Capital Flows, Financial Liberalization and Bubble Cycles

Professor Arnold Kling excerpted the latest edition from the classic Charles Kindleberger book, “Manias, Panics, and Crashes”

One of the themes of this book is that the bubbles in real estate and stocks in Japan in the second half of the 1980s, the similar bubbles...in the nearby Asian countries in the mid-1990s, and the bubble in U.S. stock prices in the second half of the 1990s were systematically related. The implosion of the bubble in Japan led to an increase in the flow of money from Japan; some of this money went to Thailand and Malaysia and Indonesia and some went to the United States....When the bubbles in the countries in Southeast Asia implode, there was another surge in the flow of money to the United States...

The increase in the flow of money to a country from abroad almost always led to increases in the prices of securities traded in that country as the domestic sellers of the securities to foreigners used a very high proportion of their receipts from these sales to buy other securities from domestic residents...It's as if the cash from the sale of securities to foreigners was the proverbial 'hot potato' that was rapidly passed from one group of investors to others, at ever-increasing prices.

Harvard economists Carmen Reinhart and Kenneth Rogoff places the culpability of the global banking crises on financial liberalization

They write

Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.

There are vast dissimilarities between political economic conditions of today and the yesteryears to simplistically impute the causal relationship of capital mobility and banking crises.

For instance, the pre-20^th century had mostly operated from precious metal based monetary system and had largely been without central banks compared to the 20^th century. Also today’s era can be characterized as having assimilated the Bismarckian welfare structured state than the pre-20^th century, which implies of a starkly different operating political system.

The economic environment had also been different. The pre-20^th century hallmarked the transition of the agricultural epoch to the industrial age. The 20^th century was the culmination of the industrial era which currently has been transitioning to the information age. There are so many many many more variables to consider.

For me, correlations like this should be meticulously scrutinized rather than just taken as “given”.

Although I won’t deny that liberalization could have been one of the many factors which may have contributed to historical episodes of banking crisis, perhaps this has not been the principal one.

However going back to the chart, one can note of the huge concentration in the incidences of banking crises (green circle) during the post-Bretton Woods; the de facto US dollar standard system of today. This comes after the Nixon Shock, a monumental event eponymous to President Nixon’s closing of gold convertibility in 1971.

The degree of concentration of banking crisis has been unprecedented when compared the cumulative interspersed banking crises of 1800-1970.

This lends credence to the “hot potato” dynamic as narrated by Robert Aliber co-author of the Charles Kindleberger’s classic.

As I have been saying here, the gamut of modern day or contemporary global bubble cycles represent as mainly the consequences of the central banking induced business cycles, the welfare state and the intensifying frictions or strains from the Triffin Dilemma that continues to plague the global fiat money system founded on the US dollar.

This “deficit without tears” paper money system which has privileged the US for the past 40 years has been unsustainable and won’t likely last (unless there would be drastic reforms on the political system).

The trend of gold prices has been showing the way.

James Grant on Faith based Paper Money and the Gold Standard

Wall Street Journal’s Holman W Jenkins Jr. interviews James Grant (hat tip Laird Smith) [bold emphasis mine]

The gold standard, he says, citing the "late, great" libertarian economist Murray Rothbard, was the "people's system. If you didn't like the currency, you could exchange your paper for gold and that sent a message."

More from Mr. Jenkins interview of James Grant

The "fiat" dollar, he adds ruefully, "is one of the world's astounding monetary creations. That a currency of no intrinsic value is accepted as money the world over is an achievement that no monetary economist up until not so many decades ago could have imagined. It'll be 40 years next month that the dollar has been purely faith-based. I don't believe for a moment it's destined to go on much longer. I think the existing monetary arrangements are so precarious, so ill-founded and so destructive of the economic activity they are supposed to support and nurture, that they will be replaced by something better."

How exactly the transition to a new gold standard might take place is a puzzle, but Mr. Grant says he's seen many "impossible" things come to pass in his career. A certain "social spontaneity" might take a hand. He points to GLD—the ticker symbol for an exchange-traded fund whose gold holdings now make it equivalent to the world's 10th largest central bank. "At the margin," he says, "people are registering dissent from the judgment of our central bankers by bidding up the price of gold."

Read the rest here

Chart from Sharelynx/goldchartrus.com

Anyone who thinks that today’s economic climate poses little risk for dramatic transitions in today’s monetary architecture should look at my post below on Dead Currencies.

