Taking The Hyperinflation Risk With A Grain Of Salt?

``But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a ‘crack-up boom’ and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis." Ludwig von Mises in Interventionism: An Economic Analysis (p. 40)

Recently a link from last year’s TV interview of an eminent Cassandra, Mr. Gerald Celente, was posted at a social community network. Mr. Celente prophesized, not only of the “greatest” depression for the US, but of an environment marked by “revolution, food riots and tax rebellions”. Such development would bring about America’s “ceasing to be a developed nation” or essentially would translate to the country’s defacement as the world’s premier economic and financial power by 2012.

The accompanying the link had a note from the link author who questioned about how such an interview was “allowed” to be aired and what was this “doomsday” scenario all about.

We have long known about such extreme views (which should include James Kunstler-another Cassandra who believes of the real risks of a world at war arising from the unsustainable energy infrastructure from which the world currently operates and survives on), but has refrained from discussing it because of our “optimistic” predilections. Nonetheless, on the account of the “ripeness” of the occasion, this article will attempt to elaborate on the risks of such concerns.

Cognitive Biases and Censorship

As Julius Caesar remarked, ``People readily believe what they want to believe."

Obviously the late great Caesar alluded to people’s proclivity to act in social norms. And as social norms, popular views are often dressed up as lies which are repeated so often and digested as the reality or the truth, especially when buttressed or promulgated by figures considered as “authorities” in their fields or from the bureaucracy. Yet, most people only look at the superficial and intuitive side of any issues without belaboring on the tacit intents proposed by the advocates or of its unseen consequences.

Bluntly put, people are basically faddish and tend to look for grounds to confirm or substantiate their beliefs or are predisposed to absorb only the quality of information which they believe suits their palate. In behavioral finance, this is known as the CONFIRMATION bias or “the tendency to search for or interpret information in a way that confirms one's preconceptions” (wikipedia.org).

Applied to social trends, the acceptance of mainstream views (or seeking “comfort of the crowds”) or conformity represents as the more psychologically rewarding route than in defiance of them (regardless of the validity of the observations or theories).

For instance, the mainstream has repeatedly mocked, jeered or scorned at those who warned of the illusions of the wealth derived from unsustainable debt driven boom. Contrarians were deemed or labeled as “killjoys” or “partypoopers”. Eventually as the boom turned into a bust, losses turned into reality, and the “IN” thing or “THE” social trend is now to be a pessimist.

The contrarians, who were previously the “outcasts”, have been exonerated and have now commanded sufficient clout of an audience enough to be embraced by mainstream media. In short, since media’s role is to sell what is mostly in popular demand, the Celente interview represents as pessimism becoming an entrenched social trend.

And that’s why gloomy videos have found their way into social networks. And that’s why too, we should expect more of these until perhaps we have reached the stage of “revulsion” or “capitulation” for one to reckon the US as in a “bottoming” phase.

Remember, throngs of “finance and banking” professionals or organizations (such as banking institutions, insurance and hedge funds) have not been eluded from such basic human frailties of “crowd” following or falling prey to “confirmation bias”. As the present bust or crisis clearly shows, technical expertise or even quant algorithmic models can’t substitute for the process ability driven emotional intelligence which is more a required attribute in the analysis of the market’s risk-reward tradeoff. As we have discussed in many occasions, most of them have even fallen prey to Ponzi schemes as the Bernard Madoff or the Robert Allan Stanford case.

I won’t suggest anyone to disregard extreme views especially if the Cassandra sports a good track record in projecting major trends and this includes Mr. Gerald Celente.

Yet, a remarkable past may not necessarily extrapolate to another successful forecast. Since any mortal can only wield so much of limited information in a highly complex world, like anyone else, his views aren’t infallible. The point is to understand the merits of his argument than simply to dismiss it out of the Pollyannaism or blind optimism or from the outrageous belief of a messianic salvation from the present leadership or fanatical subscription to the economic school of orthodoxy.

Worst of all, is the implication for the socialistic bent of “censorship” by those intolerant of diametric or contradictory perspectives. One should ask: would it be better for us to adhere to fantasies masquerading as truth and eventually suffer? Or would reading an expository “falsifiable” mind be a better alternative as to recognize potential risks and prepare for them?

