Abenomics Failure: The Unraveling of the Yen Devaluation and Tax Nostrums

Weak currency equals strong exports, which has been expected to boost the economy, has been a popular mantra embraced by the consensus. Such popular delusions are really based on the dogma of neo-Mercantilism. 

So the orthodoxy of today’s policies have been to devalue directly (monetize debt) or indirectly (inflationary boom)

The article below is an example of how perplexed the consensus has been, when economic reality debunks the popular held myth.

Japan's Abenomics should be a prime example

From the Wall Street Journal Real Time Economic Blog

If you are wondering why Japan’s exports are languishing despite the yen’s weakness, take a quick look at monthly production data released Thursday by top auto makers.

Domestic output by Toyota Motor Corp. declined 3.7% from a year earlier in July, while its overseas output rose 9.5%. Rival Nissan Motor Co. said its production volume tumbled 22.5% in Japan but rose 4.8% overseas.

Mazda Motor Corp. cut its domestic production by 5.9% but rolled out 69% more vehicles outside of Japan. Bucking the trend was Mitsubishi Motors Corp., whose result was up 1.3% in Japan but was down 3.2% abroad. Hollowing out of Japan’s manufacturing continues unfazed by the yen’s weakness.

For decades, policy makers could count on weakening of the yen to push up exports by making Japanese products cheaper and more competitive overseas.

This time it hasn’t happened. The volume of Japan’s overall exports declined year-on-year in five of the 12 months through July and rose only modestly in the other months, according to the finance ministry.

Weak exports have weighed on growth even as Tokyo took steps to stimulate the economy. And that’s in large part a reflection of the extent to which Japanese auto makers and other companies have moved production offshore, especially China and Southeast Asia.

First of all this statement--For decades, policy makers could count on weakening of the yen to push up exports by making Japanese products cheaper -- isn’t accurate. For decades long, the Yen has been strengthening against the US Dollar. It’s only during Abenomics when the Yen has weakened. So there is hardly "weak yen pushing up exports" during the previous decades. The reporter didn’t even bother to check on the facts before making such an outlandish claim.

Second, the report argues for more interventions and easing by the BoJ, which practically means doubling down on failed policies.

Third, inflationism has never been an isolated political act. In the case of Japan, another policy "arrow" has been to boost government spending via raising tax rates.

So when government disrupts the pricing mechanism massive unsustainable imbalances will emerge.

Here is what I wrote last June: (bold original)

It’s a wonder how the Japanese economy can function normally when the government destabilizes money and consequently the pricing system, and equally undermines the economic calculation or the business climate with massive interventions such as 60% increase in sales tax from 5-8% (yes the government plans to double this by the end of the year to 10%), and never ending fiscal stimulus which again will extrapolate to higher taxes.

The mainstream has all been desperately scrambling to look for “green shoots” via statistics. They fail to realize that by obstructing the business and household outlook via manifold and widespread price manipulations, this will only lead to not to real growth but to greater uncertainty which translates to high volatility and bigger risks for a Black Swan event.

And not only has exports been stagnating, the balance of trade has been in a deficit. This has been punctuated by Abenomics.

Again inflationism combined with higher taxes and other interventions has only magnified the adverse economic effects on the Japanese economy.

Today’s series of economic numbers reveals that Japan faces increased risks of a recession. (Note the three charts below are from Zero Hedge)

Unemployment rate rose to November 2013 highs.

The rebound from the recent collapse in Japanese household spending has been short-lived.

Japan’s retail sales remains moribund

Industrial production has been flat-lining (chart from investing.com). This comes as inflation continues to be elevated (33.4% in July)

At the end of the day, Japan has been showing incipient signs of stagflation. If sustained then this will put pressure on interest rates, where the latter will serve as the proverbial pin that would prick Japan’s debt bubble.

Also if the BoJ desists from inflating further, those accrued imbalances built from previous inflationism and interventions will unravel.

So Abenomics has only produced a damned if you do, damned if you don’t conditions which alternative means a no way out scenario

Bottom line: all these snake oil fixes has not only kicked the can down the road, for the benefit of vested interest cabal, but has only increased unsustainable imbalances in the system that is bound for a disorderly breakdown.

And we seem to be nearing this critical point.

Mayhem in the US Treasury Markets, No Problem, China to the Rescue!

When you're down and troubled and you need a helping hand and nothing, whoa, nothing is going right.

