The Revivalism of Friedrich Hayek's Ideas

Great stuff by Professor Russ Roberts at the Wall Street Journal on "Why Friedrich Hayek Is Making a Comeback"

(all bold highlights mine)

He championed four important ideas worth thinking about in these troubled times.

First, he and fellow Austrian School economists such as Ludwig Von Mises argued that the economy is more complicated than the simple Keynesian story. Boosting aggregate demand by keeping school teachers employed will do little to help the construction workers and manufacturing workers who have borne the brunt of the current downturn. If those school teachers aren't buying more houses, construction workers are still going to take a while to find work. Keynesians like to claim that even digging holes and filling them is better than doing nothing because it gets money into the economy. But the main effect can be to raise the wages of ditch-diggers with limited effects outside that sector.

Second, Hayek highlighted the Fed's role in the business cycle. Former Fed Chairman Alan Greenspan's artificially low rates of 2002-2004 played a crucial role in inflating the housing bubble and distorting other investment decisions. Current monetary policy postpones the adjustments needed to heal the housing market.

Third, as Hayek contended in "The Road to Serfdom," political freedom and economic freedom are inextricably intertwined. In a centrally planned economy, the state inevitably infringes on what we do, what we enjoy, and where we live. When the state has the final say on the economy, the political opposition needs the permission of the state to act, speak and write. Economic control becomes political control.

Even when the state tries to steer only part of the economy in the name of the "public good," the power of the state corrupts those who wield that power. Hayek pointed out that powerful bureaucracies don't attract angels—they attract people who enjoy running the lives of others. They tend to take care of their friends before taking care of others. And they find increasing that power attractive. Crony capitalism shouldn't be confused with the real thing.

The fourth timely idea of Hayek's is that order can emerge not just from the top down but from the bottom up. The American people are suffering from top-down fatigue. President Obama has expanded federal control of health care. He'd like to do the same with the energy market. Through Fannie and Freddie, the government is running the mortgage market. It now also owns shares in flagship American companies. The president flouts the rule of law by extracting promises from BP rather than letting the courts do their job. By increasing the size of government, he has left fewer resources for the rest of us to direct through our own decisions.

Hayek understood that the opposite of top-down collectivism was not selfishness and egotism. A free modern society is all about cooperation. We join with others to produce the goods and services we enjoy, all without top-down direction. The same is true in every sphere of activity that makes life meaningful—when we sing and when we dance, when we play and when we pray. Leaving us free to join with others as we see fit—in our work and in our play—is the road to true and lasting prosperity. Hayek gave us that map.

Despite the caricatures of his critics, Hayek never said that totalitarianism was the inevitable result of expanding government's role in the economy. He simply warned us of the possibility and the costs of heading in that direction. We should heed his warning. I don't know if we're on the road to serfdom, but wherever we're headed, Hayek would certainly counsel us to turn around.

Global Central Banking Bureaucracy And Performance

The Economist chart below shows of the bureaucracy or the ratio of number of people employed by the world's major central banks relative to the population.

According to the Economist,

``AMERICA'S Federal Reserve may be the most important central bank in the world, but it has a smaller staff than the Reserve Bank of India and employs less than half as many people as the European Central Bank. The euro area has so many central bankers per head because many euro-zone countries have not shrunk their national central banks, even though they no longer have an independent monetary policy. With 71,200 employees, the Bank of Russia has the most employees of any central bank in the world, and the number of central bankers per head in Russia is the largest of any big economy. China has only 0.19 central bankers per 100,000 people. Even Somalia (not shown) has more central bankers per head than China does." (bold emphasis mine)

Does more central bankers translate to more effective monetary policies or more balance in the economic and financial system or price stability?

Well judging from the recent boom bust cycle, the answer is clearly a NO.

Apparently based on the above table, some of the economies that had been least affected by the crisis had been those with leaner bureaucracies.

Besides it doesn't take too much of central banking 'expertise' for a nation to accumulate heaps of debt in order to juice up economic 'growth'.


According to another article from the Economist, ``The sheer scale of their fiscal burdens may tempt governments to lighten their loads by inflation or even outright default. Inflation seems increasingly plausible because many central banks are already printing money to buy government bonds. To fiscal pessimists this is but a small step from printing money simply to pay the government’s bills. Adding to their worries, many economists argue that a bout of modest inflation would be the least painful way to ease the financial hangover.

``The rich world’s build-up of debt may also cause changes in countries’ relative creditworthiness. Investors have long viewed emerging economies as riskier sovereign borrowers than rich ones, because of their history of macroeconomic instability and more frequent defaults. But the biggest emerging economies are now by and large in better fiscal shape than their richer fellows, and that discrepancy is set to widen. The emerging members of the G20 had a ratio of public debt to GDP of 38% in 2007. By 2014, says the IMF study, this is likely to fall to 35%, less than a third of the rich world’s average. As a result the gap between the yields investors demand from rich and emerging economies’ bonds is likely to narrow." (all bold highlights mine)

Moreover, as adduced in the article, the current policies by central bankers is in the direction of the money printing nostrum.

This does not require a lot of personnel, except to churn out "studies" or "reports" that have been used to justify them. Just ask Zimbabwe's Dr. Gideon Gono.

This also implies that it doesn't also take too much of bureaucratic proficiency over the marketplace to debase a currency.

On the other hand, it could be construed that central banking have been proficient in resorting to policies that have made currencies lost its purchasing power.

From AIER

The purchasing power of the currencies of major economies have been declining since 1910 as shown in the chart above. The chart ends in 2005, the declining trend should be more accentuated today.

Bottom line: based on the above evidences, the correlation between ballooning central banking bureaucracy and economic, fiscal and monetary performance appears as inverse. This implies that a bigger bureaucracy doesn't mean more policy effectiveness, instead a bigger bureaucracy could translate to more economic fiscal or monetary underperformance.

