Tuesday, November 30, 2010

Obama’s Pay Freeze and The Public Choice Theory

In contrast to his previous approach, US President Barack Obama has reportedly made a turnaround and seemingly embraced ‘austerity’.

From the Washington Post, (bold highlights mine)

Bowing to growing budget concerns and months of Republican political pressure on federal pay and benefits, President Obama today announced he would stop pay increases for most of the two million people who work for the federal government.

The freeze applies to all Executive Branch workers -- including civilian employees of the Defense Department, but does not apply to military personnel, government contractors, postal workers, members of Congress, Congressional staffers, or federal court judges and workers.

"Getting this deficit under control is going to require some broad sacrifices and that sacrifice must be shared by the employees of the federal government," Obama said in a speech Monday afternoon explaining the decision. He added, "I did not reach this decision easily, this is not a line item on a federal ledger, these are people's lives."

President Obama’s apparent change of heart mainly reflects on the outcome of the recently concluded national election, where his party got clobbered.

In other words, President Obama’s populist approach merely substituted highhanded interventionism (out of the public’s desperate sentiment which instantaneously emerged out as fallout from the financial crisis which ushered him to office) with government discipline (consequence of the failed government activism).

And this serves as a good example of how politicians pander to the electorate with the view of getting elected rather than the myth where politicians look after the betterment of society.

Like any ‘human being’, politicians exercise self interests over general interests. This is otherwise known as Public Choice.

A wonderful explanation from Professor Steve Horwitz

The Public Choice problem refers to the fact that many arguments for government intervention assume that politicians and bureaucrats are selfless and public-spirited, concerned only with doing what is best. In the real world, though, we know that politicians often act in their self-interest, just like market participants do. Unlike the market, however, political institutions do not channel self-interest into unintended consequences that benefit the public at large. Self-interested political action leads to undesirable unintended consequences. (italics his)

We should learn how to discern between reality and superstitions.

Philippine Infrastructure Development Fund: The More Things Stay The Same

In a recent conference sponsored by Finance Asia, the Philippine government showcased to international investors a proposed $280 million government funded Infrastructure Development Fund.

Unfortunately it seems that the investor response had been tepid.

This from Asian Investor, (bold emphasis mine)

As reported by AsianInvestor recently, the President of the Philippines has promised that these new public-private partnership deals would not be tainted by corruption on the part of the national government. Since he is new to the job, people may give him the benefit of the doubt until it’s proved that nothing has changed.

However, there are worries that international investment funds are going to be embezzled and siphoned off by people seeking backhanders and kickbacks, irrespective of the good intentions expressed by the head of state.

International infrastructure investors would therefore like to see a modest track record of success and a proven ability to administer this programme before they make significant commitments, even if that is based on the evidence of just a couple of honestly and effectively managed projects that can be held up as good examples.

This seems to be a natural reaction from international investors considering the poor track record and that public-private partnership deals signify no less than political concessions subject to the caprice of politicians.

As we previously said,

PPP’s signifies as politically privileged economic rent/concessions to favoured private entities that will undertake the operations in lieu of the government. They will come in the form of monopolies, cartels or subsidies that will benefit only the politically connected.

Since the private partner partnerships aren’t bound by the profit and loss discipline from the consumers, the interest of the private partners will most likely be prioritized or aligned to please the whims of the new political masters.

And because of it, much of the resources that go into these projects will not only be costly or priced above the market to defray on the ‘political’ costs, but likewise, they will be inefficiently allocated.

The more things supposedly would change, the more things seemingly would stay the same.

The Philippine growth model still depends on crony capitalism arising from its ardent adherence to the elitist based social democracy.

Monday, November 29, 2010

Ireland’s Financial Crisis Equals The Euro End Game?

There have been many commentaries suggesting that the Irish financial crisis represents as the Euro Endgame.

Well, not so fast.

This from Bloomberg, (bold emphasis mine)

Ireland’s banks will get as much as 35 billion euros ($46 billion) of aid while senior bondholders will escape the cost of the bailout led by the European Union and International Monetary Fund, the government said.

Banks will get an immediate 8 billion euros to bolster capital, and will raise a further 2 billion euros by shedding assets, the central bank said in a statement yesterday. Lenders will be able to draw on a further 25 billion euros depending on how they fare in a round of stress tests in the first half of next year, the government said in a statement…

The banks are getting the money after rising loan losses and shrinking deposits forced the government to seek the rescue. The state pledged to back all deposits in Irish banks two years ago, requiring the government to inject 33 billion euros into the lenders. The estimated cost of rescuing the banks rose to as much as 50 billion euros in September after losses from the collapse of the country’s decade-long real estate boom jumped, fueling concern Ireland couldn’t fund a rescue itself.

Ireland will in total receive 67.5 billion euros from the EU and IMF, Prime Minister Brian Cowen told reporters in Dublin yesterday after EU finance ministers backed the plan at a meeting in Brussels. The country will pay average interest of about 5.8 percent. The government will meet about half the cost of the 35 billion-euro banking bailout from its own resources, including the National Pension Reserve Fund, Cowen said.

Lenders will use the money to boost their core capital ratios, which gauge financial strength, to at least 12 percent. Bank of Ireland Plc and Allied Irish Banks Plc, the country’s two biggest lenders, will also be able to transfer all their remaining “vulnerable” commercial real estate loans to the National Asset Management Agency, the so-called bad bank set up to take over lenders’ riskiest loans, by the end of March.

As we earlier said, one of the primary role of central banks is to finance government directly or indirectly. And such redistribution process means ‘rescuing’ political privileged interest groups. Apparently this has been the case with Ireland.

Alternatively this means much of the bailouts will be coursed through stealth monetary inflation. Yes, this means you won’t read them on the papers.

