Saturday, February 28, 2009

To Nationalize or To Nationalize?

David Leonhardt of New York Times suggests of 2 kinds of government takeover of US banks:

One is premised on ideology-governments can run more institutions more "justly" or "efficiently" than private capitalists.

The second is predicated on short term expediency: government takes over (sheds shareholders, bondholders and management), repackage (segregate assets) and immediately sells back to the public.

And if the path of government action are to be based on public opinion, then the the second option appears as the proximate direction. This supposedly is the optimistic case.

But, as Ludwig von Mises once admonished, interventionism can be addictive, ``It doesn't accomplish its stated ends. Instead it distorts the market. That distortion cries out for a fix. The fix can consist in pulling back and freeing the market or taking further steps toward intervention. The State nearly always chooses the latter course, unless forced to do otherwise. The result is more distortion, leading eventually, by small steps, toward ever more nationalization and its attendant stagnation and bankruptcy."

Despite the denials of key officials, apparently the baby steps are headed towards such direction.

Thursday, February 26, 2009

Video: Milton Friedman on Greed

From the Heritage Blog,

Some excerpts from Friedman's terse but awesomely crisp rejoinder on capitalism's "greed"...

``The world runs on individuals pursuing their selfish interest. The great achievements of civilization have not come from government bureaus."

``In the only cases in which the masses have escaped from the kind of grinding poverty you are talking about, the only cases in recorded history are where they have had capitalism and largely free trade. If you wanna know where the masses are worst off is the kind of the society that departs from that. So that the record of history is absolutely crystal clear, that there is no alternative way so far discovered of improving the lot of the ordinary people that can hold the candle to the productive activities that are unleashed via free enterprise."

``And what does reward virtue? You think the communist commissar rewards virtue? Do you think a Hitler rewards virtue? Do you think, excuse me…if you’ll pardon me, American presidents reward virtue? Do they choose their appointees from the basis of the virtues of the people appointed or on the basis of political clout? Is it really true that political self interest is nobler somehow than economic self-interest?"

Wednesday, February 25, 2009

The Unintended Effects and follies of the Cap and Trade System

The unintended effects from an artificial market to aimed at reducing carbon emissions, this excerpt from Julian Glover of the Guardian (bold highlights mine),

``Set up to price pollution out of existence, carbon trading is pricing it back in. Europe's carbon markets are in collapse.

``Yet the hiss of escaping gas is almost inaudible. There's no big news headline, nothing sensational for TV viewers to watch; no queues outside banks or missing Texan showmen. You can't see or hear a market for a pollutant tumble. But at stake is what was supposed to be a central lever in the world's effort to turn back climate change. Intended to price fossil fuels out of the market, the system is instead turning them into the rational economic choice.

``That there exists something called carbon trading is about all that most people know. A few know, too, that Europe has created carbon exchanges, and traders who buy and sell. Few but the professionals, however, know that this market is now failing in its purpose: to edge up the cost of emitting CO2.

``The theory sounded fine in the boom years, back when Nicholas Stern described climate change as "the biggest market failure in history" - a market failure to which carbon trading was meant to be a market solution. Instead, it's bolstering the business case for fossil fuels.

``Understanding why is easy. A year ago European governments allocated a limited number of carbon emission permits to their big polluters. Businesses that reduce pollution are allowed to sell spare permits to ones that need more. As demand outstrips this capped supply, and the price of permits rises, an incentive grows to invest in green energy. Why buy costly permits to keep a coal plant running when you can put the cash into clean power instead?

``All this only works as the carbon price lifts. As with 1924 Château Lafite or Damian Hirst's diamond skulls, scarcity and speculation create the value. If permits are cheap, and everyone has lots, the green incentive crashes into reverse. As recession slashes output, companies pile up permits they don't need and sell them on. The price falls, and anyone who wants to pollute can afford to do so. The result is a system that does nothing at all for climate change but a lot for the bottom lines of mega-polluters such as the steelmaker Corus: industrial assistance in camouflage.”

No this isn't a market failure but a false/pretentious market that was meant to fail.

Why? Some arguments from Vincent Gioia (bold highlight mine),

``They argue that emissions trading does little to solve pollution problems overall, as groups that do not pollute sell their conservation to the highest bidder, not the worst offender...

``Another problem as The Financial Times noted in an article on cap and trade systems "Carbon markets create a muddle" and "...leave much room for unverifiable manipulation". The paper actually conducted an in-depth study of the carbon credit business and made some very revealing findings". Their investigation found:

■ "Widespread instances of people and organisations buying worthless credits that do not yield any reductions in carbon emissions.
■ Industrial companies profiting from doing very little – or from gaining carbon credits on the basis of efficiency gains from which they have already benefited substantially.
■ Brokers providing services of questionable or no value.
■ A shortage of verification, making it difficult for buyers to assess the true value of carbon credits.
■ Companies and individuals being charged over the odds for the private purchase of European Union carbon permits that have plummeted in value because they do not result in emissions cuts...

