Why Free Lunch Policies Sells

Free lunch programs are usually best sellers. Why? Because interest groups benefit from it.

In the case of the US, according to mint.com, 47% have ZERO income tax liability in 2009 while 27% will shoulder the burden for the redistribution.

While it is easy to see the numbers and think about noble goals, what is usually missed is that taxes have been punishing the most productive economic agents whom contributes to the gist of the nation's economic growth...to the benefit of the non-productive actors.

Such redistribution leaves a big segment of the population dependent on welfare and vulnerable to scheming political actors.


As Dr Richard Ebeling recently wrote,

``a number of economists, such as Nobel Laureate, James Buchanan, have taught us that the actual politics of government intervention and redistribution has little to do with high-minded notions concerning some hypothetical "public good" or "general interest." The reality of democratic politics is that politicians want campaign contributions and votes to be elected and reelected, and they offer in exchange other people's money. Those who supply those campaign contributions and votes want the money of those others, which they are not able to honestly earn through the free play of open competition in the market place.

``The bias in the democratic process toward political plunder is due to what is called a “concentration of benefits and a diffusion of burdens” that results from various government interventions.

Daniel Mitchell: The Case Against Big Government

From Daniel Mitchell of Cato.org

Cartoon of the Day: Government Can Fix...., BUT...!

The self-contradictions of US President Obama's Policies in a lampoon...

Great stuff from Michael Ramirez [HT: Mark Perry]

The Myths of Deregulation and Lack of Regulation As Causal Factors To The Financial Crisis

Professor Arnold Kling, former economist on the staff of the board of governors of the Federal Reserve System and also a former senior economist at Freddie Mac and presently a co-host of the popular EconoLog has an eloquent and impressive article refuting the popular myths peddled by liberal-progressives at the American.com, entitled Regulation and the Financial Crisis: Myths and Realities

His intro: (italics mine)

``The role of regulatory policy in the financial crisis is sometimes presented in simplistic and misleading ways. This essay will address the following myths and misconceptions

Myth 1: Banking regulators were in the dark as new financial instruments reshaped the financial industry.

Myth 2: Deregulation allowed the market to adopt risky practices, such as using agency ratings of mortgage securities.

Myth 3: Policy makers relied too much on market discipline to regulate financial risk taking

Myth 4: The financial crisis was primarily a short-term panic.

Myth 5: The only way to prevent this crisis would have been to have more vigorous regulation.

``The rest of this essay spells out these misconceptions. In each case, there is a contrast between the myth and reality."

In short, such misplaced arguments attempt to deflect on the culpability of the role of policymakers and their interventionists policies in shaping the financial crisis and instead pin the blame on "market failure" as justification for more government intervention.

Read the rest here

Professor Kling's conclusion:

``The biggest myth is that regulation is a one-dimensional problem, in which the choice is either “more” or “less.” From this myth, the only reasonable inference following the financial crisis is that we need to move the dial from “less” to “more.”

``The reality is that financial regulation is a complex problem. Indeed, many regulatory policies were major contributors to the crisis. To proceed ahead without examining or questioning past policies, particularly in the areas of housing and bank capital regulation, would preclude learning the lessons of history."

Yes, oversimplification of highly complex problems can lead to more prospective troubles than function as preventive or cure to the disease, especially when myopic prescriptions ignore the human behavior dynamics in the face of regulatory circumstances.

As David Altig, senior vice president and research director at the Atlanta Fed wrote in Markets work, even when they don’t, ``Markets are, everywhere and always, one step (or more) ahead of regulators"

Gold As Our Seasonal Barometer

``If our present inflation, as seems likely, continues and accelerates, and if the future purchasing power of the paper dollar becomes less and less predictable, it also seems probable that gold will be more and more widely used as a medium of exchange. If this happens, there will then arise a dual system of prices — prices expressed in paper dollars and prices expressed in a weight of gold. And the latter may finally supplant the former. This will be all the more likely if private individuals or banks are legally allowed to mint gold coins and to issue gold certificates.” Henry Hazlitt (1894–1993) Gold versus Fractional Reserves

I wouldn’t be in denial that seasonal factors could weigh on asset pricing as we mentioned last week.

This Ain’t 2008

But many analysts seem to have taken a rear view mirror (anchoring) of the seasonal factors on the possible performances of the global stock markets.

Given the fresh traumatic experience from the 2008 meltdown, it is understandable that many have written words of caution about navigating the turbulent periods of September and October.

But unless we are going to see another seizure in the banking system, the 2008 episode seems unlikely to be the appropriate model.

True, we could see some heightened volatility, as a result of the variable fluxes in inflation (as in the recent case of China).

But for us, the focus should be on how the US dollar index would be responding to the stickiness of inflation on the financial markets in the current environment, instead of one dimensionally looking at the stock markets vis-à-vis the seasonal forces.

In my view, gold’s strong performance during this period could be a fitting a precursor see figure 3.

Figure 3: Uncommon Wisdom/Sean Brodrick: Entering Gold’s Seasonal Strengths

If gold functions its traditional role as the archrival or nemesis to paper money, then simplistically a weaker dollar should translate to higher gold prices.

In Four Reasons Why ‘Fear’ In Gold Prices Is A Fallacy we pointed out that one of the major reasons why the mainstream has been wrong in attributing “fear” in gold prices was because of the massive distortions by governments in almost every market.

