Entrepreneurial Knowledge and Failure as Virtue

Entrepreneurial knowledge and the societal acceptance of failure should be seen as stepping stones or building blocks to economic progress.

From the Wall Street Journal Blog (bold emphasis mine)

Economists at Harvard University and Massachusetts Institute of Technology have just released what they claim to be the crystal ball of economics: a model for predicting a nation’s future growth more accurately than any other techniques out there.

“The Atlas of Economic Complexity” ranks 128 nations based on their “productive knowledge” — the skills, experience and general know-how that a given population acquires in producing certain goods. Countries with a high score in the report’s “economic complexity index” have acquired years of knowledge in making a variety of products and goods and also have lots of room for growth. Essentially, the more collective knowledge a country has in producing goods, the richer it is — or will be.

The 364-page report, a study led by Harvard’s Ricardo Hausmann and MIT’s Cesar A. Hidalgo, is the culmination of nearly five years of research by a team of economists at Harvard’s Center for International Development.

“The essential theory … is that countries grow based on the knowledge of making things,” Mr. Hausmann said in a phone interview. “It’s not years of schooling. It’s what are the products that you know how to make. And what drives growth is the difference between how much knowledge you have and how rich you are.”

The above seems quite applicable to the Philippines. As I have been pointing out, four out ten college graduates are unemployed and about 13% of college graduates emigrate.

The Philippine economic predicament has hardly been about the lack of education but mainly the inadequacy of the relevant entrepreneurial knowledge or “knowledge to make things”. And most importantly, a conducive environment for entrepreneurs to underwrite on such risks.

And because risk-taking is an integral part of the market economy, the outcome of either success or failure is indispensable. Failure should also be seen as capitalist virtue from which entrepreneurs can build on, learn and innovate from.

This excerpt from an insightful article by Professor Steve Horwitz and Jack Knych at thefreemanonline.org (bold emphasis mine)

Economists, especially those of the Austrian school, often emphasize how entrepreneurs discover new knowledge and better ways of producing things. But entrepreneurial endeavors frequently fail and the profits thought to be in hand often don’t materialize. According to the U.S. Small Business Administration, over half of small businesses fail within the first five years. But failed entrepreneurial activity is just as important as successful entrepreneurial activity. Markets are desirable not because they lead smoothly to improved knowledge and better coordination, but because they provide a process for learning from our mistakes and the incentive to correct them. It’s not that entrepreneurs are just good at getting it right; it’s also that they (like all of us) can know when they’ve got it wrong and can obtain the information necessary to get it right next time.

On this view failure drives change. While success is the engine that accelerates us toward our goals, it is failure that steers us toward the most valuable goals possible. Once failure is recognized as being just as important as success in the market process, it should be clear that the goal of a society should be to create an environment that not only allows people to succeed freely but to fail freely as well.

The seeming preference by the Philippine society to focus on mass ‘public’ education and on the growing web of regulations will serve as constant source of perpetual socio-economic frustrations because these policies have not been dealing with the fundamentals of the problem: Mass graduates in a political environment that seems unfriendly to business or to entrepreneurship which only places additional strains on current unemployment figures.

Yet fear of failure converted into public policies known as public goods or safety nets encourages political dependency, abdication of personal responsibility, indolence and importantly the curtailment of civil liberties.

From the economic dimension, this implies diversion of scarce resources from productive activities. The obverse side of each safety net underwritten or regulation imposed means employment losses somewhere.

In focusing on the wrong factors evidently we get the wrong outcomes. Worst, since current woes reflect on the failures of political policies, the effect has been noticeably widespread. Yet politicians tend to pass the blame on someone else.

Unfortunately, accountability from these policy failures has practically been absent or are imperceptible from the public’s perspective. In other words, the opportunity cost from each political action have been intangible, unseen or unnoticed by the public.

Thus, the underlying populist tendency to the current social ills has been to ask for more of the same wrong prescriptions or ‘doing the same thing and expecting different results’ a quote on insanity prominently attributed to Albert Einstein.

In politics, a culture of ‘insanity’ seems to be the norm.

Do Filipinos Need a New Attitude on Entrepreneurship?

I received a promotional email for an entrepreneurship seminar which comes with a column from Brian Quebengco entitled “Championing Philippine Ideas: The Rise of Silicon Valley in the Philippines”

Mr. Quebengco writes, (no link included in the email),

It is not an evolution that we need, nor is it a revolution. Rather, what we need is a transformation. Since the glory days of Semi Conductors and the Filipino entrepreneurs that championed them, we have evolved a great deal up to our present state. And as we are witnessing right now, a revolution in technology and communication has made the world flat. But what is lacking, and I feel the most important, is for us, the individual Filipino, to transform our attitude and ways to give rise to the Filipino Entrepreneur. We don't need mechanisms, infrastructures, or even the presence of a strong venture capital community to do this. In my own view, business is about people first, and everything else second. That transformation must and can only start with the individual Filipino.

He further says entrepreneurs should be individually motivated which should permeate to culture and subsequently to infrastructure. And from this he advocates the promotion of “a new kind of Enterpreneur”, one who will “challenge the global arena”.

I am delighted that there are local experts advocating entrepreneurship which functions as the cornerstone for any market economy.

However, I would suggest that any “new kind of entrepreneur” hardly matches the operational concept of entrepreneurship.