To say that the Euro would disintegrate because of the populist upheaval predicated on ‘lack of aggregate demand’ or the rejection of the proposed reduction in social spending programs is pure hooey. While part of the adjustments (reductions) will reflect on the fiscal side, the offsetting (expansionary) part will be the support for the banking system which benefits from such bailouts.

And we should expect to see more of this.

Central banks will use to its hilt their ‘magic wand’. The power to control money signifies an immense privilege, political and economic. It’s not a privilege that would be easily sacrificed by the bureaucracy.

Nonetheless the degree of monetary inflation will always be relative.

Besides, throughout history people flee their currency not because of fiscal austerity or discipline or bankruptcy, but because of rampant debasement or from war.

Russia’s Putin even suggests that Russia may join the Eurozone.

This from the Bloomberg

Russian Prime Minister Vladimir Putin said Friday he was confident in the euro despite Europe's debt crisis and said his country might even join the currency block itself one day.

Putin also sharply criticized the dollar's dominance as a world reserve currency.

Despite the problems in some heavily indebted eurozone countries, the euro has proven itself "a stable world currency," Putin said.

"We have to get away from the overwhelming dollar monopoly. It makes the world economy vulnerable," he told a gathering of business leaders in Berlin through a translator.

In short, like earlier said, Euro bears will be proven wrong again.

And as we earlier wrote, hardline stance by policymakers will crumble in the face of market pressures. Again current developments appear to be validating my view.

This from Bloomberg,

European finance leaders backed a Franco-German compromise on post-2013 sovereign bailouts that waters down calls by German Chancellor Angela Merkal for investors to assume losses and share the costs with taxpayers.

The paper money system is fundamentally deeply flawed. But one system is more flawed than the other. Eventually, like in all historical accounts, the whole system collapses and reverts to the commodity system or a replica of it.

This time won’t be different.

Sunday, November 28, 2010

Markets Make Opinion

On a year to date basis, Figure 1 demonstrates how Asian equity markets have been performing.


Figure 1: Asian Equity Markets: Divergent Actions (stock charts.com)

And based on the big picture, as we have earlier argued[1], Asian equity markets appear to be in a profit taking mode rather than suffering from a major reversal.

And what media says about the supposed causal linkages does not match with the actions of the equity which appears to give credence to my case.

First of all, the market leaders, the major bellwethers of Philippines (light green), Thailand (light blue) and Indonesia (fushia) has been retrenching way ahead of the Ireland crisis or China’s struggle with inflation or the North Korea incident.

Second, the South Korean bellwether the KOSPI appear to be either peaking out or transitioning towards a consolidation phase even amidst the recent unfortunate military encounter with her communist neighbour (see red arrow).

Considering the heightened degree of risks from an escalation to an all out conflagration, the KOSPI lost only 2% over the week. In other words, the Korean markets have not been jolted in as much as the news coverage had portrayed it, given the ‘surprise’ factor from the shelling of South Korea’s Yeonpyeong Island. Another way to say it is that the event risk form the Yeonpyeong incident seems to have been largely discounted (based on last week’s actions).

Third, Taiwan (violet) and Japan’s (orange) markets seem to be jaded to these adverse current events as their respective markets continue to tread higher.

So overall, the stark divergences in the performances of Asian equity markets refute arguments attributing most of the current infirmities in the region’s equity markets to recent events. This is what is known as the available bias.

[1] See Tumult In Global Markets: It Is Just Profit Taking, November 14,2010

Will A War Break Out In The Korean Peninsula?

``The market economy involves peaceful cooperation and bursts asunder when people, instead of exchanging commodities and services, are fighting one another.”- Ludwig von Mises

I doubt so.

Not unless the North Korean political leadership have gone bonkers and take upon a suicide mission that would put to risk their political privileges.

Yet the Kim Jong-il regime is a prime example of what mercantilism and protectionism leads to—absolute despotism. A centrally planned economy led by a tyrant, who sees the nation as his personal fiefdom.

Such totalitarian state has engendered massive poverty represented by rampant shortages of many goods and services which includes the rationing of electricity that has personified what “earth hour” truly means[1].

And in spite of the North Korea’s vaunted war machinery, wherein much of the misallocation of the nation’s resources had been directed, the North Korean army is in a state of dilapidation and obsolescence: they seem ostensibly good for parades and for taunting, but not for real combat.

A clue from CNN[2],

The main weakness of the North's military is a chronic shortage of computers, modern command and control and electronic warfare assets -- in other words, much of what makes up the 21st-century battlefield. At the same time, South Korea has used its economic strength to modernize its armed forces: for example, building three $1 billion Aegis-class destroyers to counter ballistic missiles...

To compensate for obsolescence, the North deploys boots on the ground in great numbers. Jane's estimates that its standing army numbers just over 1 million personnel, with reserves estimated at more than 7 million. But North Korean soldiers are poorly fed, according to analysts and reports from defectors, and rarely train due to scarcity of fuel and ammunition.

Thus, based on socio- political-economic and military calculations, the North Koreans are unlikely to pursue a path of war, because the odds are greatly against them. And their political leadership is aware of this.

The NoKors can only use political brinkmanship as leverage to extract economic concessions from other countries for the benefit of the ruling political class. This essentially is the geopolitics of blackmail[3]—the desire to extend the politics of plunder channelled through the taxpayers of other nations.

Yet there may be other possible reasons for such showcase of aggression.

This could be a diversion from internal troubles.

Recently, to arrest growth of the underground ‘capitalist’ economy, the Kim regime massively devalued her currency that reportedly triggered widespread political unrest[4]. And one way to rally public support or ease political discontent could be to divert the public’s attention via a strawman: conjuring a phony threat and an enemy as seen through the military provocation of her South Korean neighbour in the name of defence.

