Why The Sell-Offs In Global Markets Are Unlikely Signs Of A Double Dip Recession

``Public choice is like the small boy who said that the king really has no clothes. Once he said this, everyone recognised that the king’s nakedness had been recognised, but that no-one had really called attention to this fact.”-James M. Buchanan, Politics Without Romance

In this issue:

Why The Sell-Offs In Global Markets Are Unlikely Signs Of A Double Dip Recession

-President Aquino’s Baptism Of Fire: The “Wang Wang” Policy

-Misreading The Decline Of Global Markets

-Europe Tightens Monetary Spigot

-Yield Curves Does Not Suggest Of A Prospective Recession

-Gold Challenges The Recession Outlook; From Policy To Market Divergences

-Summary and Conclusion

The Phisix and ASEAN bourses continue to astonish. They weren’t immune from the steep downdraft seen in global markets. However, the degree of decline was starkly less than those suffered by their contemporaries, such as the US S&P down 5.03% or Germany Dax down 3.9% or China’s Shanghai index down 6.7%. In fact, one of the outlier, Thailand SET even rose by 1.12%.

President Aquino’s Baptism Of Fire: The “Wang Wang” Policy

The Phisix endured a 1.83% loss this week.

And if I use mainstream reasoning to connect the dots, by attaching developments in current events, then this implies that President Noynoy Aquino’s ‘baptism of fire’ policy of hunting down illegal police sirens (Wang Wang) and blinkers, which was one of the major points in his inaugural speech, has important link to the market’s loss.

In the speech, the president aims to reduce the perceived gap between the people and the political leaders, which according to this editorial[1], “Walang lamangan, walang padrino, at walang pagnanakaw. Walang wang-wang, walang counter-flow, walang tong,” he said, vowing to put an end to thievery, patronage, petty extortion, the use of sirens and traffic counter-flow.

Nevertheless, the recent populist acts by new President have several important ramifications;

One, this shows that there have been far too many unenforceable laws. The labyrinth of unenforceable laws reveals of the extent of depth of institutional deficiencies.

Two, laws get to be enforced only upon political convenience.

The law, PD 96, which was signed last 1973 have apparently been flagrantly abused, mostly by those in power. As proof of this, an industry emerged[2] to cater to this once “dormant” and ineffective law.

Moreover, when politics arbitrarily dictate on the priorities of enforceability of specific laws, then the other laws get to be overshadowed. Thereby, the ever shifting political priorities, as set by the whims of political authorities, would only undermine the effectiveness of the institutionalization of the current set of laws.

Three, the arbitrariness of application of laws subjects the enforcer and the violating parties into arbitrary relations.

Once the public gets tired of this issue or once other concerns captures or diverts the public’s attention, then this law would only be a source of corruption, extortion and other ungodly compromises. Remember since many of the offenders are from the political class, then we can expect a lot of this behind the scene reactions. Otherwise, such political vaudeville will die a natural death or revert to hibernation.

Fourth, while President Aquino’s good intention isn’t the object of our critique, this policy seems to be an extension of the political euphoria from the recently concluded elections. It appears that President Aquino mistakenly thinks of the Office of the President as a perpetual popularity contest as manifested by such action. Unfortunately the rubber will meet the road and farcical symbolisms will be exposed for what they are.

Fifth, enforcing Wang Wang laws won’t “put an end to thievery, patronage, petty extortion”. That’s because Wang Wangs are not cause of these misdemeanours. Wang Wangs are only symptoms of an underlying disease.

Therefore, this seems no more than a superficial approach to a very complex issue.

What people don’t see is that the arbitrariness of the implementation of laws signifies as one of the major causes of “thievery, patronage, petty extortion” and such political showmanship won’t resolve the deeply rooted issue.

For laws to be effective, they should be known to everyone, they should be stable for everyone to observe and follow, and they should be always enforced evenly. Therefore, changeability, arbitrariness and selective applications of laws only adds to (and not reduce) these endemic imbalances.

This only puts to light that President Aquino and his strategists reveal of the poor understanding of the drivers of the Philippine political economy and partially affirms our prognosis of the direction of his prospective political actions.

President Aquino needs to deal with the existing cobweb of laws that enables the political power centres to exist and thrive, which prompts for the concurrent inequitable distribution of political (and economic) power from which the Wang Wang pathology has emerged, and the political framework of the bureaucracy--something which incidentally would be politically inconvenient and an exercise he won’t likely underwrite.

Lastly, in my view this seems to be a strategic folly or a misstep for President Aquino. Where the miscue from present post elections euphoria could lead to what Nobel Prize winner James Buchanan[3] would call as “non-performance measured against promised claims”. Political gimmickry can only have a short term impact, thus he would need a bagful of other tricks to keep people entertained.

Yet, an overreach to implement this law at the expense of other concerns would likely lead to failed expectations and subsequently a decline in popularity ratings.

As we have said before, the more things change the more they remain the same.

Misreading The Decline Of Global Markets

Of course, the hyperbolic Wang Wang policies have little to do with the current state of market actions.

The fact is that most of the major financial markets have been in convulsion. Some see this as raising the risks of a ‘double dip’ recession while some see this as “deflation”.

We don’t share both views.

First of all, it is misguided to interpret falling markets as deflation in a monetary sense. Because deflation can used to describe the market activity, such as ‘deflation’ in the prices of stocks, deflation has been mostly utilized as an observation to “effects” rather than the enunciation of causal linkages.

