News flash: Secret central bankers’ summit in Sydney

February 7th, 2010

We just received this news tip from one of our readers: Secret summit of top bankers,

The world’s top central bankers began arriving in Australia yesterday as renewed fears about the strength of the global economic recovery gripped world share markets.

Representatives from 24 central banks and monetary authorities including the US Federal Reserve and European Central Bank landed in Sydney to meet tomorrow at a secret location, the Herald Sun reports.

This news article is reported on Rupert Murdoch’s Herald Sun on Friday/Saturday. Is this secret meeting organised in response to big trouble brewing on the horizon? That is what seemed to be implied in the article. Curiously, one paragraph reported,

Organised by the Bank for International Settlements last year, the two-day talks are shrouded in secrecy with high-level security believed to have been invoked by law enforcement agencies.

Was the meeting planned last year? Or perhaps it was brought forward because of the growing crisis in Europe? We don’t know. The central bankers’ club is certainly one of the most opaque organisations in the world- a fertile ground for conspiracy theories.

Anyway, the Greek fiscal crisis have the potential to break up the Euro i.e. currency crisis. If this turns out to be the outcome, then the trouble we wrote about in Currency crisis: first countries in the line of fire- PIIGS just a couple of weeks ago proved to be very timely.

So far, only Sydney’s Herald Sun is the only newspaper reporting this.

Tags: ,
Posted in Market Observations | Comments

How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate

February 7th, 2010

Whenever we hear that the Federal Reserve is going to keep the interest rate close to zero, we may wonder what is meant by “interest rate?” Specifically, which interest rate does it mean? After all, there are many “interest rates,” from 30-day bank bill rates to 30-year Treasury bond yields. As it turns out, the “interest rate” that the Federal Reserve controls is the Fed Funds Rate.

The Fed Funds Rate is basically the rate that banks lend to each other overnight. Also, the Federal Reserve (so do many other central banks like our RBA) does not set the interest rate in the form of a decree to be followed. Instead, the Fed Funds Rate ’sets’ the Fed Funds Rate by adjusting the supply of money such that it reaches a target that is intended (see How does a central bank ‘set’ interest rates?). The Fed Funds Rate in turn influences the interest rates in the market.

Well, not quite.

At least that’s true for the past two decades before the Panic of 2008. Ever since the September 2008 bankruptcy of Lehman Brothers, the Fed has lost control of the target Fed Funds Rate, as it begin to ‘print’ copious amount of money to save the world from a Greater Depression. As you may recall from How does a central bank ‘set’ interest rates?, the central bank can either control the quantity of money or the target Fed Funds Rate- it cannot control both. The GFC forced the Fed to flood the financial system with heaps of ‘printed’ money, which undermined its ability to control the target Fed Funds Rate.

So now the problem is to find another “interest rate” that is more relevant. As this Bloomberg article wrote,

Federal Reserve policy makers are considering adopting a new benchmark interest rate to replace the one they’ve used for the last two decades.

One of the “interest rates” that is under consideration is the interest rates paid by the Federal Reserve to commercial banks’ reserves. A simple way to understand what “reserves” are is to imagine the Federal Reserve being the bank of commercial banks. “Reserves” are simply the ‘cash’ that they ’saved’ at the Federal Reserve.

Originally, the Federal Reserve did not pay any interests on reserves. After all, the whole point of banking is to get the banks to lend out their money to the wider economy. By not paying interest on reserves, they became unproductive assets. Thus, that prodded the banks to lend out their reserves to make their assets more ‘productive.’ As you can see by now, buying supposedly ultra-safe Treasury bonds at whatever yield was even better than keeping the reserves at the Fed at zero yield.

But the GFC messed everything up.

On October 6 2008, the Fed announced that they will be paying interests on banks’ reserves. The reason for doing so is to allow the Fed to control market interest rates and the quantity of money (reserves) via its various liquidity facilities. As the Fed said in that announcement, it

… give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets [e.g. banks refusing to lend to each other] while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

In other words, the interest rates on reserves is now the only tool at the hands of the the Fed to influence market interest rates. (Note: if you want to understand why, you can read this paper from the Federal Reserve here).