Another related factor could be the succession of Kim Jong-il’s son, according to the English Chosun[5],

The North's uranium enrichment program and provocations are part of efforts to puff up the image of North Korean leader Kim Jong-il's son Jong-un in line with the Songun or military-first doctrine.

Other reasons reportedly included a supposed power struggle among factions in the ruling class or an attempt by the Kim regime to intervene in South Korean politics so as to “gain control over inter-Korean relations”[6].

Vetting On China’s Role

So aside from derangement, the only likely way for Kim Jong-il’s North Korea to pursue an all out war would be under the consent or the prodding of its patron and ally China.

Much have been said about the strategic position of the Korean peninsula as historical staging point for expansionism and for North Korea’s role as a buffer against a ‘policy of encirclement’ against perceived enemies of the West. But such an argument misleads when applied today.

While it is true that China and the North Korea has shared political experiences such as in the Korean War[7], where the two nations (along with USSR) engaged a common enemy—the Allied forces led by the US, China then was led by communist Mao Zedong’s People’s Liberation Army.

Today, China remains an avowed ‘communist’ but dons the ‘capitalist’ clothes. This means that the governing political economic framework which drives geopolitical or foreign policymaking considerations are far distinct than during the olden days.

While China may lend vocal support for her ally, she would be less interested to promote geopolitical antagonism that may undermine her interests.

One must be reminded that the success of China has been in the opening of her economy to the world. And this arises partly out of the politics carved from China’s idiosyncratic geographic landscape, which according to Stratfor’s George Friedman[8],

China is an island. We do not mean it is surrounded by water; we mean China is surrounded by territory that is difficult to traverse. Therefore, China is hard to invade; given its size and population, it is even harder to occupy. This also makes it hard for the Chinese to invade others; not utterly impossible, but quite difficult. Containing a fifth of the world’s population, China can wall itself off from the world, as it did prior to the United Kingdom’s forced entry in the 19th century and under Mao Zedong. All of this means China is a great power, but one that has to behave very differently than other great powers.

In other words, the geographic limitations of China have led to the experiment with communist isolationism which apparently ended as a grand failure, and thus, the epiphany by the present leadership to adapt an alternative option—globalization.

This also only implies that it isn’t in China interest to see world trade stymied by militant or belligerent foreign policies. Hence, in my view, the chances that China would support North Korea’s tantrums would seem small.

Bottom line: In my view, Korea’s stock markets could be accurately reflecting on the assessment that a broad based deterioration in the geopolitical conditions in the Korean Peninsula could be contained.

Said differently, though we can’t rule out fatuousness from hubris, the odds are against this.

Tenuous Relationship Between Wars And Market Collapses

Yet wars don’t necessarily lead to collapsing markets.


Figure 2: S & P 500 and The Invasion of Iraq

The Invasion of Iraq in March 20 to May 1, 2003 didn’t cause a downside collapse, instead the Gulf War of the new millennium coincided with inflating markets (red circle Figure 2). One might be tempted to link the war as having a positive effect, but this would be misguided, because it was the US Federal Reserve’s low interest rate policies that fuelled the inflation of the marketplace.

Nevertheless, past performance may have not lead to the same outcome.

Should a war occur, such event risk would depend on the participants involved and their degree of involvement. And given the above circumstance, and the deepening world acceptance of globalization, it is less likely that a war at the Korean Peninsula would escalate into a world war.

So for bears selling the war as an excuse to allege for, or predict, a market collapse, they are likely misreading and misdiagnosing the events and are most likely wrong.

[1] See Earth Hour: North Korean Version March 31, 2010

[2] CNN.com North Korea's military aging but sizable, November 25, 2010

[3] See North Korea: The Geopolitics of Blackmail, November 24,2010

[4] See The Road To Serfdom In North Korea, June 21, 2010

[5] English Chosun, Why Did N.Korea Attack?, November 28, 2010

[6] Ibid

[7] Wikipedia.org Korean War

[8] Friedman, George Chinese Geopolitics and the Significance of Tibet, Stratfor.com April 15, 2008

Ireland’s Bailout Will Be Financed By Monetary Inflation

``This is what the phrase "lender of last resort" really means: the creation of fiat money by the central bank. It means breaking the normal rules of the fiat money game. It means bailouts.”- Gary North

A short note on Ireland financial crisis.

This from the Bloomberg[1],

European finance ministers are racing to conclude an international rescue package for Ireland before markets open to stop the country’s financial crisis from spreading to the rest of the euro region.

Prime Minister Brian Cowen’s government is finalizing a bailout agreement that may amount to 85 billion euros ($113 billion) after more than 50,000 people took to the streets of Dublin yesterday to protest budget cuts. As Ireland’s crisis spreads to Portugal and Spain, investors are looking for details on the interest rate Ireland will pay on its loans and the fate of senior bondholders in the country’s banks.

It is quite nonsensical to believe that the Euro will be sacrificed for the misguided notion that austerity will compel for its disintegration as previously argued[2]. As shown in the said article, Eurozone governments have been using market actions to justify interventionism via bailouts.

I am reminded of the institutional incentives borne out of government’s control of the monetary and banking system, as the great Professor Ludwig von Mises wrote[3], (bold emphasis mine)

But today credit expansion is an exclusive prerogative of government. As far as private banks and bankers are instrumental in issuing fiduciary media, their role is merely ancillary and concerns only technicalities. The governments alone direct the course of affairs. They have attained full supremacy in all matters concerning the size of circulation credit. While the size of the credit expansion that private banks and bankers are able to engineer on an unhampered market is strictly limited, the governments aim at the greatest possible amount of credit expansion. Credit expansion is the government's foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make-everybody prosperous.

However this time we are dealing with the bailout on claims on sovereign assets, mostly for the benefit of the creditors or bondholders, which apparently are mostly held by the Euro banking system (see figure 3).


