Today, we will go deeper in depth on corporate accounting for banks. Without a proper understanding of this, it will impair our ability to appreciate a bank’s financial position. Back in Banking for dummies, we explained that

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank’s liability but your asset. In accounting technicalities, your money goes into the bank’s balance sheet as an asset with a corresponding liability.

Today, we will go deeper into that.

First, we will introduce the basics of accounting:

Assets = Liabilities + Equity

So, let’s say you deposit $100 into the bank. In this case, the highly simplified bank’s balance sheet will be:

Assets: $100 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

In this example, the bank is losing money because it is borrowing $100 from you which it has to pay interests on. But its $100 of cash is sitting there idle. Therefore, the bank has to lend out, say $90 at a higher interest rate than it borrows the cash from you. The balance sheet will now look like this:

Asset: $90 (Loans), $10 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

Let’s say it pays 5% p.a. interest rates on deposits and receives 10% p.a. interest rates on its loans. At the end of the first year, the bank balance sheet will be (assuming interest-only payments on loans):

Asset: $90 (Loans), $19 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

Now, there are 2 ratios that you need to understand. First, government regulations require that banks keep a certain ratio between equity and risky loans (in the assets) that it makes out to others. We shall call this the capital ratio. In this example, the capital ratio is 4 (Equity)/90 (Loans), which gives 4.44%. That is, its leverage is 22.5 times. There is another ratio called the reserve ratio, which is the ratio of cash and deposits. In this example, the reserve ratio is 19 (Cash)/105 (Deposits), which gives 18%.

Now, let us assume that the reserve ratio has to be, by law, a minimum of 10%. In that case, this bank has an excess reserve of 8% (see 363 tons of US dollars to Iraq—how much money will eventually be multiplied into the economy?). It can lend out an additional $8.50 to give a balance sheet of:

Asset: $98.50 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

In this case, its reserve ratio is $10.50/$105, which gives 10%. Its capital ratio is 4/98.5, which gives 4.06% (leverage of 24.6 times).

There are widespread beliefs that the Australian banking system is safer and more conservative than their overseas counterparts. Thus, it is generally assumed that the sub-prime and credit crunch problems that affected the US will not happen in Australia. But is this a reasonable assumption?

First, as we showed in Australia has no sub-prime debt? Think again!, there are real-life examples of dodgy lending by Australian banks. The question is, how widespread is such lending? Are these examples of dodgy lending indications of a systemic problem? In any case, it is obvious that it is not in the banks’ best interest to be forthright about their dubious lending practices. Perhaps you may want to do your own scuttlebutt research on this. If you have any stories about dodgy lending practices or dodgy borrowing, please feel free to share them in the comments section below.

Next, our suspicion is that Australian banks are severely underestimating their vulnerability. As Brian Johnson, a banking analyst from JP Morgan was quoted in Banks to feel more pain: analysts,

Mr Johnson believes that Australia’s banks are failing to envisage the possibility of a loan-loss cycle where asset prices [such as housing] fall, and banks struggle to recover loans from defaulters and forced sales.

…

Mr Johnson said Australian banks are actually more vulnerable to the credit crunch than many of their global counterparts because of their high levels of gearing, or loan to capital ratios.

“We’re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,” he said.

As we said before in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

In addition, the Australian banking system has a vulnerability not shared with other countries. As this news article, Fast rise of round robin lenders, reported,

The Reserve Bank of Australia has a dark worry about our banks: they get 90 per cent of their cash from each other. If one bank gets into trouble, the Australian financial system could be snap-frozen overnight.

We will give a highly simplified analogy of this problem. Imagine an economy of 3 people: Tom, Dick and Harry. Tom owes Dick $1000, Dick owes Harry $1000 and Harry owes Tom $1000. Each of them will have a balance sheet that looks something like this:

Asset: $1000
Liabilities: $1000

For each one of them, what they owe are their liabilities and what they are owed are their assets. Let’s say, for whatever reasons, Tom is unable to honour his debt repayment to Dick. In that case, Dick’s asset will go bad. As a result, he is unable to honour his debt repayment to Harry. This in turn caused Harry’s asset to go bad, which affected his ability to repay his debts to Tom. Therefore, one person’s debt problem becomes a contagion that spreads to everyone else.