Close your eyes and think of me and soon I will be there to brighten up even your darkest nights. —James Taylor, You’ve got a friend

China’s government has played the role of “savior” to what could have been a US treasury market crash last May. 

As the US Treasury markets seized up, the Chinese government added $25.2 billion to its US treasury holdings which represents the highest hoard ever.

From China Daily USA:

China, the biggest creditor to the United States, increased its holdings of US Treasury bonds by 2 percent in May to $1.32 trillion, even as foreign demand for the bonds fell for a second consecutive month, according to the US Treasury.

China had increased its holdings of US bonds by 1.6 percent in April, which was revised higher after an initially 0.4 percent drop. Japan, the second-largest buyer, trimmed its holdings 0.2 percent to $1.11 trillion in May…

US residents increased their holdings of long-term foreign securities, with net purchases of $27.2 billion, while foreign investors decreased their holdings by $39.2 billion, said the Treasury report.

The sum total in May of all net foreign acquisitions of long-term securities, short-term US securities, and banking flows was a monthly net of $56.4 billion, said the Treasury Department. Net foreign private inflows were $46.6 billion, and net foreign official inflows were $10 billion.

TIC data shows that total foreign ownership of USTs reached a fresh record of $4097.9 billion in May, surpassing the February highs of $4097.4. 

China’s additional acquisition of $25.2 billion of USTs has been the swing factor. This implies that China’s actions played a crucial role in providing counterbalance to the resurfacing of the bond vigilantes. [The Philippines joined the "you've got a friend" movement adding $.2 billion last May]

This also demonstrates of the deepening dependency by the US government on her Chinese counterpart.

Austrian economist Gary North explains;

The U.S. government is running about a $650 billion deficit this fiscal year. The People’s Bank of China is doing its part to help out. It just bought another $25 billion of this deficit last month.

Why is it doing this? To hold up the value of the dollar.

Why is it holding up the value of the dollar? To make it less expensive for Americans to buy goods made in China.

But then protectionists in Congress scream bloody murder, because China is subsidizing exports to Americans. Then they vote for federal spending that runs a huge deficit. So, in order to hold down government interest rates, the Treasury Department must find buyers of this debt, other than the Federal Reserve System. The Chinese central bank is a large buyer.

So, every time Senator Chuck Schumer of New York insists that China must be stopped from rigging its currency, he is really saying that the Chinese central bank should stop buying IOUs issued by Congress. Then he votes for another spending program.

The Chinese central bank creates money out of nothing, just as the Federal Reserve does. Then it takes this newly counterfeited money and buys U.S. government debt, just as the Federal Reserve does. It bought $25 billion of this debt last month. The Federal Reserve bought $45 billion. So, when it comes to currency-rigging, which central bank is the greater culprit?

This is the race to the bottom. Which central bank will destroy its currency first? Or, if the central banks decide not to inflate any more, which central bank will cease counterfeiting money, thereby causing an economic depression?

The two economies, China’s and America’s, are addicted to the drug of fiat money. The first central bank to quit counterfeiting — the first one to “taper” — starts the international recession. Which will it be?  The first one to stop inflating permanently will turn the recession into a depression. Which will it be?

In May of 2012, the Chinese government has been given direct access to the US Treasury which basically bypasses the crony Wall Street. That reveals of the significance of the US-China relationship.

Such dependancy extrapolates to a Dr. Jekyll and Mr. Hyde relationship where on the financial front, the US and the Chinese government have been operating stealthily as staunchest allies, as against the geopolitical front, which media paints both parties as nemesis or adversaries.

The implication as I wrote a year ago:

Of course the inference from the above statement is that the Scarborough Shoal controversy has been mostly a false flag. What you see isn't really what has been. Politicians and media has taken the public for a ride at the circus.

I would add that not only has the media portrayed conflict between US-China been to promote the military industrial industrial complex, it serves as convenient pretext for the political class of these respective nations involved in territorial disputes, to expand control on their constituents via more financial repression, more taxes, more regulations and other forms of political control...all in the name of nationalism. 

At the end of the day, the world operates in a gamed system.

Abenomics: Japan’s McDonald’s to Raise Prices by 25%

Lo and behold! This is one example of the supposed magic of Abenomics, Japan’s McDonald’s will raise prices of their products by 25% in order to offset losses!

