Cracks in the Philippine Property Bubble?

The race to build real estate projects funded by debt by property developers and by the government has been rapidly inflating domestic property prices.

I was surprised to have read an article[1] citing a Jones Lang LaSalle (JLL) research as saying with unabashed confidence that despite soaring prices and massive supply growth there is no glut in the property sector (bold mine)

A sharp increase in new supply began in 2005. Since then, supply growth has averaged more than 30% annually. The total stock of condominiums jumped from 7,000 at the beginning of the millennium, to around 90,000 units by end of 2011, according to JLL. But Jll sees no glut, and CBRE Philippines’ executive director for global research and consultancy, Victor Asuncion, shares the same viewpoint….

Vacancy rates in Makati rose to 11.7% in Q1 2012 from 9.4% a year earlier, according to Colliers. The rise is attributable to new condominiums adjacent to, but not in, Makati - and in regions near Metro Manila.

This is a prime example of Warren Buffett’s advice of “never ask a barber if you need a haircut”. People will continue to talk up their industry regardless of the risks and of reality.

Common sense tells us that if economic growth stands at 7%, and supply side growth is at 30% annually for the last 8 years, unless the law of economics grind to a halt, eventually there will be a glut.

But the statistical economic growth which the article relies on as demand for burgeoning supplies has exactly been driven by the supply side growth of the property sector.

The article says that a remittance based demand is likely to slow due to factors which they refer to World Bank as -Stricter Implementation of the migrant workers’ bill of rights; -Political uncertainties in host countries; and -The slowdown in the advanced economies. The Pollyannaish article also pins on the growth of BPO industry as potential source of demand.

Yet the rise in vacancy rates in Makati by 11.7% from 9.4% while seemingly statistically small represents a 24.45% increase! And this could be the periphery to the core process.

I have pointed out in the past that the Asian crisis was partly triggered when Thailand’s vacancy rates soared to 15%[2].

The article only confirms my observation of a debt driven property bubble.

Total real estate loans country-wide soared by 42% to PHP546.51 billion (US$12.47 billion) in 2012 from the previous year, based on figures from the Bangko Sentral ng Pilipinas (BSP), the country’s central bank. Despite the spectacular growth, the size of the mortgage market remains small at about 5.5% of GDP in 2012.

Of course, the mortgage market is small and will likely remain small because of the limited penetration level by the population on the formal banking industry. This isn’t Singapore or Hong Kong. We should see a bigger enrolment of the population on the banking industry first before we can expect the mortgage markets to expand. And the banking industry would have to downscale regulations for more people to enrol. 

The property market reflects on the conditions of the stock market. 

Figure 8 World Bank Market Cap as % of GDP

The boom in local stocks which in 2012 market capitalization of listed companies according to World Bank accounts for 105.6% of the GDP[3] has only added 22% for a total of 525,850 accounts for the entire PSE brokerages from 2007[4]. This means that booming stocks benefits less than 525,850 accounts (individuals or corporations) or particularly the 83% of market capitalization controlled by a few families whom are now using aggressive leveraging.

The article also notes that “Most houses are sold for cash or pre-sold. Property buyers also face high transaction costs, corruption and red tape, fake land titles and substandard building practices.” The cash transactions are manifestations of clout of the informal economy and the dearth of access to the formal banking sector. And part of the preselling has been financed by developers themselves which the World Bank calls as the domestic shadow banking industry[5].

Finally here is the kicker, from the same article “Recovery from the subsequent crash has been slow. Nominal prices are now back above 1997 levels, but prices are still 46% below pre-Asian crisis peak levels in real terms (Q1 2012) – an astonishing reminder of how much the crash cost.”

Real terms (based on government statistics) don’t seem as an adequate or accurate representation property values.

My neighbourhood store raised the prices of my favorite merienda lumpia by 20% about 2 weeks ago. My daughter’s favorite pie Banoffee recently jumped by 10%. My favorite vendor who maintains his fishball price at 50 cents has shown a considerable shrinkage in the size of his products. I asked why this is so, he says that his supplier can’t raise prices so they deflate the size of their products. Real time economics from the man on the street. Even government’s lotto prices has recently been doubled which accounts for 3.93% lotto inflation. My neighbourhood rental prices have increased by about 10%.