This also extrapolates that central banking have been a monstrous boondoggle at the expense of society.

A reminder from Ludwig von Mises, ``Bureaucratic management is management of affairs which cannot be checked by economic calculation."

Is Gold In A Bubble?

``Gold was not selected arbitrarily by governments to be the monetary standard. Gold had developed for many centuries on the free market as the best money; as the commodity providing the most stable and desirable monetary medium." - Murray N. Rothbard, What Has Government Done to Our Money?

In this issue:

Is Gold In A Bubble?

-Fed’s Quantitative Easing Update

-Misrepresenting Gold’s History

-The Misunderstood Role Of Central Bankers

-Appraising Gold And The Origin of Money

-Crack Up Boom Versus Bubble Psychology

Fed’s Quantitative Easing Update

The US Federal Reserve has vastly accelerated its purchases of US treasuries to the tune of about $7 billion, based on the data from the Federal Bank of Cleveland. This has been in breach of its self-imposed limits.

Likewise, the increased treasury purchases appears to be in line with the commencement of the next wave of mortgage resets that seems likely to signify as the next round of strains to the US banking system. As previously noted, ``With the risks of the next wave of resets from the Alt-A, Prime Mortgages, Commercial Real Estate Mortgages, aside from the Jumbo and HELOC looming larger, they are likely to exert more pressure on the banking system” [see past discussion in 5 Reasons Why The Recent Market Slump Is Not What Mainstream Expects].

Figure 1: Sifma, Zero Hedge: US Mortgage and US Treasury Market

Since the crisis erupted, the US government, through its GSE agencies, has virtually been THE mortgage market (see left window: blue bars FED agency mortgages, gray bars private labels).

We see the same trend for US treasuries, the US government via the Federal Reserve is on its way to become the buyer of last resort- since the activation of the QE program last March, Fed purchases (black line, right window) of US treasuries accounts for almost half of the market (Zero Hedge) displacing foreign official holdings (blue line).

The above developments dispel on the flawed notions that the US government will refuse to assume the literal role as the buyer of the last resort, especially under extreme circumstances. As a political institution, once a political expediency arises-such as a renewed threat to the survivability of its banking system that could risk undermining the US dollar standard system-the US Federal Reserve will act according to its perceived priorities. And the actions in the above markets have been telling.

Misrepresenting Gold’s History

The recent spike in gold prices has evoked shrill cries of a “bubble”.

Does rising prices automatically constitute as a mania? What distinguishes a mania from structural changes?

For us, the fundamental issue is to understand the role of gold in the marketplace or in the economy than simply presuppose or generalize a bubble.

Basically, the gold debate can be delineated into two extreme camps: the gold bugs (ideological believers that money should be comprise or be backed by gold or commodity) and its antipode (ideological believers influenced by JMKeynes where gold or commodity as money is deemed as relic or a “barbaric metal”).

Of course the issue can’t be seen as simply black or white because the mainstream fundamentally operates on gray areas, out of the lack of understanding. But have mostly been tilted towards the “Barbaric” metal persuasion.

Here are some examples, (bold emphasis mine)

The Bloomberg quotes the highly distinguished trader Dennis Gartman, ``The gold bull run is not predicated upon inflation but is instead predicated upon the notion that gold is becoming a reservable asset.”

Or from Socgen’s Dylan Grice, ``How can something with no cashflow or earnings power be valued? The simple answer is that it can't be. Intrinsically it is pretty much worthless.”

Ironically Mr. Grice predicts that the price of gold to reach $6,300 primarily because of bubble psychology, the discount value of Gold relative to US dollars issued and “insolvent governments”.

On the other hand, Mr. Gartman does not qualify on the definition of, as well as, elaborate on WHY and HOW gold is “becoming a reservable asset”.

For the Barbaric metal camp, Gold is presented mostly as an unworthy investment (see figure 2)

Figure 2: Socgen: Real Prices of Gold

According to Mr. Grice, ``But the same chart also shows how unreliable gold has been as a store of wealth. A 15th century gold bug who'd stored all of his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90% over the next 500 years (though he might take comfort from the knowledge that his financial advisor would be burning in hell). More recently, had you bought at the peak of the last bull market in January 1980 for $850, you'd have suffered a nominal decline of 70% by the time it bottomed in 1999. On an annualised basis you'd have lost 6% pa nominal and 9% real.” (bold highlight mine)

Mr. Grice’s premise seems plausible but blatantly misleads. Why?

Simply because Mr. Grice forgets to remind us that gold (including silver) was NOT held for investment, but was instead USED as money during the aforementioned eras.

And as money, gold and or silver was subjected to liquidity flows depending on the society’s perception of uncertainty, which ultimately determines the level of demand for money relative to the available supply of money. To quote Austrian economist Hans-Hermann Hoppe, ``The holding of money is a result of the systemic uncertainty of human action.”

For instance, in the mid 16^th century the fall of the real price of gold (exchange value relative to other commodities) was mainly due war “conquest” financing.

According to Professor Niall Ferguson in his latest book The Ascent Of Money, ``during the so-called “price revolution”, which affected all of Europe from the 1540s until the 1640s, the cost of food-which had shown no sustained upward trend for three hundred years-rose markedly.” [italics mine]

Professor Ferguson’s account appears very consistent with the real price trend of gold on the chart, especially on the 300 years prior to the eon of war financing.

Moreover, following the Spanish conquest of the Inca Empire by a Spanish colonel Francisco Pizzaro, huge precious metals (money) streamed into Spain, many of which came from the Potosi (otherwise known as Domingo de Santo Tomas-mouth of hell) mines in Bolivia.

