Austerity Equals Deflation? Not In The Eurozone

If you read mainstream analysis, their mantra seems to be ‘austerity equates to deflation’. (Because B follows A, B is the cause of A-post hoc analysis)

Yet when applied to the Eurozone, this seems NOT to be happening.

This from the New York Times, (bold highlights mine)

Higher energy prices drove inflation in the euro area to an annual rate of 1.7 percent in July, the highest level in 20 months but still within the range considered acceptable by the European Central Bank.

Excluding energy prices, inflation increased by 1.1 percent in July when compared with the previous year. That was up from 0.9 percent in June, Eurostat, the European Union’s statistics office, said Monday.

The rise in overall prices, from a rate of 1.4 percent in June, was not considered alarming by economists, who generally expect price pressures to remain in check as growth slows in most of Europe.

“We need to see convincing signs of an upturn in domestic demand, and we’re not seeing that just yet,” said Nick Matthews, an economist at Royal Bank of Scotland. “Underlying domestic price pressures are still quite contained.”

But the European Central Bank could have problems finding a monetary policy that is right for all 16 euro area members if prices continued to rise in some countries while holding stable or even falling in others.

This chart from Tradingeconomics.com

Additional observations:

1. The above development goes to show that inflation is always relative. Some areas experience more and some experience less. In short, money is never neutral.

2. If inflation has been rising in spite of weak domestic demand as alleged by the expert quoted, then obviously it isn’t domestic demand that is the root of inflation. So the expert failing to account for the recent rise likewise fails to look at genuine drivers or the bigger picture.

3. One should note that the inflation dynamics in the Eurozone doesn’t suggest that this is a one time event or random walk, but seemingly a momentum trend on an upswing.

4. This also shows why listening to the ideas of the mainstream seems to be like placing a noose around one’s neck.

Why Deflationists Are Most Likely Wrong Again

“After the crisis arrives and the depression begins, various secondary developments often occur. In particular, for reasons that will be discussed further below, the crisis is often marked not only by a halt to credit expansion, but by an actual deflation — a contraction in the supply of money. The deflation causes a further decline in prices. Any increase in the demand for money will speed up adjustment to the lower prices. Furthermore, when deflation takes place first on the loan market, i.e., as credit contraction by the banks — and this is almost always the case — this will have the beneficial effect of speeding up the depression-adjustment process.” Murray N. Rothbard

I find it bizarre for many mainstream experts, if not nearly all, would try to interpret government’s policy actions as means to support the economy (read: property markets) and NOT the politics (read: the banking system).

And these are the same set of people who appear to impassionedly invoke the reprehensible deities of deflation in order for the government to apply more inflationism.

Figure 1: Mark Perry[1]: Relative Bank Failures/St. Louis Fred: M2 annual change

It doesn’t really matter whether the US government put in line an estimated $23.7 billion in bailouts[2], and the countless alphabet soup of stop-gap measures or programs in terms guarantees, swaps, and the various functionality of last resorts, all of which had been applied to ensure the untrammelled flow of liquidity into the financial system.

What seem to only matter to them is that “deleveraging” and the attendant alleged price contraction on every level will be due to loss of “aggregate demand” which ensures a deflationary outcome. As if these “deleveraging” is straightforwardly corollary with “price decline” regardless of the validity and strength of causation linkages.

Yet it’s been nearly two years since deflationists have brandished charts similar to the M2 in figure 1 (right window) to call for the unsustainability of the current economic recovery, and now, since the deflationary spiral hasn’t still happen, they invoke new references such as low interest rates to try to argue their case based on a preconceived bias.

Equally, they now junk this piece of evidence since it has now gone against their argument. So selective perception dominate the mainstream’s reasoning to argue for their rabid fear of deflation.

It doesn’t really matter too, that today’s banking failure hardly matches EVEN the savings and loans meltdown during the 90s and remains a fraction to the domino effect of bank collapses during the GREAT Depression of the 1930s (left window). Yes this includes the 110^th bank in Illinois[3], which failed August 13^th.

Gustave Le Bon appear to be correct[4] anew when dealing with crowd perception, “A crowd thinks in images, and the image itself immediately calls up a series of other images, having no logical connection with the first.”

These people fail to acknowledge that the deflation mess of 1930s wasn’t only due to banking collapses which paved way for the monetary contraction but importantly had also been due to the massive waves of regulations imposed that inhibited trade (Smoot-Hawley Act) and the necessary adjustments in the price levels within the system (New Deal Programs)[5].

Blindness Stems From Political and Economic Religion

The difference why many pundits can’t seem to see is because the monetary contraction they’ve hoped for, out of their predetermined bias, had been offset by an expansion of free trade worldwide.

Thus whatever contraction in US based credit from the banking system had clearly been offset by a surge in globalization[6]and the attendant boom of credit elsewhere. And this is why despite the incremental improvement in the traditional credit system, there has been a boom ongoing in US corporate bonds[7].

Some have argued that corporate bond market are meant to fall, due to the possibility of a double dip, but which is chicken and which is the egg? Given their logic, bonds markets should have never rebounded on the first place.

Besides, there is also the uneven impact from convergent rescue policies applied by respective governments. Given the idiosyncratic nature of each economy, the impact has clearly been asymmetric. And German’s stunning 2^nd quarter outperformance in economic growth seems to be an example[8].

So far, this has been what the Fed has accomplished: By preventing the collapse in the US banking system, which incidentally still remains as the de facto reserve currency of the world, it has managed to keep afloat the payments and settlements function that has allowed the trade mechanism to flourish in spite of signs of credit contraction at home.

This represents as Pyrrhic ‘battle’ (meaning short term) victory at astounding cost to the US taxpayers to sustain the her stature as the world’s currency reserve standard, with the big possibility of a huge unintended payback in the future. That payback, from our perspective will be in the form of higher inflation, bear market in US treasuries or an overall stagflationary environment.

The point is by preventing a collapse in the banking system the Fed has effectively staved off deflation in the 1930 context.

In addition, I don’t see Japan’s lost decade[9] as the path for America in the way the mainstream bears paints her to be. So it’s hardly a paradigm for adequate comparison.

