Where Debt Goes to Die

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While the new Prime Minister and the mining industry argue over the resource super profits tax, the Australian share market remains in a kind of politically induced coma. It can’t go higher or lower until the rest of us know if the miners are going to be super taxed and if so, at what rate.

Our prediction is that by the time the miners and the PM reach a deal, the underlying conditions in the global economy will have changed so much that the case for a tax will have evaporated. How? Glad you asked…

Today we take up where we left of yesterday. The problem is that there’s disagreement over what assets are in a bubble and whether we are headed for inflation or deflation. We’re going to take on the “gold-is-in-bubble” bandwagon tomorrow. It’s getting crowded, too!

But the meandering action in the markets has caused us to step back and assess where we are at in the whole scheme of things (other than level one of an office on Fitzroy Street in a wintery St Kilda, nibbling at a chicken and bacon sandwich). Financially and historically speaking, we’re into phase two of a global debt crisis brought about by the fraud that is fiat money.

In phase one, auto makers and banks and various other firms either went out of business or had their liabilities nationalised by governments in order to…er…protect the financial system from complete collapse (or badly needed adjustment). The core of the problem: many, many bad debts. But now, those debts – some of them anyway – have been transferred to the public sector balance sheet and investors are wary of the strain it has put on already demographically-strained public finances.

How bad are the numbers? According to analyst David Rosenberg, total public and private sector liabilities in OECD nations now add up to about US$225.5 trillion. That’s about 360% of global GDP. It is, in technical terms, a lot of debt. And on this pyramid of debt are asset prices supported (houses, stocks, bonds, and commodities).

Rosenberg argues that the extinguishing of this debt is inevitably deflationary. He is not alone in this argument. As credits are written down and debts repaid, you have households and business deleveraging and, in Europe anyway, governments actually borrowing less and spending less. Austerity.

Ironically – and to your editor this is really strange – there is a valid argument that the austerity measures in Europe and private sector deleveraging in the States (lower consumption and higher savings rates) will mean (gulp) sustained demand for U.S. Treasury notes and bonds. Yes…it’s bizarre that the demand for U.S. government debt would increase at the same time the supply is growing too.

But…if European nations are issuing fewer bonds to finance stimulus measures, or if they are serious about reducing the level of public sector debt relative to GDP, then you MIGHT get a case of more investor dollars chasing fewer AAA rated sovereign government bonds. Mind you, risk-taking investors might prefer corporate bonds.

Either way, though, this who line of thought challenges one of our basic arguments, namely that US government bonds are in a secular bear market and that bond yields in the States are headed higher over time. If American savers and global investors are willing to buy U.S. bonds even at anaemic yields, it means the U.S. can continue its over-spending ways for far longer than anyone suspected, and might even enjoy a stronger currency!

In a deflationary environment where debt is extinguished and asset values fall, you get a general contraction in credit and money supply. In that sort of market, the correct position is Steve Keen’s position of cash and short-term bonds. So is that our new position?

Definitely not!

Our view is that the policy moves to support asset prices and restore economic growth in the States have largely failed. House prices are falling. Employment is stagnant. And the new financial reform legislation is likely to tighten bank lending into the real economy even more – and that’s assuming a reversal in the long process of household and business de-leveraging.

The trouble for the Federal Reserve is that the collateral of the banking sector is heavily dependent on two types of assets, mortgage-backed bonds and Treasury bonds. Last year, the Fed committed $1.75 trillion to buying both classes of securities outright. This kept U.S. interest rates and mortgage rates low and prevented an even bigger implosion in the U.S. housing market.

But now…with U.S. growth at a standstill and threatened by further housing price falls (and the damage that will do to bank balance sheets), and with Europe seemingly committed to austerity (for now), Royal Bank of Scotland analyst Andrew Roberts says the Fed will have to engage in “monster” Quantitative Easing to avoid the deflation Ben Bernanke has always feared.

And here we have the dilemma we’ve come up to several times in the last few years: can central banks create new money faster than the markets can destroy value (or more correctly, reprice assets that were inflated in the credit boom)? We don’t know the answer.

But we know that Ben Bernanke will be certain to try something extraordinary to avoid the hated bogeyman of deflation. It’s unlikely anyone in the White House or the U.S. Congress will stop him if the Fed again makes the case that the viability of U.S. banks and the housing market is what’s at stake. The political independence of the Fed will not be exercised to defend the purchasing power of the U.S. dollar. Rather, the balance sheet of the Fed will be expanded to support and absorb the liabilities of the U.S. banking sector and the U.S. government and force the public to pay for them through inflation and years of lower real GDP growth.

