Simon Black on the Herd Mentality

Sovereign Man’s Simon Black writes 

In one of the most ill-timed columns ever written, Fortune Magazine published an article entitled “10 stocks to last the decade” on August 14, 2000.

The NASDAQ Composite Index was at 3849.69… and within days of the article being published, the index would begin a ruthless decline, taking a whopping 13 years to return to that level.

And as for the 10 stocks which were supposed to last the decade? Two of them (Nortel, Enron) went bust entirely.

One of them (Morgan Stanley) would have gone bust if it hadn’t been for a $107 BILLION taxpayer bailout.

Others (Univision, Genentech) were bought out at valuations substantially lower than their August 2000 levels.

The remaining ones (like Nokia) are still out there somewhere, but their stock prices have declined as much as 83% over the last fourteen years.

To put it bluntly, not a single company on Fortune’s list of titanic, unbeatable stocks managed to generate a positive return for investors. Everyone lost.

In fairness, this isn’t a dig against Fortune; nearly EVERYONE thought that Enron was a sure bet back in 2000. (Although Fortune actually named Enron “America’s most innovative company” for six years in a row from ’96 to ’01…)

Back then no one could imagine that Enron and Nortel would soon cease to exist. Or that Nokia’s brand value would be virtually wiped out by Steve Jobs and a bunch of scrappy Koreans.

This is really a fantastic example of how a herd mentality forms about the sanctity and staying power of certain institutions.

It’s human nature to believe that whoever is in the lead now will always be in the lead.

This is a lucid example of the cognitive bias called anchoring or via Wikipedia the “common human tendency to rely too heavily on the first piece of information offered (the "anchor") when making decisions.”

Such indeed plagues the consensus who sees things moving on a linear or quasi-linear basis. 

And this goes with experts who relies mainly on statistics (economic history) as basis for crystal ball reading. 

When a trend emerges which are usually formed by first movers, this will be taken up gradually by more and more people which reinforce trend. Eventually convictions become so strong that most believe that a such trend can only move into a single direction. Such trend has been discerned as the risk free easy money trade that will be rationalized through various statistics. The upside movement accelerates.

At the day, as history always show, popular delusions will be dealt by reality in an agonizing way.

When Political Promises Fail: Kiev Doubles Prices of Cold Water

Sovereign Man’s Simon Black relates of the real time unfortunate developments in the Ukraine capital of Kiev, where political promises on public goods (water supply) appears to have been broken:  

Hours ago, the local gas company in Kiev (Kyivenergo) announced that they would be shutting off the hot water supply to most of the city.

While the official reason for the hot water shutoff is that Kyivenergo (the energy supplier to Kiev) owes a debt to the Ukrainian state gas company (Naftogaz) of over $100 million.

It’s just a quirky little coincidence that this debt suddenly became materially important only one week after Russia shut off natural gas supplies to Ukraine.

Funny thing is that Ukrainian politicians for years had been telling people not to worry about this.

You see, Ukraine has its own domestic natural gas supplies. And they tell people that the domestic gas is strictly for the people and their utilities (like hot water).

Russian gas, according to this story, is imported for businesses to use. But that domestic gas is sacrosanct, only for the people.

Clearly this turned out to be a big fat lie.

Bear in mind, it was just a few weeks ago that utility companies announced that the price of cold water would jump from 3.18 hryvnas per cubic meter to 6.22– a 95% increase, practically overnight.

So there’s an entire city now taking cold showers… and paying twice the price for the privilege! Insult. Injury.

This will be a problem once winter sets in. Nonetheless the lesson from Kiev’s water politics, again from Mr. Black (bold mine)

1. Politicians always lie. They will tell you that your nation is stronger than it really is, that your country is prepared for whatever may come, that your benefits will never be cut, etc.

And even though they may be well-intentioned, these are not promises that can be kept… especially by a nation in crisis.

2. A nation in crisis affects just about everything. It’s not just about numbers and data, or even Molotov cocktails. It’s hot water and toilet paper. It’s food on the shelves. It’s the stuff we all take for granted that suddenly doesn’t function anymore.

3. Even though the obvious warning signs are there, most people wait until it’s too late (or at least suboptimal) before considering their options. 

When you wait until a full blown crisis, you have to rush through critical decisions in haste instead of planning things out slowly, rationally.

That's the reason crises signify as Black Swans: People hardly realize of their impact.

Beware the New Government Money Grab via Banks: Dormant Accounts

Governments are also very innovative. Since they have all been so desperate to corral people’s money, they find new ways and means to do so. So here is the latest government money grab enforced through banks: Dormant accounts.

Writes Sovereign Man’s Simon Black

And over the last few years, one of the most creative ways that bankrupt governments have come up with is to confiscate what they consider “dormant” bank accounts—this would be an account without any transactions over a specified period of time.

