Monday, May 31, 2010

Venezuela's Stagflation In Graphs

In yesterday's post Why The Current Market Volatility Does Not Imply A Repeat Of 2008, I made many references to Venezuela as example.

Here are some revealing charts...(except for the Bolivar money base all the rest are from

Venezuela's deep recession

The crashing bolivar!

surging inflation!

caused by massive money printing!
yet a soaring stock market!

While Venezuela is clearly in a stagflation phase there seems to be a big possibility that these would transmogrify into a hyperinflation, which I think could occur anytime within the next 3 years, given the current pace by which Mr. Chavez seems to be financing his conversion of Venezuela into a socialist nation.

Jonathan Finegold Catalan at dwells deeper into the Venezuelan disease.

Here is an excerpt,

``By printing money, Venezuela's central bank and government are not creating capital, they are only funding their ability to bid it away from the private sector and squander it on uneconomical public programs. Imagine the average Venezuelan who receives nothing but a currency that is consistently falling in value in exchange for his resources. Simultaneously, his savings are confiscated, because they are progressively worth less in the face of rising prices. How can anybody consider this a basis for a rise in wealth?

``In Venezuela, entrepreneurship is condoned when it doesn't interfere with the plans of Hugo Chavez. Unsurprisingly, entrepreneurs in the utility industries are not part of Chavez's plans, and as such the Venezuelan utility market has been almost completely nationalized. While prior to the recent global depression Chavez stuck to nationalizing certain sectors at a relatively slow (yet steady) pace, the onset of global crisis accelerated the socialization of Venezuela's economy. Indeed, few foreign-owned oil companies were left untouched after Chavez decided to solve his debt problem by simply taking over those businesses he owed money to.

``Other key industries nationalized include the telecommunication and electrical markets. Admittedly, Chavez's nationalizations did not consist solely of expropriating the property of others for the benefit of the "people of Venezuela." Like any good politician, Chavez pandered to big business, offering two Spanish electrical companies, Iberdrola and Elecnor, a total of nearly two billion dollars to build a 1000Mw electrical plant in the city of Cumaná, in eastern Venezuela. The average construction cost for the specific type of plant being built was $0.75 a watt. Chavez paid Iberdrola and Elecnor $2 a watt."

Read the rest here

Financialization of Commodities: Boon Or Bane?

A Wall Street report recently highlighted on the "financialization of commodities" or the increasing role of commodities being used as investment assets.

They cite a study from Ke Tang at Renmin University in China and Wei Xiong at Princeton University which showed of the growing correlation between prices of commodities with stocks and the US dollar. Mr. Tang and Mr. Xiong writes,

``We find that concurrent with the growth of index investment, commodity prices have become increasingly correlated with the world equity index and US dollar exchange rate, and with oil. In particular, this trend is more pronounced for commodities in the two popular commodity indices, the GSCI 25 and DJ-UBS indices. As a result of the financialization process, the spillover effects of the recent financial crisis contributed to a substantial part of the large increase of commodity price volatility in 2008."

In addition, this has been used by some to cast a bearish light on commodities price trends.

Analyst Simon Hunt is bearish on copper, ``This economic scenario is not conducive to a strong trend growth in world copper consumption let alone to its declining intensity of use, a result of high and volatile copper prices. Moreover, copper’s end users, together with their fabricators, are fully aware that prices have not been driven by real fundamentals, but by the growing intrusion of the financial sector into treating copper, as for other base metals, as an alternative investment." (bold highlight mine)

Well in my view, financialization of commodities isn't a reason to be bearish.

This reflects on the deepening of capital markets in search of higher yield from relative returns, it also signifies the market process of discovering alternative havens or 'store of value' from inflationism and even possibly 'commodity as assets' could also function as sanctuary from numerous regulations.

Besides, commodities plays a minor role (.47%) in the $615 trillion derivatives [from the Bank of International Settlements] market largely dominated by interest rates (73.17%) and followed by foreign exchange (8%) and credit default swaps (5.32%). To consider that even weather plays a role in the derivatives market today as part of the growing sophistication of financial risk management.

