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?
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…
for The Daily Reckoning Australia