They are likely to be overestimating the strength of today’s system which have increasingly been based on serial bailout policies, especially in developed economies.

Once the tipping point from the accretion of political mistakes have been reached, we are likely to see a hastening of the implosion of today’s money system.

And as a popular Wall Street maxim goes:

Past performance does not guarantee future results.

As for the return of the gold standard, that’s something unclear for now. But as history has shown, economic forces could compel us to drastically embrace this option once the motion of monetary collapse becomes entrenched and accelerates.

Gold and the precious metal group, based on the price trends relative to the incumbent 'faith based' currencies of major economies, seem to be showing their revitalized role as man's default currency or the public's dissent over the judgment of central bankers as Mr. Grant rightly observes.

Ultimately, the fate of our currency system depends on the direction of monetary politics which constitutes a substantial tail risk that the mainstream continues to ignore.

Graphic: Dead Currencies

Below is a deck of pictures, courtesy of Casey Research, showing various currencies from different parts of the world that have expired or have been abandoned.

It is foolish or naïve, for some, to believe that political actors willed or deliberately engineered the demise of these currencies, or that these have been the responsibility of the private sector.

Instead, the spate of currency extinction overtime signifies as the outcome of a series of actions undertaken by political leaders which essentially collided with economic reality and failed.

In other words, hyperinflation or war, which had been mainly responsible for the demise of most of these currencies, represents as the unintended effects from the desire to preserve or expand of political power by incumbent political leaders during their era.

As the great Ludwig von Mises reminds us, (bold emphasis mine)

But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them.

Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.

Gold at $1,500 Settles the Jim Rogers-Nouriel Roubini Debate

Celebrity guru Nouriel Roubini has been dead wrong. Prolific investor Jim Rogers has been spot on. They had an impassioned debate in November of 2009.

Professor Roubini earlier said of gold prices,

Maybe it will reach $1,100 or so but $1,500 or $2,000 is nonsense,” Roubini said.

Professor Roubini represents the mainstream econometric model based analysis whom has constantly failed to predict the markets accurately.

As Professor Robert Higgs points out, mainstream (academia) thinking has [bold highlights mine]

little interest in the search for truth, however one might understand or pursue it. To them, their research and publication amounted to a game in which the winning players receive the greatest rewards in salary, research funding, and professional acclaim. They understood that because of cloistered academic inbreeding, economists at the most prestigious universities consider the “smartest guys” to be those who employ the most advanced, complex, and incomprehensible mathematics in their “modeling” and “empirical testing.

Gold’s record price surge has been nominal based.

Economist John Williams, who uses the old methodology (1990 CPI) to compute for inflation, says that gold is still far away from reaching its inflation adjusted high in 1980s.

The USAWatchdog quotes economist John Williams (bold highlights original)

In a recent report, economist John Williams of Shadowstats.com contends a declining U.S. currency is reflected in spiking gas prices. Williams’ said, “. . . the primary problem behind higher oil and gasoline prices is the Fed’s efforts at dollar debasement, but few in the media are willing to blame the Fed . . . Also hitting the dollar, though, are increasing instabilities in and ineffectiveness of political Washington, D.C., as viewed by the rest of the world.”

Williams says gold and silver are nowhere near their former inflation adjusted highs of 1980. Back then, gold hit $850 per ounce and silver $49.45 per ounce. To truly equal that price in today’s inflated money, gold would have to be “$8,331 per troy ounce” and silver would have to be priced at “$485 per troy ounce,” according to Williams’ recent calculations.

Yet Gold’s record price surge isn’t only a US dollar dynamic but against global currencies.

The following charts from gold.org shows of gold trends in different currencies since 1998

Euro

Yen

Pound

South African Rand

Australian Dollar

Canadian Dollar

Indian Rupee

G-5 basket

In my view, surging gold in all currencies seem to be validating Voltaire’s observation—Paper money eventually returns to its intrinsic value ---- zero.

The blunt way to say this is that zero extrapolates to hyperinflation.

Again, all these mainly depend on the prospective actions of global governments, most especially the US Federal Reserve.

How To Reform The Global Debt Biased Economic System

Harvard economist Kenneth Rogoff argues that the world’s problem has been “rooted in excessive concentrations of debt” and that the fix should focus on rebalancing debt into equity. I agree.

