Friday, April 30, 2010

In Spain, Pop Goes The Magic 'Green' Bubble

ONE of the likely casualty from the Greece led PIIGS debt crisis seems to be "Green" energy.

From Businessweek,

``Spain is lancing an 18 billion-euro ($24 billion) investment bubble in solar energy that has boosted public liabilities, choking off new projects as it works to cut power prices and insulate itself from Greece’s debt crisis...

"Spain is battling on several fronts to revive its economy and convince government bondholders it can avoid getting dragged into a Greek-style debt spiral after Standard & Poor’s cut its credit rating April 28. Solar-plant owners including General Electric Co. earn about 12 times what’s paid for power from fossil fuels. Most of that is a subsidy charged to customers

``Prime Minister Jose Luis Rodriguez Zapatero’s government last cut solar rates in 2008, hitting plants not built at the time. Now it’s weighing reductions for the thousands of installations already making power from the sun, wind and biomass.

‘Excessive Subsidy’

“This is necessary,” said Leon Benelbas, chairman of Atlas Capital Close Brothers investment bank in Madrid. “It’s an excessive subsidy at a time Spain has to gain competitiveness, and the cost of energy is a determining factor.”

``Spain’s fixed-price system for renewable power, which attracted more investment in solar panels in 2008 than the rest of the world put together, boosts the state’s liabilities even though they don’t show up on its balance sheet.

``That’s because the Spanish system delays payments by consumers for part of their electric bills for years. The government guarantees repayment to power suppliers such as Endesa SA and Gas Natural SDG SA. The cost of those unpaid bills rose last year by about 4 billion euros to 16 billion euros.

``Spain intends to revise the clean-energy rates down “to avoid damaging the competitiveness of industry,” Sebastian told the Spanish parliament yesterday."

This only shows that industries that cannot stand on its two feet, that can't compete, but survives mainly on government mandates and subsidies (or crutches), will be subjected to politics and this includes suffering from cuts in spending or support when austerity is required, especially in response to a crisis.

And the impracticality or non-feasibility would be eventually revealed from such retrenchment. In short, "the emperor has no clothes!"

Yet, "green energy" hasn't been proven to be a net positive contributor to the economy.

George Will comments on a study by Professor Calzada on Spain's alternative energy programs,

``Calzada says Spain's torrential spending -- no other nation has so aggressively supported production of electricity from renewable sources -- on wind farms and other forms of alternative energy has indeed created jobs. But Calzada's report concludes that they often are temporary and have received $752,000 to $800,000 each in subsidies -- wind industry jobs cost even more, $1.4 million each. And each new job entails the loss of 2.2 other jobs that are either lost or not created in other industries because of the political allocation -- sub-optimum in terms of economic efficiency -- of capital. (European media regularly report "eco-corruption" leaving a "footprint of sleaze" -- gaming the subsidy systems, profiteering from land sales for wind farms, etc.) Calzada says the creation of jobs in alternative energy has subtracted about 110,000 jobs elsewhere in Spain's economy."

Overall, like typical bubbles, resources spent on these government pet projects only means waste.

Thursday, April 29, 2010

Iceland's Eyjafjallajokull Volcanic Eruption In Pictures

Fantastic photographs from the recent volcanic eruption of Iceland's Eyjafjallajokull.

Find more pictures in's The Big Picture (click on the link)

Axel Merk On Greece: Political Resolve Needed On The Greece Crisis

Last night while I was scanning the TV, I came across and watched Bloomberg's Mark Crumpton's interview of Axel Merk President of Merk Mutual funds, whose insights are relevant to the ongoing concerns over Greece and the PIIGs

I scoured the internet and found the video (see below)...

Some notes:

-Spain is not a short term debt problem but very different structural issues (economic problem)

-This is not a monetary question, this is a political question. Is there political will to resolve Greece’s problem?

-would require policy measures that have teeth (to implement against Greece's profligacy)

-sovereign debt is a global issue

-there will be more sovereign downgrades outside the Eurozone.

-Collateral rules will be relaxed

-Any bailout should include Greek Banks.

-We like the Euro, others are fully priced.

-Euro is priced at an "end of the world scenario"

Graphic: Central Planning

Below is an example of how central planning looks like. (hat tip: Russ Roberts)

It's a powerpoint presentation which attempts to define the conditions in Afghanistan

Try figuring it out.

As a military official commented,

"'When we understand that slide, we'll have won the war,' General Stanley McChrystal, the US and NATO force commander, remarked wryly when confronted by the sprawling spaghetti diagram in a briefing."

Just goes to show of the impossibility of comprehending every bit of information in a constantly changing world.

As F.A. Hayek once wrote, "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

Tuesday, April 27, 2010

Key Drivers To Emerging Market Outperformance: Increasing Trends of Economic Freedom, Trade Openness And Rule of Law

US Global Investor's Frank Holmes enumerates six key drivers in favor of a secular emerging markets outperformance over the coming years.

Mr. Holmes writes(black bold highlights his, blue mine) :
  1. Rapid Economic Growth: In the coming years, growth in emerging economies is expected to outpace that of the developed world. This growth is fueling an increase in household income in places like China and India where nearly 60 million people—roughly the combined populations of Texas and California—are joining the ranks of the middle class each year.
  2. High Savings Rates in Asia: Despite rising consumption, households in emerging Asia save 17 percent of disposable income—that’s roughly four times what is saved in the U.S. and much higher than the developed world. These high savings rates allow them to meet the higher requirements for home ownership—many require at least 20 percent down—and have larger amounts of funds to invest in capital markets.
  3. Urbanization: The world’s urban population is growing by more than 70 million people each year. China already has over 100 cities with 1 million people and is expected to have over 200 of them by 2025. This urban migration has overwhelmed existing infrastructure like roads, sewers and electrical grids. The buildout of this critical infrastructure will require vast amounts of copper, steel and increase demand for all commodities.
  4. Desire for Social Stability: One main goal of emerging market governments to remain in power is to keep the public happy. They are doing this by increasing personal freedoms for citizens and providing them with opportunities to increase their quality of life. Many governments have found the key to social stability is focusing on job creation which establishes a path of upward mobility for citizens.
  5. Natural Resources Wealth: Many of today’s most promising emerging nations sit atop some of the largest oil, metal and other valuable resource deposits in the world. Many of these nations have teamed up with private and/or foreign enterprises to bring these resources to market. Revenue generated through taxation and direct ownership allows for these governments to build infrastructure, create jobs and pursue other economic opportunities.
  6. Corporate Transparency: A history of corruption and political turmoil has given way to higher standards of corporate governance in today’s globalized world. Though still far from perfect, the improved transparency and oversight has made important information available to investors and reduced uncertainty. By aligning themselves with international business standards and requirements, emerging nations will attract more foreign capital and better integrate themselves into the global marketplace.
I'd like to add three more important variables.