Now, there is a worry that with so much excess bank reserves (thanks to money printing) in the financial system, inflation will take hold once banks start lending them out again. What is the Fed going to do to restrain the banks from lending, thus causing inflation?

We will look into it in the next article.

Tags: , ,
Posted in Economics/Finance | Comments

What is the key risk faced by China (according to Jimmy Rogers)?

February 5th, 2010

Jimmy Rogers is a well-known long-term bull on China. He saw the potential of China long before the mainstream investment community even had China on its radar. Therefore, we can presume that he had already invested in China since very long time ago (say, 20 years ago perhaps??).

If you have already invested in China that long ago, the value of your investments would already have grown gigantically by today. In addition, if you hold a really long-term view on China, it does not make sense to sell your long-term investments on China (that you’ve made, say 20 years ago) unless your long-term view on China turns negative. Thus, from this perspective, any talk about impending major economic correction (see Is the Chinese economy a house of cards?) in China should not perturb you too much. On the other hand, if your investments in China are made just a few years ago, you would have missed out a lot on the way up. Consequently, you will be more concerned about any looming down-draft in the Chinese economy.

Jimmy Rogers, in a recent interview, said that he is not worried about any potential “economic hardships, civil wars and even wars” in China. He then told his listeners to look at America in the 19th century, when there were “15 Deflation, a civil war, lots of economic problems, no human rights, riots in the streets and massacres.” Yet “America emerged and became the most successful country in the 20th century.” In his opinion, all these are ‘temporary’ problems that countries can recover from.

But let’s play the devil’s advocate here. These problems are ‘temporary’ in the bigger picture that can span many decades. They can easily last beyond an investor’s lifetime. You will only adopt Roger’s view if your investment horizon is so long that you’re investing no just for yourself, but for the next generation too.

But there’s one potential problem in China that Jimmy Rogers believes will alter his long-term views on that country.

Water.

Cities, societies, nations disappear because the “water disappears.” Indeed, China has a serious water problem, especially in the north. To date, China had spent “hundred of billions of dollars” trying to solve their water problem. In other words, if the Chinese does not solve their water, then the “China story is over.” From this, we can tell that Jimmy Rogers is probably influenced by this book, Collapse: How Societies Choose to Fail or Succeed. As that book argues, throughout history, environmental crisis are often the catalysts for the collapse of complex societies all over the world.

So, in future, we will look at water problems from an investor’s perspective.

Tags: , ,
Posted in Looking Forward | Comments

Does gold hedge against inflation/deflation?

February 2nd, 2010

It is often parroted by mainstream media that gold is a hedge against inflation. Sometimes, you will hear that gold is a hedge against deflation. Also, from our previous article (Will gold mining shares hedge against deflation again since the Great Depression?), we established that even though gold stocks hedges against deflation during the Great Depression, it does not necessarily apply to today’s situation. However, one of our readers said that Marc Faber reckoned that gold and gold stock hedges against deflation.

Isn’t this very confusing? How does gold hedges against inflation and deflation?

The answer is explained clearly in our book, How to buy and invest in physical gold and silver. For those who have not read that book, we will give some hints to the answer.

First, “inflation” and “deflation” are over-generalised words. Gold is a hedge against a narrow subset of “inflation” and “deflation.” The corollary is that in certain cases of “inflation” and “deflation,” you will lose using gold as a hedge. In page 20 of How to buy and invest in physical gold and silver, we have a story of Mr Goldberg who died a miserable man because he had nothing to show for his long-term commitment to gold.

As we said in How to buy and invest in physical gold and silver, the fundamental reasons for accumulating gold as a hedge are:

  1. Lack of confidence in fiat money (to function as money)
  2. Lack of trust in the financial system

Inflation is only one of the possible symptoms of point 1. Likewise, deflation is also one of the possible symptoms of point 2. The implication is that it is possible to see these two symptoms without holding those two fundamental reasons in your heart (i.e. see some forms of price inflation/deflation and yet still trust in fiat money and the financial system). Indeed, inflation has been with most of the world in the past 20 years. Deflation has been with Japan for the past 20 years. That is why there are many people (especially those from the mainstream media) who are deriding gold and gold-bugs.