In a similar way, this is the current vulnerability of the Australian banking system. It is unique to Australia because of the shortage of government debt that could be used as bank assets and collaterals, thanks to the previous government’s budget surplus. We suggest that you read our earlier article, Banking for dummies for more details about bank balance sheets.

Of course, though it may be possible that such things may happen, it does not necessarily mean that it will happen. It’s the job of the RBA and APRA to prepare the drills in anticipation of this worst case scenario. But should it happen, what can be the possible triggers? For the answer to this question, one news article, ANZ is the big local bank most at risk, caught our eye:

ANZ Bank has been singled out ahead of other big Australian banks as most at risk of further material provisions because of its long credit default swap positions, potentially running to $2.4 billion, based on international comparisons.

National Australia Bank is not far behind in the structured credit risk stakes.

As we highlighted before in How the CDS global financial time-bomb may explode?, Australia is not going to escape unscathed when this potential disaster strikes.

In view of all these, perhaps there is little wonder that, as Fast rise of round robin lenders reported,

At a recent conference held by one of the world’s largest banks, the Australian banking system was identified as one of the best investment opportunities, for going short.

Back in February this year in Will China slow down from 2009?, we said that

Dear readers, do you see what we are trying to mean? Make no mistake about this: the Chinese economy will slow down appreciably for the Olympics. We believe it will not be just a quick and temporary once-off slowdown- rather it will be a time for the Chinese economy to take a breather and cool down significantly, both by the design of the Chinese government and the effects of a US recession. The giddy and euphoric economic growth of 2007 will not be so ecstatic in 2008 and beyond (but not forever, we guess- but touch wood, if China fall into total social breakdown, then all bets are off… again, touch wood).

It is clear that at the eve of the Olympics, statistical numbers revealed that China’s economy is slowing. As this article from FN Arena reported, China Slowing,

Chinese growth in the June quarter declined to 10.1% from 10.6% in the March quarter, an outcome slightly below consensus forecasts of an increase of 10.3%. According to Danske Bank the shortfall was largely the result of weaker export growth, as domestic demand continues at solid levels.

There are anecdotal indications of this too. Marc Faber, in a recent interview a few weeks ago (see Marc Faber: Let Big Brokers Fail; Buy Gold Not Oil ), said that

As you may know, I travel extensively and I’m not an economist like Mr. Ben Bernanke who reads textbooks and write papers; but I talk to people. And I can assure you: worldwide, there has been a meaningful slowdown in business. And I believe that the demand for commodities will come off in the second half of this year… very meaningfully, including demand in China and India and so, near term, I’m negative about commodities and I wouldn’t buy there here; whereby the commodities bull market may still be intact for many years to come…

At this point, we have to ask these crucial questions: (1) Is this Chinese slowdown merely a temporary blip for the sake of the Olympics (i.e. after the Olympics, the break-neck growth will resume again)? (2) Or is it, as we explained in Will China slow down from 2009?, a chance to catch a breather for a while? (3) Or worse still, a pre-cursor to a major economic correction, as we explained in Can China really ‘de-couple’ from a US recession??

The theory supporting (1) is that many of China’s factories closed to clear the air for the Olympics. Therefore, according to that theory, production will resume once the Olympics are out of the way. However, there is another theory against (1)- many Chinese infrastructure investment spending are for the glory of the Olympics show-case. Therefore, once it is out of the way, such investments will not proceed in the same intensity as before.

For (3), we cannot really quantify the risk of such happening. Even if it is going to happen, it may not be imminent. This falls into the realm of Black Swans.

