Debt Makes the World go Around

A change of tack today. I’ll leave the Trumpster — and what he means for markets and the world — for others to ponder. Instead, let’s look at a big problem he’ll inherit: debt.

I’ve been interested in the world economy for as long as I can remember. But it wasn’t until around 2003 — when I studied international relations as part of a postgraduate degree — that the big, ugly world of international economics and debt started to make sense to me.

That’s when I studied how the ‘US dollar as the world’s reserve currency’ worked. I studied the ‘Triffin Dilemma’, and came to understand that debt was the oxygen that allowed the post-1971 international financial system to breathe and grow.

In fact, I read so much about it that I don’t stop to think about it too much these days…which probably isn’t ideal. So thank you to a dear reader who sent in the following question:

Good morning,

I have read, with amazement in your very interesting articles, how indebted the developed world is, especially, Japan, the US, UK and Australia…

What I don’t understand is: to whom is this debt owed? Merchant and investment banks? Sovereign wealth funds, e.g. from Norway?

How can China be a massive debtor and yet at the same time have so much money stashed away in US Treasury Bonds and in foreign-exchange accounts??

I find the concept of “debt” on this scale something that is really difficult to comprehend!

Surely someone, somewhere, is holding all these trillions of dollars of IOUs, and will at sometime call them in??

Maybe someone from PPP could write a brief explanation for us plebs!!??

Firstly, let me say that despite my interest in the subject, I am hardly an authority. If you want an authority on this stuff, do yourself a favour and get your hands on Jim Rickards’ latest book, Road to Ruin.

Given the pittance you’ll pay for a copy, it’s probably one of the best investments you’ll make. Go here for more information.

Let’s get back to the question…

To Whom is this Debt Owed?

Yes, the developed world is awash in debt. That’s because in a monetary system not anchored by gold, debt = money. And because debt = credit, credit is money too!

Now, that probably all sounds a bit heavy. So let’s peel it back a bit.

Firstly, let’s think about how money enters into a local economy. Then we’ll expand this idea to the international arena.

It all starts with the banks. Banks create money by making loans. There is a myth that central banks ‘create money out of thin air’. They don’t. Not directly, anyway. I’ll show you why this is the case in a moment.

Commercial banks create money, not the central banks. In Australia, the commercial banks are (mainly) the big four.

Say you go into a bank and request a home loan. The bank says, ‘Yes, of course’ and it puts, say, $300,000 in your account. It creates the money ‘out of thin air’. All it needs to do so is your credit/credibility (it assumes you are good for it) and enough capital reserves to support the loan.

The money created is briefly in your hands, and then passes on to the vendor of the house. They may use it as equity to borrow against and buy or build another house, or they may spend it in different ways.

Whatever happens, the act of creating the loan creates money, which then flows into the economy. There are a few things that happen in the background to make the banks balance their books. But for the point of this article, understand that debt = money.

The main reason why there is so much debt these days is because low interest rates have made credit very easy to obtain.

Think of how much you could borrow back when interest rates were 10%. Not that much. Banks were much more hesitant to give you credit. But at 4% or 5%, you can borrow much more. Hence more debt.

Also, the amount of reserves banks must hold to support their loan books is much lower today than what it was years ago. This allows them to create more debt, too.

Now, if we expand this concept to an international perspective, you’ll see just how ‘magical’ the international financial system really is. It makes brilliant use of double entry accounting, which means that an asset must always balance a liability.

Earlier I mentioned how the US dollar acts as the world’s reserve currency. This system encourages the US to run trade deficits, and for other nations to run trade surpluses with the US.

Why does it do this?

Well, if a country runs a trade surplus with the US, it ends up with excess US dollars. And because the US dollar is a ‘reserve currency’, the country builds up financial reserves.

These reserves form the asset base for their own banking systems. This means their banks can start creating credit off this reserve base. I’m skipping a few steps in explaining this process, but this is the gist of it.

The point to note is that the US dollars represent the debt (liability) of US businesses, households or governments, but they are also the assets of the nations generating the trade surpluses.

These assets are then used to create more credit (debt) in the local economy in question. So the larger this asset base grows, the more credit these domestic banking systems can create in their own economies.

Can you see how more US debt = more reserves for trade surplus countries, which equals more credit-creating firepower for those countries? What a sweet system!

Let’s take China as an example, because it will answer the question of: How can China have so much debt as well as having so many trillions in US Treasuries? It’s a good illustration of how screwed up and precarious the financial system is.

China produces more than it consumes. It therefore runs a trade surplus with the US and has done for years.

These trade surpluses accumulate year after year. Now, China must do something with these ‘dollars’, so it buys US Treasuries. This stops its currency, the yuan, from appreciating, and builds up its reserves.

These reserves form the monetary base for its domestic financial system.

Since the financial crisis, China has ordered its banks to lend, and, because they have a massive reserve base from which to create credit (debt), China now has its own debt problem.

So while you might think they have plenty of assets in the form of US dollar reserves, they have also created an enormous amount of debt from these reserves. It’s why China is now having problems with capital flight.

The question was: Who holds all of this debt? The answer is everyone!

One person’s debt is another’s asset. If you have part of your portfolio invested in government bonds or fixed interest, you hold someone else’s debt.

Only in extreme circumstances does this debt get ‘called in’ on a global scale. That’s what happened during the last credit crisis. The collapsing US housing market triggered an exodus out of risky debt and into ‘safe’ debt, like US treasuries, or cash.

But central banks created enough ‘cash’ (actually, banking system reserves) to absorb the rush out of risky debt, and this halted the panic during the crisis.

The truth is that not everyone can get out of debt at the same time. If everyone paid back their debt, there would be no money in the global economy!

That old saying is still relevant. But let’s update it. Debt makes the world go around…

Regards,
Greg

From the Port Phillip Publishing Library

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Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

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