PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS, WASHINGTON DC

I would refer my readers to the Peterson Institute for International Economics in Washington DC. In recent reports, there are some salient insights from that institution for my Australian readers and some very different insights for my thousands of international readers.

To summarise:

• Countries that have reined in public spending are now growing faster whilst the profligate founder;
• Small countries with illiquid bond markets can lose access to international financing at minimal levels of indebtedness;
• Many countries hit their borrowing ceilings suddenly and unexpectedly because of the inherent volatility of credit markets;
• Northern Europe has minimised fiscal stimulus and grown reasonably well;
• Southern Europe, France and the United Kingdom have pursued fiscal stimulus and all suffered from recession;
• The earlier sufficient fiscal adjustment is undertaken, the earlier confidence can be restored amongst citizens, businesses and investors.

In the Australian context, I have pointed out before that Australia is a smallish (albeit worlds' 12th largest) economy but not as developed as other larger economies with which it is often benchmarked. It also has a small and illiquid domestic bond market and is very exposed to the vagaries of international capital and internationally traded commodities.

Hence the recent warnings about Australia from some very eminent opinion makers including Prof. Ross Garnaut and the deflationary warning signals now being commented upon in the mainstream Australian press.

In the European and German context, Northern countries are likely to continue to do reasonably well, especially as the US economy starts to grow again. Had the European institutions imposed their own regulatory standards earlier, then it is likely that the profligate fiscal and tax policies at the national level in the Southern countries would not have been able to inflict such damage on their own citizenry.

Australians take note. Think about getting your assets denominated in USD and Euros, your liabilities in AUD.

THE PRICE OF POOR PUBLIC POLICY 2

An insight into Australia's possible future lies on studying events in Europe and the United Kingdom. Policy pursued to date by the present Australian government will lead inexorably to a Southern European economic outcome. It has happened in some states of Australia previously and can happen again, nationally.

What is not often recognised is that sovereign debt in Australia is not just at the Federal level. As I remarked last week, it is also at the State level. Add in the unfunded liabilities which are not reported as part of government debt. If you do, as reported by Christopher Joye (Australian Financial Review 18th May), then you will see Australian governments debt at around 45% of GDP, not the 11% net debt widely reported internationally.

Australian governments debt has to double only once more, and the country ends up with an aggregate debt position similar to that of the problematic European countries. If you think it can't happen, then please think again. It already is, and the track to economic serfdom was layed in 2007.

Parts of Australia's non-resources economy are already in recession, and the plateauing now occurring in the resources sector will accelerate that slowdown. So would loss of the present AAA credit rating on Australian government debt. If you think that Australia could not possibly have a European style unemployment crisis, then think again. Some districts of the Australian cities already have it, and especially amongst young people and males above 50.

I have spent a lot of time studying German political and economic history. One of the insights I can share is the commonality of objective of various German governments in recent years including those those of the left wing. Not so long ago, the German Greens were part of a mainstream German government. Interestingly, not the hysterical shrieking wraiths that seem to populate the environmental movement in this part of the world, but serious and pragmatic thinkers like Joschka Fischer who led the German Greens for two decades. He became Foreign Minister and Vice Chancellor in the Federal Government.

It was that government that set the German economy on the path of flexibility (including in the labour market) that underpins economic stability and comparative prosperity in that country today.

Fischer's contributions from then are echoed today. He helped to create a European polity based on mutual trust, solidarity, the rule of law and compromise. He does not believe that austere economic policies and structural economic reform alone will solve the economic problems being experienced in the eurozone. These problems stem from profligate social expenditures, unfunded by a consistent tax base, and restrictive regulatory practices, supported by devaluing national currencies over decades.

Fischer believes that the solution lies also in a banking, fiscal and political union: in effect what we have in the United States and Australia, and what Winston Churchill proposed in 1945 - the United States of Europe. The real crisis in the EU is not financial: it is political. Whether Angela Merkel can bring the peoples of Europe together sufficiently for what could be the Final Act of this play remains to be seen. If she can, then monetary stability of the German model could be the result.