Figure 3 Bank of International Settlements: Exposures to PIIGS

According to the BIS[4], (bold highlights mine)

The integration of European bond markets after the advent of the euro has resulted in a much greater diversification of risk in the euro area. As of 31 December 2009, banks headquartered in the euro zone accounted for almost two thirds (62%) of all internationally active banks’ exposures to the residents of the euro area countries facing market pressures (Greece, Ireland, Portugal and Spain). Together, they had $727 billion of exposures to Spain, $402 billion to Ireland, $244 billion to Portugal and $206 billion to Greece.

French and German banks were particularly exposed to the residents of Greece, Ireland, Portugal, and Spain. At the end of the 2009, they had $958 billion of combined exposures ($493 billion and $465 billion, respectively) to the residents of these countries. This amounted to 61% of all reported euro area banks’ exposures to those economies.

As repeatedly argued here, redistributive policies have always been meant protect certain powerful interest groups. But they are camouflaged by the use of social welfare as cover and by the captured intelligentsia class in the provision of the technical rationalization.

Central banks, to quote Murray Rothbard[5], are ``governmentally created and sanctioned cartel device to enable the nation’s banks to inflate the money supply in a coordinated fashion, without suffering quick retribution from depositors or noteholders demanding cash. Recent researchers, however, have also highlighted the vital supporting role of the growing number of technocratic experts and academics, who were happy to lend the patina of their allegedly scientific expertise to the elite’s drive for a central bank. To achieve a regime of big government and government control, power elites cannot achieve their goal of privilege through statism without the vital legitimizing support of the supposedly disinterested experts and the professoriat. To achieve the Leviathan State, interests seeking special privilege, and intellectuals offering scholarship and ideology, must work hand in hand.”

The quote actually referred to the US Federal Reserve but can be applied universally.

Of course, the next question is how will these large scale sovereign bailouts be financed? The obvious answer by monetary inflation.

Again from Professor Rothbard[6], (bold highlights mine)

The Central Banks enjoy a monopoly on the printing of paper money, and through this money they control and encourage an inflationary fractional reserve banking system which pyramids deposits on top of a total of reserves determined by the Central Banks. Government fiat paper has replaced commodity money, and central banking has taken the place of free banking. Hence our chronic, permanent inflation problem, a problem which, if un checked, is bound to accelerate eventually into the fearful destruction of the currency known as runaway inflation.

So what we are basically seeing is a validation of the perspectives of these great Austrian economists which seem to be playing out or unfolding today in both the Euro and the US.

In short, what the mainstream mostly ignores is the political role played by the central banks on our global economy.

By the way, it would seem that I have been validated anew. I earlier said that the risks at the US housing markets could weigh on the balance sheets of the US banking system which has prompted the US Federal Reserve to pursue QE 2.0[7] despite tepid signs of economic recovery.


Figure 4: Federal Housing Finance Agency: Falling Home Prices

US home prices are reportedly falling anew[8].

Like in the US, inflating the monetary system have been designed to rescue the respective banking systems.

Austerity, hence, is a farce. US and European governments (and even Japan) will continue to inflate the system.

And like the US dollar, the Euro will be used as an instrument to achieve political goals but coursed through the central bank (ECB).

[1] Bloomberg, EU Ministers Meet to Find Agreement on Irish Bailout November 28, 2010

[2] See Ireland’s Woes Won’t Stop The Global Inflation Shindig, November 22, 2010

[3] Mises, Ludwig von Currency and Credit Manipulation, Chapter 31 Section 5 p.788

[4] Bank of International Settlements International banking and financial market developments BIS Quarterly Review June 2010

[5] Rothbard, Murray N The Origins of the Federal Reserve, Mises.org

[6] Rothbard, Murray N Central Banking: The Process of Bank Credit Expansion Chapter 11 Mystery of Banking p.176

[7] See The Possible Implications Of The Next Phase Of US Monetary Easing, October 17, 2010

[8] Bloomberg.com U.S. Home Prices Fell 3.2% in Third Quarter, FHFA Says, November 24, 2010

Wednesday, November 24, 2010

North Korea: The Geopolitics of Blackmail

Forbes columnist Gady Epstein writes, (bold emphasis mine)

North Korea’s shelling today of a South Korean island has reminded the world again of the perennial problem of what to do about the nuclear-armed state. This comes just days after we hear that North Korea has shown off an advanced uranium-enrichment facility, a reminder, too, of how dangerously resourceful this regime can be even as its people face another winter of food and electricity shortages.

In totalitarian states where society have been enslaved by the ruling political class and the bureaucracy, the state can only survive by predation.

Lacking the resources to plunder from its own, totalitarian states resort to expanding the sphere of the politics of predation, through belligerent actions, with its more prosperous neighbors.

As libertarian journalist Frank Chodorov once wrote,

But, since the State thrives on what it expropriates, the general decline in production that it induces by its avarice foretells its own doom. Its source of income dries up. Thus, in pulling Society down it pulls itself down. Its ultimate collapse is usually occasioned by a disastrous war, but preceding that event is a history of increasing and discouraging levies on the marketplace, causing a decline in the aspirations, hopes, and self-esteem of its victims.

North Korea simply fits the bill. She simply wants to live off on a free lunch through the politics of blackmail even if the desperately poor nation knowingly can’t win a full scale war.

And only through poltical brinkmanship can she be able to extract concessions.

As the Wall Street Journal writes,

The purpose is transparently to frighten the West into concluding that there is no alternative to paying off Pyongyang, lest it sell a bomb to al Qaeda or Iran. A far better policy would be a united international effort to further isolate the Kim dynasty with a goal of regime change. Only changing the government will end the North's nuclear threat and liberate its citizens from that prison state.