Entrepreneurs are those who allocate factors of production (labor, capital goods and natural resources) in the service of consumers. (Mises wiki)

Further, entrepreneurs employ “discovery” or “alertness” to profit opportunities in scanning the market horizon which can bring about innovation, better quality of goods or services or cheaper prices. (Israel M. Kirzner)

So aside from Silicon Valley which he seems to see as a paradigm to emulate, homegrown entrepreneurs are the balut vendors, carinderia operators, laundry services and etc… to the bigwig who compete internationally like Jollibee, San Miguel Brewery and others.

Each of them offers specific goods or services to serve their consumers in return for profit opportunities. These voluntary exchanges constitute the free markets.

What I am trying to say is that the marketplace hardly operates on “new” entrepreneurs founded on “new attitudes” but rather on individual specialization.

As the great Austrian economist Ludwig von Mises wrote, (bold emphasis mine)

The selection of the market does not establish social orders, castes, or classes in the Marxian sense. Nor do the entrepreneurs and promoters form an integrated social class. Each individual is free to become a promoter if he relies upon his own ability to anticipate future market conditions better than his fellow citizens and if his attempts to act at his own peril and on his own responsibility are approved by the consumers. One enters the ranks of the promoters by spontaneously pushing forward and thus submitting to the trial to which the market subjects, without respect for persons, everybody who wants to become a promoter or to remain in this eminent position. Everybody has the opportunity to take his chance. A newcomer does not need to wait for an invitation or encouragement from anyone. He must leap forward on his own account and must himself know how to provide the means needed.

It must be understood too that the entrepreneurship ethos is also hardly acquired from formal educational training.

Again from von Mises, (highlights added)

In order to succeed in business a man does not need a degree from a school of business administration. These schools train the subalterns for routine jobs. They certainly do not train entrepreneurs. An entrepreneur cannot be trained. A man becomes an entrepreneur in seizing an opportunity and filling the gap. No special education is required for such a display of keen judgment, foresight, and energy. The most successful businessmen were often uneducated when measured by the scholastic standards of the teaching profession. But they were equal to their social function of adjusting production to the most urgent demand. Because of these merits the consumers chose them for business leadership.

There is NO holy grail to successful entrepreneurship, as it takes sustained “keen judgment, foresight, and energy” to compete in the marketplace, even in the global arena.

What needs to be transformed is NOT the individual attitude towards entrepreneurship but rather the Filipinos’ seeming dependence on political means of dispensing economic opportunities.

In the environment where...

-taxes are high,

-red tapes are byzantine,

-bureaucracy is bloated

-regulatory compliance costs are numerous, time consuming and burdensome,

-corruption is rampant,

-competition is restricted,

-economic opportunities are distributed as political concessions (subsidies, monopolies, private-public partnership, cartel, and etc.)

-redistribution programs are plentiful (which essentially transfers productive resources to non-productive activities and at worst, induces people toward entitlements and subsequently takes away the drive for entrepreneurship)

-and many more,

...so even if most Filipinos would want to become entrepreneurs they can’t. That’ because the Philippine government (regardless of who is in power) prevents them from doing so. The cost of doing business or the risk premium is prohibitive enough to require high hurdle rates for entrepreneurs to generate decent returns.

All these signify as the Filipinos’ aversion to free markets which is what genuinely inhibits the Filipino entrepreneurial discovery process from taking hold.

Quote of the Day: Challenging Monopolies

From excerpt from Forbes Magazine on how John Gokongwei owned Cebu Pacific [PSE: CEB] grabbed the airline industry tiara from Lucio Tan’s Philippine Airlines [PSE: PAL]. (emphasis mine)

It was Lance's father, legendary ragsto- riches entrepreneur John Gokongwei Jr., who had the idea to start Cebu Pacific. John, now 84, sits atop JG Summit Holdings, one of the Philippines' largest conglomerates, and a family fortune that FORBES ASIA pegged at $1.5 billion last year. His interest in aviation was piqued after reading about U.S. discounter Southwest Airlines at the same time the Philippine government decided to open up the airline industry. But Lance believes there was another layer to his father's interest: "About a year before we bid for PAL and lost. So when deregulation came up, well, my dad loves challenging monopolies."

Read more here

Monopolies, which signify as government privileges, operate on principles of anti-competition. This implies that monopolies are fundamentally inefficient, are driven by political goals and irresponsive to consumer demands which all add up to say that monopolies are slow to adapt to the changes in the marketplace.

And so when industries once dominated by monopolies are deregulated, this ‘chink in the armor’ becomes exposed. In a newly deregulated environment, entrepreneurs should pounce on the opportunities to challenge government monopolies as the Gokongwei’s did.

Social Inequality: The Anatomy of Plutocracy

One of the most popular misimpressions or smear campaign tactics directed against free markets or laissez faire capitalism is that such a system promotes a political order known as plutocracy-or the rule of the wealthy.

This idea either lacks the comprehensive understanding of capitalism or simply operates on the premises of deliberate equivocation (propaganda).

The Consumer Reigns In A Laissez Faire System

In the laissez faire political economic order, it is the consumer that ALWAYS reigns supreme.

Consumers ultimately determine who to reward (by profits) and who to punish (by losses). Thus, the wealthy are those entrepreneurs who manage to continually satisfy the ever dynamic desires of consumers.

As the great Ludwig von Mises wrote, (bold highlights mine)

In the capitalistic society, men become rich — directly as the producer of consumers' goods, or indirectly as the producer of raw materials and semiproduced factors of production — by serving consumers in large numbers. This means that men who become rich in the capitalistic society are serving the people. The capitalistic market economy is a democracy in which every penny constitutes a vote. The wealth of the successful businessman is the result of a consumer plebiscite. Wealth, once acquired, can be preserved only by those who keep on earning it anew by satisfying the wishes of consumers.