So where does that leave us? Nearly out of time for today’s letter! But the real question is will another round of multi-trillion dollar quantitative easing be inflationary? Will it, in other words, lead to an even higher gold price? Michael Pascoe and Rory Robertson and David Bassanese say no.

Tomorrow, we’ll tell you while they’re all wrong. And not just about gold. But about housing, interest rates, red wine, football, and anything else we can think of. Until then…

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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76 Comments on "Where Debt Goes to Die"

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Stillgotshoeson
Guest

I see deflation and inflation in the future.. there are arguments for and against for either happening before the other.. I can’t see deflation until capitulation sets in.. the false hope, in my opinion, will need a wake up call before deflation sets in.. I think the trillions of dollars out there will try and find a home and give us a bit of inflation first, but I have no doubt deflation will be upon us and not pretty.
Looking forward to feedback on the debate with Rory….

Ross
Guest

As I see it, deleveraging starting in a corner that gets held to a prudent fiscal position that it can’t sustain, then deflation, then panic, and then inflation.

Think deleveraging, think USD and the home of global leverage in commodities, derivatives, and risk assets. 2008 proved it at a time even when US domiciled asset valuations were the ones most under the pump globally, and you would think money would flow the opposite way, the money still ran home to Daddy on cue.

Lachlan
Guest

Well the markets are deflating (futures) Currently 4312 (ASX 200).

Lachlan
Guest
Gold is under attack from youknows. They want us to think gold will suffer deflation. I knew last week they would cap the price just below the previous high for a head and shoulders on the daily chart and there are divergences on volume and RSI. I reckon the gold bubble brigade will be out in force..its a conspiracy :) . This is their big effort to save themselves. I hope they do well because I want cheap gold but with the demand increasing rapidly with lower price I reckon they’ll be lucky to get the sort of kill they’re… Read more »
David Bode
Guest
It’s gotta be deflation and lots of it! All it needs to start an uncontrollable runaway process is for a shoe to drop somewhere like a major sovereign default, and there’s no shortage of candidates for that. Then the US Fed and other central banks will turn on the printing presses like there’s no tomorrow. The fact that QE just doesn’t work entirely escapes them but what else can a banker do? Debt destruction means fiat money destruction. No matter what you may think of Klugman’s economics, he’s right about this being the start of the third great depression. In… Read more »
Lachlan
Guest

Deflation is sending gold higher since its price is not supported by leverage. In fact its price is suppressed with leverage. Note the likes of JPM who created a bus load of sales last night but lost anyhow. Markets way down. Gold up. Exter got it right before anyone.

Ben
Guest

My pick is for a mixture of inflation and deflation too. True inflation (expansion of money supply M3) will not occur at least in the next few years as people lose their love affair with debt and the governments are unable to print it fast enough. However in the adjustment process we will see asset price deflation and consumer price inflation. This process will rebalance massive income differentials in most OECD countries and reduce assets prices back to sustainable levels.

Ross
Guest

Twiggy Forrest says the Rudd tabled RSPT would for the miners mean that “Australia would pay more than double Canada’s tax rates” (as reported by WA News).

Stewart
Guest

Yeah, inflation and deflation for me, too…

Just at different times in different sectors of the economy.

Then everything inflates, then hyper-inflates.

My 2c

Greg S.
Guest
The title of your article and the picture in the caption conveys quite a truth. The absolute greatest debt any of us owe is our sin debt before God. It’s literally like owing $billions and $trillions personally, an amount that none of us could ever possibly pay. It makes our present financial situation pale in comparison. Jesus Christ, the one shown hanging on the cross, paid that debt in full for anybody willing to put their trust in Him. All you have to do is ask! It’s the greatest debt forgiveness program ever instituted since the beginning of the universe,… Read more »
huh
Guest

Thanks for that Greg, a great well rounded, well thought out commentary on the subject of the article. I also like how you’ve hidden your own personal message in amongst the literary gems too : )

Don
Guest

Looks like Greg beat you to that wearable sign caper Ned :( – too slow Joe!