``There is also the issues of what do those selling carbon credits do the reduce carbon dioxide emissions and are proponents of the idea merely using the global warming fanatics to line their pockets and do so-called environmentalists scam the system for political advantage...

Zimbabwe's Hyperinflation

Interesting Hyperinflation data...from Economist Steve Hanke of Forbes and

According to Mr. Hanke, ``Zimbabwe failed to break Hungary’s 1946 world record for hyperinflation. That said, Zimbabwe did race past Yugoslavia in October 2008. In consequence, Zimbabwe can now lay claim to second place in the world hyperinflation record books."

Highest Monthly Inflation Rates in History


Month with highest inflation rate

Highest monthly inflation rate

Equivalent daily inflation rate

Time required for prices to double


July 1946

1.30 x 1016%


15.6 hours


Mid-November 2008 (latest measurable)



24.7 hours


January 1994



1.4 days


October 1923



3.7 days


November 1944



4.5 days


May 1949



5.6 days

More from Mr. Hanke, ``Zimbabwe is the first country in the 21st century to hyperinflate. In February 2007, Zimbabwe’s inflation rate topped 50% per month, the minimum rate required to qualify as a hyperinflation (50% per month is equal to a 12,875% per year). Since then, inflation has soared."

Well as of November 14th, this was how Zimbabwe's inflation rate fared

Monthly inflation rate=79,600,000,000.00%

Annual Inflation Rate=89,700,000,000,000,000,000,000%

The magic of the printing press.

Fiscal Stimulus Debate: Oops, We’re Using The Wrong Keynes!

Given today’s worsening financial and economic crisis, the debate on the viability of the fiscal stimulus (government spending) patterned after John Maynard Keynes theories continues to rage.

courtesy of

But, unfortunately, both proponents (including uber-Keynesians) and detractors have been citing the "wrong" theories of “rock star” economist JM Keynes. That’s according to Professor Rizzo who wrote, ``we should pay attention to his mature ideas rather than to the textbook versions of what he said, some of which reflect Keynes’s earlier thinking.”

So what were the thoughts of the “matured” Keynes?

Again Professor Rizzo (all bold highlights mine), ``Keynes did not think that public works expenditure was very effective in countering existing or impending recessions. He believed that it was difficult to get the timing right.

``In the first place, he preferred that such investments be made without deficits. But if they were to be made as “loan expenditure”—that is, through a deficit in the portion of the government’s budget allocated to long-term expenditures like infrastructure—the expenditure should be covered by a surplus in the portion of the budget allocated to ordinary expenses like transfer payments, or through a special fund accumulated in prosperous times for just such purposes. If a deficit were incurred, the investments should be “self-liquidating,” that is they should repay their costs over the long run. Thus his strong, but not rigid, preference was against deficit-financed public works.

``The more fundamental reasons for his preference against deficit-financed public works, however, emerge from the theoretical framework he built in his masterwork General Theory of Employment, Interest and Money (1936). As economists Bradley Bateman and Allan Meltzer stress, Keynes was convinced that avoiding depressions required the maintenance of a high level of investor confidence. He believed that (in general and not just during slumps) confidence tended to be too low. This low confidence was due to radical uncertainty generated by speculation inherent in financial markets, especially the stock exchange. This speculation could give rise to unsustainable asset bubbles. The ever-present threat of such speculative activity creates instability in the expectation of investment returns. As a result, investment spending will fluctuate unpredictably. This in turn creates further instability of investor expectations.

``In Keynes’s view, the financial uncertainty generated by such speculation was an unnecessary social burden. It tended to keep long-term interest rates above where they would lead to full employment. The task of good economic management is to reduce this uncertainty burden and lower long-term interest rates through a kind of “socialization of investment.” The state in one way or another (Keynes is not entirely clear on this) should undertake large investments with no thought of speculative gains or advantage. The long-term social return on capital should be its only guide. And it should do this reliably, as part of a well thought-out plan, and on a permanent basis. Stabilization is to be achieved not by temporary and discretionary policies, but by permanent changes. Stimulus follows stability, not vice versa.

Read the rest here

Some observations:

The matured Keynes admits he does not “think that public works expenditure was very effective in countering existing or impending recessions”

Goes to show how interventionists have been using Keynes inappropriately for intellectual cover.

Finally, don’t be slaves of defunct immature economist!

(Hat Tip: Café Hayek)

How Math Models Can Lead To Disaster

The crash of Wall Street had been aggravated by people looking for rationales to confirm their beliefs. And there was no better source of inspiration than one modeled after a seemingly impervious mathematical formula.

