Inflation Is The Global Political Choice

``Conventional wisdom contends that the current recession was caused by the free-market zealotry of recent economic policy and by excessively low interest rates. It is an absurd view, given that interest rates are not determined by market forces. Interest rates are manipulated by central banks with a government-mandated monopoly in the issuance of money. Some of those still defending free markets protest that, contrary to popular opinion, banks were heavily regulated before the financial crisis. So they were. But this is quibbling. The role of central banks means that, at its core, we did not have a free market financial system. We had a command economy. Command economies do not fail because the central planning agencies lack the powers required to bring about the best outcomes. They fail because, without market prices, nobody has the information required to adapt the allocation of scarce resources to the demand for them. They fail because central planners have an impossible job.” Jamie Whyte, banker and philosopher and the author of Bad Thoughts: A Guide to Clear Thinking, Strip the Bank of England of its power

I find it amusing when mainstream experts and officials argue about the risks of systemic deflation. That’s simply because we understand their mental or thought process and their latent intentions-they have been selling fear in order to justify the further expanded use of government inflationary programs.

As Ludwig von Mises predicted over half a century ago, ``In discussing the situation as it developed under the expansionist pressure on trade created by years of cheap interest rates policy, one must be fully aware of the fact that the termination of this policy will make visible the havoc it has spread. The incorrigible inflationists will cry out against alleged deflation and will advertise again their patent medicine, inflation, rebaptising it re-deflation. What generates the evils is the expansionist policy. Its termination only makes the evils visible.” (bold emphasis mine)

Recently there have been raging debates on whether the US Federal Reserve Balance sheet [see Figure1] will trigger inflation or not.

Figure 1: Cumberland Advisors: Composition of Fed Balance Sheet

For the inflationists, despite ballooning reserves, the fundamental argument boils down to a highly indebted consumer that couldn’t afford take up additional or more loads of debt and the banking systems’ vastly impaired balance sheets which have opted to rebuild capital by playing the yield curve or by receiving interest payments from the US Federal Reserve on their bank reserves than to operate on the normal credit lending process.

So bloated reserves, for them, won’t translate to “circulation credit” or a credit process-which is not supported by savings or by deposits-but from money “created from thin air”.

For the mainstream, this is called the “liquidity” trap where monetary policies have been rendered impotent and where the only solution lies in a cycle of government taking over the spending process.

Further, for some, it is even held with confidence that the Fed’s interest payment scheme on bank reserves will reduce the risks of an outbreak of inflation once the credit lending process starts improving.

It’s kindda bizarre that the polemic on inflation have been reduced to a technical dimension when the essence of the entire process has been apparently circumvented or shortcircuited.

To put on our Ivory Tower thinking cap, inflation is the process of expanding government’s liabilities over the economy’s goods and services. This can be done through different channels: the banking system via circulation credit (which has underpinned the debate) or by government deficit spending programs or central banking buying of private assets (Quantitative Easing).

The point is as Henry Hazlitt wrote, ``For inflation does not come without cause. It is the result of policy. It is the result of something that is always within the control of government—the supply of money and bank credit. An inflation is initiated or continued in the belief that it will benefit debtors at the expense of creditors, or exporters at the expense of importers, or workers at the expense of employers, or farmers at the expense of city dwellers, or the old at the expense of the young, or this generation at the expense of the next. But what is certain is that everybody cannot get rich at the expense of everybody else. There is no magic in paper money.” (bold highlight mine)

Inflation As Public Policy

And what is a public policy, if not a politically determined legal action?

It is derivative from a process where the government determines the redistribution of resources coercively acquired via taxation. It’s a mechanism where some vested interest individuals or groups in the society, who intends to benefit from other people’s money, utilize the welfare state to impose regulation, subsidies, protection and other forms redistribution programs to achieve such goals at the expense of the rest.

In addition, policy decisions are always determined by political influences, ideology, party affiliation, compromises, perceptions shaped by divergent knowledge or familiarity or biases or priorities or other forms of preferences ingrained in the policymakers.

Policies are never about “right” moral virtues. In the same plane, policymakers are merely human beings, whom are subject to moral frailties, cognitive biases, limited knowledge, and operates on a preferred set of network. In short, the officialdom does not possess God like omniscience.

Proof?

The recent cap and trade bill which sailed past the house of the US Congress by a slim margin is a fundamental example, this from the New York Times, ``As the most ambitious energy and climate-change legislation ever introduced in Congress made its way to a floor vote last Friday, it grew fat with compromises, carve-outs, concessions and out-and-out gifts intended to win the votes of wavering lawmakers and the support of powerful industries.”

So for those thriving under the illusions of morality in governance- our reply is-Get Real!

All these suggest that the preferred policy route by the present policymakers in the US, the Philippines, China or elsewhere has been inflation.

It is a direction borne out of the comfort zone by the present crops of political leaders, by their adopted economic ideology, and the emphasis on narrow time preferences to approach any social or economic ills.

It doesn’t really matter if “output gaps” or “Phillips curve” didn’t work in the stagflation era of the 70s or in the Hyperinflation episodes in Weimar Germany or in Zimbabwe, what matters is that these models have been convenient tools for adopting policy frameworks used by the governing politicians and their bureaucracy and advanced by their academic allies and adherents.