The second and most important point is, the reason why monetary contraction hasn’t impacted the US the way mainstream foresees it is because they ignore that trade by itself, is first and foremost the liquidity provider.

How?

As Murray N. Rothbard explained[10],

“We come to the startling truth that it doesn’t matter what the supply of money is. Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power, or effectiveness of the gold-unit. There is no need to tamper with the market in order to alter the money supply that it determines.” (italics original)

Since money’s purchasing power will naturally adjust to the level of existing stock, then there won’t be any required money level in a free market regime. Thus, the persistence of trade is enough to assure the continuity of liquidity and the avoidance of deflation. This applies even if the Fed would remain non-activist.

Even the popular Harvard duo Carmen Reinhart and Kenneth Rogoff whom has made extensive reviews of the historical relationship of debt, inflation and economic growth during every banking and property crisis worldwide, can’t pinpoint out the definite critical offsetting threshold on how debt and economic growth balance.

Figure 2: VoxEu.org: Reinhart-Rogoff: 90% Debt As Threshold?

This comes with the exception when debt levels have reached or exceeded 90% of GDP (see figure 1), they write, “relationship between government debt and real GDP growth is weak for debt/GDP ratios below 90% of GDP” and “no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the US, have experienced higher inflation when debt/GDP is high)”.

It’s truly difficult to try and compare with past episodes because there is simply NO two similar situations, one can only make estimates and hope that the performances will fall within the ambit of models. However, their implicit point is, this addiction to debt has got to stop. And this is what truly plagues the mainstream mindset.

The third important point is that we have been validated anew.

US authorities on fear of a slowdown that may transform into a double-dip at a time nearing national elections, where the ruling incumbents seem at the risks of being politically dethroned, has called on our poker bluff.

Here is what I wrote at the start of the year[11],

``Many have used the strong showing of 2009 to advert that 2010 would be the year of “exits”. I don't buy it.

``As in the game of poker, I’d call this equivalent to a policymaker’s Poker bluff.”

The FOMC has changed tunes about adapting an exit strategy and will maintain their bloated balance sheets.

Here is the Danske Research team[12], (emphasis added)

``The FOMC revised downward the near-term growth outlook and decided to reinvest the principal payments from the Fed’s portfolio of Agency and MBS holdings in longer-term Treasuries. This implies that the balance sheet will be held constant and effectively puts the exit strategy on hold. While the amount of treasuries to be bought is insignificant, the decision sends a strong signal to markets. It provides a clear indication that rate hikes remain in the indefinite future and that the central bank is prepared for another round of quantitative easing if necessary.”

In short, the Fed’s action is a direct communication to the market that the policy spigot towards Quantitative Easing 2 is being recalibrated as insurance for any material economic growth slowdown.

So there you go—path dependency, economic ideology and the morbid fear emanating from wrong perspectives and analytics will drive the Fed to pump the next wave of liquidity into the system.

For the mainstream, anything that goes down is DEFLATION. There never seems to be within the context of their vocabulary the terms as moderation, slowdown and reprieve. Everything has got to go like Superman, up up up and away!

I’m quite sure, even if statistics would prove to be a false alarm the Fed, would be quick-handed to initiate the trigger.

Let me guess, politics will dictate such action. The Democrats don’t want go without a fight and the Fed will supposedly provide the backdrop for a benign outlook with the slowdown as pretext. It has never really been about economics but the politics of control. Yet the mainstream obstinately refuses to see this.

Of course, there are many other aspects that could debunk the deflation outlook, such actions in commodities markets, the yield curve, exploding emerging bonds and some EM equity markets.

But it really doesn’t matter, because for the mainstream these markets are out of the ambit of “aggregates”. Unfortunately, as F. A. Hayek[13], “aggregates conceal the most fundamental mechanisms of change”.

Phisix: No Decoupling, Only Outperformance

Also this is just a reminder to our Filipino colleagues and audiences where today’s market action is seen or interpreted by some as in some semblance of decoupling.

I’m glad that the ASEAN markets have been showing a steady outperformance, but the case for a decoupling hasn’t clearly been established (see figure 3).

Thus, it would be a darned big mistake to be presumptive of a “decoupling” in the event of another turbulent episode such as US recession which I don’t think will leave the Philippines or ASEAN markets unscathed.

One must be reminded that decoupling and outperformance are two different dynamics.

Figure 3: Tradingeconomics.com[14]: US and Philippine GDP

What ASEAN markets seem to imply is that the US isn’t headed for a double dip as the US mainstream bears suggests.

By the way, the definition of a Double dip recession[15] is a backslide to a recession (negative growth) following one or two quarters of positive growth. Based on semantics, the window for a double dip is fast closing—the end of third quarter of 2010 as per definition (if January of 2010 is the starting point of the recovery based on chart).

For me, if there would any immediate real risk worth monitoring this would possibly emanate from China[16] (yes she is slowing down).

That’s because she has engaged in massive credit expansion to immunize herself from a global growth slowdown in 2008 and many of these loans have channelled via shell companies[17] and lent to government projects that likewise got involved in real estate speculation which is hardly part of their core businesses. And such expansion usually creates alot of malinvestments and would likely result to capital consumption, when the imbalances are forced by the natural laws of economics to reveal themselves.

One thing going for China is that she is replete still with savings. There is as much as 9.3 trillion yuan ($1.4 trillion) of hidden assets or undeclared assets according to Yahoo News[18].

Nevertheless, I think signs are pointing to a soft landing more than a hard landing.

The problem anew for the bears is that following a slowdown and prospective stabilization, a renewed reacceleration will likely spur another episode of serious lift-off for ASEAN and many emerging markets, whom depend on China for trade and investments. And this should also help boost the US and the Eurozone too.

And another thing, for as long as the US won’t fall into a recession, the expressed policy by the Fed to indefinitely postpone the ‘exit strategy’, and reemergent possibility to engage in QE version 2 is also likely to serve as another tremendous boost for Asia.