Although Mr. Holmes did mention in passing about the increasing "personal freedom", it must be emphasized that the respect for property rights serves as the root for economic freedom and trade openness which predominates all the above.

Not to mention the legal "rule of law" framework that underpins social institutions from which all these would be operating on.

In short, prosperity or capital accumulation emanates from economic freedom, trade openness and the rule of law, where all the others are simply offshoots or products of these 'sine qua non' underlying drivers.

Outside the incentives brought about by privatize profits and socialize losses, no rational person will invest in any country or markets where they see great risk from governments' arbitrary confiscation of investor's risk capital.

In other words, it isn't much of the issue of return on investments but the return OF investments.

As you can see below, the reason for the explosive growth in emerging markets has been because of the deepening depth of economic freedom and freer trade relative to the past.

chart courtesy of Moody's/ FT Alphaville

While Moody's expects a retreat, as the reason for the orange dot (arrow from FT Alphaville) I don't share the pessimism.

That's because many, among the emerging markets, have been realizing the benefits of trade, which has started to filter into the political process of many EM countries but whose impact comes at a different scale.

Yet much of the perceived pessimism has been due to the financial crisis which caused a dramatic retrenchment in global trade.

But this seems more of a the blip, though. Most of the disruption had been triggered by the Lehman event, which prompted for a near seizure of the US banking industry, which rapidly escalated across the world. To be sure, it hasn't been due to increased signs of protectionism (as pointed out in this space, example see WTO: Little Signs Of Protectionism).

And the swift recovery in global trade (chart courtesy of finfacts) appears to validate our analysis.

Hence, the trend towards greater economic freedom and trade liberalization in key emerging markets are likely to resume as the main trend and provide the framework as to why emerging markets are likely to outperform developed markets.

Failed Predictions From Enviromental Gloom-Mongers

One of the fundamental errors of mainstream analytics is that it focuses mainly on the interpretation of available information from the present angle. It hardly, in layman terms, “put oneself in the shoes” of those who saw it earlier based on their existing knowledge or conditions.

For instance, environmentalism has long been one aspect of a social concern. While the basics (or even the politics) of environmentalism today and the past are the same, the “issues of the day” have been different. And as events are developing, the alarmist concerns of the past are being repeated today.

Yet, these predictions have been utterly wrong.

Some examples from (hat tip Cafe Hayek)

Here are some of the hilarious, spectacularly wrong predictions made on the occasion of Earth Day 1970.

“We have about five more years at the outside to do something.”
• Kenneth Watt, ecologist

“Civilization will end within 15 or 30 years unless immediate action is taken against problems facing mankind.”
• George Wald, Harvard Biologist

We are in an environmental crisis which threatens the survival of this nation, and of the world as a suitable place of human habitation.”
• Barry Commoner, Washington University biologist

“Man must stop pollution and conserve his resources, not merely to enhance existence but to save the race from intolerable deterioration and possible extinction.”
• New York Times editorial, the day after the first Earth Day

“Population will inevitably and completely outstrip whatever small increases in food supplies we make. The death rate will increase until at least 100-200 million people per year will be starving to death during the next ten years.”
• Paul Ehrlich, Stanford University biologist

“By…[1975] some experts feel that food shortages will have escalated the present level of world hunger and starvation into famines of unbelievable proportions. Other experts, more optimistic, think the ultimate food-population collision will not occur until the decade of the 1980s.”
• Paul Ehrlich, Stanford University biologist

“It is already too late to avoid mass starvation.”
• Denis Hayes, chief organizer for Earth Day

“Demographers agree almost unanimously on the following grim timetable: by 1975 widespread famines will begin in India; these will spread by 1990 to include all of India, Pakistan, China and the Near East, Africa. By the year 2000, or conceivably sooner, South and Central America will exist under famine conditions….By the year 2000, thirty years from now, the entire world, with the exception of Western Europe, North America, and Australia, will be in famine.”
• Peter Gunter, professor, North Texas State University

“Scientists have solid experimental and theoretical evidence to support…the following predictions: In a decade, urban dwellers will have to wear gas masks to survive air pollution…by 1985 air pollution will have reduced the amount of sunlight reaching earth by one half….”
• Life Magazine, January 1970

“At the present rate of nitrogen buildup, it’s only a matter of time before light will be filtered out of the atmosphere and none of our land will be usable.”
• Kenneth Watt, Ecologist

“Air pollution…is certainly going to take hundreds of thousands of lives in the next few years alone.”
• Paul Ehrlich, Stanford University biologist

“We are prospecting for the very last of our resources and using up the nonrenewable things many times faster than we are finding new ones.”
• Martin Litton, Sierra Club director

“By the year 2000, if present trends continue, we will be using up crude oil at such a rate…that there won’t be any more crude oil. You’ll drive up to the pump and say, `Fill ‘er up, buddy,’ and he’ll say, `I am very sorry, there isn’t any.’”
• Kenneth Watt, Ecologist

“Dr. S. Dillon Ripley, secretary of the Smithsonian Institute, believes that in 25 years, somewhere between 75 and 80 percent of all the species of living animals will be extinct.”
• Sen. Gaylord Nelson

“The world has been chilling sharply for about twenty years. If present trends continue, the world will be about four degrees colder for the global mean temperature in 1990, but eleven degrees colder in the year 2000. This is about twice what it would take to put us into an ice age.”
• Kenneth Watt, Ecologist

Moral: Realize that the predictions before have been wrong, and today’s alarmism is likely to reflect on the same shortcomings. Don’t fall into the environmental politics trap.

