When Animal Spirits Attack

“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.”

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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15 Comments on "When Animal Spirits Attack"

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The Chinese forex war chest buys a lot of soft diplomacy and resources equity before the music stops for the USD. That is why sneaky socio-corporatist Australia Inc was at in the back rooms sinking selected big deposit backed deals while the FIRB was still talking business as usual in the flogging off of onshore assets and balancing the AU bankster debt current account. The last laugh on the US is that the funny money they handed over for outsourced production of import merchandise secured the Chinese achieved that tangible title over resources via both stockpile and equity over those… Read more »

as an aside (almost), the biggest mal-investment will be that of suburbia, should peak oil prove to be true.



Outer suburbs might prove to be the _best_ investment, once electric cars, charged by solar, become common. China is probably going to develop these EV technologies more quickly than the West. Still like the Tesla, but my chain is yanked every time I mention the breed.


I know what you mean Biker regarding the Tesla. However I would treat it the same way as any new technology. Wait a few years until they iron out all the bugs and the performance and maintenance issues. Sort of like an iphone :)


I should qualify that I don’t actually have an iPhone but I really appreciate all the people out there forging ahead, making normal busted a*s phones cheap as chips. You know, the type that only make and receive calls and text messages. All the other functions are not worth much to me at the moment.

Comment by 89peterg on 15 July 2010: as an aside (almost), the biggest mal-investment will be that of suburbia, should peak oil prove to be true. I think Peak Oil is very real and that we have probably reached it as far as the easy stuff to drill for, future oil is going to be expensive deep sea drilling (will it make the sea floor unstable causing earthquales, tsunamis, tidal waves lowering of sea level?) and oil sand recovery such as in Canada.. Have we reached it as far as having now used up 1/2 the worlds oil… hard to… Read more »

Steve’s quote of the day

“Yep the greater fools are running out”

Ned S

Yeh, little fold up scooters they let you take on the bullet train. Lordy knows what else – I find change has gotten a bit monotonous these days. But there’s obviously lots who still enjoy it all. :)

New technologies… . You’re spot on, Don. Missus says “Never be the first kid on the block with The New Toy… !” Got into the Salsa, at last. Was told to arrive at noon… and wait patiently for a cancelled booking. Sure enough, by 12:20 pm, we were in. Enjoyed the Thai Chicken Spring Rolls with Banana Mayo and Asian Greens; while the missus raved over the Lemon Tempura Coral Trout with Makame & Kipfler Potato Salad and Panzu Aoali. Spelling may be out, but you get the drift. All washed down with a Mornington Peninsula Stoniers Chardonnay. Great restaurant.… Read more »
Seems to me that increases in oil costs will only make property close to the CBD’s more attractive, certainly within the 10km circle. Reliance on public transport will increase, with Brisbane having pretty good systems in place within that circle, and improving over the next couple of years with busways, new bridges and tunnels. Guess train lines were all built many years ago when the city wasn’t so spread out like today. I can walk from home to local station, catch train to city and walk from station to work in under 30 minutes. Find I’m hardly using my car… Read more »

That is great Biker – so glad you got in there finally :)

Another good bar in Cairns – called the Salthouse. The food has done down hill a bit but the location is nice, next to the Marina – google it as you cannot put links here. Their cocktails are worth a try or two but they may have also suffered from a downturn but that doesn’t seem to matter after a couple.


“…the Salthouse…”

One of the first places we tried, Don. You have great taste!~ :)


Talking to a taxi driver the other day – he reckons he got about 300,000 kms from his Prius battery pack before it needed to be replaced. Not too shabby.


“…300,000 kms from his Prius battery pack…”

About the life of the average internal combustion engine, I guess, Don… although some do double that.

Personally I think we’ll all be astonished how quickly the EVs take over, once oil starts to run out and the price rises. Walmart is talking about free recharge stations in their massive US and Canadian carparks. If that happens, watch the other large traders follow suit… !

Biker Pete

“…some American kid who shot his Ipad with a .50 calibre gun…”

Don’t think that Apple will treat his warranty claim as a core promise, Davo.
They did give me a free Genius for ninety minutes today, though. My MacBook* laptop bluescreened last night! Free fix… . :)

* First Mac that’s failed me in 23 years.

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