For instance, Hong Kong is already having a difficult time fighting her internal bubbles recently having to impose a “60% limit on the loan to value for property purchases worth more than $1.55 million”[19], given her peg to the US dollar which basically makes her import Fed policies. The transmission mechanism will just get magnified by the ensuing policy divergences.

So bears will continue to fumble from one mistake after another, until the broken clock finally strikes twice a day and claim victory. How bizarre.

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[1] Perry, Mark 106 Bank Failures in Perspective, Enterprise Blog

[2] See $23.7 Trillion Worth Of Bailouts?

[3] Thestreet.com Another Illinois Bank Fail, August 14, 2010

[4] Le Bon Gustave, ibid p. 23

[5] See Financial Reform Bill And Regime Uncertainty

[6] See How Free Trade Saved The World From Depression

[7] See US and Global Economy: Pieces Of The Jigsaw Puzzles All Falling In Place

[8] Marketwatch.com German GDP grows 2.2% in second quarter, August 13, 2010

[9] See Japan’s Lost Decade Wasn’t Due To Deflation But Stagnation From Massive Interventionis

[10] Rothbard Murray N. What Government Has Done To Our Money p.29

[11] See Poker Bluff: The Exit Strategy Theme For 2010

[12] Danske Weekly, Fear of a slump August 13, 2010

[13] Hayek, Friedrich August von Reflections on the Pure Theory of Money of Mr. J.M. Keynes, Mises.org

[14] Tradingeconomics.com

[15] Investopedia.com, Double-dip recession

[16] See China’s State Driven Bubble

[17] FinanceAsia.com, China's endless moral hazard, May 6, 2010

[18] Yahoonews.com Hidden trillions widen China's wealth gap: study, August 11, 2010

[19] Wall Street Journal Blog, Hong Kong Forced to Fight Fed Again, August 13, 2010

US and Global Economy: Pieces Of The Jigsaw Puzzles All Falling In Place

``Deflationary credit contraction is, necessarily, severely limited. Whereas credit can expand (barring various economic limits to be discussed below) virtually to infinity, circulating credit can contract only as far down as the total amount of specie in circulation. In short, its maximum possible limit is the eradication of all previous credit expansion.” Murray N. Rothbard

Mainstream expert analyses are mostly hinged on heuristics (mental shortcuts), except that they often argue from the context of technical gobbledygook which appeals and overwhelms the naive public to assume such abstraction as universal reality.

For instance, many go at length to argue that low interest levels in US Treasury exhibit signs of deflation. Heck, as if deflation or falling prices in the mainstream definition means the end of world. Well, falling prices also means greater purchasing power, which from the fundamental standpoint of demand and supply, it means more goods that one can acquire. So the end of the world, it is not.

For us, deflation isn’t a one size fits all dynamic. We see this market force as operating from different previous actions; one that deals with productivity growth or one that deals with government property confiscation, or bank credit contraction or cash building. So the social impact won’t be the same. Yet when the mainstream hears or reads of deflation they seem to develop a reflexive revulsion to the word.

What the mainstream actually refers to is of the credit contraction order- which according to them has a feedback mechanism which forces liquidation, reduces collateral values, curbs aggregate demand, which leads to excess supplies and subsequently falling prices which gets exacerbated by expectations of people to hoard cash and back to the loop.

It’s a story long been told even during the days of my Dad, but this has hardly occurred. Not even with Japan, which the mainstream has arrantly mislabelled[1].

Although deflation had an instance of reality in 2008, our rebuttal has been that in a world central banking, governments have the incentive and the tools to temporarily offset credit contraction by serially blowing up new bubbles. How? By keeping interest rates excessively low and by printing an ocean of money.

Yet mainstream insist that this is a demand problem and that government actions won’t have an impact.

On the contrary we persist to argue that this is mostly a supply dilemma—one where banks have been stuffed with questionable assets and that reluctance to lend is a function of some distrust.

And the disruption from the near seizure in the US banking system, which prompted for a short episode of deflation, as consequence to the Lehman bankruptcy is why the US government put to risk some $23.7 Trillion worth of taxpayer money[2], according to a US official.

In short, US officials have been acting on the current financial quandary predicated on a liquidity issue.

It’s funny how many gawk at the actions of the marketplace only to put meaning into them based on their bias or economic religion.

The mainstream refuses to acknowledge that government are people too and are driven by incentives. They see government in a paradox. On one aspect, they believe government operates like supermen whom would act on every single social problem that emerges. Yet on another aspect, particularly on the financial markets, they treat governments as passive onlookers!

From our perspective, the abnormally low yields in the US treasury markets may not be due to the fear of lending or the lack of demand to borrow, but rather from government intervention.

With the US budget deficit expected to hit $1.56 trillion in 2010[3], what better way to attract cheap private financing and create an environment of marketplace confidence (animal spirits) than by manipulating interest rates down!

Since there have been little signs of inflation in the past, then the US government can simply use its covert dealers to conduct interest rate manipulation operations.

And it may not be limited to stealth actions; it may even be reported.

In three weeks since June 30, the Federal Reserve balance sheet has registered consecutive additions to its US treasury positions by $45 billion, according to the data provided by the Federal Reserve Bank of Cleveland[4].

This seems consistent with some signs of unease from select Federal Reserve officials, such as James Bullard, president of the Federal Reserve Bank of St. Louis, who called for renewed buying of treasury securities or the resumption of quantitative easing[5].

Yet these guys seem to be looking at the wrong picture.

First of all, the banking system doesn’t represent the entire US capital markets.

Figure 4: St. Louis Fed: Consumer and Bank Credit at ALL Commercial Banks

But even if we deal with the banking system we are seeing not widespread signs of contraction but signs of credit expansion (see figure 4)!

True business and industrial loans are still down, but nominal lending in US dollars by consumers at all commercial banks have recently skyrocketed (upper window). And we seem to be seeing material improvement in credit activities of bank credit of all commercial banks, perhaps directed at consumers.

Figure 5: Yardeni.com[6]: Flow of Funds

We predicted[7] that the influence of the yield curve lags by about 2-3 year period, which if we are right we could see an acceleration in the activities in the US credit markets by this yearend, could we be seeing the seeds of this turnaround (see figure 5)? Oops....