Monday, April 26, 2010

Are We Seguing Into The Next Phase Of The Bubble Cycle?

There's been some discussions about the increasing participation of US commercial banks in the longer end of the US sovereign market.

This suggest that some of the excess reserves could now be "leaking out".

Taking a glimpse at the chart from the St. Louis Fed, I'm not sure that such "leakage" into the 10-year and 30 year treasuries has really been occurring as bank reserves remain high.

Instead the prospective seepage could likely occur elsewhere.

As seen above, there's been a recovery in commercial and industrial loans for large commercial banks, but this hasn't been true yet for all banks.

However, surprisingly, consumer loans at all commercial banks have spiked! (hat tip: Mark Perry)

And as we have repeatedly noted in this space, [e.g. see A Sweet Vindication And Validation As The Phisix Soar To A 25 Month High!], we expect the leakage to turn into a flood as global market responds to the incentives brought about by the steep yield curve.

"And as the report says, the hoarded liquidity in the US banking system is starting to find some leakage, as short term money market funds are regaining more confidence or “animal spirits” to redeploy cash into other asset markets in search of higher returns.

"And once this seepage turns into a flood, that’s where we should start to worry. But this should take more time, and possibly, based on the cyclical effect of yield curves, inflationary pressures is likely to be more apparent by the last quarter of the year."

Could this be the start of the next phase of the current bubble cycle?

Mainstream’s Three “Wise” Monkey Solution To Social Problems

Say what you want
Say what you will
'Cos I find you think what makes it easier
And lies spread on lies
We don't care
Belief is our relief
We don't care

-Roland Orzabal, Tears For Fears, Ideas As Opiates

For the mainstream, our social problems can be simplified into three “wise monkey” solutions:

First, speak no evil-throw money at every problem.

Everyone desires a free lunch. Almost everybody believes that they deserve a special place in this world. Since society’s interests are divergent, such sense of entitlement should come at the expense of someone else. It’s usually dignified and justified with the word “right”. One man’s effort is another man’s privilege.

For them, scarcity of resources can only solved by forcible redistribution. It doesn’t really matter if there are limitations to the scale of taxation. It also doesn’t matter if redistribution reduces the incentives to produce and trade. It doesn’t matter if “picking winners” takes away resources meant for productive activities which have been meant to enhance livelihood. The only thing significant is to be at the receiving end. And it’s hardly ever been asked “when is enough, enough”?

Heck, it would even be politically incorrect to argue for prudence. ‘Moral’ justifications demand for immediate gratification. It’s almost always about NOW. Forget the future.

That’s why the intellectual classes long came up with varied theories in support of these political demands.

Importantly that’s why the political classes are enamoured with these concepts. Redistribution enhances only their power, esteem and control over the others. And that’s why “inflation” has long been a part of human nature, since the introduction of government.

For as long as the system is tolerant of such nebulous tradeoff, trouble can be kept at bay, ergo speak no evil.

The other way to see it is that while everyone wants to rule the world, in reality this isn’t feasible. It’s a mass delusion. The universal law of scarcity always prevails. By force of nature, artificially induced imbalances are resolved eventually.

Second, see no evil-elect or put in place a virtuous leader.

The popular redress to most social problems has been premised mostly on hope, cosmetically embellished by “specific” ennobling goals.

In times of frustrations, the next alternative has been to look for a saviour.

Yet hope is mostly anchored on symbolism. And these are what elections are mostly all about. Even if one’s vote doesn’t truly count, everybody believes they do. Elections are reduced to the polemic of self-import.

Hardly has the directions of policies been the context of any meaningful discussion. People’s arguments will always be simplified to what seems “moral” in the popular sense. Yet, a vote on a person to office is a carte blanche vote on the ensuing policies. But it’s hardly about stakes involved and the prospective costs, but mostly about emotions and the feeling of being in the winning camp.

And since the world has been condensed into strictly a “moral” sphere, political leaders are most frequently deemed to have been transformed into demigods.

Once in power, people mistakenly believe that these entities have transcended the laws of scarcity. People have assumed that they possess the superlative knowledge that is needed to effect the exigent balance on a complex and continuously evolving society. These leaders are presumed to know of our needs, our values, our priorities and our preferences, which lay as basis of our actions in response to ever changing conditions.

Not of only of knowledge, but people also expect leaders and officials to dispense justice and equity according to our sense of definition. Many see these leaders as reflecting on their values. And that’s why many fall for the dichotomous trappings of the well meaning “motivations”. Yet, motivations barely distinguish the role of “means” and “ends”.

Essentially genuflecting on hope to see one’s moral desires as represented by politics can be construed as refusing to see evil for what it is.

And it’s only when the rubber meets the road, from which people come to realize that their expectations have misaligned with reality-and usually through deepening frustrations or in the aftermath of some horrifying outcome.

Hardly has it been comprehended that politics and bureaucratic activities are merely HUMAN activities.

That leaders and officials are subject to the very same foibles as anyone else. That these people see things and act according to the incentives brought about by their interpretation of events, their existing limited and ‘biased’ knowledge and are swayed by influences brought about by cognitive biases, networks, familiarity, assessment of prevailing conditions, information relayed by the underlings, varying degree of stakes of involved and et. al.

Importantly like everyone else, their actions skewed based on personal values. So when a political or bureaucratic leader forces upon their sense of moral vision to a constituency and which has not well received, the result in some cases has been political upheavals.

Yet in spite of the repeated errors, people never learn from George Santayana’s admonition that those who ignore the past are condemned to repeat it.

The third intuitive recourse to any social problems is to hear no evil by enacting new rules/laws.

