Headline CPI at 40-month Low Diverges with the CORE; Plummeting M2’s Savings Deposits Should Spur the BSP to Relaunch QE Soon

In any type of activity or business divorced from the direct filter of skin in the game, the great majority of people know the jargon, play the part, and are intimate with the cosmetic details, but are clueless about the subject—Nassim Nicholas Taleb

In this issue

Headline CPI at 40-month Low Diverges with the CORE; Plummeting M2’s Savings Deposits Should Spur the BSP to Relaunch QE Soon

-As Political Statistics, the CPI May Reflect on Political Agenda; Negative Variance Between Headline and CORE CPI Hits Record!

-The Logical Inconsistencies of the CPI Data

-Unrealistic CPI: Consumers on Credit-Financed Spending Spree as Supply Side Remains Lackluster

-Will Stumbling CPI Fuel a Boom in GDP and Stocks?

-Dialing Back on Rice Tariffication; DEFLATION of M2’s Savings Deposits Should Spur the BSP to Relaunch QE!

Headline CPI at 40-month Low Diverges with the CORE CPI; Plummeting M2’s Savings Deposits Should Spur the BSP to Relaunch QE Soon

As Political Statistics, the CPI May Reflect on Political Agenda; Negative Variance Between Headline and CORE CPI Hits Record!

With the roundtrip of the CPI to a 40-month low, political authorities have swiftly claimed credit for it.

Reported the Inquirer (October 4, 2019): One of the loudest cheers at the 0.9 inflation rate in September came from the Bangko Sentral ng Pilipinas (BSP) which had forecast an inflation range of 0.6 to 1.4 percent, nearly hitting the exact mark…In a statement, the BSP said the 0.9 inflation rate was “driven by continued decline in rice prices and electricity rates which offset higher prices of petroleum and selected food products.”

From another Inquirer article (October 4, 2019): Malacañang welcomed Friday the slowest inflation rate in over three years, which the Philippine Statistics Authority (PSA) pegged at 0.9 percent in September, saying that it shows the administration is “delivering results.”  “We are elated to hear the Philippine Statistics Authority report that inflation is at its slowest pace in over three years. Despite the criticisms this administration receives, economic indicators show that our government is delivering results,” Communications Secretary Martin Andanar said in a statement.”

The CPI, along with the National Accounts (GDP), represents government constructed statistics that have a significant impact on the financial and political front.  

The Philippine Statistics Authority on the Primer on the CPI: “The CPI is most widely used in the calculation of the inflation rate and purchasing power of the peso. It is a major statistical series used for economic analysis and as a monitoring indicator of government economic policy.” (bold added)

Because of the incentives to influence the political environment are inherent in a political organization, and because such statistics are not subject to audit, the CPI may be indirectly constructed to promote policy agendas than for objective reporting.

And since a critical source of government financing emanates from the capital market, which is sensitive to the perception of inflation, the central banks may use the CPI as a “signalling channel” tool designed to influence the marketplace.

This October 7th headline from the Inquirer, “T-bills sold out, but rates fall amid skimpy inflation”, provides a clue.

And for the first time since the Philippine Statistics Authority published CPI under 2012 price methodology, the September data reveals a milestone divergence between the CORE and Headline CPI! (figure 1, upper window)

That is, the free fall of the headline CPI in September was a product of the price deflation in two of its major components, namely Food and Alcoholic Beverage and the Transport CPI!

Figure 1

Comprising the component with the biggest 38.34% pie of the CPI basket, the Food and Non-alcoholic beverages (FNAB) CPI registered a -.94%, a deflation, in September from +.56% in August. (figure 1, middle pane)

Deflation in the Transport CPI, the fourth main constituent of the basket, widened to -.93% in September from -.14% a month ago.

Meanwhile, at 2.74%, the CORE CPI remains adrift, not so distant from its previous peaks of 2013 (3.27% in December 2013) and 2017 (2.89% in March 2017).

In perspective, while the CORE CPI was down by 46.3% from its zenith at 5.1% reached last November 2018, the headline CPI collapsed by 86.3% from its acme at 6.7% reached last September 2018. Put differently, the differentials between the headline and the CORE CPI rates, a negative, hit a landmark. (figure 1, lowest pane)

Such divergence, an anomaly, should put a doubt on the credibility of such data.

