Tag Archives: economics

The Australian Resources Tax

The recent announcement by the Australian Treasurer of plans to introduce a “Resource Super Profits Tax” (RSPT) has led to the longest discussion thread on the Mule Stable yet. A lot of the discussion turned on whether or not share investors can be considered to have lost anything when share prices fall if they have not sold their shares.

Whether or not “unrealised losses” should be considered real losses takes us back to an oft-visited topic: the nature of money. Money has many guises: store of wealth, medium of exchange and, most relevant here, unit of value. Finance has its jargon like any other discipline and when money serves as a unit of value, it is known as a numéraire. Today, however, I will not explore the theory of money any further (although, you can trawl through the Mule Stable discussion to gather some of my thoughts). Instead, I will focus on what has happened to mining stocks.

The chart below shows the performance of the S&P/ASX 300 share price and the Metals and Mining index. While not quite as broad as the All Ordinaries index, the Australian stock market is dominated by large companies and in fact the market capitalization* of the ASX 300 is around 85% of the All Ordinaries, so it does give a very good indication of the performance of the overall market. The Metals and Mining index simply consists of those companies in the ASX 300 that are categorised as being (no surprise) in the business of metals or mining. In order to provide a direct comparison, both of these indices have been scaled to a common base of 100 on 30 April. This was this the Friday before the weekend announcement of the RSPT.

Performance of the Mining Sector following the RSPT announcement*

As the chart clearly shows, the metals and mining index certainly did suffer more than the market as a whole in the first couple of days after the announcement. By the end of Tuesday, resources had fallen 4% more than the ASX 300. Since the RSPT can only serve to decrease not increase profits of resources companies, this fall would seem quite reasonable. Curiously though, this week resources closed the gap once more. In fact, the resources sector has now performed 0.35% better than the overall market!

Of course, one could argue that the sector returns would have been even better over the last two weeks if the tax had never been announced. That may well be the case, but it is hard to argue that the Government had caused a terrible mischief to the superannuation savings of all working Australians when resource have, well, matched the performance of the broader market.

*Data source: Standard and Poor’s

More on “Five Down”

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Yesterday’s puzzle “Five Down” stimulated a fair amount of discussion both in the post’s comments section and via email. I also exchanged emails on the topic with the author of Futility Closet (which is where I came across the puzzle) and he told me that the puzzle generated a lot of correspondence for him too.

All the commenters on the blog came up with the correct solution, but there are quite a few different ways of looking at the problem, all of which help provide insight into the nature of money. Since that is a common topic for this blog, I will consider some of these perspectives here.

First, the solution itself. The question asked was “What was lost in the whole transaction, and by whom?”. Taking the “whole transaction” to include the banker finding the counterfeit note in the first place, the answer is that no-one lost anything, subject to a couple of assumptions. These assumptions are that the banker actually owns the bank and so the bank’s gains or losses are his gains or losses (otherwise we would have to conclude that the banker was up $5 and the bank was down $5), and that the banker and his wife pool their finances (so we treat her debt with the butcher as his debt).

The first way to think of the problem is a variation of the comment from James. Imagine that the $5 was not counterfeit at all and all the same transactions took place with a genuine note. But then imagine that when the banker closed the bank at the end of the day, taking notes and coins back to his safe, the $5 slips from his hands and is blown into the fireplace. There it is quickly consumed by the fire. Earlier in the day, the banker had a windfall of $5, but then he lost the same amount to the fire. He gained in the morning, lost in the evening and, although perhaps disappointed to have lost the $5 again, he was even on the whole transaction. No-one else involved lost either as they had simply performed legitimate transactions, clearing various debts, using a valid $5 note. The question now is, how is anyone any better or worse off in this scenario than if the note had been counterfeit all along? The answer is, they are not.