The Fundamental Problem: UNSUSTAINABLE DEBT

So what seems to ail the US economy so much as to risk turning its political economy into an emerging market?

This from Bloomberg, ``Bill Gross, co-chief investment officer of Pacific Investment Management Co., said the Federal Reserve’s purchases of Treasuries and mortgage securities won’t be enough to awaken the economy.

``We need more than that,” Gross said today in a Bloomberg Television interview from Pimco’s headquarters in Newport Beach, California. The Fed’s balance sheet “will probably have to grow to about $5 trillion or $6 trillion,” he said.”

The Fed’s balance sheet is roughly around $2 trillion with an additional $1 trillion more for the QE as it gets implemented. This brings the Fed’s balance sheet around $3 trillion. Mr. Gross has asked to double the size.

Now this from Jeremy Grantham an erstwhile ferocious stock market bear whom has turned into a raging bull recently said, ``To be successful we need to halve the level of debt. Somewhere between $10 trillion and $15 trillion will have to disappear."

So how do we do that? ``Grantham sees three ways, according to the Wall Street Journal, “to restore the balance between private debt levels and asset values.” That is by “1) Drastically write down debt, 2) let the passage of time wear down debt levels, 3) “inflate the heck out of our debt” and reduce its real value.” (bold highlight mine)

In short, the fundamental problem comes with the government policy induced overdose of debt intake as shown in Figure 1.

Figure 1: American Institute for Economic Research: Total Debt by the US

AS you can see, the debt ratios for the US economy mostly held by the private sector have exploded beyond the nation’s paying capacity, according to the AIER, ``The debt-to-dollar ratio currently tops $3.50, more than double the ratio of 50 years ago.”

Given the unsustainable debt structure from which the US and the world economy has been built, the recent collapse in the financial markets (estimated at $50 trillion-ADB) and the subsequent meltdown in global trade, and investments (or deglobalization) has managed to reduce parts of such massive scale of imbalances.

But the adjustment process has a long way to go.

The US Federal Reserve’s Agency Problem

However instead of allowing for an orderly rebalancing of the US economy by permitting institutions that took upon the unnecessary burden of the speculative excess to fail or undergo bankruptcy proceedings, the US government has been pushing to revive the past Ponzi financing model by substituting the losses from these institutions with taxpayer money…to no avail so far.

And the Federal government’s heavy handed interventions in many significant parts of the economy and the prevention of price discovery has contributed to the prolonged nature of recovery and has added uncertainties in the marketplace, by distorting market price signals and altering the incentives for market participants which has been skewed towards prospective actions of the government.

The recent fracas of over the bonuses is a case in point.

Take this article from the New York Times,

``As public outrage swells over the rapidly growing cost of bailing out financial institutions, the Obama administration and lawmakers are attaching more and more strings to rescue funds.

``The conditions are necessary to prevent Wall Street executives from paying lavish bonuses and buying corporate jets, some experts say, but others say the conditions go beyond protecting taxpayers and border on social engineering.

``Some bankers say the conditions have become so onerous that they want to return the bailout money.”

In other words, some banks have resisted availing of government bailouts because of the burdensome conditions imposed on them, which is not helping the situation at all. As we said earlier the incentives in trying to normalize bank operations are being contorted by minute by minute changes in government intervention. Investors look for stability in policy.

And how much of these government intervention has been affecting the banking industry? The same New York Time article admits…

``At the height of the savings and loan crisis in the 1980s and 1990s, Congress and regulators adopted new rules known as “prompt corrective action” that required the government to quickly close weak financial institutions if they could not raise money to absorb mounting losses.

``The rules were a response to a consensus that keeping weak institutions open longer, under an earlier practice known as forbearance, damaged healthy banks competing with the government-subsidized ones and ultimately destabilized the banking system. By shutting weakened institutions before their losses grew, prompt corrective action was also seen as less costly to taxpayers and the deposit insurance fund.

``Administration officials say that some of the banks at issue today are simply too large to be seized by the government, making comparisons to the savings and loan crisis less meaningful.”