Aside from misreading cause and effect, monetary deflation isn’t the same as deflation in the stock markets because wealth and money are not only different[4] but in stock markets, where every seller (outflow) has a corresponding buyer (inflow), there are NO NET outflows or inflows or transfers of money. Therefore, changes in the pricing of stocks signify as changes in expectations.

And the fudging of definitions won’t make any analysis “sound” or “accurate”, since they are manifestations of (mostly political) bias.

Instead, people’s mental picture of “deflation” is cash hoarding similar to the Great Depression of the 1930s, which arose from frenetic liquidation activities (from intensive government intervention) which led to a massive withdrawal in the banking system. Yet, this scenario hasn’t been true today.

There was indeed a short bout of deflation in late 2008 seen in some developed economies. But this was different from the 1930s. The 2008 episode had been a consequence of a financial gridlock centered upon the US banking system. This affected both payment and settlement activities, from which many in the world resorted to barter trade and in the US the emergence of scrip “local” currency[5].

Deflation, then, didn’t signify outright lack of demand, instead it posited of a “supply shock” from the massive dislocation of monetary or financial flows in the global banking system.

Thus, when global central banks, led by the US Federal Reserve, provided “temporary” patchwork to the immobilized system, aside from applying massive inflationism by absorbing and providing guarantees to securities of dubious quality, global economic activities fiercely rebounded in defiance of the expectations of the mainstream (see figure 1).

Figure 1: Danske Bank[6]: Global Business Monitor

In fact the speed, the magnitude and the ferocity of the ensuing rebound had been so astonishing that global economic indicators as OECD leading indicator (left window- blue line) Global PMI manufacturing (left window- red line) and PMI new orders manufacturing (right window) has equalled, if not surpassed, the highs of the boom days of 2003-2007.

But unless one lives in planet Mars where some harbour the expectations of a sustained rebound in defiance of the laws of gravity, it is natural or normal to expect a “slowdown” to occur following a vigorous V-shaped rebound. Thus the basic axiom applies: no trend goes in a straight line.

True, there are meaningful signs of declines in some economic activities, such as a slowdown in China as her government tries to prevent an overheating (see figure 2), the ongoing fiscal problems and tightening monetary policy in Europe (see below)-which should translate to a temporary slowdown and signs of weaknesses in the US economy particularly seen in the survey of consumer confidence, housing market, durable goods, labor market, mortgage applications, impact from BP oil spill, state budget, and even the Economic Research Institute’s weekly Leading Indicator which has been made by deflation advocates as the primary tool today to declare a bear or market collapse. Some even use the technical death cross in the US markets to suggest of the next crash).

Figure 2: Danske Commodities[7]: Asia: Odds for soft landing in China are good

For instance, the fall in China’s market seem to exhibit manifestations of the ongoing decline in the rate of credit expansion. While this policy induced actions may account for temporary or short term pain, the plus side is that the risk of a ballooning bubble would likely be diminished.

However, the strong showing of fixed asset investments (right window-red line) amidst today’s credit conditions (note: NOT a contraction in credit but a decline in the rate of growth) still implies of a resilient but moderating economic growth.

As a side note: Again, this gives more evidence to our Machlup-Livermore model where China’s current bear market is being driven, not by changes in economic fundamentals but by changes in liquidity conditions. The slowdown in credit conditions in China has prompted for a bear market which seems quite similar to the accounts of 2008 where China did NOT undergo a recession yet the Shanghai index fell by 71%!

My point is that ALL these global economic activities can be construed as reactions by the financial markets to evolving realities from an unsustainable “winning streak” momentum.

Yet again, these indications of economic infirmities hardly exhibit signs of deflation similar to the Great Depression.

As Friedrich von Hayek described[8], (all bold highlights mine)

``How confused ideas still are with respect to the problems of the liquidation and readjustment of the economic system after a crisis is well illustrated by the vague and indefinite way in which in recent years financial journalists and others have discussed the problem of liquidation of the present depression. The analysis of the crisis shows that, once an excessive increase of the capital structure has proved insupportable and has led to a crisis, profitability of production can be restored only by considerable changes in relative prices, reductions of certain stocks, and transfers of means of production to other uses. In connection with these changes, liquidations of firms in a purely financial sense of the word may be inevitable, and their postponement may possibly delay the process of liquidation in the first, more general sense; but this is a separate and special phenomenon which in recent discussions has been stressed rather excessively at the expense of the more fundamental changes in prices, stocks, etc.”

In short, we seem to seeing natural adjustments in relative pricing and the attendant fine-tuning of economic activities from the recent dramatic ascension. Hence, the recent fall does not necessarily imply a double dip recession or deflation.

Europe Tightens Monetary Spigot

Europe seems to be defying the US in terms of monetary policy approach.

Despite the G-20 rapprochement on growth and deficit targets, which according to the Businessweek[9], (bold emphasis added)

``Advanced economies will aim to at least halve deficits by 2013 and stabilize their debt-to-output ratios by 2016, according to a statement released as leaders finished meeting in Toronto today. The G-20 said banks need to raise capital “significantly” and countries will be allowed to phase in new rules, with a goal of meeting new standards by the end of 2012…

``The G-20 had to bridge a gap between leaders such as President Barack Obama who want to focus on growth and officials such as Merkel who favor budget cuts. The statement says the global recovery, which has been faster than expected, remains “uneven and fragile.”

