When Lenders Stop Lending

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The Dow shot up 152 points yesterday…following an announcement that Greek voters had approved more austerity measures.

So, the Greek crisis has been solved…Dominique Strauss-Kahn may not have raped that hotel maid, after all…and the Chinese are buying euros.

Whew… A close call! But now the Greek crisis is behind us. We can get back to work…and all get rich.

The French and Germans will pretend to fix the problem. The Greeks will pretend to cut spending. And lenders can pretend to get their money back.

But what happened to all that debt that Greece couldn’t pay?

Wait a minute… We know what you’re thinking. You’re thinking that now that the crisis is behind us, interest rates can return to normal. And at normal interest rates there isn’t any problem. After all, it was just a temporary problem caused by jittery and greedy lenders, right? And as long as the full weight and credit of the European financial authorities – with some help from their colleagues East and West – is behind the Greeks, everything should be all right. The Greeks can borrow money to plug holes in their budget and pay the interest on past loans.

And you’re right – sort of.

Well, you would be right if lenders were born yesterday. They would just lend more and more so the Greeks could borrow more and more, forever and ever, amen.

And don’t forget the rest of Europe’s debtors – Ireland, Spain, and Portugal, for example. They’re in the same boat, more or less. They need to borrow money now, largely to service the debt they borrowed before. And as long as interest rates don’t rise, this can go on for a long time.

But what if lenders had been around the block once or twice? It’s often said that the stock market is about the future. The bond market is about the here and now. But what if bond buyers suddenly recalled how they got mugged the last time they went around the corner? What if they remembered what happens when debtors borrow so much that they could never pay it back?

Wouldn’t that lead them to think that…

  1. Lending more would be a mistake
  2. Or, at least ask for higher interest rates…?

Well, you can imagine as well as we can.

The Greeks owe too much. So do a number of European countries…and so does the United States of America.

What do we mean by “too much?” Well, nothing precise. But if you add up all the debt, it comes to over 100% of GDP. Which means, you ‘normally’ would need to devote something like 5% of GDP or more to pay the interest on it. And if a government can collect 20% or 30% of GDP in taxes, it means it has to devote as much as a quarter of all tax receipts just to cover the interest on money it already spent.

Imagine that you were in that position. Theoretically, you could still be okay. You could stop spending beyond your means…and then ‘grow your way out of debt.’ But that’s not what happens. Crowds of zombies take to the streets. Political pressures force governments to keep spending. And if your deficit is greater than your growth rate, you’re going deeper into debt.

Let’s see…the US has a GDP growth rate (taking the feds at their word) of less than 2%. What’s the deficit? About 10%? Hmmm…not good.

But this math is obvious, isn’t it? Even to the people who buy bonds, right?

So how come US bonds have generally been going up, not down?

That’s the real question, isn’t it?

NB: the Chinese are buying euros.

And more thoughts…

“The stock market is way overrated,” said a friend last night. “People think they are going to make a lot of money by being ‘in the market.’ They think that if they just choose the right stocks…or stay in the market long enough…they will get rich.

“They’re dreaming. When you buy a stock, what are you really doing? You’re buying a piece of a business that used to belong to someone else. It’s like buying a used car. And the person who used to own it…especially if he was the original entrepreneur or founder…knew it better than you did. And he didn’t want it. At least, he thought it was worth less than the money you were offering him for it. He’s moving on to something better.

“So, you’re buying a bit of a business that he wanted to get rid of… You’re also buying it after it has been puffed up by venture capitalists and IPO firms…embellished by stockbrokers and analysts…and advertised by copywriters and salesmen. Of course, as you say, investors are ready to believe anything.

“And in a bull market, nobody cares. Even the rubbish flies up in the air. But when the wind dies down, you find the stuff back on the ground where it was when it started out. You get a good look at it. And you see that it’s trash.

“According to the theorists, stocks give you a ‘risk premium.’ That is, when you give your money to someone else, you’re supposed to get something in return. That’s the going interest rate. It’s supposed to be more or less risk-free. You earn more from stocks because you take additional risk – the risk that the value of the stocks will go down.

“But you only earn a risk premium if you buy the stocks at the right price. That is, if you buy when they’re cheap. As soon as everyone thinks he can earn more money from stocks than from bonds – because he believes the ‘risk premium’ concept is immutable – the price of stocks rises. Whatever premium was available is gone. So you end up getting a ‘risk discount.’ I mean, you pay more than you should for the stocks; you’re paying just to add more risk to your life.

“It’s a crazy bargain. But it’s worse than that. Because the nature of the public markets distorts company behavior. They do things that increase the risk even more…and generally undermine the long-term results. Like GE going into the finance business. Or like that deal for Skype.

“The corporate guys are only worried about the quarterly announcements. They need to show growth. They need to have new deals. They need to have something they can tell investors to keep them excited. They need numbers that convince investors that they’re going to make more and more money.

“So they do stupid things…just to keep the kettle boiling. Things they would never do with their own money. And the average investor doesn’t have any idea of what is really going on.

“I like to stay in the real world of real businesses…owned by private investors and businessmen. The conversation you can have with them is much more sensible. Down to earth. Everyone talks the same language. There’s much less nonsense and showmanship involved.

“Forget the stock market. It’s a trap for the unwary.”

Bill Bonner
For Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
Bill Bonner

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Comments

  1. Great article Bill, it feels to me like we are all part of a great whirlpool – everyone thinks it’s fun to keep it spinning – but no one is really in control (and we’re all going down).
    So, buy gold? property? or baked beans?

    Reply

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