An article from on “Recipe for Disaster: The Formula That Killed Wall Street” by Felix Salmon, gives a splendid narrative.

Some excerpts (all bold highlights mine),

``For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

``His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored….

``It was a brilliant simplification of an intractable problem. And Li didn't just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything.

``The effect on the securitization market was electric. Armed with Li's formula, Wall Street's quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was…

``As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked.

``In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years' worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.

``As Li himself said of his own model: "The most dangerous part is when people believe everything coming out of it."

Some observations:

One. This is another example of people how people (including the majority of experts and professionals) fall prey to cognitive biases, such as the confirmation bias, in order to buttress their beliefs.

Two. This also shows of people’s penchant to trustingly espouse mathematical models to address the concerns of social structures especially in markets.

The illustrious Friedrich A. Hayek (1899–1992) in his Nobel Prize speech The Pretence of Knowledge warned of this, ``A theory of essentially complex phenomena must refer to a large number of particular facts; and to derive a prediction from it, or to test it, we have to ascertain all these particular facts. Once we succeeded in this there should be no particular difficulty about deriving testable predictions — with the help of modern computers it should be easy enough to insert these data into the appropriate blanks of the theoretical formulae and to derive a prediction. The real difficulty, to the solution of which science has little to contribute, and which is sometimes indeed insoluble, consists in the ascertainment of the particular facts.”

For pundits, math models elicit intellectual attraction of a system that can be deliberately controlled. However, the sad reality is that they hardly capture all variables required out of the complexity of the environment. And over reliance thereof may lead to disastrous consequences, similar to the LTCM fiasco.

And this applies not only to Wall Street but to the general economics or even to the environment.

Nassim Taleb: Banking System is Designed to Blow Up

From Bloomberg:

Banking with Ponzi characteristics...
People can invest in real thing...
You can't trust bankers
Hat tip infectious greed

Sunday, February 22, 2009

Do Governments View Rising Gold Prices As An Ally Against Deflation?

``One day the price of gold will be higher than the Dow Jones.”-Dr. Marc Faber

As gold nears its all time high see figure 7, public awareness in gold seems to be snowballing.

Figure 7: World Gold Council: Two Remaining Currencies Where Gold Has Yet To Establish Record High

There are only two major currencies wherein gold trades below its record high; one is the US dollar and the other is the Japanese Yen.

The chart above courtesy of the World Gold Council was last updated February 13th. But as of last Friday’s close, Gold in US dollar terms was seen nearly leveling on its previous high at 1,004.

When gold rises across all currencies, this is symptomatic of a systemic monetary disorder than just mere inflation. There appears to be an accelerating realization that paper currencies issued and guaranteed by the global governments are becoming less sacrosanct, or people have been exhibiting diminished “faith” on the present financial architecture or this has been reflective of paper money’s “race to the bottom” or the effect of the collective efforts by governments to debauch or even destroy their currencies.

Nonetheless, a recent article at the Financial Times had this unusual observation; it noted that rising gold prices seem to be operating under the auspices of governments.

This from Mr. Steve Ellis of RAB Gold Strategy at the,

``Speaking to central bankers, this is the first time I can recall them actually favouring a high gold price. Normally they see high gold prices as a lack of trust in the financial system (not to mention their ability as central bankers). Alan Greenspan, the former Fed chairman, for example used to target a gold price of around $400 to $500 an ounce.

``Recently, the central bankers have become more enamoured of higher gold prices as it would suggest that their attempts to stave off deflation were starting to work.

``Central bankers in favour of higher gold prices? Things really have changed.”

Gold’s moniker, the “barbaric metal” had been contrived by interventionists because it functioned as rabid nemesis to elastic currency or the ability of authorities to inflate the system to appease the political gods.

Thus, could central bankers truly see gold as an ally against their campaign deflation?

Three reasons why we think this is possible.

Inflation Expectations Needs To Be Reshaped

One, for central bankers, it’s all about signaling channels. This is usually known as the managing of inflation expectations, where the central bank communicates to the markets their policy intentions as to project stability.

In a recent speech, US Federal Reserve chair Ben Bernanke said, ``increased clarity about the FOMC’s views regarding longer-term inflation should help to better stabilize the public’s inflation expectations, thus contributing to keeping actual inflation from rising too high or falling too low.”

You see central bankers believe that inflation can function like a light switch that can be turned on or off, or like a genie that be called in and out of his lamp.

Unfortunately, this is an academic and bureaucratic delusion. In as much as authorities failed to predict the catastrophic consequences of a bursting bubble, they’ve nonetheless equally botched any attempt to rein its deflationary reaction. So they are now hoping that by unduly taking on the inflation risk, they can manage to steer it successfully once the crisis pasts. But like the recent activities, the inflation genie will most likely elude them, until the next crisis surfaces.