It’s almost been a forgotten principle that political leaders exists primarily for power and is hardly about plutonic salvation of their constituents- a prevarication continually peddled by media and politicians, and solemnly embraced by the gullible public.

Hence the preferred solutions have basically been short term fixes that would enable these officials to carry past any unintended effects after their tenure. And it is also why political leaders almost always fall for populism based policies.

Thereby, the risks of the unintended consequences from kneejerk reactions to the present financial market turmoil will breed and nurture the next crisis.

This has been a political, economic and social cycle.

And all these yammering about deflation risks is understandable, say from Janet Yellen, President of the Federal Reserve Bank of San Francisco (WSJ), or from mainstream’s pop economic icon Nobel Prize awardee Paul Krugman who recently wrote policymakers to “stay the course” who incidentally wrote in 2002 advocating a bubble ``To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble” or from hedge fund manager” (now you know his model depends on serial bubble blowing), or from Hedge fund manager Eclectica’s Hugh Hendry, ``I think this paranoia today that inflation is happening today I think it puts in place a motion for a decline in the economy. I think they're not printing enough money… with regards to the wealth destruction that has been happening over the past 18 months.”(CNBC/greenlightadvisor.com)

And this is why the obvious route is to inflate the system regardless of the impact of the puffed up FEDERAL RESERVE balance sheet, because the alternative recourse of policy actions could be to increase deficit spending (although this could encounter some difficulties due to the growing recognition of its attendant risks and burdens) or it may resort to the more abstract and less publicly understood central bank action known as the “printing press” or QE.

As Ludwig von Mises presciently warned over 60 years ago ``There is need to stress this point, because the public, always in search of a scapegoat, is as a rule ready to blame the monetary authorities and the banks for the outbreak of the crisis. They are guilty, it is asserted, because in stopping the further expansion of credit, they have produced a deflationary pressure on trade. Now, the monetary authorities and the banks were certainly responsible for the orgies of credit expansion and the resulting boom; although public opinion, which always approves such inflationary ventures whole heartedly, should not forget that the fault rests not alone with others. The crisis is not an outgrowth of the abandonment of the expansionist policy. It is the inextricable and unavoidable aftermath of this policy. The question is only whether one should continue expansionism until the final collapse of the whole monetary and credit system or whether one should stop at an earlier date. The sooner one stops, the less grievous are the damages inflicted and the losses suffered.”

So the US government will inflate because it deems such path as the most politically correct and justified for its interest. This implies that such policy actions would need keep asset prices afloat in order to “prevent a collapse” of the reverse debt pyramid foundation from which the US financial system has been built upon, and because the only other path of resolving the debt or overleverage problem other than inflation is to accept deflation or bankruptcy. And yielding to debt deflation essentially undermines the deified image from which has been used as rationale to undertake the vastly shifting structure of its political institutions.

Evidences Of Globalized Inflation

Moreover, in contrast to the one dimensional oversimplistic thinking that the world revolves around the US, the trend of inflationary policies has been global see figure 2.

Figure 2: DollarDaze.org: Estimated Global Monetary Aggregates

The world monetary base has been exploding.

Morgan Stanley’s Joachim Fels enumerates the inflationary actions of global central banks (all bold highlights mine),

``QE is alive and kicking... The sharp increase in US 10-year yields and mortgage rates, with 10-year yields reaching 4% in mid-June, led many investors to question the effectiveness of the QE programme. While a continued increase in yields would certainly create headwinds for economic recovery, it is important to keep in mind that keeping yields low was only one aspect of the programme. As important, if not more so, is the increase in money supply and excess liquidity. On this measure, the Fed has continued to run a successful campaign, as have a host of other countries that have implicitly or explicitly turned to QE.

``...globally: On our count, the Fed, the ECB, the BoE, the BoJ, the Swiss National Bank, the Swedish Riksbank, the Norges Bank and the Bank of Israel all adopted some form of QE around September 2008 (see "QE2", The Global Monetary Analyst, March 4, 2009). M1, the measure of narrow money supply, has been growing strongly in most of these countries since then. M1 growth in the G4 is ticking along at 12%, driven by M1 growth of nearly 20% in the US, around 8% in the euro area, and a move into positive territory for M1 growth in Japan. Outside the G4, money supply is moving up strongly in Switzerland and Israel, with the latest M1 growth numbers showing 42%Y and 54%Y growth, respectively. The Norges Bank's QE programme has kept the monetary base at highly elevated levels and M1 growth has begun to shrug off the effects of previous tightening and is now in positive territory. Finally, the increase in the monetary base allowed by the Riksbank has pushed up M1 growth to over 6%.

``While there has been no QE announcement from the Chinese monetary authorities, the efforts made to increase money supply and credit in China over the past few months have been highly successful. M1 growth has clocked in at 18.5%Y while loans are growing at 28%Y. India briefly flirted with QE-type policies by buying a sizeable chunk of government bonds since April. However, efforts to push up money supply don't seem to have been pursued vigorously since then. Both economies are expected to outperform the global economy. If anything, our economics team sees the dramatic rally in equities and property as a development that central banks will have to monitor closely.