Now that approach gives the right overall answer, but it may be unsatisfying to some as it doesn’t take account of the fact that a whole series of “invalid” transactions took place with the counterfeit note. This too can be clarified. If the note had been real, then the banker made a gain when he found the note, but finding a counterfeit note involves no gain, because it is worthless. In that case, the gain for the banker comes when he is able to discharge his debt with the butcher using a worthless note. So, he is still ahead early in the day, but the timing is slightly different. With a real note, the gain is in the finding and the transaction with the butcher is a neutral fair trade (legitimate $5 in exchange for a discharged debt). With a counterfeit note, the gain is delayed to the next step in the sequence. Of course, in receiving the counterfeit note, the butcher makes a loss. But then the butcher makes a gain when he in turn is able to discharge his debt to the farmer with a worthless note. And so on. Each person in the chain loses when they receive the $5 but has an offsetting gain when they use it to settle a debt, leaving them whole on the transaction. The chain continues all the way back to the bank, which loses $5 when the laundry woman settles her debt with the dodgy note. Assuming, as we are, that the bank’s loss is the banker’s loss, this simply offsets the gain the banker had when first paying the butcher. Again, everyone comes out even. Of course, if someone other than the banker had been left with the note, they would have been down $5 and the banker up $5. Having the transactions complete a full circle is a key part of the puzzle.

The final perspective is a more technical one. At the heart of money is the notion of a debt. Money is essentially a more convenient way of managing debts. If I buy a cow from a farmer and sell a meat pie to a patron at my restaurant, we could simply agree to record various debts: I owe the farmer one cow, the diner owes me one cow. Of course, this is inconvenient (not to mention risky) as we all have to maintain records denominated in a whole range of different commodities and I don’t really want to discharge my debt to the farmer by giving him a cow back. He has plenty already. Nevertheless, this points to the origins of money. In the excellent (if lengthy) treatise “What is Money” is it observed that “for many centuries, how many we do not know, the principal instrument of commerce was neither the coin nor the private token, but the tally”. Indeed in the Five Down puzzle, there are a whole string of tallies. Each of the players in the story has kept track of a debt due to them and one they owe to another. If the merchant did not owe the laundry woman but instead owed $5 to the farmer, the merchant and the farmer could simply agree to cancel their debts to one another. It is not so easy when the debts extend in a longer chain. Nevertheless, if one were to assemble all the parties in a single room and ask them all to consider their respective debts discharged, they should all readily agree. After all, they all owe $5 and all are owed $5 and it is much easier for everyone if that effective net zero position could really be zero without the fuss of worrying about chasing debts. It would be different if someone was owed more (or less) than they owed. We might call this simultaneous discharging of all the debts “multi-lateral debt netting”. In theory it is very attractive, but in practice we cannot get everyone in the same room to get it done. Effectively, the counterfeit note serves the purpose of facilitating multi-lateral debt netting. Because everything nets out evenly in the story, the counterfeit note can achieve the netting just as effectively as real money. The extra feature real money offers is that if the netting does not quite even out, those owed more than they owe can hang on to the money and use it for netting again in the future. Not so with the counterfeit money: once it is discovered, it loses its power to work. The solution to the puzzle lies in the fact that no debts were left over.

I will end this discussion by reprinting a very similar story that one of my email correspondents sent to me (as I understand it, it is not new but has been updated to fit the times).

It’s a slow day in a dusty little Australian town. The sun is beating down and the streets are deserted. Times are tough, everybody is in debt, and everybody lives on credit.

On this particular day, a rich tourist from down south is driving through town , stops at the local motel and lays a $100 bill on the desk saying he wants to inspect the rooms upstairs in order to pick one to spend the night in.

He gives him keys to a few rooms and as soon as the man walks upstairs, the owner grabs the $100 bill and runs next door to pay his debt to the butcher.

The butcher takes the $100 and runs down the street to repay his debt to the pig farmer.

The pig farmer takes the $100 and heads off to pay his bill at the supplier of feed and fuel.

The guy at the Farmer’s Co-op takes the $100 and runs to pay his drinks bill at the local pub.

The publican slips the money along to the local prostitute drinking at the bar , who has also been facing hard times and has had to offer him “services” on credit.

The hooker rushes to the motel and pays off her room bill to the motel owner with the $100.

The motel proprietor then places the $100 back on the counter so the rich traveller will not suspect anything.

At that moment the traveller comes down the stairs, picks up the $100 bill, states that the rooms are not satisfactory, pockets the money, and leaves town.

No one produced anything. No one earned anything.

However, the whole town is now out of debt and looking to the future with a lot more optimism.

And that, ladies and gentlemen, is how the Australian Government’s stimulus package works!!!