Yet by pushing and maintaining interest rates at near zero levels, and the policy shift to adopt the tactical measures of “quantitative easing”, most major central banks (US, Swiss, UK, Japan) appear to be communicating their desire to reignite inflation as means to restore the credit flow.

However, this hasn’t been the entire truth, as we have repeatedly pointed out- the colossal debt structures of the bursting bubble economies require governments to inflate away the real debt levels.

In addition, government’s use of the fiscal medicine to deal with national or domestic economic malaise serves as a parallel approach to stoke inflation in the economy regardless of how ineffectual such efforts are.

Nevertheless, we have almost every government in the world today rehabilitating their domestic economies by instituting inflationary policies. Thus, if gold’s rise should signify as resurgent “inflation” then governments are likely to reticently “cheer” on it.

Enhancement of the Balance Sheet of the US Federal Reserve

Two, if the aim of the US Federal Reserve is to enhance its balance sheet, a revaluation of gold reserves might be necessary.

Using the “backing theory”, which means that the currency’s worth is determined by the underlying assets and liabilities of the issuing agency (, the Federal Reserve’s attempt to debase its currency is done by absorbing more toxic assets to its balance sheet.

According to Philipp Bagus and Markus H. Schiml, ``Since the crisis broke out, the Fed has continuously weakened the quality of the dollar by weakening its balance sheet. In fact, the assets the Federal Reserve holds have deteriorated tremendously. These assets back the liability side of the balance sheet, which mainly represents the monetary base of the dollar. The assets of the Fed, thereby, hold up the value of the dollar. At the end of the day, it is these assets that the Fed can use to defend the dollar's value externally and internally. Thus, for example, it could sell its foreign exchange reserves to buy back dollars, reducing the amount of dollars outstanding. From the point of view of the buyer of the foreign exchange reserves, this transaction is a de facto redemption.” (bold highlight mine)

Hence, under the backing theory, it isn’t just quantitative easing (printing of money) that determines the currency value but also the qualitative aspects (or what it buys for the asset side of its balance sheet).

Again from Mssrs Bagus and Schiml, ``Despite of all these efforts, credit markets still have not returned to normal. What will the Fed do next? Interest rates are already practically at zero. However, the dollar still has value that can be exploited to keep the experiment going. Bernanke's new tool is the so-called quantitative easing. Quantitative easing is when a central bank with interest rates already near zero continues to buy assets, thus injecting reserves into the banking system. In fact, quantitative easing is a subsection of qualitative easing. Qualitative easing can be defined as the sum of the policies that weaken the quality of a currency.”

Simply said, as the Federal Reserve increasingly digests poor quality of assets into its balance sheet, this effectively reduces its equity ratio from which would eventually translate to its insolvency.

Hence, this would leave the US Federal Reserve with only two options, according to Mssrs Bagus and Schiml, ``Only two things can save the Fed at this point. One is a bailout by the federal government. This recapitalization could be financed by taxes or by monetizing government debt in another blow to the value of the currency.”

``The other possibility is concealed in the hidden reserves of the Fed's gold position, which is only valued at $42.44 per troy ounce on the balance sheet. A revaluation of the gold reserves would boost the equity ratio of the Fed.”

High gold prices would eventually be required for gold to be revalued to enhance the balance sheet of the US Federal Reserve.

End To Gold Manipulation?

Lastly, the surging gold prices suggest an end to possible gold manipulation.

It has been long contended by groups like the GATA that central bank gold reserves has been unofficially “sold”, through lease, swaps and derivatives to the markets, hence gold stashed in the central bank books have simply been accounting entries.

Mr. Robert Blumen of cites a report from where a broker endorsed the suspicion of gold manipulation; says Mr. Blumen, ``The major conclusion of the report is that the western central banks have sold a larger fraction of their gold reserves than they acknowledge in their official statements. The gold has entered the market through derivatives such as leases, swaps, the writing of call options against the gold. The sale of the gold is obscured in the central banks books through the representation of leased, swapped, and otherwise encumbered, aggregated together with actual physical gold held in vaults as a single asset on their books. An estimated 10,000-15,000 tons of gold has entered the market since 1996 (compared to an official number of 2,000-3,000) through these mechanisms, according to the report. The purpose of these covert gold sales is part of a larger effort to disable the functioning of inflation indicators, which operate to limit central bank credit expansion.”

Gold’s recent rise has been primarily investment demand driven, see figure 8.

Figure 8: Surging Investment Demand

The implication of which is a shift in the public’s outlook of gold as merely a “commodity” (jewelry, and industrial usage) towards gold’s restitution as “store of value” function or as “money”.

The greater the investment demand, the stronger the bullmarket for gold.