``More to come: In the major economies, there is plenty more to come. The Fed is about halfway through its US$1.75 trillion purchase programme, while the Bank of England has about 18% (£23 billion) of its programme yet to go. Meanwhile, the ECB will start purchasing €60 billion of covered bonds this month. In short, there is plenty of firepower waiting to come out of the central banks' QE muzzles. If the impact on money supply so far is anything to go by, we can expect excess liquidity to continue to grow and support economic recovery and asset markets.”

So all these unfolding events have been happening exactly in accordance of the von Mises manual or guidebook.

Reconfigured Global Economy Heightens The Inflation Transmission

In addition, structural dynamics on a national scale applied globally are likely to influence the inflation transmission by central banks.

If inflationists argue that excess capacity amidst a slack in global demand will lead to a globalized “deflation”, we have countered that nations with less systemic leverage and high savings rate will respond positively to zero bound interest rates and see an expansion in circulation credit and most likely become breeding grounds of the next bubble.

And this is the reason why we have been witnessing a big jump in emerging markets and Asian stocks.

It isn’t mainly the issue of “excess capacity” but of the issue of accelerating speculative activities induced by easy money policies.

It’s because sustained elevation of asset prices fueled by central bank policies will likely absorb some of the “idled” resources. Inflationists tend to ignore the impact of money to demand and supply of goods and services.

But again, many of the redirected flow of speculations will account for temporal misallocations that will be subject to the business cycles or boom bust cycles. Whether it is the Japan bubble bust, the Tequila Crisis, the Asian Crisis, the dot.com bust or today’s US mortgage and banking crisis, the underlying forces that cultivate such bubbles remain the same and in operation. But only this time the degree involved is way bigger than the past and is likely going to get a lot bigger.

Moreover, the unfolding accounts of deglobalization amidst a reconfiguration of global trade, labor and capital flow dynamics, which used to be engineered around the US consumer, will likely be reinforced by an increasing trend of reregulations which may lead to creeping protectionism and reduced competition and where higher taxes may reduce productivity and effectively raise national cost structures, as discussed in Will Deglobalization Lead To Decoupling?

Proof?

The gradual escalation of protectionism in the form of policy induced programs to reduce migration flows. This from The Economist, ``Governments are reducing quotas for foreign workers and imposing tougher entry requirements on them in an effort to control the flow. Some are even paying existing migrants to go home”.

Figure 3: OECD-FAO Agricultural Outlook: CPI and Food Price Inflation in select Emerging Markets and select OECD economies.

More proof?

Amidst the culmination of the near systemic collapse of the US banking system that rippled across the globe in September-October of 2008, and where global “deflation” became the main cause of concern, the chart from OECD-FAO 2009 outlook shows how CPI rates have been mostly positive on a year to year basis in most OECD or even in Emerging markets!!!

So this Ivory Tower analyst operates in a world of real evidence compared to mainstream or conventional thinking, which operates in a world of models fitted to validate their biases or data mining.

Clash in Policies And Expectations A Source Of Confidence?

Another bizarre notion is the expressed confidence over global central banks ability to overturn present policies once the recovery in the global economy gains traction.

For countries unaffected by the deluge of debt in the past bubble, this could be true. But for economies scourged by overleverage hangover, this would seem highly questionable.

For instance, the ability by the US Federal Reserve to pay interest on bank reserves has been inferred to by some as a superior tool, which would function as a brake, against the risk of an outbreak of inflation.

Yet this wonkish article Federal Reserve of Atlanta shows how the US Federal Reserve has been in a bind-it has been struggling to close the gap between Fed Fund rates and Interest on paid bank reserves. If under a benign environment the Fed seems in a predicament on managing some of its tools under watch, how much more when the psychology tips towards inflation?

Be reminded that inflation, aside from being a political process, is importantly psychologically driven. As Nassim Taleb in a recent interview said, ``Because all you need is for people to think there’s gonna be inflation to start hoarding.”

And that’s why central bankers keep a close vigil to inflation expectations as signaling channel. It is also another reason why governments can and will manipulate gold (a major barometer of inflation) or other commodities as oil, as part of their array of tools to manage inflation expectations. Hence, the idea of free markets in a world of central banking is a delusion.

Moreover, even the objectives of government policies appear similarly in a fix, as actions and intent have been in a collision. Let’s call it the paradox of save and spend.

Where savings under the present economic ideology is an anathema to aggregate spending, government deficit spending which substitutes for lost private consumption requires financing from global savers, official forex surpluses or local savers.

Nonetheless, if the official surpluses from emerging central banks or global savers won’t suffice to fill in to fund US government spending programs, then it would require resident savings to do so.

Yet ironically, the policy thrusts have been directed against attaining these goals. So essentially, clashing goals and policies from the paradox of save and spend, don’t account for an optimistic outcome.

This means that without sufficient financing, the US government would have a Hobson’s choice which is to monetize these debts.

I’d like to further point out that it’s an apples-to-orange comparison when experts use the debt to gdp ratio to account for deficits.

For instance, the US economy at $14.265 trillion is about 24% of the global economy at $60.690 trillion in 2008 (IMF), second to the Euro zone. So even if Japan’s public debt is about 170% (2008-Flag counter) of its $4.924 trillion (IMF) economy which translates to around $7.3 trillion, the US debt which is 60% of the GDP (2007) translates to some $8.6 trillion. So nominal debt figures or debt to global GDP would be a better measure since funding options would likely be on a global scale.

