Will Europe’s Austerity Mean Fireworks for Australians?

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What happens on the other side of the world has never been more important to Australians. You saw how recessions in faraway places almost halved the ASX200 in 2008. You have since been seeing what happens to people in those countries – joblessness and no interest return on savings.

Australia needs to learn from what happened there (which it probably won’t) and that you need to remain aware of what is going on in places like Europe, China and America.

Today, we focus on Europe’s malaise.

It couldn’t get any worse for Spain. This week, its two top soccer teams  both lost in the semi-finals of the world’s most prestigious club competition. Maybe it does get worse. A German and a British team beat them. Debt ratings agency Standard & Poors downgraded Spanish debt as a direct consequence.

If Europe doesn’t get its act together, 2008 will look like a bump in the road that leads off a cliff. Even for Australians. But what does ‘get its act together’ actually mean?

Does it mean austerity, stimulus, bailouts, defaults, devaluations, inflation, regulation, deregulation, a breakup of the monetary union or a bizarre combination of the above? Nobody answers the question in the same way. And most people who readily answer the question have no credibility to do so. Least of all, those who actually implement the ‘solutions’.

Politician Nigel Farage has been busily pointing that out. ‘Sorry, no one believes you anymore,’ he told his fellow members in the European Parliament, ‘The euro is doomed.’ But nobody does more damage to their own credibility than European leaders themselves.

The chairman of euro zone finance ministers Jean-Claude Juncker came up with a contender for quote of the century: ‘I would like to invite financial markets to behave in a rational way. Spain is on track.’ Unfortunately Spain is now in recession. And it got downgraded. Juncker tried to explain a similar moment previously with his other contender for quote of the century: ‘When it becomes serious, you have to lie’.

Over in America, it is taken as self-evident that austerity is a bad idea. The land of sub-prime loans dispensing financial advice seems a little odd. But do they have a point? Is austerity a bad idea because it reduces gross domestic product (GDP) while the amount of debt remains high?

This is a completely absurd argument because of the nature of GDP. If government borrows and spends, that increases GDP. The same goes for private sector borrowing and spending. If the problem facing an economy is too much debt, you need to borrow less or increase the part of economic growth that pays for the debt. Seeing as not all GDP growth pays for debt – some of it is the increase in debt – GDP is the wrong measure to use.

You have to look at the performance of the part of the economy that is not debt-fuelled growth. Strip the increase in debt out of the GDP figure and you find out whether true economic growth is occurring. The kind that doesn’t have to be paid back in the future. If that part of the economy is growing under austerity, then austerity is working.

Of course, it is unlikely this is happening in any of the countries implementing austerity. Mostly because their version of austerity includes government deficits that are still incredibly high. Government debt is still increasing rapidly in the countries attempting so-called austerity.

So perhaps inflation is the answer. That probably won’t work either. When inflation hits, it becomes more expensive to borrow for governments. People demand a higher interest rate to compensate them for the loss in purchasing power. Let’s assume for a moment government borrowing costs keep pace with the increase in inflation. Higher borrowing costs offset any decrease in the real value of the debt.

The crucial crossover where inflation actually becomes counterproductive in lowering the real value of debt is around 100% debt to GDP. At that point, any reduction in the real value of debt from inflation is cancelled out by higher borrowing costs, if you assume borrowing costs keep pace with inflation.

Of course, borrowing costs don’t keep pace with inflation – which is where things get messy.

Government doesn’t refinance its entire debt at the market rate every day. It refinances a little tomorrow, a little next year, and a little in 10 or more years. That means higher interest rates filter through to the government’s interest expense account slowly. Governments that have less debt to refinance in the short term will feel the pinch with some delay. The measure of this is called the maturity of debt.

This is why the US Federal Reserve can’t raise interest rates. US Treasuries have a fairly short average maturity. The costs of higher rates would be passed on quickly. In the US, a few years ago, the average interest rate on US government debt was 6%. If rates went back there, according to bond fund manager Jeffrey Gundlach, it would add $600 billion more in interest costs (without taking maturity into account).

That would be a complete disaster for the US government and economy. But if inflation goes up – the one situation where rates would rise – then that interest bill would rise anyway because bond rates tend to move with inflation.

The Federal Reserve would need to refinance the billions in interest, signalling more inflation, signalling higher rates. It took former Federal Reserve Chairman Paul Volcker’s 20% rates to reverse this cycle in the past. 20% interest would wipe out the US government’s tax revenue.

But there is another fly in the ointment, even for countries with debt that doesn’t mature for some time. The price of governments bonds will fall in the secondary market if there is inflation because of the low interest the bonds pay. This causes a major problem for banks holding the bonds because their assets would be worth less.

This puts the banks at risk of failure. The government may be forced to assume the banks liabilities. This is why S & P downgraded Spain. There is a fear the government will have to bail out Spanish banks soon, sending Spanish debt to GDP ratios through the roof.

But the worst offender when it comes to these implied debts the governments have been taking on is Belgium. This analysis from Out of the Box editor Mark Grant is entitled ‘I Do Not Believe, Any Longer, That The Catastrophe Can Be Avoided’. It explains just how bad implied liabilities can get.