Lachlan
Guest

What a pleasure Greg.S or is that Gregs’ plural. After 6-10000 years of human failure I will hope in God too and nothing else. And Jesus as a man I admire for his devotion to God in the face of tyranny. I believe he was Gods chosen sacrifice. Many believers have gone on to weigh down others with additional burdons however including churches. If I do good I do it for God but I cannot be perfect so my faith in Christ is a daily undertaking.

Biker
Guest
It’s difficult to align your hope for a 50% property crash this year with a belief in the Almighty, Lachlan. He would rather you prayed for a Lotto win than see the poor evicted from their homes, don’t you think?!~ ;) If The Faithful are to be rewarded for their beliefs, don’t you think this kind of heavenly intervention is preferable to the chaos for which you pray? Now I guess you could argue that God will smite the wicked, but it seems to me that widespread collateral damage always occurs when that happens. It has always intrigued me that… Read more »
Stillgotshoeson
Guest

and there are those of us that are agnostic… or even atheist.. whom believe there is no fate but what we make for ourselves..

Ned S
Guest

One of Tolstoy’s contemporaries is reputed to have remarked that after reading War and Peace for the 10th time he felt he’d gained an understanding of the meaning of life – I’m half way through my second reading and strongly suspect I’ll need at least 20! :)

Biker
Guest
“…who believe there is no fate but what we make for ourselves…” Well, it’s unlikely God will intervene to enrich one of us while torching our neighbours. Seems just a little ungodly to me, particularly given the Book of Job. ;) Belief systems are continually under the magnifying glass here. Why quarrel with believers, pantheists, agnostics or atheists; or goldbugs, traders, or savers? There will always be those who, despite or because of their beliefs, take comfort in a get-rich-quick proposition. And there will always be those who grasp for any tiny movements in marketS which herald a change in… Read more »
Lachlan
Guest

No prayers for chaos or crashes here BP.
They are only my predictions.
More or less chaos is always with us. Since I believe in God I therefore believe he allows chaos.
A cheaper house is likely to be little consolation for material losses transpiring.

To measure myself by what I (think I) own (assetts,family,friends) is to sell myself and my God out. I reject that thought.

Nothing said here will stop anything from happening which wasn’t already inevitable.

Biker
Guest
Well, you haven’t a prayer for a 50% reduction in property values this year, Lachlan!~ :) As Ned suggests, any reduction in ‘values’ may be around the 10% mark… ; and, in my view, _if_ it happens it will hit our two largest cities. I’m not really sure what would cause that to happen. A double-dip-recession is more likely to see properties withdrawn from sale across Australia. When that happens it tends to create a(n) (incorrect) perception of shortage of supply. I’ll concede that some Black Swan event might shake the property market about. We’d have to imagine the share… Read more »
Ned S
Guest
I can see “things” changing easily enough over the next 15 or 20 years – In fact it’s almost impossible to see them NOT changing. And within that context re Oz housing, if I had to take a punt, I’d be backing a call for it to be lower multiples of household income. BUT, by then lots of our housing will be 1 and 2 bedroom apartments. Or detached 1, 2 and 3 bedroom dwellings on small blocks of land. With other changes like fast rail links from far flung ‘burbs to city centres. And revamped regional centres maybe. So… Read more »
annie
Guest

Hey neighbour Ned!! Where I am in the Pine Rivers there is no subdivision and I am just outside the urban footprint. So no apartments around me thank goodness. Protects the bushland which is one reason I bought there. How about you?

Ned S
Guest

I tend to buy with an eye on future “potential” Annie. And quite intentionally bought within 500m of rail in the vague hope some nice developer might want to bulldoze my joint in 10 or 20 years … :) But the possums and koalas and your veggie patch sound great!

Stillgotshoeson
Guest
Comment by Ned S on 2 July 2010: As to the more immediate term (barring a black swan), a correction certainly seems like a possibilty again. But given the ability to tweak interest rates and stimulate, punting on a genuine short term crash of 20% plus in an asset class our banks are up to their necks in is definitely not a bet I’d make. Interest rates at near zero in the USA (mortgage rates around 5% fixed) Billions and Billions in stimulus and the housing market is still going under over there.. When the tide turns and I expect… Read more »
annie
Guest

Yes that’s good thinking Ned. I’m only 5 minutes from Petrie rail but far enough away from neighbours. The way the area is growing, I’m sure those developers will be knocking down your door sooner rather than later! People would much rather catch the train than face the bruce highway in the morning.

Biker
Guest

“Better than 50/50 chance now I think.”