Mr. Rogoff writes,

But policy-induced distortions also play an enormous role. Many countries’ tax systems hugely favor debt over equity. The housing boom in the United States might never have reached the proportions that it did if homeowners had been unable to treat interest payments on home loans as a tax deduction. Corporations are allowed to deduct interest payments on bonds, but stock dividends are effectively taxed at the both the corporate and the individual level.

Central banks and finance ministries are also complicit, since debt gets bailed out far more aggressively than equity does.

I’d like to add that this is exactly why central banks exist: they have been designed to finance and bailout the government and or her agencies (mostly by inflation), aside from promoting “consumption” debt as path to economic growth. As for the latter, don’t you see the excessive focus by the mainstream on “employment” based on “consumer spending”?

And these composite policies, all this time, has favored or privileged the central bank supported banking industry cartel.

Since the political leadership (governments) has also benefited from these arrangements, then obviously even administrative or tax policies had been molded into a “debt” bias—which incidentally becomes a feedback loop mechanism (more government spending more inflationism by central banks).

And that’s how boom bust cycles have been playing out.

And as earlier discussed in The Myth Of Risk Free Government Bonds even bank capital regulatory requirements have been tilted towards incentivizing these institutions to hold on to “less risky” government debts.

That’s because institutional holdings on “short term” government securities, under Basel Accord, which were considered as “risk free”, were not required of capital in contrast to holdings of corporate bonds. So major institutions were incentivized to fund governments, from which politicians capitalized on, and which only bloated their nation’s respective fiscal balance sheets.

But the recent crisis has only been exposing the “nudity” of the fabled risk free “emperor”.

I would say that this systemic debt bias has been intrinsic for the paper money system build around the welfare-redistributive state.

And parallel to this been the unseen incentives that drives governments and their respective central banks to gain political capital (via extended tenure and via expanded government control over the political economy) by selling “something out of nothing” to voters via the welfare state—and to reemphasize, all of which have been propped up and funded by the debt based central banking system.

In other words, for the world economic-financial framework—estimated at some $200 trillion, and which have been configured or evolved around these embedded incentives—to be able to shift from a debt to equity bias, would require an overhaul of the monetary system first and the political systems next.

Otherwise, the markets, like it or not, will do the radical debt-to-equity makeover for us.

Paper Money System: Origin And Destiny

321gold’s Darryl Robert Schoon on the origin of paper currency (he quotes Ralph T. Foster’s book, Fiat Paper Money, The History and Evolution of Our Currency)

By 1661, China finally learned its lesson and the new Qing dynasty officially outlawed paper money. Regarding China’s 600 year experiment, Foster writes:

“Over the course of 600 years, five dynasties had implemented paper money and all five made frequent use of the printing press to solve problems. Economic catastrophe and political chaos inevitably followed. Time and again, officials looked to paper money for instant liquidity and the immediate transfer of wealth. But its ostensible virtues could not withstand its tragic legacy: those who held it as a store of value found that in time all they held were worthless pieces of paper. (page 29) [emphasis mine]

As the above excerpt shows, the paper money system has been an age old predicament for political leaders who always try to circumvent the fundamental laws of economics, but always ended up a failure.

Today, paper money has been repackaged and sold to the public as a product of modernity anchored upon central banking—operating on the platform of technology aided complex and sophisticated math or quant models.

And where lessons seem to have never been assimilated or learned, the same outcome should be expected as in the past. As Voltaire once said, “Paper money eventually returns to its intrinsic value…zero.”

Paper Money Is Political Money

Populist blogger John Mauldin writes,

The euro never was an economic currency. It is a political currency, and for it to remain a currency or at some point in the future become an economic currency, it will take massive political resolve on the part of the members of the EU.

Unless the US dollar operates on a genuine gold standard or a monetary system based on free banking, then this statement or implied comparison or categorization is patently false.

Although to give credit to Mr. Mauldin for admitting that he has been a “Euro skeptic”, his opinions has apparently been shaped by biases rather than from facts.

So why is the above statement false? Because paper money has always been political money.

ALL paper money, whether the US dollar, Euro, the Yen, the Yuan or the Peso, operates on a platform which is not determined by the market forces but by the judgments of unelected bureaucracy whom are appointed by their respective governments.

Thus, from the organizational structure to the operating “technical” procedures to the underlying incentives of the bureaucracy in conducting administration of these instituted statutes or policies, which are all outside the profit and loss dimensions and whose operations are underwritten by taxpayers, all these represent the political nature of the system.

