Your Garden Variety Global Financial Crisis or Something Wilder?

The Daily Reckoning

Watching a giant kettle and tea cup stopped at the light in front on the Prince of Wales this morning, we wondered is it all just a tempest in a tea cup. St. Kilda Festival is on this weekend. So the carnival has come to town. It has put us in a carney mood.

Today’s Daily Reckoning will try to sort out if this is a garden variety global financial crisis or something wilder. We’ll also connect the dots between Ken Henry’s comments on debt yesterday in the Senate, and why Stephen Conroy made sure you couldn’t read those comments.

But first, why are companies hoarding cash? Bloomberg reports that companies in the S&P 500 have increased their cash holdings to an aggregate US$1.18 trillion dollars. The big blue chip multinationals have cut spending, frozen new hires (not literally), and generally kept cautious until more details emerge about the economic landscape.

Here in Australia the landscape doesn’t look all that bad. Rio Tinto followed BHP’s wowser result with a good one of its own. The company said it’s in cautious expansion mode after reducing debt, cutting costs, and posting a $6.29 billion annual profit. Iron ore, debt, and cash all collided on the same balance sheet.

Speaking of which, Diggers and Drillers editor Alex Cowie sent through his February issue for our review last night. Alex and his wife are getting ready to welcome their first baby into the world any day now. But he’s shown admirable focus this week looking at the latest financial statements to figure out which Aussie resource firms have the highest net cash to market cap ratios.

It’s not the first time Alex has used this financial ratio as a lead generator for investment ideas. It’s especially useful if you think credit is going to be tight. You don’t want companies that have little cash and lots of debt to roll over. That makes you vulnerable.

Alex’s list of the top twenty included a fair few energy and gold companies. But near the top of the list were a few iron ore hopefuls. And as Alex has already added gold and energy recommendations in the last six months, he’s tipping some of the ore stocks this month. D&D readers will find out which ones after the market closes on Monday.

Poor old Barnaby Joyce keeps copping it from an establishment determined to diminish worries about Australia’s long-term debt. The Senator asked Treasury Secretary Ken Henry if growing debts and more borrowing would lead to higher interest rates in Australia. The Secretary replied that, “That is a gross over-simplification of economic understanding of these matters… I think we should be … careful not to rush into simplistic relationships between levels of debt and interest rates.”

The full exchange between the two is not available at the moment because hackers have shut down the Australian Parliament site with a Denial of Service attack. More on that in just a second. But in the meantime we’ll just have to guess at what the Treasury Secretary meant by “economic understanding of these matters.”

If he meant the understanding of the economic establishment is that debt is a critical part of the world’s economy, he’s probably right. That is, most of the clods with Ivy League degrees who failed to forecast the GFC have no understanding at all that the world’s financial system is burdened by far too much debt. Most of them appear to have learned nothing from the crisis, except, perhaps, how to make fun of people who understand intuitively that you don’t get rich by spending more money.

Of course it’s true that more debt does not automatically lead to higher interest rates. Suggesting there was such a “simplistic relationship” between too much borrowing and the cost of capital would be…well…simplistic. Simplistic is pejorative. If it were just simpler, or just simple, it would be better.

Therefore a simpler understanding of the relationship between debt and interest rates is this: if you borrow a lot and invest in it unproductively, the debt will be a lifelong financial burden. And if the more short-term your borrowing is, the more interest rate sensitive is. The debt may not lead to rising interest rates directly. But if rates rise anyway, the debt becomes even more burdensome.

It’s not an issue of Australia’s credit-worthiness, at least not yet. Rates aren’t going to rise because international investors view Australia as a greater credit risk than, say, America. But it doesn’t matter. If rates rise globally, Australian borrowers (household, corporate, government) will again find themselves way back in the queue of those with empty pocket and hats in hand. Like everyone one else, they’ll pay more to borrow.

That is the ultimate risk of financing so much of your prosperity with debt (instead of savings). Your continued growth is depending on your access to credit. And if, for any reason, that is cut off, you’re in trouble, not to mention you’ll have to dedicate a larger portion of your national income just to service your debts.

No matter what the Treasury Secretary says, Australia does have a huge net foreign debt figure. The country has chosen to finance its growth with borrowed foreign money. That is what it is. But let’s not pretend than on the face of it, it’s no big deal with no big consequences.