Hence, gold or the oil markets, which represents as the major benchmarks to commodity indices, hasn’t been on free markets to reflect on pricing efficiency enough to attribute fear.

Instead, over the short term, government interventions working through different channels such as the signaling, an example would be the previous announcements of IMF gold sales [which eventually got discounted], or other forms of direct or indirect manipulation, has been used as a stick to control gold prices.

This, plus the seasonal weakness has indeed brought gold prices to a tight trading range, instead of collapse as predicted by the mainstream, thereby validating our thesis and utterly disproving the “fear” thesis.

Nevertheless, governments appear to have retreated from selling their reserves under the Central Bank Gold agreement which expires on September. Central Bank’s selling during the first 6 months of the year are down 73% at 39 tonnes (commodityonline). Although as the calendar year closes, central bank selling could step up, but this would likely be met by the seasonal strength and won’

Investment Taking Over Traditional Demand

Also, as we also pointed out in February’s Do Governments View Rising Gold Prices As An Ally Against Deflation?, the dynamics of gold pricing has rightly been changing.

Then we said, ``The implication of which is a shift in the public’s outlook of gold as merely a “commodity” (jewelry, and industrial usage) towards gold’s restitution as “store of value” function or as “money”. The greater the investment demand, the stronger the bullmarket for gold.” (see Figure 4)

Figure 4: World Gold Council: Investment Leads Gold Demand

It would seem like another vindication for us, this from the Financial Times, (bold emphasis ours)

``Total identifiable gold demand, at 719.5 tonnes in the second quarter, was down 8.6 per cent compared with same period in 2008, with jewellery consumption down 22 per cent to 404.1 tonnes.

``Investment demand, which includes buying of bars and coins as well as inflows into exchange-traded funds, reached 222.4 tonnes in the second quarter, a rise of 46.4 per cent from the same period a year ago.

``However, the second quarter was the weakest three-month period for investment demand since before the implosion of Lehman Brothers in September 2008…

``Mr Shishmanian [Aram Shishmanian, chief executive of the World Gold Council-my comment] said that although total demand had failed to match the exceptional levels seen when the economic and financial crisis was at its peak, investment demand had enjoyed a strong quarter, underlining a growing recognition of gold as an important and independent asset class.”

In short, yes, investment demand has materially been taking over the dominant role in gold demand over jewelry and industry and will continue to do so as global central banks inflate the system.

China’s Role And The Reservation Price Model

Moreover, China’s government recently loosened up on its investment rules for gold and silver and even encourages the public to participate [see China Opens Silver Bullion For Investment To Public].

On a gold [in ounces] per capita basis, China has only .028 ounces of gold for every citizen, against the US which has .9436 ounces of gold in its reserves for every Americans (Gold World). That’s alot of gold for the Chinese with its huge savings and humongous foreign currency reserves to buy. And that’s equally alot of room for gold prices to move up.

This means that if the inflation process will continue to be reflected on the financial asset prices, then the likelihood is that gold will pick up much steam going to the yearend on deepening investment demand from global investors, perhaps more from Asia and augmented by the seasonal strength.

Moreover, gold will likely serve as a better barometer for the liquidity driven stock markets, in spite intermittent volatility, than from traditional seasonal forces.

Finally, Mises Institute’s Robert Blumen gives a good account of why evaluating the price dynamics of gold shouldn’t be from the conventional consumption model but from reservation prices model.

Since gold prices are not consumed by destruction and where above ground supply remains after being processed or used, the ``owners of the existing stocks own much more of the commodity than the producers bring to market.”

Hence to quote Mr. Blumen, ``The offered price of each ounce is distinct from that of each other ounce, because each gold owner has a minimum selling price, or "reservation price," for each one of their ounces. The demand for gold comes from holders of fiat money who demand gold by offering some quantity of money for it. In the same way that every ounce of gold is for sale at some price, every dollar would be sold if a sufficient volume of goods were offered in exchange.”

Read the rest here.

Government Intervention Equals Soaring Sugar Prices

In our earlier post Food Crisis Watch: Sugar On Fire- Writing On The Wall? we attributed the current runaway prices in world sugar partly to adverse weather (in India) which has affected supply, growing world demand, and most importantly, the unintended effects from government policies (e.g. export bans).

The Wall Street Journal gives a US perspective on the current sugar pricing dynamics... (all bold highlights mine-our comment below)

``Some of America's biggest food companies say the U.S. could "virtually run out of sugar" if the Obama administration doesn't ease import restrictions amid soaring prices for the key commodity.

``In a letter to Agriculture Secretary Thomas Vilsack, the big brands -- including Kraft Foods Inc., General Mills Inc., Hershey Co. and Mars Inc. -- bluntly raised the prospect of a severe shortage of sugar used in chocolate bars, breakfast cereal, cookies, chewing gum and thousands of other products.

``The companies threatened to jack up consumer prices and lay off workers if the Agriculture Department doesn't allow them to import more tariff-free sugar. Current import quotas limit the amount of tariff-free sugar the food companies can import in a given year, except from Mexico, suppressing supplies from major producers such as Brazil.

``While agricultural economists scoff at the notion of an America bereft of sugar, the food companies warn in their letter to Mr. Vilsack that, without freer access to cheaper imported sugar, "consumers will pay higher prices, food manufacturing jobs will be at risk and trading patterns will be distorted."