Europe’s ardent desire to cut deficits seems being reflected on the monetary policies (see figure 3).

Figure 3: Danske Bank: Europe Debt Crisis Watch

The European Central Bank (ECB) has been slowing its liquidity provision to the banking system (right window) while simultaneously engaged in monetary tightening by sopping off liquidity in the marketplace (left window).

According to the Danske Bank research team[10],

``The expiry of the ECB 12-month LTRO [Long Term Re-financing Operation] on Thursday is creating jitters in the European money markets, where conditions have worsened despite a tightening of the EONIA EURIBOR spread. The 3M EONIA has risen to the highest level since July 2009, as markets are worrying that weak European banks may have difficulties rolling over short-term funding, although the ECB has announced that it will continue to provide liquidity at 1% full allotment in a three-month LTRO.

``ECB’s purchases of PIIGS government bonds remain very limited and the market is increasingly questioning the central bank’s commitment to support PIIGS.”

So like in China, falling stock markets in Europe have been evincing of a policy based liquidity slowdown, which basically reflects on the adjustments based on these events.

In other words, there seems to be a brewing policy divergence between the US, on the one side and Europe and China on the other, where both Europe and China seem willing to accept the pains of a slowdown as tradeoff to unsustainable spendthrift policies as advocated by US authorities.

These imply that economic activities that had emerged out of the false market signals via inflationism will bear the pain of losses which markets apparently have been pricing in.

As Friedrich von Hayek explained[11], (all bold emphasis mine)

But if prices then do not rise more than expected, no extra profits will be made. Although prices continue to rise at the former rate, this will no longer have the miraculous effect on sales and employment it had before. The artificial gains will disappear, there will again be losses, and some firms will find that prices will not even cover costs. To maintain the effect inflation had earlier when its full extent was not anticipated, it will have to be stronger than before. If at first an annual rate of price increase of five percent had been sufficient, once five percent comes to be expected something like seven percent or more will be necessary to have the same stimulating effect which a five percent rise had before. And since, if inflation has already lasted for some time, a great many activities will have become dependent on its continuance at a progressive rate, we will have a situation in which, in spite of rising prices, many firms will be making losses, and there may be substantial unemployment. Depression with rising prices is a typical consequence of a mere braking of the increase in the rate of inflation once the economy has become geared to a certain rate of inflation.

On the account of this policy divergence, the Euro surged by 1.59% this week.

Moreover the results of the banking stress test[12] will be published on July 23^rd, which if the results are positive should diminish the negative sentiment.

Nonetheless, outside the emergence of any unforeseen tail risks, the temporary slowdown which signals a move away from mainstream Keynesian policies, presents a medium term bullish case for European and China equities. Perhaps we shall see a bottoming of these markets in the coming quarter.

Yield Curves Does Not Suggest Of A Prospective Recession

Figure 4: News N Economics[13]: Japan And US Yield Curve, ECB[14]: Euro Area Yield Curve

The yield curve, by far, is the best indicator of recessions. The yield curve signifies as perhaps the most potent price signal which shapes the public’s expectations that coordinates the distribution of resources across the economic sphere.

As Dr. Frank Shostak explains[15], (all bold emphasis mine)

``To the extent that investors are forming expectations regarding future course of monetary policy, this only tends to reinforce the shape of the curve as set by the central bank. This means that the shift in the shape of the yield curve is ultimately set by the central banks monetary policies and not by investors’ expectations. At best, expectations can either reinforce or moderate the slope of the yield curve.

``Whenever the central bank reverses its monetary stance and thus alters the shape of the yield curve, it sets in motion either economic boom or an economic bust. The effect of a change in monetary policy shifts gradually from one market to another market, from one individual to another individual. It is this gradual increase in the effect of a change in the monetary policy that makes the change in the shape of the yield curve a good predictive tool.”

Thus, if the yield curve is instrumental in generating business cycles, then this means that part of the cyclical activities is the incentives which the yield curve provides the public to arbitrage through interest rate spreads or by profit spreads.

True, US yield curves have been flattening of late, but it is misplaced to suggest that this presages a recession, because as seen from the larger picture, US yield curves remain significantly steep since the onset of the crisis (left window).

Importantly, US yield curves (red line) can’t be compared to Japan’s lost decade. Japan’s yield curve (blue line) since 1998 has remained mostly flat. So any comparison with Japan is likely to be misguided and inaccurate.

And even the yield curve in the European Union has likewise been steep (right window).

So while the present action of the yield curve in the US may suggest of a slowdown they are far from pointing to a recession in the US or in the EU area yet.

The other point is that the monetary climate remains largely expansionary in spite of the current turbulence. And given money’s relative effects to the economy, this should likewise impact financial markets on a relative scale. And perhaps this partly explains the ongoing divergences between ASEAN and global developed markets.

Thus, we differentiate from those advancing the deflation scenario because we see the relative impact of interest rates from the perspective of money’s non-neutrality.

As Ludwig von Mises once wrote[16],

``Public opinion is prone to see in interest nothing but a merely institutional obstacle to the expansion of production. It does not realize that the discount of future goods as against present goods is a necessary and eternal category of human action and cannot be abolished by bank manipulation.”