Importantly, one mustn't forget that commodities once played the role of money, as Murray Rothbard wrote in Man, Economy and the State,

``Money is a commodity that serves as a general medium of exchange; its exchanges therefore permeate the economic system. Like all commodities, it has a market demand and a market sup­ply, although its special situation lends it many unique features. We saw in chapter 4 that its “price” has no unique expression on the market. Other commodities are all expressible in terms of units of money and therefore have uniquely identifiable prices. The money commodity, however, can be expressed only by an array of all the other commodities, i.e., all the goods and services that money can buy on the market. This array has no uniquely expressible unit, and, as we shall see, changes in the array cannot be measured."

Therefore, in today's environment where inflationism is the dominant path of policymaking, commodities can partly play the role of alternative store of value.

This means that the demand for money which consist of exchange demand (by sellers of all other goods that wish to purchase money) and reservation demand (the demand for money to hold by those who already hold it), would translate to what the mainstream sees as "speculation" or "hoarding".

In short, commodities are not just meant to be consumed (real fundamentals) but also meant to be stored (reservation demand) if the public sees the need for a monetary safehaven.

Moreover, when developments reveal heightened concerns over the accelerating loss of purchasing power in a currency, the role of commodities as money could be reinforced.

As Mr. Ludwig von Mises wrote,

``He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief: accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding. As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding. But it is different if people [p. 427] believe that they are on the eve of big cash-induced changes in purchasing power. When they expect that the money prices of all goods will rise or fall, they expand or restrict their purchases. These attitudes strengthen and accelerate the expected tendencies considerably. This goes on until the point is reached beyond which no further changes in the purchasing power of money are expected. Only then does this inclination to buy or to sell stop and do people begin again to increase or to decrease their cash holdings.

``But if once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This phenomenon was, in the great European inflations of the 'twenties, called flight into real goods (Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse). The mathematical economists are at a loss to comprehend the causal relation between the increase in the quantity of money and what they call "velocity of circulation."

So in my opinion, where commodities serve as insurance against a crack-up boom, financialization of commodities is just one additional way to obtain access to such insurance. Not bad for as long as the counterparty in these contracts produces the 'real goods', when claims are presented.

Lastly, in competition with other asset classes, the financialization of commodities should likewise add to the pricing efficiency of the marketplace.

Does The Government Deserve Credit Over Philippine Economic Growth?

Definitely not.

Not the past administration, as well as, not the future administration.

Here is another outlandish example of how politicians quibble to grab credit when none is actually due them.

This also goes to show that politicians are self-interested individuals whose principal interest is to generate 'popularity' that should transform into votes rather than to perform 'public service'.

Yet all these nitpicking over the Philippine economy are founded on the myth that government runs the economy [see previous discussion in The Myths Of Government’s Managing The Economy]

We don't have to go far to look for evidence.

Take a look at the chart above from ADB's Managing Cities.

The chart reveals that the the informal economy or the shadow or the underground economy/sector, e.g. the tricycle driver, balut vendor, sari-sari stores and etc..., comprises 40% of the Philippine economy. These are the groups that don't pay taxes and whose business are not registered with the government.

And why do informal economies exist?

Professor Friedrich Schneider with Dominik Enste at the IMF website explains,

(all bold highlights mine)

Macroeconomic and microeconomic modeling studies based on data for several countries suggest that the major driving forces behind the size and growth of the shadow economy are an increasing burden of tax and social security payments, combined with rising restrictions in the official labor market. Wage rates in the official economy also play a role.

Taxes and social security contributions add to the cost of labor in the official economy and hence are key factors driving the growth of the shadow economy. The bigger the difference between the total cost of labor in the official economy and the after-tax earnings from work, the greater the incentive for employers and employees to avoid this difference and participate in the shadow economy. The difference can be very large; in Germany and Austria, for example, the tax and social security payments by firms and their workers amount to the wages that workers effectively earn. Since the difference depends broadly on the social security system and the tax regime, these are key determinants of the shadow economy.

Several studies have found strong evidence that the tax regime influences the shadow economy. In Austria, the burden of direct taxes (including social security payments) has been the biggest influence on the growth of the shadow economy, followed by the number of regulations affecting firms and workers, and the complexity of the tax system. Other studies show similar results for the Scandinavian countries, Germany, and the United States. In the United States, analysis shows that as the marginal federal personal income tax rate increases by one percentage point, other things being equal, the shadow economy grows by 1.4 percentage points. Also in the United States, holding down the top marginal income tax rate may prevent further growth of the shadow economy...