``Officials of many food companies -- several of which are enjoying rising profits this year despite the recession -- declined to comment on how much they might raise prices if they don't get their way in Washington.

``The letter is the latest salvo fired in a long-simmering dispute between U.S. food companies and the sugar industry over federal policy that artificially inflates the domestic price of U.S.-produced sugar in order to support the incomes of politically savvy sugar-beet farmers on the Northern Plains and cane-sugar farmers in the South. Most years, the price food companies pay for U.S. sugar is twice the world level.

``Ron Lucchesi, head of procurement for Gonnella Frozen Products in Chicago, which signed the letter, said current U.S. sugar policy distorts pricing. Though sugar accounts for only 0.5% of total costs at Gonnella, soaring sugar prices are "part of the equation" that already has led the company to raise prices for kaiser rolls, hamburgers and hot dogs, all of which include sugar.

``The issue is coming to a boil again because sugar prices, both in the U.S. and globally, have soared to unusually high levels for more than a year and show little sign of easing any time soon. Prices of sugar futures contracts have risen 95% so far this year, hitting a 28-year high in recent days. On Wednesday, raw-sugar futures jumped 4.8% to 22.97 cents a pound at the Intercontinental Exchange.

``Prices are up because the world is consuming more sugar than farmers are producing. One big factor: The world's largest sugar producer, Brazil, is diverting huge amounts of its cane crop to making ethanol fuel. Likewise, the food industry has complained bitterly in recent years about the U.S. ethanol industry's ravenous appetite for corn, which helped push up prices for that key ingredient too.

``More than half of Brazil's sugar-cane crop is processed into ethanol while about one-third of the U.S. corn crop is made into the alternative fuel. An erratic monsoon season in India also has led sugar analysts to reduce their production forecasts for the world's second-largest sugar producer.

``At the same time, U.S. sugar supplies are tight. In its monthly report on global farm markets released Wednesday, the Agriculture Department said it expects U.S. sugar supplies by September 2010 to drop 43% from this fall."

Some insights from the article:

-Import quotas limits sugar imports (hence limit supply)

-Import quotas signify as subsidy to the sugar industry.

-Limited supply against greater demand equals high prices.

-Consumers ultimately pay for higher prices from which the sugar industry benefits.

Hence subsidy is a form of taxation where to quote Murray Rothbard, ``Subsidy has always meant that one set of people has been taxed and the funds transferred to another group: that Peter has been taxed to pay Paul."

Ergo, consumers are taxed and the funds/rent go to the sugar industry.

-Moreover, ethanol "clean air" mandates (another set of subsidies) have been shifting the supply and demand patterns as agri feedstocks (US corn and Brazil's sugar) for biofuel based energy now compete with food.

-End result: shortages and skyrocketing prices. In short, runaway sugar prices is a prologue to similar patterns in agricultural produce.

Lesson: To quote Milton Friedman ``If you put the federal government in charge of the Sahara Desert, in 5 years there'd be a shortage of sand!”

Warren Buffett: From Value Investor To Political Entrepreneur?

Warren Buffett has been widely known for his VALUE investing approach, largely influenced by his mentor Ben Graham.

But, lately our icon's political liberal leaning views, wherein he strongly supports government intervention in markets, appears to have similarly exposed a shift in his investing strategy, where Mr. Buffett's model appears to have evolved into investing under "government umbrella" or capitalizing on opportunities provided by the recent government sponsored bailouts.

In short, the reason he supports government intervention has been because he and his Berkshire Hathaway directly benefits from these.

Here is an excerpt from the splendid article from Reuter's Rolf Winkler, (all bold highlights mine)

``Today, Buffett remains famous for investing The Right Way. He even has a television cartoon in the works, which will groom the next generation of acolytes.

``But it turns out much of the story is fiction. A good chunk of his fortune is dependent on taxpayer largess. Were it not for government bailouts, for which Buffett lobbied hard, many of his company’s stock holdings would have been wiped out.

``Berkshire Hathaway, in which Buffett owns 27 percent, according to a recent proxy filing, has more than $26 billion invested in eight financial companies that have received bailout money. The TARP at one point had nearly $100 billion invested in these companies and, according to new data released by Thomson Reuters, FDIC backs more than $130 billion of their debt.

``To put that in perspective, 75 percent of the debt these companies have issued since late November has come with a federal guarantee...

``He even traded the bailout, seeking morally hazardous profits in preferred stock and warrants of Goldman and GE because he had “confidence in Congress to do the right thing” — to rescue shareholders in too-big-to-fail financials from the losses that were rightfully theirs to absorb...

More of the rest of Buffett's conflict of interest here.

Nonetheless Mr. Winkler, apparently dismayed with the clash in the purist market based imagery against Mr. Buffett's actual practice, concludes, ``What saddens me is that Buffett is uniquely positioned to lobby for better public policy, but he’s chosen to spend his considerable political capital protecting his own holdings."

``If we learn one lesson from this episode, it’s that banks should carry substantially more capital than may be necessary. You would think Buffett would agree. He has always emphasized investing with a “margin of safety” — so why shouldn’t banks lend with one?"

So what do you call entrepreneurs who profit from government intervention?

According to Wikipedia.org, `` a business entrepreneur who seeks to gain profit through subsidies, protectionism, government contracts, or other such favorable arrangements with government(s) through political influence (also known as corporate welfare)" is known as a political entrepreneur.