Our feeling is that, (2) is the most likely outcome. If that is the case, what will be the implication for Australia? Well, the mining sector may be doing just fine, albeit with a limited slowdown. It will not be as hot as before, when the resource boom was at its maximum intensity a couple of years ago. But with the rest of the economy slowing down, we doubt Australia’s mining sector can pull the rest of the country out of this lethargy. That is where the danger lies. With so much debt lying around, Australia’s economy cannot afford to slowdown. If it slows down too much, the economy may stall and fall into a serious recession. As we explained before in Can lower interest rates re-inflate the property price bubble?,

But what if the economy slows down too much for the RBA’s liking? In that case, given the high levels of debt of Australians, if the economy slows down too much, the Australian economy can tip into a dangerous downward deflationary spiral.

Please note: we are NOT predicting this will happen in the forecasting sense.

Yesterday, in Too eager for an interest rate cut?, we said that

Fourth, an interest rate cut by the RBA need not necessary mean a cut in the mortgage rate. In fact, the opposite can occur.

Today, we will elaborate on that.

A large fraction of Australia’s borrowed money is sourced from overseas through the ’shadow’ banking system. In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country. As we explained before in Rising price of money through the demise of ’shadow’ banking system, with the fall of the ’shadow’ banking system, the supply of credit shrinks. This resulted in a rise in the price of money.

That is why non-bank mortgage lenders (e.g. RAMS) found their business in trouble. Because they are not banks, they do not have access to deposits to fund their lending. Their only source of funding is through the ’shadow’ banking system. When money from that system dried up (i.e. credit crisis), they could no longer lend money as cheaply as before.

The banks, on the other hand, are not left off the hook. Because of their deposit base, they are in a better to weather the credit crisis storm. But overall, there is still a shortfall of deposits to provide for all the demand for lending. As the de-leveraging of the global financial system continues, the price of money will continue to increase. This left the banks with two choices:

1. Increase the cost of loans (e.g. mortgage rate).
2. Attract more deposits with higher interest rates- that’s where all the attractive term deposit interest rates from the banks come from.

For Australia to be completely free from the ’shadow’ banking system, two things must happen:

1. Borrowing must decrease.
2. Savings must increase.

This is the only way to bridge the gap left by the credit crisis in the absence of any central bank intervention. We believe that the credit crisis will worsen (see Is the credit crisis the end of the beginning?), which means the gap will widen, which in turn implies even higher lending rate. Since the Australian economy is very much addicted to credit to keep going, any dramatic fall in its supply will have serious repercussions. What to do if such a day eventuate?

Not to worry, because Australia has a central bank (note: sarcasm here)! Since the Reserve Bank of Australia (RBA) is the only institution that can create credit out of thin air, we can be sure they will cut interest rates and be the lender of last resort when the day of reckoning comes. But that does not necessarily mean that mortgage rate will come down too, as reported in this news article, RBA rate cuts may fail to ease mortgage pain,

National Australia Bank chief economist Alan Oster, just back from a month in Europe, said a reprise of the British experience, where banks failed to ease the burden on borrowers despite official rates falling 75 basis points over six months, was not out of the question.

Ever since the governor of the Reserve Bank of Australia (RBA) made the speech last week, the mainstream media has been catching on to the idea that interest rates in Australia is at the peak and the next move will be a cut. For example, The Age came up with a highly misleading and sensationalising headline: RBA chief throws borrowers a bone. We are sure that such headlines will give some property ‘investors’ (read: speculators) the wrong idea that the property bubble will re-inflate when such a day arrives.

First, let us understand the context of what Glenn Stevens said. In Australia, our central bank has a policy of targeting inflation within a band of 2% to 3%. Note: If you want to know the long story about how inflation targeting come about as a policy, take a read at our earlier article, Why should central banks be independent from the government? which contains a link to the RBA’s web site. There are some who fear that with the credit crisis and rampaging oil prices, any rigid and inflexible adherence to the inflation target band through monetary policy will result in a serious crisis for Australia. In other words, the belief is that the RBA should be flexible enough to let inflation veer off the course. We believe it is in this context that Glenn Stevens reportedly said that he will not “wait until inflation has retreated below 3 % before cutting interest rates.”