From Bloomberg

McDonald’s Corp. (MCD)’s Japan business will raise some prices by much as 25 percent next month, the fast food chain’s first increase on burgers in the country since 2008.

Hamburger prices will go up to 120 yen from 100 yen and cheeseburgers will rise to to 150 yen from 120 yen in Japan in May, McDonald’s Holdings Co. Japan Ltd. said in a statement today. The hikes are part of the company’s plan to boost profitability, it said.

McDonald’s is raising the prices after the Japanese unit reported a 12 percent drop in operating profit last year. Fewer discounts drove March same-store sales 3.6 percent lower at the local business, the 12th consecutive monthly decline.

Of course basic economics tells us that higher prices leads to lesser demand. Thus a fall in purchasing power should extrapolate to lesser sales in terms of quantity (and also quality) which eventually should put pressure on profits. 

Chart from Yardeni.com

Yet given Bank of Japan’s recourse to inflationism which hasn’t been anything new, as the Japanese government has been doing this since the start of the new millennium, but has only become more aggressive since 2008, McDonald’s has been suffering from poor sales which isn’t supposed to be the case, especially at the onset of expansionary boom. 

The employment of such poilcies embodies precisely the definition of insanity specifically "doing the same thing over and over again but expecting different results."

Inflationism will hardly bring a boost to the economy, why? Because it inhibits economic calculation and the division of labor by distorting market prices.

As the great Murray N. Rothbard explained (bold mine)

Inflation has other disastrous effects. It distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations. For example, accounting practice enters the "cost" of an asset at the amount the business has paid for it. But if inflation intervenes, the cost of replacing the asset when it wears out will be far greater than that recorded on the books. As a result, business accounting will seriously overstate their profits during inflation--and may even consume capital while presumably increasing their investments.  Similarly, stock holders and real estate holders will acquire capital gains during an inflation that are not really "gains" at all. But they may spend part of these gains without realizing that they are thereby consuming their original capital.

By creating illusory profits and distorting economic calculation, inflation will suspend the free market's penalizing of inefficient, and rewarding of efficient, firms. Almost all firms will seemingly prosper. The general atmosphere of a "sellers' market" will lead to a decline in the quality of goods and of service to consumers, since consumers often resist price increases less when they occur in the form of downgrading of quality. The quality of work will decline in an inflation for a more subtle reason: people become enamored of "get-rich-quick" schemes, seemingly within their grasp in an era of ever-rising prices, and often scorn sober effort. Inflation also penalizes thrift and encourages debt, for any sum of money loaned will be repaid in dollars of lower purchasing power than when originally received. The incentive, then, is to borrow and repay later rather than save and lend. Inflation, therefore, lowers the general standard of living in the very course of creating a tinsel atmosphere of "prosperity."

This only means that in a highly inflationary environment McDonald’s and other Japanese firms will be compelled to either reduce quality or to continually raise prices in order to survive or even speculate, which is contradictory to bring about ‘competitiveness’.

Yet any elevated accounting figures boosted by higher prices will be exposed when the BoJ desists from pursuing inflationist policies—the boom bust cycle.

Moreover, given that Japanese households are said to be ‘risk averse’ where 56% of their liquid assets are in the form of cash and where liquid ‘cash’ financial wealth accounts for 319% of Japan’s GDP, while only 5.8% have been invested in equities and .08% in foreign assets, one should expect that the massive fall in the purchasing power of the yen, will lead not to more investments, but to yield chasing masked as capital flight.

Former Morgan Stanley analyst now managing director and cofounder of SLJ Macro Partners Stephen Jen quoted by SNBCHF.com 

The first stage is foreign leveraged funds shorting the yen, acting on the rhetoric from the Abe Administration. This stage is coming to an end, to be followed by the second stage: Japanese investors selling yen

We have already seen signs where Japanese firms would rather raise financing from foreigners than to deploy domestic cash to investments.

So it would signify as a grotesquely obtuse idea to blindly believe (yes inflationism isn’t economics but religion based on heuristics) that inflation will save the day for Japan. Doing the same thing over a decade hasn't help, why should it be different this time? Because of the shock and awe?

One can only look at Argentina and Venezuela’s transition from stagflation to hyperinflation to see how disastrous a policy inflation makes.

Abenomics will only hasten Japan's path to a crisis.