The Logical Inconsistencies of the CPI Data

And what an irony, as food prices nose-dived, the Restaurant and Miscellaneous Goods (RMG) CPI had barely been changed! The RMG CPI dropped only to 2.97% in September from 3.16% in August as FNAB plunged to -.94%, a deflationary zone. (figure 2, upmost pane)

Figure 2

The first implication: instead of consuming food at home, households had their meals at restaurants. It stands to reason that the plunging food CPI, in the face of seemingly inelastic Restaurant CPI, must translate to a spike in the restaurant’s profit margins!

Such a gigantic boost on the income statement of publicly listed restaurant chains had barely found support from 1H data. The asymmetry between Food and Restaurant CPI had been a dominant phenomenon this year.

The next inference: Even the expanded demand from the Restaurant industry failed to bolster the overall prices of food indicates! Such represents statistics operating in a void!

Consequently, the marginal decline in the Restaurant CPI, if anywhere accurate, should extrapolate to lower revenues from dampened demand!

Third, the September data exhibits that the emergence of the African Swine Fever (AFS) had a NEGLIGIBLE impact on the nation’s food supply!

While the data supported the official perspective, even authorities recognize that the slack in pig supply would entail a substitution of consumption to other food items. In other words, should the outbreak intensify, the AFS would REDUCE, not just the supply of pigs, but the OVERALL or TOTAL food supply, ceteris paribus!

So UNLESS the supply of the other food items materially improves to sufficiently meet the increased demand from substitution, the AFS would represent a temporary supply shock that would noticeably raise food prices (thereby bring about an increase in supplies)!

Public official maintains a benign outlook of the impact of the AFS on the national pig supply. However, other studies see the risk that the spreading of the AFS could knock off a considerable supply of pigs!

Fourth, in the world of statistics, it is a land of aplenty!!!

So aside from rice (-8.9%) and corn (-4.1%), vegetable prices (-4.7%) likewise suffered from a deflation. So scratch out a veggie diet in September!

And since meat (+2.4%) and fish (+1.2%) prices had tempered inflation in the same period, only fruit prices (+7.9%) saw a spike.

So have households been having a mostly fruit diet at the expense of meat and veggies? Or has the general public been fasting?  Or have Martians provided the Philippines with alternative meals?

Logical inconsistencies reveal the inaccuracies from egregious errors, or numerical gymnastics applied by statisticians to arrive at such incredible self-contradicting numbers.

Unrealistic CPI: Consumers on Credit-Financed Spending Spree as Supply Side Remains Lackluster

And it doesn’t stop here.

Developments in the demand and supply spectrum, predicated on credit and liquidity data, don’t seem to fit.

The BSP reported on the Banking System’s August Loan Portfolio: “Loans for production activities—which comprised 87.4 percent of banks’ aggregate loan portfolio, net of RRPs—expanded at a slower pace of 9.0 percent in August from 9.8 percent in the previous month. The growth in production loans was driven primarily by lending to the following sectors: real estate activities (17.7 percent); financial and insurance activities (16.3 percent); electricity, gas, steam and air conditioning supply (11.2 percent), construction (39.2 percent); and wholesale and retail trade, repair of motor vehicles and motorcycle (3.7 percent). Bank lending to other sectors also increased during the month, except those in professional, scientific and technical activities (-38.9 percent) and other community, social and personal activities (-35.9 percent). Meanwhile, loans for household consumption grew by 25.4 percent in August from 23.0 percent in July, due to faster growth in motor vehicle, credit card, and salary-based general purpose consumption loans during the month.

So while the bank loans to the production side of the economy continue to decelerate, consumer borrowing caught fire! (figure 2, middle pane)

Bank lending to the consumer hit an all-time high rate of 25.4%, backed by credit card growth, which zoomed to a historic 26.4% clip! Auto loans rocketed to 28.94% in August! Even payroll loan growth jumped 7.7% from 6.4% from a month ago. (figure 2, lowest pane)

Have consumers been imbibing more leverage to augment, possibly, burgeoning deficiencies in income growth?

Bank lending to the consumer’s auto loans flourished in August, yet vehicle sales growth shrunk by 2.4%. (figure 3, upmost window) Will sales exhibited by the excess credit financing in August appear in a ‘stronger than expected’ data in September?