Of course desperate situations can lead to desperate outcomes, something which Mr. Chodorov predicted.

Nonetheless, Bastiat was right, if goods don’t cross borders armies will. Totalitarian (or despotic) states who do not respect property rights and the rule of law will eventually collapse either from internal political strife (as a consequence of economic cataclysm) or through war.

Bottom line: North Korea is a great example how closed economies (protectionism and mercantilism) through an absolutist predatory state (totalitarianism, communism and fascism) can lead to societal failure or dystopia.

Monday, November 22, 2010

Thanksgiving Day Treat: Turkey Inflation

From Wall Street Journal Blog

35%: The increase in the price of whole turkeys, from their pre-recession level

The Peak Oil Myth

Here are my thoughts on Peak oil

While peak oil (via Hubbert Peak Theory) may be a valid engineering theory, it is a poor economic concept for the simple reason that engineering theories (like quant models) do not capture people’s behaviour.

Let us learn from the history of oil as narrated by investment guru Steve Leuthold

500 Years Ago… England

First let’s go back about 500 years. During the Renaissance, wood was the critical energy component in England and other European economies, much as fossil fuel is today. Wood was the primary provider of heat, light, and food preparation. However, England, having chopped down most of its trees became a large wood importer, primarily from the Scandinavian countries.

Of course prices rose as wood became more scarce causing domestic brewers, bakers, and others to go out of business hit by lower priced imports from wood rich countries. The English citizenry rebelled, having to pay exorbitant rates for wood to heat their homes, light their nights, and cook their food. Thus in 1593 and again in 1615, Parliament enacted energy conservation legislation, including limiting the use of wood in construction and mandating the use of bricks (but it took more wood to bake the bricks than to build wood structures).

From 1600 to about 1650 the price of firewood soared 80%. Then in a single year the price of wood jumped another 300%. Some families were forced to burn furniture and even parts of their houses to survive the winters. Back then, there were no government wood subsidies for freezing families.

The Wood To Coal Transition

In the early 1600s, people were aware coal was an alternative energy source. But prior to the huge rise in wood, coal was far too dirty and expensive. Chopping down trees was easier and cheaper than hacking the coal out from underground. But, as the coal industry grew, mining sophistication and technology reduced the extraction costs and as coal supplies rose prices fell.

Coal was soon found to be a far superior industrial fuel and with vast improvements in coal mining productivity the price of coal kept falling. First iron production increased with quality improving. Then came steel and steam power. The Industrial Revolution was underway led by England, which was bigger, better and earlier than old Europe. England had become the world’s industrial revolution leader. The real catalyst was the Wood Crisis.

Over 150 Years Ago… United States

Now let’s go back about 200 years to the early 1800s. Once again it’s the beginning of another hugely important energy revolution. Since Colonial times, the primary source of illumination in the U.S. had been whale oil. But by 1850 the North Atlantic had almost been whaled out by New England’s whaling fleet. The shore price of whale oil doubled and then doubled again, even though new whaling technologies had maximized oil recovery from the whales that were taken.

The high whale oil prices were also making it profitable to harpoon smaller and smaller lesser yield whales.

The U.S. was growing fast while the North Atlantic with the whale oil field yielding less and less. At the time there were, on the East Coast, no known substitutes for whale oil. By 1848 prices had skyrocketed by 600%. Then in 1848 the shortage was temporarily alleviated by the discovery (and subsequent decimation) of the South Pacific whale herds. Whale oil prices temporarily moved lower. Yes, it was a long and expensive journey for the New England whalers exploiting the new whale oil find. A whaling expedition around the horn and back could take as much as two years.

By the advent of the Civil War even this new whale oil field was played out. Low grade whale oil was $1.45 a gallon by 1865, up from 23 cents in the 1840s. To put this in to perspective, in 1868 a complete dinner in a New York restaurant cost 19 cents. A customer could buy over seven dinners for the price of a single gallon of lighting oil. It cost restaurant owners more to light the place at night than they were paying for the food they served.

The Whale Oil To Kerosene Transition

An alternative energy source became essential as high prices, population growth and shrinking supplies of whale oil combined into a crisis for businesses in east coast cities such as New York, Boston and Philadelphia. Edwin Drake set out to find that alternative. In 1858 he first found it in Titusville, Pennsylvania.

The U.S. entered the Petroleum Age. By 1867, kerosene, refined from Pennsylvania crude broke the whale oil market. By 1900 whale oil prices had fallen 70% from their highs and whale oil lamps had become collector items. Kerosene prices, with production efficiencies, became cheaper and cheaper. More importantly, just as with the development of coal as an energy alternative 200 years earlier, a chain reaction of technological and economic development was triggered. Oil soon became the new foundation of the economy not merely the low cost provider of light at night.

Lessons gleaned from the history of oil

1. People (via supply and demand) adjust to prices, where high prices leads to conservation or substitution, e.g. the wood crisis that triggered a shift to coal, whale oil crisis that led to kerosene

2. commodities obtain values only when it becomes an economic good, e.g. oil was nothing or did not have value during the age of the wood and coal or whale oil.

3. technology enhances production.

We seem to be seeing a combination of the above dynamics playout today, where alternative energies such as the production of Shale oil has been vastly expanding


To quote University of Michigan’s Professor Mark Perry (chart from Professor Perry)

New, advanced techniques for drilling oil have revolutionized the domestic oil industry in North Dakota in ways that couldn't have even been predicted just a few years ago, and will likely also open up new oil production in other parts of the world in the near future (like the Alberta Bakken in Canada) that also would have been unimaginable before this year. That's one reason that "peak oil" is peak idiocy: it always underestimates the ultimate resource - human capital (i.e. human ingenuity and the resulting innovation, advances, new technology) - which is endless and boundless, and will never peak.