And an economy that thrives on political entrepreneurship is also pejoratively known as "crony capitalism"-an allegedly capitalist economy in which success in business depends on close relationships between businesspeople and government officials. It may be exhibited by favoritism in the distribution of legal permits, government grants, special tax breaks, and so forth (wikipedia.org).

And I mistakenly thought that political entrepreneurship only existed in "banana republics" characterized by mostly autocratic rulers (or even manipulated democracies) under unfree economies.

Has the political economy changed so much that has compelled our icon to shift strategies?

Or has Mr. Buffett's performance been a chronic "mythologizing a humble background"- typical of tycoons as Joe Studwell in Asian Godfathers observed-where reputation and reality do not match?

The Inflation Cycle Accelerates; Asia As Chief Beneficiary

``Neither China nor the US can morph into more balanced economies overnight, and China can't tolerate a sharp RMB appreciation to speed up the process. So the adjustment scenario will be disappointing, involving slower US demand and Chinese export growth. And higher US rates will be a vehicle to reinforce that outcome. In fact, the ‘impossible trinity' may be hitting Asia in reverse. An Asian rebound would normally induce capital inflows, rising asset values, a stronger currency and a tighter policy. But no one wants currency strength, and it is too soon to tighten. So, the authorities can and will intervene in FX markets and will probably tolerate too-loose liquidity and rising asset prices. As global investors seek higher returns outside US markets, the accompanying decline in risk-aversion probably won't be good, either for the dollar or for US Treasuries.”-Richard Berner, Morgan Stanley, Challenges to Rebalancing the US Economy

US dollar bulls and deflation advocates wildly gloated over China’s 7% collapse in its stock market but closed down 5% last Wednesday.

One even paraded the prediction made by a team of quants [as we earlier featured in China In A Bubble, ASEAN Next Leg Up?] as rationalization for such activities.

What was thought to be an important inflection point, eventually turned out to be a short term “tryst” as China’s stock market robustly recovered and nearly expunged the losses going into the last 2 sessions of the week.

And this was met with a deafening silence from the US dollar bulls.

Figure 2: Asianbondsonline: China’s yield curve remains steep

As we earlier said we won’t bet on the ridiculous notion that bubbles would pop so soon because, as we wrote from our earlier article, ``bubbles normally take time to reach a climax. For instance, the US real estate bubble ballooned from 2002-2006, while global stock markets inflated from 2003-2007. True, today’s China bubble could risk being pricked hastily or abruptly, but in my view, this may seem too early.”

``It’s because normal bubble cycles need sustained massive infusions (we seem to be seeing the first phase) and the vast concentrations or clustering of resource misallocations that could either become huge enough to be extremely sensitive to interest rate hikes or would require continued exponential amplification of credit to maintain present price levels or a pyramiding dynamics…until the structure in itself can’t be sustained (usually interest rates from market or policy induced does the trick).”

If we look at the China’s yield curve (see figure 2), the persistent steepness signifies as continued ultra loose monetary landscape thereby potentially posing as additional fuel for more stock market conflagration to the upside.

Although of course, since no trend goes in a straight line, the clashing combination of severely overbought conditions and price “stickiness” from the power of monetary policies could translate into sharp volatility.

But then again, the bubble cycles can stretch much further than anyone can expect them to. As mainstream’s most favorite icon, John Maynard Keynes used to say, “the markets can remain irrational far longer than you and I can remain solvent”.

Speculation Or Eroding Store Of Value?

China’s bubble isn’t confined to China.

Most emerging and Asian markets including the Philippine Phisix have now exhibited manifestations of bubble like circumstances.

Even the conditions of the US markets appear emit the same signals. Commodities are likewise manifesting bubble symptoms.

Yet all of these appear to be in response to the trajectory of the US dollar index, which as of Friday’s close appear to be at the verge of breaking both the critical support levels etched in December 2008 and June 2009, as shown last week.

The implication of a breakdown of the US dollar index is that it could further reaccelerate the “speculative” frenzy as “stickiness” from policy induced inflation appears to be accelerating.

The obverse perspective from that of speculation is the question of the state of paper money’s store of value.

Business Cycles and Speculative Errors

Curiously too, it would seem bizarre how policymakers have been drudging and debating over identifying and controlling bubbles, when bubbles are the direct and indirect consequences of their policies and seem to be popping all over like mushrooms in a field.

Haven’t you noticed, as global central banks simultaneously coordinated a zero rate bound approach with some apply quantitative “money printing” easing (QE) measures combined with massive fiscal stimulus programs, the apparent consequence has been rising stocks and commodities?

Of course, suggestions that today’s risks may pose as something like a ‘car accident’ operate from the perspective of randomness, where “animal spirits” which have gone berserk would suddenly stop for unexplained reasons.

For us, while random shocks may indeed occur, the significant part of such observation is the crucial misunderstanding of the speculative process of the policy induced business cycle.

As Jeremie T.A. Rostan fittingly explains,

``Speculative error can go on at no cost as long as that limit is not reached. In fact, there are two other limits. First, the rate of interest tends to rise to its real value, undermining the pseudoprofitability of the real assets underlying sensitive and risky assets. Thus, new credit has to be created constantly. Second, the injection of liquidity will have to be stopped at some point, or else hyperinflation will take place.”