In addition, market dominance is neither guaranteed nor in a state of permanence because consumer desires always changes.

Importantly, the highly competitive nature of markets impels entrepreneurs to attain excellence by exploiting windows of entrepreneurial opportunities.

As Professor Israel M. Kirzner writes, (bold highlights mine, italics Prof Kirzner)

What makes possible the entrepreneurially driven process of equilibration is active market competition. It is only the possibility of unrestricted entrepreneurial entry which permits more alert entrepreneurs to deploy their superior vision of the future in order to correct the misallocations of resources reflected in the false prices which characterize disequilibrium. It is the continual threat of such entry which tends to keep incumbent entrepreneurs alert and on their toes.

A good example of such process can be seen from how Apple, the technology behemoth company, has attained its present dominance.

Apple’s Sphere of Influence From Minyanville.com

Apple’s success wasn’t granted by fiat orders from political leaders but from its numerous attempts to satisfy consumer demands via competition derived innovative consumer friendly technology devices.

The above is an example of one of the many failed Apple products (chart and the rest of the story from Minyanville). In other words, Apple’s recent string of successes came at the cost of her previous failed experiences or experiments.

I have recently noted on how Mattel, makers of the famous Barbie dolls, has closed shop in China for failing to adapt to local tastes and how Philippine conglomerate Jollibee has captured the largest market share in the Philippine fast food industry by toppling US based counterpart McDonald’s by ingenously configuring her products to the palate of Filipino consumers.

The point is—the political economic order of the rule of the wealthy (plutocracy) would NOT sustainably persist or would unlikely occur under a pure laissez faire system.

State And Crony Capitalism Equals Plutocracy

The apologists for statism, who see Plutocracy as the main source for inequality, hardly realize that for the wealthy to politically sustain its dominance means to adapt ANTI-COMPETITIVE measures by co-opting with the political leaders.

Writes Art Carden (bold highlights mine)

Bourgeois riches come from customer service. Aristocratic riches are expropriated. Aristocracy rests on intrinsic value whereas capitalism rests on the exchange of value for value.

Libertarian William Graham Sumner wrote, (bold highlights mine)

[M]ilitarism, expansion and imperialism will all favor plutocracy. In the first place, war and expansion will favor jobbery, both in the dependencies and at home. In the second place, they will take away the attention of the people from what the plutocrats are doing. In the third place, they will cause large expenditures of the people's money, the return for which will not go into the treasury, but into the hands of a few schemers. In the fourth place, they will call for a large public debt and taxes, and these things especially tend to make men unequal, because any social burdens bear more heavily on the weak than on the strong, and so make the weak weaker and the strong stronger. ("Conquest of the United States by Spain.")

And it has not been different here in Southeast Asia, Joe Studwell writes, (as I earlier quoted here)

Centralized governments that under-regulate competition (in the sense of failing to ensure its presence) and over-regulate market access (through restrictive licensing and non-competitive tendering) guarantee that merchant capitalists-or asset trader, to use a more pejorative term-will rise to the top by arbitraging economic inefficiencies created by politicians. The trend is reinforced in South-east Asia by the widespread presence of what could be called as ‘manipulated democracy’, either in the guise of predetermined winner democracy (Singapore, Malaysia, Suharto’s Indonesia) or else in the scenario where business interest gain so close a control of the political system that they are unaffected by the changes of government that do occur (as in Thailand and the Philippines). In both instances politicians spend huge sums to maintain a grip on power that has some semblance of legitimacy. This can only be financed by through direct political ownership of big business or more usually, contributions from nominally independent big business that is beholden to politicians. Whichever, the mechanism creates a not entirely unhappy dependence of elites between politicians and tycoons.”

If Confucius once said that ‘give the man a fish you feed him for the day, teach him to fish and you feed him the rest of his life’.

From a political standpoint, libertarians and classical liberals advocates on the method that teaches the man how to fish, so as to make him productive to the society.

Whereas for statists, who along with politicians, will naively insist on feeding the man for the day (moment), by picking on someone else's pocket, supported by a legalized coercive framework that are enabled or facilitated by a politically constructed paper money system, which from the account of the entire history of man’s attempt to produce political nirvana has always failed.

Yet such accounts for exactly the Anatomy of Plutocracy.

Any political economic order which depends on political privileges or distribution of resources—endowments, protectionism, subsidies, bailouts, behest loans, economic concessions et. al. represents NOT a laissez faire system but a political system known as STATE CAPITALISM or CORPORATISM or CRONY CAPITALISM. The important difference is that consumers in a laissez faire system represents as real power, whereas politicians signify as the most powerful agents in the state capitalist order.

In today’s setting, the cooptation of the banking cartel-military industrial complex-green industrial-government labor union-welfare state-central banking system (in the US or elsewhere) are representative of PLUTOCRACY IN ACTION!

As the great Milton Friedman said in this lecture,

A society that aims for equality before liberty will end up with neither equality nor liberty. And a society that aims first for liberty, will not end up with equality but will end up with a closer approach to equality.

Bottom line: Statism or government interventionism, which enables or sustains a political economic order of plutocracy, is what engenders social inequality. The more societies politically organize herself towards attaining social equality, the more inequality gets amplified.

Here, noble intentions and economic reality are separated.

The Crucial Role of Entrepreneurship To Economic Prosperity

The US Economic Report of the President acknowledges the crucial role played by entrepreneurship in wealth generation...