The UK was the first on the scene with this idea with the 2008 Dormant Bank and Building Society Act. It was passed just in the knick of time right as the entire financial system was collapsing.

Within two years, the British Banker’s Association estimated that the law could raise as much as $600 million for the government… no small sum in the UK.

Earlier this year, Japan launched a similar initiative aimed at grabbing dormant bank accounts; they expect the move will raise approximately $500 million annually.

Both at least Japan and the UK have long-term thresholds. In Japan, they’ll seize an account if it has been dormant for more than 10 years. In the UK, it’s 15 years.

But there are a number of things wrong with this approach.

First, it calls into question the fundamental principle of private property. How can something be yours if the state can legislate its authority to seize it?

And even if the account holder has long since passed, shouldn’t the funds, by default, be awarded to the survivors nominated in accordance with the instructions in his/her last will and testament?

It is a rather ignoble act indeed to set aside the wishes of the dead so that the state can have yet another resource to plunder.

More concerning, though, is that if the state can simply legislate its authority to seize dormant bank accounts, then they can just as easily lower the bar.

Australia (which actually has a well-capitalized banking system and is not even a bankrupt government) passed legislation last year to reduce the threshold on seizing dormant accounts from seven years down to just THREE.

And in the last 12-months since the legislation was passed, the Australian government has seized a whopping 80,000 accounts totaling A$360 million… more than has been seized in the previous five decades COMBINED.

In case you’re wondering, yes of course, the Land of the Free has similar rules.

Read the rest here

Oh expect these dynamic to be adapted globally. 

Quote of the Day: 42.4% increase in the price of being poor

Perhaps the most striking example is the World Bank, which is now considering a massive revision to how they define ‘poverty’.

The global poverty line used to be defined as living on $1/day or less. Then they had to increase that to $1.25 in 2008, since, even for the world’s most impoverished, one dollar wasn’t such a big sum anymore.

Now the World Bank is looking at increasing that poverty line even further, to $1.78. That’s a 42.4% increase.

All of this is because new economic data from Centre for Global Development and the Brookings Institution showed that the number of people living on less than $1.25 has halved.

It’s not because there are that many fewer poor people in the world. It’s that you can’t even be poor anymore on $1.25/day.

Thanks to all the money printing that has taken place around the world, it takes a much greater sum these days… just to be impoverished.

Not that there’s any inflation.

This is from Simon Black at the Sovereign Man.

Oh with increasing risks of protectionism as world powers square off over territorial borders which has now spilled over to the economic front (so far with limited scope of sanctions), more regulations and mandates, higher taxes and the deepening global bubbles, which will result to a combo of stagflation and bubble busts, global poverty levels will rise again.

Chinese government bails out real estate markets in 6 cities; Growing Signs of Panic?

The Chinese government appears to be conducting a stealth bailout of localities affected by the rapidly unfolding periphery (rural areas) to the core (large cities) dynamic of the boom-bust cycle.

Writes Sovereign Man’s Simon Black (bold mine)

According to the Chinese financial publication Securities Daily, emergency real estate rescue packages have been launched in large cities such as Wuxi, Nanning, Hangzhou, Tianjin, Tongling and Zhengzhou in the last month alone. 

“Zhengzhou created a mortgage guarantee policy to win back banks’ confidence” according to the story.

Further, “if a borrower does not fulfill the loan repayment obligations as agreed in the contract, the guarantee institutions will have to repay the housing loans…”

What a surprise– a government guarantee.

The market is imploding and defaults are going through the roof. Property vacancy rates in Zhengzhou are an astounding 23%. So the government is putting taxpayers on the hook.

The article goes on: “A legislative affairs official of Zhengzhou revealed to the media that this was the first time for Zhengzhou to carry out such individual housing loans guarantee policy.”

In other words, the government is panicking.

Home sales in China fell last month by 18%, in no small part due to tightening credit conditions.

Developers have tried to pick up the slack and liquidate inventory by offering no money down deals… their own desperation tactic.

But it’s not working.

Over the May 1-3 holiday weekend, new home sales across China’s 54 largest cities were 47% lower than last year.

The national government in China has all but capitulated, and they’ve turned the reins over to local governments to ‘fix’ the problem.

This has been a long time in the making.

According to data from the US Geological Survey and China’s National Bureau of Statistics that was compiled by the Financial Times, in just two years (2011 and 2012), China produced more cement than the United States produced in the entire 20th century.

Much of this development came from centrally planned monster infrastructure projects– bridges to nowhere, zombie train stations, and infamous ghost cities.

So much excess inventory has built up, a major slowdown was inevitable.