Let me add that the current high prices of energy and commodities are not only from the consumption model but also from the reservation demand model—where monetary inflation influences prices.

Of course, there are other factors involved, most of which have been government imposed: geographical access restrictions, trade restrictions, price controls, subsidies, cartels, tariffs and other forms of protectionism (aside from inflationism)

Ireland’s Woes Won’t Stop The Global Inflation Shindig

``When governments try to confer an advantage to their exporters through currency depreciation, they risk a war of debasement. In such a race to the bottom, none of the participants can gain a lasting competitive edge. The lasting result is simply weaker and weaker currencies against all goods and services — meaning higher and higher prices. Inflationary policies do not confer lasting advantages but instead make it more difficult to plan for the future. Stop-and-go inflationary policies actually reduce the benefits of using money in the first place.” Robert P. Murphy Currency Wars

For the mainstream, effects are usually confused with the cause to an event. And the misdiagnosis of the symptoms as the source of the disease frequently leads to the misreading of economic or financial picture which subsequently entails wrong policy prescriptions or erroneous predictions.

Yet many mainstream pundits, whom has had a poor batting average in predicting of the markets, have the impudence, premised on either their perceived moral high grounds or their technical knowledge, to prescribe reckless political policies that would have short term beneficial effects at the costs of long term pain with a much larger impact.

Take for instance currency values. Many pundits tend to draw upon “low” currency values as the principal means of attaining prosperity via the “export trade” route. As if low prices mechanically equates to strength in exports. And it is mainly this reason why these so called experts support government interventionism via currency devaluation.

Yet what is largely ignored is that in the real world most of the world’s largest exporters have currencies that are relatively “pricier”, and that most of the “cheap” currency economies tend to be laggards in trade—the latter mostly being closed economies.

In contrast to mainstream thinking, prosperity isn’t about the unwarranted fixation of currency values, but about societies that promotes competitiveness and capital accumulation.

As Ludwig von Mises once wrote[1], (bold emphasis mine)

The start that the peoples of the West have gained over the other peoples consists in the fact that they have long since created the political and institutional conditions required for a smooth and by and large uninterrupted progress of the process of larger-scale saving, capital accumulation, and investment.

In other words, prosperity emanates from a society which respects the sanctity of property rights premised on the rule of law, which subsequently acts as the cornerstone or foundations of free trade and economic freedom that shapes the state of competitiveness of the economy.

The allure of the polemics of “cheap” currency is no less than “smoke and mirror” chicanery aimed at promoting the interests of a politically privileged class that does little or nothing to advance general welfare.

In short, what is being passed off or masqueraded as an expert economic opinion, is no less than a political propaganda.

Discipline As Basis For Bearishness?

And this applies as well to debt.

Many see the humongous debt load by developed nations as the kernel of the most recent economic crisis. They also use the debt argument as the main basis in projecting the path of economic and financial progress.

Yet debt serves NOT as the principal cause, but as a SYMPTOM of an underlying cause.

It is the collective monetary and administrative policies that have promoted debt financed consumption predicated on the presumed universal validity of AGGREGATE DEMAND that has been responsible for most of the present woes. This has largely been operating for the benefit the government-banking industry-central banking cartel worldwide[2]. Yet such irresponsible policies have spawned endless boom bust cycles and outsized government debts from repeated bailouts and various redistribution schemes which ultimately end in tears. Yet no lesson is enough to restrain these pundits from making nonsensical rationalizations of encouraging a repeat of the same mistakes.

The point is, redistribution has its limits, and we may be reaching the tipping point where the natural laws of economics will undo such false economic premises. And this would represent the grand failure of Keynesian economics from which today’s paper money standard has largely been anchored upon.

For instance the current woes in Ireland, which has not been about the imploding unwieldy social welfare programs yet, but has been about the BLANKET GUARANTEES issued by the Irish government to some of their major ‘too big to fail’ banks, have been used by perma bears to argue for the revival of the ‘deflation’ bogeyman.

While the Ireland debt crisis seem to share a similar characteristic to that of the experience of Iceland[3] in 2008, where the presumed ascendancy or infallibility of government “guarantees” crumbled in the face of economic laws, Ireland’s case is different in the sense that there appears to be political manoeuvring behind the pressure for the latter to comply with the proposed bailout.

Rumors have been rife that the proposed bailout of Ireland have been meant to raise Ireland’s exceptionally low 12.5% corporate tax rates, which has been an object of contention by European policymakers, most especially by the European Central Bank (ECB)

According to the Wall Street Journal[4],

``Brussels has always resented that Ireland transformed its economic fortunes by cutting corporate income taxes and marginal tax rates. At various times, the EU has sued Ireland to raise its rates, accused it of "social dumping" for having a 12.5% corporate income tax, and threatened to cut off European subsidies unless it hiked taxes. None of it worked, but now, with Ireland's banks teetering and its economy in its worse shape in a generation, Europe is moving in for the kill.”

And what better way to compel Ireland to accede to the whims of the bureaucrats in Brussels than to force a crisis from which Ireland would need to accept political conditionalities in exchange for a rescue!

Of course, politicians such as French President Nicolas Sarkozy had been quick to deny the political blackmail[5], saying that “But that’s not a demand or a condition, just an opinion.”

However the important point is that what is being misread by the mainstream as an economic predicament is actually a self inflicted mayhem arising from the political ruse meant at achieving certain political goals.

And unelected politicians have used the markets, largely conditioned to the moral hazard of bailouts and inflationism, to advance their negotiating leverage.

Another point I wish to make is that Euro bears have emphasized that the decision by some Eurozone members to assimilate fiscal austerity has been interpreted as a reason to be bearish on the Euro.