But any time you have good reasons to lack confidence in fiat money and/or trust the financial system, it will be the time you will want gold as a hedge before the symptoms show up unmistakably as inflation/deflation.

To help you understand, we will give an example. During the Great Depression, banks were collapsing en masse. If your bank fails, then your cash at bank disappears into thin air. If everyone’s cash at bank disappears, then you can be sure there will be falling prices because there will be a sudden shortage of cash- everyone will want to hoard whatever physical cash they have on hand. In such a situation, if you own lots physical gold then you need not fear. You can always go to the Federal Reserve (remember, it was still the gold standard back then) and exchange your gold for physical cash. Or in theory, you can transact in physical gold only.

Today, during the Panic of 2008, banks were dropping dead like flies. That’s also a good reason to own gold or government bonds (we imagine that you can insist that the government pays you the yields with physical cash instead of depositing them at a wobbly bank). But then someone like Kevin Rudd announced that the government is going to guarantee all cash at bank. If there’s going to be falling prices (deflation) and if the financial system is going to function, then government bonds and term deposits will be better than gold. If there’s going to be mild inflation and if everything is going to be fine and benign as in the past 20 years (e.g. no currency crisis, no collapse in the financial system), then cash at high-yield bank accounts will be better than gold too.

Remember. as we wrote in our book (How to buy and invest in physical gold and silver), gold will only do exceptionally well at the extremes.

Here is a quiz question for you: if there’s going to be a collapse in the global financial system (as Marc Faber described as “deflation could only be triggered by one event: a total collapse of the existing global credit bubble”), would you rather own physical gold or gold stocks?

Tags: , , ,
Posted in Gold | Comments

Will gold mining shares hedge against deflation again since the Great Depression?

January 31st, 2010

During the Great Depression, gold mining stock prices were the only bright light in the darkness. As one of our readers found a 1931 newspaper quote,

Gold mining stocks have been among the strongest performers since year-end; earnings this year seen exceeding both 1930 and 1929; miners are benefiting from stable price as production costs decline.

As we quoted the most deeply buried Austrian School 1936 classic (originally written in German), Crises & Cycles by Wilhelm Röpk in Which industry’s profitability grew as the Great Depression progressed?,

Leaving aside the industry of manufacturing books on crises and cycles, there are two big industries likely to prosper inversely to the depression, the armaments industry and the gold-mining industry.

Does that mean that gold mining shares are going to do well in times of deflation because it did well during the deflationary period of the Great Depression?

No.

Here, we have to be careful in applying the lessons learnt from history correctly. There is a reason why gold mining shares did well during the Great Depression. Unfortunately, that reason does not apply in today’s context. What is the difference between today and the Great Depression?

The gold standard.

You see, back in 1931, one ounce of gold was defined as approximately US$20. Back then, as we introduced the history of money in our book How to buy and invest in physical gold and silver, currencies (e.g. dollar, pound, franc) were merely warehouse receipts for physical gold. In a sense, the central bank was a government granted monopoly gold warehouse.

In other words, the Federal Reserve was the only institution in the world that would buy and sell gold at a guaranteed fixed price (because the US was the only country still under the gold standard). The were two implications:

  1. There was an infinite ‘demand’ for the produce of gold mining companies.
  2. The price of the what the gold mining companies produced had a minimum price.

As the Great Depression was a period of deflation, prices of everything were falling. That means the costs of gold mining companies were falling as well. So, if you have a business in which the things that it produces:

  1. Have infinite demand
  2. Have a guaranteed minimum price
  3. Are getting cheaper to produce

Wouldn’t that be a windfall for you business? Indeed, that was the fortunate position faced by gold mining companies back then. That’s why their share prices were rising. Today, no country is under the gold standard and thus, currencies are backed by nothing. Therefore, gold mining companies are facing an entire different situation:

  1. Their produce have finite demand
  2. Prices of their produce fluctuate
  3. Costs of producing are increasing

Even if real deflation is to happen today, falling cost of production will be accompanied by a fall in price of gold.

So, if you find any experts, tip-sheets and research reports justifying buying gold mining shares as a hedge against deflation by using the example of the Great Depression as the basis of their recommendation, then you know what to do.