Like any “throw the money” and “virtuous leader” syndromes, rules are little seen for its costs but nevertheless oftenly envisaged as preferred nostrums to existing problems as identified from the biased viewpoint of the observer/s.

Causal factors are hardly considered in the appraisal of the existing problems. What seems more important is to automatically blame market forces and unduly impose proscriptions. Never mind if the past ills have been caused by the same underlying dynamic-previous interventionism.

The act of simply “doing something” is meant to be perceptibly seen by the voting public for political purposes (extension of career by vote or by appointment). Thus the “hear no evil” therapy, which is merely adding rules for extant fallibilities, are simply props for more of the same malaise.

Many rules, regulations, edicts or laws are imposed upon the “populist demand of the moment”, without the realization that rules, which tend to realign people’s behaviour, can cause huge unintended consequences and likewise entails costs of enforcement. Hence when new rules create distortions in the political economic order, the instinctive response is to have more of rules or regulations.

Importantly, popular clamor for new rules/laws hardly differentiates “rule of laws” against “rule of men”.

Rule of Law are in effect, the guiding principles or the laws that had been a legacy from our forefathers, as the great Friedrich August von Hayek wrote, ``Political wisdom, dearly bought by the bitter experience of generations, is often lost through the gradual change in the meaning of the words which express its maxims[1]”. (underscore mine)

This means because these laws have been constant, are anticipated by all and easily observed or practiced, they become part of our heritage. Again we quote the Mr. Hayek, ``Stripped of all technicalities, this means that government in all its actions is bound by rules fixed and announced beforehand.[2]

In stateless Somalia, customary laws serve as default laws after her government had been eviscerated,

Benjamin Powell writes[3], ``Somali law is based on custom interpreted and enforced by decentralized clan networks. The Somali customary law, Xeer, has existed since pre-colonial times and continued to operate under colonial rule. The Somali nation-state tried to replace the Xeer with government legislation and enforcement. However, in rural areas and border regions where the Somali government lacked firm control, people continued to apply the common law. When the Somali state collapsed, much of the population returned to their traditional legal system... But Somalia does demonstrate that a reasonable level of law and order can be provided by nonstate customary legal systems and that such systems are capable of providing some basis for economic development. This is particularly true when the alternative is not a limited government but instead a particularly brutal and repressive government such as Somalia had and is likely to have again if a government is reestablished.” [bold highlights mine]

That’s simply proof that “rule of laws” exists even outside of the realm of governments, which also goes to show that society can exist stateless. None of this is meant to say that we should be stateless, but the point is rule of law is what organizes society.

Importantly, “rules of law” have been passed through the ages as a means to protect the citizens from the abuses of the authority, again Mr. Hayek[4],

``The main point is that, in the use of its coercive powers, the discretion of the authorities should be so strictly bound by laws laid down beforehand that the individual can foresee with fair certainty how these powers will be used in particular instances; and that the laws themselves are truly general and create no privileges for class or person because they are made in view of their long-run effects and therefore in necessary ignorance of who will be the particular individuals who will be benefited or harmed by them. That the law should be an instrument to be used by the individuals for their ends and not an instrument used upon the people by the legislators is the ultimate meaning of the Rule of Law.” (emphasis added)

In short, the fundamental characteristics of respected and effective laws are those that to limited, steady or constant, designed for the benefit of everyone and importantly a law that is clearly enforceable.

Of course this doesn’t overrule the occasional use of arbitrary laws, but nevertheless arbitrary rules should compliment and NOT displace the essence of the “rule of law”.

Mr. Hayek quotes David Hume[5], ``No government, at that time, appeared in the world, nor is perhaps found in the records of any history, which subsisted without a mixture of some arbitrary authority, committed to some magistrate; and it might reasonably, beforehand, appear doubtful whether human society could ever arrive at that state of perfection, as to support itself with no other control, than the general and rigid maxims of law and equity.”

In essence, in contrast to mainstream thinking, the rule of law and not simply arbitrary regulations, serves as the central element to well functioning societies.

Former President Ronald Reagan nicely captures part of our “Three Wise Monkey” solution as seen by the mainstream, “The government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it”, from which I would add, “if subsidies are not enough, elect one who makes sure it would”.

[1] Hayek, Friedrich August von, Decline of the Rule of Law, Part 1, The Freeman April 20, 1953

[2] Hayek, Friedrich August von, Decline of the Rule of Law, Part 1, The Freeman April 20, 1953

[3] Powell, Benjamin; Somalia: Failed State, Economic Success? The Freeman

[4] Hayek, Friedrich August von, The Road To Serfdom

[5] Hume, David; The history of England, from the invasion of Julius Caesar to the revolution, we earlier quoted this see Graphic: Origin of The Rule of Law

Markets Ignore US SEC-Goldman Sachs Tiff, More Political Dirty Dancing

``Popular opinion ascribes all these evils to the capitalistic system. As a remedy for the undesirable effects of interventionism they ask for still more interventionism. They blame capitalism for the effects of the actions of governments which pursue an anti-capitalistic policy.” Ludwig von Mises, Interventionism an Economic analysis

Adding more arbitrary laws or “regulations”, which are usually founded upon noble goals, have been used as the main pretext for expanding political power by the incumbents.

This unfortunately is what people refuse to see yet has been a critical cause of much of today’s ills.

For the political economy, regulations can unilaterally skew the distribution of power from the ruled to the ruler. If there is such a thing as “income or wealth” inequality, the obverse side is the “political inequality”.

Professor Lawrence White[1] on the difference of rule of law and rule of men, ``The contrast between the rule of law and the rule of men is sometimes traced still further back to Plato’s dialogue entitled Laws. In that work the Athenian Stranger declares that a city will enjoy safety and other benefits of the gods where the law “is despot over the rulers, and the rulers are slaves of the law”. In other words, government officials are to be the servants and not the masters of society. The rule of law is vitally important because it allows a society to combine freedom, justice, and a thriving economic order.”

When government officials elect to end up as “masters of society”, one of the main acts to attain such goals is to deliberately trample upon with laws of the land to allow laws to work to their favor.