The striking difference is Japan has huge surpluses ($1.02 trillion-chosun.com) and even more humongous savings ($14.9 trillion!!!-Bloomberg) that can finance most of its locally held debt.

Hence the crux of the matter is that the financing aspect of the deficits is more important than the deficit itself. And here savings rate, foreign exchange reserves, economic growth, tax revenues, financial intermediation, regulatory framework, economic freedom, cost of doing business, inflation rates, demographic trends and portfolio flows will all come into play. So any experts making projections based on the issue of deficits alone, without the context of scale and source of financing, is likely misreading the entire picture.

Finally, it is equally odd for experts to become confident on global governments exiting the remodeled structure of today’s financial markets when the underlying expectations appears to have been built around the sustained backstop of governments.

Consider this piece from Richard Barley at the Wall Street Journal (bold emphasis mine), ``As policy makers discuss how to exit from quantitative easing, investors need to position themselves for the government-bond-market turmoil that is likely to follow.

``The markets got a taste of what might be in store this week when the Bank of England decided to stop buying two bonds originally included in its £125 billion ($204.68 billion) quantitative-easing program. The prices of those bonds plummeted, suggesting there is big money to be made for investors who get their trading strategy right.

``The snag is that some government-bond markets are so potentially distorted by central-bank programs that it is hard to feel confident of where prices should be…

``But even if the bank decides to continue with quantitative easing, it may come under pressure to expand the basket of securities it is buying to avoid building up excessive holdings in other single issues…”

Three observations from this article:

One, take away the pillar of the present platform and renewed volatility follows.

Two, intervention begets even more intervention which is the basic premise of any inflationary cycles.

Three, markets are built around incentives and expectations. Short term policy based patchwork could result to a clash between policies and expectations.

Implications For The Financial Markets

What does these mean to the financial markets?

It means that global financial markets have been operating fundamentally on the expectations of sustained government interventions and persistent inflationary actions. And expectations have seemingly been geared towards the deepening of such activities.

Any expectations built on sound recovery will likely be a mirage. Any economic recovery will probably be temporary and predicated on bubble dynamics of malinvestments.

Because deflationary forces remain in several OECD economies, the policy thrust will likely be to further reinflate the system, most likely by QE, justified by low current CPI rates and the bogeyman of deflation. Nevertheless, recessionary forces and policy inflation will likely result to sharp volatilities.

Any major liquidity withdrawal, especially from the US Federal Reserve, will likely cause massive dislocations in the global markets.

Emerging markets and Asia are likely to be the center of the next bubble.

We seem to be approaching a threshold point where bubble afflicted governments will have to decide whether to embrace deflation or accelerate the inflation process to a greater level even at the risks of compromising the conditions of their currencies.

And those saying the US dollar will unlikely be replaced as the international currency reserve anytime soon should heed the lessons of inflation. Once the public recognizes that the sustained and accelerated erosion of money’s store of value, they will be replaced as history has shown. Hence, the fate of the US dollar will depend on the underlying policies taken.

As an old saw goes, nothing is certain in this world except death and taxes, and may I add, popular delusions and lies.

Phisix: From Bust to Boom?

``We’re in a government-dependent financial system; I never thought I would live to see the day… We’ve got to fight to get away from that.” Paul Volcker, Volcker: China Chose to Buy Dollars

The Phisix stormed to an 11.25% gain over the past week, and was the second best performer over the adrenaline charged Asian equity markets (although it was mostly global affair), see figure 6.

So far the latest rally has pushed up many major stock markets into the positive zone [see Global Stock Market Performance Update: The Charge of the BRICs] led by the BRICS and many EM economies in contrast to the G-7 economies that have still been drifting in the negative zone but has seen vital improvements in their standings.

Figure 6: Stockcharts.com: Performance Chart of Key Asia Bourses

From January 6^th to Friday’s close, only 4 regional benchmarks have cleared the winner’s zone and this includes China (pink), Taiwan (blue green), Indonesia (orange) and the Philippines (bright light green).

While many commentators have imputed the rising equity markets to “increasing risk appetite”, this needs to be qualified. Relative to global portfolio flows to emerging markets, the meat of the year-to-date inflows have only been accounted for just this week.

According to Marketwatch.com, ``Emerging Market Equity Funds tracked by EPFR Global took in the most money since mid-December during the week ended March 25. These funds absorbed $2.3 billion of inflows during the week, turning year-to-date flows positive by $2.03 billion.”

So nearly 90% of cross border flows came only this week. The current cross border flows signifies as marginal in comparison to size of the composite emerging market bourses. Nonetheless it can be seen as an improvement.

Here at the Philippine Stock Exchange (PSE), capital flows remains a net foreign selling for the end of the week, for the rest of the month and for the year.

This means that the recovery in the Philippine Stock Exchange has largely been a domestic investor affair. This also means that that the recent gains could possibly emanate from the transfer of local savings or possibly increased domestic leverage that could have been channeled into the local equity market. For the advanced EM markets, it could be also be due to short covering.

We can deduce such activities as largely a domestic ‘risk taking’ activity and not from the typical cross border flows.