But this is exactly what has been happening today, damaged banks have been competing with government subsidized ones at the expense of the industry and the economy. And much worst, those subsidized are banks have been TOO LARGE to be seized by government, which is why the accrued losses have led to a creeping nationalization. See figure 2…

Figure 2: BCA Research: Top 20 Banks

According to the BCA Research, ``The Chairman of the FDIC, Sheila Bair, contends that U.S. banks are well capitalized. However, she must be referring to the multitude of small banks, rather than large banks (i.e. there are many small banks that are well capitalized). The top 20 financial institutions have a thin capital cushion of only 3.4% (defined as tangible capital/total assets). In other words, it would require a writedown of total assets of only 3%-4% to wipe out all tangible capital for the largest banks. The FDIC data on the broader banking universe confirms that the capital cushion of large banks is much less than their smaller counterparts. Moreover, toxic assets are concentrated in large financial institutions.”

As you can see the risk profile of the top 20 banks have largely been because of the Level 3 assets which simply means ``Assets whose fair value cannot be determined by using observable measures, such as market prices or models.” (investopedia.com)

And what are the possible Level 3 assets? Perhaps figure 3 may provide the explanation…

Figure 3: OCC: 3^rd quarter Report: The Average Credit Exposure to Risk Based Capital

The average credit exposure to risk based capital in percentage is 317.4% for the 5 largest banks as of the third quarter of 2008! The pecking order of the riskiest banks: HSBC (664.2%), JP Morgan (400.2%), Citibank (259.5%), Bank of America (177.6%) and Wachovia (85.2%).

Moreover, consider that 96.9% of the total derivatives of the US commercial banking system is held by the just these 5 institutions according to the Comptroller of the Currency Administrator of National Banks!

In other words, of the 8,451 banks and savings institutions insured by the FDIC, or of the 7,203 commercial banks operating in US (Plunkett Research), 5 banks have essentially held hostage the entire industry, if not the economy!!!

Free market anyone?

Why is this?

Could it be because the US Federal Reserve is a privately held corporation, bestowed with a monopolistic power to create and manage the country’s legal tender, whose complex web of owners could be some of the same institutions that are presently being rescued?

According to James Quinn, ``Most Americans believe that the Federal Reserve is part of the government. They are wrong. It is a privately held corporation owned by stockholders. The Federal Reserve System is owned by the largest banks in the United States. There are Class A,B, and C shareholders. The owner banks and their shares in the Federal Reserve are a secret.”

As Henry Ford once wrote, ``It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

So could Mr. Celente’s dire projections have been partly premised from such agency problem or conflict of interest issues that would perhaps gain national consciousness over the coming years?

Regulatory Arbitrage + Regulatory Capture=Market Distortion

In addition, considering the US banking industry have been a heavily regulated industry, why have the core institutions, which originally attempted to disperse risk by introducing financial innovations, ended up with the “risk concentrations”?

This from Gillian Tett of the Financial Times, ``After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.

``But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else.

``Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.

``Far from promoting “dispersion” or “diversification”, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.”

Institutions as the AIG Financial Product (AIGFP) circumvented or went around regulatory loop holes to ante up on leverage and increase risk exposure in order to generate additional returns. Arnold Kling of Econolib.org quotes Houman Shadab, ``AIGFP was treated as a bank for its counterparties' risk-weighting purposes, but AIGFP was not regulated as a bank (or an insurance company) for its own CDS credit exposures (had it been, it would've had to set aside capital/reserves).”

In short, this hasn’t been a free market problem as some anti-market pundits paint them to be, but one of regulators conspiring with Wall Street participants to “game the system”.

For Wall Street it had been one of regulatory arbitrage (profiting from legal loopholes) but for the regulators it has been one of regulatory capture (situations where government acts in favor of the interest groups of which it is regulating).

As we have previously quoted Robert Arvanitis Risk Finance Advisers, in Seeking Beta: Interview with Robert Arvanitis, ``Being mortal, the bureaucrats desire to avoid pain is as dear to them as the desire by their counterparts in private industry to seek gain. And it is far more profitable to game the rules, for example, than to enforce them. And any system can be gamed.”

To quote Mr. Celente, ``It was Fed finagling, Washington deregulation and Wall Street’s compulsive gambling that created the crisis.”

Yet people have been distracted by the most recent BONUS issue, which simply implies that Americans have been looking for an issue to vent their wrath on (a misguided one though).

