:
    If you have the time, read the comments here:
    http://www.dailyreckoning.com.au/australian-house-prices-are-severely-and-seriously-unaffordable/2009/01/27/

    I have two points for you to consider:
    1) how do people buy Real Estate? Savings or loans? What happens if people cannot get loans? What happens if people require more than 10% deposits? (the answer is that the market dries up)
    2) is the current economic situation likely to be even faintly similar to the future situation? (eg, 5 years time?). Consider high unemployment levels, increased interest rates and cost of credit, negative equity.

    One of the biggest mistakes (well, I think it is, we don’t know just yet) people make is to make calculations based on the ‘current’ economic climate. It seems rather short-sighted. If you are making a 25yr commitment on a mortgage, I think it stands to reason that you should look at least 15 years ahead. But not only to the 15th year, to every year between.

    Click on my name, it links to a comical image relating to our ‘resources boom’. The Rudd Express.

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  12. read: “An Analysis and History of Inflation” by Don Paarlberg

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