HaHa… still a gambler, obsessed with property. First poker, now two-up. :)

Ned S
Guest

I’ve noticed the prices on acreage blocks out past what I assume is the Petrie roundabout Annie. Yep, things have definitely been hopping along over the last few years. You just don’t get that many acreage lots within a short drive of rail anymore I guess.

Ned S
Guest

“20% may well be the nation average decline in property values, some areas may well hit the 50% that others have been saying” – Shoes, you are basically predicting a depression and assigning a “Better than 50/50 chance” to it???

Stillgotshoeson
Guest

Comment by Biker on 2 July 2010:

“obsessed with property.”

Obsessed, no.. observant yes.. it is a barometer of our economy… As an investor I would be a foolish not to pay the property market any attention..

We were due the property market correction in 07/08 government intervention has delayed said correction, also made said correction more likely than not worse than it other wise would have been.. we have more people more indebted than then.

Stillgotshoeson
Guest
Comment by Ned S on 2 July 2010: “20% may well be the nation average decline in property values, some areas may well hit the 50% that others have been saying” – Shoes, you are basically predicting a depression and assigning a “Better than 50/50 chance” to it??? Unemployment rate will be the decider on recession vs depression.. Melbourne and Sydney are the cities with the greatest population and a high number of suburbs and high number of high priced homes.. a decline in those cities will effect the national average simply by the number of higher priced homes that… Read more »
Don
Guest

Biker, I hope it clears up for you but judging from the last few weeks (and today) it has been consistently overcast and raining in Cairns. The rain is not too heavy but just annoying! Anyway I trust that your plans include “in case of rain” options :)

Certainly the wettest “dry” season I have encountered up here.

Biker
Guest

Good luck with that, Shoes. You probably need another decade or so here before you realise that we’re not Americans… and we don’t chuck in the towel all that easily.

Next time you emigrate, invest in a better quality compass. :)

Stillgotshoeson
Guest

Comment by Biker on 2 July 2010:

Good luck with that, Shoes. You probably need another decade or so here before you realise that we’re not Americans… and we don’t chuck in the towel all that easily.

Next time you emigrate, invest in a better quality compass. :)

As a gambling man, should have posted that you would come back with the “were not America” “Australia is different” argument.. I say to you, good luck with that. ;) :)

Ned S
Guest

I doubt China is going to “fall over” as such – I looks like they are quite intentionally slowing their growth a bit; And other Asian countries will presumably begin to feature more prominently. Unless there is a modern day Smoot-Hawley perhaps? But that would seem extremely improbable.

Could Oz shoot itself in the foot regardless? Hopefully not – I suspect a few people have learned a few lessons from the recent super tax effort.

Biker
Guest
Don, it’s _freezing_ cold here, at the moment. We have three of our four fireplaces going 24/7. Coldest snap in decades. A lot of our time will be spent diving. We’re both FAUI… and looking forward to warmer weather… and water… . Most of our time will be spent in Port Douglas, anyway. We were interested to see that Cairns was the fastest growing city in Australia last year: 4%. We just missed an MRD Seminar in Cairns. Not all that disappointed, as we think their profit estimates are highly speculative. We’ll be interested to see how Cairns prices compare… Read more »
Stillgotshoeson
Guest

Comment by Biker on 2 July 2010:

We’ll be interested to see how Cairns prices compare with Perth… .

Hard to say which will have the greater fall :)

China is the variable

Biker
Guest
Ned: “I doubt China is going to “fall over” as such – I looks like they are quite intentionally slowing their growth a bit…” In fact their government is implementing most of the initiatives DR claims the US should have undertaken. As Twiggy Forrest remarked recently: “They’re the new capitalists… .” Lateline carried a report on just one of their motorcycle manufacturing companies the other night: 1.4 million bikes produced annually, mainly for domestic use; with a stimulus grant in the nature of a 13% discount to rural Chinese. Waiting for DR to acknowledge that the Trade of the Decade… Read more »
Don
Guest

You don’t have to worry about the temperature that is for sure – shorts and t-shirt with thongs just for good measure :), even that gets a bit sweaty after a while :)

Ross
Guest

Biker, we wonder if the Chinese may choose by way of economic stimulus and to increase the velocity of rural agrarian consolidation / productivity rise to soften the stance on the one child policy in those urban areas where many westerners have been calling that they have been overbuilding white elephant infrastructure.