In short, despots legitimize their power grab by coercively instituting their own set of laws. The Philippines is no stranger to this as seen through former President Ferdinand Marcos’ proclamation 1081, ``Marcos ruled by military power through martial law, altered the 1935 Constitution of the Philippines in the subsequent year, made himself both Head of State as President and Head of Government as Prime Minister, manipulated elections and the political arena in the Philippines, and had his political party--Kilusang Bagong Lipunan (KBL) (English: New Society Movement) control the unicameral legislative branch of government called the "Batasang Pambansa". All these allowed Marcos to remain in power and to plunder.[2]

And since the manipulation of laws tends to rearrange the political economic order according to the whims of those in power by restraining civil liberties and economic freedom, ergo, the benefits or privileges will be partial to those within the ambit of the administration.

Said differently instead of having resources distributed through the marketplace, resources will be allocated politically in accordance to the order of importance as seen by the authorities. Nevertheless when the concentration of power is left to a few to decide, then price signals will be distorted and that lobbying, favouritism, corruption and cronyism will be her common feature.

The Phony War Against The “Cockroaches”

So what has these to do with the current state of the markets?


The emergence of proposed regulatory reforms by the Obama administration for Wall Street comes timely with the US SEC-Goldman Sachs brouhaha.

Aside from the noteworthy coincidence[3], the US markets appears to be validating our view by ignoring the impact of the US SEC-Goldman tiff (see figure 1).

Figure 1: Political Act Slowly Unraveling

In contrast to the camp that sees the Goldman controversy as an issue of fraud, by looking at the incentives that drives the actions of political authorities, we have argued otherwise[4].

Besides, it is not within our ambit to comment on juridical merits of any legal case and neither are those who claim that it is about ‘fraud’. Commenting on the legal aspects based on news accounts signifies nothing but “trial by publicity”.

If Goldman had been truly a “cockroach”, then there must be other cockroaches too from which the sudden apostasy of the Obama administration must mean a total “war on cockroaches”.

And true enough, we find that Goldman’s practice hasn’t been isolated but an industry practice especially among the TOO BIG TO FAIL institutions.

According to the New York Times[5], ``Many banks on Wall Street and in Europe were even bigger players in the types of complex investment deals that Goldman is now defending. Merrill Lynch was at the top of the heap, assembling $16.8 billion worth between 2005 and 2008, according to a new report by Credit Suisse.

``UBS put together $15.8 billion worth of similar products, according to the Credit Suisse estimates, while JPMorgan Chase and Citigroup each created more than $9 billion worth. Goldman Sachs was a comparatively small issuer, at $2.2 billion.”

Yet if one looks at the market, except for Goldman Sachs (GS), the SPDR Financial Select Sector (XLF) [where JP Morgan, Citigroup, Merrill and GS is 24.3% of index weighting] and the S&P Bank Index (BIX) has simply shrugged off any “contagion” against a so-called “war on cockroaches”.

Noticeably, the broad based US markets as shown by the S&P 500 (SPX), which includes the Dow Industrials, the Nasdaq and the mid cap Russell 2000 all went to a bullish rampage by breaking to the upside as of Friday’s close.

Oddly too that the so-called aggrieved party in the controversial case was also reported as practicing the same allegedly skulduggery employed by Goldman, this from John Carney[6],

``It was a piece of regulatory arbitrage: In essence, IKB was investing in complex mortgage bonds without having to set aside regulatory capital or report the increase in risky assets to its regulators or auditors.”

``In short order, Rhineland became one of the biggest buyers of the complex investment products puked out by the likes of Lippman at Deutsche Bank, JP Morgan Chase—and Goldman. One banker told Euroweek that IKB—through Rhineland and similar tactics—had become one of the five or six largest investors in Europe. Thus, Goldman found them a willing buyer for the junk piled into Abacus” (underscore mine)

Take note of the word: regulatory arbitrage.(as we will be using this later)

More Dirty Dancing Politics

As the days go by, more and more Goldman-Washington ties are being uncovered.

In contrast to common knowledge that the Democratic Party has been less affiliated with Wall Street, this is turning out to be untrue, according to the Politico, ``The Democratic Party is closer to corporate America — and to Wall Street in particular — than many Democrats would care to admit.” A chart from the New York Times can be seen here.

Moreover, we discovered that there are five former employees of Goldman currently employed in the Obama administration. This perhaps reveals the extent of connection between the two supposed rivals.

In addition, the timing of Friday’s government lawsuit likewise coincided with SEC’s report about its “failure to
investigate alleged fraudster R. Allen Stanford”[7]. This may seem like an effort to possibly dampen media’s impact from regulatory failure by exposing a much bigger news. Apparently this succeeded.

And speaking of regulatory competence, one cannot help but guffaw at news reports where 33 SEC employees, including high ranking officials, spent much time during the crisis in porno browsing!

According to the NY Daily News[8], ``The shocking findings include Securities and Exchange Commission senior staffers using government computers to browse for booty and an accountant who tried to access the raunchy sites 16,000 times in one month.”

Perhaps, Madoff, Standford and Goldman people were trying to arbitrage falling markets with “porno” finance-whatever that means. This resonates clearly of the quality of the bureaucratic mindset.

Moreover, there have been pressures for Goldman to amicably settle with the SEC even if “they’re right on the merits of the case”[9].

And surprisingly, President Obama despite earlier reports to verbally assail Wall Street turned up with a conciliatory voice at a recent speech ``Ultimately, there is no dividing line between Main Street and Wall Street,” Obama said in his speech at Cooper Union, about two miles from the financial district. “We will rise or we will fall together as one nation.”[10]

We read a popular American blogger offer a bet against anyone who thinks Goldman will win the suit. Apparently this perspective is looking at the wrong issue.

Goldman can lose a case and still win the war. In the game of chess, this is called sacrifice or even queen sacrifice. Yet in a staged or scripted dispute, like in wrestling, one party’s loss is just a part of drama to fulfil other goals. A real life example of a staged battle is the US-Spanish “Battle of Manila”[11].