Besides, given that most central banks have been forcing policy interest rates to approach zero levels or negative real rates regime, coupled with the transmission effects of the QE measures in many major economies the opportunity cost of holding cash have been materially rising.

Put differently, policies from the central banks of the US Federal Reserve and Bangko Sentral ng Pilipinas appear to be gaining traction and skewing people’s incentives to soak up more risk.

And faced with the imminent risk of inflation, staying in cash is now becoming increasingly a risky affair, as a sudden surge in inflation could wipe out the Peso’s purchasing power.

Remember except for the external liabilities of the government, the Philippines’ private sector, as segmented into corporation and individuals, are basically underleveraged. Nearly two fifths of our domestic output can be attributed to the informal economy. Thus, there could be a sizeable surge in private borrowing that may intensify the inflation transmission into the financial asset class. On the other hand, a considerable jump in consumer inflation could also be politically destabilizing.

The initial concerns about the corporate direction of PLDT and the corporate maneuverings at Meralco appear to have been overshadowed by the flush of money from global central banks.

From Bottom To The Advance Phase?

Nonetheless, signs are on the wall that the MONETARY risk environment together with significantly improving market internals seems to be suggesting of an important breakaway for the Phisix from its current “bottoming” cycle to the “advance” cycle.

Figure 6: Daily Traded Issues and Advance Decline Differentials

The Pink line represents the daily traded issues. This is one of the market breadth indicators which deals with the broad market sentiment. A surge in daily traded issues could mean broad based buying specifically when corroborated by an improvement in the advance decline differentials as shown at the same chart. Below is the daily traded issues. The green circle shows of the simultaneous progression.Figure 7: PSE Daily Trades: Another Improving Indicator

Another improving indicator is the number of daily trades. This market breadth indicator also reveals of the risk appetite of investors. A rising incidence of daily trades suggest of more market participants and or more churning activities from existing participants.

It essentially reveals of the market’s sentiment or as confidence barometer. In a bear market, a sudden spurt in daily trades frequently signifies panic selling as in the October-November 2008 experience.

For now, all three indicators are seemingly in synch adrift the resistance levels. And this synchronicity hasn’t been the seen for quite sometime.

Nevertheless, a breakout above the 2,100 level for the Phisix alongside with a breakout for these market internal indicators will indeed be very bullish for the Phisix. Of course, this has to be equally matched by improvements in the market’s overall volume.

As a short reminder, I don’t know when the Phisix will breakout. It could be next week or in the coming weeks or months. Sorry but I am not a seer. What we seem to be seeing is a long awaited improvement in the overall activities within the Philippine Stock Exchange. And if these should continue as I expect it would, then a breakout is more likely sooner than later.

And as stated before, the Phisix can’t rise alone. This means that the regional activities will likewise underpin the success or failure of today’s rally. Although given the conditions stated above, China has so far almost singlehandedly led the rally in the region and seems to have “pulled” many emerging markets along with it. Of course, it’s rather insane to suggest that a $4.22 trillion economy will pull the rest the world (US $14.33 trillion, Eurozone $18.85 trillion or Japan $4.84 trillion).

What we are likely witnessing is the impact from “combined” money printing by global central banks more than an economic recovery. If these measures succeed to buoy most of the region’s economies unimpaired by the credit maelstrom, the “super” inflation could be deferred.

Nonetheless today’s seemingly booming inflationary driven environment will also mean a forthcoming bust in the far end of the road (sometime 2013-2015?). But for now, present risks seem to emanate from a super inflation, than a deflationary bust.

How Political Tea Leaves Will Shape The Investment Landscape

``One key attribute that gives money value is scarcity. If something that is used as money becomes too plentiful, it loses value. That is how inflation and hyperinflation happens. Giving a central bank the power to create fiat money out of thin air creates the tremendous risk of eventual hyperinflation. Most of the founding fathers did not want a central bank. Having just experienced the hyperinflation of the Continental dollar, they understood the power and the temptations inherent in that type of system. It gives one entity far too much power to control and destabilize the economy.” Dr. Ron Paul, The Neo-Alchemy of the Federal Reserve

Never has ascertaining the probabilities of the rapidly evolving highly fluid macro environment been as critical today in shaping one’s portfolio or even in anticipation of the how to allocate resources in the coming business environment.

Why? Because future revenue streams, productivity levels, earnings and all other micro metrics, aside from market or business cycles, will all depend on the outcome from the present set of policy choices.

While the investment field shudders at the thought mentioning such ominous phrase; ``it’s different this time”, well, it hard to say it but it does seem different this time.

As we noted in last week’s Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?,

``Even as global governments have been rapidly anteing up on claims to taxpayers’ future income stream by a concoction of “inflationary” actions such as lender of last resort, market maker of last resort, guarantor of last resort, investor of last resort, spender of last resort and ultimately buyer of last resort, a credit driven US economic recovery isn’t likely to happen; not when governments are tightening supervision or regulatory framework, not when banks are hoarding money to recapitalize, not when borrowers are tightening belts and suffering from capital losses on declining assets and certainly not when income is shrinking as unemployment and business bankruptcies rise on falling profits, and most importantly not when the collective psychology has been transitioning from one of overconfidence to one of morbid risk aversion.

``Thus the best case scenario for the credit driven “economic growth” will be a back to basics template-the traditional mechanisms of collateralized backed lending based on borrower’s capacity to pay. But these won’t be enough to reignite the Moneyness of credit. Not even under the US government’s directive.”