America’s small businesses are an essential building block to economic growth and prosperity, in part because entrepreneurs create a disproportionate share of net new jobs in the U.S. economy.

The report includes the following data. (bold highlights mine)

One particularly important contribution of small firms to the Nation’s well-being is the jobs they create. According to the SBA’s Office of Advocacy, small firms accounted for 9.8 million of the 15 million net new private sector jobs created between 1993 and 2009—nearly two out of every three of the period’s net new jobs. In normal times, new small businesses account disproportionately for employment growth. Although many new firms fail, surviving Supporting America’s Small Businesses | 145 firms create enough jobs to offset those lost to firm exits, so that most jobs created by firm births persist. A recent Kauffman Foundation study, for example, shows that startup firms created 3.1 million gross jobs in the United States in 2000. By 2005, about half of the initial firms had failed, but the survivors still employed 2.4 million people (Kane 2010).

(source Tim Kane, Growthology.org Kauffman The Foundation of Entrepreurship)

I am reminded of the great Ludwig von Mises who wrote,

In the capitalist system of society's economic organization the entrepreneurs determine the course of production. In the performance of this function they are unconditionally and totally subject to the sovereignty of the buying public, the consumers. If they fail to produce in the cheapest and best possible way those commodities which the consumers are asking for most urgently, they suffer losses and are finally eliminated from their entrepreneurial position. Other men who know better how to serve the consumers replace them.

Entrepreneurs, aside from the capitalists, are the heroes of the modern capitalist (market) economy.

Why The Philippine Phisix Will Climb The Global Wall Of Worries

``And this is the problem with just about every lame speech, every overlooked memo, every worthless bit of boilerplate foisted on the world: you write and write and talk and talk and bullet and bullet but no, you're not really saying anything...Most people work hard to find artful ways to say very little. Instead of polishing that turd, why not work harder to think of something remarkable or important to say in the first place?” Seth Godin, But you're not saying anything

In this issue:

Why The Philippine Phisix Will Climb The Global Wall Of Worries

-The Variable Influences Of Markets On Profits

-The Relative Effects Of Inflation To Prices And Real Returns

-Inflationism Via Deficit Spending

-The Austrian Business Cycle Applied To The Philippine Economy and Markets

-Conclusion And Short Term Outlook

IT should come as no surprise to the readers of this post that the Philippine equity benchmark, the Phisix, recently smashed its barriers to set a new 29 month high.

Simply put, this has been part of the long cycle, which we have been pointing out since 2008[1]. And not only that, we made the case that the recovery of 2009 would be anchored on today’s events[2]. Apparently the markets have been steadily validating our views.

The Variable Influences Of Markets On Profits

But what has come as a big surprise is that the recently established milestone seems to be in defiance of the prevailing doldrums seen in the global markets.

Although we have repeatedly been asserting that “decoupling” or divergences would be hard to realize (see figure 1), considering the deepening instances of globalization- in terms of trade and investment flows, labor and migration and importantly, synchronization of monetary policies - any outperformance would likely emanate from parallel, or at least, near parallel circumstances.

And where today’s markets have seen a trend towards the deepening of interrelationships, there will be little instances of disregard when local markets will be confronted by adversarial forces such as recessions from major economies, another bout of paroxysm in the global banking system and or a bear market from tightened money conditions. Here, divergences in the marketplace will hallmark exceptions, rather than the rule.

Figure 1: stockcharts.com: Tidal Flows Of Asian-US Markets

As one would note from the chart, Asian markets (ex-Japan and China) have basically exercised synchronized actions, where the motions of ebbs and flows seems to be uniform. The difference is in the extent or the degree of the surges and or the depths of the retracements. And since I can’t seem to adjust the chart on a year-to-date basis, I have instead presented this based on the available node.

Nevertheless, on a year-to-date basis, you’d be surprised to learn that emerging frontier stocks[3] have vastly outperformed the region.

Here is the pecking order of Asia’s best performers based on Bloomberg’s Asia-World Index[4] as of Friday’s close: Mongolia’s MSE Top 20 (49.32%), Bangladesh’s DSE Gen (36.76%), Sri Lanka’s Colombo All Share (28.61%), Indonesia’s JKSE (11.4%), Philippine Phisix (9.97%), Thailand’s SETI (5.02%), Pakistan’s Karachi (2.66%) and Malaysia’s KLSE (1.7%). All the rest of MAJOR Asian markets are in red led by China’s Shanghai Index (-22%).

The outlier gains can be categorized into 2 classes: Frontier South Asian markets and emerging Asia or ASEAN markets.

As a reminder, I am categorically NOT saying that decoupling can’t or won’t ever occur; that would seem like anchoring too much onto current developments. As the ubiquitous axiom goes, ‘Past performance may not guarantee future outcome’ or whatever we see today may or may not be tomorrow’s dynamics or trends. Hence interpreting today’s market activities linearly and discounting randomness is likely to be highly flawed (this should apply to perma bears).

What I am saying is that decoupling may not be ripe yet. As evidences lucidly demonstrate developed Asian markets have had tight correlations with the S&P 500, except for frontier markets and partly developing Asia.

Thereby unless we see deepening signs of “divergences” it would seem foolhardy and reckless for anyone or for any experts to allege for a “decoupling”.

Yet in a world of relative returns, where asset classes ALL compete for your or everyone else’s “scarce” money and where globalization has naturally defined boundaries, theoretically, real returns should be distinct for every country.