Five Down

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One of my favourite blogs is Futility Closet, which is sadly appropriate given its tagline “An idler’s miscellany”. This week it featured a puzzle called Five Down devised by the English mathematician Henry Dudeney. Since the subject of the puzzle is money, it seems like an appropriate one to share here on the Mule.

A banker in a country town was walking down the street when he saw a five-dollar bill on the curb. He picked it up, noted the number, and went to his home for luncheon. His wife said that the butcher had sent in his bill for five dollars, and, as the only money he had was the bill he had found, he gave it to her, and she paid the butcher. The butcher paid it to a farmer in buying a calf, the farmer paid it to a merchant who in turn paid it to a laundry woman, and she, remembering that she owed the bank five dollars, went there and paid the debt.

The banker recognized the bill as the one he had found, and by that time it had paid twenty-five dollars worth of debts. On careful examination he discovered that the bill was counterfeit. What was lost in the whole transaction, and by whom?

I will not reveal the solutiuon here to give you a chance to think about the puzzle. What I will reveal is that the “solution”, originally published in The Strand in 1917, was re-published on the blog yesterday but it is in fact incorrect! Understanding what is wrong with the original solution (and the blog’s author was quick to provide an update following feedback from his readers) gives some insight into two of the roles money plays: a medium of exchange and a store of value.

Cash rates and mortgage rates

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At 2.30pm this afternoon, the Reserve Bank of Australia (RBA) will announce whether or not they will be changing the official cash rate. The bank began increasing the cash rate just over a year ago and since then it has risen by 1.25% to its current level of 4.25%. Most observers in the financial markets expect the RBA to lift the rate another 0.25% today, pointing to last week’s inflation figures as one of the key factors. One of the RBA’s stated objectives it to attempt to maintain “an inflation rate of 2–3 per cent, on average, over the cycle”. That phrase “over the cycle” gives the bank a fair amount of wriggle room, nevertheless it will certainly be concerned that the inflation rate for the March 2010 quarter was 0.9% (or 3.6% on an annualized basis). The RBA uses a number of smoother measures of inflation that aim to strip out some of the volatility in the headline inflation numbers. One of these, the “trimmed mean”, is widely considered to be one of the bank’s favourite smoothed measures and the March quarter reading has now nudged outside the 2-3% target band.

Australian Inflation (2003-2010)

However, the point of this post is not to speculate on the likelihood of another rate hike, but to respond to a query from a reader about the link between the RBA official cash rate and mortgage rates.

In Australia, most home owners have “variable rate” mortgages, so their interest rates can go up and down over the life of the mortgage. It is possible to lock in “fixed rates”, although typically the fixed rate periods only last from between 1 to 5 years. In contrast, the most common mortgage product in the United States is a 30 year fixed rate mortgage, which certainly takes away a significant element of risk for borrowers. An indication of just how significant this risk can be is evident in the fact that the US “sub-prime” mortgages at the heart of the global financial crisis were not fixed rate mortgages and big increases in interest rates tipped many borrowers into default.

The United States aside, variable rate mortgages are very common around the world. What is rather unique to Australia is the way in which rates can vary. In most countries, variable rates are set relative to a standard published benchmark. Since the point of a variable rate is to allow lenders to increase (or decrease) what they charge borrowers as their own short-term borrowing costs change, these benchmarks are typically short-term market rates such as surveyed inter-bank lending rates (typically a 1 month or 3 month rate) or perhaps the official central bank cash rate. These central bank rates apply to very short-term borrowings, typically applying for somewhere between one day and one week (for example, the RBA cash rate is an overnight rate), but have the advantage of not moving around too often. A mortgage-lender might then quote their mortgage rate as, say, 2% over the benchmark rate.

In Australia, things are a little different. The standard variable rate is a so-called “discretionary variable rate”. Put simply, this means that the rate can be whatever the lender wants it to be. Try explaining that to anyone from another country and they would be horrified (I can speak from experience here), but in Australia we seem to have become accustomed to giving all this discretion to our lenders. The usual justification for this approach is that competitive pressure would stop a bank abusing the power inherent in that word “discretionary” and in practice all the banks move their rates in line with the RBA cash rate anyway.