This is a huge issue for China given that housing sales comprised nearly 12% of GDP last year.

Even President Xi Jinping recently stated that his nation must adapt to a ‘new normal’ of slower economic growth.

And like the butterfly that flaps its wings, a slowdown in China has substantial effects on the rest of the world.

Please read the rest here.

Some comments

1. So in addition to the PBoC’s implicit stimulus, I wrote why these bailouts aimed at “kicking the can” will buy only limited time yesterday. (bold original)

What they are really doing is to buy time from a devastating meltdown. Yet by doing so, they will increase the magnitude of a disorderly market clearing as resources continue to flow into speculative capital consuming ventures.

The decline in property prices has been manifested by a slowdown credit expansion. This simply means that the diversion of something for nothing bubble activities will materially decline. And a lot of the unproductive bubble projects will continue to surface as debt delinquent entities.

And demand that has emerged from the bubble boom will equally subside which should aggravate the surpluses.

And as the property sector slows, all other industries attached or that has emerged out of the bubble will also be significantly affected. There will be a contagion.

And feedback loop between problematic debt and the rapidly slowing economy enhances the risk of a credit event—a Black Swan moment.

If China’s bubbles has overwhelmed her residual real savings (which have been sunk into capital consuming speculative projects as embodied by vacant properties and ghost projects), then the policies to “kick the can down the road” will buy limited time.

This also means that throwing money into the system will extrapolate to the law of diminishing marginal returns—more debt produces lesser growth, but on the other hand, amplifies systemic risks.

2. I previously dealt with the illusion or the myth of infrastructure spending or “centrally planned monster infrastructure projects”. Here is a slice. 

The fundamental reason why Bastiat argued against the age old economic myth is that resources used by the government will always have to be taken away from somewhere: particularly resources (savings) or output (income) of non-political economic agents. The result will be a NET transfer of resources from productive agents to unproductive agents. Costs are not benefits.

Public choice theorists would further expand on Bastiat’s opposition, noting that “costs are diffused, while benefits are concentrated”. 

Bridges to nowhere have been the same infrastructure problem bugging the US.

3. More and more bailouts will mean more and more resources being transferred in support of unproductive activities. This also means goodbye reform agenda. Thus President Xi is correct when he says that the world should expect a ‘new normal’ of slower economic growth. 

4. “Substantial effects” extrapolates to transmission mechanism via economic and financial markets. This implies a short-lived EM stock market rally which will likewise affect US and Europe as global economic growth declines. This also posits rising risks of a global Black Swan moment.

Oh, substantial effects may also postulate into amplified tensions over territorial disputes. 

Anti Chinese riots in Vietnam claimed 1 life with 90 injured yesterday.  The riots has not been exclusive to Chinese companies but was anti-Asian in nature. From the CNN: “the arson was indiscriminate, with Korean-, Taiwanese- and Japanese-owned properties also torched by the angry mob.”

This implies the rise of protectionism which means decreased economic activities, deterioration in social order or peace and stability and greater risks of violence and an outbreak of military conflict.

Yet for the don’t worry be happy crowd, stock markets will keep roarin’.

Third Wave Politics: Failing Nation States and the Growing Secession Movement

Industrial age centralized governments will pave way for decentralization.

In the observation of Europe Day Sovereign Man’s Simon Black writes:   (bold mine)

But what is true is that European imperialists conjured entire nations in Africa out of thin air from their palaces in Brussels, Paris, and London.

And all of this was done without any regard for ethnic, linguistic, religious, and historical divisions among the various tribes that inhabited Africa.

But what few people realize is that Europe is no different.

Think about it—the United Kingdom consists of England, Wales, Scotland, and Northern Ireland lumped together in a political union.

Each is entirely different from the others. And secessionist movements are alive and well. 

Scotland will hold a referendum about its independence in September. And the troubles in Northern Ireland have plagued the region for decades. 

Belgium is a completely artificial country, and the Flemish are actively pursuing independence from the Walloons. 

In the late 19th century, Germany and Italy were both unified into modern countries from diverse fiefdoms and city-states with strong regional identities.

Those regional identities are still present today. Just a few weeks ago, a vote was held in Venice over independence for the wider region. 

The Basque separatist movements in Spain are stronger than ever. The Balkans were an absurd experiment. I could go on and on.

Europe is the best example that borders and countries are completely arbitrary. 

They are created to serve one purpose—consolidating authority over a piece of land and the people living upon it. 

Today just happens to be “Europe Day”, a holiday in which Europeans are supposed to commemorate the Schuman Declaration that jumpstarted today’s European Union. 

This is a continent that has a long history of constantly going to war with itself.

They slapped lines on a map, formed some new countries, and expected that everything would be OK.