Japan’s Ticking Time Bomb: Worsening Streak of Current Account Deficits

We have been told by mainstream media and experts that PM Shinzo Abe’s inflationist policies popularly coined as “Abenomics” will deliver economic “competitiveness” .

Yet even in the short term, where the magic of inflationism should work best, Abenomics fails. 

Exports which supposedly should have been boosted by a devalued currency shrank, while imports continue to surge.

From Bloomberg,

Japan posted its longest run of trade deficits in three decades as exports fell in February, underscoring challenges for Bank of Japan (8301) Governor Haruhiko Kuroda in reviving the world’s third-biggest economy.

Shipments dropped 2.9 percent from a year earlier, the Finance Ministry said in Tokyo today. The median estimate of 22 economists surveyed by Bloomberg News was for a 1.7 percent decrease. Imports rose 11.9 percent, leaving a trade shortfall of 777.5 billion yen ($8.1 billion).

Kuroda, who began his tenure as governor yesterday and will give his first press briefing this evening, is pledging more aggressive monetary easing that may further weaken a yen down about 10 percent against the dollar this year. While the currency’s decline boosts the outlook for exporters in coming months, it’s already swelling the nation’s import bill as nuclear-plant shutdowns force bigger imports of fossil fuels.

Apologists for Abenomics say that a “time lag” exists for such policy to create “traction”. But contrary to such an absurd idea, rising input or producers prices, e.g. energy, will neutralize any gains from the supposed currency panacea. (chart from tradingeconomics.com)

Yet consumers have also been exhibiting signs of a squeeze in purchasing power through reduced spending.

And a string of worsening current account deficits will parlay into a drawdown on savings or increasing reliance on foreigners that amplifies the fragility of Japan’s precarious fiscal balance. As I previously wrote,

Worst, a sustained deterioration of current accounts means that Japan will increasingly rely on foreign capital and or draw down from the her pool of savings which has been estimated at $19 trillion and which could also extrapolate to a reduction of assets held overseas or $4 trillion net foreign investment position.

And given the deliberate debasement of the yen, I am not inclined to see a reduction of foreign assets by Japanese households. Instead, Japan’s private sector will likely increase their exposure overseas couched under euphemism of Foreign Direct Investment (FDI) or portfolio flows when in reality they account for as “capital flight”.

So “Abenomics” will mean that Japan will transition from a net savings-net creditor nation to eventually a net debtor country overtime or a sordid tale of from riches to rags, if such policies continue.

And given the nation’s colossal debts, any signs of funding stress will mean a jump in interest rates which should further aggravate highly vulnerable Japan’s fiscal balance. This increases Japan’s potential transition to a crisis whether through a debt or through a currency strain, depending on how policymakers will react.

One recent positive development though is Shinzo Abe’s proposal for Japan to join the Trans Pacific Partnership Free Trade Agreement (FTA). 

Yet it remains to be seen if gains from expanding trade will be enough to offset the negative effects from massive interventionist measures of monetary easing and fiscal stimulus.

Does Unemployment Cause Deflation?

I was apprised by a dear friend that in a part of the US, call center jobs have been migrating to the Philippines. Such phenomenon he sees as having a “deflationary” impact on the US economy. 

Such popular reasoning is fairly simple. Lack of jobs equals a fall in aggregate demand. Falling demand leads to falling prices. Falling prices result to more job losses. Thus the circular reasoning translates to an endless loop: a deflationary spiral.

The bottom line from such aggregate demand framework is that unemployment causes price deflation.

Of course, the alternative implication is that the Philippines, like China through alleged currency manipulation, has been “stealing jobs” from Americans.

And equally this means that for them, the optimal political solution is to inflate or apply protectionist measures or apply both against countries like the Philippines or China.

Have job losses or unemployment resulted to price deflation as alleged?

Here is a list of the largest world unemployment rates from Wikipedia.org.

Since there are many nations with over 10% in unemployment rates, I will only reckon with nations with over 50% in unemployment rates

Nauru 90%

Vanatu 78.21%

Turkmenistan 70%

Zimbabwe 70%

Mozambique 60%

Djibouti 59%

Given the huge unemployment rate, then we assume that these countries, according to the aggregate demand theory, to be in a deflationary depression.

Note: there is no price inflation figure for Nauru

Vanatu’s inflation rate (chart from Index Mundi) Positive inflation.

Turkmenistan price inflation rate (chart from tradingeconomics.com) Positive inflation.

