This Time Things Really are Different

The 2008 Global Financial Crisis (GFC) brought the global financial system to its knees.

Economic collapse was averted by a coordinated international effort that ultimately resulted in the nationalisation of stricken industries and financial institutions. This was coupled with a rapid decline in central bank interest rates, high levels of government borrowing and, in some instances, the benignly named ‘quantitative easing’.

In layman’s language that means printing money, a formula that can only result in inflation and the ultimate demise of the currency in question. A brief examination of history will demonstrate that no fiat currency has ever survived such a policy approach.

Unfortunately for the world economy, this unprecedented expansion in the money supply and massive increase in government debt has only papered over the financial problems and has not redressed the substantive issue that needs to be dealt with: too much debt in the system.

The end result has been a transfer of personal and corporate debt into government debt.

That means that we (the national taxpayers) have now assumed responsibility for the imprudence of some of the world’s largest companies. While in some instances this has temporarily supported the respective national economy, it has placed into question the future financial viability of a number of sovereign nations.

Ireland, Portugal and Spain are all teetering on the edge of financial default. They have hitherto only been propped up by massive bailouts from the European Central Bank and are now incurring annual interest bills that they cannot sustain.

Greece is as close to broke as a nation can get without actually declaring the national equivalence of bankruptcy. The Greek government, on behalf of her 11 million citizens, now owes over $485 billion. It has no prospect of paying this off and default is simply a matter of time.

Notwithstanding the size of the Greek problems, they pale in comparison with Italy’s. Should the Italian financial system require a bailout, the cost will be in the trillions rather than the billions. There is no way that Europe could afford such a measure.

Like a chain of dominoes, should one of these nations fail financially so too could the accord that underpins the European Union and its common currency, the Euro.

However, the implications of such a cascade of failure would be felt far wider than Europe. America too has an unsustainable fiscal position. In fact, per capita America’s debt is higher than Greece’s, although it is somewhat mitigated by the innovation and enterprise of the American people. That said, it is almost inconceivable that the USA can resolve its debt position without destroying the ‘reserve currency’ status of the US dollar.

Which leads me to China, the powerhouse of the global economy. Without China, there would be almost no serious external buyer of American and European debt. Demand for commodities would decline substantially and the global economy would be in even greater trouble.

The difficulty is that China has been building an unsustainable boom all of its own and carried many other nations along with it.

Reports of the construction boom in China and the massive growth story linked to it abound. Indeed there is no doubt that the voracious Chinese demand for our raw materials has been driven by their rapid industrialisation, which in turn has spread a healing balm of cash into our national accounts.

However, there is now an increasing number of reports that this demand has created Chinese cities with no residents, transport hubs with little traffic and freeways with no cars.

One traveller recently went to the three story Guangzhou South train station where they reported it to be a virtual ghost town. Rather than a bustling metropolis befitting a station the size of the Melbourne Cricket Ground, most of the service windows were closed or unmanned. There were literally a few dozen passengers and a single train in the multitude of rail docks. By all accounts it was a similar story at Wuhan station, some four hours away, where the traveller’s service terminated.

Hearing stories like this prompts one to ask: how long can the Chinese Field of Dreams (build it and they will come) approach be sustained?

Despite their enormous trade surplus and foreign currency reserves, a recent Chinese national audit office report found that local government debt in China is a reported $1.7 trillion. This is around 27 per cent of GDP and even the Chinese central bank thinks this figure underestimates the total level of indebtedness by up to a third.

Such figures beg the question as to what happens when the Chinese central planners decide that they have enough unused infrastructure, empty buildings, terminals and roads for the time being? What happens if demand for Chinese manufactured goods by Western nations dries up and their factories are left idle?

It used to be that when the American economy sneezed, Australia caught a cold. I suspect that if China now gets a sniffle, the entire world could catch a form of financial pneumonia.

In the event of such a scenario, there would be little that nation states could do to avert a serious financial catastrophe. Interest rates are already at or near zero in most major economies, existing government debts are increasingly unserviceable and, in many areas, consumer demand is sluggish to say the least.

In the financial world it has long been said that the most dangerous words in investing are ‘this time it’s different’.

I agree, but this time, compared with how relatively manageable things were at the beginning of the 2008 GFC, things really are different; and that makes the global financial outlook very scary indeed.