For this camp, the alleged political angst from imposing fiscal discipline would allegedly force the disintegration of the currency union. This is plain AGGREGATE DEMAND based hogwash.

How can it be bearish for individuals or nations (which comprises a community of individuals within defined territorial or geographical boundaries) to act on cleaning up their balance sheets? The excuse is that the lack of AGGREGATE DEMAND will pose as a drag to the economy undergoing the process of “develeraging” from which the government should takeover. What works for the individuals does NOT work for the nation.

Of course the distinction of the paradox can viewed based on time preferences: short term negative and long term positive. People who emphasize on the long term see the positive effects of the structural adjustments even amidst the necessary process of accepting short term pain. Like any therapeutic process, it takes time, regimented diet and regular exercise to recover. There is no short cut, but to observe and diligently work by the process.

On the other hand, there are those who cannot accept any form suffering, or the entitlement mentality. And this mindset characterises the advocates of short term policy fixes.

For politicians who depend on the electoral process to remain in office, any form of suffering represents a taboo as this would signify as loss of votes and consequently the loss of office. Thus, politicians have used short term premised Keynesian economics to justify their actions mostly via the magic of turning bread into stones—printing money.

For unelected bureaucrats the incentives are almost similar, the consequences of any imbalances must be kicked down the road and burden the next officeholder.

For academic or professional supporters, whom are employed in the industries that have privileged ties with the government or whose institutions are funded directly or indirectly by the government, they serve as mouthpieces for these interest groups by embellishing propaganda with expert opinion covered by mathematical models.

The point is this that the AGGREGATE DEMAND paradigm from debt based consumption is not only unsustainable but unrealistic. Yet mainstream experts purposely confuse interpreting the effects as the cause to advance vested interest or for blind belief from dogmatism.

Remaining Bullish On The Euro

And having to confuse effects with the cause is one way to take the wrong side of the markets.


Figure 1: Ireland Government’s Spending Binge

As we pointed out above it is not debt but the incentive by politicians to spend taxpayer money to the point of accruing heavy debt loads that has aggravated the present woes.

As Cato’s Dan Mitchell[6] points out in the case of Ireland,

``When the financial crisis hit a couple of years ago, tax revenues suddenly plummeted. Unfortunately, politicians continued to spend like drunken sailors. It’s only in the last year that they finally stepped on the brakes and began to rein in the burden of government spending. But that may be a case of too little, too late.”

And contrary to the outlook of the Euro bears, the incumbent low corporate taxes seem likely to attract many investors into Ireland.

According to the Economist[7],

IDA Ireland, the agency that targets such investors, says FDI in 2010 will be the best for seven years. A new generation of firms, including computer-gaming outfits like Activision Blizzard and Zynga, are joining the established operations of Intel and Google. Ireland’s workforce is young, skilled and adaptable. Rents are coming down even faster than wages.

So not limited to low taxes, Ireland’s less activist government has resulted to more market based responses in the economy that seems to have also been generating incentives for investors to react positively in spite of the ongoing crisis.

Euro bears are wrong for interpreting discipline and responsible housekeeping as a bearish sign, and equally mistaken for prescribing unsustainable policies that play by the book of mercantilists.

We must be reminded of Professor von Mises’ advise on assessing currency values where ``valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and demand for, money”[8]

This means that in terms of relative policies between the US and the Eurozone, the policy of inflationism as administered by the US monetary authorities, seem to tilt the relationship between the quantity (via Euro austerity) and demand, in favour the Euro, whose rally we have rightly predicted[9] in mid of this year.

Alternatively this means that any dip should be considered as a short term countercyclical trend or must be considered a buying window.

Misunderstanding Deflation

Finally, those who continually obsess over the prospects of a deflation environment similar to that of the Great Depression are bound to be incorrigibly wrong.

The Great Depression wasn’t not only a result of contraction of money supply via collapsing banks, but likewise the curtailment of trade from rampant protectionism (Smoot Hawley) and obstructionist policies (regime uncertainty) that inhibited the incentive of the public to invest.

Left to its own devise and unobstructed by government, the marketplace would result to an optimal supply of money. This means for as long as globalization remains operational there won’t be “deflation”.

As another great Austrian Economist, Murray N. Rothbard explained[10],

But money is uniquely different. For money is never used up, in consumption or production, despite the fact that it is indispensable to the production and exchange of goods. Money is simply transferred from one person’s assets to another. Unlike consumer or capital goods, we cannot say that the more money in circulation the better. In fact, since money only performs an exchange function, we can assert with the Ricardians and with Ludwig von Mises that any supply of money will be equally optimal with any other. In short, it doesn’t matter what the money supply may be; every M will be just as good as any other for performing its cash balance exchange function.

If there is any deflation it won’t be from what the mainstream expects, because price deflation would emanate from productivity growth instead of debt deflation, Think mobile phones or computers.

And that’s the reason why perma bears have gotten it miserably wrong, even all the credit indicators previously paraded to argue their case based on the flawed AGGREGATE DEMAND have NOT materialized[11] and worked to their directions.

Now that these indicators either have bottomed out or have manifested signs of improvements, they have NOT been brandished as examples.

So perma bears have been desperately looking for scant real world evidence to support their views.

Bond Markets Reveal Upsurge In Inflation Expectations

IF there would be any ONE thing that would crush the ongoing liquidity party it would be a chain of interest rates increases that eventually would reach levels that would trigger many projects or speculative positions financed by leverage or debt as unprofitable. This would be the credit cycle as narrated by Hyman Minsky.

This means that a bubble fuelled by systemic leverage would be pricked by the proverbial interest rate pin that would unleash a cascade of asset unwinding. This has been a common feature of our paper money system which only shifts from certain asset markets to another.