Second, though it may be true that the next interest rate move in Australia will be down, it may not be imminent. In fact, it may be quite a while before it happens. So, those who are waiting for an interest rate cut to do wonders to their asset speculation should not be too hopeful yet.

Third, should interest rates be cut sooner than expected, it will probably happen in the context of a credit deflation, which is hardly good for asset prices. In other words, you will not want to see the day when the RBA is forced to cut interest rates desperately because it will be a day when the economy is slowing too dangerously. As we said before in Can lower interest rates re-inflate the property price bubble?,

But what if the economy slows down too much for the RBA’s liking? In that case, given the high levels of debt of Australians, if the economy slows down too much, the Australian economy can tip into a dangerous downward deflationary spiral.

Fourth, an interest rate cut by the RBA need not necessary mean a cut in the mortgage rate. In fact, the opposite can occur. How? Why? We will discuss more about this in our next article. Keep in tune!

Yesterday, we discussed about the importance of central banks being independent from the government in Why should central banks be independent from the government?. In particular, we mentioned that

Our fear is that with this credit crisis worsening by the day, deflation may prove such a unthinkable threat (e.g. see How do we all pay for the bailout of Fannie Mae and Freddie Mac?) that the government will ‘roll back’ all these rules one by one in order to keep the entire financial system solvent. As the ancient Chinese saying goes, the journey of a thousand mile begins with the first step. Therefore, the journey towards a hyperinflation hell will begin with such measures (see Recipe for hyperinflation).

Incidentally, Jimmy Rogers said in a video interview, Rogers Calls Fannie, Freddie Rescue Plan a `Disaster’ that

This is a disaster for America. This is a disaster for the world. Ben Bernanke and Paulson are bailing out their friends on Wall Street, but there are 300 million of us Americans who are going to have to pay for this and there are six billion people in the world who are going to have to pay for this. And they are doing it with no authorization from anybody.

Paul Volcker said a couple of weeks ago that perhaps what the Federal Reserve has done is illegal. I would submit it is illegal what they have done and what they are doing. They are saddling all of us with hundreds of billions of dollars of debt that they have no authorization to do.

We are no legal experts here and thus, we have no say on the legality of what the Federal Reserve and Treasury is doing (or about to do). But we are confident of this: IF this is illegal, then emergency laws will be passed to legalise them. As we said before in Recipe for hyperinflation,

Now, imagine that those above-mentioned ‘rules’ are being relaxed such that the government can order the central bank to bail out everyone and every business that is financially insolvent by giving them freshly printed money. Overnight, this will solve the problem of bad debts and we will not have any credit crisis to worry about. Everyone will be happy right?

Indeed, Wall Street may be happy, but the rest of us will not be. As Marc Faber said in this video interview,

Let’s say if I’m a manufacturer and I’m a bad businessman and I go out of business, who’s going to help me? But Bear Stearns and the Wall Street elite because they’re tied into the Treasury and the Federal Reserve and they lunch together, it’s a club… and they’re bailed out. I mean it’s a joke.

It is no coincidence that the world is facing accelerating inflationary problems (see Who is to blame for surging food and oil prices?).

Yesterday, one of our readers asked us this question:

Why is it important to keep central banks independent from the government? Wouldn’t it be better if the board of directors of a central bank are selected by the people, and therefore held accountable to the people for decisions, mistakes, and misjudgements?

At what point did central banks become concerned about targeting inflation? Before they existed, inflation was close to 0%, so surely they wouldn’t have been created with inflation targeting in mind?

The more I read, the more I feel that your ideal of a 100% reserve banking system with no central bank is the best way to control inflation (and to allow the people to understand the true cost of government projects [wars, etc] that is currently paid for through inflation). But why didn’t this work in the first place?