Of course, since the onset of the global financial crisis put pressure on funding costs for banks, this link between the official cash rate and mortgage rates has broken down. Back when the RBA was cutting rates, banks were cutting mortgage rates by less than the RBA cut and, on the way back up, they have been hiking in bigger increments than the RBA*. Some have even increased rates “out of cycle” (i.e. independently of the RBA cash rate movements). Once upon a time, the then Treasurer Peter Costello said that any bank not passing on an RBA cut in full was a “bastard”. Things are different now and if the RBA does indeed increase rates today and you have a mortgage, do not be too surprised if your mortgage rate goes up by even more. If you don’t have a mortgage, try not to gloat. It is unseemly.

* UPDATE: as noted in the comments below, the RBA has estimated that mortgage rates have increased by around 1.3-1.4% more than the official cash rate.

The Mule trips up

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In my last post, I fell into a common trap when dealing with financial time-series data: I did not adjust for inflation. The post examined recent trends in US personal consumption and concluded with the following chart showing a long history of year-on-year consumption growth.

Year-on-year Growth of US Personal Consumption (1959-2010)

What stands out in the chart is the high rate of growth in the 1970s and 80s, a phenomenon that was picked up in comments on the blog post. Of course, the problem is that inflation was high in the 1970s and 80s and so at least some of that growth can be attributed to rising prices rather than increased consumption of “stuff”.

What I should have done is adjust the personal consumption expenditure (PCE) data for the effect of inflation. This is made easier by the fact that the Bureau of Economic Analysis publishes a companion to the PCE which serves exactly that purpose. The PCE price index (PCEPI) provides a measure of inflation very much like the consumer price index (CPI), but it is based on the particular basket of goods used in the PCE index. Using this index to scale consumption to 2010-equivalent dollars and then looking at the annual growth in this measure of “real” consumption results in a rather different picture.

Year-on-year Growth of US Personal Consumption (1959-2010)

As is often the case with inflation-adjusted data, this chart is noisier than the previous one, and real consumption exhibits bigger swings than the original “nominal” consumption figures. While there is still a declining trend in consumption over time, it is a more modest decline and the 1970s and 80s no longer appear to be a particularly unusual period. Futhermore, the contraction of consumption seen in the wake of the recent economic crisis no longer stands out so dramatically. The falls in real consumption in 1974, 1980 and 1991 were all of a similar size. In fact, the biggest fall was in the 12 months to November 1974. (Note that the github code repository has been updated to include this new chart).

I can be quick to criticize the charts in other publications, so it is only fair that I correct my own mistakes too.

UPDATE: a regular reader has suggested that for a series like the PCE, looking at the original series in nominal (not inflation-adjusted) terms actually is the most appropriate way to look at the data, so that the original post was actually fine. I’m still thinking this through….stay tuned, but it sounds like I will have to correct the correction!

Has the US consumer shaken off the financial crisis?

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A few years into the global financial crisis, US unemployment remains high and the economy still appears fragile. Nevertheless, American consumers appear to be returning to their old ways. For years they were seen as the engine of global growth. Their consumption drove exports in countries around the world. However, in the aftermath of the financial crisis, the unemployment rate in the United States soared to double figures, the collapse of property prices around the country eroded the wealth of many Americans and banks reined in their lending, while many borrowers cut their spending to pay down their debts. This appeared to set the scene for a change in the long-standing tradition of US consumer-led economic growth.

However, the latest personal consumption expenditure figures released a few weeks ago by the Bureau of Economic Analysis show another month of consumption growth in February. This is the fifth month in a row of strong personal consumption in the United States. Seen over the broad sweep of the last 50 years, the global financial crisis starts to look like a mere blip in an inexorable climb in personal consumption. (Note: the chart below uses a logarithmic scale so that a straight line indicates a steady rate of growth).

US Personal Consumption Expenditure (1959-2010)

Focusing on the last five years reveals that, while consumption collapsed in mid-2008, by the end of that year consumption began to recover. A little shakily at first, consumers appear to have returned to the pattern seen before the crisis and by late 2009, total personal consumption had exceeded pre-crisis levels.