The statistical world is far from the real world. It seems ivory tower economists don’t ever spend at all to know of this reality.

And by the way, a domestic central banker admits that CPI prices don’t accurately reflect on real inflation. At a Bank of International Settlements paper BSP Deputy Governor Diwa C Guinigundo writes[6] (bold mine)

Excluding asset price components from headline inflation also has little effect. Currently, the CPI includes only rent and minor repairs. The rent component of the CPI is, however, not reflective of the market price because of rent control legislation. The absence of a real estate price index (REPI) reflects valuation problems, owing largely to the institutional gaps in property valuation and taxation. While the price deflator derived from the gross value added from ownership of dwellings and real estate could represent real property price, it is also subject to frequent revisions, making it difficult to forecast inflation.

There you have it. The cat is out of the bag. Philippine CPI inflation is NOT a reliable indicator of inflation.

Importantly, real estate nominal prices have reached the 1997 highs.

And lastly I often hear officials say how much a backlog in demand for property in the low end market as a retort against suggestions of bubbles. They have suggested that the shortage of the housing industry is as much as 7 million units[7].

The problem with this concept is that low cost and socialized housing is not a market based demand, but rather a political demand for housing.

The basic assumption is that lack of housing is mainly a pecuniary factor caused by inequality or the lack of social justice. So the government undertakes programs to expand homeownership via socialized or subsidized housing.

So for instance when the BSP claims that 68% of households owns or co-owns their houses[8], this leaves 32% of households who don’t own their homes. This includes me. 

So from the government perspective this represents “demand”. Since there are 20.2 million household according to Bureau of Census estimates as of 2010[9], 32% equals 6.4 million!

But homeownership has not just been a function of income. It is also a choice. I personally know of a family who rents their residence at a posh exclusive village in Makati for years even when they can afford to buy 10 of them.

So the reality is that when vested interest groups ask the government to undertake mass housing projects to fill in an imagined demand gap for a cosmetic goal of social justice, the real issue is the transfer of resources from taxpayers to politically connected business firms, bureaucrats and to some welfare beneficiaries.

My guess is that the ongoing leveraging by players in the property sector whom has access to the banking system may be acquiring properties from the 68% of households and selling these projects to the same high end sector whom have been speculating both in stocks and in properties

Figure 9 US Homeownership rates

At the end of the day political demand via interventions to attain homeownership goals by blowing bubbles usually end up with the opposite effect. This can be seen in Figure 9[10]

The US experience should be a valuable example where homeownership rate has plunged to almost the 1995 levels even as homeownership programs spanned from different administrations[11].

Property bubbles will hurt both productive sectors and the consumers. Property bubbles increases input costs which reduces profits thereby rendering losses to marginal players but simultaneously rewarding the big players, thus property bubbles discourage small and medium scale entrepreneurship. Property bubbles can be seen as an insidious form of protectionism in favor of the politically privileged elites.

Property bubbles also reduces the disposable income of marginal fixed income earners who will have to pay more for rent and likewise reduces the affordability of housing for the general populace.

Outside the ethics of the property bubbles, the mania as shown by chronic overconfidence by industry participants, nominal prices of real estate at 1997 highs and signs of rising vacancy rates could be seen as a potential red flag especially if the bond vigilantes will reassert their presence.

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[1] Global Property Guide House price rises accelerating in the Philippines September 11, 2013

[2] see Phisix’s Mania: We’re Still Dancing March 11, 2013

[3] World Bank Market capitalization of listed companies (% of GDP)

[4] See Phisix: Will the Fed’s Spiking of the Punchbowl Party Be Sustainable? September 23, 2013

[5] See The Flaws of BSP’s Real Estate Monitoring and Banking Stress Tests May 20, 2013

[6] Diwa C Guinigundo Measurement of inflation and the Philippine monetary policy framework Bank of International Settlements

[7] Business Mirror Developers see housing woes worsening September 28, 2013

[8] Bangko Sentral ng Pilipinas 2012 Annual Report

[9] Bureau of Census Household Population of the Philippines Reaches 92.1 Million

[10] The Atlantic Cities The Steady Decline of Homeownership for Everyone, Everywhere July 31 2013

[11] See Will Record Rental Prices lead to Higher US Consumer Inflation? A Redux July 31, 2013

Bullish Signal Confirmed as Phisix Sets New Record High

As I said last week, rising stock prices on a slew of internal and external bad news usually signifies as bullish indicators.