Government regulations can substantially raise the cost of labor to firms in the official economy. Such regulations include license requirements, labor market regulations, trade barriers, and labor restrictions for foreigners. Employers in the official economy who shift most of the associated additional costs on to their employees give them a strong incentive to move into the shadow economy.

In short, the informal or the shadow economy exists as a consequence to government's actions, particularly tax policies, assorted regulations, welfare programs and others.

Bottom line: The huge share by the informal or shadow economy only proves that the Philippine economy manages to grow in spite of the government. Therefore, credit is due NOT to politicians but to local entrepreneurs most especially to the shadow economy for defying all these regulatory and political obstacles.

Sunday, May 30, 2010

Why The Current Market Volatility Does Not Imply A Repeat Of 2008

``The confusion of inflation and its consequences in fact can directly bring about more inflation.”-Ludwig von Mises

Every time financial markets endure a convulsion, many in the mainstream scream “DEFLATION”!

Like Pavlov’s dogs, such reaction signifies as reflexive response to conditioned stimulus, otherwise known as ‘classical conditioning’[1] or ‘Pavlovian reinforcement’.

Where the dogs in the experiment of Russian Nobel Prize winner Ivan Pavlov would salivate, in anticipation of food, in response to a variety of repeated stimulus applied (although popularly associated with the ringing of bells, but this hasn’t been in Ivan Pavlov’s account of experiments[2]), the similar reflexive interpretation by the mainstream on falling markets is to allege association deflation as the cause.

Not All Bear Markets Are Alike

Yet not all bear markets are alike (see figure 1)

Figure 1 Economagic: S&P 500, CRB Commodity Index and 10 year treasury yields

As one would note, the bear markets of the 70s came in the face of higher treasury coupon yields, represented by yields of 10 year treasuries (green line), which accounted for high inflation. This era of ‘high inflation-falling market’ phenomenon (or stagflation) is especially amplified in the recessions of 1974, 1980 and 1982 (shaded areas) as markets have been accompanied by soaring commodity prices (CRB Index-red line).

Thereby, the 1970s accounted for ‘deflation’ in terms of stock prices, borrowing the definition of the mainstream, amidst a high inflation environment, as referenced by rising consumer prices. As you would also note, the term ‘deflation’ is being obscured and deliberately misrepresented, since markets then, adversely reacted to the recessions brought about by a high inflation environment.

I’d also like to point out that surging inflation and rising stocks can be observed in 1975-1981, in spite of the 1980 recession. Although of course, the real returns were vastly eroded by the losses in purchasing power of the US dollar.

But in anticipation to the objection that high interest rates and high inflation extrapolate to falling stock markets, this isn’t necessarily true. As shown in the above, stocks can serve as an inflation hedge. And one can see a present day paradigm of this ‘surging inflation-rising stock markets’ dynamic unfolding in Venezuela!

Comparing 2010 To 2008

We always say that markets operate in different environments, such that overreliance on historical patterns could prove to be fatal. While markets may indeed rhyme or have some similarities, the outcomes may not be the same, for the simple reason that people may react differently even to parallel conditions.

For us, what is important is to anticipate how people would possibly react to the incentives provided for by current operating conditions.

We have been saying that this isn’t 2008. There is no better proof than to show how markets have responded differently even if many are conditioned to see the same (see figure 2) out of bias.

Figure 2: Market Volatility of 2008 and 2010

If one would account for the major difference between 2008 and 2010, it is that markets today appear to be pre-empting a 2008 scenario.

In 2008 (chart on the left window represents the activities of the year 2008), the post Lehman bankruptcy saw the S&P crash first before other markets followed, particularly oil (WTIC), and the Fear Index (VIX).

Even the US 10 year treasury yields (TNX) reacted about a month AFTER the crash in the S&P 500. This belated impact could be due to the spillover effects from the large build up of Excess Reserves (ER) to interbank lending rates as the increased in supply lowered rates at the front end, aside from ‘flight to safety’ reasons, which curiously emerged a little past the peak of the crash.

This time around (right window is the 2010 year-to-date performance), the market’s reaction has been almost simultaneous, this perhaps partly reflects on the Pavlov conditioned stimulus. And this could be the reason why many cry out “deflation”, when they seem to be deeply confused about the referencing of the term.

As we’d like to repeat, falling markets don’t reflexively account for ‘deflation’. Dogs do not think, but we do; therefore, we must learn to distinguish from the fallacies of ‘conditioned stimulus’ with that of the real events.