Then they made those lines even broader when they consolidated everything into the European Union. And EU politicians are trying to make things even bigger.

History shows that when economic times are good, people are happy about unity. 

But when times are tough as they are now, divisions start creeping up. People look around and say “this system isn’t working”. 

They demand change. Sometimes violently. And we would be foolish to presume that this time is any different.

The immediate avenue for this conflict to play out is still through peaceful means—referendums and the rise of nationalist and Eurosceptic political parties. 

But it’s clear that the trend is to get smaller, not bigger. And for the system to change entirely. 

Like feudalism before it, the nation state is a failed experiment that will ultimately be replaced. It’s already happening. 

Pls continue to read here 

I previously noted that growing secession movements marks the “gradual confirmation of the predictions of futurist Alvin Toffler as elucidated in his highly prescient 1980 book, The Third Wave (p.317)

National governments, by contrast, find it difficult to customize their policies. Locked into Second Wave political and bureaucratic structures, they find it impossible to treat each region or city, each contending racial, religious, social, sexual or ethnic group differently, let alone treat each citizen as an individual. As conditions diversify, national decision-making remains ignorant of the fast-changing local requirements. If they try to identify these highly localized or specialized needs, they wind up deluged with overdetailed, indigestible data…

In consequence, national governments in Washington, London, Paris or Moscow continue, by and large, to impose uniform, standardized policies designed for a mass society on increasingly divergent and segment publics. Local and individual needs are forgotten or ignored causing the flames of resentment to reach white heat. As de-massification progresses, we can expect separatist or centrifugal forces to intensify dramatically and threaten the unity of many nation-states.

The Third Wave places enormous pressures on the nation-state from below.

Bursting bubbles will only compound on such trend.

Simon Black: No Money Loans Down are signs of Philippine Bubbles

Just as the S&P blindly upgrades Philippine credit ratings again (which they will reverse soon), Sovereign Man’s Simon Black sees bubbles in the Philippines

Mr. Black writes: (bold mine)

My partner Tim Staermose and I were talking about it this morning, as he’s currently traveling in the Philippines.

When he went to collect the mail at his old office address yesterday, one of those credit card offers was waiting.

It was sent by a local bank, according to them because Tim is a long-standing customer.

Curiously, though, his account at the bank has less than $400. They know nothing about his ability to repay. They have no clue if he is gainfully employed, or even where he lives. But they sent a pre-approved credit offer regardless.

Another bank– a Philippine branch of a large US bank, mailed him an offer for a “no questions asked” cash loan of about US$11,000, to be paid back over a period of time of his choosing.

And of course, real estate agents are out all over town flogging Philippine investment properties, offering ‘no money down’ deals.

People only make such an offer if they

1) Expect everything to keep rising forever [which is a really baaaaad notion], or

2) They have so much money to deploy, they are forced to make rash decisions and assume tremendous risk just to be able to invest.

Both of these are incredibly dangerous and lead to disastrous consequences.

We remember the last time people thought that ‘real estate can only increase in value…’ Or the last time banks were making no money down loans.

Yet markets, bankers, central bankers, and politicians all have very short memories. This time, it always seems, will be different.

It never is.

But everything is now so interconnected that a credit unwinding in a place as small as the Philippines could actually have a substantial impact on the rest of the world.

It was the same during the Asian Financial Crisis in the late 90s, and exactly the same in 2008 nuclear banking meltdown.

The dominos in the global financial system are spaced so closely together you can hardly see any daylight between them. And a tiny central banking elite is lording over them all, clumsily and hastily cramming even more dominos onto the table.

This isn’t an environment where traditional financial thinking is going to prevail.

From ‘buy and hold’ index investing to the solvency of our banks to the basic premise of paper currency, nothing can be taken for granted any longer.

Real assets– productive land, precious metals, private businesses, etc. are much safer alternatives right now.

One of these days, someone is going to bump the table and all the dominos will start to fall. You won’t want your savings anywhere near it when that happens.

Deterioration of lending standards and one way trade are indeed symptoms of a bubble, but there's even more signs--Mr. Black and Mr. Price can know more of the details here.

Asia’s Richest Man Li Ka Shing has been in an asset selling binge in China

Watch what smart money does rather than what they say.

Asia’s richest man has been in an asset selling spree in China. Sovereign Man’s Simon Black explains:

Here’s a guy you want to bet on– Li Ka-Shing.

Li is reportedly the richest person in Asia with a net worth well in excess of $30 billion, much of which he made being a shrewd property investor.

Li Ka-Shing was investing in mainland China back in the early 90s, way back before it became the trendy thing to do. Now, Li wants out of China. All of it.