We found our assertions pleasantly echoed by the world’s Bond King in his latest outlook; from PIMCO’s Mr. William Gross (who confirms our cognitive biases-emphasis ours)

``My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”

So as global governments take up the shoes from the private sector, the outcomes as reflected by market conditions and on the economic landscape will obviously be different, see Figure 1.

Figure 1 Gavekal: Portfolio Distribution In Different Environments

From Gavekal’s Brave New World is a simplified template where we see basically four economic environments; from which a long term theme, at the moment, has been struggling to emerge, albeit under a current, possibly temporary, dominant theme which are being battled out by government forces.

But nonetheless, we can identify whence our recent past, posit on the present environment and identify possible outcomes.

From the privilege of hindsight the most obvious is the inflationary boom, which was characterized by a credit inspired boom in almost every asset classes across the world, but in contrast to the template, this includes a boom in government bonds!

Today we are seeing the opposite- a market driven deflationary bust, where the unwinding debt burden has prompted for a reversal of the former order or an across the board selling except for US treasuries and the US dollar. Thus the characteristics as described in the template are presently still being perfected.

Yet, given the observable actions of governments, one may infer that the current deflationary bust phase is being engaged in with a tremendous surge of inflationary forces (bailouts, guarantees, lending, capital provision, etc.) in the hope to restore the former order.

And this has been the source of the fierce debates encapsulating the investment industry; will today’s deflationary bust outrun inflationary forces and transit into a modern day global depression? Will the unintended consequences of the concerted inflationary injections by global central banks result to a US dollar crisis or inflationary bust or hyperinflationary depression? Or will Goldilocks be resurrected with government stilts?

Deflation and Endowment Effects

The basic problem is the house of cards built upon by an unsustainable credit structure from which the world’s economy has been anchored upon, see figure 2.

Figure 2: courtesy of contraryinvestor.com: Unsustainable Credit Market

As we previously noted there are basically two ways to preside over such predicament. One is to allow market forces to reduce debt to levels where the afflicted economy could pay these off. Two, is to reduce the real value of debt via inflation. Of course, there is always the third way: the default option.

But since we believe that the US government and the other debt laden economies are likely to avoid the third option, as their taxpayers have been aggressively absorbing the losses, these relegate us to the first two options.

Deflation proponents (mostly Keynesians) argue that the central bank measures are proving to be impotent when dealing with the tsunami of debt because losses have simply been staggering to drain “capital” than can be replaced and which has similarly devastated the credit system beyond immediate repair. Hence, the global central bank actions are unlikely to rekindle a credit driven (inflationary boom) economic recovery.

In addition, they argue that because of the credit prompted seizure in the banking system its spillover effects to the real economy will lead to a much further decline in aggregate demand which accentuates the overcapacity in the global trade network which will further transmit deflationary forces worldwide.

Moreover, they’ve boisterously indulged in a public blame game in the context of trade balances. They accuse the current account surplus economies, who still seem reluctant to abide by their behest of absorbing declining world aggregate demand via their prescribed policies of increasing domestic consumption, of being ‘beggar thy neighbor’. Some of them have even implied that the continued thrust towards mercantilism in today’s recessionary as “Protectionism In Disguise” (PID).

This of course, according to our self-righteous omnipotent camp will lead to further deflation as excess capacity will forcibly be dumped into the markets and may result to countervailing protectionist actions.

Grim indeed.

The bizarre thing is that Keynesians have been fighting among themselves: the insiders or policymakers believe that eventually their actions will triumph, while the outsiders believe that their sanctimonious wisdoms represent as the much needed elixir to the present predicament.

Yet all of these exhibits nothing more than the cognitive bias of the “endowment effect” or placing a higher value on opinions they own than opinions that they do not.

The rest is speculation.

End Justifies The Means: The Gathering Inflation Storm?

There are two ways one can categorize all these competing analysis.

One, means to an end- (free dictionary) something that you are not interested in but that you do because it will help you to achieve something else; or applied to the recent events, the analysis that “my way has to be followed” regardless of the outcome.

Yes, the US and many European governments have practically followed nearly all Keynesian prescriptions short of outright nationalizations of the affected industries, yet NO definitive progress.

In short, we see many analysis based on the strict adherence to ideological methodologies than the actual pursuit of economic goals.

Of course, this will have to be wrapped with technical gobbledygook, such as liquidity trap, debt trap, and assorted claptraps (possibly even crab traps), to entertain and wow their audience, especially catered to those seeking easy answers or explanations to the performance of today’s market as the trajectory for the future.

Two, end justifies the means- (free dictionary) in order to achieve an important aim, it as acceptable to do something bad or the end result determines the course of action.

As we have earlier said the major alternative recourse to deal with an unsustainable debt structure is to ultimately inflate the real value of debt, which essentially shifts the burden from the debtor to the creditor.

And there have been rising incidences of voices expressing such direction:

This from Atlanta Federal Reserve President Dennis Lockhart (Wall Street Journal) ``A direct path to recovery is unlikely, as we have seen, events arise that knock us off the path to a stable credit environment…the Fed retains a number of options to help the economy.” (highlight ours)

This from former IMF Chief Economist Kenneth Rogoff whom we earlier quoted in Kenneth Rogoff: Inflate Our Debts Away!

``Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitisation, structured finance and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed….

``Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20% or 30% instead of 5-6%. Indeed, fear of overshooting paralysed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.

This from a commentary entitled “Central banks need a helicopter” by Eric Lonergan a macro hedge fund manager at the Financial Times (highlight mine),

``What is lacking is a legal and institutional framework to do this. The helicopter model is right, but we don’t have any helicopters…Central banks, and not the fiscal authorities, are best placed to make these cash transfers. The government should determine a rule for the transfer. It is the government’s remit to decide if transfers should be equal, or skewed to lower income groups….The reasons for granting this authority to the central bank are clear: it requires use of the monetary base. Granting government such powers would be vulnerable to political manipulation and misuse. These are the same reasons for giving central banks independent authority over interest rates.”

Let’s go back to basics, the reason governments are inflating the system away (albeit in rapid phases) is because of the perceived risks of destabilizing debt deflation. Yet you can’t have market driven deflation process without preceding government stimulated inflation. Thereby deflation is a consequence of prior inflation. It is a function of action-reaction, cause and effect and a feedback loop- where government tries to manipulate the market and market eventually unwinds the unsustainable structure.

Our point is simple; if authorities today see the continuing defenselessness of the present economic and market conditions against deflationary forces, ultimately the only way to reduce the monstrous debt levels would be to activate the nuclear option or the Zimbabwe model.

And as repeatedly argued, the Zimbabwe model doesn’t need a functioning credit system because it can bypass the commercial system and print away its liabilities by expanding government bureaucracy explicitly designed to attain such political goal.

As Steve Hanke in the Forbes magazine wrote, ``The cause of the hyperinflation is a government that forces the Reserve Bank of Zimbabwe to print money. The government finances its spending by issuing debt that the RBZ must purchase with new Zimbabwe dollars. The bank also produces jobs, at the expense of every Zimbabwean who uses money. Between 2001 and 2007 its staff grew by 120%, from 618 to 1,360 employees, the largest increase in any central bank in the world. Still, the bank doesn't produce accurate, timely data.”

In other words, the Rogoff solution simply qualifies the ‘end justifying the means’ approach, where the ultimate goal is political -to reduce debt in order for the economy to recover eventually or over the long term for political survival, than an outright economic end. Yet because of the vagueness of such measures, there will likely be huge risks of unintended painful consequences. But nonetheless, if present measures continue to be proven futile, then path of the policy directives could likely to lead to such endgame measures-our Mises moment.

Yet, the Rogoff solution simply cuts through the long chase of the farcical rigmarole advanced by deflation proponents who use their repertoire of technical vernaculars of assorted “traps” to convey a deflation scenario. When worst comes to worst all these technical gibberish will simply evaporate.

Moreover, deflation proponents seem to forget that the Japan’s lost decade or the Great Depression from which Keynesians have modeled their paradigms had one common denominator: “isolationism”.

Japan’s debacle looks significantly political and culturally (pathological savers) induced, while the Smoot Hawley Act in the 1930s erected a firewall among nations which essentially choked off trade and capital flows and deepened the crisis into a Depression.

This clearly hasn’t been the case today, YET, see Figure 3.

Figure 3: US global: Global Central Banks Concertedly Cutting Rates

There had been nearly coordinated massive interest rate cuts this week by several key central banks; the Swedish Riksbank slashed its rates by nearly half, cutting 175 bp to 2%, followed by the Bank of England, which slashed rates by 100bp (last month it cut by 150 bp), while the ECB was the most conservative and cut of 75bp. Indonesia followed with 25 bp while New Zealand cut a record 150bp to 5% (guardian.co.uk).

And as we quoted Arthur Middleton Hughes in our Global Market Crash: Accelerating The Mises Moment!, ``the market rate of interest means different things to different segments of the structure of production.”

If the all important tie that binds the world has been forcible selling out of the debt deflation process, then as these phenomenon subsides we can expect these interest rate policies to eventually gain traction.

And it is not merely interest rates, but a panoply of distinct national fiscal and monetary policies targeted at cushioning such transmission.

Remember, even in today’s globalization framework, the integration of economies hasn’t been perfect and that is why we can see select bourses as Tunisia, Ghana, Iraq or Ecuador defying global trends, perhaps due to such leakages.

The point is there is no 100% correlation among markets and economies. And when the forcible selling (capital flow) fades, the transmission linkages will focus on other aspects as trade or remittances which have varying degrees of external connections relative to their national GDP.

Thus, considering the compounded effects of individual economies and their respective national policy actions, market or economic performances should vary significantly.

The idea that global deflation will engulf every nation seems likely a fallacy of composition if not a chimera.

Reviving Smoot-Hawley Version 2008?

Next, there is this camp agitating for a revised form of protectionism.

They accuse nations with huge current account surplus, particularly China, for nurturing trade frictions amidst a recessionary environment-by obstinately opting to sustain the present trade configuration which is heavily modeled after an export led capital intensive investment growth.

The recent surge of the US dollar against the Chinese Yuan and China’s recent policies of providing for higher rebate and removal of bank credit caps have been interpreted to as being implicitly protectionist.