Tags: ,
Posted in Gold, History | Comments

Protecting yourself against currency crisis

January 29th, 2010

Today, we will continue from the final question asked at Next phase of GFC is when governments go bust,

When governments go bust, we will have currency crisis. How do you protect yourself against this?

First, let us begin with understanding what a currency crisis is. From the Wikipedia,

A currency crisis, which is also called a balance-of-payments crisis, occurs when the value of a currency changes quickly, undermining its ability to serve as a medium of exchange or a store of value…  Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country’s own currency reserves or its foreign reserves (usually in euros, US dollars or UK pounds).

Basically, a currency crisis occurs when there is a problem in a country’s balance of payments (see Understanding the Balance of Payments). The currency will depreciate very rapidly and as a consequence, cannot be used as money and cannot function a store of value effectively. This usually manifests itself as sky-rocketing price inflation, which undermines everyone’s standard of living. When Hugo Chavez recently announced the planned devaluation of the Venezuelan currency (that’s not technically a currency crisis, but this is just an example to show you its effects), people rushed out to buy consumer goods in anticipation of price inflation.

From this, you can see that obviously, the key to protecting yourself from a currency crisis is to diversify your savings away from the affected currency (e.g. foreign currency, gold, silver, etc). Does it mean that all we have to do to hedge ourselves is to go to our local bank branch, open a foreign currency account and then transfer some of our savings to that account?

Unfortunately, that’s true only in a perfect world. In reality, when there’s a currency crisis, there’s a high chance that a banking crisis will come along with it. For example, in Argentina’s currency crisis (1999-2002), the government froze bank accounts in an attempt to prevent a run on the banks. In some cases, governments may even impose capital controls (especially in pegged currencies), which basically means your money will be stuck.

In such an environment, Black Swans abound, which means the financial system may be dysfunctional. That means your foreign currency stored in your local bank’s foreign currency account can be, for all intent and purposes, useless. In today’s modern economies, since exchange of physical cash forms a tiny percentage of commercial transactions, a dysfunctional financial system will affect most commercial transactions in the economy, which in turn implies that the economy will be paralysed. Even if the financial system is working, price inflation will make life miserable for most people.

In such a bleak environment, we can imagine people resorting to barter, physical cash (both foreign and local) and even physical silver and gold. Hopefully, local governments and communities will take the initiative and come up with complementary currencies so that the economy can still function (otherwise, everyone will be reduced to primitive bartering). In Argentina, a spectrum of complementary currencies had emerged, in such a large scale that some of them are even called “quasi-currencies.”

Personally, we feel that the best way to protect yourself from a currency crisis is to leave the country before TSHTF. If not, stock up some physical cash (both foreign and local), physical gold and silver (see our book, How to buy and invest in physical gold and silver) and supplies- these will tide you over while the sh*t is hitting the fan. For the longer term, you may want to move some of your savings overseas- you may not be able to use them in the midst of the crisis, but when it is all over, the local currency may no longer exist (e.g. you may have to convert the old currency to a new one at unfavourable rates).

Note: All these are NOT personal advice- they’re just ideas for you to consider.

Tags:
Posted in Currencies | Comments

Currency crisis: UK, Japan and US

January 26th, 2010

Continuing from Currency crisis: first countries in the line of fire- PIIGS, we will discuss more on the next sequence of events to happen. As we said before, we are not ‘predicting’ or forecasting the future- what we are presenting is just a rough sketch of what may possibly happen.

After the PIIGS countries, the next country to be in danger of public debt default or currency crisis is the United Kingdom. At the current rate of deterioration of its public finance, the national debt of UK will reach 17% of GDP in 2010 and 100% by 2013. Niall Ferguson, author of the famous The Ascent of Money series, said

We’re not Iceland or Ireland, but we’re closer to them than we are to the U.S.

The reason why the UK is in a more vulnerable than the US is because,

The big difference between the two countries is that the U.S. issues the world’s No. 1 currency and is regarded, partly for that reason, as a safe haven,” Ferguson says. “The U.K. used to be, but we’re not anymore. That means we have much more currency risk here.

Of course, this does not mean that the UK government will default or that the pound will face a currency crisis. But certainly, the risk is increasing as shown by the increase in price for the credit default swaps (CDS) of UK government debt. The time-frame for a currency crisis in UK is around the vicinity of 3 to 5 years.