Again from Niall Ferguson’s Ascent of Money, ``between 1556 and 1783, the rich hill yielded 45,000 tons of pure silver to be transformed into bars and coins in the Casa de Moneda, and shipped to Seville…Pizarro’s conquest, it seemed, had made the Spanish crown rich beyond the dreams of avarice.” Thus, the relative surplus of gold and silver against other commodities explains anew the depressed real prices of gold and is consistent with the price action of gold chart above.

Yet going into the industrial revolution in 1800s-1913, one would observe that the real price of gold has mostly stabilized.

Notes Professor Michael Rozeff, ``Before there is a central bank and when metals are being used in the money and banking system, there is greater price stability. There is no contest. Pre-1913, the price level falls gently each year on the average by less than ½ of one percent. After 1913, the price level rises each year by 6.8 times as much as it used to decline before 1913 (in absolute value.)” [italics his]

Following the introduction of the US Federal Reserve in 1913, real prices of gold have gyrated mostly higher over time. And the upside volatility has been accentuated after the Nixon Shock or when former President Nixon closed the gold window or ended the Bretton Woods system on the 15^th of August 1971.

In other words, the chart above from 1265-1971 or in 7 centuries gold chiefly performed the role of money. Today, this hasn’t been the case...yet.

To conclude, to use gold real prices as a metric to justify on gold’s poor investment returns is highly inconsistent, flawed and a misrepresentation. Gold’s role today isn’t like in the past where gold functioned as a medium of exchange, which should be nuanced from the current role as non-money commodity.

To add, since gold isn’t used in transactions by the general public today, then fundamentally gold isn’t money. Only to the eyes of central bankers could gold be deemed as a form of money. Thereby comparing gold as money and gold as non-money is like comparing apples to oranges.

The Misunderstood Role Of Central Bankers

Some have cited the activities of central banks as possible indication for inflection points on gold prices. For instance, the sale of UK Chancellor Gordon Brown of 400 tonnes of gold reserves in 1999 coincided with the end of the bear market. In other words, central bankers are thought to resemble retail investors, whom traditionally play the role of the greater fool during market extremes.

Yet like all human beings, while central bankers are subject to the corporeal frailties and could be influenced somewhat by the developments of the marketplace, what seem glaringly overlooked by mainstream’s oversimplification are the governing incentives from which the political bureaucracy operates on.

As Professor Ludwig von Mises rightly notes of the crux of the distinction, ``For it is a fact that as a rule the authorities are inclined to deviate from the profit system. They do not want to operate their enterprises from the viewpoint of the attainment of the greatest possible profit. They consider the accomplishment of other tasks more important. They are ready to renounce profit or at least a part of profit or even to take a loss for the achievement of other ends.” (bold emphasis mine)

So unlike typical investors driven by profits, political leaders and the bureaucracy, being political actors, fundamentally operates on political goals. In short, central banks transactions in the marketplace may represent price insensitivity, and importantly, are most likely subject to political ends that may be extraneous to market forces.

Manias are essentially founded by a massive credit boom and underpinned by government policies to create boom conditions, from which induces investor irrationality responses based on expectations of perpetually easy profits. Therefore, a gold mania cannot mechanically be attributed to central bank activities because this would highly depend on the underlying political goals in support of their activities.

Furthermore, a mania depends on pyramiding leverage or accelerating credit boom. At the present moment, central bank buying of gold has been funded from their stash of US foreign exchange surpluses.

The tiny resort island of Mauritius recently followed India to acquire 2 metric tons from the IMF (Bloomberg).

Figure 3: Virtual Metals: Gold Demand Trends, Central Banks As Net Buyers

In addition, central banks accounted for as net buyers for the second successive quarter this year, where according to mineweb.com, ``the official sector was a net purchaser of gold in the third quarter, although the figures are low, at five tonnes in Q2 and 15 tonnes in Q3. The underlying trend is "expected to remain intact" as central banks, like private investors, continue to look for diversifiers, especially with respect to the dollar. Central banks outside the CBGA agreement that the WGC identified as gold purchasers included Mexico and the Philippines.” (see Figure 3-right window)

It is noteworthy that gold prices continue to rise, in spite of the massive net gold sales by the official sector even when gold’s bullmarket has been on the fringe.

Again from mineweb.com, ``at the end of 1998, world central bank holdings of gold amounted to 33,500 tonnes and that by the end of 2008 this was down to 29,700 tonnes so that the rate of disposal over the decade was the fastest in history - and still the price doubled.”

The important point is that the complexion of gold’s pricing dynamics has been significantly transforming from traditional “jewelry” based to “investment” based (left window). And this has been responsible for today’s buoyant gold prices, even in the face of central bank selling.

There is no better way to parse on central banking mindset than from their statements or “rationalization”. Mineweb’s Rhona O’Connell covers M. Paul Mercier, the European Central Bank's Principal Advisor in Market Operations, who in a recent speech gave four reasons why central bankers value gold.

From Ms. O’Connell (all bold and italics emphasis mine), ``The four primary reasons for a central bank to hold gold were listed as follows:

-Economic security. The physical and chemical characteristics of gold with its high density and resistance to oxidation, for example (unlike silver, the oxidation of which is the cause of tarnishing) combine with the fact that it is the only asset that is no-one else's liability to make it a vital element of foreign exchange reserves. Holding another party's securities always carries the possibility that the behaviour of the counter-party can affect the value of those securities.

-Unexpected needs. There is always a possibility, albeit very low, of highly damaging developments such as war or high inflation that can have a severe impact on sovereign debt, or result in a country's isolation. As the ultimate global means of payment gold is an important insurance policy. It can also be used as international collateral (for example the loan to the Banca d'Italia from the Bundesbank in the early 1970s).

-Confidence. Although gold no longer backs currencies in circulation, M. Mercier argued that it helps to underpin international confidence in any one currency, especially since, without gold's formal backing, currency values are based on faith in one another. He reminded us of the IMF's recent reiteration of the IMF's statement about hoe gold gives a "fundamental strength" to its balance sheet.