Gold Challenges The Recession Outlook; From Policy To Market Divergences

Furthermore, as we previously[17] pointed out, another indicator that doesn’t suggest of a market collapse or the imminence of recession is Gold.

True, gold prices fell by 3.55% this week but that’s after setting a new nominal record (see figure 5).

Figure 5: Gold’s Retreat From Record Run, Emerging Divergences

Therefore, gold’s price action can be deemed as merely a routine correction following the new milestone high.

Remember, gold prices have NOT been immune to recessions[18]. Therefore, we take this as signs that gold isn’t a hedge against deflation[19]. Hence, a prospective recession is also likely hammer hard on gold prices. So far this hasn’t been the case yet.

Unless gold continues to fall hard, we should take the recent action to be a normal phase of adjustments based on evolving conditions.

I would like to further add that the so called fiscal austerity or the shift away from Keynesian policies is likewise going to somewhat hurt gold. That’s because gold has essentially been riding on global government’s reckless adaption of Keynesian policies.

And as the G-20 meeting has demonstrated, the policy divergences by Euro-China relative to the US would likely have disparate impact on gold prices. Gold is likely to underperform in Euro and Yuan terms, but outperform based on the US dollar terms as the US government is likely to pursue policies of inflationism.

And such policy divergences will also likely disharmonize the impact on financial asset markets.

And possibly the current disparities in the gold-copper market (where gold drifts near record highs while copper prices have been lethargic) and the emerging market stocks (EEM)-bonds (XESDX) [where EM stocks have been sluggish while EM bonds have been recovering) have been suggesting of these developments.

Finally it’s also a mistake to equate falling commodity prices as signs of deflation.

As Ludwig von Mises explained[20], (all bold highlights mine)

``As soon as the depression appears, there is a general lament over deflation and people clamor for a continuation of the expansionist policy. Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holding. This may be properly called deflation. But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after greater cash holding. The causation is the other way around. Prices of the factors of production--both material and human--have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labor unions to prevent or to delay this adjustment merely prolongs the stagnation.”

In short, while falling commodity prices may suggest of a forthcoming recession, they do not automatically suggest signs of deflation-since recessions are manifestations of adjustments from the misallocation of resources through price signals.

Summary and Conclusion

To recap:

Falling global markets doesn’t necessarily imply a forthcoming recession or deflation. More importantly little of the current market actions signal “monetary deflation”.

Following a surge in the activities in the global economy it would be normal to see a moderation of activities which may have been reflected on the markets. Thus the retreat in the momentum suggest of a market misread by some as a “double dip” or deflation.

Despite the G-20 consensus, US and Europe appears to have drawn the proverbial line on the sand; there will be policy induced divergences among G-20 member nations.

Europe and China appears to be in a tightening mode, hence their markets seem to be reflecting on such policy actions.

Europe seems signalling a retreat from Keynesian policies. Current weakness should be seen as temporary. The Euro is already affirming this action.

The US will likely continue to inflate, where more signs of market distress would possibly lead to the reactivation of the Quantitative Easing facility.

Policy divergences are likely to impact markets distinctly. Therefore, we may be seeing further signs of market disaccord or decoupling.

The yield curve remains steep in the US and Europe or in Asia. This hardly signals a double dip or of deflation. Perhaps too, the steep yield curve has prompted Europeans to engage in tightening and to veer away from Keynesian policies.

Gold’s recent retreat from its record run doesn’t signal a return of recession.

There seem to growing signs of divergences across asset markets seen even in the commodity and in emerging markets.

Falling commodity markets doesn’t automatically translate to deflation.

Philippine President Noynoy Aquino’s first “Wang Wang” policy shouldn’t have any impact on the markets and could herald the general direction of his administration’s policy.

ASEAN markets continue to display peculiar resiliency. Should global markets begin to recover, ASEAN markets are likely to go on full throttle and outperform the rest. This includes the Philippine Phisix.

This means a buy on the Phisix and the Peso.

---

[1] Philippine Star, EDITORIAL - No more wang-wang, July 2, 2010

[2] GMANEWS.TV, Cops helpless vs 'wang-wang' dealers, July 2, 2010

[3] Buchanan, James M. Politics Without Romance

[4] See Are Recessions Deflationary?

[5] See Emerging Local Currencies In The US Disproves The 'Liquidity Trap’

[6] Danske Bank, Global Business Monitor

[7] Danske Bank, Commodities Monthly: New price floors materialising, June 30, 2010

[8] Hayek, Friedrich von The Present State And Immediate Prospects. Of The Study Of Industrial Fluctuations Profits, Interest And Investment P.176

[9] Businessweek, Bloomberg G-20 Agrees to Cut Deficits Once Recoveries Cemented, June 27, 2010

[10] Danske Bank: Europe Debt Crisis Watch, June 29, 2010

[11] Hayek, Friedrich August von Can We Still Avoid Inflation? The Austrian Theory of the Trade Cycle

[12] ABC News, European Bank Stress Test Results Due on July 23, July 4 2010

[13] News N Economics, Yield curves in Japan and the US: similar but not the same, June 29, 2010

[14] European Central Bank, Euro Area Yield Curve

[15] Shostak, Frank, What's With the Yield Curve?, Mises.org

[16] Mises, Ludwig von The Monetary or Circulation Credit Theory of the Trade Cycle, Chapter 20 Section 8, Human Action

[17] See What Gold’s Latest Record Prices Mean

[18] See Why The Current Market Volatility Does Not Imply A Repeat Of 2008

[19] See Gold Unlikely A Deflation Hedge

[20] Mises, Ludwig von, The Gross Market Rate of Interest as Affected by Deflation and Credit Contraction Chapter 20 Section 7, Human Action

Update: Since I'm not familiar with the new Google doc set-up, I am having a hard time trying to integrate the new format to my blog. Hence the bold highlights noted above were not reflected.The original document can be found below...