Globalization has its natural limits predicated on the idiosyncrasies inherent in each nation such as cultural preferences, political economic structure, political trends, degree of economic freedom, depth and sophistication of markets, demographic trends, breadth of education, quality and quantity of, as well as, access to labor, tax, regulatory and legal framework, security, maturity and effectiveness of social institutions, level of infrastructure development and many more.

And such disparateness account for as “false prices” that convey profit opportunities for entrepreneurs. Since “false prices”, according to Israel M. Kirzner[5] ``reflect the decisions of entrepreneurs who have not yet understood the correct implications of consumer preferences (present or future) for the relative values of resources today. The way in which entrepreneurial activity tends to correct such false prices is through their realization of the profit possibilities inherent in such false prices.” (bold emphasis added)

In genuinely free markets, the profit gaps tend to converge or disappear, as Ludwig von Mises wrote[6], ``If all entrepreneurs were to anticipate correctly the future state of the market, there would be neither profits nor losses. The prices of all the factors of production would already today be fully adjusted to tomorrow's prices of the products.” (bold emphasis added)

So while the proclivity of free markets has been to converge or narrow the differentials in entrepreneurial profits or as seen on real returns, the inherent obstacles to free markets function as divergent profit windows for opportunities which serve to distinguish the level of real returns.

And the variability in the performances of frontier and emerging markets vis-a-vis developed economies appear to be highly demonstrative of this phenomenon.

Since developed Asian economies have been more integrated with Western economies, the returns exhibit close correlations with the latter as compared to the less integrated economies as seen in emerging Asia and the Asian frontier markets.

The Relative Effects Of Inflation To Prices And Real Returns

Well globalization isn’t limited to only trade, finance or labor, but similarly to market’s response to the conduct of monetary policies as well (see figure 2).

Figure 2: MoneyWeekAsia[7] and ADB[8]: Annualized Total Return On Equity and Policy Rates

Yet it’s fundamentally naive to argue that markets solely reflect on the real returns from the real economy in a world of central banking or outside of politics.

As we have shown in the past, in 2007, the components of total nominal returns for the major US bellwether the S&P 500 can broken down into: 20.9% capital growth, 53.8% dividends and 25.29% inflation.

I wrote then[9],

``Notice that inflation had been a factor only since the US Federal Reserve was born in 1913. Prior to 1913, equity returns had been purely dividends and capital growth.

``And further notice that the share of inflation relative to total returns has rapidly accelerated since President Nixon ended the Bretton Woods standard by closing the gold window in August 1971 otherwise known as the Nixon Shock.

``To add, the share of inflation has virtually eclipsed the growth in real capital!!!”

And over the years, inflation as a share of equity returns has indeed been ballooning. Therefore to ignore the influence of inflation is to patently misread the markets, since inflation has been the fastest growing segment in the relative total real returns on equity markets.

And this hasn’t been a US phenomenon but a global phenomenon.

The chart in the left window of figure 3 illustrates of the contribution of inflation to the relative real returns on major global equity markets while the right window reveals of how Asian authorities responded by jointly slashing policy interest rates.

From 1900-2009, inflation composed over 50% of the annualized total returns on equity assets in Italy, Japan, Denmark and Finland, while the rest of the markets accounted for over 25%, this includes the US, except for Switzerland (CH).

Yet the mainstream misinterprets inflation as either having little effects on the real economy or having insignificant impact to earnings. This is patently false.

First of all, inflation is always political. It involves the redistribution of resources which stem from political preferences by the political instead of the consumer demands, and consequently creates favoured sectors or classes.

According to Henry Hazlitt[10], (bold emphasis mine)

``Inflation, in brief, essentially involves a redistribution of real incomes. Those who benefit by it do so, and must do so, at the expense of others. The total losses through inflation offset the total gains. This creates class or group divisions, in which the victims resent the profiteers from inflation, and in which even the moderate gainers from inflation envy the bigger gainers. There is general recognition that the new distribution of income and wealth that goes on during an inflation is not the result of merit, effort, or productiveness, but of luck, speculation, or political favoritism. It was in the tremendous German inflation of 1923 that the seeds of Nazism were sown.”

Next, the impact of inflation isn’t absolute both in terms of degree and in time scale. Instead, the effects of inflation have always been relative or dissimilar.

In other words, since inflation is a redistributive political process, groups that directly benefits from government redistribution programs are bestowed with the privilege of acquiring goods and services from yesterday’s “cheaper” prices by bidding up resources which forces up prices at the expense of those that don’t benefit from such programs.

Again Henry Hazlitt[11], (bold highlights mine)

``Inflation never affects everybody simultaneously and equally. It begins at a specific point, with a specific group. When the government puts more money into circulation, it may do so by paying defense contractors, or by increasing subsidies to farmers or social security benefits to special groups. The incomes of those who receive this money go up first. Those who begin spending the money first buy at the old level of prices. But their additional buying begins to force up prices. Those whose money incomes have not been raised are forced to pay higher prices than before; the purchasing power of their incomes has been reduced. Eventually, through the play of economic forces, their own money-incomes may be increased. But if these incomes are increased either less or later than the average prices of what they buy, they will never fully make up the loss they suffered from the inflation”

And in contrast to mainstream expectations, inflation does not impact every aspects of society at the simultaneously.