The next country in the line of fire is Japan. We all know about the demographic time-bomb in the United States (see How is the US going to repay its national debt?). But Japan’s population is ageing earlier than the US. Worse still, they’re ageing at a time when their government debt is twice the size of their GDP. The reason why Japanese government debt could get so high in the first place is because Japan is a nation of savers. Currently, only 6% of their national debt are held by foreigners, whereas it is 57% for the United States. However, the problem for Japan is that as their population ages, their savings rate will have to fall. That implies that buyers of Japanese government debt will turn to sellers. That means that the Japanese government will have to look to borrowing from foreigners. Time-frame: say, 5-10 years time.

Finally, the next in the line of fire is the United States. We had already mentioned about them at How is the US going to repay its national debt?, Is the GFC the final crisis? and America’s balance sheet. The time-frame is around 10 to 12 years. Others believe it is 5 to 10 years time. That’s why President Obama is pursuing health care reforms. As he admitted on TV, if the US does not solve its health care issues, the Federal government will go broke (see Ladies and Gentlemen, the US Is Insolvent).

On that note, Australia is not in better position either. As PM Kevin Rudd warned recently (see Work harder to support ageing Australians: Rudd), Australia’s time-frame is around 15 years time onwards.

Tags: , , , ,
Posted in Currencies, Looking Forward | Comments

Money & politics to cause more sell-off ahead?

January 24th, 2010

Today, we are supposed to discuss the “next sequence in the time-line” from our previous article. But before we go into that, we will discuss some new developments that is more urgent.

As we all know, last week was a very bad week for the global stock markets. On Wednesday, various markets (including the commodity markets) had hit the trend lines in price charts. What this means is that prices had reached the minimum in which the up-trend was still regarded as being intact by technical analysts. On Thursday, many trend lines were breached simultaneously. The last time such a similar event happened was in August 2008, which heralded the Panic of 2008.

Is this the beginning of the correction that many (including us) since September last year (see Aborted correction)? Back then, stocks were already in highly overbought territory and some contrarian traders were even shorting stocks. In the reverse sense, that was very similar to November 2008 when stocks were in highly oversold territory and many were anticipating a rally. The rally did not arrive until March 2009. In the same way, has the long anticipated correction finally arrived?

Those who enjoy having adrenaline rushes may want to take the courageous step of shorting the S&P 500 index. Historically, years ending with zeros tend to perform badly (for whatever reason that we have no idea). Also, election years tend to be bad for stock markets. 2010 is the mid-term election for the United States.

The Chinese government’s decision to halt lending (after an orgy of lending in the first couple of weeks of 2010) was the initial pin-prick against the up-trend. Commodity prices in general fell, with the exception of palladium and platinum. But Thursday’s news that Barrack Obama is going for the jugular of Wall Street (you can read the details from the mainstream press) was the trigger for the reversal in trend that even brought down strong and steady palladium and platinum. Since 2010 is the year for mid-term elections in the US, it is hardly surprising that Obama is embracing populism with stronger gusto. Also, there are rumours that Ben Bernanke, who is perceived to be too soft on Wall Street, may be ousted as chairman of the Federal Reserve (in a vote by senators). It is no secret that Wall Street is perceived to have looted Main Street. So, in an election year, politicians will pander for the support of Main Street.

In principle, we support Obama’s stand against Wall Street. But we disagree with his counter-productive way of dealing with Wall Street by imposing more regulations. The reason why we believe this is counter-productive is because in general, more regulations:

  1. Implies more red-tape
  2. Increase costs of doing business
  3. Restrictive on the good guys as well

Instead, we take the same approach as Jimmy Rogers, whom we quoted at Jimmy Rogers: ‘Abolish the Fed’,

More regulations? You want Alan Greenspan and Ben Bernanke? These are the guys who got us into this situation. They are supposed to be regulating the banking system for the past 50 years. These are the guys who let it all happen. I don’t want more regulations. Let the market regulate it. If xyz needs to go bankrupt, let them go bankrupt. I promise you, that will send a very straight signal and you will have a lot of self-regulation when these guys [Wall Street] start to go bankrupt.

