Leverage: Economics For the Gifted and Talented

There is a giant veil of stupidity lying across the eyes of the world’s money printers. We thought it might lift during our mini vacation last week. Alas, it did not. The dumb are getting dumber. It reminds us of this old favourite from Gary Larson’s Far Side cartoons:

Far Side cartoons
Source: The Far Side

You would think that by now, central bankers and economists would have learned that ‘easy’ monetary policy doesn’t do a thing to reduce annual deficits, long-term debts, or excessive government spending. But no. The only answer any of them have is always the same: lower interest rates, print more money.

It’s not working. But they’ll keep trying, especially after last week. US employment data came out on Friday, showing that the private sector added just 80,000 jobs in June. The world’s largest economy failed to create more than 100,000 jobs for the third month in a row. Stocks fell. What does that tell you?

It tells us that there are a fair few people in full denial about the economic facts. The facts are pretty simple. Two decades of global GDP growth were ‘brought forward’ with credit expansion and deficit spending. Households borrowed, businesses speculated, governments printed, and Wall Street laughed all the way to the bank.

Now, according to Paul Brodsky of QB Asset Management, you have a global banking system with $100 trillion in assets perched on top of about $9 trillion in real collateral. The whole system remains heavily leveraged. And there are only two ways out of leverage.

Central banks can’t do anything to promote growth as long as the world’s pile of debts remains so high. One is bad for stocks. The other is also bad for stocks, but less directly.

The easiest way to reduce debts is to sell assets. You raise cash by selling off your investments. Those investments could be stocks, government bonds, commodities, or real estate. With $100 trillion in assets sitting on top of $8 trillion in liquid collateral, this approach to deleveraging means a lot of selling and much, much, much lower stock prices. We suspect this plays a part in Murray’s ‘Big Wednesday‘ scenario. It’s the once-in-a-generation trade.

Incidentally, we’re frequently asked by new readers who all this debt is owed to. There’s an intuition that, if everyone owes everyone else money, we could all just forgive each other our trespasses (and debts) and call it good. The reason that can’t happen is that creditors (in the banking system) count the debtor’s liability as an asset. If you take a loss or write-down on that asset, you may be forced to increase your core, liquid capital (assets that are not someone else’s liability).

In other words, everyone can’t just forgive everyone else’s debts. It would result in a balance sheet bloodbath. The world’s banking system wouldn’t just be deleveraged. It would be decapitated.

The alternative to beheading the world’s financial system — which may just happen if political conditions start to echo the French Revolution — is to deleverage through capital injections. That is, offset the losses and write-downs in assets by creating new money at the central bank level and injecting it into the banks.

Central banks would buy the least liquid, most troubled assets in the banking system and remove them from the balance sheet. The bad debt cancer would be cut out.

Central banks have done exactly that already, at least to some extent. The US Federal Reserve bought $2.5 trillion worth of mortgage bonds and government bonds. But now we are on the edge of a new frontier in monetary futility. Central banks have no more room to cut rates. Many short-term rates are already negative in real terms. The only option left is monetising bank assets.

This is where Quantitative Easing is headed, if it’s allowed by politicians and regulators (there is some doubt about whether the ECB can legally monetise debt this way). The assets of the banking system will be liquefied through new money printing. And given the size of assets in the banking system, it’s going to take a LOT of money.

You’d imagine the creation of that much new money would be inflationary. At least we’d imagine so. So if we’re right, what’s the right investment play as we head into new monetary territory? More on that tomorrow.

Incidentally, our mate Greg Canavan reckons the Chinese have foreseen this already and adopted an investment strategy to hedge . If you want to invest alongside the Chinese, you can. You just need to know what they’re doing first.


Dan Denning
for Markets and Money

From the Archives…

How to Survive Inside China’s Financial System
06-07-2012 – Greg Canavan

China’s Economic Policy of Denial
05-07-2012 – Greg Canavan

The Question China Has To Answer Fast to Save Its Economy
04-07-2012 – Callum Newman

How Investing in Commodities Can Prevent a Personal Financial Crisis
03-07-2012 – Dan Denning

Wouldn’t it Be Nice to Not Lose Money on the Australian Share Market?
02-07-2012 – Dan Denning

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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For Watcher with thanks from the rhyming acolytes at Breaking Views:

Libor scandal rhymes with history

You couldn’t make it up

09 July 2012 | By Hugo Dixon

In 1957 traders dumped gilts just before the Bank of England hiked rates, allowing them to avoid losses and prompting allegations of insider trading. The opposition Labour party demanded a judicial inquiry. The BoE governor’s first name was Cameron. His deputy was called Mynors.


Rhyming history because human nature never changes. The majority spend a life time attempting to supplant their emotion with some wisdom. But that’s only 75-80 short years by which time two new generations are going through the same inevitable process.


Maybe temper a better word than supplant.

Rick W
There are many articles written on “Peak Oil” but we do not see many on “Peak Debt”. The private sector in Japan reached peak debt in 1997. This was due to demographics. The population as a whole became net savers as the baby boomer peak moved beyond 50 year old. The need for internal investment reversed as growth slowed. The current account grew due to the reduced private expenditure. The government needed to suck up savings by increasing government debt to avoid huge international imbalances. Japan is now close to or beyond Peak Savings and the government debt has leveled… Read more »
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