Importantly, the paper money system is founded from legal tender laws, which according to Wikipedia.org, is “a medium of payment allowed by law or recognized by a legal system to be valid for meeting a financial obligation”.

In other words, a monetary system imposed by the government (by fiat or decree), which has largely been operated by central banks, has always been political.

Yet to speak of an “economic currency” extrapolates to a market based currency from which the legal tender-paper money system is not required.

According to the great Friedrich August von Hayek,

We owe it to governments that within given national territories today in general only one kind of money is universally accepted. But whether this is desirable, or whether people could not, if they understood the advantage, get a much better kind of money without all the to-do about legal tender, is an open question. Moreover, a "legal means of payment" (gesetzliches Zahlungsmittel) need not be specifically designated by a law. It is sufficient if the law enables the judge to decide in what sort of money a particular debt can be discharged.”

Thus, to besmirch a currency without the appropriate consideration of the overall framework of the system would seem misguided if not a flimflam.

Caveat Emptor.

QE 2.0: It’s All About The US Banking System

``But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public.” Ludwig von Mises

It’s time for a little gloating.

Last week we noted how global financial markets would likely respond to two major events that just took place in the US this week.

Globalization Versus Inflationism

We noted that while the outcome of the US elections would matter, it would be subordinate to the US Federal Reserve’s formal announcement of the second phase of the Quantitative Easing or QE 2.0.

Nevertheless we mentioned that in terms of the US Midterm Elections, still the odds greatly favoured a rebalancing of power from a lopsided stranglehold by left leaning Democrats towards the conservative-libertarian right that could result to what mainstream calls as “political gridlock”.

Such stalemate would thereby reduce the chances of government interventionism, which should have positive implications for both the markets and the US economy[1].

Figure 1: The Drubbing Of Keynesian Policies (USA Today[2])

Of course, what the surveys earlier conveyed had been merely translated into actual votes-Americans largely repudiated the highhanded Keynesian spend and tax policies adapted by the Obama administration. This also signifies as a decisive defeat for President Obama’s illusory “Change we can believe in”.

Except for the Senate which had only 37 seats, out of the 100, contested, Republicans swept the House (239-188) and the Governorship position (29-18). Yet, even in the Senate, the chasm in the balance of power held by the Democrats had been significantly narrowed (from 57-41 to 51-46).

To rub salt into the wound, even President Obama’s former seat at Illinois was won by a GOP candidate[3], Mark Kirk.

The burgeoning revolt against interventionist Keynesian policies has likewise been an ongoing development in Europe[4].

And as we have repeatedly been pointing out, two major forces have been in a collision course: technology buttressed globalization (represented by dispersion of knowledge and the deepening specialization expressed through free trade) and inflationism (concentration of political power).

The rising tide against Keynesianism, which translates to a backlash from these two grinding forces, can be equally construed as a manifestation of an evolving institutional crisis or strains from traditional socio-political structures adjusting to a new reality.

As Alvin and Heidi Toffler presciently wrote[5],

``Bureaucracy, clogged courts, legislative myopia, regulatory gridlock and pathological incrementalism cannot but take their toll. Something, it would appear will have to give...

``All across the board –at the level of families firms industries national economies and the global system itself—we are now making the most sweeping transformation ever in the links between wealth creation and the deep fundamental of time itself. (italics mine)

For now, the forces of globalization appear to be the more influential trend.

Validated Anew: QE 2.0 Is About Asset Price Support

However, as we also noted, Keynesianism hasn’t entirely been vanquished[6]. They remain deeply embedded in most of the political institutions represented as unelected officials in the bureaucratic world. Importantly, they are personified as stewards of our monetary system.

Here is what I wrote last week[7],

``The QE 2.0, in my analysis, is NOT about ‘bolstering employment or exports’, via a weak dollar or the currency valve, from which mainstream insights have been built upon, but about inflating the balance sheets of the US banking system whose survival greatly depends on levitated asset prices.

Straight from the horse’s mouth, in a recent Op-Ed column[8] Federal Reserve Chair Bernanke justifies the Fed’s QE 2.0,

``This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. (bold highlights mine)

Once again I have been validated.

The path dependency of Ben Bernanke’s policies has NOT been different[9] from his perspective as a professor at Princeton University in 2000 when he wrote along the same theme.