Besides, the fixation on ‘conditioned stimulus’ can account for, in behavioural science, as ‘anchoring’ effect, or where people’s tendency is to “rely too heavily, or "anchor," on a past reference or on one trait or piece of information when making decisions (also called "insufficient adjustment")[3]”. In short, trying to simplify analysis by means heuristics through anchoring is likely to be flawed one. And investors would only lose money from sloppy thinking.

Yet it is also worth pointing out that price level conditions of 2008 appear to be different.

In today’s market tumult, the fear index (VIX) has been rising but is still far away from the highs of 2008; where the highs of today are the low of 2008! Moreover while oil prices have dramatically fallen, an equally swift reversal seems to be in place!

Gold Sets The Pace

Figure 3: The Faces of Gold and Silver in 2008 and 2010

Another feature in 2008 which looks distinct today is the reactions in the precious metal markets (see figure 3).

In 2008 (left window), gold prices reacted instantaneously with the collapse in the S&P 500, but recovered about a month after, just as other markets displayed the aftershocks. Gold’s recovery portended a strong rebound in risks assets thereafter.

In 2010 (right window), we seem to be seeing an abridged (déjà vu?) version of 2010 for gold only. Gold appears to have responded in the same fashion by falling with the initial shock in global stock markets. But this seems to be ephemeral as gold prices appears to have bounced back strongly.

Yet Gold prices are only a stone throw’s distance from its record nominal highs. And if Greece would serve as an indicator of the direction of Gold’s prices, which reportedly were recently priced at 40% premium of the current spot prices or at $1,700 per ounce, then we could see gold prices closing this gap over the coming months.

Nevertheless, if inflation and deflation are defined in the context of changes in the purchasing power of money (the exchange ratio between money and the vendible goods and commodities), then gold, which isn’t a medium of exchange today, but a reserve asset held only central banks, are unlikely to function as a deflation hedge for the simple reason that our monetary system operates under a legal tender based fiat ‘paper’ money standard[4].

In an environment where people scramble for cash or see an enormous increase in the demand for cash balances, gold which isn’t money (again in the context of medium of exchange), won’t serve as a hedge. It is counterintuitive to think why people should buy gold when cash is what is being demanded.

Figure 4: Uncommon Wisdom[5]: Rising Gold Prices In Major Currencies

Hence rising gold prices represents either expectations of increases in inflation or symptomatic of a burgeoning monetary disorder. And since gold prices are up relative to all major currencies (see figure 4), then obviously, it would appear to be the latter.

So it would be another flagrant self-contradiction to argue for ‘deflation’ when markets are signalling possible distress on the current currency system.

And when people lose trust in money, this is not because of ‘deflation’ (where people have more trust in it), but because of inflation—the loss of purchasing power.

One very good example should be Venezuela. As Venezuela’s President Hugo Chavez regime seems hell bent to turn her country into a full fledged socialism, the bolivar, Venezuela’s currency, seem in a crash mode. Capital flight has been worsening in the face of soaring inflation. The Chavez regime is reportedly trying to arrest ‘inflation’ and the crashing ‘bolivar’ by raiding the foreign exchange black market[6]. Mr. Chavez does not tell the public that his government has been printing money like mad.

One objection would be that the US isn’t Venezuela, but this would be a non-sequitur, the point is people flee money because of inflation fears and not due to ‘deflation’ expectations. So rising gold prices are indicative of monetary concerns and not of deflation.

The Difference Of Inflation And Deflation

On a special note, I’d like to point out that it is not only wrong to attribute the impact of deflation and inflation to unemployment as similar, this is plain hogwash and signifies as misleading interpretation of theory.

Here, deflation is being referenced as consequence of prior policy actions of inflationism, which leads to unemployment. In other words, unemployment is the result of unwinding of malinvestments from previous bubble policies from the government which isn’t caused by ‘deflation’ per se.

Where the rise in purchasing power means cheaper goods and services or where people can buy more stuff, how on earth can buying more stuff (deflation) and buying less stuff (inflation) be deemed as equal?