To answer these questions, we will turn back to history. As we explained before in A brief history of money and its breakdown- Part 2,

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ‘currency’ was just a definition of a weight of gold. For example, the ‘dollar’ was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury.

Under an international gold standard, there was an automatic market mechanism to keep government from inflating the money supply and to keep each country’s balance of payment in equilibrium. Hence, the world enjoyed the benefits of only one monetary medium, which facilitated trade, investment and travel. Prices were also kept in check (see What is inflation and deflation?). During that time, there were periods of price rises (e.g. during war) followed by periods of price falls (e.g. when war ends), with relatively stable prices in between.

Why did it not work out in the end? Well, thanks to the First World War. As we all know, modern wars are terribly expensive. Under a gold standard, no country can ‘afford’ to fight any war for an extended period of time. Therefore, the only option was to go off the gold standard and resort to purely fiat paper money as it is today. You can read the rest of the monetary breakdown story at A brief history of money and its breakdown- Part 2.

Now, you know how the US is able to ‘afford’ to fight extended wars in Iraq and Afghanistan with expensive professional armies today.  A gold standard will make this truly unaffordable.

Today, the central banks of the US and Australia follows an inflation targeting policy. That is, monetary policy is set ensure that there is a consistent price rise within a target range. How did inflation targeting develop? Well, it is another long story. You can read about it straight from the RBA at Inflation Targeting: A Decade of Australian Experience.

Next, we come to the most important part: why should central banks be independent from the government?

First, we have to understand the basics. What is the purpose of money? In essence, money functions as (1) a medium of exchange, (2) unit of account and (3) a store of value. To perform these functions, money has to fulfil certain properties as described in Properties of good money and its integrity cannot be tampered with.

Now, consider the situation that we described in Recipe for hyperinflation:

… imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn’t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others.

Under the gold standard, gold is money that is under the control of the free market. No one or institution ‘owns’ or control the money. But today, the central bank is the only institution that has the authority to create money out of thin air. As we said in Recipe for hyperinflation,

Look at any piece of paper money today and you will find the words of a government decree (e.g. “This Australian note is legal tender throughout Australia and its Territories”) and perhaps a signature or two.

In Australia, the signature belongs to the RBA governor.

What if we give the government (which already has executive power) the power to create money? This will give the government a deeper concentration of power! If you believe the old adage that power corrupts and absolute power absolutely corrupts, then you will not want such a deep concentration of power. As we said before in Have we escaped from the dangers of inflation?,

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

That is why today, central banks are independent of the government, with complex and elaborate rules of money and credit creation (the exception will be Zimbabwe under Robert Mugabe). Our fear is that with this credit crisis worsening by the day, deflation may prove such a unthinkable threat (e.g. see How do we all pay for the bailout of Fannie Mae and Freddie Mac?) that the government will ‘roll back’ all these rules one by one in order to keep the entire financial system solvent. As the ancient Chinese saying goes, the journey of a thousand mile begins with the first step. Therefore, the journey towards a hyperinflation hell will begin with such measures (see Recipe for hyperinflation). Your belief in whether you will see hyperinflation in your lifetime will depend on your faith on the government to maintain the integrity of money.

Next, what if we let the people vote for the board of directors who control the central banks? If shareholders have trouble keeping the directors of their company honest and accountable, then it will be the same for the central bank.

Some of you may have subscribed to value-oriented stock research newsletter. One thing you may notice is that as the market enters deeper into the bear market, the number of “Buy” recommendation increases. From that perspective, these value-oriented stock research are ‘bullish.’

Before we comment on the wisdom of their recommendations, we will have to explain the philosophy of value-oriented stock research. As we explained to one of our reader’s comment in Confidence back? Beware of bear market rally,

… for long-term value investors, they follow the ‘bottom-up’ approach. That is, they (i.e. the value investor) invest in businesses based mainly on its individual merits (i.e. is it a good solid long-term safe businesses whose stock price is undervalued? Bear Stearns is definitely ruled out in this case) and not worry about the macroeconomic big picture, the business cycle, e.t.c. … In that sense, such value investors are neither ‘bullish’ or ‘bearish.’ Rather, they have a neutral view on the business cycle and other macroeconomic big-picture.

