Your editor had a couple of items on the agenda today. But there isn’t the space for both of them today. The second item was tax. It continues to baffle your editor how willing the mainstream press is to tow the line that tax breaks are evil and they must be closed.
While we agree that the entire notion of taxing things and then creating loopholes to favour some taxpayers over others is ridiculous and inefficient, it would surely be much simpler to abolish most taxes and therefore remove the need to create loopholes.
The mainstream press typically doesn’t agree. Instead they prefer to do the government’s bidding and attack tax exemptions and tax deductions. I’ll have more on that tomorrow.
But for today an apt dose of reader mail:
“The government continues to borrow at unprecedented levels. No one I have asked knows from whom this money is being borrowed and on what terms. Do you know the answer to this?”
Julanne
It just so happens we do know the answer. Actually there are two parts to it. The buyers and the sellers – obviously.
A few weeks ago Dan Denning upstairs at the Daily Reckoning brought to attention the workings of a government department called the Australian Office of Financial Management (AOFM).
You can access the department’s website here. This is what the front page of the website tells you:
“The Australian Office of Financial Management (AOFM) is a specialised agency within the Treasury portfolio responsible for management of Australian Government debt. The AOFM’s activities include the issue of Treasury Bonds, Treasury Notes, management of the Australian Government’s cash balance, and management of a portfolio of debt and investments.”
“The AOFM aims to manage Australian Government net debt at least cost, subject to an acceptable level of risk, and to contribute to supporting financial market efficiency.”
Not surprisingly there hasn’t been too much activity at the AOFM in recent years. Not since the bond market was almost closed down a few years ago.
Since late last year however, well according to today’s Australian Financial Review (AFR), the AOFM will be increasing staff numbers by 10% from 30 to 33. That’s not a big number. But what is a big number is this…
“The total face value amount of Treasury Bonds on issue at end-June 2009 will be around $79 billion, an increase of around $30 billion on end-June 2008.”
“Treasury Bond issuance in 2009-10 is expected to be around $60 billion. After accounting for maturities of $6.0 billion this represents a net increase of $54 billion in the face value amount of Treasury Bonds on issue.”
“The face value amount on Treasury Bonds on issue at end-June 2010 is projected to be around $133 billion.”
Boy, those guys know how to raise money. So, by June 30th 2010, the total amount of government debt on issue will be $133 billion, compared to around $50 billion at June 30th last year.
It’s not surprising the AOFM is increasing staff numbers. So far this year it has held 31 bond tenders. And we’re only in May. From 2006 through until 2008 there were a total of 41 issues. By the time this financial year ends, the AOFM will have held a further twelve tenders.
That means in the six months of this year the AOFM will have held more tenders than in the entire previous three-year period.
In fact yesterday the AOFM issued another $700 million in debt. All of it snapped up by investors. With an average yield of 3.86% that will cost taxpayers $27 million in interest payments by this time next year.
But of course that isn’t a one-off. Remember, debt will stand at $133 billion by the end of June next year. And the interest cost on that? For one year, you the taxpayer will pay a total of $5.13 billion in interest.
That’s about $500 per year for each taxpayer. Doesn’t sound like much? Don’t forget, that’s just the interest. And that will be charged each year the debt is outstanding.
And there’s still the principle to pay back as well…
Which if you spread across the roughly ten million employed persons, equals around $13,000 each.
Look, we could go into more detail and make it more complicated, but some things don’t need to be made more complicated. There is one simple fact which the mainstream media, commentators and analysts have missed. And that is there is no such thing as a good or manageable or acceptable level of government debt.
You could argue there is no such thing as government debt if we’re being picky, because the debt is completely underwritten by the taxpayer. Taxpayers that are about to be hit with $133 billion of debt at a time when they are least able to afford it.
But I said there were buyers and sellers of the government debt. The sellers are the AOFM. But who’s buying this stuff?
Do you remember part of the reason why the US has got itself into a big hole? OK, there’s a bunch of reasons. But one reason is that it became over reliant on the consumer. Credit was easily available and so people spent up big. They mistook that spending for wealth.
The US government burdened its industry with so many rules and regulations that it became uncompetitive. So business sent manufacturing off shore, or they closed up shop in the face of stiff competition from Asia.
Foreign companies received billions of dollars as payment for goods sold to the US, but either had nowhere else to invest the money or keen to keep their currencies weak to encourage more exports they didn’t bother converting those dollars back to their own currency. They bought US government debt instead.
And so, the US government issued more and more and more of the stuff. “An economy doesn’t need to produce anything if these suckers accept our IOUs” they must have thought.
Of course now, realization has hit that without production an economy cannot survive.
Which brings us to who’s buying Australia’s debt? Again, a visit to the AOFM website spills all the beans. Here you can view the presentation given in Dubai by the CEO of the AOFM, Neil Hyden.
In other words, our beloved policy makers have set themselves on course to repeat the same mistakes that hapless public servants have committed overseas.
Worse than that is it’s creating the perfect storm for inflation. In the short term there will be demand for sovereign government debt both domestically and from overseas. This is likely to increase the price of bonds and decrease the yield. But it will only be for the short term.
You see, as with any non-market driven actions it has what the mainstream call ‘unintended consequences.’
As we’ve written with the housing market, government involvement always leads to a distortion of supply and demand. So, in the short run there will be a big demand for Australian sovereign government debt. After all, there isn’t much “quality” debt being issued at the moment – remember it’s all relative.
But as more and more debt is issued the appetite from investors will become less and less. Either because they already have enough invested or because of the over-issuance, investors are now demanding a higher yield.
Think of it this way, the more debt on issue the less valuable or scarce existing and new issues become. Therefore the price must be lower. And if the price is lower then equally the yield must be higher. Think of it another way, if you already own a large amount of something (debt for instance), then your appetite to buy more is less. So you will pay less for it at a higher yield.
But even worse than that is the impact on corporate equity and debt raising. If government debt is viewed as risk-free, then corporate debt and equity has to be priced at a premium to reflect the fact that it is not risk free.
This means that as yields on government debt rises, yields on corporate debt must also rise. In other words, the cost to a company to raise finances becomes more expensive thanks to the distortion created by the government.
It creates a spiraling effect, from which it’s difficult to emerge.
The endgame is rampant inflation. We’re already seeing higher inflation even though the official statistics aren’t showing it yet.
The massive stimulus packages and wasteful infrastructure spending by the government is preventing prices from falling – which is what should happen in a recession. This means that as the cost of money rises, prices are rising from a previously inflated point rather than from a depressed point.
Eventually foreign investors will realize that apart from Australia’s natural resources, there is little else for them to buy with their Australian dollars and a flight from the Aussie dollar will follow.
This will put even greater pressure on interest rates, and make imports even more expensive pushing inflation up further.
It’s a dark scenario. And it’s inevitable if policymakers continue down the path of debt fuelled spending. Australia’s one exit point from this mess is the reincarnation of the resources boom.
But even with that, it will only delay the inevitable unless current policies change
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