Here is what I wrote,

Foreign trades have also been sluggish with paltry changes over the last two weeks. Yet, despite the marginal actions by foreign investors, the Philippine Peso posted modest advances.

So essentially, last week’s action suggest of a rotation away from second and third tier issues back into the blue chips.

Yet I expect to see normalization of trading activities in terms of Peso volume which should undergird either the current consolidation phase or a fresh attempt to break away into new highs.

When the markets to defy the spate of bad news that signifies as a bullish signal.

Speaking of luck that’s exactly how it turned out the week!

First of all, the Phisix broke into fresh nominal record high even as the Scarborough issue has not been resolved.

As an aside, I would reiterate that for whatever innuendos about resources alluded by media, the Spratlys-Scarborough issue has not been about oil or commodities but more about unspecified political agenda which could be related to promoting arm exports or ploys to divert the public from festering real political issues or as justifications for inflationism.

I might add that the heated kerfuffle over territorial claims has expanded to cover the disputed Senkaku Islands, where Japanese authorities has jumped into the fray to announce of their acquisition of the island from the “owners”. This has resulted to a political backlash from Chinese authorities.

Given that politics in Japan seems to have been entangled with monetary policies, Japan’s recent provocative foreign policy posture could be portentous of Bank of Japan’s (BoJ) moves to expand its stimulus (via asset purchases), perhaps under the pretext of increasing military spending.

Going back to the Philippine stock market, given the record performance, we can’t discount the prospects of interim ‘profit taking’. But again I think momentum still favors the bulls.

Second, net foreign trade has turned significantly positive mostly bolstered by the GT Capital’s listing last Friday

Third market breadth also turned positive…

…as advancing issues took the driver’s seat anew.

If the positive momentum, which is likely to be reflected on the actions of the benchmark Phisix should persist, then we would see a broadening of gains over the broader market.

Most of the gains had been concentrated on the sectoral leaders since the start of the year, particularly, property, finance and holding companies or mother units of the former two.

I think that rotation will occur among the heavyweights as the current leaders may take a short reprieve.

Importantly the Peso volume DID normalize…

Daily traded Peso volume (averaged weekly) surged amidst as last week’s record breakout.

I see a continuity of the bullish or upside momentum of the financial markets which may last until the first semester of the year, where central bank steroids are due for expiration. While this may lead to an interim volatile phase perhaps backed by deteriorating economic or financial conditions in Europe or in China, we should expect downside volatility to be met by aggressive responses from central bankers. This feedback mechanism between markets and central bank interventions has not only been made to condition the markets, but has become the central bankers’ guiding policy of crisis management.

BSP’s Euthanasia of the Rentier

This dogmatic approach has been assimilated even by the local central bank, the Bangko Sentral ng Pilipinas (BSP).

Just last week, domestic interest rate policies have been kept at “historics” lows whose levels were justified as “sufficient to help boost economic activity and avoid potential spike in inflation amid volatile global oil prices”.

The BSP blames external factors as secondary variables of domestic inflation through a “likely rise in foreign portfolio investments and higher prices of electricity amid petitions for further power-rate increases.”

In reality, interest rates policies that has driven been to superficially “historic” lows that are financed by “money from thin” are the real cause of inflation

Austrian economist Dr. Frank Shostak explains,

The exchange of nothing for something that the expansion of money out of "thin air" sets in motion cannot be undone by an increase in the production of goods. The increase in money supply — i.e., the increase in inflation — is going to set in motion all the negative side effects that money printing does, including the menace of the boom-bust cycle, regardless of the increase in the production of goods.

And symptoms from BSP’s actions have been manifesting on the domestic credit markets. Notes the Inquirer.net

True enough, credit growth so far this year has been robust. As of February, data from the central bank showed that outstanding loans by universal and commercial banks grew by 18 percent year on year to P2.74 trillion. The BSP said the increase in bank lending benefited both individual and corporate borrowers.

A boost in bank lending is not “a one-size-fits-all” thing.

A boost in bank lending that has NOT been prompted by consumer preferences but from the skewing price signals due to political “money printing” policies designed to achieve quasi permanent booms leads to bubble cycles.