Cheap Labor Theory And Economic Growth: Philippine Edition

If we go by the mainstream's view of how trade competitiveness is achieved or how unemployment can be resolved, they'll reason out that cheap wages holds the magic wand in establishing "equilibrium".

Let's see if this reasoning works using the Philippines as example.

The above table shows of the daily minimum wages rates per region from the Department of Labor and Unemployment.

I'd be using the non-agricultural rates as basis for comparison. From this perspective, the highest wage rates can found in the National Capital Region (NCR) which is at Php 404 (US $8.6) while the lowest can be found in region 5 (Php 196-239) and the ARMM area (php 210 or US$4.5) or a spread of about 82-90% compared to the NCR.

So based on mainstream reasoning, Region 5 and ARMM should be thriving with economic activities.

The table above from the National Statistical Coordination Board shows of the regional economic growth rates in terms the industry (upper window) and the service sector (lower window) from which the above wages apply.

As a side note, the above table are referenced from 2006-2008, but the minimum wages are current. Nevertheless, I don't see material deviances in the changes of regional minimum wages, which are determined by the Regional Tripartite Wages and Productivity Boards, enough to affect the relevance of this discussion.

Despite the huge wage disparity, Region 5 and the ARMM hasn't significantly outperformed the NCR in the service sector from which growth rates seems to be about just even.

However, the NCR has substantially outperformed these regions in terms of industry.

This runs in contrary to mainstream thinking where investors should be stampeding into these "cheap wage" regions and where NCR's industry should be suffering from these losses.

To add, the NCR appears to be expanding its share of the pie relative to the other regions in terms the national output.

However, I have to admit that NCR has the highest unemployment rates of all, while the ARMM has the least, according to the NSCB.

Finally, the above table from ADB shows that the ARMM has the highest poverty incidences in spite of low unemployment rates while Region 5 has the third highest. So people in ARMM have jobs alright, but they are still very poor.

Seen from a different light, the reason why NCR maintains its dominance in spite of higher wage levels is because per capita GDP is the highest in the country. The variance is just too evident.

To conclude, NCR is where the concentration of capital accumulation is and where capital backed labor productivity is the highest. Therefore, NCR commands the region's highest wage levels in the country. And this hasn't reduced her trade competitiveness. Albeit, one reason why unemployment have been the highest here is because of the above average population growth rates and not due to losses from industry shifting to ARMM or Region 5. Yes, wealth attracts migration flows or urbanization.

Put differently, the cheap labor theory accounts for as an oversimplified and mercantilist mythology which is no less than a political propaganda to justify government interventionism or inflationism.

The other way to say this is that in order to drive down wages, one has to inflate strongly enough to reach levels that would drive down the standards of living to prompt for a surge in poverty levels. What a way to achieve economic prosperity!

Yet, as shown above, the expected economic advantages isn't assured.

To quote fund manager Rob Arnott, ``When data contradict theory in a discipline like physics, there is excitement among scientists about the potential to improve the theory. When data contradicts theory in finance, there is dismissal."

Are Recessions Deflationary?

John Maudlin writes,

``My main concern, as readers know, is that we may have a weak economy in the latter half of the year and then introduce a large tax increase, which my reading of the economic studies on tax increases suggests will throw us into recession. Recessions are by definition deflationary." (bold emphasis added)

How true is the last statement?

If we measure inflation based on changes in consumer prices (annual change), then since 1970 when our monetary system shifted to a US dollar standard, out of the seven recessions, only the 2008 episode manifested a short bout of deflation.

In addition, his preferred measure of monetary aggregates, the MZM have practically shown little correlation in the annual rate of change in MZM and previous recessions. There had been two instances where recessions had been followed by higher MZMs and there had also been two instances where falling MZM succeeded recessions.

Besides it is misplaced to think that falling asset prices automatically equates to deflation, that's because money and wealth are two different things.

As Robert Murphy explains, (all bold highlights mine)

``In general, when investors reduce their demand for risky assets and flee to safe assets (such as cash), this will depress the market value of the risky assets. However, widespread selling of stocks by itself can't increase the total quantity of money.

``In the real world, things are complicated by the fact that our banking system uses fractional reserves. In this case, people really can influence the total quantity of money, based on their allocation of wealth. Specifically, if people withdraw their funds from banks in order to hold physical currency, then the banks must contract their outstanding loans because of legal-reserve requirements. If we are using a monetary aggregate such as M1, which counts checking account balances as part of the money stock, then an increased demand to hold physical currency can shrink "the money supply."

``Similarly, there are also complications if we take "money" to be one of the broader aggregates, such as M2 or M3, which include deposits in money-market accounts. In this case, if people transfer their wealth from a money-market account into a straight checking account or physical currency, this too can affect "the money supply."