If the estimated number of 10,000 to 15,000 tons, is anywhere close to being accurate, then this translates to 40-50% of world central bank gold reserves of 29,697.1 tonnes ( as of December 2008) as having been “shorted”.

Therefore, “short” positions in a rampaging gold bullmarket will extrapolate to additional national balance sheet losses. This implies that world governments, whom are net short positions, will likely be net buyers in the near future.

Although I haven’t been totally convinced about the “gold manipulation theory”, I am, however, open to it, in the understanding of the political nature of central banking. Central bankers don’t want competition or interference from gold, thus, the odds that price controls may have attempted in the past.

The implication is that the bullmarket in gold will possibly be accelerating once governments’ covers open short positions. And if we see $100 dollar a day moves, perhaps this theory might be validated.

And since the gold market is an iota or about 6% or $5 trillion (165,000 tonnes of above ground gold) relative to the overall financial markets, this suggests that a bullmarket market will likewise spillover to important key commodities as silver, copper and oil.

Moreover, any panic into gold will likewise see a panic to own producers, which functions as proxy to gold by virtue of reserves.

For now, central bankers would likely to be “sleeping with the enemy”.

Central And Eastern Europe’s “Sudden Stop” Fuels US Dollar Rally

``Big government reforms, bailouts, stimulus, and “change" in general create negative expectations of the future along with a great deal of uncertainty. This leads to inaction and fear — the preconditions for a crash in the stock market. All it needs now is the appropriate trigger.” Mark Thornton, Unhinged

Except for some currencies such as the Norwegian Krone, British Pound or the Swiss Franc, the US dollar surged against almost every major currency including those in Asia…the Philippine Peso included. (Be reminded this has nothing do with remittances)

Since the forex market is a huge liquid market, with daily turnover of nearly $ 4 trillion dollars, this means there has been an intense wave of ex-US dollar liquidation. And to see such a coordinated move suggests that the global financial system could be faced with renewed dislocations in a disturbing scale. So the likely suspects could be either major bank/s in distress, or a country or some countries could be at a verge of default.

Central an dEastern Europe’s “Sudden Stop”

With no major spike in the major indicators which we monitor, such as the Libor-OIS, TED Spread, EURIBOR 3 month, Hong Kong Hibor, BBA LIBOR 3 months and 3 MO LIBOR - OIS SPREAD, the epicenter of last week’s pressure appears to emanate from the Central and Eastern European (CEE) region.

Regional credit spreads and Credit Default Swap (CDS) prices soared, as credit ratings agency the Moody’s issued a warning last week of the possibility of credit ratings downgrades in the region’s debt amidst a deteriorating global economic environment, See figure 1.

Figure 1: Danske Bank: CEE Under Pressure

According to the Danske Bank, ``Credit spreads have had a hard time during the week – especially for banks. The investment grade CDS index, iTraxx Europe, currently trades at 174bp up from 154bp last Friday. The high yield index iTraxx Crossover currently trades at 1085bp up from 1070bp last week. The senior financial index has also widened considerably and now trades at 152bp. As long as sovereign CDS prices are under pressure CDSs on senior bank debt are also likely to suffer as the two are heavily interlinked due to the various state guarantees on bank debt.”

The turbulence affected every financial market in the region; the CEE currencies crumbled, regional bond markets sovereign spreads widened, and regional equity markets tanked see figure 2.

Figure 2: Danske Bank: Emerging Europe currencies slump, Euro bonds

All these resemble what is known as the “sudden stop” or capital stampeding out of the region.

Somehow the CEE crisis approximates what had happened in Asia 12 years ago or what was labeled as the 1997 Asian Financial Crisis.

Central and Eastern European Crisis A Shadow of the Asian Financial Crisis?

So what ails the CEE?

As in all bubble cycles, the common denominator have always been unsustainable debt. And unmanageable debt acquired by the banking system and Eastern European households during the boom days had been manifested through burgeoning current account or external deficits. And these deficits had been balanced or offset by a flux in capital flows, mostly bank loans see figure 3.

Figure 3: Emerging Europe Crisis versus the Asian Crisis

The Bank of International Settlements (BIS) makes a comparison between the present developments in Emerging Europe with of Asia 12 years ago.

From the BIS, ``The crisis was preceded by rapid growth in credit to the private sector, with a significant share of loans denominated in foreign currency. East Asian economies also recorded large current account deficits, mainly induced by the private sector. These deficits were financed by strong debt inflows, which reversed sharply following the crisis. A further similarity lies in exchange rate policies. Prior to the crisis, East Asian economies had fixed nominal exchange rates (in their case against the US dollar). Moreover, the economies relied heavily on a single foreign creditor – Japanese banks. Emerging European countries currently show a similar level of dependence on a few European banking system creditors. For example, claims by Austrian-owned banks are equivalent to 20% of annual GDP in the Czech Republic, Hungary and Slovakia, while claims of Swedish-owned banks on the Baltic states are equivalent to 90% of their combined GDP. An adverse shock to one or more of these foreign banks could result in them withdrawing funds from emerging European countries.”