History As Guide To Future Actions

Let us put the issue in historical context.

Rightly or wrongly banks and financial institutions have been in the public “hot seat” from nearly time immemorial[12]. But in contrast to having reduced power from financial reforms, the banking system had even acquired more political clout in spite of these. The Federal Reserve was even stealthily hatched amidst scepticism over the banking industry.

Here is G. Edward Griffin’s speech[13], Author of The Creature from Jekyll Island, on the inception of the Federal Reserve (all bold highlights mine),

``Why not? why the secrecy? what's the big deal about a group of bankers getting together in private and talking about banking or even banking legislation. And the answer is provided by Vanderlip [Frank Vanderlip president of the National City Bank of New York] himself in the same article. He said: "If it were to be exposed publicly that our particular group had gotten together and written a banking bill, that bill would have no chance whatever of passage by Congress." Why not? Because the purpose of the bill was to break the grip of the money trust and it was written by the money trust. And had that fact been known at the get-go, we would never have had a Federal Reserve System because as Vanderlip said it would have had no chance of passage at all by Congress. So it was essential to keep that whole thing a secret as it has remained a secret even to this day. Not exactly a secret that you couldn't discover because anybody can go to the library and dig this out, but it is certainly not taught in textbooks. We don't know any of this in the official literature from the Federal Reserve System because that was like asking the fox to build the henhouse and install the security system.

``That was the reason for the secrecy at the meeting. Now we know something very important about the Federal Reserve that we didn't know before, but there's much more to it than that. Consider the composition of this group. Here we had the Morgans, the Rockefellers, Kuhn, Loeb & Company, the Rothschilds and the Warburgs. Anything strange about that mixture? These were competitors. These were the major competitors in the field of investment and banking in those days; these were the giants. Prior to this period they were beating their heads against each other, blood all over the battlefield fighting for dominance in the financial markets of the world. Not only in New York but London, Paris and everywhere. And here they are sitting around a table coming to an agreement of some kind. What's going on here? We need to ask a few questions.

``This is extremely significant because it happened precisely at that point in American history where business was undergoing a major and fundamental change in ideology. Prior to this point, American business had been operating under the principles of private enterprise--free enterprise competition is what made American great, what caused it to surpass all of the other nations of the world. Once we had achieved that pinnacle of performance, however, this was the point in history where the shift was going away from competition toward monopoly. This has been described in many textbooks as the dawning of the era of the cartel and this was what was happening. For the fifteen year period prior to the meeting on Jekyll Island, the very investment groups about which we are speaking were coming together more and more and engaging in joint ventures rather than competing with each other. The meeting on Jekyll Island was merely the culmination of that trend where they came together completely and decided not to compete--they formed a cartel.”

In other words, the trend towards consolidation of the industry via “financial reforms” has empowered more cartelization than less. And today’s proposed financial reform bill will enhance and not reduce such relationship in contrast to opinion of the reform advocates.

John Paulson And The Survivorship Bias

I’d like to show the relevance of hedge fund manager John Paulson’s reputation during the latest boom-bust cycle (see figure 2).

Figure 2: Google Trend/Wall Street Journal: John Paulson’s Popularity

As we have earlier argued, the SEC-Goldman dispute is a fait accompli argument (Wall Street seems to agree[14]).

That’s because Mr. Paulson, among the 12,400 hedge funds as reported by during the 3rd quarter of 2007, only shot to fame in early 2008 (left window) after profits in his fund skyrocketed (in mid 2007) which left the field biting his dust (right window).

In most of 2007, John Paulson, like Manny Pacquiao in the early 90s, was relatively an unknown figure (Mr. Paulson has hardly been searched by anyone)! This means that counterparties when appraised of Mr. Paulson’s participation in early 2007 would have simply ignored him as he was just one among the many “mediocre” aspiring hedge fund managers.

This also reveals that many people tend to read and value information based on today’s account and not during the time when the controversial transactions was developed. This cognitive error is known as the survivorship bias, or the ``the logical error of concentrating on the people or things that "survived" some process and ignoring those that didn't[15].”

[1] White, Lawrence Avoiding and Resolving Financial Crises: The Rule of Law or The Rule of Central Bankers?

[2], Proclamation No. 1081

[3] Norris, Floyd, Fortunate Timing Seals a Deal

[4] See Why The US SEC-Goldman Sachs Hoopla Is Likely A Charade

[5] New York Times, Questions for Banks That Put Together Deals

[6] Carney John, Goldman’s Dirty Customers, The Daily Beast

[7] Wall Street Journal, The SEC's Impeccable Timing The Goldman suit helped to hide the IG report on the Stanford debacle.

[8] NY Daily News; While economy crumbled, top financial watchdogs at SEC surfed for porn on Internet: memo

[9] Bloomberg, Goldman Sachs Should Cut Losses in SEC Standoff, Lawyers Say

[10] Bloomberg, Obama Challenges Financial Industry to Join Regulatory Overhaul

[11], The Battle of Manila (1898)

[12]see Quote of the Day on Wall Street: After Nearly A Century, Hardly Any Change

[13]; A Talk by G. Edward Griffin Author of The Creature from Jekyll Island

[14] See SEC-Goldman Sachs Row: The Rising Populist Tide Against Big Government

[15], survivorship bias

Sunday, April 25, 2010

Sand Castles From US Regulatory Reforms

“Any fool can make a rule. And any fool will mind it.” - Henry David Thoreau

Among the popular misconceptions about resolving today’s social and institutional problems is the issue of regulation.

For many (particularly for the left), the recent Financial Crisis had been a product of “free markets” or “market fundamentalism”. This notion is totally absurd.(there can be no pure free market in a world of central banking)

For instance many hold that the repeal of the Glass Steagall Act via the Gramm-Leach Bliley as responsible for today’s crisis.