And what is deemed as “robust growth” by media are, in reality, signs of malinvestments and speculative diversion of productive capital. Some of these borrowed money will find their way to the local stock exchange, real estate properties, bond markets and much of which will be diverted into consumption spending or misallocated capital that leads to capital consumption.

And adding to the policies of the promotion of “aggregate demand” or “the euthanasia of the rentier” through “historic” low interest rates has been the announcement by the local version of the welfare state, the Social Security System (SSS), to lower interest rates and to increase loanable amount to members for housing loans.

Apparently, little has been learned by local political authorities of the lessons from the latest US centric political homeownership crisis that has diffused across the world and whose phantom continues to haunt the political economies of the developed world.

Noble intentions eventually get burned by politically instituted economically unfeasible projects.

Sell In May?

Fund manager David Kotok of Cumberland Advisors rightly points out the differences in the current environment from yesteryears, such that seasonal statistical patterns like Sell in May and Go Away may not be relevant to current conditions.

History shows that ‘Sell in May and go away’ has applied when the Federal Reserve was in a tightening mode during the six-month span from May to November. If the Fed was actively raising interest rates, withdrawing or constricting credit, imposing additional reserve requirements, or taking an action that was of a tightening mode, stock markets were usually punished in that six-month period.

When we did the study we examined what the Fed did, not what it said. We used actual changes in the Federal Funds rate to determine whether the Fed was tightening, easing, or neutral. Once the Fed took the interest rate to zero at the end of 2008, the historical data series lost its power for forecast purposes, since the Fed cannot take the rate below zero. However, we believe the concept is valid even if the present measurement problem exists.

It is human action and NOT charts (for example the failed death cross pattern of the S&P 500 of 2011) or seasonal patterns, based on either statistics or historical outcomes, that determines future outcomes.

The substantial impact of central bank policies on the markets has been through the manipulation of money. Since money is a medium of exchange which represents half of every transactions people make, tinkering with money has greater tendency to alter or reshape the incentives of people.

Manipulation of money through inflationism tend to narrow people’s time orientation or increases time preferences which has been and will be ventilated through several attendant actions, as higher inclination to take debt, misdirection of investments via distorted price signals, consumption based lifestyles or pejoratively known as “consumerism”, greater risk appetite or higher inclinations towards speculation.

So when major central banks combine to tamper with money, which among themselves account for about 85% of the capital markets of the world, we can expect participants of the marketplace to adjust accordingly to these newly implemented policies. Current policies have been engendering asset inflation, which in reality has been designed to keep the flagging banking system and the unsustainable welfare states afloat.

Even emerging market central banks, as the Philippines have employed the same policies which are often justified from “growth risk”. Yet despite the standardization of monetary policies, the differences in market outcomes have been resultant to variances of people’s actions relative to the idiosyncratic structural compositions of each political economy.

In addition, while monetary policies have significant effects on people’s incentives other policies also matters such as fiscal policies and tax regimes, rule of law and protection of property rights, trade and economic freedom, and regulatory policies.

The bottom line is all these policies would have a greater impact to people’s action than simply reading numbers and history as basis for predictions.

As the great Ludwig von Mises wrote in Theory and History

Historicism was right in stressing the fact that in order to know something in the field of human affairs one has to familiarize oneself with the way in which it developed. The historicists' fateful error consisted in the belief that this analysis of the past in itself conveys information about the course future action has to take. What the historical account provides is the description of the situation; the reaction depends on the meaning the actor gives it, on the ends he wants to attain, and on the means he chooses for their attainment...

The historical analysis gives a diagnosis. The reaction is determined, so far as the choice of ends is concerned, by judgments of value and, so far as the choice of means is concerned, by the whole body of teachings placed at man's disposal by praxeology and technology.

Along the lines of the Professor von Mises, my former idol the exemplary stock market guru but who now has been converted to a crony, Warren Buffett, once lashed out at the tendency of people to anchor or rely heavily on past performance. The ailing 81 year old billionaire Mr. Buffett said

If past history was all there was to the game, the richest people would be librarians.

How Capital Regulations Contributed to the Current Crisis

At the Wall Street Journal, American Enterprise Institute’s Peter J. Wallison explains how capital regulations are partly responsible for the current mess (bold emphasis mine)

Basel is the Swiss city where the world's bank supervisors regularly meet to consider and establish these rules. Among other things, the rules define how capital should be calculated and how much capital internationally active banks are required to hold.

