It’s only three more days until our Australia in the Red debt summit.
You don’t need to be a Yale educated Harvard professor to work out the main subject of the evening.
But this means your editor is moving into debt summit preparation mode.
The first thing we need to ask is whether all debt is bad? Wouldn’t we all be better off if there was no means to borrow and no means to lend?
If that were the case we could only ever buy what we needed with the money we actually owned.
There would be no mortgages, no car loans and no credit cards. There would be no business lending and no government borrowing.
You want it? You better earn the money to buy it first.
Does that all sound so bad? If you read the mainstream press recently, listen to the pollies, and take at face value what the bank economists say, then it’s terrible.
The whole economy, according to them, thrives on credit. Without it, the economy is dead. US president Barack Obama said that credit needed to flow again.
Over the weekend, UK chancellor of the exchequer Alistair Darling said “We need to get to the bottom of what is happening with individual banks, to see if loans are being made available and to check that [banks] are not charging more than is justified.”
In other words, not only do the banks need to lend but they better not make more profit than necessary.
And according to today’s The Age newspaper, investment is only possible if there is borrowing and lending, “Private investment has fallen to a record low as firms struggle with tight borrowing conditions that are likely to worsen during the next year, a leading forecaster says.”
It’s quoting David Rumbens from Access Economics.
So, to paraphrase Jerry Seinfeld, “What’s the deal with borrowing?”
Well, in actual fact we don’t have a problem with borrowing at all. Borrowing simply means that you’re able to spend now to rather than spend later.
As an example, for businesses it means they can borrow money now to buy machinery now. This enables them to produce products which they can sell now.
Without borrowing the money to buy the machinery the business may have to wait several months or years before it could afford to pay for it in cash. For a large company that is already operating maybe that isn’t a problem.
But what about a start-up company that has an idea but not the capital to put those ideas into practice? Without borrowing and lending, that small idea may never get off the ground and could be lost forever.
For individuals, borrowing means being able to buy something now that the individual needs/wants now rather than waiting for it. It means taking out a loan for a car or a house rather than saving up to buy it.
In effect, borrowing is bringing forward expenditure. Like I said, we’re not talking Harvard PhD stuff here.
Naturally, if you borrow now you have to pay it off later. Rather than forgoing the item now and saving, you are forgoing savings in order to buy the item.
The point is, it has to be paid off. Very rarely do you get something for free.
If that’s the case, why is borrowing money to have things now, seen as bad? Surely, if it’s as easy as buying now to pay back later, there shouldn’t be a problem. Providing borrowers don’t over-commit themselves, then repaying a loan now at a specific cost over a period of months or years is acceptable rather than saving over a similar period to spend in the future.
The problem comes if everyone is trying to join the same side of the ledger, ie. Everyone is trying to borrow, or everyone is trying to save.
That’s where interest rates – in a free market – help to determine whether we become borrowers or lenders.
And it’s also where the distortion of the interest rate market flows through to create a distortion between borrowers and lenders. Similarly, other interventions in the market such as subsidies only help to distort the market further.
You see, the cure to getting businesses or individuals to spend isn’t to reduce interest rates to an artificially low level. Hang on, but isn’t that exactly what is supposed to happen so that it encourages people and businesses to borrow money to spend in the economy?
If interest rates are low, then businesses can borrow on the cheap to invest for the future. They can buy now, knowing that those that are saving will have money to spend later on. Isn’t that what all the stimulus programmes are about?
Stimulating the economy to spend now, to prop things up and smooth out economic imbalances?
Trouble is, that’s not what’s happening. Spending is being made in all the wrong places. Money is being misallocated due to cheap money in some places and expensive money in others.
Look at it this way. Why would you save when the interest rate on those savings is barely above the level of inflation? If you rely on your savings as a source of income then there is even less incentive for you to save, considering that you’ll be lucky to eke out a 1% return on your cash balance.