Now as we earlier said, banks aren’t the sole source of funding for the US economy, which the mainstream loves to fixate on. And I think signs have saying they’re dead wrong.

Why? Because the corporate bond market is likewise booming!

This from Businessweek/Bloomberg[8],

``U.S. corporate bond sales soared 31 percent to $85.7 billion this month, the busiest July on record, as yields fell to the lowest in more than six years on growing investor confidence in the economic recovery. The London interbank offered rate, or Libor, which banks say they can borrow at for three months in dollars, fell the most today in almost 11 months, dropping to the least since May 14.”

And the boom in the bond markets aren’t restricted to the US markets but around the world!

According to the Wall Street Journal[9], (bold emphasis mine)

``The global corporate-bond boom is gathering steam as companies rush to take advantage of some of the lowest borrowing costs in history....

``This month has been the busiest July on record for sales by U.S. companies with junk-credit ratings. Asia's debt market is on pace for a record year, and European companies are also raising money apace.

``The low borrowing costs are the culmination of an unprecedented bond-market rally that began in the depths of the credit crisis in late 2008 and early 2009 and has defied every prediction that it would soon run out of steam. But individual and professional investors continue to plow money into the bond market, giving companies a constant source of funds to tap.”

Defied every prediction? Not for us, as we have been predicting this all along!

And in terms of bank lending guess where the gist of the activities has been? (see figure 6)

Figure 6: Yardeni.com Lending by International Banks

If you guessed the Emerging Markets and Asia, then you are absolutely correct!

Now if we examine the contribution of economic growth in the US by sector, the mainstream seems caught somewhat surprised. Growth expectations didn’t come from the sectors they’d expected them to be (see figure 7).

Figure 7: Northern Trust: Sectoral Contribution To Growth Rates

According to Asha Banglore of Northern Trust[10], (bold highlights mine)

``In the second quarter of 2010, equipment and software spending (+1.36%) made the largest positive contribution to real GDP, followed by exports (1.22%), consumer spending (1.15%), inventories (1.1%), and residential investment expenditures (0.6%).

``In terms of growth rates, equipment and software spending posted a hefty increase of 21.9% after an upwardly revised 20.4% gain in the first quarter. Consumer spending moved up 1.6% in the second quarter after a downwardly revised 1.9% gain in the first quarter.

So technology and the world economy appear to be heavy lifting the growth momentum of the US economy.

As per the technology sector, here is what I wrote last February[11],

``What I am trying to say is that the contribution of the technology sector to the real economy could perhaps be more accurately reflected on the performance of S&P, however, such contribution may have been underrepresented by conventional statistical metrics.”

Not anymore.

For us, the current developments postulates to the following:

-US economic growth dynamics seem to be shifting from the housing to the technology and export sector.

-Investment in the US and the job growth will likely gravitate into these sectors.

-The pattern of growth in the US seem to confirm the boom in the global bond markets and the bank lending patterns of international banks

-Since technology is partly tied to exports, wealth accumulation in emerging markets is likely to fuel increasing demand for tech savvy products

-the global economy should be expected to sustain momentum as globalization deepens, and this will be in stark contrast to the prediction of deglobalization advocated by PIMCO’s Bill Gross.

-Of course, this is another bubble cycle. The next bubble will likely emanate from the emerging markets or the US technology industry[12], or the US treasury. But the risk of bubble implosion would only surface as inflation accelerates and hamstrings government efforts to intervene.

Speaking of which, where inflation is thought to be non-existent, here is a little surprise (see figure 8)...

Figure 8: stockcharts.com: Commodity Laggards

Oops, even the commodity laggards seem to be generating some reanimated activities!

We seem to seeing resurgence in agricultural products (DBA-Powershares DB Multisector Commodity Trust Agricultural Fund), as well as in Natural gas (NATGAS), the Industrial metals (Dow Jones UBS Industrial Metals-DJAIN) and the broad based commodity index (Reuters-CRB).

So far, pieces of the grand jigsaw puzzle seem to be falling in their rightful place, as we have seen it.

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[1] See Japan’s Lost Decade Wasn’t Due To Deflation But Stagnation From Massive Interventionism, July 6, 2010

[2] See $23.7 Trillion Worth Of Bailouts?

[3] CNN Money U.S. deficit streak at 20 months, June 20 2010

[4] Federal Reserve Bank of Cleveland, Credit Easing Policy Tools

[5] New York Times, Fed Member’s Deflation Warning Hints at Policy Shift, July 29, 2010

[6] Yardeni.com: Flow of Funds, July 7, 2010

[7] See Influences Of The Yield Curve On The Equity And Commodity Markets, March 22, 2010

[8] Businessweek, Bloomberg: U.S. 10-Year Swap Negative for Fourth Day as Debt Sales Rise, July 30, 2010

[9] Wall Street Journal, Bonds Soar to Rare Heights, July 29, 2010

[10] Northern Trust, U.S. Economy – Q2 GDP Contained a Few Surprises Although Headline Was Close to Forecast, July 30, 2010

[11] See Statistics Don't Reveal Extent Of The Evolution To The Information Age, February 15, 2010

[12] See ASEAN Markets Surge, Where will The Next Bubble Emerge?, July 11, 2010

Japan’s Lost Decade Wasn’t Due To Deflation But Stagnation From Massive Interventionism

Many of you may be familiar with the idiom to “fit a square peg to a round hole”. This simply means, according the Free dictionary, “trying to combine two things that do not belong or fit together.”

From Oftwominds.com

I think this expediently characterizes mainstream’s misplaced notion about Japan’s long held predicament: deflation.

Because of the mammoth boom-bust cycle seen in Japan's property and stock markets, which led to Japan’s economic “lost decade”, the image of the Great Depression of the 1930s has frequently been conjured or extrapolated as the modern version for it.

Of course, there is a second major reason for this, and it has been ideologically rooted, i.e. the bubble bust has been used as an opportunity to justify the imposition of theoretical fixes by means of more interventionism.

Has a deflationary depression blighted Japan?

If the deflation is measured in what mainstream sees as changes in the price level of the consumer price index, then the answer is apparently a NO.