Since August of last year, he’s dumped billions of dollars worth of his Chinese holdings. The latest is the $928 million sale of the Pacific Place shopping center in Beijing– this deal was inked just days ago.

Once the deal concludes, Li will no longer have any major property investments in mainland China.

This isn’t a person who became wealthy by being flippant and scared. So what does he see that nobody else seems to be paying much attention to?

Simple. China’s credit crunch.

After years of unprecedented monetary expansion that has put the economy in a precarious state, the Chinese government has been desperately trying to reign in credit growth.

The shadow banking system alone is now worth 84% of GDP according to an estimate by JP Morgan. The IMF pegs total private credit at 230% of GDP, jumping by 100% in the last few years.

Historically, growth rates of these proportions have nearly always been followed by severe financial crises. And Chinese leaders are doing their best to engineer a ‘soft landing’.

If they’re successful, the world will only see major drops in global growth, stocks, property, and commodity prices.

If they fail, the spillover could become pandemic.

This isn’t important just for Asian property tycoons like Li Ka-Shing. Even if you don’t know Guangzhou from Hangzhou from Quanzhou, there are implications for the entire world.

Read the rest here

Mr. Li Ka Shing’s last sale concluded last week, from wantchinatimes.com (bold mine)

Despite claims by Asia's richest man that he has not offloaded his mainland investments, Hong Kong multi-billionaire Li Ka-shing has got rid of over 20 billion yuan (US$3.23 billion) in Chinese property holdings since August last year.

The latest is the HK$7.2 billion (US$930 million) sale of Beijing's Pacific Century Place shopping center by Pacific Century Premium Developers, a company headed by son Richard Li. When the sale is completed in August, the company will have no more major investments in the mainland.

This comes amidst more signs of big trouble in the big China.

Officials of a local government have reportedly been scrambling to settle a troubled steel maker’s debt.

From Caixin online:

Officials in a city in northern China have been busy recently sorting out a steelmaker's debt mess that could involve as much as 20 billion yuan, even as the firm's owner avoids attending meetings on the matter, sources close to the situati0n say.

Highsee Iron and Steel Group Co. Ltd., which is based in Yuncheng City's Wenxi County, ceased production on March 18. It has seen a host of creditors including big banks line up to get their money back.

And the fractures from the humungous credit financed property boom has been accelerating or intensifying as vacancy rates have been ballooning even in prime areas. From South China Morning Post: 

According to property firm Jones Lang LaSalle, vacancies in Grade A office buildings in the area's major cities will stay high in the coming years due to weaker-than-expected demand.

While a loan default by a developer in Zhejiang sparked fears of a collapse of the residential property sector, the situation in the office sector appears to be even worse . Residential property developers can at least slash prices to dispose of flats to recover part of their investment. Half-empty buildings, however, are not just white elephants but financial black holes.

Jones Lang LaSalle found that at the end of last year, occupancy rates for Grade A office buildings stood at 58 per cent in Wuxi, Jiangsu, and 30 per cent in the Zhejiang capital, Hangzhou . In other major delta cities, which together make up the most vibrant and developed regional economy on the mainland, occupancy rates also hovered around 30 per cent last year.

In Wuxi, the vacancy rate was expected to stand at 48 per cent in 2016, it said. By the end of that year, the stock of prime office space in the city would nearly triple from last year's amount to 565,000 square metres

And here is what delusions that spawns a boom-bust cycle have been made of: (bold mine)

Over the past decade, delta cities have pulled out all the stops to launch one new town one after another. Located on the suburban fringes of each city, they are designed to accommodate millions of residents and attract more corporate investors.

The boom was based on officials' unshakeable faith that sustainable growth of delta cities would last for decades.

Developers splashed out billions of yuan to build office buildings, shopping malls and entertainment complexes in the new towns, believing an affluent population of 75 million would be enough to support their businesses. Unfortunately, reshuffles of municipal officials led to dramatic changes in urban development plans. New leaders would map out their own blueprints, earmarking more untapped land for new high-rise residential areas or industrial zones.

This resonates with what’s been going around in ASEAN including the Philippines. The difference is that China seems at an inflection point while the ASEAN contemporaries are approaching the inflection point where troubles in China (Japan, Ukraine or elsewhere) can hasten the process.

Nonetheless the estimated risks of transmission or contagion via merchandise trade with China from George Magnus (Business Insider)

The bottom line is that the mainstream has been severely underappreciating the risks from China’s boom bust cycle which could also be a major source for a global economic and financial Black Swan.

Accounting Magic: Double Economic Growth Overnight, Nigeria Edition

All it takes for Nigeria to magically double the size of her economy is to apply some accounting-statistical trickery.

From Simon Black at the Sovereign Man (bold mine)

Over the weekend, Nigeria’s government made an accounting adjustment in how it calculates its GDP statistics.