First decreed in 1988 and refined several times since then, the Basel rules require commercial banks to hold a specified amount of capital against certain kinds of assets. Under a voluntary agreement with the Securities and Exchange Commission, the largest U.S investment banks were also subject to the form of Basel capital rules that existed in 2008. Under these rules, banks and investment banks were required to hold 8% capital against corporate loans, 4% against mortgages and 1.6% against mortgage-backed securities. Capital is primarily equity, like common shares.

Although these rules are intended to match capital requirements with the risk associated with each of these asset types, the match is very rough. Thus, financial institutions subject to the rules had substantially lower capital requirements for holding mortgage-backed securities than for holding corporate debt, even though we now know that the risks of MBS were greater, in some cases, than loans to companies. In other words, the U.S. financial crisis was made substantially worse because banks and other financial institutions were encouraged by the Basel rules to hold the very assets—mortgage-backed securities—that collapsed in value when the U.S. housing bubble deflated in 2007.

Today's European crisis illustrates the problem even more dramatically. Under the Basel rules, sovereign debt—even the debt of countries with weak economies such as Greece and Italy—is accorded a zero risk-weight. Holding sovereign debt provides banks with interest-earning investments that do not require them to raise any additional capital.

Accordingly, when banks in Europe and elsewhere were pressured by supervisors to raise their capital positions, many chose to sell other assets and increase their commitments to sovereign debt, especially the debt of weak governments offering high yields. If one of those countries should now default, a common shock like what happened in the U.S. in 2008 could well follow. But this time the European banks will be the ones most affected.

In the U.S. and Europe, governments and bank supervisors are reluctant to acknowledge that their political decisions—such as mandating a zero risk-weight for all sovereign debt, or favoring mortgages and mortgage-backed securities over corporate debt—have created the conditions for common shocks.

I have explained here and here how Basel capital standard regulations does not address the root of the crisis—fiat money and central banking—and will continue to churn out rules premised on political goals, knee jerk responses to current predicaments (time inconsistent rules) and incomplete knowledge.

A manifestation of the institutional distortions as consequence to regulations which advances political goals can be noted at the last paragraph where US and European governments and bank supervisors are “reluctant to acknowledge that their political decisions”, which have not only “created conditions for common shocks”, but has existed to fund the welfare state and the priorities of political leaders in boosting homeownership ownership which benefited or rewarded the politically privileged banks immensely.

Capital regulation rules will continue to deal with the superficial problems of the banking system which implies that banking crises will continue to haunt us or won’t be going away anytime soon despite all model based capital ratio adjustments. It's been this way since the closing of the gold window or the Nixon shock (see above chart from the World Bank)

US Homeownership Program Had Been Meant To Promote Financialization

Cato’s Mark Calabria says that mortgage subsidies in the US has not materially improved homeownership but has instead promoted a culture of debt.

Mr. Calabria writes, (bold highlights mine)

One of the rationales commonly given for massively subsidizing our mortgage market is that without such homeownership would be out of reach for many households. Such a rationale implies that more debt should be associated with more homeownership. (Let's set aside the obvious, how are you actually an owner without any equity?)...

By 1960, the homeownership rate was already over 60%, yet debt-to-value was less than 30%, half of the current value. Even in 1990, when homeownership reached over 64%, debt-to-value was still under 40%. From 1990 until today, the percentage of mortgage debt to value increased by over 50%, all to gain a 2 percentage point increase in homeownership. So it seems the story of the last 20 years has been a massive increase in home debt with very little increase in actual homeownership rates. The converse should also hold: reducing homeowner leverage should have little, if any, impact on homeownership rates.

Increasing debt hasn’t substantially lifted homeownership. This represents a failure of the program.

I have been saying that intentions and actions are two different things. People may say one thing, but do another. Since politicians and bureaucrats are people too, they are likely to fall into the same intent-action disparity trap.

Importantly, many people, especially those in the political arena, rake in the dough out of deliberately fudging the relationship of intent and action. They say one thing which would sounds politically correct, but applies actions that covertly benefit another party using the former as a cover.

I’d say that homeownership has merely been a strawman meant to boost another sector’s profits.