US Personal Consumption Expenditure (2005-2010)

Looking at year-on-year consumption growth gives further insight into the underlying pattern. Growth peaked in the late 1970s, followed by a slowly declining smoothed trend* to growth rates just above 5% per annum. While the growth in consumption over the 12 months to February 2010 has not quite returned to the 5% level, that period includes weaker figures from early 2009. Annualizing quarterly growth over recent months gives figures back around the 5% mark.

Year-on-year Growth of US Personal Consumption (1959-2010)

This may simply be a bounce back to earlier consumption levels and growth may now slow once more. But, economists, policy-makers and America’s trade partners will all be watching closely to see whether indeed the US consumer has shrugged off the financial crisis and is set to recover its place as the driver of the world economy. This scenario seems all the more likely if consumers forget the lessons offered by the crisis about the perils of excessive debt and once again turn to borrowing to finance consumption.

* For the technically-minded, the smoothing is performed with a LOWESS local regression. The code used to produce all of the charts is available on github.

Where is debt headed now?

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There have been a lot of posts about debt on this blog and the chart comparing government and household debt, which appeared in two of those debt posts, has proved particularly popular in discussion forums focusing on Australian property prices. Since producing the chart, the Australian government stimulus spending has continued to work its way through the economy and has been pushing up the levels of government debt. While I would still argue, as I have done many times before, that we should not follow the likes of Barnaby Joyce in getting agitated about public debt, it does seem worth updating the chart to illustrate recent developments. The regions shaded red denote Labor party governments in power.

Australian Government and Household Debt (1976-2010)

As expected, government debt levels exhibit a marked up-swing (note that the government data includes Treasury projections to the end of the current financial year). What is striking, however, is that the levels of household debt have not yet fallen. While some of the weakness in the economies of countries like the US and the UK is attributed to consumers “deleveraging” (a fancy term for paying down debt rather than buying flat-screen televisions), Australian households are showing no signs yet of reducing their debt. And 90% of that debt is for housing.

While it may not be evident here, there is in fact a tight relationship between debt levels in different sectors of the economy. If I spend money then either I reduce my financial assets (drawing on my savings) or I increase my liabilities (borrow on my credit card or some other form of debt). Exactly the reverse is true of whomever I give my money to (let’s call them Joe for argument’s sake): Joe’s assets go up or his liabilities go down. Spending money is an example of a “zero sum game”. If I add the change to my net worth (assets minus liabilities) to the change of Joe’s net worth it adds to zero. My negative change offsets Joe’s positive change. Aggregating over the whole economy, the sum is still zero.

Now consider what happens if we divide the economy’s net financial worth into that of the government sector, the private sector and the foreign sector (which includes overseas governments). Any changes in net worth across all three have to add to zero. As a result, the change in the government position is the opposite of the change in the private sector and international positions combined. If the government debt is going up, debt must be going down somewhere else. Now we know the household sector is not reducing debt, but what if we look at the private sector overall, including businesses? A different picture emerges.

Australian Government and Private Sector Debt (1976-2010)

Taken as a whole, over the 12 months to the end of 2009, private sector debt fell by about 2.5% of GDP. This was almost as much as government sector debt rose (about 3% of GDP). The difference can be explained both by the role of the foreign sector as well as slight differences in data collection methods across different sectors. Keep in mind that chart includes the government debt projections out to June 2010, while the private sector debt data only extends to the end of January 2010.

Since household debt has continued to increase, what this means is that Australian businesses have in fact been reducing debt significantly. The reduction in non-household private sector debt over 2009 was almost 7% of GDP. Businesses appear far more concerned about their debt levels than home-buyers do. It will be very interesting to see what happens once the first time home buyers scheme is fully unwound.

Data sources:

Government debt to 2008: A history of public debt in Australia
Government debt for 2009: Reserve Bank of Australia – Series E10
Government debt for 2010: Australian Treasury – Budget Estimate

Private sector debt: Reserve Bank of Australia – Series D2

Gross Domestic Product: Australian Bureau of Statistics – Series 5206.0

Mule Stable demo video

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Last weekend, the Mule Stable* was launched as a forum for discussions that may tie in to topics here on the Stubborn Mule, and then again may not. A number of discussion groups have already been set up there, including groups on modern monetary theory (aka chartalism), economics, and politics.