Besides, based on the political aspects of the distribution of the credit process, inflation benefits debtors at the expense of the creditors, and vice versa for deflation. As Ludwig von Mises clearly explained[7],

``Many groups welcome inflation because it harms the creditor and benefits the debtor. It is thought to be a measure for the poor and against the rich. It is surprising to what extent traditional concepts persist even under completely changed conditions. At one time, the rich were creditors, the poor for the most part were debtors. But in the time of bonds, debentures, savings banks, insurance, and social security, things are different. The rich have invested their wealth in plants, warehouses, houses, estates, and common stock and consequently are debtors more often than creditors. On the other hand, the poor-except for farmers—are more often creditors than debtors. By pursuing a policy against the creditor one injures the savings of the masses. One injures particularly the middle classes, the professional man, the endowed foundations, and the universities. Every beneficiary of social security also falls victim to an anti-creditor policy.

``Deflation is unpopular for the very reason that it furthers the interests of the creditors at the expense of the debtors. No political party and no government has ever tried to make a conscious deflationary effort. The unpopularity of deflation is evidenced by the fact that inflationists constantly talk of the evils of deflation in order to give their demands for inflation and credit expansion the appearances of justification.” (bold highlights mine)

And this is apparently true today. Governments (global political leaders and the bureaucracy), the global banking and financial system and other political special interest groups (e.g. labor union in the US), which have benefited from redistributive “bailout” policies, have done most of the borrowing (see figure 5).

Figure 5: Businessinsider[8]: Total Debt To GDP by Major World Economies

Yet, the current inflationist policies, e.g. zero interest rates, quantitative easing, bailouts, subsidies and etc.., have been designed to filch savings of the poor and the middle class to secure the interests of these debtors.

So deflation isn’t a scenario that would be easily embraced by these interest groups, who incidentally controls the geopolitical order. Where deflation would reduce their present privileges ensures that prospective policy actions will be skewed towards the path of more ‘inflationism’.

Hence the political aspects of credit distribution, variances in the changes in purchasing power from politically based policies and the ramifications of inflationism does not only translate to a difference in the impact of inflation and deflation on every aspect of the markets and the economy, but importantly, tilts the odds of policies greatly towards inflationism. And eventually these policies will be reflected and/or vented on the markets.

For deflation to take hold would extrapolate to a major shift in the mindset of the mainstream politics.

Again deflation-phobes try to justify inflationism by the use of specious, deceptive and fallacious reasoning.

Groping For Explanation And The Bubble Mechanism

Another reason why today is going to be different from 2008, is that during the last crisis, the public single-mindedly dealt with the busting of the US housing bubble. First it was the collapse of mortgage lenders, then the investment banks, and the eventual repercussion to the US and global economies.

Today, the public seems confounded about the proximate causes of market volatility; there have been many, including the default risks of Greece, a banking system meltdown in the Eurozone, dismemberment or collapse of the EURO (!!!), another housing crash in the US, a China crash, and for fans of current events the standoff in the Korean Peninsula[9]!

And all these groping in the dark for an answer or for an explanation to the current market circumstances implies rationalization or information bias arising from “people’s curiosity and confusion of goals when trying to choose a course of action”[10].

When the public seems perplexed about the real reasons, then this volatility is likely a false signal or a noise than an inflection point.

Moreover, the alleged collapse of the Euro seems the most outrageous and symptomatic of extreme pessimism. Not that I believe in the viability of the Euro, I don’t. But such myopic assumptions ignore some basic facts, such as the recently reactivated swap lines by the US Federal Reserve--which incidentally have been insignificantly tapped, to which could possibly be indicative of less anxiety; according to the Wall Street Journal[11] ``reduced demand indicates that conditions are stable enough that overseas banks aren’t willing to tap into the swaps”--and that the IMF will contribute to the “bailout” of the Eurozone[12], which makes the Euro bailout a global action mostly led by the US.

Of course if the conditions will worsen in Europe, then it is likely that the US Federal Reserve may reduce its penalty rate to these emergency facilities to encourage increased access.

All these simply reveals of the cartel structure of global central banking system. This means that central banks around the world will likely work to buttress each other, as we are seeing now, to ring fence the banking system of any major economy from a collapse that could lead to a cross country contagion.

The Wall Street Journal quotes, Federal Reserve of St. Louis President James Bullard[13], ``Major nations “have made it very clear over the course of the last two years that they will not allow major financial institutions to fail outright at this juncture.” Since these “too-big-to-fail guarantees are in place, the contagion effects are much less likely to occur.” (emphasis added)

The sentiment of Mr. Bullard illuminates on the prevailing mindset of the monetary and political policymakers. Hence governments will continue to inflate, which has been the case, as we have rightly been arguing[14].