More from Henry Hazlitt[12], (bold highlights mine)

“What we commonly find, in going through the histories of substantial or prolonged inflations in various countries, is that, in the early stages, prices rise by less than the increase in the quantity of money; that in the middle stages they may rise in rough proportion to the increase in the quantity of money (after making due allowance for changes that may also occur in the supply of goods); but that, when an inflation has been prolonged beyond a certain point, or has shown signs of acceleration, prices rise by more than the increase in the quantity of money. Putting the matter another way, the value of the monetary unit, at the beginning of an inflation, commonly does not fall by as much as the increase in the quantity of money, whereas, in the late stage of inflation, the value of the monetary unit falls much faster than the increase in the quantity of money. As a result, the larger supply of money actually has a smaller total purchasing power than the previous lower supply of money. There are, therefore, paradoxically, complaints of a "shortage of money."

This uneven distributional dynamics of inflation as exhibited through the variable changes in pricing mechanism is mainly due to psychological factors based on the expectations ``concerning the future quantity as well as the future quality.”

In other words, the direction of political developments ultimately shapes social psychology which impacts inflation in the mainstream economic sense.

And this is why despite mainstream’s tautology about deflation, whether in Greece[13] or in Hungary[14] or the US[15], political economic events have been manifesting signs of emerging stagflation rather than Fisherian paradigm of debt deflation.

Inflationism Via Deficit Spending

And how has inflation been transmitted into equity assets?

We see such transmission in two major ways, one is deficit spending and the other is artificially suppressed interest rates.

Figure 3 Asian Development Bank: Fiscal Balance[16] and Yield Spread[17]

While most of the deficit spending has been attributable to infrastructure projects, perhaps some of them may have surfaced through the recently held elections, wherein part of these funds could have ended up in the local equity markets.

In the Philippine Stock Exchange, among the sectoral indices, it is the Holding index which has posted the most significant increase (up 40.49%) as of Friday’s close on a year-to-date basis, whereas the Phisix is up only by 9.97%.

And many of the component issues in the index are involved in infrastructure directly or indirectly, e.g. Aboitiz Equity Ventures (+122%), Ayala Corp (+7.44%), SM Investments (27.69%), DMC Holdings (72.68%), JG Summit (134.82%), Benpres Holdings (8.57%) and Metro Pacific (11.54%).

Nevertheless, for a local expert[18] to predict for an economic slump arising from the slack in deficit spending signifies as sheer nutcase. If printing money has been the solution to all social problems then people need NO reason to work, save and invest and Zimbabwe would have been the most prosperous in the world.

Yet such presumptuousness exhibits Kip’s Law where “Every advocate of central planning always — always — envisions himself as the central planner” and is symptomatic of the arrogance of omniscience. Friedrich A. Hayek demeans such haughtiness as “Fatal Conceit”, where he says, ``The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design”

I find Hayek comments almost accurate, as most high profile liberals, seen in media foreign or local, can’t even predict the markets accurately or has used “fear” or “pessimism” to argue for more interventionism and inflationism in order to uphold their personal or their corporate interests.

The same holds true for bureaucrats, most of them can’t prosper through markets and instead opted to use pretentious expertise to get employed in governments and have their personal interests bankrolled by taxpayers, all in the name of public service.

The Austrian Business Cycle Applied To The Philippine Economy and Markets

Going back to the second channel where inflationism appears to be taking place is in the suppressed level of interest rate.

An artificially lowered interest rate regime is a policy that punishes savers and creditors in favour of debtors. Low interest rates essentially fuels boom bust cycles. By engendering false signals through makeshift appearance of a deluge of savings, artificially suppressed rates entices businessmen to undertake long range investments, but which are not aligned with consumer preferences. Hence, such undertaking would account for as “malinvestments”.

Under free markets conditions, where rates are determined by consumer preferences, such projects won’t emerge since they won’t be viable.

And such malinvestments would run in conflict with the consumers who would use false signals from low interest rates to expand consumption.

And the ensuing collision between short term oriented consumer preferences and long term investments leads to a race to consume resources which eventually results to higher prices, higher interest rates and an eventual bust.

Thomas E. Woods Jr. observed of the typical Austrian Business Cycle in the “Forgotten depression” of the 1920s[19], (bold highlights mine)

``When the market's freely established structure of interest rates is tampered with, this coordinating function is disrupted. Increased investment in higher-order stages of production is undertaken at a time when demand for consumer goods has not slackened. The time structure of production is distorted such that it no longer corresponds to the time pattern of consumer demand. Consumers are demanding goods in the present at a time when investment in future production is being disproportionately undertaken. Thus, when lower interest rates are the result of central bank policy rather than genuine saving, no letup in consumer demand has taken place. (If anything, the lower rates make people even more likely to spend than before.) In this case, resources have not been released for use in the higher-order stages. The economy instead finds itself in a tug-of-war over resources between the higher- and lower-order stages of production. With resources unexpectedly scarce, the resulting rise in costs threatens the profitability of the higher-order projects. The central bank can artificially expand credit still further in order to bolster the higher-order stages' position in the tug of war, but it merely postpones the inevitable.”

Today, the artificially low interest rates in the region, has prompted the Philippines to account for the steepest yield curve (chart 3 right window). The Philippines has been followed by Indonesia in 2009 and by Hong Kong, India and Singapore in 2010.

A steep yield curve usually prompts for financial institutions to engage in maturity transformation where they “borrow short-lend or invest long” or the conversion of short term liabilities into long term assets[20].

And it is no coincident that Indonesia has outperformed the region followed by the Philippines in terms of today’s stock market performances while there have been ongoing concerns over brewing property bubble risks in Hong Kong[21] and Singapore[22].

Meanwhile, India has raised interest rates for the second time[23] along with China and Brazil as Indian authorities have been fretful of economic overheating as credit growth[24] has accelerated.