Proof?

China has been warning its banks over the possibility of asset bubbles. And through fiat has directed ``banks to ensure unprecedented volumes of new loans are channelled into the real economy and not diverted into equity or real estate markets” reports the Financial Times.

When two banks reportedly responded to curb lending the result was Wednesday’s stock market crash.

This from Robert Flint of the Wall Street Journal (all bold highlights mine), ``On Tuesday, two of China's major lenders were quoted as saying they would sharply slow credit growth in the second half. This prompted fears of a sudden tightening of credit that could choke off the loans which have so far eased the effects of the world recession. Shanghai equity prices plunged as much as 7.7% at one point Wednesday and closed 5.0% down on the day.

``Later on Wednesday, the PBOC said it will emphasize market-based systems, rather than administrative controls, in guiding the appropriate growth of credit. PBOC Vice Governor Su Ning's comments appeared to signal the PBOC wasn't about to set loan curbs in the second half of this year to cool explosive lending growth, as it had done in 2008.

``Nevertheless, Mr. Su's comments were the most forceful yet from China's central bank in trying to talk down the lending spree put into motion by Beijing's massive stimulus program.”

So the Chinese government tried unsuccessfully to jawbone down the credit bacchanalia but the violent response from its credit addicted stock market, sent officials on an apparent U-turn.

Inflation Cycle and Price Controls

Has this been a surprise to us? The answer is NO.

We have been repeatedly saying all along that governments will persistently attempt to put a kibosh on the gamut of exploding surges of asset prices but the fear of recidivist recession or deflation will force them back into the same accommodative and expansionary stance.

That’s the legacy of government policy trends derived from the influences of central banking dogma.

And China’s official response has fallen precisely into the ambit of our expectations.

Moreover, policymakers are in a policy dilemma.

The appearance of short term gains from levitated asset prices has a reflexive feedback loop- it has successfully created the impression of an economic recovery, which subsequently has loosened up risk aversion thereby reducing demand for money but increasing the demand for holding assets.

Nevertheless these account for as footprints of inflation.

Policymakers are then on the hook to at least maintain present levels. Paradoxically, this requires even more credit creation.

As Ludwig von Mises wrote in Inflation and Price Controls (bold highlights mine),

``The problems the world must face today are those of runaway inflation. Such an inflation is always the outcome of a deliberate government policy. The government is on the one hand not prepared to restrict its expenditure. On the other hand it does not want to balance its budget by taxes levied or by loans from the public. It chooses inflation because it considers it as the minor evil. It goes on expanding credit and increasing the quantity of money in circulation because it does not see what the inevitable consequences of such a policy must be.”

And governments will attempt to conceal the adverse impact from their inflationary policies by diverting the public’s attention into scapegoating private enterprises and markets.

This extrapolates to the next measure-PRICE CONTROLS.

Again from Mr. von Mises from the same article, ``The real danger does not consist in what has happened already, but in the spurious doctrines from which these events have sprung. The superstition that it is possible for the government to eschew the inexorable consequences of inflation by price control is the main peril. For this doctrine diverts the public’s attention from the core of the problem. While the authorities are engaged in a useless fight against the attendant phenomena, only few people are attacking the source of the evil, the Treasury’s methods of providing for the enormous expenditures. While the bureaus make headlines with their activities, the statistical figures concerning the increase in the nation’s currency are relegated to an inconspicuous place in the newspapers’ financial pages.”

Evidence?

Each time oil prices went down during the last month they coincided with a barrage of fire from regulators whom have threatened to curb speculative trading (July 7, NYT) or impose additional regulations supposedly inspired from purported study that is due out soon, that pins the blame on speculators as “driving the wild swings in oil prices” (WSJ July 28)

Figure 3: Stockcharts.com: Oil Prices and Threats of Price controls

The blue arrows denotes of the dates where the threats of added scrutiny or imposition of price controls on oil trading had been broached.

Apparently, the efficacy of such government sponsored communication signals to rein the oil markets appears to be diminishing.

In addition, because of the fear of further reemergence of falling prices from short selling, new rules are being imposed (WSJ, July 28)

Since regulators such as David Altig, senior vice president and research director at the Atlanta Fed, concede that ``Markets are, everywhere and always, one step (or more) ahead of regulators”, this implies that stifling regulation will only cause market inefficiencies by the circumvention of the regulation by arbitraging on different but related markets or financial innovation.

To quote the WSJ, ``The [CME group] exchange's chief executive, Craig Donohue, said: "We are deeply concerned that inappropriate regulation of these markets will cause market participants to move to dark pools and other unregulated markets, causing irrevocable harm to the entire U.S. economy." Dark pools are private markets where large orders are transacted.” (bold highlight mine)

In effect, adamant denials of the culpability of government inflationary policies will only result to the aggravation of the problem and only heighten volatility risks.

Too bad regulators can’t seem to accept God’s natural laws of supply and demand as having more power than their bloated egos.

Asia: More Room For Bubble Blowing

Going back to Asia this very interesting chart from Nomura Securities (see figure 4). (HT: Fullermoney) appear to support the legs for a continued bubble blowing.

Figure 4: Nomura Securities: Asia & West At Opposite Poles

In Nomura’s Mixo Das and Paul Shulte chart, they project that Asia will likely outperform for the following reasons:

One. Low banking system leverage.