However, inflation as a policy is simply unsustainable. Hence, in my view, the current paper money system will likely tilt towards a disintegration sometime in the future. That crucial ordeal is not a matter of IF but a question of when. Of course, the other alternative, that could save the system, would be through defaults. But since debt defaults are likely to reduce the political and financial privileges of those in and around the seat of power, it is likely a contingent or an action of last recourse.

This means that default, may be an option after an aborted attempt to ‘hyper or super’ inflate the system. Where the consequences may be socially traumatic that would lead to a change in the outlook in public sentiment, only then will these be reflected on the polity.

Yet, both these scenarios aren’t likely to happen this year or the next, for the simple reason that consumer inflation is yet suppressed, which is likewise reflected on current levels of interest rates. And these artificially low rates allow governments more room to adopt popular inflationist measures[15].

And 2008 could be used as an example for this boom bust mechanism, where oil prices soared to a record high of $147 per barrel even as the economy and the markets were being blighted by strains from the housing bubble bust. The record high oil prices, weakening of the economy, the spreading of the unwinding of malinvestments and the mounting balance sheet problems of the banking and financial system all combined to serve as manifestations of a tightened monetary environment that seem to have immobilized the hands of officials relative to market forces. Eventually the culmination of these concerted pressures was seen in the ghastly crash of global asset markets.

Again this isn’t the case today.

Influences Of The Yield Curve, China and Political Markets

This also leads us back to our long held argument about the impact of the yield curve to the markets and to the economy[16].

The Federal Reserve of Cleveland demonstrates the effects of the yield curve to the real economy (see figure 6)

Figure 6 Federal Reserve of Cleveland: The Yield Curve May 2010

Inverted yield curves have been quite reliable indicators of recessions and economic recovery or the business cycles.

Yield curves tend to have 2-3 years lag. The recession of 2008-2009, was clearly in response to or foreshadowed by an inverted yield curve in early 2006-2007 (right window). Since the world went off the Bretton Woods gold dollar standard in 1971, the yield curve cycles have had very strong correlations, if not perfect (left window) with market activities and the real economy.

It is true that the past may have different influences in today’s yield curve dynamics, as Joseph G. Haubrich and Kent Cherny of the Federal Reserve of Cleveland[17] writes,

``Differences could arise from changes in international capital flows and inflation expectations, for example. The bottom line is that yield curves contain important information for business cycle analysis, but, like other indicators, they should be interpreted with caution.”

Nevertheless in contrast to the mainstream, which has patently ignores this important variable and instead continually blether about liquidity trap and ‘deflation’, one reason to depend on the reliability of the yield curve is due to the “profit spread”.

Again we quote anew Murray N. Rothbard[18],

``In their stress on the liquidity trap as a potent factor in aggravating depression and perpetuating unemployment, the Keynesians make much fuss over the alleged fact that people, in a financial crisis, expect a rise in the rate of interest, and will therefore hoard money instead of purchasing bonds and contributing toward lower rates. It is this “speculative hoard” that constitutes the “liquidity trap,” and is supposed to indicate the relation between liquidity preference and the interest rate. But the Keynesians are here misled by their superficial treatment of the interest rate as simply the price of loan contracts. The crucial interest rate, as we have indicated, is the natural rate—the “profit spread” on the market. Since loans are simply a form of investment, the rate on loans is but a pale reflection of the natural rate. What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers’ goods prices falling faster than do consumer goods’ prices.”

In short, interest rates which fuels boom-bust cycles, also represents the profit spreads in the credit market as seen in the context of ``saving, investment, and the rate of interest are each and all simultaneously determined by individual time preferences on the market.[19]

And considering that all the major economies are now on zero bound interest rates (which is likely to be extended), has steep yield curves and are engaged in some form of quantitative easing, while interest rates remain low, as seen in the long term yields of major economies sovereign papers and muted consumer price inflation, it is my impression that there won’t be any crashes, as peddled by the perma bears.

Of course, this is conditional to the surfacing of tail risks such as political accidents e.g. outbreak of military clash in the Korean Peninsula, unilateral call by Greece to default or secede from the European Union, and a crash in China etc...

And speaking of China we learned the authorities have shifted gears from “tightening” back to an “accommodating” policy (see figure 7).