``There’s no denying that a collapse in stock prices today would pose serious macroeconomic challenges for the United States. Consumer spending would slow, and the U.S. economy would become less of a magnet for foreign investors. Economic growth, which in any case has recently been at unsustainable levels, would decline somewhat. History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse. (bold emphasis mine)

Figure 2: stockcharts.com: Global Equity Markets Explode!

The net effect of QE 2.0 has been almost surreal.

Global equity markets (DJW), as expected, skyrocketed to the upside from the higher than expected $600 billion or $75 billion a month (for 8 months) of US treasury long term security purchases that the Federal Reserve will be conducting with new digital dollars. Markets reportedly estimated the QE program at $500 billion[10].

And the Federal Reserve made sure in their announcement that $600 billion will not be a limiting condition. The FOMC said that they “will adjust the program as needed to best foster maximum employment and price stability”[11].

It’s simply amazing how the Fed’s QE 2.0 transmission mechanism has been worldwide. Whether in Asia (P1DOW-Dow Jones Asia), Europe (E1DOW-Dow Jones Europe) or Emerging markets (EEM-iShares MSCI Emerging Markets Index), the story has all been the same—markets breaking out to the upside.

I’d like to add that such bubble blowing policies has NOT been limited to the Federal Reserve.

Immediately after the Fed’s announcement, the Bank of Japan voted unanimously to support the domestic stock market by engaging on their own version of QE that would include “exchange-trade funds linked to the Topix index and Nikkei Stock Average, and Japanese real-estate investment trusts rated at least AA, the bank said. It said it would begin buying Japanese government bonds under its new program next week.[12]” (bold emphasis mine)

Add to these the inflation of global central banks international reserve position to the tune of $ 1.5 trillion over the past 12 months[13].

Hence the consequences of massive inflationism are likely to be fully felt yet in the markets.

The False Premise: Aggregate Demand Story

The substantiation of our analysis isn’t limited to Bernanke’s statements alone. Markets have likewise bidded up the major beneficiaries of the QE 2.0 program—the banks and the financial industry (see figure 3).

Figure 3: Financial Industry: From Laggards to Leaders (charts from US global Investors and stockcharts.com)

The mainstream wisdom goes this way: Money printing does not create inflation. With low inflation, printing money is, therefore, needed to generate demand that would spur inflation. This form of circular reasoning[14], which characterizes Keynesian economics, is what is sold to public as rationalization for the current policy. The mainstream sees it as an aggregate demand problem that can only be addressed by money printing.

The mainstream fails to see that there is NO such thing as a free lunch or that prosperity cannot be conjured or summoned by the magic wand of the printing presses.

All these so-called technocratic experts refuse to learn from history or deliberately distort its lessons, where debasing money has always been meant to accommodate for the political goals or interests of the ruling class.

Yet monetary inflation eventually crumbles to nature’s laws of scarcity for the simple reason that it is unsustainable. Printing of money does NOT equate anywhere to the same degree as producing goods and services. Printing of money can be limitless, while production of goods and services are limited to the available scarce resources.

Unknown to many, printing of money is subject to the law of diminishing returns (getting less for every extra output or a law affirming that to continue after a certain level of performance has been reached will result in a decline in effectiveness[15]) and law of diminishing marginal utility (general decrease in the utility of a product, as more units of it are consumed[16]).

And it is why repeated experiments with paper money throughout the ages of human affairs have repeatedly failed[17]. And I don’t see why the grand US dollar standard experiment today as likely to succeed either. The QE programs fundamentally reflect on the same symptoms of any degenerating or festering de facto money regime. We should expect more QE programs to happen.

Yet the aggregate demand story is basically premised on debt. To promote aggregate demand is to promote debt. Debts either incurred by the private sector or by governments in lieu of the private sector. While productive debt and consumption debt are hardly distinguished, consumption debt is promoted. Savings are disparaged as economically harmful. And the promotion of debt is the essential or critical element to fostering bubbles.

Figure 4: World Bank: Banking Crisis Since the 1970s

Hasn’t it been a wonder that since the closing of the Bretton Woods gold-dollar window in 1971, bubbles became a permanent fixture worldwide?

Yet, the public hardly can see through who the major beneficiaries from the debt based aggregate demand story. Obviously, it is the banking and the financial industry as they represent as the major funding intermediaries or financiers to both the private sector and importantly to the government.