The only segment that showed an increase in the CPI data — a huge one — was alcoholic beverage and tobacco [ABT] CPI, which vaulted to 14.3% in August from 10.07% in July, a 42.07% spike. The ABT spiral may be due to hoarding in anticipation of the likely imposition of a higher sin tax.

Outside vehicle sales and rice, what undergirded the consumer's booming use of credit card and the improvement in payroll loans? If not for spending, has these been about the settlement of existing loans? Why has the CPI not manifested these? Has the supply side of consumer goods grown at the pace of credit-fueled demand?

Figure 3

Neither domestic production nor imports support the view that the supply side matched consumer demand growth. The PSA’s August data on industrial production reported a 7.8% contraction, its 9th straight month, or a recession! Food manufacturing even crashed by -18% in August, worse than -11.4% in July. (figure 3, middle window)

Meanwhile, import growth shrunk 11.77% in August, according to the PSA, marking the fifth consecutive month of declines!  

Downside pressures have afflicted the supply side for months, in response to the softening of previous demand as a consequence of a liquidity crunch. Since the August CPI was 1.7%, September’s .9% could even mean lower numbers! (figure 3, lowest pane)

If the boom in consumer credit has been about spending, why should the CPI sink to such level when the supply has barely been growing?

The CPI is supposed to represent a process, a trend. Therefore, the time lag in the published data of the bank credit and supply side showcases the previous infirmities contributing to the September’s .92% CPI.

Will Stumbling CPI Fuel a Boom in GDP and Stocks?

Falling CPI, it has been popularly held, would automatically translate to boost in the consumer’s spending power that should distill into earnings and GDP.

While this notion embeds some grain of truth, the CPI should reflect on the balance of demand and supply. What has caused the plunge of the CPI? Has it been an avalanche of output? Or has relatively weaker spending, from the productive sector or the households or both, been its cause?

Figure 4

Instead, the current CPI downturn has been a product mostly of demand, as evidenced by the downtrend in the growth of credit in the production sector, which has diffused into money supply growth.

Falling CPI equals a boom in GDP? Even empirical evidence defies this notion! Tumbling CPI translates to a raging PhiSYx? Empirical evidence points to the other direction! (figure 4)

In contrast, in the past, it has been loose money conditions, which drove the CPI higher that has provided a boost not only to the Nominal GDP but also to the stock market with a time lag. When surging CPI reaches a threshold of pain, ventilated through political outcries, that’s when the CPI backfires on the GDP.

To be sure, it is true that real economy inflation has been decelerating, but the CPI has been overstating this.

Dialing Back on Rice Tariffication; DEFLATION of M2’s Savings Deposits Should Spur the BSP to Relaunch QE!

But the CPI should mount a comeback.

First of all, shifting political winds may alter the supply-side conditions.

The record divergence of the Headline and the CORE CPI alludes to the politicization of the rice supply in response to last year’s shortages. Or, the frantic political response has signified a critical source of the so-called deflation in the food CPI, and consequently, the headline CPI.

Cascading rice prices, which have affected farmer's income, nevertheless have prompted the National Government to reckon with a dial back on the shift to tariffs from quotas for rice imports. Rice inventories in September 2019 soared by 57.9% from a year ago, according to the PSA.

And the proposed adjustments on the Tariffication law would come in the form of significant hikes in tariffs and from the likely imposition of non-tariff barriers, through quality restrictions or ‘safeguard duties’.

Once this political change takes hold, then the manna from the deflation of rice prices should reverse.

Next would be the demand component from money supply growth.

From the BSP’s August report on Domestic Liquidity: “Preliminary data show that domestic liquidity (M3) grew by 6.2 percent year-on-year to about ₱11.9 trillion in August 2019, slightly slower than the 6.7-percent growth in July. On a month-on-month seasonally-adjusted basis, M3 increased by 0.3 percent. Demand for credit remained the principal driver of money supply growth. Domestic claims grew by 6.2 percent in August from 5.8 percent (revised) in the previous month. This was due mainly to the sustained growth in credit to the private sector. Loans for production activities continued to be driven by lending to key sectors such as real estate activities; financial and insurance activities; electricity, gas, steam and airconditioning supply; construction; and wholesale and retail trade, repair of motor vehicles and motorcycles. Loans for household consumption increased due to the growth in credit card loans, motor vehicle loans, and salary-based general purpose consumption loans during the month. Meanwhile, net claims on the central government grew by 2.1 percent following a 1.8-percent contraction in July, reflecting the increased borrowings by the National Government.” (bold added)

Because “demand for credit remained the principal driver of money supply growth”, the sinking growth rate of the banking system’s overall portfolio have not only reduced growth in the benchmark M3 money supply but also contributed to the CPI’s crash. 