By changing the base-year in GDP calculations from 1990 to 2010, Nigeria increased the reported size of its economy by 89% over the weekend.

So with a stroke of a pen, the West African nation leapfrogged South Africa to become the continent’s largest economy.

And in doing so the country’s debt-to-GDP ratio fell below 20%. The ratio of bad loans in the banking system when compared to the overall size of the economy also dramatically declined in proportion.

The same thing happened in Poland last year when the government there made a grab for private pensions, then counted those new assets against government debt.

It was just another accounting scam. But it dramatically lowered Poland’s debt-to-GDP ratio on paper, even though the government had not actually gotten any ‘richer’.

And how the same accounting-statistical manipulation can be seen applied to the balance sheets of the ECB and the US Federal Reserve. Again Mr. Black

Just hours ago, the European Central Bank released its 2013 annual report, showing a massive 44% surge in profits.

Diving into the numbers, though, it turns out that most of the ECB’s profits come from funny accounting tricks—revaluing a permanent swap line they have with the Federal Reserve, and moving funds from the “risk provision” column into the profit column.

I’m also reminded of the Federal Reserve’s own admission that they had $50+ billion in ‘unrealized losses’ due to the erosion of their portfolio of US Treasuries.

This is almost as much as their entire capital reserve… meaning that the Fed is practically insolvent by its own admission.

Not to worry, though. The Fed gets to employ its own accounting tricks to make these losses disappear, marking the assets on the balance sheet at their much higher ‘book value’, rather than the much lower ‘market value’.

Of course, the US government does exactly the same thing… often conveniently leaving out huge portions of its total debt such as the non-marketable securities it owes to the Social Security trust funds.

All of this really just goes to show how absurd it is to rely on these numbers conjured by politicians and central bankers.

And I’ve been repeatedly saying that since government issues all the accounting based statistics they will show what they want to show rather than what really has been.

To give you more example of fallacies of mainstream statistics,  the great dean of the Austrian school of economics Murray N. Rothbard exposed on the flagrant errors of the Keynesian multiplier. Mr. Rothbard’s case more lucidly explained by Professor Steven Landsburg: (bold orginal)

If you studied economics from one of the classic textbooks (like Samuelson) you might remember how this goes. We start with an accounting identity, which nobody can deny:

Y = C + I + G

Here Y represents the value of everything produced in (say) a given month, which in turn is equal to the total income generated in that month (because producing a $20 radio allows you — or perhaps you and your boss jointly — to earn $20 worth of income). C (which stands for consumption) is the value of the output that ends up in households; I (which stands for investment) is the value of the output that ends up at firms, and G (which stands for government spending) is the value of the output that ends up in the hands of the government. Since all output ends up somewhere, and since households, firms and government exhaust the possibilities, this equation must be true.

Next, we notice that people tend to spend, oh, say about 80 percent of their incomes. What they spend is equal to the value of what ends up in their households, which we’ve already called C. So we have

C = .8Y

Now we use a little algebra to combine our two equations and quickly derive a new equation:

Y = 5(I+G)

That 5 is the famous Keynesian multiplier. In this case, it tells you that if you increase government spending by one dollar, then economy-wide output (and hence economy-wide income) will increase by a whopping five dollars. What a deal!

Now, though I cannot seem to find a reference, I have a vague memory that it was Murray Rothbard who observed that the really neat thing about this argument is that you can do exactly the same thing with any accounting identity. Let’s start with this one:

Y = L + E

Here Y is economy-wide income, L is Landsburg’s income, and E is everyone else’s income. No disputing that one.

Next we observe that everyone else’s share of the income tends to be about 99.999999% of the total. In symbols, we have:

E = .99999999 Y

Combine these two equations, do your algebra, and voila:

Y = 100,000,000 L

That 100,000,000 there is the soon-to-be-famous “Landsburg multiplier”. Our equation proves that if you send Landsburg a dollar, you’ll generate $100,000,000 worth of income for everyone else.

The policy implications are unmistakable. It’s just Eco 101!!

See how accounting identities can create a paradise for everyone?

Social Cycles: The Rise and Fall of Civilizations

Cycle as defined by dictionary.com is “any complete round or series of occurrences that repeats or is repeated.”

And cycles are not only evident in natural sciences (e.g. planetary, organic, physics), but most importantly in the dynamics of human social relations.

Aside from business economic cycles which occupies much of the discussion of this blog, the rise and fall of civilizations is another example of such social cycles.

There are important lessons to learn from social cycles.

As example, Sovereign Man’s Simon Black has an eloquent narrative of the rise and fall of the French empire. (bold mine)

Throughout the 18th century, for example, France was the greatest superpower in Europe, if not the world.