So the emerging similarities seen in both crises have been strong debt inflows, fixed nominal exchange rates and the concentration of source financing.

As the above chart shows, FDIs (red line) and Bank loans/Debt (blue line) composed most of the inflows in Emerging Europe (left window) whereas the Asian crisis bubble (right window) was almost entirely financed by debt from bank loans.

According to BIS, one marked difference for the strong capital flows in Emerging Europe had been due to the “strengthening in GDP growth and policy frameworks due to closer EU integration.” Plainly put, the integration of many of these countries into the Eurozone facilitated capital flows movement in the region, which may have abetted the bubble formation.

Moreover, another important difference was that Asian debt was principally channeled into the corporate sector while the liabilities in Emerging Europe have been foreign currency related.

Like the recent debacle in Iceland, Emerging Europe’s households incurred vast mortgage liabilities through their banking system in unhedged foreign currency contracts (mostly in Euro and Swiss Francs), which was meant to take advantage of low interest rates while neglectfully assuming the currency risk. In short, Emerging European households engaged in the currency arbitrages or otherwise known as the CARRY TRADE.

So when the sharp downturn in economic growth occurred, these capital starved economies failed to attract external capital, hence, the net effect was a drastic adjustment in their currencies which prompted for a capital flight.

Households which took on massive doses of foreign currency liabilities or loans saw their debts balloon as their domestic currency depreciated.

And it is not just in the households, but foreign investors too which incurred substantial exposure through local currency instruments. Morgan Stanley estimates Turkey, Hungary, Poland and Czech having non-resident exposures to equities and bonds at 30%, 18%, 17% and 10%, respectively.

Thus, the sharp gyrations in the currency markets have accentuated the pressures on the underlying foreign currency mismatches in the region’s financial system.

Another source of distinction has been the degree of exposure of the Emerging Europe’s debt to the European banking system. As noted by the BIS above, the Asian crisis further undermined Japan’s banking system, which provided the most of the loans, at the time when its domestic economy had been enduring the first leg of its decade long recession. On the hand, over 90% of the distribution of loans $1.64 trillion loans held by Emerging Europe have been scattered between the European and Swedish banks.

Doom Mongering: Will Eastern Europe Collapse the World?

Nonetheless this has been the key source of pessimism in media, especially by doom mongers whom have alleged that the failure to salvage East Europe will either lead to a worldwide economic catastrophe or to the disintegration of the Euro, as major European economies as Germany and France may opt NOT to bailout the crisis affected union members or union members whose banking system are heavily exposed to Eastern Europe of which may lead to cross defaults and culminate with a collapse in the monetary union.

In addition, they further assert that due to the huge extent of financing requirements, the IMF would deplete its funds and may be compelled to sell its gold hoard in order to raise cash. And to prim their narrative, they’ve made use of the historical parallelism to bolster their views or as possible precedent; the Austrian bank collapse in 1931 triggered a chain reaction which ushered in an economic crisis in Europe during the Great Depression years.

We are no experts in the Euro zone and Emerging Europe markets, but what we understand is that these doomsayers appear to be inherently biased against the Euro (on its very existence, even prior to these crisis), or alternatively, have been staunch defenders of the US dollar as-the-world’s-international-currency-standard, and have used the recent opportunities to promote their agenda.

Moreover, these doom mongers appear to be interventionists who peddle fear to advocate increased government presence and interference, which ironically has been the primary cause of the present predicament.

Be reminded that the fiat paper money system exists on the basis of trust by the public on the issuing government. Conversely, a lost of faith or trust, for whatever reason, may indeed undermine the existence of a monetary framework, such as the US dollar or the Euro. Thus rising gold prices are emblematic of these monetary disorders and we can’t disregard any of these assertions.

Although, for us, the claims of the tragic collapse from the ongoing CEE crisis could be discerned as somewhat superfluous.

One, the argument looks like a fallacy of composition- as defined by is true of the whole from the fact that it is true of some part of the whole (or even of every proper part).

Figure 4: BIS: Foreign Liabilities Varies Across EM Regions

The CEE debt problem has been interpreted as something with homogeneous like dynamics, where the assumption is that every country appears to be suffering from the same degree of difficulties even when the economic structures (leverage, deficits etc.) are different.

They even apply the same logic to the rest of the world including Asia, where, as can be seen in Figure 4, have different scale of foreign liabilities exposure.

Two, because a large part of the Emerging Europe’s banking system is owned by European banks (see Figure 5) some have alleged that European governments have been indiscriminately pressuring their domestic banks with exposures to Eastern Europe to abruptly reduce or pullback their exposure to these countries, such as Greek banks in Balkans. There may be some cases, but a wholesale withdrawal would seem unlikely.

