Spending Our Way to a Depression

Reddit

“A surprisingly bleak forecast for the world economy pushed stocks to their biggest loss in two months.”

That’s not something we’ve said, that’s straight from the Associated Press. It’s based on research released by the World Bank.

Considering the fairly poor record of any government endorsed institution to predict the current economic downturn, we’re almost tempted to think we should view this as a reason to become bullish on the global economy.

But we won’t just yet.

If you fancy reading the full report from the World Bank, you can do so by clicking here. It’s 167 pages of pure delight.

The World Bank is clearly in a difficult position. It needs to lay on the sauce to highlight how bad things are – so it can get increased funding – yet compliment its paymasters (governments) on the:

“[A]mbitious unilateral and multilateral actions, both conventional and unconventional, governments have drawn on monetary policy, fiscal stimulus, and guarantee programs to shore up the banking industry, which lay at the epicenter of the crisis.”

All of which “are beginning to have a positive impact on financial markets.”

They are certainly having an impact. Whether it is positive is another matter.

In fact, based on the story on the front page of today’s Australian Financial Review (AFR), the seeds for a further slump appear to have not only been sowed, but are being nicely watered in as well.

The AFR tells us:

“Business stocks up on stimulus-package tax breaks.”

The story goes on to say, “Businesses are pulling forward capital expenditure to take advantage of the Rudd government’s $3.7 billion tax break for investment in new plant, equipment and motor vehicles before the end of the financial year.”

Conventional wisdom, ie, the wisdom of the mainstream press, is that this is good. They’ll tell us it’s a good sign for the economy. They’ll tell us that business is seeing the ‘green shoots’ of recovery. Just like they have done about rising bond yields – more on that below.

They’ll also tell us this will be good when the consumer is ready to spend again next year.

We don’t have a problem with predictions. We’re prone to make the odd one or two as well. But we do have a problem when the entire basis of the prediction stems entirely from arbitrary and non market-driven government aid.

Let’s look at the facts. Why are these businesses bringing forward capital expenditure? They are doing so for one reason only – for a tax break. There is little difference between a business and an individual making an investment purely due to a tax break.

They are both destined to end in tears, unless there is a genuine economic or financial reason for the investment. As you know, we’re not a fan of taxation. But we also know that governments have no intention of lowering the tax burden. Any tax cut today, is a tax increase tomorrow.

The AFR points out Caltex is bringing forward “$9 million of pump supply and installation at its service stations.” For what reason? “before July 1, when the 30 per cent investment allowance for large businesses winds back to 10 per cent.”

But as Money Morning reader Andy asked yesterday on the subject of government spending, “isn’t this consistent with one of the aims of government – to smooth out the cycles – by creating jobs in a recession, and restricting job growth in a boom?”

The simple answer to that is, that’s what governments will tell you they do. Hence the clamour to get all the stimulus packages approved, so that government could “fill the gap” left by the private sector, and to be seen to be doing something.

What they forget to add is that it’s the policies of government and central bankers that cause the problems in the first place – I guess you could argue it’s only right they try and fix it! Except they just end up making it worse.

As we’ve stated before, government incentives and tax breaks only succeed in misallocating resources at precisely the wrong time. Currently the economy is trying to shrink. It has experienced a boom and therefore it must shrink.

Any attempts to stand in the way of this merely prolong the effects of the downturn and makes it worse.

If we use the example of Caltex above, we can assume they already had plans to invest in “pump supply and installation” at its service stations. Based on its revenues and profitability and budgeting we’ll assume it had previously planned to do this sometime later than July 1st.

Perhaps much later.

However, the incentive of a government subsidy has caused Caltex to bring that expenditure forward. Possibly forward to a time when they hadn’t considered it to be economic.

The government incentive changes that. We can assume therefore that Caltex is taking on extra risk by doing so. Instead of basing its decision on profitability, it is basing the decision on getting a tax break.

If we amplify this same example across the entire economy, there will be thousands of businesses contemplating exactly the same thing. They will splurge on capital goods now, just because the market is being distorted with the tax break.

Of course no-one’s forcing them to do it. But that’s where the fear of losing out comes in. If Business A doesn’t invest now, he’ll fear that his competitor – Business B – will do so, and potentially gain at Business A’s expense if the economy does pick up.

Normally a business would make the judgment to invest based on expected profitability of the investment – sometimes they get it right and sometimes they get it wrong.

The real danger now is that money is being borrowed and profits spent in the hope that the increased capital expenditure will pay off next year as demand rises from business and consumer customers.

The only problem is that if all the spending is taking place now, who will be left to spend next year? Especially as the costs of these expenditures have to be built into the product price.

What happens if spending doesn’t pick up? Because businesses have brought forward all their investment to today. Don’t forget, there are still forecasts for unemployment in Australia to rise above 7.5% – some have even forecast closer to 10%. Companies are laying off staff, and corporate and government borrowing must still be repaid.

And it doesn’t help matters when bond yields continue to rise, as you can see from an update to the Aussie Bond Yield Curve we’ve been publishing recently…

Interests rates are moving higher and therefore the cost to business and consumers is moving higher. That’s when the impact of inflation really starts to bite.

So, far from government stepping in to smooth out the business cycle, it actually steps in to contribute to the booms and busts and damage the economy further.

Based on the reaction of the markets in recent weeks, the rose-tinted glasses worn by those who believed in a strong economy next year are starting to become a little more tarnished.