But they became complacent, believing that they had some sort of ‘divine right’ to reign supreme, and that they could be as fiscally irresponsible as they liked.

The French government spent money like drunken sailors; they had substantial welfare programs, free hospitals, and grand monuments.

They held vast territories overseas, engaged in constant warfare, and even had their own intrusive intelligence service that spied on King and subject alike.

Of course, they couldn’t pay for any of this.

French budget deficits were out of control, and they resorted to going heavily into debt and rapidly debasing their currency.

Stop me when this sounds familiar.

The French economy ultimately failed, bringing with it a 26-year period of hyperinflation, civil war, military conquest, and genocide.

History is full of examples, from ancient Mesopotamia to the Soviet Union, which show that whenever societies reach unsustainable levels of resource consumption and allocation, they collapse.

Mr. Black goes on to cite a recent NASA funded study which identified 32 advanced civilizations that rose and collapsed. Again Mr. Black.

A recent research paper funded by NASA highlights this same premise. According to the authors:

“Collapses of even advanced civilizations have occurred many times in the past five thousand years, and they were frequently followed by centuries of population and cultural decline and economic regression.”

The results of their experiments show that some of the very clear trends which exist today– unsustainable resource consumption, and economic stratification that favors the elite– can very easily result in collapse.

In fact, they write that “collapse is very difficult to avoid and requires major policy changes.”

This isn’t exactly good news.

But here’s the thing– between massive debts, deficits, money printing, war, resource depletion, etc., our modern society seems riddled with these risks.

And history certainly shows that dominant powers are always changing.

Empires rise and fall. The global monetary system is always changing. The prevailing social contract is always changing.

Social cycles are a product of the same series of human interactions that leads to parallel consequences. In short, people hardly ever learn from mistakes to keep repeating them. And such cyclical transitions are hardly ever smooth sailing.

But not everything is bad news. 

Again Mr. Black.

But there is one FAR greater trend across history that supercedes all of the rest… and that trend is the RISE of humanity.

Human beings are fundamentally tool creators. We take problems and turn them into opportunities. We find solutions. We adapt and overcome.

The world is not coming to an end. It’s going to reset. There’s a huge difference between the two.

Think about the system that we’re living under.

A tiny elite has total control of the money supply. They wield intrusive spy networks and weapons of mass destruction. The can confiscate the wealth of others in their sole discretion. They can indebt unborn generations.

Curiously, these are the same people who are so incompetent they can’t put a website together.

It’s not working. And just about everyone knows it.

We’re taught growing up that ‘We the People’ have the power to affect radical change in the voting booth. But this is another fairy tale.

Voting only changes the players. It doesn’t change the game.

Technology is one major game changer. The technology exists today to completely revolutionize the way we live and govern ourselves.

Today’s system is just a 19th century model applied to a 21st century society. I mean– a room full of men making decisions about how much money to print? It’s so antiquated it’s almost comical.

But given that the majority of Western governments borrow money just to pay interest on money they’ve already borrowed, it’s obvious the current game is almost finished.

When it ends, there will be a reset… potentially a tumultuous one.

The 19th century industrial age top-down centralized model has been running on a head on collision with the deepening of the information age characterized by decentralization. And such underlying seismic shifts causes massive societal strains as previously discussed. This is what futurist Alvin Toffler once predicted as the Third Wave. 

And when the socio-political-economic system has been routinely abused to the point that the accrued imbalances reaches a climax and a critical mass, the system eventually implodes. Nonetheless people will adjust to such changes.Thus a reset.

This quote MISattributed to British lawyer and Alexander Fraser Tytler on democracy captures some of the essence of the political-behavioral cycle (wiikiquote):

The average age of the world's greatest civilizations from the beginning of history has been about 200 years. During those 200 years, these nations always progressed through the following sequence:

-From bondage to spiritual faith; 

-From spiritual faith to great courage; 

-From courage to liberty; 

-From liberty to abundance; 

-From abundance to complacency; 

-From complacency to apathy;

-From apathy to dependence;

-From dependence back into bondage.

The reset nears.

This isn’t your granddaddy’s bond markets

Sovereign Man’s Simon Black puts my “grotesque mispricing of bonds via the convergence trade” into perspective: (bold mine)

This is really amazing when you think about it. Central bankers have destroyed money and interest rates to the point that near-bankrupt companies in shaky jurisdictions can borrow money for practically nothing.

It’s an utter farce. The rate of inflation is -at least- 3% in many developed countries. Central bankers will even say they are targeting 3% inflation.

This means that if investors simply want to generate enough income so that their after-tax yield keeps pace with inflation, they have to assume a ridiculous amount of risk.