To consider, the enormous backlash over the $168 Million is a pittance over the money spent by US taxpayers ($178 BILLION) to sustain AIG counterparties as Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). Big foreign banks also received large sums from the rescue, including Société Générale of France and Deutsche Bank of Germany, which each received nearly $12 billion; Barclays of Britain ($8.5 billion); and UBS of Switzerland ($5 billion) and some 20 largest states (New York Times).

Yet as the Federal government expands its presence into industries these governance conflicts, e.g. as in the proposed bonuses of Freddie Mac and Fannie Mae, will certainly serve or operate as a major disincentive that would impact diverse institutions from meeting desired goals, which eventually results to an increased overall inefficiency in the system.

Again, with big government comes the inevitable ramifications: resource allocation inefficiencies or wasteful spending, incompetence, corruption, dispensation of favors to political constituents, conflicts of interests, governance conflicts which may lead to organizational demoralization and reduced productivity, bureaucratic rigidities (tendency to be too technical or legal), crowding out of private sector investments, massive distortion of incentives, a vague pricing system which increased uncertainties and other impediments –all of which obstructs on the US’s economy wellbeing.

Obviously, governance policies based on populism will do harm than good.

Signs of Resurgent Inflation?

Now that the US policymakers appear to be losing out of ammunition, they have begun to openly resort to the crudest of all central banking policy approach-money printing.

As mentioned above our money experts have recommended “inflating away debts levels” which means reducing the currency’s purchasing power (or raise price levels) in order to diminish real debt levels, from which our policymakers have obliged.

According to the Economist, ``Mr Bernanke showed his own will on Wednesday March 18th, when the Fed’s policy panel said it would purchase $300 billion in Treasury debt, mostly maturing in two to ten years, starting next week. It will also boost its purchases of mortgage-backed securities to a total of $1.25 trillion from a previously announced $500 billion, and its purchases of debt issued by Fannie Mae and Freddie Mac, the mortgage agencies, to a total of $200 billion from $100 billion.”

But since the US is privileged to have her debts denominated on her own currency, when she can’t payback her obligations, instead of defaulting, she may resort to flooding the economy with money enough so as to reduce the value of liabilities at the expense of her existing creditors-i.e. local savers and foreign creditors.

Of course, these will temporarily benefit those who own financial assets, because “money out of thin air” will likely be absorbed by the institutions who will sell their portfolio of treasuries or mortgages to the US government. Eventually, the proceeds can be expected to be recycled into the financial markets. Although the policymakers are hoping that a revival in the capital markets will fire up the credit process by reigniting the speculative “animal” spirits.

Unfortunately the “moneyness” of Wall Street instruments (e.g. structured products, MBS, ABS etc…) has been lost and is unlikely to be revived anytime soon.

But on the other hand, any flow of credit to parts of the world where credit conditions have remained unimpaired is likely to fuel a surge in asset prices first, then consumer prices, next. Apparently such dynamics appear to have emerged, see Figure 4.

Figure 4: A Return of Inflation?

Oil has sprinted beyond the $50 mark and this has been accompanied by Dr. Copper (upper window) and even some industrial metals. Oil’s rapid rise may suggest of a rising wedge or a forthcoming decline. Anyway, the surge in key commodity prices comes alongside with a rally in Dow Jones Asia (ex-Japan) seen at the pane below the main window and Emerging Markets index (lowest pane), as the US dollar index suffered its 3^rd largest one day decline.

The unfortunate part for the US is that a resurgent inflation will likely induce more sufferings to the middle and lower class and possibly worsen the political scenario by provoking a “class” conflict.

When price levels of consumer goods are raised at a time when unemployment is high or possibly even growing, where real income levels are also diminishing, and where corporations faced with a struggling environment will be faced with higher costs of operations, these combined could redound as the ingredients for a large scale hunger triggered political malcontent.

Moreover, inflation, as seen through higher cost of money and shrinking purchasing power, is likely to wreak havoc on the cash flows of those attempting repair their overleveraged balance sheet by increasing savings and paying off debts.

And the orthodoxy is putting so much hope that the authorities will know the right time when to close the barn doors before the horses run astray, a hope that seems unfounded to begin with as the authorities have failed to recognize the crisis in advance or limit the scale of its impact.

Again from Mr. Celente, ``What "steps?" The Bernanke Two-Step? Adjust interest rates or print more money? Neither stopped the credit crisis from worsening, the real estate market from tanking or the stock markets from crashing.”