As you would notice from the graph from moneyandmarkets.com, deflation isn’t only episodic (or not sustained), but likewise Japan’s intermittent economic growth (blue bars) came amidst the backdrop of negative or almost negative CPI (red line)! In other words, economic growth picked up when prices where in deflation--this translates to real growth.

And if measured in terms of changes in monetary aggregates, then obviously given that the changes in Japan's M2 has been steadily positive, as shown by the chart above from Northern Trust, all throughout the lost decade, then we can rule out a "monetary deflation".

Of course, the next easiest thing for the mainstream to do is to pin the blame on credit growth.

chart from McKinsey Quarterly

While there is some grain of truth to this, this view isn’t complete. It doesn’t show whether the lack of credit growth has been mainly from demand or supply based. It doesn't even reveal why this came about.

We can even say that such generalizations signify as fallacy of division. Why? Because the problem with macro analysis is almost always predicated on heuristics-or the oversimplification of variables involved in the analytic process.

Banks have not been the sole source of Japan’s ‘credit’ market. In fact, there are many as shown below.

According to Promise.co.jp (bold emphasis mine)

``Providing credit to consumers is generally referred to as "consumer credit." This can be classified into two types. The first is providing credit to allow consumers to buy specific goods and services, which is called "sales on financing," and the second is providing credit in cash, which is called "consumer finance." There are many types of financial service companies that offer consumer finance, including banks, but compenies which specialize in providing small loans to consumers are referred to as "consumer finance companies."

Further promise.co.jp describes the function of consumer finance companies as providing credit

``including loans but, unlike banks, do not take deposits are referred to as "non-banks." Leasing companies, installment sales finance enterprises, credit card companies, and consumer finance enterprises belong to the non-bank category.”

So how has Japan’s alternative financing companies performed during the lost decade?

Promise provides as an especially noteworthy chart. It shows of the following:

1) During the lost decade or from 1989-2007, the share of consumer financing companies (yellow-orange bar) has exploded from 15.6% to 41.9%!

2) Other forms of credit (apple green bar) also jumped from 13.4% to 30.1% during the same period.

3) The bubble bust has patently shriveled the share of 'traditional bank' based lending or the share of lending from commercial financial institutions collapsed from 48% to 12.4%.

4) The sales financing companies likewise lost some ground from 22.4% to today’s 15.6%.

All these reveals that while it is true that nominal or gross lending has declined, there has been a structural shift in the concentration of lending activities mainly from the banking to consumer financing companies and "other" sources.

And importantly, it disproves the idea that Japanese consumers have “dropped dead” or that the decline in lending has been from the demand side.

Obviously banks were hampered by the losses stemming from the bubble bust. But this wasn’t all, government meddling in terms of bailouts were partly responsible, as we wrote in 2008 Short Lessons from the Fall of Japan

``One, affected companies or industries which seek shelter from the government are likely to underperform simply because like in the Japan experience, productive capital won’t be allowed to flow where it is needed.

``Thus, the unproductive use of capital in shoring up those affected by today's crisis will likely reduce any industry or company’s capacity to hurdle its cost of capital.

``Two, since capital always looks for net positive returns then obviously capital flows are likely to go into sectors that aren't hampered by cost of capital issues from government intervention.

``This probably means a NEW market leadership (sectoral) and or money flows OUTSIDE the US or from markets/economies heavily impacted by the crisis.”

Apparently, our observation was correct, the new leadership had shifted to the financing companies.

But there is more.

Because the banking system had been immobilized, which conspicuously tightened credit access, the explosive growth of the financing companies emerged as result of demand looking for alternative sources of supply.

In addition, financing companies, who saw these opportunities circumvented tight regulations or resorted to regulatory arbitrage, in order to fulfill this role.

According to the Federal Bank of San Franscisco, (bold emphasis mine)

``Prior to the passage of the new legislation, Japan had two laws restricting consumer loan interest rates. The Interest Rate Restriction Law of 1954 set lending rates based on the size of the loan, with a maximum rate of 20 percent. The Investment Deposit Interest Rate Law, last amended in 2000, capped interest rates on consumer loans at 29.2 percent on the condition that any rate exceeding 20 percent requires the written consent of the borrower. Most Japanese CFCs have been operating in this “gray zone” of interest rates, charging rates between 20 and 29.2 percent.

``Non-bank consumer finance companies in Japan comprise a ¥20 trillion industry, averaging 4 percent annual loan growth over the past decade while bank loan growth was negative. Most of the approximately 14,000 registered lenders are small, with the largest seven operators-which include the consumer finance arms of GE Capital and Citigroup- having a 70 percent market share. The significant growth in this industry can be traced directly to the collapse of the asset bubble in the early 1990s when consumers whose collateral had dwindled in value turned to CFCs offering uncollateralized loans. Adding to the success of the industry was the fact that CFCs were more service-oriented than the retail operations of Japanese banks, offering a wider network of loan offices, 24-hour loan ATMs, and faster credit approval.”

In short, banking regulations and policies proved to be an important obstacle to credit access.

Yet, the Japanese government worked to rehabilitate on these legal loop holes. This led to further restrictions to credit access.

According to Yuki Allyson Honjo, Senior Vice President, Fox-Pitt Kelton (Asia), [bold emphasis mine]

``The Supreme Court made a ruling in 2006 to make it easier for individuals to collect repayment of interest in excess of that allowed under the Interest Rate Restriction Law (grey zone interest). The court ruling called into question the legality of the grey zone. This prompted revisiting of the rules governing money lending and forced companies to create grey zone reserves. People were entitled to claim the "extra" interest they paid from their lenders.

``Revisions to the money lending laws were passed, and by June 2010, the maximum lending rate will be unified to rates specified under the Interest Rate Restriction Law, thereby eliminating the grey zone. Loans will be limited to a third of borrowers' annual income. For loans exceeding 1 million yen, moneylenders would be obligated to inquire about the applicant's annual income. Implementation is still ambiguous. Regulators are to have more power, such as the ability to issue business improvement orders.