For anyone already familiar with the twitter social network, finding your way around the Stable will be breeze. But for those less familiar with the conventions, here is an introductory video showing you how to get started on the Stable. Keep an eye out for more videos explaining more advance tips and tricks you can use at the Stable, and don’t forget to sign up and join in!

If you are finding this video a bit too small, there is a larger screen version.

* Thanks again to the StatusNet developers responsible for the software that powers the Stable.

Junk Charts #3 – US Business Lending

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Today’s “Chart of the Day” from Business Insider’s Clusterstock blog presents an alarming picture of the US economy viewed through the prism of bank business lending. The chart, which I have reproduced below, shows a precipitous collapse in lending*, described in dramatic language as “falling like a knife”. There is no doubt that the US economy remains in very poor health, but should we be getting as excited as Clusterstock?

Annual Change in US Commercial and Industrial Loans

Closer examination of the chart reveals that it is in fact quite misleading.

For a start, it makes the very common mistake of plotting a long series of data without adjusting for the fact that over time the value of the dollar has declined through inflation and the US economy has grown. As a result, more recent movements in the data take on an exaggerated scale.

Also, the chart shows annual changes without providing any sense of the base level of lending. Not only that, while attention is drawn to the US $300 billion annual decline in lending, the increase of close to US $300 billion just over a year earlier is ignored, when in fact the two largely offset one another. Certainly lending has declined, but rather than taking us into historically unprecedented territory, as the Clusterstock chart suggests, it actually means loan volumes are back to where they were in late 2007.

Both shortcomings are addressed in the chart below, which shows the history of loan volumes themselves rather than annual changes and overlays a series scaled by the gross domestic product (GDP) of the US to represent lending in “2010 equivalent” dollars.

US Commercial and Industrial Loans

Changes in lending do provide a useful reading of an economy’s health. But, it is important to be careful when using annual changes to read its current state. The change from January 2009 to January 2010 is affected just as much by what happened a year ago as by what happened last month. Since monthly data is available, we can in fact look at changes over a shorter period. The charts below show monthly changes, which are probably a little too volatile, and quarterly changes which are probably the best compromise. Since these charts extend only over a five year period, it is not as important to adjust for changes in the value of the dollar and the size of the economy.

Monthly Changes in US Commercial and Industrial Loans

Quarterly Changes in US Commercial and Industrial Loans

Both of these charts reveal an economy that certainly remains unhealthy and lending volumes are still declining. However, the declines of the last couple of years evidently reflect an unwinding of the enormous increases of a few years earlier. So rather than fretting that lending is “falling like a knife”, we can take some comfort from the fact that the rate of decline is diminishing from the worst point of the third quarter of 2009. The moral of the story is that charts can mislead as easily as words and should always be treated with caution.

* The data is sourced from the St Louis Fed “FRED” economic database.

Blame Greece’s Debt Crisis on the Euro

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The shadow finance minister, Barnaby Joyce, has been waxing hysterical of late about Australia’s “unsustainable” public debt. This is not a new line to take in Australian politics. Last year when the then leader of the opposition, Malcolm Turnbull, began attacking the government’s stimulus package, I argued in “Park the Debt Truck” that there was very little reason to be worried about Australia’s public debt.

This phobia of government debt is not unique to Australia. In the US, national debt is one of the primary bug-bears of the “Tea Party movement” that emerged in 2009. Widespread concern about government borrowing is helped along by the sort of simplistic fear-mongering evident in the so-called “debt clock” (and yes, I am aggrieved to say, there is an Australian version of the debt clock).

The catalyst for the current focus on sovereign debt is the crisis faced by Greece. Stimulus spending to combat the economic fall-out of the global financial crisis has led to significant growth in government debt around the world, prompting fears that Spain, Portugal, Ireland or even the United Kingdom or the United States will be the “next Greece”. This week, Business Insider published what it dubbed “the real list of countries on the verge of sovereign default”. Sourcing its information from a Credit Suisse paper via the FT Alphaville blog, they rank United States government debt as riskier than Estonian debt. That alone should raise eyebrows and suggests that Credit Suisse needs to join Barnaby Joyce in some remedial lessons in economics.