Figure 5: yardeni.com: Net Foreign Selling Are These Signs On The Wall?

The United States’ Treasury International Capital flow have registered a significant net foreign selling (excluding US T-bills) last January see figure 5, although as an important reminder-one month does not a trend make.

While others have argued that such fall in capital flows may have been a function of reduced growth of foreign exchange surpluses, the growing restiveness by global policymakers over the US dollar, could be another incipient dynamic at work.

Over the past weeks we heard resonating voices suggesting a move away from the US dollar as the world’s reserve currency- from Joseph Stiglitz, a UN Panel and Russia at the G20, which was reportedly backed by China, India, South Africa and South Korea.

While there has been no unanimity on the possible replacement, most have recommended the IMF’s Special Drawing Rights or the old European Currency Unit Ecu, albeit both of which have been “combinations of currencies, weighted to a constituent's economic clout, which can be valued against other currencies and against those inside the basket” (Reuters).

Importantly, a new currency can’t takeoff without OECD participation which includes the US. Thus, such cacophony appears to be more symbolic- an implied protestation over the risks of imprudent government spending.

Take The Risks of Hyperinflation With A Grain of Salt At Your Peril

Finally, we can’t discount the risks from the ravages from hyperinflation.

As we brought up in 2009: The Year of Surprises?, a tip over from deflation expectations towards a ramping up of inflation will be a tough act to manage. If government starts to tighten as inflation rises, the ensuing effect will be a sharp fall in prices from which government will need to restoke the inflation engine again.

Again to quote Murray Rothbard in Mystery of Banking,

``But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races. Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,” doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.”

In essence Mr. Celente’s Tax Revolt, Food Riots, Revolution and the return to a banana republic or the state of an emerging market is nothing more than a function of hyperinflation. (Of course, we’re not suggesting that this will surely happen, but what we are saying is that the present actions of the US policymakers have been increasing the odds for such risks to occur. America’s hope depends on the world to absorb those surplus dollars enough to pull the US out of its debt trap.)

So for those hoping against hope that the present administration will deliver the economy’s much needed elixir in defiance of the fundamental function of the natural laws of economics, good luck to you. No economy has survived by merely the government running on the printing press, ask Dr. Gideon Gono.

One must be reminded of US 33^rd President Harry S. Truman’s noteworthy comment, ``It's a recession when your neighbor loses his job; it's a depression when you lose your own.”

Take this risk with a grain of salt until such scenario becomes a personal depression.

10 Reasons Why Pump Priming Won’t Work As Planned

``The Marxians, Keynesians, Veblenians, and other "progressives" know very well that their doctrines cannot stand any critical analysis. They are fully aware of the fact that one representative of sound economics in their department would nullify all their teachings. This is why they are so anxious to bar every "orthodox" from access to the strongholds of their "un-orthodoxy."- Ludwig von Mises, Economic Teaching at the Universities

Here are 10 reasons why Keynesian stimulus won’t help pull the US out of its economic miseries.

1. Money will have to be paid by someone.

From Wall Street Journal Street, ``Whether or not you think new spending will stimulate the economy, the one undeniable truth is that this money has to come from somewhere, which means that it is borrowed or taxed from the private economy. This spending blowout is all but guaranteeing huge future tax increases, and anyone who thinks only the rich will pay is living an illusion.”

There is NO free lunch. Stimulus will have to be paid by higher taxes, increased borrowing or inflation.

2. Incoherent plan addled by too many objectives.

From the New York Times, ``Some caution that President Obama’s proposals try to achieve too many objectives — for example, broader health care coverage and energy efficiency — at the expense of focusing tax dollars on the core issue of job creation. By this argument, more should be spent on things like infrastructure repair, either directly or by channeling money to the states for projects now delayed for lack of adequate tax revenue.

``Others argue that the best bang for the buck would come from a stimulus package devoted mainly to tax cuts rather than public investment. The breakdown in the $819 billion bill that the House approved on Wednesday and the Senate will take up next week is two-thirds spending, one-third tax cuts.

From the Washington Post, ``All of those ideas may have merit, but why do they belong in an emergency measure aimed to kick-start the economy?”

Acts of desperation to come up with messianic one off solutions will only lead to more extravagance, leakages and ineffective policies all at the expense of the taxpayers.