-Risk diversification. This, he asserts, is probably even more highly valued by central banks than it is by other investors. There is a considerable body of study that quantifies the ways in which gold brings robustness to a portfolio, most notably, for a central banker, the reduction in volatility.”

Ironically after selling 3,800 tonnes over the period where central banking dogma thought that they have successfully lorded over inflation [see Rediscovering Gold’s Monetary Appeal], counterparty risks, insurance, confidence and risk diversification suddenly becomes an issue for central bankers in reconsidering gold sales.

What has impelled them to raise such concerns?

Obviously signs like this… (all bold emphasis mine)

The Financial Times on India’s IMF’s gold’s purchase, ``Pranab Mukherjee, India’s finance minister, said the acquisition reflected the power of an economy that laid claim to the fifth-largest global foreign reserves: “We have money to buy gold. We have enough foreign exchange reserves.” He contrasted India’s strength with weakness elsewhere: “Europe collapsed and North America collapsed.”

Unsettling concerns over new bubble cycles emanating from the low interest rates regime implemented by the US Federal Reserve as articulated by the Chinese and Japanese leadership, from Bloomberg, ``“The continuous depreciation in the dollar, and the U.S. government’s indication that, in order to resume growth and maintain public confidence, it basically won’t raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation,” Liu, chairman of the China Banking Regulatory Commission, said in Beijing yesterday.

``While lower interest rates will help Americans pare debt, “there are also risks involved in continued low rates,” Shirakawa said today at a Paris Europlace Financial Forum in Tokyo. Having borrowing costs near zero may strain government finances if it spurs speculation that the dollar will continue to slide, he said, while warning that easy policy by officials globally may have repercussions in the long term.

``“Monetary easing in advanced economies has stimulated capital inflows to emerging economies,” Shirakawa said. If emerging nations continue to recover at a faster pace than advanced ones, they “might overheat and experience financial turmoil, triggering a recession,” he said.

Hong Kong’s monetary authority likewise includes the FED’s Quantitative Easing program aside from the prevailing low interest regime over concerns on formative bubbles, this from the Wall Street Journal, ``“The question one really has to ask is to what extent quantitative easing is necessary. Is the dosage right, because $2 trillion is a lot of money in the banking system, it’s high power money,” said Norman Chan, monetary authority chief executive. He and Ms. Yellen were at a forum sponsored by the Institute of Regulation & Risk. Ms. Yellen gave a speech that touched on how policymakers should address future asset bubbles.

“In Asian economies, Hong Kong included, we have seen a very massive inflow of funds that is explainable by the very low global interest rates and coupled with this huge amount of quantitative easing,” Mr. Chan said. “This question of potential risk of asset bubbles forming if this is to continue for a long period of time is a big challenge for us,” he said to Ms. Yellen.”

Basically, it’s been a predicament for Asian central banks to raise interest rates because higher rates will widen the currency yield spreads in their favor and exacerbate inward money flows. This, in essence, will blow the region’s asset bubbles faster. Yet by suppressing interest rate asset bubbles could be internally generated.

To quote CLSA’s high profile strategists Christopher Woods (highlight mine), ``The irony is that the more anaemic the Western recovery proves to be, the longer it will take for Western interest rates to normalize and the bigger the resulting asset bubble in Asia. Emerging Asia, not the U.S. consumer, will be the prime beneficiary of the Fed's easy money policy.

And the prospect of fostering asset bubbles has prompted for Asian central banks to consider imposing capital controls.

So Gartman’s argument where “gold is becoming a reservable asset” increasingly seems as a protective or insurance cover against the possible impacts from globalized systematic inflation (instead of no inflation), such as blossoming asset bubbles, emerging malinvestments, rampant speculation, financial and economic imbalances, arbitrages and carry trades, ballooning systemic leverage and surging inflation, which could all end up in tears. All these signify as inexorable monetary disorder.

In other words, many central banks have been insuring themselves, from inflation and counterparty risks by taking on gold as reservable asset. In short, gold’s appears to be gradually regaining its role as money.

Yet it would also be a grievous mistake to read bubbles as routinely blowing and popping without taking into account the magnitude where bubble cycles are becoming larger in scope and more damaging in scale upon impact when the mean reversion occurs.

Figure 4: Socgen, wikipedia: Central Bank Gold Shocks, Zimbabwe Dollar

A more fatal mistake would be to misjudge the impact from a lethal policy mix of flagrant money printing programs and low interest rate regime that could transmogrify a bubble cycle into hyperinflation.

So while global central banks could be buying gold today as shield against bubble cycles, they and everyone else would be stampeding into gold if and when the risks of a currency crisis becomes imminent.

Hence basing a projection on past performance (left window figure 4), where central banks bought during the 70s, which eventually turned into 2 gold shocks of sharply higher gold prices, assumes that present monetary disorder would be resolved in the traditional sense. We aren’t that confident. And Zimbabwe’s real life hyperinflation (right window) which ended last year should serve as reminder.

Appraising Gold And The Origin of Money

Many have made the case of valuing gold by discounting currency in circulation with that of available gold reserves.

As in the case of Socgen Dylan Grice, “So one way to value gold, therefore, is to ask at what gold price the value of outstanding central bank paper would be completely backed by gold. The US owns nearly 263m troy ounces of gold (the world's biggest holder) while the Fed's monetary base is $1.7 trillion. So the price of gold at which the US dollars would be fully gold-backed is currently around $6,300.”

Or based on Professor Michael Rozeff’s Zero Discount Value where ``value for gold such that every outstanding dollar liability in the central bank’s monetary base (currency plus bank reserves) is backed by an equivalent dollar’s worth of gold. It is what the dollar price of gold would be if the central bank’s liabilities were 100 percent backed or covered by gold.”

