Posted by: Spenceee | April 25, 2012

GFC v2.0 (Sovereign Defaults)

There has been a phenomenal amount of information in the newspapers about the US debt ceiling and the concept of a default.  A lot of people don’t realise that the way a currency works is surprisingly straightforward.  You may remember that in 2008 the Lehman Brothers investment bank filed for bankruptcy which caused the Global Financial Crisis (GFC).  The GFC in a nutshell was caused by banks being so afraid that they would have to pay a debt caused by or as a result of the Lehman bankruptcy that they refused to lend their cash to business.  This meant that business in the US stopped growing and started to contract as no one could borrow money to finance their business.  There is a saying that “when the US sneezes, everyone else catches a cold”. In a globalised economy this is the case because if US business is not going well, then economies worldwide are affected by USA consumers not consuming.

So how does the USA Government borrow money? They issue a bond, which is known as a US Treasury Bond.  This is a contract which promises in various ways over various time periods that if you purchase a Bond from me today at $1,000,000 USD that I will pay it back to you with interest at the interest rate set by the US treasury.  When people refer to the 14 Trillion dollars ($14,000,000,000,000) of US Debt, they mean that the USA government has allowed this much in US treasuries to be purchased with a promise that it will be paid back.  The whole thing works on trust that the USA government is good for the debt and won’t change their exchange rate of the value of the currency.  When people talk about “printing” money, what they mean is exactly that, printing money to pay off the bonds.  But doing this will devalue the US dollar causing all currently held bonds to be worth significantly less money and massively harming the US economy by making everything foreign become more expensive and preventing their businesses from being able to borrow money from overseas at a reasonable rate.

So what does it mean for us here in Australia.  The current Labor government would have you believe that the $900 cheque (vote?) that the government issued you in 2008 somehow saved Australia from the effects of the GFC.  Unfortunately, like most things that come out of a politician’s mouth, this was untrue.  The reason that Australia didn’t suffer during the GFC was due to an event that occurred on April 21st, 2006, the Debt Free Day.  The Howard government under Peter Costello made a concerted effort to not only balance the budget so we didn’t go further into debt, but to actually pay off the debt that we had.  Howard took office in 1996 and I have found an excellent chart here from the Treasury that shows what Peter Costello did with the GDP starting from 1996 all the way through to creating the future fund.  Note what happened in 2007/2008 when Labor took over…

Graph of Australian Debt as Percentage of GDP

Australian Debt over time as Percentage of GDP

Not only did the Australian government not have any net debt in 2008, but also had the future fund to help it ride out any difficulties.  Combined with the excellent regulation of the Australian banking system provided by the APRA our banks had cash, low exposure to high risk debt and the support of a currency which was considered to be a “safe haven” because of our excellent track record and low sovereign risk.  This allowed the Australian banks to continue lending during the GFC which meant that our economy did not suffer anything near to what the USA banks suffered.

So to the point of my post, GFC v2.0.  Both the USA and the EU are having enormous trouble swallowing the massive amounts of debt that they have in their economies.  The EU has a far more interesting conundrum due to the fact that the central EU government has no control over it’s member states economic policies.  Many countries in the EU are facing massive backlash over the fact that the government policies which have allowed massive government spending and deficits will now result in huge changes to their economies.  France and Greece come to mind as the two key countries which could have an enormous effect on the financial markets, case in point:  The IMF is injecting funding into first world western countries!  The world now is sitting on a precipice where almost all parties will write off debt to restore their country’s economies or we will see a dissolution of the euro and further turmoil in the USA as they deal with the mountain of debt that they have taken on.

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