As stock markets crumbled under the weight of the credit crunch, billions of investor’s dollars have been washed away like sand on a beach. Shudders were sent through the European stock market today, as another bank brinked on the edge of the financial precipice. The financial earthquake has destroyed all in its wake and looks to consume another victim in its destruction. Australia’s central bank cut interest rates by 1 basis point, but this did little to alleviate the market’s fear of a global meltdown. The infamous American $700 Billion Bailout was passed a few days ago, however, stock markets moved together in the only one direction they knew: DOWN!

The Iceland stock market halted all stock trading today, as its second largest bank was taken over by the government. The Tokyo stock market tumbled to its lowest point in 4 years. The American government pondered whether they should buy short term bonds in an unprecedented move that would cross the line between sound economic policy and lending directly to the market. The European central finance ministers got together to discuss a bailout, but no resolution was made as political maneuverings show the fractured nature of European states. The markets looked worse today, than they have ever looked before. Like a stranded boat in the open ocean, the financial waves thrashed relentlessly as its sailors/investors looked for help – yet no miracle in the sky came to rescue them.

I believe that most Australians do not understand the magnitude of the situation, even though there is almost daily news about it on the front page of the newspaper I read every morning. Being so geographically remote from the rest of the world, it has its advantages. Sometimes. We are immune to a lot of the news that has engulfed the world. Our stockmarkets are still relatively stable compared to overseas, but it is only a matter of time before we are subject to the same market forces engulfing the rest of the world.

Or are we?

We are all part of the financial ecosystem, whether we like it or not. For those of us like me who are earning a wage (or those that are retired with their savings), we have 10% of our salary compulsorily put into superannuation. Thus we all have a stake in the financial crisis – some more than others. Those with direct investments in shares, derivatives, bonds, and other financial instruments will have a much greater exposure.

 

As I opened up my superannuation statement today, I read the financial return: -6.6%. Six percent, fantastic! Then I realised the minus sign in front. Ahhh, a negative return! Even better news. It not as bad as my new superfund, which made -8%. So for that, I should be thankful.

Unfortunately, a lot of superfunds to balance the risk and return, invest in overseas shares as well as domestic shares. As overseas equities take a beating like Rodney King, it will only have a flow on effect on to our domestic market. In fact, it already has. Why do you think the Reserve bank cut the cash rate – to relieve the pressure on mortage owners and to stimulate the economy. Many of the managed funds (not just mine!) have been posting negative returns. If any of them posted a positive return this financial year, I’d questioned their earnings statements (profit and loss statement).

The interesting thing is that superfunds and private equity firms, still have mandates to invest. Money is still flowing in from compulsory superannuation – where do you think our 10% goes? Money needs to have a home, except the banks are too scared to lend to anyone for the risk of default (see Lehman Brothers, Bear Stearns, et al). American banks have cut back their lending to a daily basis and money has shifted into safer and more secure assets like fixed term deposits and shoe boxes at the bottom of your bed. The thing is, what could be more secure than short term bonds? The smart thinking was that you would be paid in interest and when those bonds matured – even that’s too risk now. Better to buy a big safe and toss all your money in there. At least it will still be there when you wake up.

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Enough doom and gloom.

Instead of pondering on what has happened and all the negativity around it, I have discussed some measures below that would help the global economy at large.

1. Reduce or eliminate capital gains tax (CGT) on shares

I had a lively debate over the internet with my friend in the US who suggested this to me. Since no one is buying shares anyway and everyone is selling, could this be a viable option?

Governments around the world introduced capital gains tax to prevent people from shifting their income into capital for the tax difference. For example, in Australia prior to 1984 (or whatever that date is), people that earned income were taxed according to their tax bracket – as they are now. If that income was deemed to be of capital nature, it was not taxed at all. So smart people with money, simply shifted their income to capital, made gains and were untaxed. Thus capital gains tax was introduced to capture this missing link in the tax landscape to prevent the arbitrage between capital and income.

Whilst, I do not fundamentally believe that reducing or eliminating CGT on shares will have the required effect, it does have some sway. When the economy is in such a dire state, we need liquidity in share markets. People need to buy and sell. We are stuck with the present situation where people are selling and no one is buying. Thus, there is no liquidity (i.e. turnover) in the market.

Margin loans are been called like bluffs at Texas Hold’em, and everyone is losing to the house. Banks have mortgages and other assets which they cannot unload. Eliminating CGT on shares and possibly other assets like real estate, would encourage trading and a greater flow of money into the economy. Yes, some sharp people out there (with tax accountants at their disposal) would shift their income to capital, but is this a bad thing? These are the people with money at their disposal and we need them to do something with it!

The problem with introducing such a financial incentive is that once you unleash it, it is very hard to claw back. Could you imagine the political backlash that would occur if you gave people a tax break and then took it away?

This measure alone cannot be effective in restoring stability into financial markets, but has some merit.

2. Introducing tax breaks for entrepreneurs, greater tax rebates for R&D and innovative practices

I have grouped these together because fundamentally they are similar. We are just trying to encourage a bit of risk taking and expansion of activities that help drive our economy. I can’t speak for other countries as I am not too aware of their tax practices, but from an Australian perspective, surely more than can be done in this area.

Yes, we should encourage entrepreneurs to open more businesses, to think of more ideas, to be able to benefit from their financial losses. They need to fail faster, so they can learn from their mistakes. It is ideas and people that start billion dollar corporations, franchises, improve people’s standard of living and create value. We don’t have enough of them.

Similarly, we need business practices to be more creative and more open minded. Although Australian businesses do punch above their weight in the international arena, I do not believe that the government has enough financial encouragement for new R&D. From memory (and this was a while back), I think the rebate was 125% and the way it works is that for every $1 dollar you spent on R&D, the government reimbursed you with $1.25. I do not see why more money could not be given back to businesses that are becoming world beaters, that are making new production methods and so on.

I have used tax as my first two examples, and this is because the taxation is a natural solution to stimulate economic growth. Tax does several things, and the one good thing it does is that it acts as an automatic stabilizer (inset – see your yr 12 economics textbook).

3. A change in the way we do our accounting and lending practices

Although I have been harping on about tax for a while, it does not solve the core of the problem. The root cause is that some bad decisions were made, assets were overvalued, and some people got a bit too greedy. The problem began with mortgages made to people which were beyond their means, hence the so called “sub prime” crisis.

Banks and other financial institutions have overvalued these assets. Obviously some lax lending practices were involved as well. The bailout is necessary (though financial pundits of free market forces may disagree), but it sets a dangerous precedent. Will banks change their practices? Will anything be learned?

Surely, banks and other corporate institutions need to be more open about their valuation practices. Mark-to market accounting must be adopted i.e. valuing assets at their market value rather than at their historic values. Investors have a right to know if the value of the assets are sinking faster than quicksand.

But fundamentally, more must be done around changing the thinking behind our accounting practices. Accounting standards should at their purpose focus on disclosure rather than measurement. Investors need to know all the financial risks involved. And I believe more investors (especially unsophisticated investors) need to be encouraged to understand how to read financial statements and disclosures.

The problem is that is so much information hidden in financial reports and off balance sheet assets, and continuous disclosure does nothing more than flood more irrelevant information into the market place. There is not space to discuss changes in lending practices, so more on this another day I’m afraid.

4. Increase production of shoe boxes

If all the above fails, and the Bailout does nothing to alleviate concerns in the market place, there is one practice that has stood the test of time. Find a box, preferably of small to medium size, depending on the amount of cash you intend to hoard, and stuff it in a box.

Place it safely under your bed and sleep soundly, for you have avoided yet another day, another financial disaster.

Matt.