As per Nomura’s Mr. Das and Shulte, ``Asia has NO forced sale of assets, so it gets free reflation. Under-performance by Asia mutual/hedge funds, cash piles everywhere.”

Two. Deleveraging in bubble bust economies are likely to cause divergent flows in asset pricing trends with the East outperforming (aha! Decoupling is a myth!).

Three, Corporate tax increases in response to government programs to shore up national economies are likely to translate to higher relative shift in income that would benefit Asia and

Lastly, central bank balance sheets seem likely to favor Asia, as asset components are mainly on “safer” US treasuries compared to “toxic” or high risk assets for US or UK.

In short, yes, the bubble dynamics in Asia seem to have ample room to run based on sustained expansionary monetary policies coupled with conducive economic stories that should underpin the relative advantage of Asia vis-à-vis the West.

Risk Of Food Crisis Creeping Back?

In a recent article Whatever happened to the food crisis?, The Economist drudges anew over the enigma of conflicting developments: rising food prices in a recessionary environment.

Nonetheless like us they see the risks of a food crisis creeping back.

(bold emphasis mine)

``If this was happening during a boom, it might be understandable. But recession would normally dampen down price rises. So what explains the return of food-price inflation? And does it mean that the so-called world food crisis is returning?

``There are two clusters of explanation: cyclical factors—features of the farm cycle and world economy that fluctuate from season to season—and secular, long-term factors. Cyclical influences include re-stocking: cereal stocks were run down as prices spiked and need to be replenished. In 2006 and 2007, stocks fell below 450m tonnes, about 20% of consumption; now they are back up over 520m, or 23%. That is one source of new demand. Another comes from ethanol. As oil prices rise, ethanol starts to be competitive again (as a rule of thumb, ethanol is profitable when petrol costs $3 a gallon in America, a level it has just reached in California). The fall in the dollar and in freight rates has also kept the local-currency costs of importing a tonne of cereals lower than dollar-denominated world prices. This has encouraged many countries to buy more.

``Lastly, it is possible that the widespread hunger brought about by soaring prices—the FAO says a billion people will go hungry this year—may have reached a peak and the poor may be back in the market for grain again. This may sound unlikely, as traditionally poor consumers have had little influence over world food prices, but economic growth has continued in the largest emerging markets (notably China and India) and governments in much of the developing world have been expanding aid programmes for the poor, such as conditional cash-transfer schemes. That may be boosting demand; it would explain why prices of grain, which everyone eats, have been rising this year while prices of meat—the food of the rich and aspiring middle classes—have continued to fall."


My comment: So cyclical factors of restocking, rising oil prices (transmitted via the ethanol channel) and low prices could have contributed to a demand boost, although the Economist admits that government programs-such as aid expenditures could have also been key variables.

And as we have long mentioned inflationary policies impact prices relatively. It affects sectors that are the primary beneficiaries of government programs- in this case, aid spending which could have resulted to the disparities between meat and grain price trends.

However, sustained government fiscal spending is likely to cause a diffusion of increases consumer which means that even meat prices will likely increase over time.

The Economist adds some important secular trend dynamics,

``But the world food crisis of 2007-08 showed that food prices are not influenced solely, or even mainly, by cyclical factors. They soared in large part because of slow, irreversible trends: population growth; urbanisation; shifting appetites from grain to meat in developing countries. There is no sign that these trends are abating."

Finally, the Economist imputes regulatory and political obstacles as substantially distorting the marketplace.

``The failure of farmers in poor countries to respond to price signals does not mean they are deaf to them. Rather the signals they get are often scrambled or muted. Farmers were frequently not paid the full world price for their crops, because governments were determined to keep local prices low in order to relieve hard-pressed consumers. Some governments also banned food exports.

``Even in rich countries, farmers are responding to many things other than food markets. Take oil prices, for example: these (and government subsidies) determine how much maize is planted for ethanol. That in turn influences how much land is planted to soyabeans, which for American farmers are interchangeable with maize. Growers are also responding to the flow of investment capital into farming as a result of the global financial meltdown. Food is recession-resistant, and farming has been one of the sectors least affected by the worldwide slump. The FAO’s Abdolreza Abbassian argues that increasing links between farming and other parts of the economy are making it more difficult for farmers to calculate in advance the profitability of any one crop, so the area they plant is tending to fluctuate more sharply from year to year. Farming—as the past two years have clearly demonstrated—is becoming a more volatile business, both in terms of price and area planted."

``On the face of things, markets last year were adjusting exactly as economic theory predicts they should: prices rose, drawing investment into farms; supplies then rose sharply, pushing prices down. But that was not the whole story. The price fluctuations of 2007-09 suggested that uncertainty in the world of agriculture was deepening under the influence both of oil prices and capital flows. The fact that prices are still well above their 2006 average, even in a recession, suggests that the spike of 2008 did not signal a mere bubble—but rather, a genuine mismatch of supply and demand. And this year’s price increase suggests that there is a long way to go before that underlying mismatch is eventually addressed. “I don’t see that anything has fundamentally changed,” says Mr Abbassian. “That means we cannot go back to where we were in 2007.”

While the Economist alludes to capital flows as another variable in passing, it didn't dwell on the influence of global monetary policies -where zero bound interest rates and a loosened credit policy environment have sparked credit booms in emerging markets as China and may have added further pressures on the demand side.