Biker
Guest
“…white elephant infrastructure…” Maybe they saw the film, Ross! I guess if you have a 100-Year-Plan, you start assembling the bits-and-pieces well before you need them. DR’s analysis of increased rail infrastructure in China leads me to believe that the Chinese concept of a ‘helicopter view’ may differ slightly from Bernanke’s. I’ve convinced my FA that a look at these mysterious WEIs is worth doing in 2011, once she retires. Are the Chinese simply moving the deckchairs about, or is there method to their madness? DR has unquestionably shifted from a position of the former to the latter… . Must… Read more »
Joseph Gontier
Guest
Hey fellow Aussies, I’m just an observer and that is all. I’ve been living here in Sydney in Surry Hills with my Aussie wife. I’m from Los Angeles. I was in LA when everything was booming. A property wouldn’t be on the market for no more than a couple of hours before it was sold. There was money to be made. People that had bought their first home in 2004 saw it go up by at least one third by early 2007. Those people were leveraging the equity in their first home to buy a second and even third home.… Read more »
Ross
Guest

Too bad we can’t get you there earlier Biker. Now I did see a TV show on a New Yorker who took his Harley to China some years ago. Maybe you can track that down.

Ross
Guest

Nice to hear from you Joseph.

Steve
Guest

It is all about the “greater fool,” says Shedlock. Just like the stock market, people are buying houses now because they think they’ll sell them for more later—hopefully a lot more. But inevitably, “the pool of greater fools runs out.” There is no one left willing to pay an even higher price in the speculation that prices will keep rising.

Biker
Guest
“Just like the stock market, people are buying houses now because they think they’ll sell them for more later…” People buy houses for many reasons, Steven. Most Aussies buy homes for shelter. A mere 14% buy them as investments. This seventh of Aussie buyers are generally better-insulated from debt than many other groups, including the group _you’ll_ join when houses plunge 33.3%: the First Home Buyers. Just imagine your excitement when you become part of that group of homebuyers you’ve reviled for the last couple of years… !~ :) We _build_ houses because it costs us less. We do the… Read more »
Stillgotshoeson
Guest
Comment by Biker on 2 July 2010: Most Aussies buy homes for shelter. A mere 14% buy them as investments. This seventh of Aussie buyers are generally better-insulated from debt than many other groups See this is where you are wrong. 1 in 7 may be property investors with 1 or more investment properties, however many buyers of homes have been buying under the spruikers “buy now before you priced out of the market”, “property can only go up”, “you can’t lose with property” mantra… These people are about to learn that property can indeed stop going up and not… Read more »
Stillgotshoeson
Guest

“Biker”
Oh but Shoe_son you have got it all wrong the government will do whatever it can to protect the housing market.. they will put more stimulus into the economy to keep it ticking over and that will stop the correction from happening and all will be good….

Oh really Biker… maybe have a read of this and let me know how well stimulus measures work….

http://www.nytimes.com/2010/07/03/business/economy/03jobs.html?hp

bearamundi
Guest

Thanks for the heads-up Steven, and I hope you enjoy Australia. Your concerns sure strike a chord with me. Perhaps some of the buy to let sector, or build to let if you want to get pedantic about it, might also be hearing similar music and not gazing so gleefully at The Big Banana on their travels. Or is it The Big Pineapple? Whatever, I’m sure you get the drift…otherwise, why the need to incessantly build yourself up?

Ned S
Guest

Sounds like we are about to see some real world hypothesis testing in action … Haven’t had this much fun since me last visit to the casino! :)

nv
Guest
Comment by bearamundi on 3 July 2010; “The Big Banana on their travels. Or is it The Big Pineapple?” Oh yeah, there’s The Big Banana and The Big Pineapple and then there’s The Big Merino and The Big Shrimp and The Big Pie and then there’s The Big Wombat and The Black Stump then Tucker Box a few other big’ns and by the time you finish visiting them you may lucky enough to experience the spectacle of quite a few ossies getting The Big Shaft to add to their collection. Not sure which city, town or highway will have the… Read more »
Biker
Guest
“Sounds like we are about to see some real world hypothesis testing in action … Haven’t had this much fun since me last visit to the casino! :)” HaHa, I doubt it, Ned. :) You and I have been reading this kind of stuff here, year after year. Other than Keen’s walk to visit The Big Mountain, what has changed? The same noise, different names, but no change of any consequence. You have to admire the sheer persistence of the sad bears. Daily posts flagging a crash, all their guru’s predictions on property, unemployment and interest rates woefully wrong… and… Read more »
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