From our point of view, while these hypotheses could serve as meaningful concepts to measure gold, they are predicated on the assumption where variables (as monetary base) remains stable, secondly the world currency system persists on operating under the present US dollar standard, and lastly assumes that gold’s valuation in the light of current and constant conditions, hence won’t likely serve as accurate barometers, in my view.

Since we believe the world operates in a highly action-reaction dynamic, the complexity of the distribution isn’t likely to lead into a modeled outcome that can be easily captured by math estimates.

Instead we believe that policy actions are likely to be more of an accurate gauge to implied directions of the marketplace.

And it would also be true, to affirm with the behavioral camp, that human emotions will be an elaborate part of the price setting of gold, and thus is likely to cause price exaggerations beyond any models especially in bubble cycles.

In addition, while it seems conceivable to argue that gold’s rise could be a function of a bubble psychology, as per Socgen Dylan Grice, ``If my "valuation" of gold strikes you as a desperate attempt to value something which can't be valued, it's no different from metrics such as the "market cap to clicks" or "ARPU" ratios which were used in the late 1990s during the technology bubble when demand for bullish "valuation analysis" mushroomed”, this observation is far from accurate.

Yet Mr. Grice borrows some monetary aspects to rationalize an argument for a bubble cycle, ``Like today, central banks weren't buying gold in the late 1960s to prop it up, they were abandoning attempts to prop up the dollar.”

Using behavioral aspects he adds, ``Today, central banks are monetising government deficits to accommodate the recessionary effect of the credit crisis. Then the convincing narrative was that with the Middle East controlling our energy from abroad and aggressive trade unions rampant at home, policymakers were no longer in control. Today, the perception of central bank infallibility has been permanently ruptured by their collective failure to see the 2008 crash coming. Nagging concern at their over-willingness to inflate, at the blurring of monetary and fiscal policy and over long-term government solvency gives traction to a similar narrative today.”

In short, Mr. Grice utilizes the behavioral finance perspective to argue for a gold bubble and simultaneously disparage gold’s role in society.

The idea that gold is intrinsically worthless is to argue against 4,000 years of history whereby gold or silver has accounted for as money. To quote Murray Rothbard in What Has Government Done to Our Money?, ``Money is not an abstract unit of account, divorceable from a concrete good; it is not a useless token only good for exchanging; it is not a claim on society; it is not a guarantee of a fixed price level. It is simply a commodity.”

Yet gold, as commodity money, didn’t just pop out of nowhere, nor had they been they imposed by Kings or political leaders to be accepted by their constituents as money. On the contrary, historical evidences reveal that money evolved from the market’s selection process.

Some earlier forms of money that were used in select societies, such as cowrie shells in Maldives, peppers and squirrels skins in parts of Europe (The Ascent of Money), fish on the Atlantic sea coast of colonial America, beaver in the old Northwest, and tobacco, in Southern colonies (Rothbard-Mystery of Banking) salt, sugar, iron hoes, feathers, leaves and seeds, land to even huge stones weighing up to 500 lbs in the Pacific Islands of the Yap, failed to generate wider acceptance.

Instead, commodity metals, particularly of the precious metals family –gold, silver and copper- had been largely adopted due to its marketability.

According to Professor Ludwig von Mises in The Theory of Money and Credit, ``There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained. Which was universally employed as a medium of exchange; in a word money.”

Aside from marketability, commodity money has acquired its role due to added special traits as being highly divisible, portable, high value per unit weight and highly durable (Rothbard-Mystery of Banking).

Yet money in a conventional sense, to quote Professor Niall Ferguson in The Ascent Of Money, is a medium of exchange, which has the advantage of eliminating inefficiencies of barter; a unit of account which facilitates valuation and calculation and a store of value, which allows economic transactions to be conducted over long periods as well as geographical distances.

In other words, it would seem incoherent, if not self contradictory or plain arrogance, for anyone to claim that an object is intrinsically useless yet is considered as the most marketable combined with special traits for it to assume the role of money for thousands of years. It’s like arguing that Manny Pacquiao is a loser in spite of snaring a world record breaking title win!

Crack Up Boom Versus Bubble Psychology

Yet forecasting gold prices at $6,300 driven by plain narrative based bubble psychology is like proposing to buy or exchange something you own for something that is essentially a chimera. Or simply, would you buy rubbish simply because everybody else is doing so? How logically consistent can this be? To recall Warren Buffett’s priceless words of wisdom, ``the dumbest reason in the world to buy a stock [or any investment –mine] is because it's going up.”

Furthermore, the argument for a ‘displacement’ that would trigger a bubble cycle predicated on the rationale of “insolvent governments” ignores the psychology that drives money-FAITH.

In essence, bubble psychology deals with investor irrationality, cognitive biases and the animal spirits, which eventually revert to the mean. It underestimates and overlooks on the impact of the bubble cycles on monetary health conditions and sees a limited effect only to investment assets.

On the other hand, the truism is that money is driven by trust or faith accrued over the long years of established virtues or properties acquired which allowed money to assume its role. Confusing one for the other would be misleading.

Figure 5: Casey Research: Weimar Hyperinflation: How Faith Evaporates

As to how faith in money can vanish (see figure 5-the Weimar Germany experience) beyond the realm of behavioral finance, again this quote from Prof. von Mises, ``But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.”

In finale, my view of rising gold prices is that it reflects on a burgeoning global monetary disorder based on the incumbent operating currency platform (US dollar standard) more than simply bubble symptoms. It’s more than a narrative; it is an underlying degenerating malaise that places at risks faith in our money.

Although a gold bubble cycle CANNOT be discounted, we’d like to see evidences of a credit driven euphoria underpinning private or public sector acquisition. Absent credit expansion, which is the sine qua non fuel for any bubble, rising gold prices signify as a symptom.