``Notwithstanding these complications, the simple economy in this article is a good starting point to clarify our thinking. Money and wealth are distinct, and we should not assume that a fall in the stock indices necessarily means that "that money" has now been transferred someplace else."

Wealth Makes Health And Intelligence

The Economist shows a study associating intelligence with incidences of infectious diseases.

The Economist writes,

"HUMAN intelligence is higher, on average, in some places than in others. And researchers at the University of New Mexico have come up with an explanation, published in the Proceedings of the Royal Society. Comparing the average IQ in a particular country with its disease burden (based on the reduction in life expectancy caused by 28 infectious diseases) reveals a striking correlation. At the bottom of the IQ list is Equatorial Guinea, followed by St Lucia, with Cameroon, Mozambique and Gabon tied for third last. These countries also have among the highest burdens of infectious diseases. At the opposite end of the scale, Singapore, South Korea, China and Japan show the highest intelligence scores and relatively low levels of disease. America, Britain and a number of European countries also place in the top left-hand corner of the chart."

Well, correlation doesn't imply causation. Besides, not all education can be treated as equal, as education can represent political or religious indoctrination. In addition, some people can finish traditional academic requirements but they may remain "inadequately" educated.

Instead, what we suggest as a meaningful causal link behind education and disease is capitalism.

Where capitalism allows people to generate wealth, wealth allows the financing of education and the preservation of health or disease avoidance.

The Gapminder chart above shows of this strong correlation.

As Matt Ridley writes in The Rational Optimist: How Prosperity Evolves (hat tip Mark Perry)

``The availability of almost everything a person could want or need has been going rapidly upwards for 200 years: years of lifespan, mouthfuls of clean water, lungfuls of clean air, hours of privacy, means of traveling faster than you can run, ways of communicating farther than you can shout, and with more access to calories, watts, lumen-hours, square feet, gigabytes, megahertz, light-years, nanometers, bushels per acre, miles per gallon, food miles, air miles, and of course dollars than any who went before."

Trojan Horse Advise Of PIMCO's Bill Gross

PIMCO's William Gross writes, (bold highlights mine)

``It is this lack of global aggregate demand – resulting from too much debt in parts of the global economy and not enough in others – that is the essence of the problem, which only economists with names beginning in R seem to understand (there is no R in PIMCO no matter how much I want to extend the metaphor, and yes, Paul _Rugman fits the description as well!). If policymakers could act in unison and smoothly transition maxed-out indebted consumer nations into future producers, while simultaneously convincing lightly indebted developing nations to consume more, then our predicament would be manageable. They cannot. G-20 Toronto meetings aside, the world is caught up as it usually is in an “every nation for itself” mentality, with China taking its measured time to consume and the U.S. refusing to acknowledge its necessity to invest in goods for export.

``Even if your last name doesn’t begin with R, the preceding explanation is all you need to know to explain what is happening to the markets, the global economy, and perhaps your own wobbly-legged standard of living in recent years. Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened. We have arrived at a New Normal where, despite the introduction of 3 billion new consumers over the past several decades in “Chindia” and beyond, there is a lack of global aggregate demand or perhaps an inability or unwillingness to finance it. Slow growth in the developed world, insufficiently high levels of consumption in the emerging world, and seemingly inexplicable low total returns on investment portfolios – bonds and stocks – lie ahead. Stop whispering (and start shouting) the words “New Normal” or perhaps begin to pronounce your last name with an RRRRRRRRRRRR. Our global economy, our use of debt, and our financial markets have changed – not our alphabet or dictionary."

Well this is one good example why the Fed economist Kartik Athreya recently assailed on economic bloggers for trying to "oversimplify economics".

What's wrong with the picture described by Mr. Gross?

Many. But we will stick with two major flaws: Producers are painted to be distinct from consumers and that all debts are treated as equal.

Nations constitute people and that production and consumption are activities aimed at satisfying peoples' desire. In other words, people produce to consume. The difference is that in emerging markets, consumption is mostly funded by savings (surplus production output) and little of debt. In developed economies consumption is mainly financed by debt.

Mr. Gross wants EM economies and developed economies to trade places in terms of consumption and production. He sees government as using its force to make this shift on their people, according to his simplified gospel of prosperity.

He is not straightforward to say that when people undertake debt to finance spending on consumption goods, that would be equivalent to capital consumption (spending more than one earns). He isn't even candid to say that this had also been the root of the recent crisis.

In other words, to advance the notion that people should indulge in unproductive debt is equivalent to an advocacy of poverty. Therefore, Mr. Gross' recommendation would seem like an implicit trojan horse recipe for people in emerging markets-an advise that should be ignored. His agenda is that inflationism would lift total returns of investment portfolio for his self interest.

Moreover, I wonder how Mr. Gross would react if the US government strictly applies his recommendation---that would require him and/or PIMCO to forcibly go into manufacturing and forego of their current financial investments model. His outlook assumes that everyone else has a problem but him and his RRRR, such that government should apply his remedies only to the others.

Finally, another important thing Mr. Gross glosses over is that since governments are also run by people whose interests are determined mostly by local political factors, this translates to innate policy divergences in national and global issues for every country. Thus, there is such a thing as competition among governments. The other way to say this, is that harmonization of policies among governments is another mirage.

Credit Default Risk: From PIIGS To The 4 US States

Four US states, particularly California, Illinois, New Jersey, and New York, has been in a race with the European "PIIGS" in terms of credit risks or default risk as measured by CDS (Credit Default Risk).