And the banking system had been structurally incented to hold (or buy or finance) government debts into their balance sheets as they have been classified as less risky assets and thus requires less capital in accordance to the Basel Accord[18].

During the last crisis the unholy alliance of the central banking-banking industry cartel had been exposed as seen by the trillions worth of bailouts by the US Federal Reserve[19].

Yet the politicized nature of central banking (everywhere) obviously leads to cartel structured relationships, as survivability depends not on profitability based on market forces, but from the privileged conditions bestowed upon by the political strata.

And the QE 2.0, which I argued as having been unmoored from the prospects of the US or global economy, but rather aimed at safeguarding the balance sheets of the banking system has successfully boosted the prices of financial equity benchmarks, such as S&P Bank Index (BIX), the Dow Jones Mortgage Finance Index (DJUSMF), the S&P Insurance (IUX) and the Dow Jones US General Financial Index (DJUSGF), all along the lines of Bernanke’s design.

The industry that had miserably lagged[20] the recent stock market recovery in the US has in one week suddenly outclassed the rest.

Of course people who argue about the success or failure of policies frequently look at the effects depending on the time frame that support their bias.

For instance, policies that induce bubbles will benefit some participants, during its heydays. Hence, policy supporters will claim of its ‘success’ seen on a temporary basis as the bubble inflates. Yet overtime, an implosion of such bubbles would result to a net loss to the economy and to the markets. The overall picture is ignored.

And the same aspects would also apply to those arguing that the Fed’s rescue of the banking system has been worthwhile. They’re not. The benefits of a temporary reprieve from the recent crisis envisages greater risks of a monumental systemic blowup. If Fed policies had been successful, then why the need for QE 2.0?

So for biased people, the measure of success is seen from current activities than from the intertemporal tradeoffs between the short term and long term consequences of policies.

In other words, yes, the QE 2.0, which constitutes the continuing bailout of the US banking industry, seems to successfully inflate bubbles, mostly overseas. But at the end of the day, these bubbles will result to net capital consumption, if not the destruction of the concurrent monetary regime.

The next time a major bubble implodes there won’t likely be free lunch rescues as these will be limited by today’s massive debt overhang.

The Effects of QE 2.0: Promotes Poverty And A Shift To A New Monetary Order

Of course while the equity price performance of the US financial industry stole the limelight the next best performers have been the Energy and the Materials Index.

In other words, as I have long been predicting, the accelerating traction of the inflation transmission channels are presently being manifested in surging prices of commodities and commodity related equity assets aside from global equity markets.

While this should benefit equity owners and producers of commodity related enterprises, aside from the financial sector, those who claim that inflationism is justifiable and a moral policy response to the current conditions are just plain wrong. Such redistributive policies to the benefit of the banking sector come at the expense of the underprivileged.

What is hardly apparent or seen is that the current government structured inflation indices have been vastly underreporting inflation.

Yet surging agricultural and food prices would not only harm a significant percentage of financially underprivileged by reducing their money’s purchasing power but also promote poverty in the US and elsewhere.

Figure 5: Food Expenditures By Income Level

Tyler Durden of Zero Hedge quotes a JP Morgan study[21], (bold emphasis mine)

When the Fed considers the possible consequences of a falling dollar resulting from QE2, it should perhaps focus on food and energy prices as much as on traditionally computed core inflation. First, the food/energy exposures of the lower 2 income quintiles are quite high (see chart). Second, the core CPI has a massive weight to “owner’s equivalent rent”, which suggests that the imputed cost of home occupancy has gone down. Unfortunately, this is not true for families living in homes that are underwater, and cannot move to take advantage of it (unless they choose to default and bear the consequences of doing so). Due to the housing mess, there has perhaps never been a time when traditionally computed core inflation as a way of measuring changes in the cost of things means less than it does right now.

Figure 6: ADB[22] Asia’s Share of Food Expenditure to Total Expenditure

And as said above the effects are likely to hurt the underprivileged of the emerging markets more than the US.

So inflationism or QE 2.0 poses as a major risk to global poverty alleviation and prosperity, a blame that should be laid squarely on these policymakers and their supporters.

Of course as the ramifications of inflationary policies worsen, the subsequent scenario would be for political trends to shift towards holding the private sector responsible for elevated prices and for ‘greed’ in order to institute more government control and inflationism.