One very important distinction why credit response have been gaining traction in Asia compared to her contemporaries in developed economies has been due to numerous factors, which as we have previously mentioned[25], consists of “low systemic leverage, high savings rate, unimpaired banking system, current account surpluses, a trend towards deepening regionalization and integration with the world economy.”

In the Philippines, I have been receiving loan offers via text or via call center agents in countless times over a given week. This anecdotal evidence perhaps could be representative of the (yield curve) incentives guiding the domestic banking industry today.

Nevertheless, the impact of low interest rates have been almost clinically precise, according to how the Austrian Business cycle model should operate, credit growth is seen widespread, in domestic consumer loans[26] (+8%), automobile loans[27] (22.1%!), real estate loans[28] (+4.9%), credit card receivables[29] (+4%), the banking industry’s exposure to real estate[30] (+9%) and other consumer related loans[31] (+5.9%) have been variably higher on a year to date basis.

All these seem to exhibit incremental growth in long term investments (via housing or the property sector) and simultaneously an increase in consumer durable consumption via bank loans.

So credit growth alone seems more than enough to provide “traction” into the economic growth cycle which doesn’t merit more fiscal spending. Yet if a full blown bubble cycle occurs sometime in the future, where a bust is the endgame, the country will be out of ammunition to conduct policy based “automatic stabilizers” if government spending continues to swell today.

Let me further drive the point that one possible reason why the Phisix appear to be resilient is that the trend of foreign uptake has been diminishing.

In the recent past, I have demonstrated[32] how the share of foreign trade have diminished from more than 50% in (2003-2007) to about 30-40% today.

Yet in contrast to claims where foreign houses have been bullish and where foreign money are expected to balloon, the fact is, we seem to be seeing little participation from foreigners during this run (see figure 4), except for some occasions.

Figure 4: PSE: Year To Date Net Foreign Trade In (Thousands)

My guess is that foreign appetite for Philippine stocks will become apparent when the US dollar index starts to decline. And once foreign money comes in this will be a huge boost to the domestic market.

So streams of evidences suggest to us that locals have been very responsive to the monetary stimulus from an artificially low interest rate regime.

Of course the icing to the cake will always be psychology.

And people subliminally entranced by a low interest rate regime will always look for rationalization or resort to assorted cognitive biases to justify their actions, whether it is politics—“hallelujah a New incorruptible regime!!!” or through attractive valuations (see figure 5).

Figure 5: Money Week Asia[33] and ADB: P/Book Ratio (ex-Japan) and PER (Asia)

Experts may argue that low price to book ratio and modest Price Earnings Ratio for Asia would make her a buy.

The point is inflationism creates an illusion of prosperity by inflating asset bubbles in domestic market such as in the Philippines or in the Asian region, which eventually would exact toll on the society. The normative outcome of any bubble bust would be high rate of unemployment, output and capital losses, political turmoil, aside from a lowered standard of living via more incidences of poverty.

Yet many will be unaware of how these dynamics influence the real economy via market price signals and distortions in the economic structure.

On the sidelines I’d like to add that once the new Philippine President assumes office, my bet is that popularity ratings will decline as people’s “sanguine” expectations will be envisaged with political reality. However the rate of decline is something we can’t foretell.

We seem to be seeing this today in the US, and an even worst episode recently just took place in Japan, where Yukio Hatoyama[34] the former Prime Minister (PM), because of an astounding nine month collapse in popularity ratings, was forced out and had been replaced by newly elected Naoto Kan[35], who now serves as the 5^th PM in about three years!

None the less, declining popularity ratings of political leaders and stock market performances have had little correlations. Although, a seemingly attractive subject, this would make for a good discussion sometime in the future.

Conclusion And Short Term Outlook

Free markets tend to converge or merge real returns.

On the contrary, inherent obstacles to free markets serve as profit windows for entrepreneurs which prompt for “divergences” in real returns.

Such obstacles include monetary policies, which are innately inflationist or politically oriented. Thus the more inflationist a political economy is, in theory, the more “divergent” in real returns.

Yet unknown to many, inflation has continually been expanding its role in moulding real returns among risk assets, including the equity markets, across the world which ironically has been integrating via trade, investments, labor and even through coordinated monetary policies (which not only incorporates interest rates but also currency swaps[36]).

As such, inflationism and globalization have been two major but antipodal forces at work in today’s marketplace.

Hence, inflationism is being transmitted on a global scale which appears to fuse the performances of markets through tidal ebbs and flows.

So discussions over decoupling and recoupling could be construed as relative issues depending on the frame used based on these two major forces at work.

The Philippine Phisix has outperformed the market of late because local monetary policies seem to be quite effective in redirecting the public’s incentives towards absorbing more credit from an industry incented by a steepened yield curve, from an economic system with less systemic leverage and a financial system least affected by the previous global bust.

Figure 6: stockcharts.com: Divergence between The Phisix and the US S&P 500

Moreover, locals have assumed leadership in daily transactions in this cycle in contrast to the previous. And this seems likely a testament to a broad credit expansion dynamic taking place.

An outlier occurred last week where the Phisix, pole-vaulted even as US markets fell significantly last Tuesday (see figure 6-blue circle). The net result looked like a short-term decoupling!

We are not sure if such dynamic will hold as US markets sharply swooned last Friday and whose aftershocks are still to be felt and digested by the local and regional markets on the opening bell tomorrow, Monday.

My guess is that if the impact would be much less than the losses in the US, then the resilience would likely be sustained. Besides, it would seem natural for the Phisix to pause following two weeks of hefty turbocharged advances.