The sector I am referring to is the US financial sector which has benefited greatly from government sponsored homeownership programs. Some calls this the financialization or financial capitalism.

According to Wikipedia.org, (bold highlights mine)

Financialization is a term that describes an economic system or process that attempts to reduce all value that is exchanged (whether tangible, intangible, future or present promises, etc.) either into a financial instrument or a derivative of a financial instrument. The original intent of financialization is to be able to reduce any work-product or service to an exchangeable financial instrument, like currency, and thus make it easier for people to trade these financial instruments.

Workers, through a financial instrument such as a mortgage, could trade their promise of future work/wages for a home. Financialization of risk-sharing makes all insurance possible, the financialization of the U.S. Government's promises (bonds) makes all deficit spending possible. Financialization also makes economic rents possible.

The GDP share of the US Financial Industry has been exploding. Recently even after the crisis, profits from the financial industry now accounts for ONE third of all operating profits.

Notes the Wall Street Journal Blog, (bold highlights mine)

During the darkest days of the financial crisis, when Lehman Brothers and Washington Mutual went belly up and the U.S. government had to bail out other institutions, the finance sector reported an annualized loss of $65.2 billion in the fourth quarter of 2008. It was the only quarterly loss recorded in the government data.

Since then, the sector has come roaring back. The GDP report shows finance profits jumped to $426.5 billion. While profits haven’t returned to their high levels of 2006, the gain in finance profits last quarter more than offset a drop in profits posted by nonfinancial domestic industries.

After rising like the Phoenix, the financial industry now accounts for about 30% of all operating profits. That’s an amazing share given that the sector accounts for less than 10% of the value added in the economy.

Wall Street and banking critics have pointed out the finance industry enjoys government supports not given to other companies. That includes the low cost of funds from the Federal Reserve. As a result, critics say, the U.S. economy is overly skewed toward finance.

From Yardeni.com

In my view, homeownership is a (political) means aimed at promoting an end (crony capitalism of the financial industry)

Inflationary Policies Have Vastly Been Changing The Market Landscape

``During a boom, inflation creates illusory profits and distorts economic calculation. What the free market does best is penalize the inefficient and reward the efficient. But when you get a boom, the rising tide lifts all boats…Because of these illusory profits, everybody wants to get in on the boom. Everyone thinks they can do everything…Furthermore, during inflation, the quality of work goes down. Everyone tries to manufacture products as quickly as they can. There's no emphasis on how long things will last…In general, people become enamored with get-rich-quick schemes. In fact, entire countries have done this with the collateralized debt obligation (CDO) market. Iceland, for instance, has become one big hedge fund. And now we're going to have entire countries go broke.” Doug French, Bubble Economics: The Illusion of Wealth

In the field of politics, rendering social services for the people is always bruited about as the ultimate goal.

Unfortunately, the harsh reality of life is that policymakers or political leaders and their bureaucracy are only concerned with their self interests. But the sad fact is that their erroneous interventionist policies have lasting adverse consequences on the society’s standard of living.

Worst of all, is that a big segment of the public have been deluded to adamantly embrace the promises of politicians and of the attendant false ideologies in support of their “robbing Peter to pay Paul” policies.

Also, in no way do inflationary policies work better than the market forces.

Another proof?

From an earlier article Myths From Subprime Mortgage Crisis, Ms. Yuliya Demyanyk of the Federal Reserve of Cleveland wrote how policies aimed to increase homeownership has markedly failed.

Again from Ms. Yuliya Demyanyk (bold emphasis mine)

``The availability of subprime mortgages in the United States did not facilitate increased homeownership. Between 2000 and 2006, approximately one million borrowers took subprime mortgages to finance the purchase of their first home. These subprime loans did contribute to an increased level of homeownership in the country—at the time of mortgage origination. Unfortunately, many homebuyers with subprime loans defaulted within a couple of years of origination. The number of such defaults outweighs the number of first-time homebuyers with subprime mortgages.

``Given that there were more defaults among all (not just first-time) homebuyers with subprime loans than there were first-time homebuyers with subprime loans, it is impossible to conclude that subprime mortgages promoted homeownership."

That’s why it pays never to trust politicians.

So in general, society vastly suffers under the artificial nature of bubble cycles caused by government interventionism.

Moreover, it isn’t just me this time bewailing how interventionism or how inflationary policies have been obscuring traditional means of evaluating financial markets.