Economist and Professor Luigi Zingales argues otherwise[1], ``In 1984, the top five U.S. banks controlled only 9% of the total deposits in the banking sector. By 2001, this percentage had increased to 21%, and by the end of 2008, close to 40%. The apex of this process was the 1999 passage of the Gramm-Leach-Bliley Act, which repealed the restrictions imposed by Glass-Steagall. Gramm-Leach-Bliley has been wrongly accused of playing a major role in the current financial crisis; in fact, it had little to nothing to do with it. The major institutions that failed or were bailed out in the last two years were pure investment banks — such as Lehman Brothers, Bear Stearns, and Merrill Lynch — that did not take advantage of the repeal of Glass-Steagall; or they were pure commercial banks, like Wachovia and Washington Mutual. The only exception is Citigroup, which had merged its commercial and investment operations even before the Gramm-Leach-Bliley Act, thanks to a special exemption.” (bold emphasis)

On the other hand, the Community Reinvestment Act (CRA), whose regulations forced financial institutions to accept risky borrowers have also been held responsible.

According to Peter J. Wallison of the American Enterprise Institute[2], ``In 1995, the regulators created new rules that sought to establish objective criteria for determining whether a bank was meeting CRA standards. Examiners no longer had the discretion they once had. For banks, simply proving that they were looking for qualified buyers wasn’t enough. Banks now had to show that they had actually made a requisite number of loans to low- and moderate-income (LMI) borrowers. The new regulations also required the use of “innovative or flexible” lending practices to address credit needs of LMI borrowers and neighborhoods. Thus, a law that was originally intended to encourage banks to use safe and sound practices in lending now required them to be “innovative” and “flexible.” In other words, it called for the relaxation of lending standards, and it was the bank regulators who were expected to enforce these relaxed standards.”

Meanwhile, the Cleveland Fed downplays the role of the CRA in this crisis[3].

There has been “no consensus” as to which of the two laws had truly an adverse impact on the markets. Since there has been no perfect correlation, the ensuing tit-for-tat in the media had been reduced into a debate based on ideological slant.

In addition, we also said that the impact of laws tend to be divergent and ‘time sensitive’, where some laws could have positive interim term effects but with negative long term impact, and vice versa.

As caveat, while correlations may not appear to be outright linear, as the debate above holds; it would be misguided to attribute the lack of correlation to a single variable or to one law considering that there are many other laws or variables that also combine and or compete to expand or diminish the effects of a particular law.

Here the underlying general principles or theory will be more dependable than simply relying on statistics or math. Murray Rothard notes of the observation of John Say in distinguishing these[4],

``Interestingly enough, Say at that early date saw the rise of the statistical and mathematical methods, and rebutted them from what can be described as a praxeological point of view. The difference between political economy and statistics is precisely the difference between political economy (or economic theory) and history. The former is based with certainty on universally observed and acknowledged general principles; therefore, “a perfect knowledge of the principles of political economy may be obtained, inasmuch as all the general facts which compose this science may be discovered.” Upon these “undeniable general facts,” “rigorous deductions” are built, and to that extent political economy “rests upon an immovable foundation.” Statistics, on the other hand, only records the ever changing pattern of particular facts, statistics “like history, being a recital of facts, more or less uncertain and necessarily incomplete.” (underscore mine)

In short, trying to pinpoint the effects of one law based on oversimplified statistics to the political economy can be tricky. And this is where the left has used statistics or math to obfuscate evidences.

More of John Say from Murray Rothbard, ``The study of statistics may gratify curiosity, but it can never be productive of advantage when it does not indicate the origin and consequences of the facts it has collected; and by indicating their origin and consequences, it at once becomes the science of political economy.” (underscore mine)

Regulatory Arbitrage And Fighting The Last War

And as we earlier pointed out to the contrary, where laws are lengthy, ambiguous, partisan and subject to political discretion, they tend to be distortive and create imbalances in the system. And the impact of some of these laws indubitably accentuated the crisis.

Nevertheless there had been some policies or regulations that had relatively more material impact among the others (see figure 3).

Figure 3: Bank of International Settlements: Ingredients of the Crisis

The apodictic evidence from last crisis had been the surfacing of the “shadow banking system” (see right window).

As pointed out earlier above, one of the unintended consequences of bad laws or overregulation is to have regulatory arbitrages, where markets look for regulatory loopholes from which it exploits. These are parallel to the emergence or existence of black markets over economies that operate heavily under price controls[5].

So even the multilateral government agency as the UN via its subsidiary the UNCTAD had to admit this[6], ``Recent United States banking regulations, for example, were designed to control risk through the measured capital ratio used by commercial banks, the report says. This attempt backfired because bank managers circumvented the rules either by hiding risk or by moving some leverage outside the banks. This shift in leverage created a "shadow banking system" which replicated the maturity transformation role of banks while escaping normal bank regulation. At its peak, the US shadow banking system held assets of approximately $16 trillion, about $4 trillion more than regulated deposit-taking banks. While the regulation focused on banks, it was the collapse of the shadow banking system which kick-started the crisis.”

The lesson of which clearly is that politics, no matter how heavy handed, can hardly control the fundamental laws of economics.

Another problem with regulation is that it fights the last war.

For instance during the last bubble, the issue of prominence had been the accounting fraud from Enron, Tyco International, Worldcom, Adelphia and others that gave rise to the Sarbanes-Oxley Act[7].

Obviously, from a hindsight bias the regulation failed to make any headway to stop the recent crisis. Again that’s because markets are dynamic and seizes the next loopholes as opportunity to expand.

Nonetheless some has argued that the Sarbox law itself has been a drag to the recovery of the US. An example is this commentary from Wall Street Journal’s James Freeman[8],

``Is Sarbox to blame? Many financial pundits say no, but the SEC survey results point in the other direction. When public companies are asked whether Section 404 has motivated them to consider going private, a full 70% of smaller firms say yes, and 44% of all public companies also say yes.

``Has Sarbox driven businesses out of the country? Among foreign companies, a majority in the survey say that Section 404 has motivated them to consider de-listing from U.S. exchanges, and a staggering 77% of smaller foreign firms say that the law has motivated them to consider abandoning their American listings.”