Philippine Politics: Always Waiting For Godot

``In our age there is no such thing as ‘keeping out of politics’. All issues are political issues, and politics itself is a mass of lies, evasions, folly, hatred, and schizophrenia.”-George Orwell, Politics and the English Language

Philippine elections are near, and so the politicization trends have apparently been intensifying.

In contrast to the public, whom are seemingly severely obsessed with sensationalism, we think that the Con Ass is nothing but a diversionary ploy, because it lacks the time element and the legal channels and risks running the same parallels to the Honduran experience.

This means I don’t buy the balderdash that the highly unpopular PGMA will run anew or that the passing of President Corazon Aquino will “harm” PGMA’s political interest for the said reasons.

For me, the ‘Hello Garci scandal’ signifies as the apogee of any political capital damaging events that could have undone her, yet she persisted.

Media and its gullible captive audiences, simply loves to pick on fights that can’t go beyond superficialities. Worst, they promote abstractions (fair, good or evil, greed or etc…), when the truth is that political winds always see a shift in allegiances.

In politics (here or elsewhere), the rule of thumb has been ‘there are no permanent friends only permanent interests’.

As an aside, it would be downright naïve to also believe that Philippine politics runs on simple “partyline” platforms; as if ideology ever mattered.

Yet do any of the aspiring candidates have one?

Yes, every candidate wants corruption free “good” government alright, but unfortunately their aspirations operate asymmetrically on the platform of free lunch and an ever expanding bureaucratic based redistributive system of command and control. Regrettably, a system, which runs utterly in conflict to such supposed goals and which always penalizes the productive segment of the economy.

The reality is that politicians organize and run their bureaucratic network not by appointing people of virtue or by meritocracy but by political affiliations and interests.

Hence, policies are determined politically by populism or by political lobbying groups (hence the proclivity to corruption) or by the quirks of political leaders- preferences based on personal value priorities or marginal utility, familiarity (e.g. would favor industry from which the politico has experienced with), biases, perception and interpretation of events, ego, comfort zones and or preferred social networks (e.g. schoolmates, social organizations etc…).

Robert Ringer has this piquant quote to analogize our version of democratic politics ``You have to throw welfare programs at people — like throwing meat to a pack of wolves — even if the programs don't accomplish their alleged purpose and even if they're morally wrong." liberal Bennett Cerf quoted by Nathaniel Branden in Judgment Day: My Years With Ayn Rand” (emphasis added)

Political advertisements that dangle free this or free that or give away houses over media are fundamental examples.

The popular delusion is that the deliverance of the Philippines will come from a SAINT like leader. This shows that what matters for Philippine politics has been personality imagery, which signifies as the lotto mentality of short term gratification and is hardly about the realities of correcting the deeply flawed institutionalized political patronage system that relies on license based economic rents. Hence, the clueless citizenry will remain perpetually Waiting for Godot who in Samuel Beckett’s play never appears.

Moreover, since national election is just a few months away political forces have been mobilizing. And considering that the elite constituency of the Philippines have related or shared interests or direct/indirect affiliations, it is likely that unpublished alliances will determine the 2010 outcome.

This is where I think the administration and their allies will field multiple candidates, some camouflaged as the “opposition” or Trojan Horses.

So for clues of the possible contestants for the national elections, simply watch for the actions of the kingmakers involved in the ongoing Meralco episode as discussed in Bubble Thoughts Over Meralco’s Bubble.

Bottom line: The upcoming presidential election will likely have two known characteristics well described in quotes:

one, the road to hell is paved with good intentions, and

second, the more things change the more they remain the same.

Hence, I don’t expect any fundamental change in the political economy unless it is demanded for and in the interest of the political elitist segment of our society.

Bubble Thoughts Over Meralco’s Bubble

``The lies the government and media tell are amplifications of the lies we tell ourselves. To stop being conned, stop conning yourself.”-James Wolcott, American Journalist

Meralco is in the spotlight anew.

The country’s premier utility firm, which holds the exclusive franchise for the electricity distribution for the National Capital Region (NCR), caught the public’s attention following a spectacular record romp by its share prices.

And last week’s parabolic vertiginous ride appears to have been playing out the blowoff phase of a conventional bubble cycle. (see Figure 1)

Figure 1: Bubble cycle (left) and Meralco (black candle right)

Importantly, like typical bubbles, the culmination of which can be identified by delusional rationalizations aided by experts exacerbated by media- Meralco’s skyrocketing price has been attributed to speculations on a prospective ‘tender offer’ (Bloomberg)!

Allegedly one of the titans involved [see King Kong Versus Godzilla at the PSE; Where Politics Trumps Markets] in the drama of the recent corporate joust has acquiesced to a purchase price of Php 300 per share which would require a mandated offering to minority stockholders!

Yet rising prices and some special trades (block sales and cross trades) have been used as signs to confirm on such myths.

Why do we think all these rationalizations seem ridiculous?

Simply said, because logical reasoning has been totally thrown out of the window!

As financial writer and investment speaker Joe Granville warned, ``the media is the biggest enemy of the small investor, mostly headlining the wrong news at the wrong times, playing on his misguided reliance on fundamentals and his normal fears and greeds.”

Putting A Perspective On Meralco’s Price And Corporate Disconnect

To put on some level headed perspective we will deal with some key issues.

First, on a year to date basis, despite the recent turbocharged upsurge, Meralco hasn’t been the only leader with 284.87% of gains (as of Friday’s close).

Other issues like Phisix component mining giant Lepanto Consolidate (+271.43%) and Business Process Outsourcing Paxys (+358.33%) have seen the similar or greater level of share price action as seen in the above chart represented by the green and red lines respectively.

As an aside, I wouldn’t suggest that the latter two would seem in a bubble considering the U-shaped recovery vis-à-vis Meralco’s actions which appear to have replicated the motions of a bubble paradigm as shown in the chart.