3. Ambiguous “targeting” and chronic “deficits”.

From Henry Hazlitt in Man vs. The Welfare State (all bold highlights mine),

``The reason the Keynesian medicine can work — under special conditions and for short periods — is that by increasing monetary demand and prices it may increase both sales and profit margins, and so restore production and employment. Yet this could be done even more effectively — and without the poisonous side effects and aftereffects — by restoring freedom of competition and individual coordination of prices and wages.

``The Keynesians think in terms of aggregates. Their remedy is to increase the total money supply, and thereby to bring the price "level" sufficiently above the wage "level" to restore or maintain profit margins and so keep the wheels of industry spinning at full speed.

``This remedy is defective in two respects. It tacitly assumes that there is a uniform discrepancy between prices and wages and a uniform percentage of "idle capacity" throughout industry. Neither is true. If "industry" is estimated to be operating at 80% of capacity, we must remember that this figure is at best an average. It may cover a situation in which, say, industry A is operating at only 60%, industry B at 63%, and so on up to industry M at 97% and industry N at 100%. If we try to expand the money supply enough to return industries A and B to full capacity, we may completely "overheat" industries M and N and produce serious productive distortions and bottlenecks.

``What is more, an increase in the stock of money, contrary to Keynesian theory, will begin to force an irregular increase in prices long before "full capacity" has been reached and the "slack" taken up — if only for the reason that the "slack" is never uniform throughout industry. In a very short time, also, with the increase in prices and the increase in the demand for labor, wages will start climbing too. Then, if the previous trouble was that most wages were already too high in relation to most prices, there will again be discoordination between wages and prices; and the Keynesian prescription will call for still further doses of government spending, deficits, and new money.

``So the Keynesian medicine must lead to chronic deficits and chronic inflating of the money supply. This is precisely what we have had. It is no accident that we have just run eight annual deficits in succession, and that we have had 32 deficits in the last 38 years. It is no accident that the US money supply (currency plus demand deposits) has been increased more than fivefold — from $36 billion at the end of 1939 to $199 billion in September, 1969. And so it is no accident that, in spite of a tremendous increase in industrial production in this thirty-year period, consumer prices have increased (to June, 1969) by 164%.

Good or bad economics can always be distinguished from the perspective of time horizon, particularly the tradeoff between short versus long term. Where the policy priority seems focused on short term relief and eventually countermanded by long term pain, such represents as bad economics.

``In the long run, we are all dead” is a tenet espoused by economists with no children who will pay for future bills.

4. Mistaken assumptions lead to flawed economic models.

From the Heritage Foundation, ``Policymakers are basing the “stimulus” bill on economic models that wrongly assume every $1 of government spending increases the economy by approximately $1.60. Is it really that simple? By that logic, debt-ridden, big-government countries like Italy, France and Germany should be wealthier than America. And why stop at $800 billion? Such logic suggests unlimited prosperity could be guaranteed by the government borrowing and spending $800 trillion. Should America be basing such costly decisions on these types of economic models?

From Harvard Professor Robert Barro at the Wall Street Journal, ``What's the flaw? The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system.

``John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall. So, something deeper must be involved -- but economists have not come up with explanations, such as incomplete information, for multipliers above one.

Selectivity bias- experts blinded with economic ideology selectively use data which supports their argument even if the assumptions are defective.

5. Inefficient or wasteful government spending because it is NOT demanded for by the markets.

From Professor Gary Becker, ``Putting new infrastructure spending in depressed areas like Detroit might have a big stimulating effect since infrastructure building projects in these areas can utilize some of the considerable unemployed resources there. However, many of these areas are also declining because they have been producing goods and services that are not in great demand, and will not be in demand in the future. Therefore, the overall value added by improving their roads and other infrastructure is likely to be a lot less than if the new infrastructure were located in growing areas that might have relatively little unemployment, but do have great demand for more roads, schools, and other types of long-term infrastructure.”

Not all infrastructure spending works. Ask Japan.

6. Theory and reality don’t match.

In theory, deficit spending should be switched on during bad times and switched off during good times.

But in reality, deficit spending has been a permanent affair.

Figure 7: Heritage: Real annual federal spending has more than tripled since 1965 and has nearly doubled since 1980.