It is a pity that given Australia does not have these impediments to conquer, it is nonetheless following the southern european path of unfunded policy profligacy. The outcome, if left unchecked, will be the same.

As I wrote last week, younger Australians will have good cause to look back in anger at the 2007-13 period and the opportunity costs to them and the nation of poor public policy.

JAPANS' BRAVE NEW WORLD: DEFLATION OR INFLATION?

There has been so much focus on China this last decade that the world has perhaps lost sight of developments in Japan. It is still the worlds' third largest economy and one of Australia's largest trading partners, especially for its commodities exports.

When I first visited Japan in the 1980's, real estate in Tokyo was the most expensive in the world. Two decades of deflation later, the present Japanese government and its central bank have embarked upon a massive program of money printing in an effort to stimulate inflation.

Change always creates opportunity for investors. Ask Kyle Bass and Richard Howard from Hayman Capital. Bass predicted the US sub-prime crisis and the European Sovereign debt explosion. They publicly predicted a "full blown bond (Japanese) bond crisis in the next few years". This arises from the threat of rising Japanese interest rates on sovereign debt consuming the "bulk of the nation's entire tax take". Hayman's view of Japan is cathartic.

That assumes the money printing instituted by Haruhiko Kuroda at the Japanese central bank does generate the required inflationary policy objective. It may not, as Ben Bernanke has found out in the United States. They can both control the supply of money, but they cannot control demand for it, or the velocity of its circulation. In the US, the velocity of circulation has been dropping - less activity for a quantum of money supply. That is one reason why the money printing to date in the US, UK, Europe has not resulted in inflation, or even inflationary expectations of consumers. Demand for money has dropped. Prices have deflated.

The same could occur in Japan. Hayman might be wrong, but keep an eye on its Japan Macro Opportunities Fund. That will give you some clues as to where Australia is going to head, both from a trade and an investment perspective.

Volatility in Japan could mean asset allocations to other countries, including Australia. That has implications for the relative value of the Australian dollar and its exports to its second largest trading partner.

Given the size of the Japanese money printing, a bet either way can have massive gains or losses at the fund and at the country level.

(You can find a full discussion at Australian Financial Review 11th May 2013 written by Jonathan Shapiro).

THE PRICE OF POOR POLICY

The policies pursued by the present Australian Federal Government are now starting to hit home. And not in a good way. The effects, already apparent if you look, are now going to be apparent to every household and business.

Having pilloried the entrepreneurial people of this country, and targeted the so-called rich, government finances are now so precarious that the reach of the taxman is now extending beyond those small groups into middle Australia. Higher marginal tax rates, additional levies, and increased costs are now going to suck the financial life out of these households.

Imagine, an outer suburb, pleasant and leafy, but not wealthy, two children and a couple of dogs. A 4WD and an old second car for shopping and school. A belief in personal and social responsibility. The backbone of the nation. These are the people who are now going to pay the price because there are not enough "rich entrepreneurs" to go after, even if this were a proper policy goal.

It is going to take many years before the full impact of policy error works its way through the community, and as Maurice Newman comments "Younger Australians are entitled to look back in anger as they realise how recklessly their future has been mortgaged".

Add in the facts of the struggling SME sector where most of the employment presently is - (some of this is anecdotal, much is not):

• 1,000 restaurants to close;
• 62% of SME's are chasing late payments from debtors totalling over A$10.00 billion;
• 240,000 jobs lost in the SME sector;
• Reduced hours because of penalty rates, even if people wanted to work those hours at the normal rate;
• 51% fall in engineering vacancies.

The list goes on.

Two of Australia's most eminent academic economists in a recent paper argue that "commodity prices, resources investment, and resources exports would shift from being a powerful stimulus .... to a deflationary influence of similar force over the next 18 months". (Reported by David Uren, Australian 13th May).