Take the recent Westpac ASFA Retirement Standard numbers that show a retired couple with a modest lifestyle needs to spend about $27,000 per year. Based on a 1% return after inflation, they need about $2.7 million in savings in order to not eat into their capital.
As soon as the capital is used then their return above inflation must naturally be higher.
So, due to the low interest rates and high inflation, savers are being forced to take bigger risks. Perhaps at a time when they should be taking lower risks.
If, according to The Age and Access Economics, private investment funding is so low that the government ‘needs’ to ‘step-in’ where is the borrowing and lending happening?
Of course, it’s all happening in the housing sector. Because not only are the low interest rates helping to suck in buyers, but the government bribes are creating an artificial demand for housing.
Naturally the banks are more keen than ever to keep the housing bubble propped up because it’s such a large percentage of their assets. They know as well as anyone that a slump in property prices means a US style banking collapse (by the way, 64 US banks have failed this year, despite their bailouts!)
Normally, in order to attract savers, the banks would have to raise interest rates to encourage people to deposit their money into a savings account. This money can then be used as collateral to lend out to borrowers (let’s forget the concept of fractional reserve lending for a moment).
The only problem with that is in order to attract those savers it means jacking up interest rates to borrowers new and old. That’s something the banks cannot afford to do. Not because they wouldn’t like to, but because as we mentioned above, we would see a massive increase in debt defaults, a slump in property prices, and a collapse of the banking system.
And thanks to the fact that Australian housing loans are recourse, a borrower could face not only being evicted from their home but continuing to pay off a debt against which there is no asset.
It’s one reason why the borrowing costs to business have not fallen as much as they have to homeowners. The banks don’t want to lend to businesses.
Again, they’d like to, but they have got themselves into such a big hole there’s nothing they can do about it except continue to dig.
The banks know they can turn off the taps to business because most businesses are productive and will continue to produce products and sell them to customers – customers that are being encouraged to buy now rather than save due to the low interest rates.
Most businesses don’t need to be directly propped up.
In contrast, once a house is built it is not productive. Whatever property spruikers tell you. It’s something for you to live in. It’s a dwelling. By itself it does not create a further benefit to the economy.
Even an investment property is non-productive as most landlords are content to charge less in rent than they receive in income due to negative gearing and the belief that property prices always rise.
The non-productive nature of housing means that if a borrower loses their means of income (ie. They lose their job), the house isn’t going to supplement the income. The borrower may be forced to sell it.
For most businesses it is different. Sure, they are also at risk of losing income, but most businesses do not rely on a single source, or two sources as do the majority of home owners.
That’s why the banks have had to go to the equity markets to raise additional capital. Again, this has been portrayed as an example of the strength of the Australian banking system when it is in fact a sign of the complete opposite.
A strong bank with a healthy loan book should not need to raise capital. It should be confident of its own risk exposure that it can safely raise both borrowing and lending rates without it having a disastrous impact on borrowers.
That Australian banks have been unable to do this, while instead relying on government guarantees and capital raisings is a strong sign that the banking system and the housing market are in a very precarious position.
So precarious in fact, that measures being taken today to avoid a collapse in both, are only making an even worse collapse inevitable in the near future.
Other Stuff on the Markets
The S&P/ASX200 gained 1.2% yesterday, while on Wall Street the Dow Jones Industrial Average added 15 points. In Europe the FTSE100 gained 0.21% and the CAC40 added 0.18%.
The price of gold in Australian dollars is trading at $1,160.54, while in US Dollars it is trading at $952.90.
The Aussie dollar remained strong versus the US dollar and Japanese Yen, trading at USD$0.8225, and JPY78.35.
Crude oil remained higher, closing at USD$68.11.
For the biggest movers on the market yesterday click here…
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“”"So precarious in fact, that measures being taken today to avoid a collapse in both, are only making an even worse collapse inevitable in the near future.”"”
so bigger financial problems in the australian are yet to happen???????
or are you scaremongering people into the sharemarket?????????