Does the Reserve Bank need a reality cheque?

So continuing on from last post on the the PPoD I saw an article today discussing the Reserve Banks recent rate rise and their take on the PPoD. This is perhaps most succinctly expressed with a quote from Tuesday's rates announcement.

"To date, there has been very little contagion outside Europe" Glenn Stevens

It is almost as though the market itself heard these words and decided to prove him wrong. Just two days later the DOW plummeted and over the course of the ensuing 4 days the global markets lost around 10%. Of course this is ridiculous, the reality is of course that there is a lack of understanding of the wider impacts of global debt servicing problems across the board.

Or rather it is not that there is a lack of understanding, it is that there is a distinct lack of the ability for existing forecasting and modelling to handle such discontinuities as a Greek default on debt, or an unpronounceable volcano grounded all  aircraft in Europe, or the Federal Reserves printing press breaking and throwing their currency devaluation plans into disarray (more on this in a future post).

The problem really arises from the fact that it is nigh on impossible to firstly predict events, such as a volcano or an accidental order to sell ten times as many shares as planned and secondly to predict the markets reaction to these events. The initial prediction can for the most part be covered by the traditional assumptions of randomness and probably bludgeoned into submission with some Monte Carlo simulation, the real difficulty comes with assessing the impacts of the initial event.

So, what is the Reserve bank to do? It would seem to be that they would be better off being over cautious in the current climate than over zealous. This will probably mean that we have seen the last rate rise for a while indeed, we may be at an inflection point, where we are not climbing out of the original recipe GFC but falling into the grasp of the second "Zinger" financial crisis which will be spurred on by the collapse of countries under high debt loads. They may have stumbled through the last crisis only to succumb to a second wave of market doubt and volatility.

Why the Stock Market doesn't like Souvlaki

The PIIGs Pentagon of Debt

This image (from the New York Times which I found in a thread on forums.overclockers.com.au) is what I loving refer to as the PIIGS' (Portugal, Italy, Ireland, Greece and Spain) Pentagon of Debt or PPoD.

The PPoD sums up the debt fears that are weighing down the stock and lending markets across the world. Now, like most Australians I used to think, who cares that the Greeks are having little trouble paying off a few loans. Well, basically the financial woes of Greece are small compared to the wider PIIGS debt levels and this pales into insignificance when you consider that the US debt is currently at around $12.5 trillion dollars, that is ten times that of Italy and approaching the value of their GDP.

So why do we need to care?

Well, basically the cost of borrowing money is going up. This obviously hits us quite close to home (literally) as it forces the banks to increase the spread between the Reserve Bank rate and the actual home loan rate that you are receiving. So, while the general public focus is on the Reserve Bank rates here in Australia, there should also be more consideration of the increasing loan costs by the Average Joe. The problem is that there is no easily accessible or understandable figure. There is the US Prime Rate and the London Inter Bank Offered Rate (LIBOR) which are the  rates that the banks used on a day to day basis to lend money to each other. But it is hard to draw a useful affect of the day to day changes of these rates against the long term cost of borrowing money from your local branch.

There is also the effect that this has on Australian and International business, it becomes harder and harder to fund new ventures and to generate new value when the cost of borrowing money goes up, this has the flow on effect of decreasing the productivity and ultimately the profitability of businesses, this means their stock is worth less and this leads to the widespread drops that you see in the global stock markets.

Also, in the end the markets value stability and while the Greek Parliament has passed the Austerity Bill we still don't have a clear picture of how the other PIIGS will perform. Or for that matter the US.

So, hang on to your seats folks, because I fear we are in for a bumpy ride.