Although from a trough to peak basis, Meralco, hands down based from last year, does hold the tiara for market outperformance (700%).

Nonetheless, one must be reminded that past performances are not indicative of future outcomes.

Two, Meralco’s share in the Phisix has now jumped to 7.7% from less than 1%, as we similarly pointed out in Beware Of The Brewing Meralco Bubble!, and now holds the second spot after PLDT in terms of free floated market cap.

This for a company whose profits are constrained by political forces! (see below)

Meralco has effectively, leapfrogged over former heavyweights Ayala Corp, Bank of the Philippines, Globe Telecoms, Ayala Land and SM Investments.

With Meralco’s share of the Phisix gaining more weight, any ensuing volatility from its share prices will likely be reflective on the directions of the Philippine benchmark unless counterweighted by the lagging erstwhile behemoths.

Three, financial valuations, if any of these apply at all, have ENTIRELY been jettisoned for wanton speculations and nonsensical justifications.

As we discussed in Meralco’s Run Reflects On The Philippine Political Economy, the share price movements in the local markets hardly reflects on corporate fundamentals.

The first three factors cited above have clearly been validating our Livermore-Machlup model where Philippine equities move in tidal fashion underpinned by liquidity or loose monetary landscape.

This climate essentially begets a predominant horse racing outlook or mentality, where canards touted as facts mostly emanating from the foibles of cognitive biases.

In short, NO liquidity from loose monetary policies equals NO bubbles, and all the rest are simply footnotes.

As writer Peter McWilliams warned (bold highlights mine), ``The media tends to report rumors, speculations, and projections as facts... How does the media do this? By quoting some "expert"... you can always find some expert who will say something hopelessly hopeless about anything..” Indeed.

Fourth, common sense should dictate to us that perhaps none of these engaged (supposedly cunning and astute) Taipans, whom have built their wealth and “credibility” over the years, would likely pay for excessively or overpriced assets, unless they have other undeclared agenda in mind, which are exclusive of profits meant for the institutions which they represent.

Yet, any outrageous and reckless acquisitions, that would put at risk the interests of such institutions involved, could provoke a minority shareholder revolt. That’s assuming shareholder activism is alive here. Nevertheless, even in the absence of it, we should expect the minority foreign shareholders to vote with their feet.

In short, the supposed buyout, from the alleged stratospheric levels, signifies as tremendous costs to the interests of the company they represent from both the majority and minority stakeholders’ perspectives.

Needless to say, the present day hysteria from rising share prices is temporal in nature and subject to market cycles and does NOT represent the underlying fundamentals. Unless people think that these tycoons are dimwits, I would bet on the opposite…that the so called godfathers involved are cognizant of this!

Fifth, even if the so called buyout does occur, it is less likely that such deal would be consummated in transparency or reflective of market conditions.

These titans could have such transaction wrapped up much earlier than known by the public, or have done so with attendant compromises such as rebates et.al., and could use recent actions as a partial exit point to profit from today’s insanity.

Lastly, as we have been repeatedly arguing, the Meralco brouhaha is beyond the sphere of normal financial analysis because it is a POLITICAL SENSITIVE public listed company.

You can’t just attribute earnings without comprehending on the business model from which the company operates on.

Besides, here, the interests of the owners under the said platform are divergent from the interest of the minority shareholders.

Here is why.

Meralco’s Business Model: From RORB TO PBR

Lately, Meralco’s business model has shifted from Rate of Return Based (RORB) to Performance Based Rating (PBR).

According to GMANews.tv, ``The new PBR scheme also replaces the return on rate base (RORB) formula, which charges customers for using Meralco assets — including posts and cables — in bringing electricity to its end-users.

``Under the RORB, public utilities such as Meralco are disallowed from charging rates exceeding 12 percent of the worth of its total assets.”

So what’s PBR?

According to the same article, ``The new scheme provides “rewards and penalties for performance and non-performance respectively, Jose de Jesus, Meralco president said.

``Under the said mechanism, Meralco may be required to pay fines should its performance — such as failing to immediately respond to a blackout — fall below certain standards.”

And why PBR?

According to the “quasi independent” regulator of Meralco the Energy Regulatory Commission (ERC),

``The ERC adopted the PBR for distribution utilities starting in 2005 pursuant to its authority under Section 43 (f) of Republic Act No. 9136 (EPIRA) to adopt internationally accepted rate making methodologies. PBR strives to achieve a balance between efficient price levels, allowing utilities efficient revenue to ensure their sustainability, and maintaining or improving network service performance levels. It provides strong incentives to improve operational efficiencies. International experience (Australia and United Kingdom) indicates that, over time, with its built-in mechanisms for incentives and fines depending on the utilities’ performance, PBR leads to reductions in the real price of electricity distribution while improving service levels.”

Aside, the ERC has required Meralco to implement a subsidized rates for the poor by the so-called “NEW LIFELINE program, where ``The ERC reiterated that customers consuming only 20 kWh and below shall continue to enjoy the 100% discount granted them and shall pay only the adjusted PhP5.30 per month metering charge, while the other lifeline customers shall enjoy a discount corresponding to the consumption level under the new lifeline program approved under the DTI case, including the PhP21.00/customer/month minimum charge.”

Implications Of The Business Model: Absolute Dependence On Political Discretion!

What ALL of these means:

1. Basically prices charged to the paying consumers of Meralco are solely determined by the ERC and NOT by the markets.

This means that Meralco’s profits are ultimately determined by fickle political winds.

As Ludwig von Mises described of Bureaucratic Management of Private Enterprises, ``But ours is an age of a general attack on the profit motive. Public opinion condemns it as highly immoral and extremely detrimental to the commonweal. Political parties and governments are anxious to remove it and to put in its place what they call the “service” point of view and what is in fact bureaucratic management.”