In short, another unintended consequence of having more regulation is to raise the cost of compliance.

In a globalized market, investors can arbitrage away regulatory burden or the cost of compliance by simply transferring to where there is less onus or costs.

Yet fighting the last war means attacking past problems which may not be the source of the next crisis.

Another factor that is seemingly ignored is that the leverage, which is now a “prominent” factor, acknowledged by the mainstream seems to be building not in the previous sectors, which suffered from a bust, but instead in government debt.

As in the earlier chart (figure 3 left window) from the speech of Hervé Hannoun[9] Deputy General Manager of the BIS, low interest rates which has allowed for the chasing of yields, low volatility and high risk appetite, were outstanding features of the last crisis. However, practically the same ingredients in the past we are seeing today.

And governments are in a tight fix because, as we have been saying[10], “ governments will opt to sustain low interest rates (even if it means manipulating them-e.g. quantitative easing) as a policy because ``governments through central banks always find low interest rates as an attractive way to finance their spending through borrowing instead of taxation, thereby favor (or would be biased for) extended period of low interest rates”

So governments are operating in a policy paradox.

They pretend to know the main sources of the crisis yet are addicted to it for political reasons. An addict can hardly refuse what’s keeping them going. It’s simply path dependency from what we call as policy “triumphalism”. According to the G-20, ``The global recovery has progressed better than previously anticipated largely due to the G20’s unprecedented and concerted policy effort.”[11]

Again we are being validated.

Agency Problem And Socializing Losses While Privatizing Profits

There is another problematic aspect in regulation; it’s called the agency problem or the principal agent problem.

It’s a problem which emanates from different incentives or goals by those operating within the industry.

For instance during the last crisis, risk monitoring was fundamentally outsourced by risk buyers to the ratings agencies (yes in spite of the army of professionals). On the other hand, originators of risk securities or risk sellers tied fees due the credit ratings agencies on the credit ratings they issued which were then sold to “sophisticated” financial institutions.

Said differently, the job of credit appraisals were delegated to the ratings agencies which incidentally derived its income from the issuers of securities, and not from the buyers. Whereas buyers of securities fully delegated the role of due diligence to the ratings agencies.

So credit risks had been ignored in the assumption that someone else would do it for them. As Charles Calomiris Columbia University recently said in an interview[12], “Agency problem...Ratings agencies were a coordination device for plausible deniability."

Figure 5: The Economist: Reforming Banking

Perhaps the ultimate source of ‘plausible deniability’ comes with attendant with the current structure of the banking system-it’s basically called the fractional reserve based banking platform (see figure 5).

Bank equity as % of assets is now nearly at the lowest level since the introduction of central banking and deposit insurance.

In a BIS paper from Andrew Haldane of the Bank of England[13] writes, ``Over the course of the past 800 years, the terms of trade between the state and the banks have first swung decisively one way and then the other. For the majority of this period, the state was reliant on the deep pockets of the banks to finance periodic fiscal crises. But for at least the past century the pendulum has swung back, with the state often needing to dig deep to keep crisis-prone banks afloat. Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing.”

This means that the banking system’s ability to take more risks comes under the broadening premise of “privatizing profits and socializing losses” as the guiding policy.

This means that aside from central banking, deposit insurance is another means to “privatizing profits and socializing losses” which allows the banking system to absorb more risks, while on the hand tolerates the expansion of regulatory powers by the central bank.

As Murray N. Rothbard wrote[14], `Under a fiat money standard, governments (or their central banks) may obligate themselves to bail out, with increased issues of standard money, any bank or any major bank in distress. In the late nineteenth century, the principle became accepted that the central bank must act as the “lender of last resort,” which will lend money freely to banks threatened with failure.

``Another recent American device to abolish the confidence limitation on bank credit is “deposit insurance,” whereby the government guarantees to furnish paper money to redeem the banks’ demand liabilities. These and similar devices remove the market brakes on rampant credit expansion.”

So moral hazard and the agency problem seem to be significant factors that had been transforming the developed world banking system.

Of course there are other potential sources of regulatory problems, such as economics and behavioural aspects of enforcement, conflicting laws, a multitude of arcane laws which the public can’t comprehend, Arnold Kling’s legamoron (laws that could not stand up under widespread enforcement) and others, but due to time constraints we will be limited to the above.

At the end of the day, those building up the expectations for more regulations as elixir to the current problem would likely fail them. Why? Because there will be a new crisis down the road and hardly any of the current reforms will stop it.

Until they deal with roots of the problem, bubbles like the game called whack-a-mole will keep reappearing. Yet history says that all paper money is bound to go back to its intrinsic value-zero.

[1] Zingales, Luigi Capitalism After the Crisis, National Affairs

[2] Wallison, Peter J. The True Origins of This Financial Crisis, American Spectator

[3] Nelson, Lisa Little Evidence that CRA Caused the Financial Crisis, Cleveland Fed

[4] Rothbard, Murray N. Praxeology as the Method of the Social Sciences

[5] An example of this is North Korea, which recently massively devalued her currency to fight the black markets. But unlike before where policies where met with passive resistance, riots broke out from which tempered Kim’s political approach. See Will North Korea's Version Of The 'Berlin Wall' Fall In 2010?

[6] UNCTAD, Shadow banking system that escaped regulation, faith in ´wisdom´ of markets led to meltdown, study says

[7], Sarbanes-Oxley

[8] Freeman, James The Supreme Case Against Sarbanes-Oxley, Wall Street Journal

[9] Hannoun, HervĂ© Financial deepening without financial excesses, Bank of International Settlements, 43rd SEACEN Governors’ Conference, Jakarta

[10] See How Myths As Market Guide Can Lead To Catastrophe

[11] Wall Street Journal Blog, Text Of G-20 Finance Ministers, Central Bankers’ Statement

[12] Calomiris Charles, Econolog David Henderson: Calomiris on the Financial Crisis

[13] Haldane, Andrew Banking on the state Bank Of International Settlements

[14] Rothbard, Murray N., The Economics of Violent Intervention, Man, Economy and State