As Bespoke Invest notes,

``All four states are closer to the top of the list than the bottom in terms of default risk. As noted earlier, Illinois has the highest default risk at 368.6 bps. The state sits between Dubai and Bulgaria. California ranks second out of the four at 352.9 bps, while New York and New Jersey are both right around the 290 bp level. Illinois and California are both at higher risk than Portugal, while all four are in a worse situation than Spain. In terms of year-to-date change, Illinois default risk is up 117%, New York and New Jersey are both up about 87%, and California is up 35%."

The difference is that the European PIIGS constitute about 18% of EU's GDP while the US contemporary is about 29% of the US GDP. Incidentally, the 4 states are among the biggest (in terms of share of GDP): California (ranked 1st), New York (3rd), Illinois (5th) and New Jersey (8th).

Yet financial markets seem to be singing contrasting tunes which seem inconsistent: jump in the Euro, firming CDS of 4 US states while new lows in 10 year US treasury yields. If there is a shift in concerns towards the 4 US states then treasuries yields are suppose to go higher.

I'd like to add that the gap between the PIIGS and the US-4 relative to the ASEAN-4 led by Indonesia and the Philippines seems to have widened. This partly explains the signs of 'decoupling'.

Remembering Frédéric Bastiat

Yesterday marked Frédéric Bastiat's 209th birthday.

And below is a favorite essay of mine " The Little Arsenal of the Freetrader" from a collection of articles in Economic Sophism, which deals with common objections to free trade.

Here is Frédéric Bastiat... (all bold emphasis mine)

Suppose someone tells you: "There are no absolute principles.

Interdiction can be bad, and restriction good."

Answer: "Restriction interdicts the importation of everything it prevents from entering."

Suppose someone tells you: "Agriculture is the nutricial mother that furnishes the whole country with food."

Answer: "What furnishes the country with nutriment is not strictly agriculture, but wheat."

Suppose someone tells you: "The sustenance of the nation is dependent on agriculture."

Answer: "The sustenance of the nation is dependent on wheat. That is why a law compelling the nation to obtain two hectolitres of wheat by agricultural labor instead of the four hectoliters it might have obtained, in the absence of the law, by applying the same amount of labor to industrial production, far from being a law for the people's sustenance, is a law for their starvation."

Suppose someone tells you: "Restricting the importation of foreign wheat is conducive to an increase in domestic agriculture and, therefore, to an increase in domestic production."

Answer: "It is conducive to the extension of agriculture to the rocky slopes of mountains and the barren sands of the seashore. If you milk a cow and keep on milking, you will get more milk; for who can say just when you will no longer be able to squeeze out another drop? But that drop will cost you dear."

Suppose someone tells you: "Let the price of bread be high, for the farmer who becomes rich will enrich the industrialist."

Answer: "The price of bread is high when it is scarce; but scarcity makes only for poor people, or, if you like, starving rich people."

Suppose someone presses the point and says: "When the price of bread goes up, wages go up."

Answer by showing that in April, 1847, five-sixths of the workers were living on charity.

Suppose someone tells you: "A rise in wages must necessarily follow a rise in the cost of living."

Answer: "That is tantamount to saying that in a ship with no provisions everyone has as much to eat as if it were well stocked."

Suppose someone tells you: "The man who sells wheat must be assured a good price."

Answer: "Very well. But in that case the man who buys it must be assured a good wage."

Suppose someone tells you: "The landowners, who make the law, raised the price of bread without concerning themselves about wages because they know that, when the price of bread goes up, wages go up quite naturally."

Answer: "By the same token, then, when workers make the law, do not blame them if they fix a high wage rate without concerning themselves about protecting wheat, for they know that, when wages are raised, the cost of living rises quite naturally."

Suppose someone asks you: "What must we do, then?"

Answer: "Be just to everyone."

Suppose someone tells you: "It is essential for a great country to have an iron industry."

Answer: "What is more essential is that this great country have iron."

Suppose someone tells you: "It is indispensable for a great country to have a clothing industry."

Answer: "What is more indispensable is that the citizens of this great country have clothes."

Suppose someone tells you: "Labor is wealth."

Answer: "That is not true."

And, by way of explanation, add: "Bloodletting is not health; and the proof is that its object is to restore health."

Suppose someone tells you: "To compel men to dig a mine and to extract an ounce of iron from a quintal of iron ore is to increase their labor and consequently their wealth."*

Answer: "To compel men to dig wells by forbidding them to take water from the river is to increase their useless labor, but not their wealth."

Suppose someone tells you: "The sun gives its light and heat without remuneration."

Answer: "So much the better for me; it costs me nothing to see clearly."

And suppose someone replies: "Industry in general loses what you might have spent for artificial illumination."

Parry with: "No; for what I save by paying nothing to the sun, I use for buying clothing, furniture, and candles."

Similarly, suppose someone tells you: "These English scoundrels have amortized their investments."

Answer: "So much the better for us; they will not oblige us to make interest payments."

Suppose someone tells you: "These perfidious Englishmen find iron and coal in the same pit."

Answer: "So much the better for us; they will not charge us anything for bringing them together."

Suppose someone tells you: "The Swiss have lush pastures that cost little."

Answer: "The advantage is on our side, for this means that less labor will be demanded on our part to promote our domestic agriculture and provide ourselves with food."