``The rate decline held various consequences for the industry. Margins were lowered as lenders were forced to lower their lending rates. There was a reduction in volume, with loans to current borrowers no longer being profitable, some customers were deemed too high-risk to borrow at the lower rates. Customers could borrow less due to new legislation restricting total loans as a percentage of income. Also, there has been a rise in write-offs.

``The result of all of this is that the number of registered money lenders has dropped precipitously since regulation began in 1984. The loan market is an oligopoly with 60% of the total loan balance with the Big Four, and 90% percent with the top 25 firms. This oligopoly was created in reaction to regulation.

``Stock prices for money lending companies began to drop steadily in 2006, predating the current economic crisis. The necessity for grey zone reserves has caused problems in money lenders' balance sheets. In March 2007, there are many large negative numbers visible in the balance sheets of Aiful, Takefuji, Acom and Promise. Loans approval rates crashed around 2006, with Aiful only accepting 7% of loans recently, down from over 50% before the 2006 Supreme Court rulings. Every month, 25-30 billion yen is paid out by money lenders to customers in grey zone claims, increasing steadily since 2006. Grey zone refunds have begun to pick up recently as a result of the recent economic crisis.

``The consequences of the court ruling and the re-regulation are that the Big Four companies found direct funding difficult. Credit default swaps have increased dramatically for Takefuji and Aiful, who are now essentially priced to fail. Bond yields also increased and going to market is difficult for these companies.

``From the regulator's perspective, re-regulation has been largely a success, given their aims. The size of the industry and the number of players have been reduced. The government has greater control on the industry and over-borrowing has been reduced. In regard to this last goal, its success is unclear as black market statistics are not reliable. In fact, anecdotes suggest that black market lending demand has increased.”

So aside the aftermath bubble bust, the bailouts of zombie institutions and taxes we discovered that government diktat have been the instrumental cause of supply-side impairments in Japan's credit industry.

Moreover, the other consequences has been to restrain competition by limiting the number of firms which led to the persistence of high unemployment rates, and fostered too-big-to-fail "oligopolies" institutions.

So we can conclude two things:

1. Japan’s economic malaise hasn’t been about deflation but about stagnation from wrong policies.

2. The weakness in Japan’s credit growth essentially has also not been about liquidity preference and the attendant liquidity trap, or the contest between capital and labor, or about subdued aggregate demand, but these has been mostly about the manifestations of the unintended consequences of the Japanese government's excessive interventionism.

As Ludwig von Mises wrote,

``The various measures, by which interventionism tries to direct business, cannot achieve the aims its honest advocates are seeking by their application. Interventionist measures lead to conditions which, from the standpoint of those who recommend them, are actually less desirable than those they are designed to alleviate. They create unemployment, depression, monopoly, distress. They may make a few people richer, but they make all others poorer and less satisfied.”

And it is here that we see how the mainstream can't seem to fit the square peg (deflation) to the round hole (stagnation).

Are Recessions Deflationary?

John Maudlin writes,

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

How true is the last statement?

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

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

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

As Robert Murphy explains, (all bold highlights mine)

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

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

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

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

How Myths As Market Guide Can Lead To Catastrophe

``This is how humans are: we question all our beliefs, except for the ones we really believe, and those we never think to question.” -Orson Scott Card

If I told you that the global financial markets have been simply looking for reasons to correct from its overbought position, would you buy this argument?

For many the answer is no. People look for news to fill this vacuum or what is known as a “last illusion bias” or “the belief that someone must know what is going on[1]”.

Because it is the proclivity of man to seek more complicated explanations, the Occam Razor’s rule[2]-the simplest solution is usually the correct one- is usually perceived as inadequate. Yet even if profit taking is a real phenomenon on the individual level, outside of the realm of statistics or news linkages, this is usually deemed as inconceivable by an information starved mind.

I would surmise that such a human dynamic could be a function of esteem based reputational incentives, or the need to seek self-comfort in being seen as “sophisticated”.

And stumbling from one cognitive bias to another, this camp usually associates cause and effects to “availability heuristic” or what we simplistically call “available bias” or the practice of “estimating the frequency of an event according to the ease with which the instances of the event can be recalled”[3]. And this is so prevalent in newspaper based accounts of how the markets performed over a given period.

Though we can’t discount some influences from news on a day-to-day basis, they may contribute to what we call as “noise”, since they represent tangential forces that are distant to the genuine “signals” that truly undergirds market actions.

In other words, people frequently mistake noise for signals.

And worst, for financial market practitioners scourged by an innate “dogma” bias, a characteristic seen among the extremes, particularly in the Pollyanna and Perma Bear camps, the attempt to connect the cause and effects of market actions and the political economy is largely predicated on spotty reasoning; specifically what I call as “Cart Before the Horse” reasoning - where X is the desired conclusion, therefore event A results to X.

This can actually be read as combining both logical fallacies (Begging the Question and Post Hoc Ergo Propter Hoc) and cognitive biases, particularly Belief bias or the “evaluation of the logical strength of an argument is biased by their belief in the truth or falsity of the conclusion[4]”, from which they apply behavioral decision making errors by selective perception or choosing data that fits into their desired conclusion (while omitting the rest), by the focusing effect or placing too much emphasis on one or two aspects of an event (at the expense of the aspects) and by the Blind Spot bias or reasoning that fails to account of their personal prejudices.

In short, the deliberate misperception of reality is a representation of distorted beliefs on how the world ought to be.

Clearing Cobwebs Of Cognitive Biases and Logical Fallacies

Let apply this into today’s market actions.

In the US equity markets, the bulls have fallen short of SEVEN CONSECUTIVE[5] weeks of broad market gains following Friday’s SEC-Goldman Sachs related sell-off as the week closed mixed for key US bellwethers.

The S&P 500 was the sole spoiler among the big three benchmark, where the Dow Jones Industrials and the technology rich Nasdaq still managed to tally seven straight weeks of advances (despite Google’s 7.59% loss prior to the Goldman Sach’s news).

Yet in spite of Friday’s selloffs, the week-on-week performance by the different sectors constituting the S&P had been also been mixed (see figure 1).