This is a really important point to understand given that the global bond market is so massive– roughly $100 trillion, with nearly $1 trillion traded each day in the US alone.

This is almost twice the size of the global stock market. And even if people never invest in a bond themselves, they’re directly connected to the bond market.

Your pension fund owns bonds. The bank that is holding on to your money owns bonds. The companies listed on the stock market that you invest in own bonds.

Yet bonds are some of the worst investments out there right now. And that’s saying a lot given how overvalued stock markets are.

Here’s the bottom line: adjusting for both taxes and inflation, bondholders are losing money, even on risky issuances.

Think about it– if you make a 4% return and pay 25% in taxes, your net yield is 3%. If inflation is 3%, your entire gain is wiped out… so you have taken that risk for nothing.

If inflation rises just a bit then you are in negative territory.

There are those who suggest that deflation is a much greater risk right now than inflation… and that bonds are great investments to own in the event of deflation.

But here’s the thing– even if deflation takes hold and prices fall, anyone who is deeply in debt is going to feel LOTS of pain. Instead of their debt burden inflating away, now they’ll be scrambling to make interest payments.

So while bonds are a sensible deflationary investment in theory, in practice deflation will only increase the likelihood of default. This puts many bond investments at serious risk.

Last, if interest rates rise from these all-time lows, a bond’s value in the marketplace will plummet. So not only will you have made zero income, you would be looking at a steep loss if you try to sell.

Longer term, fixed rate bonds in weak currencies are almost guaranteed losers and should be avoided at all costs. You would be much better off setting your cash ablaze in a bonfire. It’s at least a better story to tell and will save you years of anguish watching your position erode.

Oh stagflation, which pervades in ASEAN markets, equates to weak currencies. As noted above, if there will be more inflation, bond markets will lose. And if stagflation pricks the asset bubble, bonds lose too as debtors default or see rising real costs of debt amidst weak economic growth. Also an asset bust would mean tighter credit conditions that affects growth 

The convergence trade is destined for a reversion to the mean as easy money transitions into tight money. And since pension funds, publicly listed companies and banks hold bonds, such reversion to the mean will extrapolate into financial losses. 

Central banks have altered the complexion of the bond markets to the point that this isn't your granddaddy's bond markets.

The IMF Hearts Debt

In the implied promotion of debt by the IMF, Sovereign Man’s Simon Black caustically asks, what are these people smoking? 

You may recall the case of Harvard professors Ken Rogoff and Carmen Reinhart who wrote the seminal work: “This Time is Different: Eight Centuries of Financial Folly”.

The book highlighted dozens of shocking historical patterns where once powerful nations accumulated too much debt and entered into terminal decline.

Spain, for example, defaulted on its debt six times between 1500 and 1800, then another seven times in the 19th century alone.

France defaulted on its debt EIGHT times between 1500 and 1800, including on the eve of the French Revolution in 1788. And Greece has defaulted five times since 1800.

The premise of their book was very simple: debt is bad. And when nations rack up too much of it, they get into serious trouble.

This message was not terribly convenient for governments that have racked up unprecedented levels of debt. So critics found some calculation errors in their Excel formulas, and the two professors were very publicly discredited.

Afterwards, it was as if the entire idea of debt being bad simply vanished.

Not to worry, though, the IMF has now stepped up with a work of its own to fill the void.

And surprise, surprise, their new paper “[does] not identify any clear debt threshold above which medium-term growth prospects are dramatically compromised.”

Translation: Keep racking up that debt, boys and girls, it’s nothing but smooth sailing ahead.

But that’s not all. They go much further, suggesting that once a nation reaches VERY HIGH levels of debt, there is even LESS of a correlation between debt and growth.

Clearly this is the problem for Europe and the US: $17 trillion? Pish posh. The economy will really be on fire once the debt hits $20 trillion.

There’s just one minor caveat. The IMF admits that they had to invent a completely different method to arrive to their conclusions, and that “caution should be used in the interpretation of our empirical results.”

But such details are not important.

What is important is that the economic high priests have proven once and for all that there are absolutely no consequences for countries who are deeply in debt.

And rather than pontificate what these people are smoking, we should all fall in line with unquestionable belief and devotion to their supreme wisdom.

Well, who has benefited from debt?

The McKinsey & Company diagram above reveals of the distribution of the US $225 trillion capital market as of the second Quarter of 2012.

The biggest beneficiaries in terms of growth rate from 2000-2012 (red rectangles) has been the government bonds and non-securitized banking loans. A close third are corporate bonds.

Add to the above the recent dynamic where central banks accepts various bonds from banks and financial institutions as collateral in exchange for loans to buy government debt meant to push down bond yields...plus where the IMF gets their funding...we can deduce on 'whose pipes these people have been smoking on'.