Here, we see a potential trap for the unwary value investor. Back in February last year, as we explained in What to avoid at the peak of the business cycle?,

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle. Since the stock market always anticipates the future earnings of companies, cyclical companies will look ‘cheap’ (i.e. low P/E ratio) during the peak of the boom.

During the turning point of the business cycle, the P/E ratios of good quality companies in a bear market may look very enticingly cheap. But as we explained in Why accumulating stocks on the ‘cheap’ can be deadly to your wealth?, during such a time,

… a falling average P/E ratio does not imply that stocks in general are cheap. Yes, with careful and judicious stock picking skills, you may be able to find really cheap stocks. But do not let falling average P/E ratio fool you.

Low P/E plus the “Buy” recommendations from the value-oriented stock research may make buying stocks of good quality companies look like astute contrarian moves.

But this is where the Achilles’ heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses. This news article, Bottom-up analysts ignore the big picture, sums it well:

“You have got a set of numbers that assumes some sort of recovery,” Macquarie’s equity strategist, Tanya Branwhite, said when releasing the report. “Unfortunately, that’s premised on the cycle we have seen in the last five to 10 years. What is facing the economy at the moment is nothing like we have seen in the last five to 10 years.”

One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ‘typical’ bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current “Buy” recommendation will be very wrong.

To illustrate this point, we will give you two examples.

After the stock market crash of 1987, the world economy did not fall into a Depression as initially feared. By 1989, stock markets had more or less recovered. If you bought into the market after the crash, you would have profited greatly.

But what if you bought into the market after the stock market crash of 1929 (see The Great Crash of 1929)? Or you bought Japanese stocks just after the bursting of the bubble in the late 1980s? The outcome will be completely different if you had done so.

In short, not all bear market purchase will turn out to be astute if the timing is way too early.

Last week, the US Federal Deposit Insurance Corporation (FDIC) took over IndyMac, an insolvent US$32 billion Californian mortgage bank. As if this is not bad enough, two of the America’s largest government-insured mortgage lender, Freddie Mac and Fannie Mae, were losing the market’s confidence in their solvency status. The level of confidence was so low that both the Treasury and Federal Reserve had to step in over the weekend to announce their plan to prop them up. This look to be reminiscent echo of the Bear Stearns bailout in March this year (see New tricks required to bail out financial system).

For those who do not yet already know, Freddie Mac and Fannie Mae are US government-sponsored enterprises (GSE) in which their bonds are insured by the US government. That is, if the US home-owners default on their mortgage debt, the US government will ‘insure’ the shortfall between what they are obliged to pay to their investors and lenders and what they collect from the impaired mortgage debt payments. Now, they can be regarded as insolvent. As we explained before in Banking for dummies,

… the banking business is a balancing act of managing a portfolio of assets and liabilities.

This means that Freddie Mac and Fannie Mae, thanks to the rising debt default of American mortgages, is failing to do a proper job in the balancing act. As we explained with an example in De-leveraging in the real economy- mortgages, with falling house prices and rising debt defaults,

… if house price goes down by more than 10%, then the home ‘owners’ will not only lose their savings for the 10% deposit, they will still owe the bank money after the house is foreclosed. In the US, house prices have fallen by 13% in one year. So, you can imagine that there will be a lot of misery going on.