Figure 1 US Global Investor: Weekly Sectoral Performance and stockcharts.com: S&P 500 Financial Sector

This means that while Friday’s market selloff had been broad based, it wasn’t enough to reverse the general trend over the broader market, even considering the largely overheated pace of the ascent for the overall markets. Yes, we have been expecting a correction[6] and perhaps this could be the start of the natural phase of any market cycle.

Moreover, while the SEC-Goldman Sachs (explanation in the below article) news may have triggered the selloff on Friday, the largest loss over the week had been in the materials and telecom sectors with the Financial, where Goldman Sachs belongs, took up the fourth position.

Considering that the S&P Financial Index took a severe drubbing on Friday (down 3.81%-see left window), this only exhibits that the sector’s muted loss on a weekly basis had been an outcome of an earlier steep climb or an upside spike!

In short, in whatever technical indicator (MACD, moving averages, or Relative Strength Index) one would look at, the US financial sector has been severely in overstretched and overbought conditions which have been looking for the right opportunity for a snapback. Apparently, the SEC-Goldman event merely provided the window for this to happen.

Perma Bears: Broken Clock Is Right Twice A Day

Now for the Perma bear camp, whom have been nearly entirely wrong since the crash of 2008, seems to have nestled on the current hoopla over the SEC-Goldman Sachs as the next issue to bring the house down.

And like a broken clock that is right only twice a day, never has it occurred to them that since markets don’t move in a straight line, they can be coincidentally ‘right’ for misplaced causal reasons.

Their horrible track record in projecting a market crash early this year predicated on the US dollar carry trade bubble and the Greek Debt Crisis has only manifested events to the contrary of their expectation in terms of both the markets and the political economy. Instead, what seem to be happening are the scenarios which we have had pointed out[7].

Here is Oxford Analytica on the US dollar carry trade[8], ``As financial markets possess a demonstrable tendency to overshoot expectations, the carry trade probably is stoking market euphoria in certain places. However, this may only be partially significant, as underlying fundamentals still inform a large cross-section of investment activities.” (bold emphasis mine).

As you can see the deepening lack of correlation, which highlights on the glaring lapses in causality linkages, from which the 2008 crash became a paradigm for the mainstream, is now being accepted as “reality”. The rear-view mirror syndrome or the anchoring bias is becoming exposed as what it is: A fundamental heuristical flaw, which cosmetically had been supported by misleading reasoning.

And as for the Greek Tragedy, the resolution is increasingly becoming a bailout option. Writes the Businessweek-Bloomberg, ``The euro may receive a temporary boost to $1.38 when Greece accesses a 45 billion euro ($61 billion) bailout plan before traders reestablish bets that the shared currency will decline, according to UBS AG.[9]”

And Morgan Stanley’s Joachim Fels, who among the mainstream analysts we respect, decries the prospective action, ``The bail-out and the ECB's softer collateral stance set a bad precedent for other euro area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time.[10]” (bold highlights mine)

The difference between us and Mr. Fels is that we look at the political incentives that impels the decision making process of policymakers-where the default option or the path dependency by any government, in a world of central banking, has been towards inflationism as recourse to any critical economic problem.

And Mr. Fels appears to be reading the market along our lines.

Price inflation, which Mr. Fels warns of, is starting to creep higher and becoming more manifest even in economies that have been expected to have lesser impact from inflation due to more monetary constraints, such as the Eurozone (see figure 2).

Figure 2: Danske Bank: Will Nasty Inflation Challenge the ECB?

The Danske team, led by Allan von Mehren, expects an inflation surprise[11] to challenge the European Central Bank (ECB) based on 3 factors, rising oil prices, rising food prices and depreciating Euro.

For us, these factors are merely symptoms of the political actions and not the source of inflation.

And for those plagued by the said dogmatic biases, they keep repeatedly asking the wrong question-“where is inflation?”-even when (corporate and sovereign) bonds, commodities, stocks, derivatives and most market signals have been pointing to inflation, across the world.

The fact that inflation is in positive territory for most economies, already dismisses such a highly flawed argument.

Yet, the narrowed focus or the ‘focusing effect’ or excessive tunneling on business or industrial credit take-up or unemployment rates or on rangebound sovereign yields (particularly in the US) purposely disregards the fact that inflation is a political process.

Government which resorts to the printing press as the ultimate means to resolve economic predicaments can only reduce the purchasing value of every existing currency from the introduction of new ones.

Tea Parties As Signs Of The Reemergence Of The Bond Vigilantes

In addition, such outlook neglects the fact that

-inflation has existed even during high period of unemployment rates as in the 70s,

-consumer credit isn’t the principal cause of inflation but intractable government spending and

-as argued last week, governments will opt to sustain low interest rates (even if it means manipulating them-e.g. quantitative easing) as a policy because ``governments through central banks always find low interest rates as an attractive way to finance their spending through borrowing instead of taxation, thereby favor (or would be biased for) extended period of low interest rates.[12]”

Moreover, for a population with a deepening culture of dependency on government welfare programs, the inclination is to accelerate government spending[13] in order to keep up with public demands for more welfarism. And this can only be funded by borrowing, inflation, and taxes in that pecking order.

Why taxes as the lowest priority? Because to quote Professor Gary North[14], ``Politicians fear a taxpayer revolt. Such a revolt is unlikely until investors cease buying Treasury debt. For as long as the government can run deficits at low interest rates, that is how long they will continue.”

The ballooning Tea Party in the US, for instance, which reportedly accounts for 15-25% of the population is relatively a new spontaneously organized political movement that has apparently emerged in response to the prospects of significantly higher taxes.

For the politically and economically blinded progressives to demean this as “superficial” accounts for as utter myopia. How superficial is it to resist a runaway government spending spree, which should translate to prospective higher taxes and or lower standards of living via inflation?

As author and Professor Steven Landsburg rightly argues[15], ``Once the money is spent, the bill must eventually come due—and there’s nobody around to foot that bill except the taxpayers. We are locked into higher current spending and therefore locked into higher future taxes. The president hasn’t lowered taxes; he’s raised and then deferred them. To say otherwise is—let’s be blunt—a flat-out lie.” (bold highlights mine)

Instead, the superficiality should be applied to the fabled belief that government spending and inflationism will account for society’s prosperity. Name a country over human history that has prospered from the printing press or inflationism?!

