Italians Seek “Master Solution”

–Here’s hoping this week is a bit quieter than last week.

–The Aussie market will start the week scratching its head over an unfortunate choice of words in Italy. The Italians have adopted $61 billion in spending cuts. The newspapers and the government call this austerity. But it’s really just living within your means.

–The Italians have also introduced a “solidarity” tax on those who earn more than €90,000 per year. What is a solidarity tax? It’s what you call a tax that forces other people to pay for the standard of living you believe you deserve. It’s the sort of thing people ask for when they believe the world owes them something.

–Free insight of the day: the world doesn’t owe you anything.

–Europe’s leaders are still calling plays from the 20th century’s playbook. Italian Finance Minister Giulio Tremonti called for more “integration and consolidation of public finances in Europe,” and a “master solution” to Europe’s problems. By that he means a “Eurobond” that would allow greater levels of borrowing.

–Hmm.  Maybe it’s just us, but the term “master solution” conjures up an image of a Super Nanny Police State. That’s kind of creepy. Besides, the European Social Democratic welfare state has spent itself into oblivion. Government finances have become so unsustainable that Europe’s most indebted governments can’t borrow in their own name any longer.

–The solution is obvious. They need a new name!

–Eurobonds would be guaranteed by the full faith and credit of the European Union. It would “collectivise” Europe’s credit rating. Because the collective credit rating would include Europe’s bigger economies with smaller government deficits, it would be cheaper for everyone to borrow in Eurobonds. This would make it possible for Italy, Spain, Ireland, Portugal and everyone to refinance government debts at a much lower interest rate.

–Of course, a Eurobond wouldn’t impose any spending discipline on national governments. It would just make it cheaper for them to borrow now. Of course they love the idea! It permits deficit spending by allowing the permanent expansion of government debt. This is the whole fiscal model of the Welfare State.

–Poor Germany. It’s going to cop it the worst if the Eurobond gets pushed through. The Germans know that national governments will abuse the borrowing privilege as they always have, while not really cutting spending or pruning back the Welfare State.  Fortunately, Germany has a history of doing what’s best for Europe in order to avoid a wider conflict.

–Post-war Europe has too much invested in the idea of political and financial union to abandon the idea now. The core of the idea—that you can live at each other’s expense and have something for nothing—is proving to be a monumental fraud. But rather than acknowledging that reality, the Europeans keep trying to extend the fantasy.

–Buy gold on the dips.

–Meanwhile, here in Australia, one thing we learned over the last two weeks is that China can’t save us. That is, trouble in European and American debt markets travels on a fast train straight to the Australian stock market. This belies the notion that “China will save us”.

–“Only Harry Potter and the Communists can save us now”, we wrote in our latest monthly report for Australian Wealth Gameplan. China spent nearly $600 billion in stimulus in 2008. It followed that up with over $1 trillion in new loans from the official banking system in both 2009 and 2010.

–That massive expansion of credit propelled China’s fixed asset investment spending to historic levels (nearly 70% of GDP). It also kept prices high for iron ore and coal and other commodities. And these figures don’t include the expansion of credit from China’s “shadow banking system”.

–That’s where local governments can borrow money from banks through special off-balance-sheet vehicles, using land values as collateral. These local government financing vehicles (LGFVs) are to China what special purpose vehicles (SPVs) were to the US sub-prime crisis. They’ve allowed for massive and reckless risk taking, which has blown up asset values and will soon blow up banks (in the financial sense, not literally).

–It’s a proper mess brewing up. But don’t tell Wayne Swan. He’s on his way to China. And perhaps not aware that the Chinese government is terrified of the inflation monster it’s unleashed. China’s central bank has been busy raising interest rates and reserve requirements to try and control inflation (which ran at 6.5% in July).

–Despite this, Swan says:

“China has the policy flexibility to fire up its domestic engines of growth if external conditions fall sharply…Capital investments, rather than exports, are increasingly driving China’s economy…in recent years half the nation’s growth has come from building things like roads, bridges, and homes.”

–Oh dear. The treasurer believes the economy is a machine that can be piloted. Just step on the gas baby. That is the fatal conceit of central planners. He’s probably going to China to take notes on how to command an economy and force it to do your bidding.

–Our research into the matter shows that China’s high rates of capital spending on infrastructure projects is  of dubious long-term value, and that’s being generous. The Austrian school might call it a good old-fashioned credit bubble leading to a massive misallocation of resources. And that’s what Australia has to worry about.

–The resources, being misallocated, are often dug up here in Australia. If China’s central planners crack down on local government borrowing to contain inflation, it will mean less capital spending on roads and bridges to nowhere. You’ll get slower growth and lower resource demand. The big capital spending boom planned here—to deliver China what it needs—may not materialise. Nor will the jobs. Nor will the export earnings. Nor will the state royalties.

–And that’s assuming it’s an orderly wind-down from China’s lending boom. A disorderly wind down is a fancy way of saying China could have a credit bust equal to or larger than what’s happening in America and Europe. Clearly that’s not good news for Australia.

–Of course we predicted a big Red Bust much sooner, in May of last year. We were wrong. Why? We failed to anticipate how much China would expand credit to artificially stimulate growth. Two-and-half-trillion dollars is a fair effort. The difference between 2008 and now is that China can’t stimulate growth without fuelling inflation. And inflation in food and fuel prices leads to social instability.

–Are Australian funds prepared for an era of lower Chinese growth? It’s impossible to say if you don’t know how Aussie funds have their money allocated. More on that tomorrow. Until then…


Dan Denning
Markets and Money Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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There may be many Germans asking themselves “what would Konrad Adenauer have done now”?

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