The motion of rising interest rates would surface from a pick-up in credit demand, which may reflect on policy induced illusory economic growth, broad based consumer inflation as a consequence to sustained monetary inflation or a dearth of capital, which may be prompted for by a surge of protectionism, a collapse in the banking system or snowballing questions over the credit quality on major institutions, if not on claims on sovereign liabilities.


Figure 2: Municipal Bonds by Rising Yields Over The Long End

Despite the recent statistical reports of muted consumer price inflation which marked “the smallest increase since records started in 1957”[12], one must be reminded that consumer price indices represent a basket of goods, services and assets based on the construct of the US government. And these hardly reflect on the accuracy of the real rate of consumer price inflation because they are determined based on the interpretation of government technocrats on what they perceive constitutes as a meaningful measure of “inflation” based on the aggregate assumptions.

So even if food and oil prices have been rising (CCI index in figure 2) it appears that these increases have hardly filtered into the government’s statistical data.

Yet the contradiction appears to have been vented on the bond markets as US treasury yields surge across the long end of the curve as seen in the US 1 year yield (UST1Y) and the 10 year yields (TNX).

As we have been echoing the view of Austrian economists, the inflation which signifies as a political process, would have uneven effects on the economy.

As Professor von Mises wrote, (bold highlights mine)

``Changes in money prices never reach all commodities at the same time, and they do not affect the prices of the various goods to the same extent. Shifts in relationships between the demand for, and the quantity of, money for cash holdings generated by changes in the value of money from the money side do not appear simultaneously and uniformly throughout the entire economy. They must necessarily appear on the market at some definite point, affecting only one group in the economy at first, influencing only their judgments of value in the beginning and, as a result, only the prices of commodities these particular persons are demanding. Only gradually does the change in the purchasing power of the monetary unit make its way throughout the entire economy.

So yes the ‘definite point’ where the symptoms of inflation appear to emerge can be seen in emerging markets, commodities and commodity related industries, with the succession of growing inflation expectations permeating presently into the bond markets.

Remember, recently investors bought into US Treasury Inflation Protected Securities (TIPs) at negative interest rates[13] indicative of mounting expectations of the resurgence of inflation.

So pundits sarcastically questioning “inflation where” are misreading the gradualist dynamics of deepening and spreading inflation. They will instead show you employment data and output gap to argue for “no” inflation regardless of what the bond, stockmarket and commodity markets have been saying.

The other sins of omission by the mainstream has been to read present trends as tomorrow’s dynamics.

Now the tax free US municipal bond markets had likewise been slammed by the surging treasury yields (despite the Fed’s QE 2.0 aimed at keeping interest rates at artificially low levels). As long term US treasury yields have soared, so has these tax free yields.

Other reasons attributed[14] to the recent collapse in muni bond markets have been the expectations of more issuance from many revenue strained states and the potential abbreviation of issuance of Build American Bonds (BABs) given a gridlocked in the US House of Congress, which may have prompted for a deluge of offering in order beat the deadline.

In my view, all these other excuses appear to be secondary to the deepening trend of inflation expectations.

Of course rising interest rates would also put more pressure on the already strained recovery in the US housing markets which I believe has been the object of QE 2.0.

Yet earlier this year we have debunked claims by the government officials and the mainstream pundits supporting the notion of “exit strategies” which I labelled as Poker bluff[15]. (Yes we are once again validated)

And this means that further stress into the housing markets which would translate into balance sheet problems for the US banking system will be perceived by officialdom as requiring more QE’s. So you can expect the Federal Reserve to feed on more QEs as strains on the housing sector remain unresolved.

Another beneficiary of the QE has been the US Federal government. While government spending may be curtailed under the new US Congress, concerns by emerging markets over “currency wars” may lead to less appetite in financing of US debts. This implies that the US will likely resort to the age old ways of financing deficits-debase of the currency. In short, more QEs to come.

So what all these imply for the markets?

It’s still an inflation shindig ahead.

Of course considering the inflation process distorts the market mechanism, we should expect sharp swings in the upside as well as the downside, but with the upside trend becoming more dominant as US monetary authorities resort to more QEs which will be transmitted globally.

Nevertheless, the so-called “crack up boom” or the flight from paper money appears to be taking place worldwide as gold has been fervently rising against all currencies.

With markets expectations over inflation getting more widespread, stay long commodity or commodity related investments.

Lastly, avoid the confusion trap of misreading effects as causes.

[1] Mises, Ludwig von, Period of Production, Waiting Time, and Period of Provision, Chapter 18 Section 4, Human Action

[2] See QE 2.0: It’s All About The US Banking System, November 8, 2010

[3] See Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?, October 14, 2008

[4] Wall Street Journal Editorial Target: Ireland, October 5, 2010

[5] Bloomberg.com Ireland Aid From EU Won’t Require Tax Increase, Sarkozy Says, November 21, 2010

[6] Mitchell, Daniel J. Don’t Blame Ireland’s Mess on Low Corporate Tax Rates, November 18, 2010

[7] The Economist, Saving the euro, November 18, 2010

[8] Mises, Ludwig von Monetary Stabilization And Cyclical Policy (1928) The Causes Of The Economic Crisis, p.18

[9] See Buy The Peso And The Phisix On Prospects Of A Euro Rally June 14, 2010

[10] Rothbard, Murray N. Mystery of Banking, p. 34

[11] See Trick Or Treat: The Federal Reserve’s Expected QE Announcement, October 31, 2010

[12] Reuters.com Dollar hampered by tame U.S. inflation data November 17, 2010

[13] See Trick Or Treat: The Federal Reserve’s Expected QE Announcement, October 31, 2010

[14] Mousseau, John The Spike in Muni Yields - an Opportunity, cumber.com November 16, 2010

[15] See Poker Bluff: The Exit Strategy Theme For 2010, January 11, 2011