As the great Ludwig von Mises once wrote[23],

``They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices. While the [the government] is busy annoying sellers as well as consumers by a flood of decrees and regulations, the only effect of which is scarcity, the Treasury [and the Fed] go on with inflation”

Here free trade will likely give way to protectionism; that is if public remains ignorant of true causes of inflation and if the world would stubbornly stick by the US dollar as preferred global medium of exchange.

Of course Asian nations were hardly receptive to the unilateral actions by the Federal Reserve. The conventional recourse in dealing with QE 2.0 has been via currency appreciation, tightening of domestic liquidity by raising bank reserves or increase policy rates or lastly ‘temporary’ capital controls. So far some countries as South Korea have threatened to impose some variation of capital controls.

Yet we should expect the world to shift out of the US dollar regime once inflationism becomes rampant enough to pose as a meaningful hurdle to national economic development and global trade. The Bloomberg quotes China’s Central Bank adviser Xia Bin[24],

``China should counter the U.S. through regional currency alliances, speeding international use of the yuan and seeking stability in exchange rates through the Group of 20, which holds a summit next week”

A currency from a political economy that engages in significantly less inflationism, has deep and developed sophisticated markets, has a convertible currency and hefty geopolitical exposure is likely to challenge the US dollar hegemony, whether this would be the yuan (which for the moment is unlikely) or the Euro, only time will tell.

Of course, we can’t discount gold’s role in possibly being integrated anew in the reform of the monetary architectural system.

Figure 7: Virtual Metals[25]: Central Bank Gold Holdings and Sales

Global Central banks appears to be rediscovering gold as possibly reclaiming its role as money in a new monetary order. A new monetary order is not question about an if, but a when.

Once as net sellers, central banks seem to be transitioning into potential net buyers.

So again, our peripheral insight seems being validated with the ongoing process of shifting expectations by authorities on the functions of gold.

As I pointed out last year[26], gold is presently seen by an ECB official as a form of economic security, risk diversification, a confidence factor and an insurance against tail risks. Once these factors become well entrenched, a store of value role would likely be the next step. And more QE’s would only serve to push gold towards such a path.

Those who obstinately relish the bias that gold is nothing but a barbaric relic will likewise suffer from taking on the wrong positions. But they eventually will succumb to the shifting expectations as with many monetary authorities today. The reflexive process of having prices influence fundamentals has clearly been taking shape.

With gold prices at $1,390 mainstream economists like celebrity Nouriel Roubini[27], who last year debated savvy investor Jim Rogers and declared “Maybe it will reach $1,100 or so but $1,500 or $2,000 is nonsense”, must be squirming on his seat for the likelihood to be proven wrong once again.

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[1] See US Midterm Elections: Rebalancing Political Power And Possible Implications To The Financial Markets, October 31, 2010

[2] USA Today, 2010 Elections: Live Results

[3] Politico.com Roland Burris will serve in November, November 5, 2010

[4] See An Overextended Phisix, Keynesians On Retreat And Interest Rate Sensitive Bubbles, October 25, 2010

[5] Toffler, Alvin and Toffler, Heidi Revolutionary Wealth Random House p.40

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

[7] Ibid

[8] Bernanke, Ben What the Fed did and why: supporting the recovery and sustaining price stability, Washington Post, November 4, 2010

[9] Bernanke, Ben A Crash Course for Central Bankers, Foreign Policy.com or wikiquote Ben Bernanke

[10] Macau Daily Times Asian markets rise, dollar falls, November 5, 2011

[11] Board of Governors of the Federal Reserve System, November 3, 2010 Press Release

[12] Marketwatch.com Bank of Japan holds steady, details asset plans, November 4, 2010

[13] Noland, Doug QE2 Credit Bubble Bulletin, Prudent Bear.com

[14] See Thought Of The Day: The Keynesian Circular Thought Process, June 22, 2010

[15] Wordnetweb.princeton.edu law of diminishing returns

[16] Wiktionary.org law of diminishing marginal utility

[17] See Surging Gold Prices Reveals Strain In The US Dollar Standard-Paper Money System, November 1, 2010

[18] See The Myth Of Risk Free Government Bonds, June 9, 2010

[19] See $23.7 Trillion Worth Of Bailouts?, July 29 2010

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

[21] Durden Tyler, How Ben Bernanke Sentenced The Poorest 20% Of The Population To A Cold, Hungry Winter, Zerohedge.com November 5, 2010