The thing is, WHY has the money supply has been in a slump?

Figure 5

The BSP defines money supply M3 as composed of the following:

M1: currency outside depository corporations (in circulation) and Transferable Deposits included in broad money

M2: M1+ other deposits in broad money consisting of savings deposits and time deposits, lastly

M3: M2 + securities other than shares included in broad money (deposit substitutes)

The collapse of the savings deposits component of M2 has fundamentally fueled the plummeting M3 rate.

M2’s Savings Deposits shriveled (-) 2.2% in August, the second time after June’s -.6%, representing the biggest contraction of the year! The last time banks suffered from savings deposit deflation, as reflected in the money supply conditions, was over 10-years ago or in February 2009 in the aftermath of the Great Recession!

At any rate, savings deposits deflation signifies more symptoms of the banking system in distress.

But the growth rates of the other M3 components have been headed downhill too.

After its growth pinnacle in April 2016 at 20.2%, cash in circulation has been southbound. It registered a 12% clip in August, a 27-month low, was slightly down than 12.4% rate in July. Needless to say, the growth rate of cash last August has signified a 40.6% crash from its April 2016 apex.  

The growth rate of M2’s Time Deposits slipped to 11.7% in August from 13% a month ago, but has rallied from a 5.3% low in September 2018. Time Deposits growth has climaxed at 22.7% rate in September 2017.

In the meantime, the growth rate of M1’s Transferable Deposits growth almost doubled to 8% from 4.8% over the same period.  The spike of M1 had been accounted for by Transferable Deposits and not by cash in circulation.  According to the BSP’s Glossary: Transferable Deposits Included in Broad Money, Other Resident Sector refers to the “BSP's peso deposit holdings of its employees' provident and housing funds.” So funds from the BSP’s employees had been responsible for such an upside spiral.

And deposit substitutes have signified the only M3 component in a steady uptrend. Following a trough in December 2016, Deposit substitutes (Securities Other Than Shares Included in Broad Money) growth continued to climb higher and has presently been drifting at a 10-year high.

And since ‘Securities Other Than Shares’ represent all types of money market borrowings by banks like promissory notes, repurchase agreements, commercial papers/securities and certificates of assignment/participation with recourse, its surge highlights the financial system’ sharp increase in the use of leverage, including very short-term lending!

So not only have savings deposits flowed into the coffers of the National Government and the banking system, but it has funded many forms of leveraging too amplifying systemic fragility!

With the stumble of M3’s savings deposits into deflation territory, the BSP will likely supercharge its QE, if the RRR cuts would prove to be ineffectual.  Liquidity represents the primary risk, as admonished the BSP Governor Ben Diokno in their latest (2018) FSR, “If there are risk issues to raise, it will have to be the prospects of managing liquidity”.*

*Diokno’s 2018 FSR Report Warns on Bank’s Mounting Liquidity, Fund Mismatching, Settlement Fails and Concentration Risks; the BSP Chops RRR rates by 100 bps! October 6, 2019

And history should rhyme.  When the headline CPI dropped to deflation in September (-.4%) and October (-.2%) 2015, the BSP revved-up the direct funding (net claims) to the National Government that catapulted the CPI, the GDP and the USD-php.

While current conditions are different compared to 2015, the BSP would surely mount a rescue of the banking system.

As it stands, the steepening of the Philippine treasury curve, suggests a forthcoming revival of the moribund CPI, which most likely will usher the era of stagflation!

Summary and Conclusion

In summary…

As a politically sensitive statistic, the CPI may manifest on the administration’s political agenda than objective reporting.

Several inconsistencies have emerged in the CPI, mainly stemming from the unmatched divergence between the Headline and the CORE as exhibited by logical contradictions.