Suppose someone tells you: "The fields of the Crimea have no value and pay no taxes."

Answer: "The profit is on our side, since the wheat we buy is exempt from these charges."

Suppose someone tells you: "The serfs of Poland work without wages."

Answer: "The misfortune is theirs, and the profit is ours; since their labor does not enter into the price of the wheat that their masters sell us."

Finally, suppose someone tells you: "Other nations have many advantages over us."

Answer: "Through exchange, they are, in fact, compelled to let us share in these advantages."

Suppose someone tells you: "With free trade, we are going to be flooded with bread, beef _ la mode, coal, and overcoats."

Answer: "Then we shall be neither hungry nor cold."

Suppose someone asks you: "What shall we use for money?"

Answer: "Don't let that worry you. If we are flooded, it will be because we are able to pay; and if we are not able to pay, we shall not be flooded."

Suppose someone tells you: "I should be in favor of free trade if foreigners, in bringing us their products, took ours in exchange; but they will take away our money."

Answer: "Money does not grow in the fields of the Beauce any more than coffee does, nor is it turned out by the workshops of Elbeuf. For us, paying foreigners with cash is like paying them with coffee."

Suppose someone tells you: "Eat meat."

Answer: "Permit it to be imported."

Suppose someone tells you, like La Presse: "When one does not have the means to buy bread, one must buy beef."

Answer: "This is advice just as wise as that of Mr. Vulture to his tenant:

"When one does not have the means to pay his rent, One has to get a house of one's own."

Suppose someone tells you, like La Presse: "The government should teach people why and how they ought to eat beef."

Answer: "The government has only to permit the importation of beef; the most civilized people in the world are sufficiently grown up to learn how to eat it without being taught."

Suppose someone tells you: "The government should know everything and foresee everything in order to manage the lives of the people, and the people need only let themselves be taken care of."

Answer: "Is there a government apart from the people? Is there any human foresight apart from humanity? Archimedes could have gone on repeating every day of his life, 'Give me a fulcrum and a lever, and I will move the earth'; he would never, for all that, have been able to move it, for want of a fulcrum and lever. The fulcrum of the state is the nation, and nothing is more senseless than to base so many expectations on the state, that is, to assume the existence of collective wisdom and foresight after taking for granted the existence of individual imbecility and improvidence."

Suppose someone tells you: "Good heavens! I am not asking for favors, but just enough of an import duty on wheat and meat to compensate for the heavy taxes to which France is subjected; only a small duty equal to what these taxes add to the sales price of my wheat."

Answer: "A thousand pardons, but I too pay taxes. If, then, the protection that you are voting yourself has the effect of adding to the price I pay for wheat an amount exactly equal to your share of the taxes, what your honeyed words really come to is nothing less than a demand to establish between us an arrangement that, as formulated by you, could be expressed in the following terms:

'Considering that the public charges are heavy, I, as a seller of wheat, am to pay nothing at all, and you, my neighbor who buys it, are to pay double, viz., your own share and mine as well.' Wheat merchant, you may, my neighbor, have might on your side; but you surely do not have right."

Suppose someone tells you: "It is, however, very hard for me, who pay taxes, to compete in my own market with a foreigner who pays none."

Answer: "1. In the first place, it is not your market, but our market. I, who live on wheat and pay for it, ought to count for something too.

"2. Few foreigners nowadays are exempt from taxes.

"3. If the tax that you are voting repays you, in the form of roads, canals, security, etc., more than it costs you, you are not justified in barring, at my expense, the competition of foreigners who do not pay the tax, but who, by the same token, do not enjoy the advantages of the security, roads, and canals that you have. It would make just as much sense to say: 'I demand a compensatory duty, because I have finer clothes, stronger horses, and better plows than the Russian peasant.'

"4. If the tax does not repay you what it costs, do not vote it.

"5. And finally, after voting the tax, do you desire to exempt yourself from it? Then contrive some scheme that will shift it onto foreigners. But the tariff makes your share of the tax fall upon me, who already have quite enough of my own to bear."

Suppose someone tells you: "For the Russians free trade is necessary to enable them to exchange their products to advantage."

[Opinion expressed by M. Thiers in committee, April, 1847.]

Answer: "Free trade is necessary everywhere and for the same reason."

Suppose someone tells you: "Each country has its wants and it must act accordingly." [M. Thiers.]

Answer: "It does so of its own accord when it is not hindered from doing so."

Suppose someone tells you: "Since we have no sheet iron, we must permit its importation." [M. Thiers.]

Answer: "Much obligedl"

Suppose someone tells you: "Our merchant marine needs freight. The lack of cargoes on return voyages prevents our ships from competing with foreign vessels." [M. Thiers.]

Answer: "When a country wants to produce everything at home, it cannot have cargoes either to export or to import. It is just as absurd to want a merchant marine when foreign products are barred as it would be to want carts where all shipments have been prohibited."

Suppose someone tells you: "Even granting that the protectionist system is unjust, everything has been organized on the basis of it: capital has been invested; rights have been acquired; the system cannot be changed without suffering."

Answer: "Every injustice is profitable for someone (except, perhaps, restriction, which in the long run benefits nobody); to express alarm over the dislocation that ending an injustice occasions the person who is profiting from it is as much as to say that an injustice, solely because it has existed for a moment, ought to endure forever."