Greece, China & the Fed's Printing Press

What Athens can't do, the US central bank is only too willing to try once again...

WHETHER GREECE'S debt crisis ought to have any real affect on the share prices of Aussie banks and resource companies is debatable, says Dan Denning in his Daily Reckoning Australia.

What's not debatable is that stock markets all over the planet are selling off on the down-grading of sovereign debt in Greek and Portugal. The S&P was down 2.3% in the US, London down 2.6%, Germany's Dax down 2.7%, and in Lisbon the market sold off by 5.4%.

All of that was a bit predictable, given how far markets have come since last March without, we'd argue, much improvement in the debt picture that caused the whole global financial crisis in the first place. What is persistently strange about these sell offs in European and emerging markets is how it causes a rally in the US Dollar and US Treasury bonds, given how lousy America's fiscal position is.

But the bond market has ruled with the big thumbs down on Greek debt. In the last two weeks, the yield on 2-year Greek debt has more than doubled from 6.1% to 15.35%. This means the market is not confident Greece can meet its obligations and roll over new debt by May 19th. And the market is essentially rejecting the bailout/back stop offer engineered by the EU and the IMF.

The soaring bond yields are just another way of saying that investors now expect a restructuring of Greek debt which includes a default. Bond investors are not going to be made whole. But something will have to be better than nothing.

The fact that Greek trouble has spread to Portugal and many of the other fiscally-challenged European states shows what really needs restructuring-expectations on the level of social welfare the nation state can be expected to deliver without bankrupting an economy. But this is a larger issue than politicians have the stomach (and the intellect) to deal with.

So a great whirlpool of uncertainty now begins to swirl over who is going to pay for what, or whether it can be paid for at all. That is not good for investors in the short-term. But there IS one way in which it's useful. It's preview.

That is, the Greek problem is also a Euro problem. And the Euro problem is a paper money backed by nothing problem coupled with high levels of debt. You can see that the only resolution to a sovereign debt crisis is default of inflation. Because it does not control its own interest rates or money printing (monetary policy) the Greek government is at the mercy of the European Central Bank. And being genetically descended from Germany's Bundesbank, the ECB is not willing to print Euros in order to save Greece.

The US Federal Reserve, of course, CAN print as much as it would like. And this is why we firmly believe the resolution of America's own sovereign debt problem will be inflation. That's the investment scenario we're preparing for...a world awash in increasingly worthless paper claims on the full faith and credit of the United States government. But in the interim, the Dollar is getting the 2008-like "flight to safety and liquidity" bid.

You may not believe this, but in the midst of the accelerating Greek crisis, it's not even the country that keeps us up at night. That distinction would have to go to China. Mind you we're not sharing the same bed with China. It's a big country. It wouldn't fit on our queen sized mattress.

But like it or not every Australian investors is in bed with China, or in a relationship if you prefer. And for the last ten years, that's been a very amicable relationship. And arguably, as big a story as the sovereign debt crisis is (because it impacts global capital flows, which highlights an Australian vulnerability to the rising cost of capital), what happens in China will have a longer-lasting effect on the Aussie share market and the Aussie economy.

Shanghai stocks fell 2.1%. According to BusinessWee, "Concerns about government efforts to cool a housing price boom have hurt makers of building materials and construction-related machinery, said Liu Feng Feng, a strategist for Central China Securities in Shanghai."

China has become a giant construction site where loose credit policies have unleashed a building boom that's fuelled demand for Aussie resources. When China's credit bubble pops, the real estate money machine will grind to a halt. And then?

It all depends on how much confidence you have in men to manipulate markets. It would be more than a little ironic if Beijing's central planners pop the bubble and unintentionally unleash a real estate collapse. But this is the trouble with thinking a small committee of decision makers can manage an economy of 1.3 billion people.

The problem, as Friedrich Hayek pointed out, is one of knowledge. There is just too much to know for so few people. How is any one group of people supposed to know what the idea price of money is, or where credit should be allocated and to whom? Those decisions are best left to individuals with local knowledge acting in their own best interests with transparent pricing information that actually reflects what people want and what they're willing to pay.

China can tax third homes on individuals and curb credit or it increase land supply to try to make home values appreciate more slowly. But its property market is fundamentally organised to maximise revenues for local government. It encourages speculation. And the bubble is already baked, full of Australian coking coal and iron ore and zinc and copper and coal.

It's the bursting of China's centrally planned bubble that looms largest for Aussie investors. So even if you get a relief rally after some transparently false resolution to the Greek crisis, you may want to consider a much bigger picture and a longer-term investment game plan. Stay tuned for that.

And here's a bonus thought for the day: what if the inevitable collapse of the social welfare state funding model leads people to change their primary loyalty from the State to something more local? For starters, it would mean, we reckon, that the centralising principle of the last 200 years of Western history (in commerce, politics, and living arrangements) may have reached its natural limits.

The centralizing principle would reach those limits for various reasons. One is the inherent fragility of complex systems and their increasing vulnerability to systemic collapse. Globalization and the division of labor on a global level creates tremendous complexity AND vulnerability.

Politically, the centralizing principle, as emotionally successful as it has been in winning market share/votes (let us live at one another's expense) is being exposed as economically fraudulent (as well as morally wrong to coerce other people to your way of thinking through taxation). It's a nice idea, but it may be unaffordable without literally mortgaging the future or destroying our standard of living in the pursuit of a social welfare utopia.

Just to refresh, Robb defines a primary loyalty as:

"A connection to a non-state group that is greater than loyalty to a state. These loyalties include those to clan, religion, tribe, neighbourhood gang, etc. These loyalties are reciprocated through the delivery of political goods (by the group that the state cannot or will not deliver)."

In a prosperous liberal democratic state where people see justice as fair and view the burden of civilization (taxes) as equitably shared, where corruption is not rife and opportunities exist for social and economic mobility, having your primary loyalty to an abstraction (the rule of law or the State) is no problem. It is the norm.

But when the State expands the promises it makes and then fails to deliver on more basic ones, people begin to question their primary loyalty. This doesn't mean they revolt. No one really wants to do that. You only do that when you have no recourse economically and no better prospects.

We reckon a retreat to a more local way of life is in the works. The rising cost of energy and capital will be one factor. And frankly, to use a Marxist term, people might feel less alienated from their labour and life if they felt more connected to their neighbours and their work. And that's more possible in a small, more sustainable resilient community than it is.

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