The basis of Credit Suisse’s sovereign risk ranking is mysterious. It supposedly takes into account, amongst other things, the market pricing of credit default swaps (CDS). However, they are clearly not listening too closely to the market, otherwise Argentina would be at the top of their list and the United States at the bottom (the chart below shows the actual Credit Suisse ranking). Of course, the market is not always right: just look at the tech bubble or the US housing bubble. Indeed, I know of one person working in the markets who refers to sovereign credit default swaps as a device for “taking money from stupid people and giving it to smart people”, so perhaps Credit Suisse are right not to put too much weight on these prices.

Credit Suisse Sovereign Risk Ranking*

It would appear that Credit Suisse is primarily concerned about the amount of public debt each country has (although if this was the sole criterion, Italy would rank above Greece).

Many who fret about the risk of government debt appeal to an analogy with a household budget. Just as you and I should not live beyond our means and put more on the credit card than we can afford to repay, so the government should not spend more than it earns in the form of tax. This analogy is simple and compelling. However, just as H. L. Mencken once wrote, “For every problem, there is one solution which is simple, neat and wrong,” this analogy is simple neat and wrong. The circumstances of the government are fundamentally different from yours or mine.

In “How Money Works” I explained the difference between money which derives its value from being convertible to something else, such as gold or US dollars, and “fiat money” for which there is no convertibility commitment. As I wrote in that post,

However, in a country with fiat money, the central bank makes no convertibility commitments…It has monopoly power in the creation of currency. So, the government simply cannot run out of money.

The United States, United Kingdom and Australia are all examples of countries with fiat money with floating exchange rates. None of these countries can ever be forced into default. Contrary to the alarmists, none of these countries are reliant on China (or anywhere else) for their money. Here is a simple thought experiment: when China “lends” the US government money by buying Treasury bonds, where does that money come from to buy the bonds? From US dollar mines by the Yangtzee river? No. All of the money comes from China taking US dollars as payment for their exports. So China is “lending” the US government money that was all created in the United States in the first place. While any of these countries could decide for political reasons not to repay their debt, that is extremely unlikely in current circumstances. So the United States, United Kingdom and Australia and indeed many other countries with fiat money and free-floating exchange rates should all be considered to pose an extremely remote risk of sovereign default.

But what about Greece? Unfortunately for the Greek government, ever since they joined the European monetary union and adopted the euro as their currency, they lost the power to create their own money. While the US government cannot run out of dollars, the Greek government certainly can run out of euros. To make matters worse, they are subject to the tight controls of the Growth and Stability Pact as part of the Maastricht Treaty which severely restricts their ability to use the sorts of stimulus measures Australia, the United States and others have turned to in the face of economic downturn. In fact, their national debt levels are already well over the Pact maximum of 60% of their gross domestic product.

Like the other members of the monetary union, Greece is effectively operating on a gold standard only substituting euros for gold. In A Tract on Monetary Reform, John Maynard Keynes referred to the gold standard as a “barbarous relic” and the European Union is now learning how right he was. They adopted a common currency with an eye on the benefits of streamlining commerce between member countries, but without understanding the implications for times of economic crisis. The Union is now in a bind: do they allow Greece to fail, only to see Portugal, Spain and others tumble in its wake? Or do they ignore the rules of the Pact and bail Greece out, a course of action which would doubtless leave Ireland feeling that their fiscal austerity measures were an unnecessary hardship? In all likelihood, they will find a way to dress up a rescue package with all sorts of tough language and pretend that the union is as strong as ever. The fact remains, that the euro is the real reason Greece finds itself facing a debt crisis.

But what of Estonia being less risky than the United States? The Estonian kroon is pegged to the euro, so despite not yet being part of the European currency union, Estonia has chosen to give up sovereign control of its currency. As long it goes down this path, Estonian government debt has to be considered a far riskier proposition than US government debt. Clearly Credit Suisse’s sovereign risk analyst does not understand this. Little wonder it is lost on Barnaby Joyce.

* India, which ranks between Egypt and Italy, is not shown in the chart because no CDS data is provided. The “CDS spread” represents the annual cost of buying protection against an event of default. This cost is measured in basis points (1 basis point = 1/100th of a percentage point). For example, in the chart above, the CDS Spread for Australia is reported as 50 basis points (i.e. 0.5%). This means that to buy protection against default on $100 million of Australian government bonds would cost $500,000 each year. A typical credit default swap runs for five years.