Figure 5 BIS: Foreign Bank Ownership in Emerging Markets

Yet according to the BIS, ``a large part of most emerging European banking systems is foreign owned. These banking groups appear to be financially strong currently, as reflected in standard –albeit backward-looking – measures of financial strength such as capital adequacy ratios and profitability. The foreign subsidiaries should have better risk management techniques in place, more geographically dispersed assets and, in principle, good supervision (from the home country on the consolidated entity).” [bold highlight mine]

Three, emerging markets have been reckoned as “more inferior and risk prone” asset class compared to the securitized instruments sold by the US.

As the Europe.view in the Economist magazine aptly remarked, ``Foreign-currency borrowing by east European households was seriously unwise. But it does not compare with the wild selling of sub-prime mortgages in America that turned balance sheets there to toxic waste. It may be necessary to restructure some of these loans, or convert them into local currency (perhaps with statutory intervention). That will hurt bank profits. But it will not mean American-style write-offs. Bank lending to foreign companies based in eastern Europe is still a good business.”

Divergences Even Among Emerging Markets?

While it could be true that some European banks could be heavily levered compared to their US counterparts and has significant exposure to the CEE region- where the latter seem to be encountering an Asian Crisis like unraveling due to outsized external deficits, large internal leverage and foreign currency mismatches in their liabilities- it is unclear that the deterioration in the financial and economic environment would result to an outright disintegration of the Euro monetary union or trigger an October 2008 like contagion across the globe.

Figure 6 Danske Bank: EM Stock markets

The fact that EM stockmarkets have been performing divergently as shown in figure 6, where LATAM (blue), Asia (apple green), CIS (Commonwealth of Independent States-gray) appear to be recovering, while the CEE (red) and MSCI (dark green) index are down, hardly implies of a contagion at work yet.

Moreover, as we earlier noted, credit spreads of major indicators haven’t seen renewed stress and seems to remain placid despite the recent CEE ruckus.

Thus from our standpoint the present strength of the US dollar encapsulates the ongoing Emerging Market phenomenon called the “sudden stop” or capital “flight” (resident capital) or “exodus” (non-resident capital) from the region, which has siphoned off the availability and accessibility of the US dollar in the global financial system which has probably led to the steep rally in the US dollar almost across-the-board.

We believe that 2009 will be a year of divergence as concerted policy induced liquidity measures will likely have dissimilar impact to all nations depending on the economic, financial markets, and political structures aside from the policy responses to the recent crisis and recession.

Even among Emerging Markets such divergences will likely be elaborate.

Saturday, February 21, 2009

Deglobalization and Economic Fascism

From a monetary policy induced globalization boom to a deglobalization bust, the global political economy is ostensibly undergoing a dramatic transformation.

According to the Economist (bold emphasis mine), ``THE economic meltdown has popularised a new term: deglobalisation. The process of the global integration of goods, capital and jobs is in trouble. The IMF predicts global growth of 0.5% this year, the worst in 60 years. World trade has plunged. Foreign direct investment, a common route to transfer skills and technology from rich to poor countries, fell by 21% in 2008 to $1.4 trillion and will contract by another 12-15% this year. Unemployment is expected to rise by 30m from 2007 levels by the end of this year. A poll taken in the last two months of 2008 by Edelman for the World Economic Forum found that 62% of repondents in 20 countries said they trusted companies less, with a majority keen on more state regulation.”

This trend towards more government, higher taxes and increased regulation or socialism is based on the belief of quick fixes. People are now invoking for a sacrifice of civil liberties for economic "salvation" based on serfdom.

And this had been foretold by Ludwig von Mises (Human Action), ``The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”

This addiction to inflation is also equivalent to embracing economic fascism.

Professor Gary North in Economic Fascism And The Bailout Economy elaborates (bold highlight mine)…

``Liberals love to call conservatives fascists. The problem is, the liberals are right. Of course, well-informed conservatives like to call liberals fascists, and they are correct, too. Everyone who believes in the efficiency of the so-called government-business alliance is a fascist.

``The fascist State was always an attempt to control private industry by means of inflation, taxation, and regulation. Fascism was always a system of keeping the big boys alive and happy at the expense of the taxpayers. Of course, the faces changed. The system was always one gigantic system of cartels, regulation, and fiat money.

``The modern economic system is one gigantic interlocking system of promised bailouts, beginning with Social Security. In commerce, it is a system designed to keep large producers protected from consumers

But will a more socialistic form of government succeed in restoring economic growth?

