Financial Repression Drives The Bond Markets

Truth has to be repeated constantly, because Error also is being preached all the time, and not just by a few, but by the multitude. In the Press and Encyclopaedias, in Schools and Universities, everywhere Error holds sway, feeling happy and comfortable in the knowledge of having Majority on its side. -Goethe

One of the most bizarre ironies which can be observed from the mainstream is the selective use of market signals for analysis.

A conventional mantra is that because actions in the bond markets have been benign, therefore experts say that inflation risks have not been apparent. Others argue that actions in the bond markets signal deflation instead of inflation.

On the one hand, these mainstream experts and their acolytes don’t trust the markets. They see markets as inherently unstable thus always opine for some form of government intervention. They believe that through mathematical equations, governments can simply adjust economic conditions similar to a thermostat of an air conditioner.

On the other hand, in justifying the selective use of market prices for government intervention, they specifically see bond markets as conveying the actual state of affairs of the credit markets. In other words, they see the bond markets as being “efficiently” priced.

The Policy of Permanent Quasi Booms

It is pretty much naive to suggest that bond markets accurately represent price signals that exhibits the actual time preferential balance of savings and loans.

First of all bond markets operate under government’s guiding dogma meant to promote the permanence of quasi boom.

From John Maynard Keynes,

The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.

Hence by actively intervening in the marketplace by forcing down interest rates implies that bond markets have already been significantly distorted which has led to serial boom bust cycles.

Further proof of the Fed’s Zero Bound interest rate policy from a Federal Reserve Paper authored by Ben Bernake, Vincent Reinhart and Brian Sack

Central banks usually implement monetary policy by setting the short-term nominal interest rate, such as the federal funds rate in the United States. However, the success over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound on interest rates. When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely instead on “non-standard” policy alternatives...

In this paper, we apply the tools of modern empirical finance to the recent experiences of the United States and Japan to provide evidence on the potential effectiveness of various nonstandard policies. Following Bernanke and Reinhart (2004), we group these policy alternatives into three classes: (1) using communications policies to shape public expectations about the future course of interest rates; (2) increasing the size of the central bank’s balance sheet, or “quantitative easing”; and (3) changing the composition of the central bank’s balance sheet through, for example, the targeted purchases of long-term bonds as a means of reducing the long-term interest rate. We describe how these policies might work and discuss relevant existing evidence.

This paper was done in 2004. Apparently the Bernanke led US Federal Reserve has put this study into action.

This means that aside from Zero bound interest rate policies; activist policymaking today includes the expansion of the balance sheet of the US Federal Reserve.

And this operating precept appears to have been exported to the US major trading partners.

Chart from Danske Bank

Financial Repression As A Driving Force

Second, seen from the distribution of ownership of Federal securities or US treasuries, 80% appear to be owned by governments.

The chart from Wikipedia shows of the expanding share of Federal Reserve and intragovernmental holdings, along with foreign governments which accounted for 28% in 2008. And this chart was prior to the activation of the Quantitative Easing programs.

Adding up the local and state government and state and local government (pensions) the share of government ownership rises above 80%.

The private sector (profit oriented segment) only holds a paltry (less than 20% share) in contrast to (politically motivated) governmental ownership.

In short, who or which entities will do the selling?

While it is true that like the stock markets, prices are set on the margins, there is another factor which attempts to protect treasury ownership from a panic: regulations on the banking system via the BASEL III accord.

According to this Bloomberg article, (bold emphasis mine)

Lenders have an added incentive to buy Treasuries after the Basel Committee on Banking Supervision proposed rules on Oct. 4 that banks increase available capital and improve their measurement and control lending risk.

Banks will have less than five years to comply with the so- called Basel III rules for minimum tier-1 capital ratios and until Jan. 1, 2019, to meet the capital buffer requirements. The Treasury Borrowing Advisory Committee forecast in February that banks may have as much as $1.6 trillion in demand for Treasuries in the next five years based on the evolving rules.

So new regulations will essentially force the private (banking) sectors to buy and own Federal securities, despite of the environment of higher commodity prices, which have been signaling inflation.

Thus the only marked threat of a potential selloff will likely emanate from politically motivated foreign governments.

The key question is what would motivate them to do so? A selloff would only devastate the value of their stash of US dollar reserve holdings.

And to reiterate, even if some foreign entities, like China seems reluctant to acquire US federal securities, the Fed appears to have an open checkbook—which may only be constrained by an explosion of inflation.

The chart from the Cleveland Federal Reserve shows the Fed as huge buyers of US long term treasury and Fed agency debt (yellow) and Mortgage backed Securities (brown)

Hence, anyone who argues from the standpoint of market prices without considering these variables either have been misdiagnosing real events or deluding themselves.

Yet all these constitute what Carmen Reinhart and Kenneth Rogoff calls as “Financial Repression” [This Time Is Different (p. 143)] (bold emphasis mine)

Under financial repression, banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options. They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation. Citizens put money into banks because there are few other safe places for their savings. Governments, in turn, pass regulations and restrictions to force the banks to relend the money to fund public debt. Of course, in cases in which the banks are run by the government, the central government simply directs the banks to make loans on it.

Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

These are Harvard guys. But their observations square with the Austrian school’s position of the enmeshed clandestine relationship between central banks, the banking system and the government.

According to Murray N. Rothbard,

The Central Bank has always had two major roles: (1) to help finance the government's deficit; and (2) to cartelize the private commercial banks in the country, so as to help remove the two great market limits on their expansion of credit, on their propensity to counterfeit: a possible loss of confidence leading to bank runs; and the loss of reserves should any one bank expand its own credit. For cartels on the market, even if they are to each firm's advantage, are very difficult to sustain unless government enforces the cartel. In the area of fractional-reserve banking, the Central Bank can assist cartelization by removing or alleviating these two basic free-market limits on banks' inflationary expansion credit.

This means that bond markets almost everywhere operate under the same dynamics. That’s until they became unsustainable (such as in Greece).

Bottom line:

Bond markets reflect more on the effects of government policies rather than market price based distributions.

The bond markets have been so distorted by a myriad of deeply embedded government interventions such that they cannot be used as dependable standalone indicators in analyzing the marketplace or the economy.

How To Reform The Global Debt Biased Economic System

Harvard economist Kenneth Rogoff argues that the world’s problem has been “rooted in excessive concentrations of debt” and that the fix should focus on rebalancing debt into equity. I agree.

Mr. Rogoff writes,

But policy-induced distortions also play an enormous role. Many countries’ tax systems hugely favor debt over equity. The housing boom in the United States might never have reached the proportions that it did if homeowners had been unable to treat interest payments on home loans as a tax deduction. Corporations are allowed to deduct interest payments on bonds, but stock dividends are effectively taxed at the both the corporate and the individual level.

Central banks and finance ministries are also complicit, since debt gets bailed out far more aggressively than equity does.

I’d like to add that this is exactly why central banks exist: they have been designed to finance and bailout the government and or her agencies (mostly by inflation), aside from promoting “consumption” debt as path to economic growth. As for the latter, don’t you see the excessive focus by the mainstream on “employment” based on “consumer spending”?

And these composite policies, all this time, has favored or privileged the central bank supported banking industry cartel.

Since the political leadership (governments) has also benefited from these arrangements, then obviously even administrative or tax policies had been molded into a “debt” bias—which incidentally becomes a feedback loop mechanism (more government spending more inflationism by central banks).

And that’s how boom bust cycles have been playing out.

And as earlier discussed in The Myth Of Risk Free Government Bonds even bank capital regulatory requirements have been tilted towards incentivizing these institutions to hold on to “less risky” government debts.

That’s because institutional holdings on “short term” government securities, under Basel Accord, which were considered as “risk free”, were not required of capital in contrast to holdings of corporate bonds. So major institutions were incentivized to fund governments, from which politicians capitalized on, and which only bloated their nation’s respective fiscal balance sheets.

But the recent crisis has only been exposing the “nudity” of the fabled risk free “emperor”.

I would say that this systemic debt bias has been intrinsic for the paper money system build around the welfare-redistributive state.

And parallel to this been the unseen incentives that drives governments and their respective central banks to gain political capital (via extended tenure and via expanded government control over the political economy) by selling “something out of nothing” to voters via the welfare state—and to reemphasize, all of which have been propped up and funded by the debt based central banking system.

In other words, for the world economic-financial framework—estimated at some $200 trillion, and which have been configured or evolved around these embedded incentives—to be able to shift from a debt to equity bias, would require an overhaul of the monetary system first and the political systems next.

Otherwise, the markets, like it or not, will do the radical debt-to-equity makeover for us.

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.

Kenneth Rogoff: Inflate Our Debts Away!

As what we’ve been repeatedly saying, this episode is unlikely to be dealt with economically but politically.

Now, Kenneth Rogoff, professor at Harvard University and formerly chief economist at the IMF seems to be the first among the high profile experts to candidly acknowledge the urgency (and helplessness) of the situation and has subsequently called for the use of our nuclear option-the Mises Moment.

Stating the obvious, the political "nuclear option" solution is to inflate all debts away!

From Mr. Rogoff (read entire article here: guardian.co.uk),

(all highlights mine) ``Yes, inflation is an unfair way of effectively writing down all non-indexed debts in the economy. Price inflation forces creditors to accept repayment in debased currency. Yes, in principle, there should be a way to fix the ills of the financial system without resorting to inflation. Unfortunately, the closer one examines the alternatives, including capital injections for banks and direct help for home mortgage holders, the clearer it becomes that inflation would be a help, not a hindrance.

``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.

Dr. Gono of Zimbabwe should even be more delighted with this apparent exoneration of his model, as policy directives appear increasingly headed for a Zimbabwean denouement!

As Ludwing von Mises wrote in Human Action, ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved”