Why Rising Government Debt is the Last Straw for Our Ponzi Economy

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The Aussie market did well to ignore the bearish lead from Wall Street yesterday. And it appears justified in doing so. Overnight, the Dow and S&P500 bounced back from the previous days selling.

The oil market continues to regain a bit of balance as well, with prices up a strong 4.5% on rumours of supply cuts. They’re just rumours though. The simple fact is that oil was way oversold and when that happens, prices eventually bounce back to restore balance to the market.

You’re seeing that now. But oil has suffered such a nasty bear market over the past few years that it would be unusual to see a strong and sustainable bounce back from here. More than likely, you’ll need to see prices form a ‘base’ over a multi-month period before getting excited about a sustainable recovery.

That’s assuming this rally isn’t just another opportunity for the short sellers to get active again and take oil down to new lows.

I guess what I’m saying is don’t try and pick the bottom here. It could be a while before you see oil in a bull market again.

Being the last trading day for the month, it will be interesting to see whether the ASX 200 will close back above the 5,000 level. If it can’t (future prices indicate it will struggle) it will represent the lowest monthly close since June 2013.

What does that mean? Well, monthly price data is useful when trying to discern longer term trends. A monthly close below support at 5,000 points suggests the index will go lower. The next level of monthly support sits at 4,800.

Keep that in mind when looking at today’s close…

What else is happening this Friday morning?

Well, it appears the hand wringing over the government’s budget deficit is on again. According to the Financial Review:

Treasury secretary John Fraser has backed the idea of imposing a limit on government spending of 25 per cent of gross domestic product and warned against community and political complacency over the likely cost of funding the growing debt burden. 

He said a return to more long-run borrowing costs could see the Commonwealth’s interest rate burden blow-out by $29 billion over three years.

In a speech that underscored the need for tough budget choices to avoid lumbering future generations with the burden of today’s budget shortfalls, Mr Fraser said if spending remained above the 25-per cent level, taxes would need to be hiked “very substantially” to balance the budget.

I agree that the government has a budget problem. I wrote about this a lot last year. And it’s only going to get worse. Cutting spending in a weak economic environment is political suicide. So is raising taxes.

Australians are addicted to handouts. The government spends 25% of the nations’ economic output and we can’t find a way to pare that back. That’s worrying.

Meanwhile, thanks to falling commodity prices and weak economic growth, government tax receipts aren’t keeping up with spending commitments. As a result, you’re likely to see larger budget deficits in the years ahead. Unless you think the government can remove layers of entitlement spending that Aussies think they’re, well, entitled to.

While the budget deficit is a growing problem, no one seems to lambast the household sector for its decision to take on record amounts of debt. That’s probably because nearly everyone in this country is complicit in the great household debt binge.

According to researcher Phillip Soos, Australia’s unconsolidated household debt is around $2 trillion dollars. Given the size of the economy is around $1.6 trillion, it represents a household debt to GDP ratio of 123%. Soos says that’s the highest in the world.

But you don’t hear too much tut-tutting about this debt, do you?

My guess is that in 2016, you’ll start to hear a bit more…

That’s because foreign creditors supply a good portion of this debt. And we need to pay interest on it, which represents an outflow of capital from the economy.

According to a government paper, ‘Australia’s foreign debt: a quick guide’, in 2013/14 the interest bill on our foreign debt was $23.3 billion. It doesn’t provide a breakdown on what the government paid versus households, but given household debt is so much bigger, I’d assume the household sector paid a large part of the bill.

Where does Australia find the income to pay these bills?

We do so by selling stuff to foreigners, things like iron ore, coal, LNG, tourism and education. (We also sell a lot of land, but that doesn’t show up in the trade data.)

But we’re not selling enough goods or services. Despite the biggest commodity investment boom in Australia’s history, we’re still running persistent trade deficits. That is, we’re consuming more than we’re producing.

We make up the difference by borrowing from offshore. And we pay interest on the debt and then must borrow to cover the interest bill too. If we can’t borrow enough, our dollar will fall to attract the necessary capital.

When you think about it this way, Australia’s economy is a pretty good example of Hyman Minsky’s ponzi economy. That is, the need for constant borrowing to keep things afloat.

But you won’t read about this in the mainstream press. Everyone has too much of a vested interest in keeping the game going to want to shine a light in the dark corner of the room. They want to leave the cockroaches to themselves.

But you can’t fool the laws of economics. At some point the market will suddenly wake up and reprice the terms of Australia’s credit.

Which brings me back to the budget deficit. Perhaps the market was OK with a large amount of household debt as long as the government kept its house in order? But if both sectors start to lose the financial plot together, maybe that’s the sign for the market to impose its ruthless brand of discipline?

My guess is that in 2016, as China continues to implode, you could well see the market turn on Australia. That would not be good…

Greg Canavan,

For The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely 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. For more on Greg go here.
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