What’s more, I am not convinced that global markets are due to fall apart for reasons I explained last week[37] which needs no repetition.

Yet if there might be any particular major force behind the spate of weaknesses, it’s likely because the US Federal Reserve has been offloading both US mortgages over the past 3 weeks, along with some US long term treasuries (for this week only), which have been part of the recently closed “credit easing” /Quantitative Easing program.

Figure 7: Cleveland Federal Reserve: Credit Easing Tools

In short, the US markets could be reflecting the adjustments from the trial exit strategies being stealthily implemented by monetary officials, and sustained adverse actions in the markets are likely to prompt for them to desist, and at worst, reopen these defunct credit easing programmes.

The fact that markets have been fumbling to explain current losses (Greece, China, Goldman, US unemployment and now Hungary) could simply be signs of cognitive dissonance. This makes risks of a double dip recession and or risks of contagion from the Eurozone debt crisis not as significant, as seen by the perma bears.

Moreover, it would be misplaced to argue that current interest rates reflect on the natural rate[38] for the simple reason that whether the short end or the long end, as shown by the above table, central banks have been major influences in determining the yield curve.

Figure 8: Danske Bank: Credit Spreads[39] and Leading Indicators[40]

Finally, current market turmoil could also be indicative of a peaking of an overstretched growth momentum as seen in the OECD leading indicators (lower left window) and in the survey of new manufacturing orders in major economies (lower right window).

Again, despite the current string of market turmoil, we seem to be seeing little repetition of a severe credit squeeze similar to that of 2008 (upper windows) in major credit indicators.

Given all the above, the odds seem in favour of a sustained upside ascent for the Phisix at least until the end of the year, possibly in fulfilment of the loose monetary fuelled Presidential Honeymoon cycle which will likely be interspersed with retracements (like on Monday). And such weaknesses should serve as buying windows.

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[1] See Focusing On The Future: the Phisix and the Philippine Presidential Cycle

[2] See 2009: Phisix and Peso Will Advance!

[3] Frontier markets are a subset of emerging markets, where the difference compared with developed emerging markets lies in the liquidity market depth or market depth, market capitalization and lower correlation. See Wikipedia, Frontier Markets

[4] Bloomberg World Index, Asia

[5] Kirzner, Israel M. Reflections on the Misesian Legacy in Economics, Mises.org

[6] Mises, Ludwig von, Entrepreneurial Profit and Loss, Chapter 15 Section 8 Human Action

[7] MoneyWeekAsia, Why Asian currencies will keep going up Interest rates will have to rise in Asia

[8] Asian Development Bank, Capital Markets Monitor, May 2010

[9] See Worth Doing: Inflation Analytics Over Traditional Fundamentalism

[10] Hazlitt, Henry Hazlitt, What You Should Know About Inflation p.130

[11] Ibid

[12] Hazlitt, Henry The Velocity of Circulation

[13] See Is Greece Suffering From Deflation?

[14] See Is Hungary Suffering From Debt Deflation?

[15] See Where Is Deflation?

[16] Asian Development Bank, Bond Monitor March 2010

[17] Asian Development Bank, Capital Markets Monitor, May 2010

[18] Inquirer.net, RP economy headed for slump, says former national treasurer

[19] Woods, Jr. Thomas E., The Forgotten Depression of 1920

[20] Wikipedia.org, Financial Intermediary

[21] Marketwatch.com, Is Hong Kong ready for reverse property bubble?, February 28, 2010

[22] The Temaske Review When will Singapore’s public housing bubble burst?, February 28, 2010

[23] Investors.com, Money Policy Tightens In Brazil, India, China, June 1, 2010

[24] Business Standard, Bank credit up 18%; infra sector gets lion's share June 3, 2010

[25] See What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?

[26] Bangko Sentral ng Pilipinas, Consumer Loans Reach P417 Billion in First Quarter 2010, June 4,2010

[27] Bangko Sentral ng Pilipinas, Automobile Loans Up by 5.5 percent From Last Quarter, June 4,2010

[28] Bangko Sentral ng Pilipinas, Residential Real Estate Loans Up By 3.5 Percent From Last Quarter, June 4,2010

[29] Bangko Sentral ng Pilipinas, Credit Card Receivables Stand at P130.7 Billion in First Quarter of 2010, June 4,2010

[30] Bangko Sentral ng Pilipinas, Exposure to Real Estate Sector Up 1.8 Percent in 1st Quarter, June 4,2010

[31] Other CLs refer to loans granted to individuals to finance other personal and household needs such as purchase of household appliances, furniture and fixtures and/or to pay taxes, hospital and educational bills. Bangko Sentral ng Pilipinas, Other Consumer Loans Stand at P39.2 Billion in First Quarter 2010, June 4,2010

[32] See External Developments Are Prime Movers of Philippine Markets

[33] Money Week Asia, Why Asian currencies will keep going up Interest rates will have to rise in Asia

[34] See How Populist Leadership Goes Kaput: Japan Edition

[35] Reuters, Obama calls to congratulate Japan's PM-elect Kan, June 5, 2010

[36] Businessweek, South Korea Urges Central Bank Currency-Swap System, May 30, 2010

[37] See Why The Current Market Volatility Does Not Imply A Repeat Of 2008

[38] See Does The Yield Curve Reflect On The Natural Rate Of Interest?

[39] Danske Bank, Weekly Credit Update, June 4, 2010

[40] Danske Bank, Global: Business Cycle Monitor, June 2, 2010