Mr. David Kotok of Cumblerland Advisors in a fantastic discussion about Ricardian Equivalence [or as defined by investopedia.org as ``An economic theory that suggests that when a government tries to stimulate demand by increasing debt-financed government spending, demand remains unchanged. This is because the public will save its excess money in order to pay for future tax increases that will be initiated to pay off the debt”] demonstrates this.

From Mr. Kotok, (bold highlights mine, all caps his)

``We are issuing massive amounts of debt in order to finance loads of current consumption. Rational expectations would have the markets immediately adjust prices for the future tax burden associated with the servicing of the debt. But more than HALF OF THE WAGE EARNERS IN THE COUNTRY ARE NOW NOT PAYING ANY SIGNIFICANT INCOME TAXES. Sure, they are paying Social Security withholding and state taxes, but their share of the federal personal income tax receipts is very small. They are positioned with inconsistency when thinking about Ricardian equivalence, since they do not experience nor expect to experience the tax burden associated with the huge debt…

``The taxing decisions that impact the minority of the American wage-earner population are not made by them. Those decisions emanate from the Congress and the White House. Those policy makers have a time inconsistency which conflicts with successful Ricardian equivalence. Their time horizon is mostly less than two years until the next election. In the case of Obama it is less than four years, and the handlers of his political apparatus are already at work on the re-election campaign.

``So we have two inconsistencies at work. Agent inconsistency exists, wherein only the minority of the taxpayers is paying the longer-term burden of the substitution of debt for taxes. And time inconsistency, where the decision-maker's time horizon is much shorter than the expected debt-load servicing time horizon. Two inconsistencies equal a failure of the Ricardian equivalence.

``For portfolio managers this poses a difficult dilemma. We know about the inconsistencies. We can estimate the impacts when they are finally resolved. But we have no way to estimate WHEN the inconsistencies will emerge as the force that alters market values. And we cannot be sure of the method by which they will impose their imprint on the markets when they do. Sure, it could be higher taxation or slower growth or more inflation or a weaker dollar or flight of citizens or less productivity or diminished innovation. There are many such characteristics of a society that has overextended itself and has to pay the price. But WHEN and HOW and at WHAT COST? These are the imponderables.”

Again, parallel to the China example, the conflict of interests between the interests of policymakers and their preferred policies relative to the consequences to markets and the political economy are evolving to become major variables in the asset pricing dynamics and have increasingly been contributing to the growing state of non-Priceable Knightean uncertainty conditions.

When a group of distinguished economists wrote to the Queen of England explaining why “no one foresaw the timing, extent and severity of the recession”, they failed to explain to Her Majesty the following:

1) mainstream economics (via monetary and fiscal inflation) had been the primary cause of it, and since they’ve been the principal advocates they wouldn’t undermine the underlying theories that support it. In other words, mainstream economists are blighted with a bias blind spot.

As Murray N. Rothbard explains in Money Inflation and Price Inflation, ``There are very 'good reasons why monetary inflation cannot bring endless prosperity. In the first place, even if there were no price inflation, monetary inflation is a bad proposition. For monetary inflation is counterfeiting, plain and simple. As in counterfeiting, the creation of new money simply diverts resources from producers, who have gotten their money honestly, to the early recipients of the new money-to the counterfeiters, and to those on whom they spend their money.” (emphasis added)

2) mainstream economics deal with superficialities and unrealistic models and is constrained by the short term outlook.

``I think it is the inability to reconcile a reasonable treatment of radical uncertainty with the strictures of out-of-control formalism” observed Professor Mario Rizzo.

3) it isn’t true that no one foresaw the crisis since even US congressman Ron Paul saw this crisis and along with Dr. Marc Faber, Jim Rogers, Stephen Roach, Nouriel Roubini, Gerald Celente, George Soros and many more (this includes us) especially the underappreciated Austrian School of Economics.

The point is mainstream economics and financial models have failed miserably.

In a world where inflationary forces are fast becoming the dominant factors in asset pricing dynamics, traditional fundamentalism have been ineffective in keeping apace with the underlying structural changes in the risk equation.

So the mainstream can dream about the financial fiction of PE, Book Values, or etc… when money printing bubble cycles are becoming the chief dynamic in pricing stock markets as well as in the other asset markets.