At the end of the day, the growing risks of a food crisis all boils down to extensive government intervention that has deadened market price signals, and severely distorted the balance of supply and demand.

Aside, this could also possibly signify a flight to commodities or the crack up boom phase of our Mises moment.

WHO's Pandemic Alert On Swine Flu: Real Pandemic Threat Or Other Unspecified Motives?

The Swine Flu has officially been declared by the WHO as a pandemic.
This from the Economist, ``THE World Health Organisation raised the threat level for swine flu on Thursday June 11th to pandemic status, the highest possible. It is the first influenza pandemic since 1968, when Hong Kong flu killed 1m people. Almost 28,000 cases of swine flu and 141 deaths have been confirmed in 74 countries since the A(H1N1) virus was first identified in Mexico in late March. In Australia alone, the number of people infected has jumped from around 500 to 1,200 in one week. However, in a new paper published in Nature on Thursday, researchers suggest that the strain had probably been in existence for months before it was isolated, highlighting the need for good surveillance."

I'm no health expert, but I remain a skeptic.

The figures are telling; 141 out of 28,000 cases translates to a .5% fatality rate. The 1918 pandemic had a case fatality (CF) ratio of 3-6% according to wikipedia.org.

Moreover, 28,000 cases in 3 months against a world population of 6.7 billion doesn't seem to project anywhere near the same degree of impact relative to the 1918 case.

Then, some 25 million people had reportedly been killed during the first 25 weeks of the outbreak according to wikipedia.org.

Of the world population of approximately 1.6 billion, estimated fatalities for the 2 year lifespan of the pandemic reached a third or about 500 million-again from wikipedia.org.

Under the same rate, we would now have tens of millions of infected people and casualties that would run in the hundreds of thousands if not in millions.

Of course, one may argue that- this is what the pandemic alert is for-to prevent the spread of the disease and fatalities!

But where should the line be drawn between the use of "fear" from pandemics (or as an excuse) for expanded government control of our lives and the real menace of swine flu as pandemic? Or how do we know if the pandemic alert is genuinely about disease prevention or about some implicit interests being foisted on us by government/s? How do we know if this isn't about propping up sales of pharmaceuticals, some of which are said to be partly owned by certain politicos or a thrust to impose global taxes or other concerns outside of the pandemic issue?

See past articles:
Swine Flu: Mostly A Media Fuss
Swine Flu: The Politics of Fear and Control
Swine Flu: The Black Swan That Wasn’t

Bond Vigilantes Are Waiting At The Corner!

``Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession. The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably. And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.”- John Taylor Exploding debt threatens America

The Bonds Vigilantes are back! That’s according to the newswires and the opinion pages.

Bond vigilantes are supposedly a class of bond investors who serve as disciplinarians against government overspending. Sensing the perpetuation of profligacy, these market enforcers would sell sovereigns which would translate to rising interest rates and which effectively functions as a kibosh on the extravagancies of government.

The recent volatility in the long dated US treasuries markets (see figure 1) apparently breathed life on such market persona after more than two decades long of hibernation.

Figure 1: Bloomberg: UST 10 year yields (orange), Freddie Mac Mortgage Rates (green), Bankrate 30 year mortgages (yellow)

The recent surge in yields has prompted for concerns on the marketplace over the sustainability of stock market gains. Rising interest rates, as interpreted by the mainstream, may yet foil government measures to resuscitate the housing market and US consumers. As you will notice in the chart above, long dated treasuries often serve as benchmark to bank lending rates-so rising Treasury yields means higher mortgage rates.

But often doesn’t mean always. And with US government’s severe scale of marketplace interventions, mortgage rates and treasury yields departed earlier, as we noted in early May, see US Mortgage Rates versus Treasury Yields: Does Divergence Signal An Anomaly or A New Trend?

Yet the dynamics of the bond markets of the yesteryears haven’t been the same as today; foreigners have been pinpointed as the potential source of rising yields, through liquidations.

According to this report from Bloomberg, ``The bond vigilantes are being led by international investors, who own about 51 percent of the $6.36 trillion in marketable Treasuries outstanding, up from 35 percent in 2000, according to data compiled by the Treasury.”

Unfortunately, the classic definition of the bond vigilantes doesn’t hold true today, because rising long dated yields doesn’t automatically equate to investor selling YET see figure 2.

Figure 2: Yardeni.com: Foreign Buying of US Treasury Bills Have Surged!

As noted in last week’s $200 Per Barrel Oil, Here We Come!, the composition of the ownership of US treasuries held by foreigners, mostly by China, has dramatically shifted. In the face of declining foreign currency surpluses, foreigners have sold US agencies and reallocated their holdings mostly into short term bills.

This, we argued, has been primarily politically motivated. China doesn’t want to seen as ruffling the feathers of the US leadership and instead would like to be perceived as in “cooperation” and “collaboration” with them, despite expressing displeasure over the direction of present policies. This essentially places the responsibility of the repercussions from US policies entirely on US policymakers. So in contrast to bond vigilante actions of liquidations, foreigners have continued to buttress the US treasuries market, however yields continue to climb.

As example, Thursday’s US Treasury issuance of $26 billion in 7 year notes had been fully subscribed and this adds to the week’s total of $101 billion. While demand for the 7 year notes have been ample, ``the Treasury was forced to raise the yield by nearly 0.03 percentage points to entice buyers” reports the Associated Press.