Think $100 oil. Rising energy prices are likely to stoke political discomfort among the society’s underprivileged from which would force politicians to focus on “windfall profits”.

Yet, in a world where profits will be deemed as inconsistent with political interests, the owners of Meralco will likely wring profits out through other mechanisms, e.g. off balance sheet transactions, loans or contracts to affiliated parties, transfer pricing and etc.

In short, where financial reports will unlikely be transparent, the interests of the owners of Meralco and the minority shareholders departs.

2. Meralco maintains a subsidy for the poor from which are tacitly charged to the account of the middle and high income consumers.

This exemplifies as a “private” company, functioning under stringent control of political interests, conducting the political redistribution aspect in behalf of the government. Hence Meralco acts as a subcontracted implementing agent under political behest.

This implies that economic rents or “profits” for Meralco’s owner managers will only be attained under the auspices of the political leadership for as long as the political interests are served.

3. Under the PBR, the ERC determines the “carrot and stick” for Meralco.

Basically, Meralco’s lifeline hangs on ERC’s dictate!

This implies that the ERC and Meralco will haggle over what comprises as sufficient or inadequate under the PBR guidelines and NOT the consumers.

And since rules are always technically subjective and subject to nonlinear or amorphous interpretations, they will be subject to compromises. Ask the lawyers.

Therefore this implies two things:

One absolute subservience to the political office, where to quote Ludwig von Mises in Bureaucracy, ``Under this system the government has unlimited power to ruin every enterprise or to lavish favors upon it. The success or failure of every business depends entirely upon the free discretion of those in office.” (bold highlights mine)

Second, instead of looking after the welfare of its clients (Metro Manila consumers), the unlimited dependence on the discretion of the government bureaucracy means conflict of interests from parties involved abound.

Principally, the owner’s priorities will mostly be directed into the realm of public relations; of wheedling or currying favor with that of ‘The Powers That Be’. Satisfying the public will requirements will be subordinate to this.

Again from Ludwig von Mises, ``In such an environment the entrepreneur must resort to two means: diplomacy and bribery. He must use these methods not only with regard to the ruling party, but no less with regard to the outlawed and persecuted opposition groups which one day may seize the reins. It is a dangerous kind of double-dealing; only men devoid of fear and inhibitions can last in this rotten milieu. Businessmen who have grown up under the conditions of a more liberal age have to leave and are replaced by adventurers.” (bold emphasis mine)

The sordid and unfortunate experience of the current managers in the besieged Lopez group (who appear to be outgoing****), having to oppose the PGMA administration politically, serves as fundamental and shining example of the consequences of political defiance.

So those nurturing the view that owner-managers of political enterprises will be looking for one dimensional financial bottom line growth are living in a world of fairy tales.

Thus, financial statements have little relevance to Meralco’s valuation as a financial security because economic rents accruing the owner-managers of Meralco may come in sundry forms, than simplistically “profits” as defined by textbooks.

Besides, as pointed out in Has Meralco’s Takeover Been A Good Sign?, the current managing owners of Meralco have to deal with socio-political, bureaucratic and political risks, which ultimately mean that they need to be in constant harmonious relations with the current and forthcoming political leaders.

These are things that are learned outside of traditional or mainstream school curriculums. And yet these signify as unorthodox or contrarian views that operate realistically.

4. The ERC’s leadership is appointed by the President of the Philippines.

This makes the agency hardly independent as purported to be, but instead beholden to the administration.

Again since political appointments are almost always based on political affiliates or interests and are hardly ever about virtues or meritocracy, the direction of regulatory implementation and compliance will likely be dependent on the caprices of the political leadership.

Conclusion/Additional Comments

All these imply that the rewards from the ownership of Meralco comes with the blessings of the ‘Powers That Be’ combined with a possible implied backstop (guarantee) in the case of failure or bankruptcy, provided that the interests of the company’s owner managers or political entrepreneurs operate along the lines of interests of the incumbent political leaders.

Therefore it would be foolhardy or naïve to believe that the tycoons that got engaged in Meralco with billions of pesos of investments, had been there to only leverage on the political misfortunes of the present owners and to speculate on share prices while at the same time ignoring the risks associated with the political aspects of having a stake in Meralco.

Also, this implies that the changing dynamics of the ownership structure of Meralco strongly alludes to the next president-the identity of which only the kingmakers or the chief Meralco proponents know.

****The prevailing notion is that there has been an ongoing power struggle in Meralco.

For me, this seems like an oversimplistic crock.

In my view, both protagonists appear like unheralded allies, only awaiting the appropriate opportunity for a graceful exit for the Lopezes, which I think should come after the elections.

As per Joe Studwell in Asian Godfathers, ``The reality is that tycoons are typically forced to invest together because of the environment in which they operate.” (emphasis mine)

Considering that Meralco’s destiny is fundamentally intertwined with the Presidency, this probably implies that both godfathers could be straddling in support of different candidates in the forthcoming Presidential elections where its outcome will decide who among the two groups will takeover.

Although it is most likely that a price agreement for the prospective exchange may have already been sealed but perhaps at prices much less than the rumors (my guess is anywhere Php 90-120).

Moreover, it has been my inclination to believe that the Meralco saga will unfold similar to the Philippine Airlines privatization, where former PLDT chair Antonio Cojuangco initially fronted for the bidding which ultimately landed in the laps of Taipan Lucio Tan, the current owner.

Finally, of course, both parties would want to see Meralco’s share prices remain elevated, hence through various associates or intermediaries, they might continue to float stories from which the public so eagerly yearns for, as appetizer for their innate speculative instincts operating under today’s loose monetary environs.

However, the idea is-once the political matters have been settled, excess shares could be sold through the markets or that if any contingency arises (such as a dark horse winner in the Presidential elections) both parties can avail of present lofty prices as an exit strategy.