By the way, why was the Parliament website under assault from global hackers? Well, who knows? But it could have something to do with the fact Google revealed yesterday it had been asked by the Australian Government to censor certain YouTube videos by putting them into YouTube’s “refused classification” category.

You cannot be serious.

Communications Minister (increasingly an ironic title for a man bent on censoring the Internet) Stephen Conroy apparently asked Google to filter Australia’s YouTube content the way it filters content in China and Thailand. Google, which has recently found a backbone about cooperating with the ‘requests’ of oppressive regimes, said it would not “voluntarily” comply with the request.

So if the Minister wants Google to censor Australia’s YouTube options, he’s going to have to do it the old fashioned way, via legislative coercion. The minister, via the government, appears ready to just that by submitting legislation that would force Aussie ISPs to block websites that were “refused classification.”

Ah yes! The famous black list. No one knows if they’re on it, how they got on it, or how to get off of it. But someone in the government keeps it and if you’re on it, may god and a very good legal team help you. It’s astonishing that after so much opposition, the Minister pushes ahead with his plan. It’s almost like everyone in government thinks you need to be protected from yourself.

Some people will say that reasonable attempts to police the Internet aren’t any different than attempts to police the real world. The distribution of pornography is regulated and limited. The same goes for alcohol and tobacco. Why, the argument goes, should the Internet alone be free of any sensible attempt to determine what people are allowed to consume.

Well, why not let sensible people make that determination in the privacy of their home, as adults? If the government gets to determine what’s sensible for you to see, they will invariably abuse that authority, even if it begins in good faith (protecting kids from sexual predators, for example).

But it’s hard to see you promote a free-thinking and thoughtful society by controlling what people see. That’s paternalistic. What’s worse, it’s a well-dressed up and mild-mannered kind of authoritarianism that should be mocked, resisted, and defeated whenever you get the chance. Don’t worry. They’ll keep coming for you. You just have to keep fighting.

Or have we finally lost the plot? Are we so deeply immersed in the idea that the funding model for the fiscal welfare state is fundamentally broken that we’re being unreasonable? Maybe. But we hope not.

In previous financial crises, the contraction that came with global recession was avoided by either more money or cheaper energy. These kept the whole system growing. Capital and energy are important inputs into any growing system.

But what we’ve seen in the last year is that the flood of capital and credit has gone to prop up fewer and fewer large institutions. The big governments bailed out the big banks and left the little banks to hang. But who is going to bail out the big governments?

They’ve taken on all the risks and bad debts of the private sector. Now all that risk is concentrated in fewer places with a greater strain. These governments aren’t too big to fail either. But their failure will be even more catastrophic for ordinary savers and investors.

That’s what’s different this time, we reckon. For the better part of 200 years, the tides of prosperity have lifted more and more people out of poverty. Mind you there are still billions of people living on less than a dollar a day. But standards of living for more people are higher than they’ve ever been.

We wonder now if the 200-year expansion is due for a contraction. More expensive energy and credit slow the growth of the system. More importantly, globalisation is clearly detrimental to the interests of some nation states, especially in those countries where wages are falling at just the time millions of Boomer’s hope to retire on generous pensions or accumulated financial assets (houses and stocks).

That’s not a tempest in a teacup. That’s a teacup shattering on the kitchen floor when you realise the government is coming for your 401(k) or Superannuation assets to pay for its deficits, which in turn pay for promises it can no longer keep.

Even if Europe finds a cosmetic remedy for the Greek crisis, the real problem is a world that borrowed a lot of its current prosperity. The debt overhang is too great to permit an easy way out of all this. Default in the debtor nations which borrowed in Euros and dollars is inevitable.

For the UK and the US, which largely borrowed in their own currencies, inflation is much more likely. In this scenario, we’d again recommend you sell into rising stock markets when you get the chance. Stocks could rise as investors shun sovereign debt markets. And once the Fed, like the Bank of England, is forced into monetising more government borrowing right away, look out for much higher precious metals prices.

Yep. It’s a carnival of creative destruction. Stay on your toes! Until next week…

Dan Denning
for The Daily Reckoning Australia

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