If you can’t grow your way out of debt – and it looks increasingly likely that total debt in the Western world is growing faster than the economy – what else can you do? You’re left with only three choices: default on it, print money to pay for it (quantitative easing, or inflationism), or cut spending and raise taxes.
The task of today’s Markets and Money is to look at which scenario is most likely and what investments will benefit (or suffer) the most. But, as you’ll see in the note from our friend Dr. David Evans in the other featured article, we have entered unknown territory in the size of public sector debt creation. This can keep asset values inflated for longer than you might expect. But it can’t prevent their ultimate deflation.
That’s what you have to be worried about now: widespread asset deflation. Even gold – which set a record high USD terms overnight – will not be immune. In fact, any time you see something making record highs, a correction is not far away. With gold, investment demand (as a hedge against bad monetary policy) is pushing the price up.
Deflationist Robert Prechter says a genuine Europe debt crisis and technical momentum are setting up gold for a 40% fall from its highs. He cites the uber-bullishness of gold investors, with 98% being bullish. But then, you would be bullish if you were buying, wouldn’t you? Why else would you buy if you didn’t think the price was going up?
We mention Prechter’s prediction, though, because it’s prudent to do so. The bigger the debt bubble, the harder they fall. Ultimately, gold (physical gold anyway) is a kind of insurance policy against whole-sale value destruction in paper assets. Like most insurance, you hope you don’t have to use it because the world will be a lot less pleasant place if you have to.
And to the extent that investor sentiment ebbs and flows with the news cycle, gold is like any other asset in its volatility. But fundamentally, we’d say it will survive the coming credit write downs a lot better than credits. There is an advantage to not being anyone else’s promise to pay. Those promises are going to be hard to keep, even if bigger and bigger institutions are guaranteeing them.
As Bill noted last week, the current sovereign debt troubles in Europe (and America, and Japan, and the US) are a consequence of the collectivisation of irresponsibility. The risk of loss from bad lending (and borrowing) has been transferred to larger and larger entities…from the individual to the investor…from the investor to the money centre bank…and from the money centre bank to the nation state.
And now, bond traders are betting that in places like Greece, the most likely outcome is default, not austerity. According to a Bloomberg poll, 73% of traders think Greek debt is already zombie debt.
Pimco’s Anthony Crescenzi says we are at a “Keynesian endpoint.” Someone, by the way, should mention this to Wayne Swan, Kevin Rudd, the Coalition, and anyone who thinks spending money you don’t have improves your economy. It stimulates activity. But that is not the same thing as growing prosperity.
When you “bring forward demand” by giving away money or granting tax credits for the purchase of big ticket items like cars and houses, where you think that demand is coming from? The future, of course. That means it won’t be there when you get to the future. But the debt you took on to bring forward demand will be. How selfish and adolescent.
And worse, when you “bring forward demand” you bring it into the world prematurely. In a financial sense, this means homebuyers who, financially speaking, may not be ready to endure the hardships that come with rising interest rates and unemployment. They can only hope that things don’t happen. If they do, the demand brought forward could get crushed.
Standard and Poor’s credit analyst said as much in a report about the Australian housing market widely quoted in the press. She wrote that, “‘We believe the larger debts and higher leverage expose some Australian mortgage holders, especially those with less equity in their houses, to potentially greater financial shock if high unemployment and interest rates, alongside a collapse of residential property values, were to occur.”
To be fair, she went on to say that she thought the housing market fundamentals in Australia were strong. And you won’t have any shortage of real estate spruikers to tell you that unemployment won’t ever rise in Australia (can’t happen here mate) and neither will interest rates. This means not only will homeowners never go into negative equity, it means the collateral of Australian banks – over 50% residential housing – is, well, safe as houses.
They were saying the same thing about American mortgages in 2004.
But while Australia stews on what risk, if any, there is in having $774 billion in mortgage debt as a nation, Europe is dealing with the fact that you can’t spend money you don’t have and improve solvency issues. This is why Keynesianism is dead and why tax grabs are in vogue. When there’s no more money to redistribute (steal from one group to give to another) and the government can’t borrow, the only alternatives are outright inflationism (the farcical printing of money to buy government debt), default, or austerity.
Pimco’s Crescenzi writes that, “Time, devaluations, and debt restructurings might be the only way out for many nations…Debt-fuelled spending programs aimed at combating the global financial crisis of 2008 are among policy tools now being seen as a magic elixir that has morphed into poison.”
And if you think we’re just picking on Europe, think again. Ratings agency Fitch stuck it to David Cameron in the UK and said his deficit reduction plans aren’t good enough. And in our homeland, the debt-to-GDP ratio is fixing to exceed 100%. The only reason no one is panicked is that the US dollar, for all its grotesque deformities, is not the Euro.
All of this raises serious issues for emerging market nations. Do they continue to invest in the sovereign bonds of Western Welfare states? And if not, what will they invest in? And if their primary export markets embrace slower growth and austerity, will emerging market nations face slower growth themselves, with smaller trade surpluses and less capital available to finance other people’s debts?
Hmm. This is a lot to think about. Your editor is on a plane to Seattle early tomorrow morning and will be out of touch for the next five business days. But thinking will be done. And writing. In the meantime, you’ll hear an entirely different perspective from our trader colleague Murray Dawes.
for Markets and Money