Obama’s plan requires the approval of Congress. We can be sure that Wall Street, with their money, will lobby Congress and fight tooth and nail to frustrate Obama’s plan. That goes without saying.

Not only that, we believe that Wall Street will step up the pressure against Obama by dumping everything in sight on the stock market, perhaps even going to the extent of doing naked short-selling (see Short selling, who loans their share?). Since selling begets more selling, a plunging stock market will bring back memories of the Panic of 2008 to Main Street, which in turn can do damage to consumer sentiments (see Do sentiments make the economy or the economy makes the sentiments?). Of course, this is just our conjecture. If our theory is correct, then it implies that there will be more sell-offs in the days to come.

This is indeed money and politics.

Tags: , , ,
Posted in Looking Forward | Comments

Currency crisis: first countries in the line of fire- PIIGS

January 21st, 2010

In our previous article (Next phase of GFC is when governments go bust), we wondered how can someone protect their savings in the event of currency crisis. Since the word “currency crisis” is a very broad term that can cover all kinds of scenarios, there is no one-size-fit-all solution to this problem. Hopefully, our musings will give you a better idea of where to start investigating and seek professional advice.

As we mentioned before in our previous article, there is a downward trend in many governments’ credit rating. The next stage of the GFC will see governments going bust. The main thing to understand is that this event need not necessarily be imminent. Also, you must not make the mistake of seeing that as a singular event- in reality, it will be a sequence of events punctuated by calm in between, as each country is at different stages of the fiscal cycle. The reason why we say that is because there are plenty of investment tip-sheets, newsletters and reports persuading people to buy their wares by giving the impression that government defaults are imminent events that will happen all at once. The mainstream media is not too helpful too. As investors, you have to be clear that there are time-frames and order of sequences in these events. Not only that, some of these events may not happen at all.

With that, we will continue. Please note that we are not ‘predicting’ or forecasting the future. What we are presenting is just a rough sketch of what may possibly happen.

Currently, the most vulnerable countries to default are the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain). It does not mean that all of them will blow up tomorrow. Marc Faber reckons that a couple of them will blow up within the next two years. Even though we do not know which ones and when exactly it will happen, one thing is clear- since these countries uses the Euro, the viability of the Euro as a currency will be put in question. As we said before in Is this a bear market rally or a turning point?,

The European Union is an economic union but not a political union. Therefore, the European Central Bank (ECB) does not have the same level of authority and political support as the US Federal Reserve. Individual nations using the Euro as their currency cannot simply print money to bail out their financial system because they have surrendered their economic sovereignty to an intra-national authority. To do that, there can be a situation whereby taxpayers of say, Germany, are asked to bail out the taxpayers of say, Spain. Politically, this is too much to ask.

This is where the uncertainty lies. There will be political and legal wrangling on what to do with these wayward PIIGS nations. Will the Euro survive the wrangling? No one knows. Since financial markets hates uncertainty, the Euro will continue to face downward pressure (which is happening right now). Of course, if it is suddenly clear that the Euro will not survive, then its value will be zero straight away. Should that happen, there will be a currency crisis, derivative meltdown (as an effect of PIIGS default or implosion of the Euro) and another global financial panic this very second. Since it is not clear yet, the Euro will continue its orderly descent. In the meantime, the financial markets will keep on guessing while the European authorities will not reveal much of what’s happening in the discussions behind closed doors.

Now, the question is, against which currency will the Euro depreciate against? Someone once said, if currencies are in a beauty contest, the winner will be the least ugly one. The US dollar, even though it is flawed and may not survive as a currency in the long run, has more time on its side. It is less ugly than the Euro. As far as the eye can see, it is more likely to survive longer than the Euro. Therefore, we will see the US dollar ’strengthening’ against the Euro.

If you are one of the citizens of the PIIGS countries and if it so happen that it is your country that is going to blow up, then there’s no better time to prepare than right now.

In the next article, we will turn our eyes to the next sequence in the time-line.