Hence, the emergence of the Tea party movement appears to sow the seeds of a taxpayer revolt, or as seen in the market, the soft resurfacing of the long absence in the bond vigilantes, who could be simply waiting at the corner to pounce on the policy mistakes based on the delusions of grandeur by charlatan governing socialists and their followers, at the opportune moment.

Until the tea partiers gain a political upperhand, the deflation story is nothing but a justification to undertake more inflationism.

The Siren Song Of Inflation

Going back to the naïve outlook for deflation, the lack of borrowing from both domestic and overseas savings doesn’t close the inflation window, in fact it enhances it. This will entirely depend on manifold forces as culture, habit (or addiction)[16], time constancy of political sentiment and political tolerance and etc...and importantly, the attendant policies in response to the political demands.

Nevertheless, Morgan Stanley’s Spyros Andreopoulos enumerates why inflation is seemingly a siren song[17] for policymakers in dealing with a gargantuan and burgeoning debt problem.

From Mr. Andreopoulos (bold emphasis his, italics mine):

``Public debt overhang: The higher the outstanding amount of government debt, the greater the burden of servicing it. Hence, the temptation to inflate increases with the debt.

``Maturity of the debt: The longer the maturity of the debt, the easier it is for a government to reduce the real costs of debt service. To take an extreme example, if the maturity of the debt is zero - i.e., the entire stock of debt rolls every period - then it would be impossible to reduce the debt burden if yields respond immediately and fully to higher inflation. Hence, the longer the maturity of the debt, the greater the temptation to inflate.

``Currency denomination of the debt: Own currency debt can be inflated away easily. Foreign currency-denominated debt on the other hand cannot be inflated away. Worse, the currency depreciation that will be the likely consequence of higher inflation would make it more difficult to repay foreign currency debt: government tax revenues are in domestic currency, and the domestic currency would be worth less in foreign currency. So, the temptation to inflate increases with the share of debt denominated in domestic currency.

``Foreign versus domestic ownership of debt: The ownership of debt determines who will be affected by higher inflation. The higher the foreign ownership, the less will the fall in the real value of government debt affect domestic residents. This matters not least because only domestic residents vote in elections. Note that unlike domestic owners, foreign owners may not necessarily be interested in the real value of government debt since they consume goods in their own country. But they will nonetheless be affected by the inflation-induced depreciation. So, the temptation to inflate increases with the share of foreign ownership of the debt.

``Proportion of debt indexed to inflation: By construction, indexed debt cannot be inflated away. Hence, the higher the proportion of debt that is indexed to inflation, the lower the temptation to inflate.

``To these purely fiscal arguments we add another dimension, private sector indebtedness:

``Private sector debt overhang: An overlevered private sector may generate macroeconomic fragility and pose a threat to public balance sheets. Hence, high private debt also increases the incentive to inflate.

As per Mr. Andreopoulos perspective, there are many alluring technical reasons on why the political option is to inflate rather than adapt market based austerity or to allow market forces to clear up previous imbalances so as to move to the direction of equilibrium.

And combined with today’s prevailing economic dogma and direction of political leadership, the path dependency will most likely be in this direction.

Real Economic Progress And Deflation

None the less, real progress is characterized by increasing efficiency and technological advances that decreases costs of production and increases in output.

The result of which is a rising value of purchasing power of money or “deflation” (see figure 3) and not higher inflation which is the result of excessive government intervention.

Figure 3: AIER: Purchasing Power of the US dollar

This was mostly the case in the United States until the introduction of the US Federal Reserve in 1913, from which the US dollar has been on a steady decline or where the only thing constant today is to see the US dollar collapse in terms of purchasing power.

Going to the US government’s Bureau of Labor Statistics’ inflation calculator, $100 US dollars in 1913 is now only worth $4.55. That’s a loss of over 95%!

So aside from death and taxes, another thing certain in this world is that the value of paper money is headed to its intrinsic value-Zero[18]!

Yet it is funny how protectionists, who stubbornly argue about the “overvalued” currency of the US as the main source of her problem, have been only been asking for more of the same nostrums, instead of looking at WHY these has emerged on the first place.

Like in reading markets, belief in myths can be the greatest error that could lead to tremendous losses that investors can get entangled with.

As former US President John F. Kennedy once said, ``The great enemy of the truth is very often not the lie -- deliberate, contrived and dishonest, but the myth, persistent, persuasive, and unrealistic. Belief in myths allows the comfort of opinion without the discomfort of thought.”

---

[1] Wikipedia.org, List of cognitive biases

[2] Wikipedia.org, Occam Razor

[3] Taleb, Nassim Nicolas; Fooled By Randomness, p. 195, Random House

[4] Wikipedia.org, Belief Bias

[5] The emphasis on seven is meant to highlight the degree of overextension or overheating

[6] See US Stock Markets: Rising Tide Lifts Most Boats And Is Overbought

[7] For my earlier treatise on the US dollar carry bubble see What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?, and Why The Greece Episode Means More Inflationism for my discourse on the Greece crisis.

[8] Oxford Analytica; Dollar Carry Trade No Longer a Sure Bet, Researchrecap.com

[9] Businessweek, Greek Bailout in ‘Matter of Days” to Boost Euro, UBS Says, Bloomberg

[10] Fels, Joachim, Euro Wreckage Reloaded April 16, 2010, Morgan Stanley Global Economic Forum

[11] Mehren, Allan von; Euroland: Nasty inflation surprise will challenge ECB, Danske Bank

[12] See How Moralism Impacts The Markets

[13] See Where Is Deflation?

[14] North, Gary The Economics Of The Free Ride

[15] Landsburg, Steven; Tax Relief, Obama Style, thebigquestions.com

[16] See Influences Of The Yield Curve On The Equity And Commodity Markets

[17] Andreopoulos, Spyros; Debtflation Temptation

[18] See Paper Money On Path To Return To Intrinsic Value - ZERO