“Yes that’s a gun in my hand. Yes it’s pointed at your head. And no, I have no intention of pulling the trigger. Would you like some whiskey?”
More on this hypothetical line of thought below.
But first, all appears to be right with the world today. Stocks are up locally. Last night in New York investors got it in their pretty little heads that earnings for corporate America were better than expected. The catalyst for that notion came from a $136 million net profit from aluminium producer Alcoa.
That’s definitely good news for Alcoa. But how does it measure up against the big picture we laid out yesterday? Can you continue to have good corporate earnings performances in an economy that’s in the middle of a structural deleveraging?
Maybe. We doubt it. Most companies will see smaller profits and less growth if households deleverage. And of course, households are deleveraging partly because businesses are deleveraging too. And business spending, for the most part, drives growth in household incomes.
But what are we talking about anyway? Australia is not America. And Australia isn’t deleveraging at all. As Steve Keen pointed out awhile back, Australia was one of few countries where households actually RE-leveraged during the GFC. Household debt – mostly mortgage debt – is now 155% of GDP according to the Reserve Bank of Australia. It was either a very contrarian move…or a case of animal spirits gone wild!
Of course you need to feel like tomorrow is going to be better than today in order to take a risk. This is fundamental not just to markets, but, we reckon, to life as well. Otherwise, why else would you get out of bed if you didn’t things were going to be better? Why would you go out on a first date…or lean in for a first kiss…or sign your first pre-nuptial agreement?
Growing economies…growing people…growing anything…it all requires the proper spirit of enterprise.
But life is not a theory. How you feel about something is how you feel about it. It doesn’t alter what the thing is. We realise this point is arguable if you’re a physicist. And it might even be arguable if you’re an economist. After all, what people are willing to pay for something is part of what prices communicate, and prices vary based on an aggregation of personal preferences (another miracle of the market).
And what people are willing to pay is influenced by whether they think, economically, every day is getting better and better (in which case they buy a tall latte with extra caramel and emerging market bonds or commodity currencies) or whether they think things are not getting better (in which case they hoard cash and gold and drink tap water and read Foucault and Derrida while buying extra razor blades).
But sentiment and confidence are not the ultimate factors, we’d argue, in deciding what a thing is worth. Or whether a thing is even a thing. Which brings us back to the subject of bank capital.
Yes, you’d think it would be pretty straight forward deciding what a capital asset is and what it is not. Definitions shouldn’t be that hard, unless you’re deliberately trying to confuse people. A capital asset – an asset whose purpose is to make money – should be tangible, relatively easy to value, and thus form the foundation for a well-capitalised company.
You’d think. If you think.
But along comes this stunner of an article from Bloomberg yesterday. You know the world’s banking system is well and truly stuffed when bankers can’t even agree amongst each other on what capital is. The reason they’re disagreeing, you’d suspect, is that depending on the definition, some firms are better capitalised than others. And some are not well capitalised at all.
According to the article, “The 36-year-old Basel committee, a body of central bankers and regulators that sets capital standards for banks worldwide, was asked by the Group of 20 nations to draft new rules after the worst financial crisis in 70 years caused lenders to write off $1.8 trillion.”
By the way, we reckon that’s roughly have of the total losses that will be realised by the time the global deleveraging is done. That argues for taking out the 2003 lows on stock markets…eventually.
Why were the G-20 leaders so keen to redefine capital? “G-20 leaders urged the committee to improve the quantity and quality of bank capital, strengthen liquidity requirements and discourage excessive leverage. They set a deadline of December for making the rules and originally gave countries until the end of 2012 to implement them.”
The trouble is that if you have an exact definition of capital and you strengthen liquidity requirements and discourage excessive leverage, you probably get a huge reduction in loan growth from the banks to the real economy. That means less growth. And it also means contraction. The spirit is willing, but the balance sheet is weak.
No one wants contraction, though. So they’re going to redefine just what capital is. “Representatives from the U.S. and the U.K., who have sought to rein in risk-taking, are willing to compromise on how capital is defined to reach an agreement at a committee meeting that begins tomorrow, the people said…The committee is expected to decide on the definition of capital this week and defer issues such as capital ratios until its meetings in September and October, according to members.”
When in doubt – or when the existence of large financial institutions is at stake – change the rules! But changing the rules does not change the reality…it only delays the inevitability of what must happen. What must happen is that the bad debts accumulated during the excesses of the global credit boom must be liquidated.
Until they are, there will just be more garbage money thrown by governments to prop up asset values….mostly of assets that aren’t producing income. That’s a massive amount of mal-investment…and it chokes off the flow of real credit to real enterprise, which is pretty discouraging if you think about it. If you think.
And finally, what do you make of the story last week that China’s State Administration of Foreign Exchange said it won’t go nuclear on the free-spending Americans and dump their Treasury bonds, crash their dollar, and generally prosecute an unconventional and unrestricted economic war on Uncle Sam?
The committee that manages China’s $900 billion investment in Treasury bonds and its $2.45 trillion in foreign exchange reserves said that, “Any increase or decrease in our holdings of U.S. Treasuries is a normal investment operation.” The acronym for the committee is, without any trace of irony, SAFE.
SAFE says, “U.S. Treasury bonds deliver fair good security, liquidity and market depth with low transaction costs.” SAFE says gold is not liquid enough to figure prominently in the diversification of China’s big pot of reserves. SAFE says gold, “cannot become a main channel for investing our foreign exchange reserves.” SAFE also says that dollar devaluation is bad for SAFE and everyone else.
So SAFE says it’s happy to buy U.S. bonds and not so happy to buy gold.
Do as I say, not as I do.
Of course the forex war chest is a problem of China’s own creation. It’s not a horrible problem to have, mind you. But when you’ve generated a giant trade surplus, what you do with that money becomes a pressing issue. Invest at home? Buy U.S. bonds? Sell the bonds and crash the dollar, damaging the value of your own asset but ruining your adversaries finances in the process? Hmmn.
“No that’s not a gun in my hand at all. It’s my finger. Bang.”