Scary stuff.

I have long commented that political and institutional Australia has been hiding behind aggregate economic data. Now the tide is going out and we all shall see - especially middle Australia - who has clothes on.

Please review my blogs of 6th December 2012 ("Finally the truth is out") and 18th February 2013 ("Lions led by donkeys"). What you read in those blogs is now becoming daily news.

As Henry Ergas reports (Australian 4th May 2013), "Bad policy just does not happen". How right he is.

For my non-Australian readers, the Australian economy is being squeezed from several directions at once. Some of these pressures are inflicted by its own government, and some are the consequences of a globalised world and just have to be managed.

What is clear, and many Australians are starting to become very concerned about their specific situations, is that the future is not going to be like the immediate past. Why?

First: The money-tap is being tightened by falling real commodity prices and increasing supply sources. This will also apply to LNG and other commodities as the United States and Canadian suppliers change patterns and pricing in world markets. Reversion to the long term price mean results in lower prices for Australian producers.

Second:The global sea of newly created money in the United States, United Kingdom, Europe, and Japan pushes down the relative quantity of Australian dollars, and increases its relative price, especially since the Federal debt remains AAA rated, along with Norway, Switzerland, Canada, and Sweden. The ECB may reduce European interest rates to zero or below. Australia has relied heavily on foreign capital inflows, which presently upwardly support the relative value of the Australian dollar. But, because Australia is not a "developed" country in the sense that Switzerland is, and Australia will continue to require capital inflows to "develop", then the policy measures to reduce the relative strength of the Australian dollar need to be be different. Taxing those foreign inflows, as proposed by eminent economist Henry Thornton (nom de plume), may not be the solution. And reductions in Australian official interest rates are probably akin to pushing on a string.

The chances are therefore, that the relative value of the Australian dollar will remain where it is. That changes the producer economics permanently and reduces domestic profit margins hugely at a time of rising unit cost structures. Hence the lower corporate tax receipts, even though Australian corporate taxes are high by world standards.

Third:Australian public debt as a percentage of GDP is reported to be relatively low by "developed country" standards. What is not reported is that if you add in the sovereign debt of the Australian States and Territories (who can themselves borrow on world capital markets), you get a vastly higher level of sovereign debt (about twice Federal debt). This is already becoming a political issue in Australia with fiscal consolidation occurring Federally and in the States. Governments are needing to borrow for well into the foreseeable future.

Four: Price inflation for tradeable goods and services is presently benign in Australia. Price inflation for statutorily mandated services, pensions, labour, electricity, and utilities is significant,  and is causing increasing business and household distress. So are personal tax rises. Australians pay a top marginal rate of almost 50% if you include levies and other quasi income taxes. The marginal rate in Singapore is 20% and in New Zealand 33%, and both countries are competitors for Australian talent.

Five:It is inevitable that measured unemployment will rise. The real killers, as I have blogged before, are underemployment, a belief that jobs aren't available, and a decline in entrepreneurial activity. It is this loss of confidence that is deflating property prices. If people are not confident, or they know people who are not confident, they will not borrow money, no matter how low the interest rate. Go back to 1991. At some point, this will affect the banks and the bubble in bank share prices will be pricked as a result.

This all points to a deflationary domestic environment. Real spending in government, business, and households will decline. So will the velocity of circulation of money. This makes Australia and Australians vulnerable and uncertain. That is certainly the feeling you get talking to real people. Real people understand intuitively and from walking around that things are not as well as they were. Political and institutional Australia is only now waking up to that reality. Their problem is that they have lost control and do not have the necessary policy tools to regain it without significant forthcoming pain.

More and personalised guidance can be found at www.corpbuilders.com.au

INVESTING IN VOLATILE TIMES

For my many readers who have been following the themes in these blogs, you can gain some insight into how this is being developed into investment strategy by visiting: http://www.abnnewswire.net/press/en/75159/Article