Make no mistake about it: this development is highly serious. To give you a sense a scale of the problem, consider this (as reported in this news article- Federal Reserve to rescue US mortgage giants):

1. Both of them owns around US$5 trillion worth of mortgage bonds, which is almost half of all mortgages in the US.
2. US$ 5 trillion is the GDP of Japan, the world’s second largest economy.
3. As at June 2007, foreigners hold US$1.3 trillion long term debts issued by all GSE (which includes Freddie Mac and Fannie Mae). This was 21.4 percent of the total debt. China and Japan holds US$376 billion and US$229 billion of these debts respectively.
4. The rest of them are held by mum and dads, state and local governments, banks, insurance companies, pension funds, retirement funds, money markets, managed funds and so on.

As you can see, if Freddie Mac and Fannie Mae fail, it will not not just affect the US. Financial assets all over the world will be affected. It could be your superannuation and pension funds holding the bag of worms!

We believe the de-leveraging process still has to continue (see Is the credit crisis the end of the beginning?), it will only be a matter of time before Freddie Mac and Fannie Mae will really become insolvent. If a US government-insured bond becomes defaults on its debt, it will be as good as a default by the US government on its debt. If that ever happens, you can be sure this will descend into an extremely ugly global US dollar crisis. Therefore, both of them are too big to fail.

The only way out of this is, as we explained before in Recipe for hyperinflation,

… once those ‘rules’ are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins.

The collapse of Freddie Mac and Fannie Mae will result in a colossal deflation. Can the US allow such an unthinkable to happen? If the answer is no, then inflation is the only path out of it, in which the road to hyperinflation hell begins. This is also unthinkable. Which road will the US take? If the US takes the latter route, all of us will be paying for their bailout via inflation.

In our previous article, Australia’s money supply & credit growth in April 2008, one of our readers asked,

I’m a little confused. I thought we had an inflationary problem here, not deflationary

For starters, let us all agree on the definitions of inflation and deflation. Our guide, What is inflation and deflation?, will be used for this article’s definition for inflation (expansion of money and credit) and deflation (contraction of money and credit). Please make sure you understand this guide well because this article assumes that you already know the pre-requisite knowledge contained in that guide.

So, where is the world economy heading? Inflation or deflation?

We read a story that Warren Buffett said that only 2 people in the world know where interest rates are going. Both of them are in Switzerland and both their views are diametrically opposed. We do not know how true this story is, but it underlies are very important point. The inflation and deflation debate is highly polarising, splitting the deflation and inflation camp right down to the deepest bone marrow. There is a very good reason for the deflation case (see Are we heading for a deflationary type of recession?) and there is also a very good reason for the inflation case (see Recipe for hyperinflation).

If inflation is just the expansion of money and credit and deflation is the contraction of money and credit, wouldn’t a reliable statistic of money and credit supply tell us whether we are heading towards the former or latter? Well, as we said before in What is money?,

… in this modern age of finance, money is far more complicated than what it was used to be. It has come to the point that it is very hard to even define what money is, let alone measure its quantity. Alan Greenspan, the former head of the US Federal Reserve was believed to have said “We don’t know what money is, any more.”

Those in the inflation camp will point to one measurement of money, MZM, to support their case. Those in the deflation camp will point to another measurement of money, TMS, to support their opposing case. Between both of them, they will argue whether credit can be considered money and hence, argue whether MZM or TMS is the valid measurement of the supply of money.

It is no secret that we are more inclined to the latter case. You may have a different inclination than us and that is perfectly okay. The truth is that, no one really knows what will happen (of course, some people in either of the opposing camps will have strong convictions on what is going to happen). We see that the world is resting on a knife-edge between inflation and deflation- it can tip either way. Which way it will tip is not something that economics or finance alone can satisfactorily explain. To do so, we will have to venture into the murky world of politics, law and who-knows-what.

Amidst the arguments between the two opposing sides, we see symptoms of both inflation and deflation- rising gold, silver, oil, food and other commodity prices and falling asset prices. If these two symptoms continue, it will be the most damaging to investors because we will see the nominal value of our assets fall, along with the fall in their real value.

In any case, regardless of whether inflation or deflation will win, life will be very much more difficult for all of us in the years to come. Therefore, it is important to hedge against both.