Zimbabwe’s post hyperinflation CPI (chart from tradingeconomics.com) Positive inflation.

Mozambique’s inflation rate (chart from tradingeconomics.com) Positive inflation.

Djibouti’s inflation rate (chart from tradingeconomics.com) Positive inflation.

Surprise, ALL 5 nations with the largest unemployment have ZERO account of price deflation!

So what’s wrong with such a claim or theory?

The fundamental premises are essentially misplaced:

-People all think the same or people don’t think at all. People mechanically and homogeneously follow the circular reasoning that falling demand leads to falling prices in a perpetual feedback loop to an eternal hellhole.

-People’s don't have marginal utility. All people share the same set of values, priorities, incentives and time preferences. 

-People are not human. People simply stop eating, drinking or clothing or finding shelter under a deflationary spiral. Maslow’s hierarchy of needs have been jettisoned out of the window. People are caught in a stasis, freeze like a deer caught in headlights, where demand totally evaporates.

-When people don’t think or when people think the same or when people stop being people then obviously the demand and supply curve, the law of scarcity and opportunity costs becomes inapplicable or ceases to exists.

-Capital has been nonexistent to people who act or behave in aggregates.

-Inflation is NOT a monetary phenomenon so does the consequent deflation.

In the real world, economies are vastly complex, with millions of spontaneously operating parts such that wages represents only part of the myriad of factors that influence the economic environment.

Other real factors are equally or even more important, e.g. proximity to markets, size and categories of markets, state of basic infrastructure, access to credit, connectivity, technology and labor, quality of labor force, comparative advantage/s, state of legal, political and regulatory institutions and environment, tax levels, state of economic freedom, depth of capital markets, monetary regime and much more.

Most important is property rights. When property rights are not secure, no one will dare to invest no matter the relative lower, if not the lowest costs, in terms of labor wages. Who invests in North Korea or in the above 5 nations with the largest unemployment (presumably the cheapest labor force) in the world where one's capital are likely to be arbitrarily seized by the incumbent authorities?

These are real factors that can't be seen as having neutral effects on people's incentives or which operates on a vacuum. 

How about the solution where government must step in to provide jobs, by inflation or protection? 

Well government, of course, comprises of people too.

Under the aggregate demand framework, the political class have been glorified as representing “superior” set of people in terms of knowledge and virtues, relative to the market which is seen as inferior non-political people, that lays ground for interventions on so-called “market failures”.

Such is an unalloyed myth. If the romance on politics is true, then inflation or deflation won’t exist. There won’t anything known as economics.

The reality is that inflation and protectionism represents two sides of the same coin: the political economy of destruction.

As the great Ludwig von Mises explained (bold mine)

By destroying the basis of reckoning values—the possibility of calculating with a general denominator of prices which, for short periods at least, does not fluctuate too wildly—inflation shakes the system of calculations in terms of money, the most important aid to economic action which thought has evolved. As long as it is kept within certain limits, inflation is an excellent psychological support of an economic policy which lives on the consumption of capital. In the usual, and indeed the only possible, kind of capitalist book-keeping, inflation creates an illusion of profit where in reality there are only losses. As people start off from the nominal sum of the erstwhile cost price, they allow too little for depreciation on fixed capital, and since they take into account the apparent increases in the value of circulating capital as if these increases were real increases of value, they show profits where accounts in a stable currency would reveal losses. This is certainly not a means of abolishing the effects of an evil etatistic policy, of war and revolution; it merely hides them from the eye of the multitude. People talk of profits, they think they are living in a period of economic progress, and finally they even applaud the wise policy which apparently makes everyone richer.

But the moment inflation passes a certain point the picture changes. It begins to promote destructionism, not merely indirectly by disguising the effects of destructionist policy; it becomes in itself one of the most important tools of destructionism. It leads everyone to consume his fortune; it discourages saving, and thereby prevents the formation of fresh capital. It encourages the confiscatory policy of taxation. The depreciation of money raises the monetary expression of commodity values and this, reacting on the book values of changes in capital—which the tax administration regards as increases in income and capital—becomes a new legal justification for confiscation of part of the owners' fortune. References to the apparently high profits which entrepreneurs can be shown to be making, on a calculation assuming that the value of money remains stable, offers an excellent means of stimulating popular frenzy. In this way, one can easily represent all entrepreneurial activity as profiteering, swindling, and parasitism. And the chaos which follows, the money system collapsing under the avalanche of continuous issues of additional notes, gives a favourable opportunity for completing the work of destruction.

