OUR economic ‘confidence’ problems are created because no-one knows which businesses, banks, people or countries may be unable to pay their debts.

Whole countries are in serious trouble (e.g. Iceland, Pakistan, Ukraine, Austria) and the US has an external debt of $12 trillion (1). Many of our biggest companies grew to their current size on debt and no-one really knows which of them will default – perhaps they all will.

The latest IMF forecasts reveal countries that are living beyond their means. The Saudis are in by far the strongest financial position, investing more than 30 percent of GDP in offshore loans and securities. The next tier includes China, Japan and Switzerland. All show healthy trade surpluses and should see their currencies appreciate if this continues. Spain and Greece (not shown) are in real trouble, with deficits of 10 percent or more; while Australia, the UK and US are in an uncomfortable position, with deficits approaching 5 percent of GDP.   

It’s worth noting that the countries in trouble are, or were, mainly members of ‘the Coalition of the Willing’. Perhaps it’s not a coincidence – a kind of Empire mafia maybe?

With countries and companies ability to repay in question, our banks are also exposed. How many of their outstanding loans cannot be repaid?

Even individual companies and governments may not know their own exposure to debt and losses because they may not know what the assets that they have are actually worth. Even blue chip shares have collapsed in price. Many financial ‘instruments’ may turn out to be near worthless. Business contracts may also turn out to be disasters. Now business plans and forecasts are all suspect as forward orders are cancelled or massively downgraded.

It is for these classes of reason that confidence has been eroded.

Gunns

An instructive case is self professed fibre company Gunns.

According to their 2008 Annual report (2) their profits over time versus their income looks like this:
2004 2005 2006 2007 2008
Revenue $674 m $670m $638m $682m $862m
Profit (AT) $105m $100m $87m $76m $64 m

Profits have been declining each year despite similar or better revenues which indicates a fundamental flaw in their business model and/or the competence of its management.

With outstanding loans of around $1 bn against a market capitalisation of $850 million in September – the company was underwater.

In that environment, John Gay’s pulpmill promise seems hollow. How could they borrow another $2 billion when their assets are at $500m and they already owe around $700m?

In September, as their shares sank below $1.70, Gunns engaged in a capital raising to reduce debt (presumably at the instigation of their bank) and gained $320 million from an issue of shares at $1.50, putting their loan at around $700 million. They also said they’d sell $170 million of plantations but that hasn’t happened, and probably won’t.

Now, after more market sinking, Gunns market cap has sunk below $500m (shares at $0.75 at this writing) so they are still deeply underwater – their debt stayed the same but their assets sank.

The self-valuation of their ‘sustainable plantation estate’ is almost certainly over optimistic. Much is low value pulpwood. Who will want to buy pulpwood plantations, particularly after the industry had the law changed to declare tree plantations as ‘forestry in perpetuity’ and hence unsuited for any other (higher value) use? The plantations appear to only be worth anything to a wood processing company.

Because Gunns is a monopsony (monopoly buyer) plantation buyers would have to sell to Gunns who could dictate the price that they paid for the timber. Anyone buying plantations in that environment would have a lot more money than sense, particularly as oil has sunk to below US$50 per barrel, making biofuels a less attractive option.

Because Gunns has gambled on their ‘sustainable plantation estate’, they now appear stuck with trying to convince markets that their pulp mill will go ahead to convince markets and banks that they can turn around their poor profit performance. That amounted to a return of around 3% on total assets and income. Half of what you could earn in the bank and losing ½ of your capital in lost share value!

In fairness, Gunns isn’t the only company with financial problems. We’ve already seen major groups like Lehman Bros and ABC learning going down. No-one knows who will be next. It seems that only companies with low levels of debt are reasonably secure.

Confidence springs from knowledge

When the amounts of money involved are so large, and the ability to repay is entirely suspect, who can be surprised when people lack confidence?

That effects of the lack of confidence are currently most pronounced in stock and financial markets where loan exposures are daily concerns.

So far, the full impacts of these problems haven’t been visited on the general population except those with big debts relative to their ability to repay, and those relying on superannuation and other investments in stock markets.

The transient relief presented by interest rate cuts is also cushioning many from the worst of the problems.

It turns out that the almost total lack of transparency in many financial instruments clouded our ability to understand the risks created by regulation failures.

Because monetary policy is to issue money roughly proportionate to the amount of debt underwritten by our banks, growth is (more or less) relative to debt created.

The trouble is that debt accumulates over time and it’s pretty obvious that we could reach a limit that we cannot afford to repay. If that happens – growth stops, confidence collapses and we face a great unwinding. At this point our economic assumptions about growth would be rendered false and economic and political models collapse into irrelevance.

With real financial transparency, we might have run into a smaller version of this crisis many years ago as we realised that we were trying to service too much debt, but by disguising debt as an investment then multiplying its apparent worth by 30 or 40 times, we managed to hide the total debts that we were incurring along with our inability to repay.

In this way we hid the problem while it rapidly became larger and more dangerous (just as we did with climate change).

The result was a bubble of growth and wealth that was based on nothing of real value. That bubble is now deflating and no-one knows how low we’ll have to go to find the bottom.

We can’t even compare our money to anything real because we have a fiat currency – that is its value is declared arbitrarily by our government. Hence there’s no real ‘bottom’ to our problem, nothing we can use to underpin our currency or the value of our companies and assets.

Correcting these conditions is a major task that could require a complete rethink of monetary policy and the assumptions that governments have used to underpin growth.

Whether volume growth is good really depends on whose viewpoint you take. It’s always good for the beneficiaries but bad for those who suffer, including our resource stocks and the environment in which we live. Now many will be suffering and the entire assumptions about growth need to be re-explored.

Of course we could grow in quality instead (as did Japanese car makers) but that requires skill and care, characteristics that appear unknown to our governments who seem to prefer rhetoric and sound grabs.

Responses to climate change present us with major opportunities to correct our situation, for example connecting our money supply to our energy supplies as proposed by Odum.

To change the fundamental assumptions upon which our society is based requires big and creative thinking.

Whether our politicians are up to it remains to be seen.

Whatever the case, they’ll need encouragement from the public, possibly with 2 x 4s or similar.

So get out those hunks of wood and start giving your politician the good news.

Watch this space

Mike Bolan
http://www.abetteraustralia.com
Mike is a complex systems consultant, change facilitator and executive/management coach.

1. https://www.cia.gov/library/publications/the-world-factbook/geos/us.html
2. http://www.gunns.com.au/corporate/download/GunnsAnnualReport2008.pdf
3. http://en.wikipedia.org/wiki/Monetary_policy
4. http://www.eoearth.org/article/Howard_T._Odum_Collection
Note. The author welcomes constructive criticism and new information that adds to our understanding of these matters.

Mike Bolan
Because monetary policy is to issue money roughly proportionate to the amount of debt underwritten by our banks, growth is (more or less) relative to debt created. The trouble is that debt accumulates over time and it’s pretty obvious that we could reach a limit that we cannot afford to repay. If that happens – growth stops, confidence collapses and we face a great unwinding. At this point our economic assumptions about growth would be rendered false and economic and political models collapse into irrelevance.