Figure 7: Businessinsider[20]: China Is Back To Pumping Liquidity Into Its Financial System

Again this gives more credence to our view that policymakers approach social problems by throwing money at them, by regulation or by taxation or by a change in leadership[21]. All of which are meant to resolve the visible short term effects at the expense of the future.

Finally, Ludwig von Mises[22] on the deliberate distortions of the terms of inflation and deflation,

``The terms inflationism and deflationism, inflationist and deflationist, signify the political programs aiming at inflation and deflation in the sense of big cash-induced changes in purchasing power.”

In short, everything about the markets is now politics.

[1], Classical Conditioning

[2], Ivan Pavlov

[3], Lists of Cognitive Bias

[4] See In Greece, Gold Prices At US $1,700 Per Ounce!

[5] Brodrick, Sean, Get Your Gold and Silver Coins Now, Uncommon Wisdom

[6] Businessweek, Chavez Says Unregulated Currency Market May Disappear

[7] Mises, Ludwig von Interventionism: An Economic Analysis by Ludwig von Mises

[8] Businessinsider, Here's Everyone Who Would Get Slammed In A Spanish Debt Crisis

[9] See On North Korea's Brinkmanship

[10], Information Bias

[11] Wall Street Journal Blog, A Look Inside the Fed’s Balance Sheet

[12] See The Euro Bailout And Market Pressures

[13] Wall Street Journal Blog, Fed’s Bullard: Europe Woes Unlikely to Trigger Another Recession

[14] See Why The Greece Episode Means More Inflationism

[15] See Global Markets Violently Reacts To Signs Of Political Panic

[16] See Influences Of The Yield Curve On The Equity And Commodity Markets

[17] Haubrich, Joseph G. and Cherny, Kent, Federal Reserve of Cleveland, The Yield Curve May 2010

[18] Rothbard, Murray N. America’s Great Depression

[19] Ibid

[20] Businessinsider: China Is Back To Pumping Liquidity Into Its Financial System

[21] See Mainstream’s Three “Wise” Monkey Solution To Social Problems

[22] Mises, Ludwig von Cash-Induced and Goods-Induced Changes in Purchasing Power, Human Action, Chapter 17 Section 6

Does High Debt And Falling Credit Lead To Deflation?

``The chief source of the existing inflationary bias is the general belief that deflation, the opposite of inflation, is so much more to be feared that, in order to keep on the safe side, a persistent error in the direction of inflation is preferable. But, as we do not know how to keep prices completely stable and can achieve stability only by correcting any small movement in either direction, the determination to avoid deflation at any cost must result in cumulative inflation." Friedrich A. Hayek

Many say that huge debt loads carried by the world today would lead to deflation.

While there is some truth to this, the answer isn’t straightforward.

This mainstream view is best represented by economist Irving Fisher’s description of the events of the Great Depression, which we covered in 2008[1], ``Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes A fall in the level of prices, in other words, a swelling of the dollar.”

This simplistic narrative makes an impression that all debts are similar. Yet, this does not take into consideration the many other factors that hold sway to such an outcome, such as the monetary standard that the Great Depression operated on, regulations that limited interstate branch banking (McFadden Act[2]) which prevented banks from diversifying portfolios, the legal tender laws from central banking which prohibited the US banks from issuing their own notes[3], ‘bank holidays’ which denied depositors access to funding which equally increased uncertainty[4], and importantly the boom bust cycle or the clusters of malinvestment created by earlier monetary policies to uphold certain political interests.

According to Murray N. Rothbard[5], (bold emphasis mine)

``But a more indirect and ultimately more important motivation for Benjamin Strong's inflationary credit policies in the 1920s was his view that it was vitally important to "help England," even at American expense. Thus, in the spring of 1928, his assistant noted Strong's displeasure at the American public's outcry against the "speculative excesses" of the stock market. The public didn't realize, Strong thought, that "we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis." An unexceptionable statement, provided that we clear up some euphemisms. For the "decision" was taken by Strong in camera, without the knowledge or participation of the American people; the decision was to inflate money and credit, and it was done not to help the "rest of the world" but to help sustain Britain's unsound and inflationary policies.”

So such storyline, which looks intellectually formalistic, sells well to the mainstream. What seems plausible is accepted without question or examining its basis.

But of course not all debts the same.

There are debts that are funded from savings and there are debts financed from ‘money from thin air’. The distinction is important because this defines the conditions that affirm or debunk the dynamics of Fisher’s debt deflation.