The bottom line is that previous interventionists policies, e.g. policy induced boom bust cycles, regulatory mandates, entitlements etc..., have resulted to such lack of competitiveness which neo-mercantilists try to shift the blame onto the others. Yet they are asking for more of the same thing that led to this or they seek doing the same thing over and over again but are expecting different results.

The economics of aggregatism, thus, has mostly been about pretentious or pseudo-economics wrapped in populist anti-market politics constructed from heuristics, political religion and cognitive biases, or might I say, a grand deflation in logic.

Quote of the Day: How Devaluations Make Difficult Economic Calculation

Governments in countries like the United Kingdom have destroyed much of their manufacturing industry through currency depreciation, while Germany contrasts with a history of engineering excellence and a firm currency. The German business owner in the post-war years had relative certainty of economic calculation, allowing him to build up his productive wealth; while the British business lobby resorted to encouraging successive governments to keep costs down by devaluing the pound, rather than investing their own resources in more efficient production.

Reducing costs by managing the currency is, to put it less politely, all about robbing the workforce of the purchasing power of its wages. But the workforce is, in economic terms, made up of individual entrepreneurs selling their skills and labour to employers. They are the unconscious victims of devaluation as indeed are small businesses, but at least in the short-term the central planners manipulating fiat money congratulate themselves that jobs have been saved.

The cost comes later, as consumers – who in turn are also entrepreneurs and savers – pay the bill through higher prices and lose on their savings through lower interest rates and monetary value. So where’s the benefit?

None. The history of nations whose governments respect sound money, such as Germany and Japan in the post-war years, has been one of persistent economic progress, despite otherwise economically incompetent governments. This is in contrast with the UK and some European countries, whose continual devaluations were always accompanied by economic underperformance. Since then all governments have increased their currency debasement efforts. Nevertheless, it is striking that businesses do better with a stable currency in the long run than with the supposed benefits of these continual devaluations.

This is from GoldMoney’s Alasdair Macleod on the Impossibility of Economic Calculation in a fiat world

Different Trading Partners And The Currency Option

Another reason why proposed mercantilist policies particularly based on the currency valve option are not likely to work: different trade partners by different states or regions.

This from the Wall Street Journal Blog, (bold emphasis mine)

But the dollar’s impact will not be equal on each state or region. That’s because, for instance, Texas ships more exports to Mexico while New York sends more exports to Canada. Understandably, then, the health of Texan exporters depends more on changes in the dollar-peso rate while New York exporters care more about the U.S.-Canadian exchange.

To gauge the regional impact of exchange rates, the Federal Reserve Bank of Dallas has developed a real trade-weighted value of the dollar index for each state.

Foreign-exchange markets tend to focus on the dollar’s value versus the euro or yen. But for state exporters, the exchange rates in emerging nations and our NAFTA partners Canada and Mexico are probably more important.

“National exchange rate indexes do not always reflect individual state experiences,” the report says. “States at times face sharply different effective exchange-rate shifts, often provoked by economic or financial crises.”

This should not even be limited to the state or region level.

Competitiveness can be analytically regressed to independent enterprises where each firms operates on distinct cost structures, have different fields or areas of specialization and of the idiosyncratic competitive advantages, [even if they come from the same industry and operate in the same territory].

Where exchange rates could have diverse effects from the micro level from the different location of trading partners, the transmission mechanism of proposed exchange rate policies are likely to be ambiguous.

The other way to say this is that one size fits all exchange rate option is a political gamble undertaken by technocrats with society’s equity at stake.

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

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

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

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

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

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

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

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

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

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

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

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

Discipline As Basis For Bearishness?

And this applies as well to debt.

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

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

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

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

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

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

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

According to the Wall Street Journal[4],

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Remaining Bullish On The Euro

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

Figure 1: Ireland Government’s Spending Binge

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

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

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

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

According to the Economist[7],

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

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

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

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

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

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

Misunderstanding Deflation

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

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

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

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

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

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

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

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

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

Bond Markets Reveal Upsurge In Inflation Expectations

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

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

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

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

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

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

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

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

As Professor von Mises wrote, (bold highlights mine)

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

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

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

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

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

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

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

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

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

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

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

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

So what all these imply for the markets?

It’s still an inflation shindig ahead.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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