In other words, rising yields hasn’t been due to foreign investor liquidations YET, but from oversupply or overissuance of US sovereigns relative to available capital, where the markets has been pricing a premium (through higher yields) for scarce capital to fund US government expenditures.

Nevertheless, events seem to be unfolding in an extremely fluid mode, such that we can’t count on the persistence of foreign support on US treasuries, especially if markets do turn disorderly.

Although the news report cited above, didn’t account for the category of buyers of the recently issued 7 year treasury notes, the US Federal Reserve can pose as the “buyer of last resort” as it can simply “monetize” debts through its digital or printing presses, since an “auction failure” can be highly disruptive to the financial markets, especially to the US dollar.

Bond Vigilantes Ahoy!

Nonetheless the bond vigilantes appear to have indeed surfaced in select US debt markets, concentrating on areas where governments have intervened to favor “political classes”. Here, comparable spreads have ostensibly widened between companies or industries affected by state intrusion relative to those without.

According to the Reuters (bold emphasis mine), ``To gauge whether those cases have made debtholders wary of other companies with so-called favored political classes, Garman compared spreads, or bonds' extra yields over U.S. Treasury yields, for companies with collective bargaining agreements with the high-yield bond market as a whole…

``Apart from automakers, sectors heavily influenced by collective bargaining agreements include supermarkets, construction, wired telecommunications, delivery and healthcare, Garman found. Gaming, select media and publishing companies and paper and textile companies also made his list.”

Uncertainty over the arbitrary selection of winners by the US government, the clash of objectives or priorities between management and government and the fickleness, changeability or instability of policies has translated to investor aversion or bond vigilantism.

Decoupling In Global Bond Markets?, Monetary Forces Gains Momentum

And as almost every government in the world have massively applied “stimulus” to their respective economies to provide for “cushion” from recession and to “jumpstart” economic growth, as discussed in Ignoble Deficits And The $33 Trillion Global Government Debt Bubble?, they will be competing with the private sector for access to funding in the capital markets which implies for “higher yields”.

Moreover, the capital markets will likely be the primary conduit for these fund raising activities as the banking system remains substantially dysfunctional, particularly in the bubble bust affected areas.

Evidences of such dynamics have begun to emerge, according to this Wall Street Journal report (all bold highlights mine),

``In the first quarter of the year, the value of corporate investment-grade bond issuance globally rocketed to $875.1 billion -- a 124% increase from the same period last year. That boom stands in sharp relief to a fall in the market for syndicated loans, in which a syndicate of banks makes a loan to a corporation, spreading the risk of the corporation's default between them.

``The value of banks' new corporate investment-grade lending fell 40% to $349.3 billion compared to the same period last year, according to financial data from Dealogic….

``There are two main reasons why loans from banks are stuttering: banks' available capital and banks' cost of funding. Both have made the interest terms that banks are offering corporations relatively high, making the bond market a preferable route to financing…

``Bank lending to the corporate sector has shrunk dramatically. In the nine months to December last year, global cross-border bank lending shrank almost $5 trillion -- the sharpest fall on record -- according to research out this month by the Bank for International Settlements.”

In other words, the current operating dynamics as seen in the US treasury markets will likely be applied elsewhere, but to a lesser degree on Emerging Markets and in Asia as the latter’s banking system have largely been unimpaired.

Proof?

The US bond market volatility in conjunction with a falling US dollar have prompted for a divergence or “decoupling” in bond activities see Figure 3.

Figure 3: stockcharts.com: Emerging Market-US Sovereigns “decouple”

The Morgan Stanley’s fund of investment in US treasuries as represented by the USGAX (red-black line), which according to Google, “normally invests at least 80% of net assets in U.S. government securities, which may include U.S. treasury bills, notes and bonds as well as securities issued by agencies and instrumentalities of the U.S. government” has been diverging with the JP Morgan’s benchmark for Emerging Debt JEMDX (black line) which according to Google invests in ``a portfolio of fixed-income securities of emerging-markets issuers. The fund normally invests at least 80% of assets in emerging-market debt investments. These emerging-market securities may be denominated in foreign currencies or the U.S. dollar.”

Last week, emerging market bonds posted their best week since 2002 (Bloomberg) in spite of the turmoil in the US sovereign markets as US bond yields rose to nearly a 6 year high (Bloomberg). If this isn’t decoupling, I don’t know what is.

Yet the falling US dollar (USD- lower window in the chart) has easily been made as a scapegoat for the actions in the volatility in the US treasury markets. The simplified explanation is this- a weaker US dollar extrapolates to higher value of emerging market currencies, ergo high bond prices for Emerging Market Bonds.

But this dynamic hasn’t been in place when the US dollar index fell from its peak in 2002 until its trough in early 2008!

In other words, the languid performance of US dollar index and the divergences in emerging markets sovereign relative to the US sovereign hasn’t likely been the underlying cause and effect. Instead, we suggest that it has been monetary forces that has accounted for as the principal driver of this rapidly evolving phenomenon-globally.

In short, monetary inflation has been getting a far bigger pie of the activities in the financial markets as well as in the real economy.

All told, as capital markets takes on a bigger role in the distribution of limited capital over banking system, in the choice of either funding government expenditures or private investment, the resurgent function of bond vigilantism will likely be accentuated as time goes by.