[22] Asian Development Bank: Food Prices and Inflation in Developing Asia: Is Poverty Reduction Coming to an End? April 2008

[23] Mises, Ludwig von The Truth About Inflation

[24] Bloomberg.com Asians Gird for Bubble Threat, Criticize Fed Move November 4, 2010

[25] Virtualmetals.co.uk The Yellow Book September 2010

[26] See Is Gold In A Bubble? November 22, 2009

[27] See Jim Rogers Versus Nouriel Roubini On Gold, Commodities And Emerging Market Bubble, November 5, 2009

Surging Gold Prices Reveals Strain In The US Dollar Standard-Paper Money System

Tocqueville Asset Management LP’s John Hathaway poignantly writes:

The world’s monetary system is in the process of melting down. We have entered the endgame for the dollar as the dominant reserve currency, but most investors and policy makers are unaware of the implications.

The only questions are how long the denouement of the dollar reserve system will last, and how much more damage will be inflicted by new rounds of quantitative easing or more radical monetary measures to prop up the system.

Whether prolonged or sudden, the transition to a stable monetary system will become possible only when the shortcomings of the status quo become unbearable. Such a transition is, by definition, nonlinear. So central-bank soothsaying based on the extrapolation of historical data and the repetition of conventional wisdom offers no guidance on what lies ahead.

History has shown that paper money system don’t last long.

The only exception is that of the medieval Chinese experience which reportedly lasted 600 years. But the historical account of this isn’t certain: wikipedia says it was during the Song Dynasty, the Buttonwood’s Blog at the Economist says it was during Emperor Tsung while Dollardaze.org’s Mike Hewitt says this was during the Tang dynasty.

Meanwhile Murray Rothbard argued that the first paper money in the US was issued by the colonial government of Massachusetts in 1690.

Nevertheless Dollardaze’s Mike Hewitt examined 775 world currencies which includes the 176 in circulation (as of 2009) and 599 not in circulation, and found that

-the “median age for all existing currencies in circulation is only 39 years” and

-that the extinction of currencies had primarily been through acts of war and hyperinflation.

Incidentally and ironically, the US dollar standard since 1971 is 39 years old and seems to feel the same strain from old political habits.

Yet the attraction of the paper money system is that it allows government to pursue its political agenda via unsustainable free lunch policies.

As Murray Rothbard wrote in Mystery of Banking,

The inventions of paper and printing gave enterprising governments, always looking for new sources of revenue, an “Open Sesame” to previously unimagined sources of wealth. The kings had long since granted to themselves the monopoly of minting coins in their kingdoms, calling such a monopoly crucial to their “sovereignty,” and then charging high seigniorage prices for coining gold or silver bullion. But this was piddling, and occasional debasements were not fast enough for the kings’ insatiable need for revenue. But if the kings could obtain a monopoly right to print paper tickets, and call them the equivalent of gold coins, then there was an unlimited potential for acquiring wealth. In short, if the king could become a legalized monopoly counterfeiter, and simply issue “gold coins” by printing paper tickets with the same names on them, the king could inflate the money supply
indefinitely and pay for his unlimited needs.

Eventually, as always, monetary debasement gets abused and suffers from rampant inflation or at worst hyperinflation. And this will require either massive reform or a new currency system.

The current US dollar standard paper money system seems to be in a no different path from its forbears, as free lunch and mercantilist policies are being subtly pursued through global currency debasement.

Some call this the “currency wars”. I call this cycle the Mises moment.

And rampaging gold prices priced in every major currency (US dollar, Euro, Yen, Pounds, Canadian Loonie, Aussie Dollar, Indian Rupee, South African Rand and Gold in G5 index) seems to be saying this for quite sometime—the endgame could be near.

Charts from Gold.org (as of October 25, 2010)

For the “gold is barbaric metal” camp, paper money will reign forever even when unsupported by history and economic laws for the simple reason of dogmatic belief over free lunch politics.

But as Professor Ludwig von Mises once wrote,

The return to gold does not depend on the fulfillment of some material condition. It is an ideological problem. It presupposes only one thing: the abandonment of the illusion that increasing the quantity of money creates prosperity.

Unfortunately, anything unsustainable won’t last. And Voltaire would be validated anew, paper money eventually returns to its intrinsic value—zero.