A good rally to sell into?

Ok, we promise today’s Markets and Money won’t be about Greece…for most of it anyway. But before we get to reckoning about other parts of the global economy, there’s one historical anecdote about Greece – or more accurately Greece’s debt – worth recounting.

Back in the early 1820s, the newly formed and fragile Greek government was in a struggle for independence with the Ottoman Empire. Unlike today, the Western European powers weren’t overly enthused about helping Greece out. Actually, for the previous 500 years or so the West wasn’t really interested in helping its Christian ‘brothers’. See the benefits that debt brings?

So assistance largely came down to the individual. One of those individuals who rallied to the Greek cause was Lord Byron, a flamboyant British aristocrat whose love of all things Greek cost him his life.

Byron arrived in Greece in 1823. Within a few months, the new government hit him up for a loan of 4,000 pounds. From what we can tell it was never repaid.

It didn’t really matter. The next year Byron was dead, cause unknown. After dreams of heroically fighting for Greek independence, his contribution in the end – apart from advertising the plight of the Greeks to the West – was minimal. But he goes down as perhaps the first creditor to suffer a default by the Greek government.

He won’t be the last.

Not that the markets are concerned anymore. According to the Wall Street Journal, Greece won’t have any need for more cash until about September. So it’s speculation time.

But it probably won’t take that long for reality to hit.


The global monetary system, which is just a mechanism to create debt, is breaking down. Credit growth around the world (except perhaps in China, but that is also slowing) is anaemic. In the US, the household sector continues to pay down debt. Only the government’s tremendous borrowing program keeps the system from shrinking…or, from the ‘money power’s’ perspective -imploding.

This is the reason why it’s dangerous to jump wholeheartedly into the current rally. It’s built on relief, not fundamentals. Murray Dawes thinks so too. Check out his latest charting analysis.

Here’s why.

Think of a small economy with a money supply of $1 million. This economy practises fractional reserve banking, so a few people go into the bank and borrow $100,000. Only a very small portion of the $100,000 comes out of the economy’s existing savings. The rest is created by the bank.

All of a sudden the amount of money in the economy increases by around 10 per cent. Credit growth is therefore around 10 per cent.

Now, the beneficiaries of this growth depend on the way it is spent. If we assume the economy is dysfunctional and people mostly borrow to speculate on financial assets, then obviously asset prices will benefit the most from the expansion of credit. Wage earners and those on fixed incomes benefit the least, as they get their pay rises only after prices rise throughout the rest of the economy (resulting from the increase in money supply).

While things look good if you’re an owner of those assets, beneath this veneer the actual economy is struggling. The increase in credit, or debt, has financed mostly speculative activity, not real investment in technology, plant and equipment etc.

So productivity slows and inflation increases. The people soon realise they’ve been idiots. They look to pay down their debt and asset markets fall back in line with the fundamentals because credit growth is too low to keep pushing prices up.

Miraculously, the government decides not to do anything to help. People go back to focusing on working hard and using debt productively. Before long the economy improves…

Back in the real world, people realised they were idiots back in 2008. Everyone wanted to pay down (non-productive) debt. In the US, the household sector has been reducing its debt load ever since. According to the Fed Flow of Funds report, in the March quarter the household sector paid down another $270 billion in debt.

Without government intervention, this would have resulted in a very sharp fall in asset prices. It would have been painful, sure. But it would have been quick and at least have purged much of the unproductive debt from the system.

Instead, the US government borrowed $1.24 trillion in 2008, $1.44 trillion in 2009, $1.58 trillion in 2010 and is on target for another $1 trillion plus in 2011. Foreign governments funded much of this new debt, largely via the printing press, in order to keep their currencies from rising.

Combined with the Fed monetising trillions in bad and unproductive debt, the result has been a flood of money into the economy. Most of it has found its way into speculative asset markets – commodities, currencies etc. Much of it is unproductive.

The point of all this is that our debt dependent financial system relies on constantly growing debt to survive. As this debt is created, it flows in complex and intricate ways through the financial system and into the real economy, ending up as wages, company revenues and profits, taxes and government handouts.

But somehow, this system knows when the gig is up. Unproductive debt doesn’t create real wealth and so doesn’t sustain itself. After a while, the holders of unproductive debt want to get rid of it. This leads to a downturn but also produces the conditions to enable the next upturn.

Unfortunately, unproductive private debt has been replaced by government debt, which is even more unproductive.

And now the Fed has turned the switch off on QEII, a form of credit creation has gone for the time being. How will the world fare?

According to the Wall Street Journal, the Fed has monetised about 85 per cent of all US Government borrowing since the start of QEII. While private buyers will need higher yields to entice them to fund the government’s debt, the bigger issue is that a very large supply of funds and a major source of liquidity are now out of the market.

In our impaired monetary system, you need credit growth to keep the funds flowing throughout the global economy…and to keep asset markets rising. In Australia, credit growth for the year to May is just 3.1 per cent. With the RBA taking liquidity out of the market over the past 18 months or so, it’s no wonder our market has gone nowhere.

But just as the RBA looks like taking a break from interest rate rises for a while, we’ll need to contend with the implications of the Federal Reserve taking a break from money printing.

For world markets addicted to liquidity, this looks like a good rally to sell into.

Greg Canavan
Markets and Money Australia

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money 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 Markets and Money for free here. If you’re already a Markets and Money 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 Markets and Money emails. For more on Greg go here.

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Our monetary system is based on credit or debt, and without constantly continuing issuance of debt, the whole thing falls apart. Our system of ‘fractional reserve banking’ gives commercial banks a licence to literally create money out of thin air – and then charge interest on the money they created. Fractional reserve banking is the cause of spiralling debt.

A public campaign has started to end fractional reserve banking, and I recommend readers to look at the http://www.Positivemoney.org.uk website which explains further and support the campaign.

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