Kris Sayce
for The Daily Reckoning Australia

Kris Sayce
Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Daily Reckoning e-newsletter in 2005. He is currently the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service — Money Morning.
Reddit

Leave a Reply

17 Comments on "Spending Our Way to a Depression"

Notify of
avatar
Sort by:   newest | oldest | most voted
Nick
Guest
Some time over the next five to ten years all the tools and equipment in my fairly extensive home workshop will have to be replaced. Should I do it now because VAT is going back up in the near future? I rather think not although I may replace one or two which seem to be nearing the end of their life. There is however one scenario which might persuade me to invest in new equipment now as opposed to waiting for the natural replacement time and that is the possibility of really scary inflation. I shall be watching this like… Read more »
Pete
Guest
Nice article Kris. Took a while to get there, but got there in the end (excuse my hypocrisy). “The only problem is that if all the spending is taking place now, who will be left to spend next year?” Exactly. Just like the FHB’s. If you bring FHB demand forward by giving them enticing grants, what will be there to replace that demand when it wears thin? Stamp duty cuts? Okay…then what? Its all the same story. At some point everything will be brought so far forward that just over the hill there will be a HUGE drop-off. And all… Read more »
The Outback Oracle
Guest

Chrysler Ford and GMH tried this in the US and where did they end up?

travelite
Guest

“Interests rates are moving higher and therefore the cost to business and consumers is moving higher. That’s when the impact of inflation really starts to bite.”

Absolute Nonsense!

That only applies in an credit inflationary period. In a credit contraction it is nothing compared to the reduction in lending that occurs.

Sure, the cost of money is rising, past the massive reduction in credit will reduce prices overall.

Greg Atkinson
Guest
Oh come on Kris, if you have never run your own business and managed a CAPEX budget then just admit it. A good company or business does make a capital investment just because of a tax break…the mere fact that it is bringing an capital investment forward indicates that a business case already existed to justify the capital expenditure hence the reason it was planned in the first place! So the investment is brought forward simply to take advantage of the tax break as opposed to what you are suggesting, which is that the only reason the investment is made… Read more »
Pete
Guest
But Greg…the business investments may not have been made ‘at this time’ without the tax break. These investments are being brought forward, without the companies actually seeing what the future demand will be. Hence, they are tempted to ‘predict’ the future and then over-invest early. This brings up several issues of: – artificial demand spike (eg, companies who supply petrol pumps) – potential capital wastage (what if demand does not reach the expected levels? what if they didn’t need so many new petrol pumps?) – potential future capital shortage (if they spend a lot of money now, will they be… Read more »
Pete
Guest

travelite: I think your interpretation is correct, however I also think another interpretation could be that inflation (regardless of the amount) will be an ‘added’ burden, when interest rates will be causing pain. For people or businesses operating on a capital knife-edge, even the smallest amounts will hurt.

I don’t actually know what Kris meant though. Maybe he got caught up in the moment.

Biker Pete
Guest

What America needs is a superhero: http://sendables.jibjab.com/originals/hes_barack_obama

Greg Atkinson
Guest
Pete there are incentives around for business and companies to invest in a wide range of areas all the time so I think it is going too far to suddenly think there is going to be a huge amount of over investment just because of a new temporary government incentive. In addition I doubt many companies or business owners will be keen to take on debt at the moment just to take advantage of a tax break. We all know that a tax break is not the same as revenue and that it does not really help cash flow. (best… Read more »
Pete
Guest
Greg: I wasn’t suggesting that companies would go into debt in order to take advantage of the tax break. I am sure some will, but when I was talking of a shortage of capital I actually meant available ‘cash’. I don’t think we should go on underestimating the stupidity of some companies though. Most did not foresee or allow for a crisis such as the GFC, even though there were plenty of warning signs. The banks have been playing the fool all this time, although perhaps I am not the only one to notice all the little advertisements and incentives… Read more »
Greg Atkinson
Guest
Pete…you were not suggesting a company would take on debt I agree…the author of the article did this when he stated “The real danger now is that money is being borrowed and profits spent in the hope that the increased capital expenditure will pay off next year as demand rises from business and consumer customers.” Everything you say makes sense, my issue is with the author Kris Sayce. I wonder if he has ever actually run a business or CAPEX budget or is he just sniping comments from the peanut gallery ;) Some companies will make bad decisions that is… Read more »
Justin
Guest
The IMF applauds the depreciation of the AUD?, says the RBA should not raise interest rates? Sell AUD, buy gold. The sooner everyone sells paper and holds gold, silver (and sugar) the sooner the government and the bankers will be unable to destroy the country by slowly sucking the life from it. A story I heard the other day, North Coast NSW so many new apartments have been built in the last number years that buyers will not even look at apartments that are not brand new. Also, my cousin is assistant manager at a hardware store servicing mainly building… Read more »
Biker Pete
Guest

Sugar? Sweet! Melts quicker than gold and silver, but it’s sticky stuff… . You’re a dentist in QLD, right, Justin?

Justin
Guest

Since I can’t hear the tone of your voice, I have to assume you are being sarcastic and say;

If you knew anything, you’d know sugar is one of the most hoardable commodities.

Biker Pete
Guest

Hoardable? Moi? I eat the stuff, religiously. Haven’t you seen all the health warnings about aspartame since ’74?! (Seriously, you have warehouses full of the stuff, right? I’m into tangibles… and sugar is as tangible a substance as anyone can touch, but until now, it wasn’t up there with gold, platinum and silver… .)

Justin
Guest

And there are not warehouses full of gold and silver?

Biker Pete
Guest

Yer a persuasive fella, Justin. I’ll bury a couple of blocks in the backyard… . ;)

wpDiscuz
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au