From the Heritage Foundry, ``According to the suddenly back in style Keynesian theory, government can stimulate economic growth by temporarily increasing government spending. Problem is, there was nothing temporary about increases in government spending under Nixon and there is nothing temporary about the trillion dollars in new spending currently being debated in Congress.”

7. Stimulus meant to impose political IDEOLOGY than sound economics.

From Wall Street Journal, ``The spending portion of the stimulus, in short, isn't really about the economy. It's about promoting long-time Democratic policy goals, such as subsidizing health care for the middle class and promoting alternative energy. The "stimulus" is merely the mother of all political excuses to pack as much of this spending agenda as possible into a single bill when Mr. Obama is at his political zenith.

Some have used the “stimulus” as a vehicle to impose on the society their personal ideological convictions. Ultimately it is the people that pay for flawed ideologies. Think Marx, Lenin, Stalin, Mao, Pol Pot, Hitler, etc…

8. Time Lag for Government Spending.

Where spending is supposedly needed NOW, public works spending will come later.

Again, from Professor Gary Becker, ``Efficiency is not likely to be high partly because of the fundamental conflict between the goal of stimulating employment and output in order to reduce the severity of the recession, and the goal of concentrating infrastructure spending on projects that add a lot of value to the economy. Stimulating the economy when employment is falling requires rapid spending of this huge stimulus package, but it is impossible for either the private or public sectors to spend effectively a large amount in a short time period since good spending takes a lot of planning time.

The net effect is that the stimulus will either be late or unneeded.

9. Inefficiencies due to political dispensation.

From Mr. George Melloan at the Wall Street Journal, ``The central defect of government bailouts and stimulus packages is that the money is allocated through a political process. It goes to recipients who have the most political influence. Private entrepreneurs and even big business, by contrast, employ investment to earn a profit. The record shows that the latter yields greater economic efficiency, and hence creates real jobs.”

Political doleouts are almost always based on political affiliations and not on economic needs. The net effects are, wastage, corruption and inefficiencies.

Fellow Filipinos, learn that it isn’t personality based leadership that drives corruption but big bureaucracy, escalating government spending and the subsequent political process driven distribution of government endowments and the dependency and rent seeking culture.

10. Chronic Deficits Equals Inflation.

From John Hussman, ``It's tempting to think that somehow printing money means an increase in spending power, while issuing bonds means that the government is taking something in return for what it spends, but it's important to focus on the general equilibrium. In both cases, regardless of whether government finances its spending by printing money or issuing bonds, the end result is that the government has appropriated some amount of goods and services, and has issued a piece of paper – a government liability – in return, which has to be held by somebody. Moreover, both of those pieces of paper – currency and Treasury securities – compete in the portfolios of individuals as stores of value and means of payment. The values of currency and government securities are not set independently of each other, but in tight competition. That is particularly true today, when bank balances are regularly swept into interest earning vehicles as often as every night. To the extent that real goods and services are being appropriated by government in return for an increasing supply of paper receipts, whatever the form, aggressive government spending results in a relative scarcity of goods and services outside of government control, and an increasing supply of government liabilities. The marginal utility of goods and services tends to rise, the marginal utility of government liabilities of all types tends to fall, and you get inflation.”

The end result of stimulus programs: a greatly debased currency (lower standard of living).

How can these be of any good?

Video: Inflation=Prosperity???

This video is an example of Keynesian Propaganda aimed at hoodwinking the public of the supposed magic of devaluing a currency (via the printing press) to create prosperity. (Hat Tip iTulip, Lew Rockwell).

Oh, this isn't just a US phenomenon, most politicians and academic experts here are likewise proponents of the devaluation of the Philippine Peso for the alleged benefit of the economy (a.k.a. exports or OFWs).

Meanwhile, the public is unaware that noble sounding projects/programs/policies only benefit the politically connected, government officials and the primary recipients of government inflation. The rest of the public suffers via higher prices.

How Political Tea Leaves Will Shape The Investment Landscape

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

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

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

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

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

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

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

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

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

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

Figure 1 Gavekal: Portfolio Distribution In Different Environments

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

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

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

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

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

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

Deflation and Endowment Effects

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

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

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

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

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

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

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

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

Grim indeed.

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

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

The rest is speculation.

End Justifies The Means: The Gathering Inflation Storm?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Reviving Smoot-Hawley Version 2008?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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