 

Nowhere is the danger greater than in Belgium at present… Taken all together this totals $213.8 billion which is nowhere to be found in their debt to GDP ratio. Just these liabilities alone are then equivalent to 41% of Belgium’s GDP. On 4/20/12 the central Bank of Belgium admitted the economy was in contraction and that the current “official” debt to GDP ratio was 98.2%.

 This then takes financial sector contingent liabilities and the “official” debt to GDP ratio to an astounding 139.2% but the story does not end there. Belgium is accountable for $132.8 billion of the ECB’s balance sheet, $50 billion for the Stabilization Funds, $36 billion for the Macro Financial Assistance Fund, $26.8 billion of the European Investment Bank’s balance sheet which adds another $245.6 billion to Belgium’s liabilities. Consequently Belgium’s European liabilities are an additional 64% of their GDP. Then the gross total is: 203.2%

Now guarantees and promises and contingent liabilities are funny things. You can pretend that they aren’t there but then they show up and demand payment.

 

You’re getting a taste of what it’s like to be a government official these days. Nothing but dead ends everywhere. And governments built the walls that now trap them.

Still, there is the occasional good news item amongst the doom and gloom. Governments are being forced to peg back rules and regulations in an attempt to grow the economy. Bloomberg reported on some examples already playing out in the US:

 

Andy Webb, owner of Captain Boom Fireworks LLC in Otsego, Michigan, says he plans to hire more salespeople this season after the state decriminalized items such as bottle rockets and Roman candles.

 Led by Republican administrations such as those in Michigan and Florida, states are relaxing restrictions or considering regulatory relief on things from motorcycle helmets, firearms and tanning beds to bunny dyes and the size of a barber’s trash can. 

 

Maybe Australian Treasurer, Wayne Swan will resort to such extremist measures in his attempt to balance the budget. Fireworks – we can hardly wait!

But it’s more likely we’ll get a different sort of entertainment. In a hilarious video, this clever currency analyst reckons Spain’s downgrade is a good thing ‘because it is behind us.’ The fact that this is true of all bad news which comes out is lost on him. Then he goes on to claim that Spain’s downgrade is a good thing because really poor quality debt is supported by the European Central Bank (ECB), while moderately poor debt is not. This kind of ridiculous thinking just typifies the European mess:

 

‘The ECB can’t say “we’re going to help one country but not another”, but they can say, “for all BBB bonds of a sovereign nature we can do this”. Well, BBB bonds of a sovereign nature – who comes into that category? Only Spain.’ 

 

The only thing more ridiculous than this is the Australian Labor Party’s insistence that a person, namely Peter Slipper, is innocent until proven guilty. Haven’t they read their own laws?

 

Fair Work Act 2009

s. 361 Reason for action to be presumed unless proved otherwise

… it is presumed … that the action was, or is being, taken… unless the person proves otherwise.

 

Until next week,

Nickolai Hubble.

The Daily Reckoning Weekend Edition
ALSO THIS WEEK in The Daily Reckoning Australia

 

A Bankrupt Idea Whose Time Has Gone

By Dan Denning

You are the one who is paying if it’s growth through government debt. You are the one who is paying if it’s growth achieved by reducing the purchasing power of money and fuelling asset price bubbles. Activity for its own sake is growth without real demand. It’s not real economics. It’s busy work…But now we’ve reached a cross roads. Political and social pressure is being put on the RBA to engineer prosperity through monetary policy. It is the last, best, and eternal hope of people who believe you can get something for nothing. It’s false hope.

Investor Choices – Do You Have a Lifeboat or a Bottle of Brandy?

By Tim Price

One scene from the movie depicts a lounge in one of the upper class quarters of the ship as it slowly sinks beneath the waves. Notwithstanding the vessel listing alarmingly, a motley band of toff revellers are determined to go out in the finest style. Some continue to play at cards with a fatalistic resolve while others determinedly quaff spirits direct from the bottle. Having considered for some time the most appropriate metaphor for the current market environment, we think this may be it: one may be doomed, but one can still party on.

How Not to Fix A Debt Problem

By Bill Bonner

The banks have a lot of bad debt, left over from the go-go lending mania in the bubble years. Led by Ireland, the governments bailed them out. But that put the governments themselves in jeopardy. They didn’t have any real money to lend the banks. They had to borrow. They just gave the banks money that they had borrowed themselves. So then investors began to wonder about Ireland, Greece, Portugal, Spain and Italy. And guess what? They found that they were going broke too…You see the problem, don’t you?

When Freedom Comes Under Threat of Violence

By Joel Bowman

If, indeed, that was Justice Holmes’ idea of “civilized,” we shudder to think what he regards as uncivilized. But shudder we will…Let us consider, by way of illustration, the concept of the caveman, that apocryphal amalgam of prehistoric humans so often used to epitomize the unwashed, uncivilized elements of mankind’s past. To what does this boorish troglodyte resort when it comes to resolving complex matters of dispute? What is his go-to instrument for dealing with the problem posed by, say, the natural scarcity of goods? With what tool does he arbitrate over issues involving titles, rights and claims?

Pozieres

By Greg Canavan

Pozieres occupied the high ground and was therefore a strategic piece of land for the Germans and Allies. It was a key objective for the planned assault on the German fortress of Thiepval, which actually lay in front of the village. The idea was to go around Thiepval, capture Pozieres and Moquet Farm, and then attack Theipval from in front AND behind. Like so much WWI planning, it was good in theory.

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can 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.
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