Besides, the banking system’s loan portfolio and liquidity conditions also reveal its economic flaws. For instance, while the consumer credit growth rate has stormed to unparalleled heights, production loans have fallen to multi-year lows. If consumer credit has been about augmenting spending, why would prices not reflect such a spike on the slack in production?

The mainstream tells the public that lower CPI equals a boost to consumer spending, thereby diffusing into the GDP. While such may hold some grain of truth, this depends on the cause. If a shortfall in demand has prompted for a lower CPI, rather than from a deluge of supply, such would hardly provide support to consumption. At present, constraints in financial liquidity have contributed to the deficiencies in demand.

But like in 2015, CPI’s decline is likely temporary. Politics will likely be its primary cause.

On the supply side, the slump in rice prices, which constituted the gist of the current downturn in the CPI, has also signified a political response to the last year’s crisis. Since there has been a political backlash on the Tariffication Law, authorities have considered taking measures of walking back some of its features. Such actions are likely to put a stall on the current inventory buildup of rice, thus reverse food deflation.

On the demand and monetary side, the contraction in savings deposits has incited the sustained plunge in the money supply conditions. In 2015, when money supply growth pulled the CPI to the deflationary zone, the BSP responded by launching the Philippine version of Quantitative Easing, or the direct financing of the NG through debt monetization. This time with savings deposit under pressure, to jumpstart liquidity and rescue the banking system, aside from RRR cuts, the BSP is likely to recharge QE. The reactivation of QE should re-ignite the CPI upwards.

The domestic treasury market has been signaling the reemergence of inflation through its steepening slope.

War Against Market Prices: South Korea Imposes Ban on Short Sales

Regulators generally have deep aversion for falling prices (deflation), or applied to financial markets, they fear bear markets.

So they apply all sorts of price control measures to prevent the required adjustment in prices that essentially reflects on the underlying fundamentals of the securities or markets.

Today, South Korea copycats Greece.

Here is Bloomberg, (emphasis mine)

South Korea banned equity short sales for three months while the two biggest state-run funds said they may boost investments as the government seeks to shore up a market that’s had its biggest six-day drop in three years.

The Financial Services Commission said it will ban short selling on all shares until Nov. 9 from today. The National Pension Service, the country’s biggest investor, said yesterday it plans to buy more stocks this month than it originally targeted. Korea Teachers Pension said it purchased about 70 billion won of stocks amid the sell-off and may buy more.

South Korea joins Greece this week in banning short selling after the Kospi Index (KOSPI) slumped 17 percent in six days. The gauge reached an intraday level yesterday that was 24 percent below its May 2 record close. Domestic institutions should play a bigger role to contain volatility that is often caused by sell- offs by overseas investors, the FSC’s Chairman Kim Seok Dong told lawmakers in parliament yesterday.

The current ban exhibits the same attempt made in September 2008.

From the same article,

South Korea imposed a ban in 2008 on short sales following similar actions taken by U.S. and U.K. regulators in the aftermath of Lehman Brothers Holdings Inc.’s collapse. Korea lifted the rule from June 2009, while keeping the ban for financial stocks. The nation already bans so-called naked short sales, where investors don’t need to borrow the shares.

How effective has the been the ban which South Korean authorities imposed in September 30^th of 2008?

Apparently a big failure as the Kospi index’s crash even accelerated when the ban was imposed (blue arrow).

Korea wasn’t alone, she was accompanied by Taiwan and Indonesia who also imposed short trading prohibitions.

And the results were identical.

Like South Korea, both Taiwan (TSEC black candle) and Indonesia (JKSE-blue candle) fell sharply during the final phase of the bear market of 2008, in spite of the short selling ban. In short, regulators failed to control their respective equity markets.

The good news is that actions of regulators are almost always mechanically reactive to unfolding events (present and past events). Usually the failed policies they implement occur during the culmination of major inflection points.

Another good example of this was UK’s Gordon Brown infamous “bottom” selling of the Bank of England’s gold reserves in 1999. BoE’s loss has been the market gains.

An important lesson is that actions of politicians may function as good or reliable contrarian indicator.

Applied to the short selling ban by South Korean authorities, if the past will rhyme, short-term market pressures may still proceed, but this may also signal the near conclusion of the current selling pressure (mid term) cycle.

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