Financial Problems – Thy Name is Debt!

Bill Bonner
Provided as a courtesy of Agora Publishing
& The Daily Reckoning
Nov 26, 2010

Is our "Crash Alert" flag still flying?

It is?

Good. Just checking.

Don't breathe too hard. Don't touch anything. We're on tiptoes... So many things could bring this stock market crashing down. We can go around the world and point at them. China. Ireland. America itself...

And, oh yes, North Korea is firing rockets at South Korea....

Yesterday, the Dow lost 142 points. Gold rose $19.

Over time, the tensions, contradictions and pressures build up. You try to fix one thing with a little central planning...but the thing doesn't cooperate. So you try to fix something else. And then another thing goes phlooey and you have to fix that.

One day you're trying to keep Ireland afloat in the North Atlantic. The next day you're worrying about an explosion in the Middle Kingdom. And then, wouldn't you know it, a problem flares up right at home.

Financial problems - thy name is debt!

What's the matter in China? Too much debt in the LGFVs - Local Government Funding Vehicles. A municipality thinks it will be a better place if it had a new mall. So it makes a deal. It helps borrow the money. It helps with the plans. The pols feel like big shots. Money changes hands...some of it legit, a lot of it under the table.

What's not to like?

Well, do that a few thousand times all over China and pretty soon you have a lot of debt based on projects that never really made any sense in the first place. And where is the debt? In the banks, probably. Who knows what's in the banks? But they're the same banks that are funding the most reckless, breakneck speed capital investment program of all time.

Americans consume. The Chinese build. They're building roads, bridges, towns, railroads, rail links, railheads - everything you can think of. Of course, some of this is necessary. Some of it is productive. But how much? How many local governments are making wise, productive investment decisions?

The Chinese are now spending almost half of their GDP on fixed investments - you know, the kind of stuff that has concrete and steel in it. One out of every two dollars goes to building something more or less permanent.

But how many of those decisions are going to pay off? How much of that investment is going to pay for itself? How much of the debt is going bad?

Darned if we know. No one knows. But Dear Readers are advised to be somewhere else when all this blows up.

It will. We're sure of it. You can't make that many capital investment decisions without making a lot of bad ones. You can't grow that fast without some pretty severe growing pains.

And that's just China. What about the Emerald Isle? Their problem is debt too. But it's not LGFV. It's MBL - mortgage backed lending. Europe's big banks lent to Irish banks so the Irish banks could lend to Irish homeowners. Trouble is, the Irish homes are now not worth what the Irish homeowners paid for them. So, the micks and paddies have a lot of debt that is never going to be repaid.

Who will take the losses? Normally, it's a simple question with a simple answer: the people who made the bad investments. But not now.

The news yesterday was that it would take $114 billion to keep Ireland open for business. And Spanish bond yields were hitting new records - investors are afraid they might be the next to go.

European authorities - including the Irish themselves - are afraid that if they let the chips fall where they may...many of them will fall on their own heads. They're afraid of "contagion" - that is, they're afraid that if the Irish get sick, they might get sick too. If Irish debt is allowed to collapse, in other words, so will their own bad debt. And who knows where that will lead?

We don't. But we want to find out. Because we don't see any better way to get rid of it than just letting it collapse. And so what? A few banks go bust. A few large investors jump off bridges. Heck, there are plenty of bridges in Europe. What's the trouble?

And more thoughts...

When we are in a thoughtful mood, we try to get out of it as soon as possible. Nothing like thoughts to trouble a man's sleep.

But sometimes a thought gets a grip on us and we can't get rid of it until we've meditated, prayed, and drunk a whole bottle of Bordeaux.

Thus it was that we were puzzling over the strange events of the last few years. Why was Ireland so desperate to save its banks? Why did the US rush to keep Fannie and Freddie out of juvenile detention? Why put at risk the entire world financial system in order to try to get US employment down from 9% to 6%?

People have a deep-seated fear of capitalism, we conclude. They will do almost anything to avoid it. Capitalism works by "creative destruction." They're happy with the creative part. But they can't bear the destruction. Ireland's biggest banks go broke? No way! America's leading housing lender in Chapter 7? We can't let that happen!

They imagine that the "destructive" part of capitalism is a kind of disease or mechanical breakdown. If must be something that can be fixed, they conclude. And so they look for the cure...the fix...the solution.

They must realize that adding paper money to a society that is already saturated in debt is a rather far-fetched solution. But what else can they do? They tried the elixirs and the home cures. Monetary stimulus didn't work. They tried fiscal stimulus, too. And even after the biggest stimulus of all time what have they got? Nearly 10% unemployment, falling house prices, little or no real (non-government) growth, falling incomes, and consumer price increases that are the lowest ever (if you take the figures at face value).

What do they have left but "unconventional" methods. And so what if they don't really make any sense. You gotta do something, right?

The simple minded morons.

*** "Corporate profits are the highest on record," says the latest news. Some investors take this as good news. But if profits are already the highest on record...how likely is it that they will go higher?

The high margins probably result from the weakness in labor costs. Businesses were startled by the downturn of '07-'09. They cut costs (employees) quickly. So far, they've been reluctant to hire people back. That leaves the poor ex-employee without a job, but it also leaves the business with a decent bottom line.

But after you've cut expenses, what do you do next? If you're going to add to your profits you have to count on growth in revenue. So, where are these extra sales coming from?

Most likely, sales growth will be very slow...and profits will inevitably decline from these all-time highs. Falling profit margins will be another reason to get rid of stocks, so stock prices (and p/e ratios) will probably fall.

*** The New York Times reports that "house sales fell sharply in October." We don't have additional information or insights. But what did you expect? It's a Great Correction, after all.

Regards,

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source: http://www.dailyreckoning.com.au/financial-problems-thy-name-is-debt/2010/11/25/

Bill Bonner
email: DR@dailyreckoning.com
website: The Daily Reckoning

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