Tags: , ,
Posted in Currencies, Looking Forward | Comments

Next phase of GFC is when governments go bust

January 19th, 2010

10 months have passed since the Panic of 2008 brought global stock markets to a low in March 2009. Since then, we had the “green shoots” of recovery (where economies were getting from worse to bad) and hopes of recovery. By today, we have some semblance of ‘recovery.’ But this ‘recovery’ is very uneven. For example, unemployment is not turning around yet in the United States. Much of Europe and Japan are still in the doldrums. Australia, on the other hand seems to be recovering and China is roaring ahead with an expected growth of 10% in 2010.

During the Panic of 2008, we had financial institutions and businesses going bust like dominoes, threatening to pull the world down into a Greater Depression. Governments all over the world suddenly became Keynesians and switched on their massive money printing press to bailout, rescue and spend, spend, spend in the name of ’stimulating’ their economies. But as we said before in Will governments be forced to exit from ’stimulus?’,

In fact, the word ’stimulus’ is the most misleading word in economics lexicon because it conveys the idea of a surgeon ’stimulating’ a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven’t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ’stimulating?’.

So, with economies seemingly on the path to ‘recovery’ (especially in Australia and China) from a near death experience, this looks like a free lunch from the government isn’t it?

Unfortunately, the answer is “No!” Then what is the risk of governments putting economies on a crutch for an extended period of time?

As we quoted the BIS in July 2009 at Bank for International Settlements (BIS) warning on stimulus spendings,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly.

As we said before, during the Panic of 2008, we had financial institutions and businesses going bust like dominoes. This time round, governments will be going bust like dominoes. Today, if you read the financial press, you will find this disturbing trend: credit rating agencies are downgrading and threatening to downgrade the credit ratings of government debts.

While we do not trust credit rating agencies (since they are the ones who gave sub-prime CDOs triple-A ratings), we will treat their ratings as overly-optimistic in the first place. For investors, what is significant is not the ratings themselves. Rather, it is the pervasive trend of more and more downgrades that is much more indicative. As this article compiled a non-exhaustive list of news excerpt of sovereign debt downgrades, we noticed a very disturbing fact- a large number of countries (some of them are major countries) are involved.

Can this trend turn around (i.e. governments become more prudent in their fiscal management)?

We doubt so. As we said before, the word “stimulus” is a weasel word that is misleading and deceptive. Economies suffering from debt deflation cannot be ’stimulated’ into self-sustaining growth. A better word is “crutch.” The problem with using crutches to prop up economies is that the longer they are in place, the more dependent economies are on them. Eventually, if they are in place for too long, the economy will descend into stagflation (see Supplying never-ending drugs till stagflation). Once you understand this, you will be able to read between the lines of this BBC article,

The International Monetary Fund head has warned that the global economy could experience another downturn – a so-called double dip recession.

Dominique Strauss-Kahn said countries should not exit from stimulus packages that have bolstered growth through huge amounts of government spending.

The longer governments delay from removing economic crutches, the bigger government debts will become. That, along with Medicare and social security liabilities for the growing ranks of retirees and shrinking rank of workers means that eventually, governments will become insolvent (not technically because they can resort to printing money).

Consider these countries:

  1. Japan, the world’s second largest economy, is a welfare superpower with a rapidly ageing population. Twenty years of economic ’stimulus’ under debt deflation has resulted in government debt of almost 200 percent of GDP.
  2. The US government is the next to arrive, as they are currently where Japan is 20 years ago, with an unfunded Medicare and social security liabilities looming (see America’s balance sheet).
  3. As this Financial Times article warned,

    After crunching the data, McKinsey estimates that the gross level of British private and public debt is now 449 per cent of GDP – up from 350 per cent at the start of the decade.

    And even excluding the liabilities of foreign banks based in the UK, the ratio still runs at 380 per cent – higher than any country except Japan (closely followed by Spain where debt has also spiralled dramatically, according to a McKinsey report issued today.)

  4. Then we have the PIIGS countries, namely Portugal, Ireland, Italy, Greece and Spain, where Marc Faber warned that one or more of these governments will likely blow up in the next couple of years. This will plunge the viability of the Euro as a currency in grave doubt. Will a default trigger a derivative meltdown?
  5. Then we have the other European countries like Latvia and Ukraine…

When governments go bust, we will have currency crisis. How do you protect yourself against this? Keep in tune!

Tags: ,
Posted in Looking Forward, Market Observations | Comments

« Older Entries