Trading Economics

The closest thing we have to Austerians are the Germans, whose GDP growth has been stellar despite the controversial austerity. The bailed out for now, Iceland and Ireland, are doing much better now that they have implemented austerity. The half-hearted Austerians, the UK and France, are struggling along, but still positive. The soon-to-be defaulters, also known as PIGS , are barely breaking even on GDP growth just this year. (Note that Greek data for Q2 2011 was not included.)

Obama's Keynesianism has the US in the middle of the pack in terms of growth. As you'd expect, stimulus increases GDP growth in the very short run, but drags on it thereafter. That's why the Keynesian curve above is in steady downtrend.

What's interesting is that American stimulus efforts pushed US growth beyond Germany's only until the end of 2009. Since then, Germany has outperformed on growth. Considering the US has been spending like mad, while the Germans have been cutting back, that is pretty pathetic.

Which is why Republicans and Democrats are unhappy about more stimulus (for now). But the Keynesians will stage a comeback. Some are already suggesting the world should declare a war on imaginary aliens, just to revive government spending. What's odd about that is that economies do not recover during wars, but after them - when government recedes and public debts are paid off. You could say that the US economy is at war level government spending, while the German economy is at post-war level.

Anyway, don't count a Keynesian comeback out for 2012. Even in Germany. The frightening thing is that governments will have trouble funding their stimulus efforts. That leaves the central banks.

But central bankers are probably sick of 'pushing on a string'. That's the acadmic name for the phenomenon when central banks pump money into the economy, but it only gets as far as the banks. Eventually, central bankers and their friends in parliaments around the world will find ways around the banking system.

That would mean inflation.

Remember, the Federal Reserve created trillions of dollars to save banks around the world. You have to think they would be willing to do the same for governments who have spent themselves into a hole.

But to justify any extraordinary central bank actions, the economic climate must be equally extraordinary. The question is how bad things have to get before policy makers ride to the rescue on their show ponys.

That question is the answer to the recent volatility. The worse things get, the better the chance of intervention. Traders are betting on the point at which some interventionist somewhere does something.

It must be driving stock brokers nuts to see their client's wealth appear and disappear daily. No doubt property investors are having a chuckle. But Murray Dawes' target="_blank">here.

In the end, if inflation does win out, both equities and property should do well. But they will both be hit hard in the meantime. So you can either target="_blank">hold a diversified portfolio and preserve wealth for now.

With the latest rally in stocks, now might be a good time to find out what to sell if things go bad again. According to Greg Canavan in Thursday's Money Morning article, the rally isn't going to last. You can read about why below. Greg has prepared his subscribers with a

Australia's Subprime Crisis

"Mark my words," says value expert Greg Canavan. "In 2012 you'll see the first headlines about Aussie mum and dad investors being forced into 'negative equity' - owing money to the banks after the sale of their property."

Find out what that means for the economy and your investments
By Greg Canavan on 6 October 2011

-- If you like catching up with Murray Dawes on YouTube, bullish...

--He reckons there could be a market rally in the offing... and if he's right about that, he has an idea where the ASX could be headed. He also has an idea about what to do if it gets there...

and that involves some pretty major selling. But Murray's musings come with a caveat: "If Soc Gen or BNP fall over then all bets are off..." To watch Murray's brand new market update video now - go

-- That's not the funny bit though. Check this out: Apparently European finance ministers have asked the European Banking Authority (EBA), Europe's top (we use the word loosely) banking regulator, to stress test Europe's banks - again.

-- You may remember the same incompetent organisation conducted stress tests in 2010 and 2011. The latest one, completed in July this year, found European banks to have a capital deficiency of just €2.5bn. At the same time as Athens was burning, these pompous fools didn't even model a sovereign default. Now, just a few months later we're talking about a need for €200 billion in fresh bank equity.

-- But instead of all being sacked and the organisation shut down - as would happen in the private sector - these imbeciles get another go. We can only conclude the EBA is a corrupt organisation in the palm of the bankers. And it's supposed to be their regulator?

-- Look, the bank recapitalisation plan is on the right track. We don't dispute that. But it's a plan being put together by a bunch of squabbling politicians who put their own re-election prospects ahead of anything else. So the chances of it actually being done properly are remote.

-- As we wrote in our Sound Money. Sound Investments email update yesterday - bank recapitalisations will be beneficial as long as they are accompanied by bad debt write-downs. The main problem with the global economy today is the amount of bad debt festering on bank balance sheets. This impedes the creation of new, productive debt.

-- It also affects confidence. Banking is - and has always been - a business based on confidence. Without it, banks are exposed as the highly leveraged and fragile institutions that they are.

-- So to improve confidence you need to purge the bad debt out of the system. This requires bank recapitalisations to absorb the coming write-downs. Before we go any further, just what do we mean by 'bank recapitalisation'?

-- The process is best explained with reference to a bank's balance sheet. In balance sheet land, a company's assets are equal to its liabilities and equity. The 'equity' value of a company is traded on the stock market. It is this portion usually referred to as 'bank capital'.

-- If you're still with us, we'll show you French basket case Société Générale's balance sheet.

Assets €1.158 trillion
Liabilities €1.106 trillion
Equity €52.1 billion

-- Here's how it works. A write down in the value of its assets must be matched by a write down in the value of the equity. If the value of the banks assets fell by just 5 per cent, all the equity would be wiped out and the bank would be insolvent. This just goes to show how highly leveraged European banks are.

-- Actually the bank's assets have probably already fallen by 5 per cent. Luckily, it's not required to 'mark its assets to market'. Banks aren't allowed to fail remember?

-- Société Générale's current market capitalisation is just €14 billion. This is what investors think the bank's equity value is worth. It will probably prove optimistic.

-- This is where a recapitalisation comes in. The Euro bailout fund, the EFSF, will contribute funds to banks in need of new equity capital. This should take the form of 'preferred equity', which will rank above existing equity when it comes to absorbing write-downs. That way anyone punting on European bank shares will take a hit before new taxpayer funds do.

-- If all the bad sovereign debt in the system is really purged (which it won't be, but bear with us) most of the existing equity holders will be wiped out. The pie-in-the-sky plan would then be for the preferred equity to convert to ordinary equity. Once this whole debt crisis thing blows over, say by Christmas*, the taxpayers would sell out for a profit, proving the eurocrats' plan to be pure genius.

-- There's no harm in dreaming of course, but it won't work out that way. There will be squabbling about which banks receive capital and how much is actually needed. If estimates of €200 billion are correct, the recapitalisation plan will leave the EFSF just about empty, with no more funds to buy other struggling sovereign debt.

-- And don't forget, bad sovereign debt is the cause of the crisis. Insufficient bank capital is just a symptom of the problem. A Greek default still awaits.

-- The Europeans are only just beginning to realise how big their problems are. So enjoy the rally, it won't last for long.

* Remember in World War One the conventional European wisdom was the 'it would be over by Christmas'. Christmas 1914 that is.