Gold News

Economic Illiteracy

How government thinks things work, compared with how they do...

JUST TO BE CLEAR, the big trends now are soaring inflation and falling financial asset prices, along with increased energy scarcity, writes Dan Denning in the Australian Daily Reckoning.

This produces a variety of pair trades, which include:

  • short government bonds, long energy;
  • short residential housing, long gold; and probably
  • short commercial real estate and corporate bonds as well, while going long farmland and agriculture.

But how corporate bonds fare in the coming months depends a bit on government bond yields. So let's get stuck into them, shall we?

Over in America, ten-year Treasury bond yields – the rate of return offered by their fixed-income interest if you bought at current prices – have advanced to their highest level since last October. It happened just as Uncle Sam was throwing an additional $19 billion of ten-years over the line and into the battle against deflation. The latest sale of the bonds took place at an average yield of 3.99%.

Thursday this week marks the auction of $11 billion in 30-year bonds. Thirty-year yields are already as high as they've been since October of 2007. And by extension, borrowing costs linked to government bond yields will rise too. Mostly this affects the US mortgage market. It means that refinancing a mortgage-providing you can find a willing lender-will get more expensive.

But we think rising US bond yields indicate that the Credit Depression is entering a new phase. The cost of capital is rising, after slumping to historic lows during the credit boom. Investors – including other sovereign nations outside the United States – will demand higher yields to loan to deficit-challenged governments. Or they may just dive into asset classes with better growth prospects.

For example, Russia's central bank says it may switch out of US bonds and into IMF bonds. Russia's Finance Minister Alexei Kudrin says Russia will buy $10 billion in IMF bonds. China floated a balloon earlier in the week about buying $50 billion in IMF bonds. Brazil said it will buy $10 billion worth of IMF bonds.

This is just the beginning of the beginning. Or maybe it's the middle of the beginning. Or it could even be the end of the beginning. But it's pretty clear that the balance of power in the global financial system is shifting. It favors real resource producers and creditors. It does not favor governments with big deficits and bad demographics (i.e. more recipients of governments in retirement years and fewer workers to support those retirees).

You can see that Australia fits into both categories. It's a resource producer with high levels of personal and corporate debt. We reckon that over the coming years, government debt will grow too. But Australia will likely be a target for international investment, given its resource wealth and comparatively high interest rates. That means the country shouldn't have a huge amount of difficulty financing Kevin Rudd's deficits.

That doesn't make said deficits a good thing. And it doesn't mean Aussie interest rates won't rise too, making borrowing more expensive for Aussie businesses and households. But an auction for American bonds is more likely to fail than an auction for Aussie bonds right now.

Aussie deficits are still wrong-headed and unnecessary, mind you. This recession (and it IS a recession, despite the statistical flim-flammery) was not caused by insufficient consumer and business demand, as Wayne Swan and others stupidly repeat. That's what all the Keynesians say. Thus, their policy prescription is for the government to run a deficit and support spending until consumers and businesses get back on their feet.

When you diagnose the problem incorrectly, your cure will be faulty too. But this is a balance sheet recession. The cause of it was the accumulation of too much leverage at the household and business level. The only cure for this kind of a recession is the write down in non-productive investment made with credit (residential housing, for example) and deleveraging (paying down of debt).

A recession that was caused by too much credit and massive bad investment is not cured by more government spending. It's like trying to cure a cold by kicking a dog. What's more, when you have over-capacity in global industrial production, lowering interest rates to try and stimulate the demand that you think is missing will prove a waste of time. Business won't borrow at lower rates when they don't need to. Why expand production when there is already too much to begin with? Demand is stagnant in most places and falling in the rest.

Besides, what does a government really accomplish when it manages to increase consumption through transfer payments? In most of the Western world, increased consumer spending primarily benefits the producers of consumer goods. Those producers are in China and the developing world, not America and Australia or the UK. It's true that local retailers may profit. But the bulk of the profits go back overseas anyway.

At the heart of this bad policy is a simple mistake, built upon economic illiteracy. This mistake is thinking that prosperity comes from consumption. Spending money doesn't create wealth. Prosperity begins with capital formation and production. You have to make something you can sell in order to earn an income you can trade for other goods. If you don't make anything, you can't consume.

For some reason, most modern policy makers have it all backwards. They think wealth begins with consumption and spending. And in the meantime, they have – thanks to a big assist from the financial industry – engineered a structural change in Western economies that favors the financial industry (which doesn't produce anything) over manufacturing or real goods production.

That's turning out to be a world historical mistake of the first order. But at least for Australia's sake, the consequences of that economic strategy will be somewhat beneficial. As America produces less and borrows more, the buyers of its bonds and dollars will defect to better investments in other places.

Australia is one of those places. So is gold. So is oil. Housing? Not so much. Government bonds? Definitely not. And common stocks? We'll see.

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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