The alleged risks is that given the slackening of aggregate demand, China’s export oriented growth model could pose as furthering the deflationary environment by dumping excess capacity to the world.

Echoing former accusations of currency manipulation, but in a variant form, the adamant refusal by China to reduce its export subsidies (via Currency controls etc.) at the expense of domestic consumption, is seen by critics as tantamount to fostering protectionism and thus, should require equivalent punitive sanctions.

Recessions are, as seen from the mainstream, defined as a broad based decline in economic activity, which covers falling industrial production, payroll employment, real disposable income excluding transfer payments and real business sales.

But recessions or bubble bust cycles are mainly ``a process whereby business errors brought about by past easy monetary policies are revealed and liquidated once the central bank tightens its monetary stance,” as noted by Frank Shostak.

In other words, when China gets implicitly or explicitly blamed for “currency manipulation” or for failing to adopt policies that “OUGHT TO” balance the world trade, it assumes that the US, doesn’t carry the same burden.

But what seems thoroughly missed by such critics is that the extreme ends of the current account or trade imbalances reflect the ramifications of the Paper-US dollar standard system. You can’t have sustained and or even extreme junctures of imbalances under a pure gold standard!

Besides, since the supply or issuance of currencies is solely under the jurisdiction of the monopolistic central banks, which equally manages short term interest rate policies or the amount of bank reserves required, then the entire currency market operating under the Paper money platform accounts for as pseudo-market or a manipulated market.

To quote Mises.org’s Stefan Karlsson, ``Any currency created by a central bank is bound to be manipulated. In fact, manipulating the currency is the task for which central banks were created for. If they didn't manipulate the currency, there would be no reason to have a central bank.” (underscore mine)

In addition, the fact that the US functions as the world’s reserve currency makes it the premier manipulator- for having the unmatched privilege to extend paper IOUs as payment or settlement or in exchange for goods and services.

We don’t absolve the Chinese for their policies, but perhaps, by learning from the harsh experience of its neighbors during the Asian crisis, the Chinese have opted to adopt similar mercantilist nature to protect its interest but on a declining intensity as it globalizes.

The point that Chinese authorities are considering full convertibility of the yuan, as per Finance Asia (emphasis mine), ``The Chinese authorities should raise the profile of the renminbi during the global financial turmoil and get ready for the currency’s full convertibility, according to Wu Xiaoling, deputy director with the finance and economic committee of the National People’s Congress”, or this ``Wu, who was a deputy governor of the People’s Bank of China (PBOC) until earlier this year, told a seminar in Beijing in November that the renminbi should become an international reserve currency in tandem with its full convertibility, reflecting a renewed interest in loosening control of the currency as the country becomes more deeply integrated in the world financial system. She said it was difficult to find an alternative reserve currency but added that the renminbi was ready to become an international currency to replace the dollar,” equally demonstrates the political thrust to gain superiority by becoming more integrated with the world via reducing mercantilist policies and adopting international currency standards.

But, unlike the expectations of our magic wand wielding experts, you don’t expect them to do this overnight.

Figure 4 Gavekal: China Reserves Outgrow China’s Trade Surplus & FDI

Also during the past years, China’s currency reserves didn’t account for only trade surpluses or FDI flows, but as figure 4 courtesy of Gavekal Capital shows, a significant part of these reserves could have emanated from portfolio or speculative flows even in a heavily regulated environment.

Thus, the recent surge of US dollar relative to the Yuan may not entirely be a policy choice but also representative of these outflows given the current conditions. The fact that China’s real estate has been decelerating and may have absorbed most of these speculative flows could reflect such dynamics.

Nonetheless Keynesians always focus on the aggregate demand when recessions or a busting cycle also means a contraction of aggregate supply.

Malinvestments as seen in jobs, industries or companies or likewise seen in supply or demand created by the illusory capital or “money from thin air” which would need to be cleared. Or when the excesses in demand and in supply are sufficiently reduced or eliminated, and losses are taken over by new investors funded by fresh capital, then the economy will start to recover.

Again Frank Shostak (highlight mine), ``Contrary to the Keynesian framework, recessions are not about insufficient demand. In fact Austrians maintain that people's demand is unlimited. The key in Austrian thinking is how to fund the demand. We argue that every unit of money must be earned. This in turn means that before a demand could be exercised, something must be produced. Every increase in the demand must be preceded by an increase in the production of real wealth, i.e. goods and services that are on the highest priority list of consumers (we don't believe in indifference curves).”

The point is whatever decline in aggregate demand also translates to a decline in capacity as losses squeezes these excesses out. Today’s falling prices may already reflect such oversupply-declining demand adjustments.

Said differently the calls to maintain or support “demand” by means of more government intervention aimed at propping up of institutions, which are not viable and can’t survive the market process on its own, isn’t a convincing answer. The pain from the adjustments in debt laden Western economies is also felt but to a lesser degree in Asian economies.

Likewise, imposing undue protectionist sanctions to suit the whims of such pious and all knowing experts, will likely have more unintended consequences, foster even more imbalances and or risks further deterioration of the present conditions.

Forcing China to radically reform, without dealing with the structural asymmetries from today’s fractional reserve banking US dollar standard, won’t resolve the recurring boom-bust cycles. This simply deals with the symptoms and not the cause.