Gold News

War is peace, debt is wealth

Australians used to owe 35 cents for each Dollar of income. Now they owe $1.58...

THE WORLD is not flat. Instead, it increasingly resembles a piece of cheap elastic, stretching beyond what we ever thought was possible.

   Sooner or later we expect the elastic to snap, leaving a giant red welt on someone's backside. But until then, what exactly is unfolding – and what does it mean for investors?

   At the upper end of the elastic band are the money shufflers. These days, the money shufflers are best represented by Stephen Schwartzman and his merry band of pirateers at Blackstone. The good ship Blackstone was up 13% on Friday in its first day of trading as a listed stock.

   But hey – if you can make money buying and selling assets with other people's money, why not? We have nothing against the pirates personally. But when the chief preoccupation of the market is making deals and not building businesses, well then, we've reached a very late, decadent stage of the credit cycle.

   At the other end of the elastic band is the stretched middle class of the Western world. Okay, things don't look so bad right now. Low consumer price inflation has kept the supply of electronics and manufactured goods down. It's not exactly bread and circuses. But with a decent credit line, you can have a lot of fun at Bunnings.

   However, the reality is at odds with the appearance of growing wealth. "Real wages fall as profits rise," writes David Uren in The Australian. Two factors have kept real wages low for Australian workers. First, the globalization of the work force keeps a lid on wage growth. This is simple supply and demand. As the supply of labor has grown with the inclusion of China and India into the global economy, the price of labor, generally has gone down.

   And then there is the distribution of profits. Workers are getting less of them directly while corporations are taking a larger share. In the US, corporate profits as a share of national income are up from 7.8% in 2002 to 10.5% today. The same general trend can be found in France, Germany, Japan, and Australia.

   In fairness, corporate spending in the form of business investment has also kept the unemployment level at all-time lows. Business spending is the key to a healthy business cycle. So the fact that corporate profits are up as a percentage of national income isn't automatically a sign that big, bad, corporate fat cats are doing well...while the working stiff is getting stiffed.

   But despite the cheap electronic goods on sale at Harvey Norman, the working stiff has got to start wondering if this whole globalization thing is going to work out for him. "The average household is now supporting debts that are 58.7% greater than their total annual income, whereas at the last election, debts were 41.3% more than a year's income." This from a Reserve Bank of Australia study released this week. But that data doesn't really tell the whole story.

   In 1977, the household debt to disposable income ration was 35.1%. Obviously, that meant for every Dollar of income a household had, it had only thirty-five cents in debt. Today, every Dollar in income is burdened by $1.58 in debt. This is progress?

   But wait! That debt also shows up on the household balance sheet as an asset. That's because the biggest component of household debt is the mortgage. "Debt levels are rising, but we are choosing to use the debt more productively to buy assets that traditionally rise in value, like shares and property," says CommSec economist Martin Arnold.

   Fair enough. But here's the question...if Australians are forced to go deeper in debt for longer and spend more of their disposable income on an asset they never fully own, just what kind of an asset is a house anyway? Aren't you better off renting? Renting doesn't have the same tax advantages, of course. But it doesn't have the same debt disadvantages.

   What about capital gains? That is the holy grail of property investment. But here's the thing. Assets fluctuate in value. Debts do not. Right now, Australians are comfortable loading up on debt just so long as the assets they buy with that same debt go up faster than the cost of servicing it. But that's the flimsy and false logic behind all credit bubbles...that you can borrow cheap, bid up an asset, and flip it to some other schmuck before interest rates rise, money supply shrinks, and assets fall in value again.

   The assets will fall in value again, both absolutely and adjusted for inflation. And then what is your average Australian left with? A whole lot of debt, an asset falling in value, and flat wage growth in a cut-throat global economy. Argh! Sounds like walking the plank to us.

   Will super funds save everyone? "Balanced super funds will return about 15% net of fees and taxes in the 2007 financial year," reports a newswire article. This is how Australians benefit indirectly from rising corporate profits. Those rising profits translate into earnings growth, which translates into higher share prices as money managers buy the stocks.

   We say "indirectly" though because time will tell how much of those super gains will be left by the time people begin to need them. Our long-term forecast? Inflation will erode the value of super returns the way it erodes the value of cash year after year. When you throw in a massive liquidity-contraction correction in markets, well then it looks even gloomier for the Aussie investor/worker/shareholder.

   Taking on debt is not a way to get rich. It's only a kind of financial newspeak that makes it seem like taking on debt is okay. "War is Peace. Ignorance is Strength. Freedom is Slavery," Orwell wrote. "Debt is Wealth," he would have added if he were writing today.

   What to do?  The credit boom may keep on booming for another few years. That means rising share prices, commodity prices, and even property prices. There are ways to make money in that time.

   But longer term...?

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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