``This economy will revive, but it will revive a new basis. It is no longer possible for someone who understands Austrian School economics to look at this economy as anything remotely resembling a free-market economy. At the very core of the free-market economy, as Mises said in 1912, is the monetary system. That system is now completely and openly run by a cartel that is now trapped by the Federal government. The Federal Reserve System is soon going to have to bail out the Federal government. The Federal government is bailing out the commercial banks, and if the Federal government cannot bail out the banks, the Federal Reserve has got to do it directly. In either case, the banks are busted…

``These scholars agree: we are seeing the bankruptcy of every Western government that has made too many big promises to too many voters regarding free healthcare and guaranteed retirement. All of it will collapse. The tatters of the promises will point to the tatters of those who made the promises -- politicians -- and the tatters of the system that supposedly was going to guarantee delivery of the promises.

``The academics still believe in the healing power of the State. The voters still believe this, too. But voters are catching on more rapidly than the academics that the State is running out of wiggle room. Millions of voters have figured out that they are going to get stiffed. They don't know what to do about it, but at least they understand that they really are going to get stiffed…

Yes, economic transformation will occur. However, economic realities will compel a reawakening of the people mesmerized by the delusion of prosperity based on policy based manipulation.

And how will this happen?

``We will have another round or two of centralized government, and probably more than one or two rounds of increased monetary expansion. But what we will not have is a restoration of anything resembling the financial world that existed prior to September 2008. That world is gone. The insiders will not get it back. They may get an imitation of it, based on fiat money that does not buy very much, but they will not see the world of 2007 restored. The power base of the modern fascist State is unraveling rapidly."

According to von Mises, ``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.”

In other words, repeated attempts to manipulate-the grandest experiment of all time-the fractional reserve paper money system will lead to a government debt bubble which may ultimately implode at the cost of the world’s monetary system.

Professor North’s suggested course of action…

``This is why it is important for you to preserve your assets by not believing the official assurances. Put your money where the experts tell you should not put your money. You should take your money out of those segments of the economy which the experts say you should put your money, and will soon boom. They have ignored the fact that the stock market has been a losing case since March of 2000. They would not admit it then; they will not admit it now. Anybody who bought and held a portfolio of indexed American stocks in March of 2000 has lost well over half of his money. Investors will learn, even though academic economists will not.”

The last word from von Mises, ``It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights.”

Spending Trillions to Break the Barriers in Lending, Will it work?

Interesting article from the New York Times on the present crisis in the US,

The Present Dilemma (all bold highlights mine)…

``Largely hidden from view is a vast financial system that serves as the banker to the banks. And, like many lenders, this system is in deep trouble. The question is how to fix it.

``Most banks no longer hold the loans they make, content to collect interest until the debt comes due. Instead, the loans are bundled into securities that are sold to investors, a process known as securitization.

``But the securitization markets broke down last summer after investors suffered steep losses on these investments. So banks and other finance companies can no longer shift loans off their books easily, throttling their ability to lend.

``The result has been a drastic contraction of the amount of credit available throughout the economy. By one estimate, as much as $1.9 trillion of lending capacity — the rough equivalent of half of all the money borrowed by businesses and consumers in 2007, before the recession struck — has been sucked out of the system.

The Proposed Solution…

``The Obama administration hopes to jump-start this crucial machinery by effectively subsidizing the profits of big private investment firms in the bond markets. The Treasury Department and the Federal Reserve plan to spend as much as $1 trillion to provide low-cost loans and guarantees to hedge funds and private equity firms that buy securities backed by consumer and business loans.

``The Fed is expected to start the first phase of the program, which will provide $200 billion in loans to investors, in early March.

``But analysts question whether this approach will be enough to unlock the credit that the economy needs to pull out of a deepening recession. Some worry it may benefit only select investors at taxpayer expense.

``The program also does not try to change securitization practices that, many investors say, spread risks throughout the world and destroyed financial institutions. Policy makers acknowledge that for now, fixing credit ratings, reducing conflicts of interest and improving disclosure can wait.”

My comments:

-This exactly is how crony capitalism takes root. Political dispensation from economic rent results to skewed incentives and bureaucratic corruption even without the guaranteed normalization of the credit process. The end result would be more inefficiencies in the ecosystem.

-Spending $1 trillion to the US economy won’t be inflationary?

``The very high inflationary trend that the country has been experiencing in the recent years is a direct result of, among other factors, massive money printing to finance government expenditures and government deficits.

That’s the observation of Albert Makochekanwa of the Department of Economics of the University of Pretoria, South Africa on Zimbabwe’s hyperinflation model (as previously discussed in Will Debt Deflation Lead To A Deflationary Environment? and in Low Hyperinflation Risk For the US?).

In short, the restoration of the credit process isn't a sine qua non for inflation to be reignited, all it needs is massive money printing and subsequent government spending-the Dr. Gono approach. And Obama's policies seem to be taking us there.