Dr. Frank Shostak[6] explains, ``when Joe lends his $100 to Bob via the bank, this means that Joe (via the intermediary) lends his money to Bob. On the maturity date, Bob transfers the money back to the bank and the bank in turn (after charging a fee) transfers the $100 plus interest to Joe. Observe that here money never disappears or is created; the original $100 is paid back to Joe.

"A fall in normal credit (i.e., credit that has an original lender) doesn't alter the money supply and hence has nothing to do with deflation."

``Things are, however, quite different when Joe keeps the $100 in the bank warehouse or demand deposit. Remember that by keeping the money in a demand deposit, Joe is ready to employ it at any time he likes.

``Now, if the bank lends Bob $50 by taking it from Joe's demand deposit, the bank will have created $50 of unbacked credit, out of "thin air." By lending $50 to Bob, the bank creates $50 of extra demand deposits. Thus, there is now $150 in demand deposits that are backed by only $100.

``So in this sense, the lending here is without a lender. The intermediary, i.e., the bank, has created a mirage transaction without any proper lender. On the maturity date, when Bob repays the money to the bank, that money disappears. The money supply falls back to $100, dropping by 33%.”

Robert Blumen[7] argues from the gold standard perspective,

``Suppose that on an isolated island the total money supply consisted for 1000 oz of gold and there are no fractional reserve banks. Now suppose that people lend either other various sums of money. Total debt could expand if the same money were lent and re-lent by the borrower more than once (which happens with a lot of securitized financial instruments). Suppose that total nominal debt reached 2000oz of gold, twice the money supply. Now if all of this debt defaulted (not realistic but for the sake of discussion), would there be any general deflation? No, because the money supply remained the same.”

In short, bank credit deflation as described by Mr. Fisher is conditional to debts funded by fractional banking system which causes contraction in the money supply.

According to Joseph Salerno[8],

``During financial crises, bank runs caused many banks to fail completely and their notes and deposits to be revealed for what they essentially were: worthless titles to nonexistent property. In the case of other banks, the threat that their depositors would demand cash payment en bloc was sufficient reason to induce them to reduce their lending operations and build up their ratio of reserves to note and deposit liabilities in order to stave off failure. These two factors together resulted in a large contraction of the money supply and, given a constant demand for money, a concomitant increase in the value of money.”

Yet if large debts presumptively results to a reduction in demand or a slack in credit takeup which leads to ‘deflation’, as linearly thought by the mainstream, inflation would be an imaginary event or that we would be seeing a fall in prices everywhere (see figure 8).

Figure 8 St. Louis Fed and Fall in credit and inflation

The upper window in figure 8 is a favourite chart by perma bears who love to spook themselves with the deflation phantom. It shows of the falling demand for credit, which according to them should be ‘deflationary’.

Yet since 2008, commercial and industrial loans have serially declined, yet inflation has been rising, after a short “foray” in the deflation territory in middle of 2009 until the end of the year.

So the deflation theory does not match real events. The reason for this is that there are many other factors, as government spending, QE, zero interest rates, steep yield curve, globalization and etc... that influences these financial, economic and political conditions.

But I see more problems for the perma bears. Commercial and industrial loans at all banks seem to cease declining and could be bottoming out. And if I am right, where the response to the yield curve will prompt for a material improvement in the health of the credit conditions by the end of the year, this chart will be excluded in the presentation for deflation.

Last word, today’s markets have been tidal driven, and there is little substance to argue for a micro based ‘decoupling’. Although inflationism has relative effects, global markets generally move in synch with the actions of the US markets. But this can be differentiated by the degree of gains or losses.

As such, the only way for the Philippine or Asian markets to outperform is for the US markets to trade sideways or head higher. Asian markets can’t and won’t defy a US crash. Nevertheless, we remain bullish with Asian markets for the simple reason that we don’t see a crash in the US markets or a redux of 2008.

[1] See Demystifying the US Dollar’s Vitality

[2], McFadden Act

[3], Federal Reserve Note

[4], Emergency Banking Act

[5] Rothbard Murray N., Reliving the Crash of '29,

[6] Shostak, Frank, Does a Fall in Credit Lead to Deflation?

[7] Blumen, Robert Massive Debt Deflation in Store? Mises Blog

[8] Salerno Joseph T. An Austrian Taxonomy of Deflation